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Full text of "General explanation of the Tax reform act of 1976 : (H.R. 10612, 94th Congress, Public law 94-455)"

GENERAL EXPLANATION 

OF THE 
TAX REFORM ACT OF 1976 

(H.R. 10612, 94TH CONGRESS, PUBLIC LAW 94^55) 



PREPARED BY THE 
STAFF OF THE 

JOINT COMMITTEE ON TAXATION 




DECEMBER 29, 1976 



GENERAL EXPLANATION 

OF THE 
TAX REFORM ACT OF 1976 

(H.K. 10612, 94TH CONGRESS, PUBLIC LAW 94-455) 



PREPARED BY THE 
STAEF OF THE 

JOINT COMMITTEE ON TAXATION 




DECEMBER 29, 1976 



U.S. GOVERNMENT PRINTING OFFICE 
79-667 O WASHINGTON : 1976 JCS-33-76 



For sale by the Superintendent of Documents, U.S. Government Printing Office 
Washington, D.C. 20402 



Stock No. 052-070-03860-1 



CONGRESS OF THE UNITED STATES 

(94th Cong., 2d sess.) 

Joint Committee on Taxation 
Senate House 

RUSSELL B. LONG, Louisiana, Chairman AL ULLMAN, Oregon, Vice Chairman 
HERMAN E. TALMADGE, Georgia JAMES A. BURKE, Massachusetts 

VANCE HARTKE, Indiana , DAN ROSTENKOWSKI, Illinois 

CARL T. CURTIS, Nebraska HERMAN T. SCHNEEBELI, Pennsylvania 

PAUL J. FANNIN, Arizona BARBER B. CONABLE, Jr., New York 

Laurence N. Woodworth, Chief of Staff 
Herbert L. Chabot, Assistant Chief of Staff 
Bernard M. Shapiro, Assistant Chief of Staff 

(ID 



LETTER OF TRANSMITTAL 



Congress of the United States, 

Joint Committee on Taxation, 
Washington, D.C., December 29, 1976. 

Hon. Russell B. Long, Ohmrman, 

Hon. Al Ullman, Vice Chairman, Joint Committee on Taxation, 
U.S. Congress, Washington, D.C. 

Dear Messrs. Chairmen : While committee reports explain the posi- 
tion of the House Committee on Ways and Means, or the position of 
the Senate Committee on Finance, they do not in all cases explain 
the tax legislation as finally passed by the Congress. This becames par- 
ticularly important in the case of major legislation where there are 
many changes between the bill as passed by the House, or as passed by 
the Senate, and the bill which finally becomes public law. The Tax 
Reform Act of 1976, because of its comprehensive scope and because of 
the many changes which were made in this legislation, both by the Sen- 
ate and subsequently by the conferees, is an illustration of where the 
differences were especially significant. 

This document represents the effort of the staff of the Joint Com- 
mittee on Taxation to provide an explanation of the Tax Reform Act 
of 1976 as finally enacted and is comparable to a number of similar 
documents prepared by the staff on other revenue acts in recent years. 
For the most part, where provisions which were unchanged in confer- 
ence were described in either tlie House or Senate report, that explana- 
tion is carried over in this document. No attempt is made here to carry 
the explanation further than is customary in the case of committtee 
reports and therefore it does not deal with issues which are customar- 
ily explained in regulations or rulings. 

The first major part of the document contains a summary of and the 
reasons previously given for the various provisions. The second part 
contains the revenue estimates on the legislation as finally enacted and 
the third part is a general explanation of the provisions appearing in 
the order in which they appear in the public law. 

This material has been prepared by the staff of the Joint Committee 
on Taxation after the Tax Reform Act of 1976 was passed. It has not 
been reviewed by the tax committees and therefore only reflects the 
staff's view as to'the intent of Congress. It is hoped that this document 
••will be useful in gaining a better understanding of the Tax Reform Act 
of 1976. 

• Sincerely yours, 

Laurence N. Woodworth, 

Chief of Staff. 

(in) 



LEGISLATIVE HISTORY OF THE ACT 

The Tax Eeform Act of 1976 was the result of over two years of 
legislative deliberations largely during the 94th Congress, although 
some of the provisions were originally considered by the House Ways 
and Means Committee during the 93rd Congress.^ Consideration of the 
Act in the 94th Congress proceeded on the following schedule : 

June 23 through June 25, 1975 : Panel Discussions before the House 
Committee on Ways and Means. 

July 8 through July 31, 1975 : Hearings before the House Commit- 
tee on Ways and Means. 

November 12, 1975 : Bill (H.R. 10612) reported by the House Com- 
mittee on Ways and Means (House Report 94-658) . 

December 3 and 4, 1975 : Bill considered and passed by the House of 
Representatives. 

March 17 through April 13, 1976; July 20 through 22, 1976: Hear- 
ings before the Senate Committee on Finance. 

June 10, 1976 : Bill reported by the Senate Committee on Finance 
(Senate Report 94-938) : Supplemental report filed by Senate Com- 
mittee on Finance on July 20, 1976 (Senate Report 94-938, Part 2). 

June 16-18, 21-25, 28-30, July 1-2, 20-23, 26-30, and August 3-6, 
1976: Bill considered and passed by the Senate. 

September 13, 1976: Committee on Conference submitted Confer- 
ence Report (House Report 94-1515; Senate Report 94-1236). 

September 16, 1976: Conference report (and House Concurrent 
Resolution 751) approved by the House and Senate. 

October 4, 1976: Tax Reform Act of 1976 (Public Law 94-455) 
signed by the President. 

1 The Ways and Means Committee did not report a tax reform bill in the 93rd Congress 
but did hold extensive discussions (February 5-28, 1973) and hearings (March 5 
through May 1, 1973) on the subject. The Ways and Means Committee also held legisla- 
tive markup sessions on tax reform late in the 2nd session (1974), but had only made 
tentative decisions prior to the end of the 93rd Congress. In addition, H.R. 17488, The 
Energy Tax and Individual Relief Act of 1974, reported by that committee on November 
26, 1974 (House Report 93-1502), Included provisions relating to real estate invest- 
ment trusts and the taxation of foreign Income, much of which was later Included in 
the Tax Reform Act of 1976. 

(V) 



CONTENTS 



Page 

Transmittal Letter iii 

Legislative History of the Act v 

I. Summary and Reasons for the Act 1 

A. Tax Revision 2 

B. Tax Simplification 7 

C. Extension of Tax Reductions 8 

D. Capital Formation 10 

E. Administrative Provisions 11 

F. Estate and Gift Tax Provisions 12 

II. Revenue Effects of the Act 15 

III. General Explanation of the Act 25 

A. Tax shelter provisions 25 

1. Real Estate 25 

a. Capitalization and Amortization of Real Property 

Construction Period Intei est and Taxes (Sec. 201) . 25 

b. Recapture of Depreciation on Real Property (Sec. 

202) ■ 29 

c. Five- Year Amortization for Low-Income Rental 

Housing (Sec. 203) 32 

2. Limitation of Loss to Amount At- Risk (Sec. 204) 33 

3. Farm Operations 40 

a. Farming Syndicates (Sec. 207) 40 

b. Limitation of Loss With Respect to Farms to the 

Amount for Which the Taxpayer Is At Risk (Sec. 

204) 50 

c. Method of Accounting for Corporations Engaged in 

Farming (Sec. 207(c)) 51 

d. Termination of Additions to Excess Deduction? 

Accounts Under Sec. 1251 (Sec. 206) 57 

e. Scope of Waiver of Statute of Limitations in Case of 

Activities Not Engaged in for Profit (Sec. 214) 59 

4. OilandGas i 62 

a. Limitation of Loss to Amount At Risk (Sec. 204) 62 

b. Gain From Disposition of an Interest in Oil and Gas 

Propertv (Sec. 205) 64 

5. Motion Picture Films 67 

a. At Risk Rule and Capitalization of Production Costs 

(Sees. 204 and 210) 67 

b. Clarification of Definition of Produced Film Rents 

(Sec. 211) 75 

6. Equipment Leasing — Limitation on Loss to Amount At 

Risk (Sec. 204) 77 

7. Sports Franchises and Player Contracts (Sec. 212) 82 

8. Partnership Provisions 87 

a. Partnership Additional First- Year Depreciation 

(Sec. 213(a)) 87 

b. Partnership Syndication and Organization Fees 

(Sec. 213(b)) 89 

c. Retroactive Allocations of Partnership Income or 

Loss (Sec. 213(c)) 91 

d. Partnership Special Allocations (Sec. 213(d)) 94 

e. Treatment of Partnership Liabilities Where a 

Partner Is Not Personally Liable (Sec . 2 1 3 (e) ) 96 

(VII) 



VIII 

III. General Explanation of the Act — Continued 

A. Tax shelter provisions — Continued '^"■^^ 

9. Interest 97 

a. Treatment of Prepaid Interest (Sec. 208) 97 

b. Limitation on the Deduction for Investment Inter- 

est (Sec. 209) 102 

B. Minimum and Maximum Tax 105 

1 . Minimum Tax for Individuals (Sec. 301) 105 

2. Minimum Tax for Corporations (Sec. 301) 107 

3. Maxim.um Tax Rate (Sec. 302) 109 

C. Extension of Individual Income Tax Reductions (Sees. 401 and 

402) 111 

D. Tax Simplification in the Individual Income Tax 115 

1. Revision of Tax Tables for Individuals (Sec. 501) 115 

2. Alimony Payments (Sec. 502) 116 

3. Retirement Income Credit (Sec. 503) 117 

4. Credit for Child Care Expenses (Sec. 504) 123 

5. Sick Pay and Certain Military, etc., Disability Pensions 

(Sec. 505) 127 

6. Moving Expenses (Sec. 506) 131 

7. Tax Simplification Study by Joint Committee (Sec. 507) 135 

E. Business-Related Individual Income Tax Revisions 136 

1. Deductions for Expenses Attributable to Business Use of 

Home (Sec. 601) 136 

2. Deduction for Expenses Attributable to Rental of Vaca- 

tion Homes (Sec. 601) 141 

3. Deductions for Attending Foreign Conventions (Sec. 602) _ _ 146 

4. Qualified Stock Options (Sec. 603) 151 

5. Treatment of Losses From Certain Nonbusiness Guaranties 

(Sec. 605) 156 

F. Accumulation Trusts (Sec. 701) 159 

G. Capital Formation 165 

1. Investment Tax Credit — Extension of 10-Percent Credit 

and $100,000 Limitation For Used Property (Sees. 801 

and 802) 165 

2. First-In-First-Out Treatment of Investment Tax Credits 

(Sec. 802) 166 

3. ESOP Investment Credit Provisions (Sec. 803) 167 

4. Investment Credit in the Case of Movies and Television 

Films (Sec.-804) 176 

5. Investment Tax Credit in the Case of Certain Ships (Sec. 

805) 186 

6. Net Operating Losses 188 

a. Net Operating Loss Carryover Years and Carrj'- 

back Election (Sec. 806(a)-(d)) 188 

b. Limitations on Net Operating Loss Carryovers (Sec. 

806(e)) 190 

7. Small Commercial Fishing Vessel Construction Reserves 

(Sec. 807) 205 

H. Small Business Provisions 206 

1. Extension of Certain Corporate Income Tax Rate Reduc- 

tions (Sec. 901) 206 

2. Changes in Subchapter S Rules 207 

a. Subchapter S Corporation Shareholder Rules (Sees. 

902 (a) and (c) ) 207 

b. Distributions by Subchapter S Corporations (Sec. 902 

(b)) 209 

c. Changes to Rules Concerning Termination of Sub- 

chapter S Election (Sec. 902(c)) 211 

I. Tax Treatment of Foreign Income 212 

1 . Exclusion for Income Earned Abroad (Sec. 1011) 212 

2. U.S. Taxpayers Married to Nonresident Aliens (Sec. 1012). 215 

3. Income of Foreign Trusts and Transfers to Foreign Trusts 

and Other Foreign Entities (Sees. 1013-1015) 218 

4. Amendments Affecting Tax Treatment of Controlled 

Foreign Corporations and Their Shareholders (Sees. 
1021-1024) 227 



IX 

III. Greneral Explanation of the Act — Continued 

I. Tax Treatment of Foreign Income — Continued Page 

5. Amendments to the Foreign Tax Credit (Sees. 1031-1037) . . 233 

6. Exclusion From Gross Income and From Gross Estate of 

Portfolio Investments in the United States of Non- 
resident Aliens and Foreign Corporations (Sec. 1041) 255 

7. Changes in Ruling Requirements Under Section 367 and 

Changes in Amounts Treated as Dividends (Sec. 1042) _ _ _ 256 

8. Contiguous Country Branches of Domestic Insurance 

Companies (Sec. 1043) 267 

9. Transitional Rule for Bond, Etc., Losses of Foreign Banks 

(Sec. 1044) 271 

10. Tax Treatment of Corporations Conducting Trade or 

Business in Possessions of the United States (Sec. 1051) _ 272 

11. Western Hemisphere Trade Corporations (Sec. 1052) 278 

12. ChinaTrade Act Corporations (Sec. 1053) 280 

13. Denial of Certain Tax Benefits for Cooperation With or 

Participation in an International Boycott (Sees. 1061- 

1064, 1066and 1067) 282 

14. Denial of Certain Tax Benefits Attributable to Bribe- 

Produced Income (Sec. 1065) 288 

J. Domestic International Sales Corporations (Sec. 1101) 290 

K. Administrative Provisions 301 

1. Public Inspection of Written Determinations by Internal 

Revenue Service (Sec. 1201) 301 

2. Disclosure of Tax Returns and Tax Return Information 

(Sec. 1202) 313 

3. Income Tax Return Preparers (Sec. 1203) 345 

4. Jeopardy and Termination Assessments (Sec. 1204) 356 

5. Administrative Summons (Sec. 1205) 364 

6. Assessments in Case of Mathematical or Clerical Errors 

(Sec. 1206) 371 

7. Withholding Tax Provisions 375 

a. Withholding of State and District Income Taxes 

for Military Personnel (Sec. 1207(a)) 375 

b. Withholding State and City Income Taxes From 

the Compensation of Members of the National '• ' 
Guard or the Ready Reserve (Sec. 1207(b)) 377 

c. Voluntary Withholding of State Income Taxes 

From the Compensation of Federal Employees 

(Sec. 1207(c)) 378 

d. Withholding Tax on Certain Gambling Winnings 

(Sec. 1207(d)) _ 379 

e. Withholding of Federal Taxes on Certain Indi- 

viduals Engaged in Fishing (Sec. 1207(e)).- ._. 380 

8. State-Conducted Lotteries (Sec. 1208) 383 

9. Minimum Exemption from Levy for Wages, Salary, and 

Other Income (Sec. 1209) __' 384 

10. Joint Committee Refund Cases (Sec. 1210) 386 

11. Use of Social Security Numbers (Sec. 1211) 387 

12. Interest on Mathematical Errors on Returns Prepared by 

IRS (Sec. 1212) '. 388 

L. Tax-Exempt Organizations 390 

1. Modification of Transitional Rule for Sales of Property 

by Private Foundations (Sec. 1301) 390 

2. New Private Foundation Set-Asides (Sec. 1302) 391 

3. Reduction in Minimum Distribution Amount for Private 

Foundations (Sec. 1303) 394 

4. Extension of Time To Conform Charitable Remainder 

Trusts for Estate Tax Purposes (Sec. 1304) . _._ _ 396 

5. Income From Fairs, Expositions, and Trade Shows (Sec. 

1305) 398 

6. Declaratory Judgments as to Tax-Exempt Status" as 

Charitable, etc.. Organization (Sec. 1306) _ _ 400 

7. Lobbying Activities of Public Charities (Sec. 1307) _ 407 



III. General Explanation of the Act — Continued 
L. Tax-Exempt Organizations — Continued 

8. Tax Liens, etc., Not to Constitute "Acquisition Indebted- Puse 

ness" (Sec. 1308) 416 

9. Extension of private foundation transition rule for sale 

of business holdings (Sec. 1309) 418 

10. Private foundations imputed interest (Sec. 1310) 420 

11. Unrelated Business Income from Services Provided by a 

Tax-exempt Hospital to Other Tax-exempt Hospitals 

(Sec. 1311) 421 

12. Clinical Services Provided to Tax-Exempt Hospitals (Sec. 

1312) 422 

13. Exemption of Certain Amateur Athletic Organizations 

From Tax (Sec. 1313) 423 

M. Capital Gains and Losses 425 

1. Deduction of Capital Losses Against Ordinary Income 

(Sec. 1401) 425 

2. Increase in Holding Period for Long-Term Capital Gains 

(Sec. 1402) 426 

3. Capital Loss Carryover for Regulated Investment Com- 

panies (Sec. 1403) 427 

4. Gain on Sale of Residence by Elderly (Sec. 1404) 428 

N. Pension and Insurance Taxation 430 

1. Individual Retirement Account (IRA) for Spouse (Sec. 

1501) 430 

2. Limitation on Contributions to Certain H.R. 10 Plans 

(Sec. 1502) 431 

3. Retirement Deductions for Members of Armed Forces 

Reserves, National Guard and Volunteer Firefighters 

(Sec. 1503) 432 

4. Tax-Exempt Annuity Contracts in Closed-End Mutual 

Funds (Sec. 1504) 433 

5. Pension Fund Investments in Segregated Asset Accounts 

of Life Insurance Companies (Sec. 1505) 433 

6. Study of Salary Reduction Pension Plans (Sec. 1506) 434 

7. Consolidated Returns for Life and Mutual Insurance ^ 

Companies (Sec. 1507) 435 

8. Guaranteed Renewable Life Insurance Contracts (Sec. 

1508) 438 

9. Study of Expanded Participation in Individual Retirement 

Accounts (Sec. 1509) 439 

10. Taxable Status of Pension Benefit Guaranty Corporation 

(Sec. 1510) 440 

11. Level Premium Plans Covering Owner-Employees (Sec. 

1511) 440 

12. Lump-Sum Distributions From Pension Plans (Sec. 1512) _ _ 441 
O. Real Estate Investment Trusts 443 

1. Deficiency Dividend Procedure (Sec. 1601) 445 

2. Distributions of REIT Taxable Income After Close of 

Taxable Year (Sees. 1604 and 1606) 449 

3. Property Held for Sale (Sec. 1603) 451 

4. Failure to Meet Income Source Tests (Sec. 1602) 452 

5. Other Changes in Limitation; and Requirements (Sec. 

1604) 453 

P. Railroad and Airline Provisions 460 

1. Treatmentof Certain Railroad Ties (Sec. 1701(a)) 460 

2. Limitation on Use of Investment Tax Credit for Railroad 

Property (Sec. 1701(b)) 461 

3. Amortization of Railroad Grading and Tunnel Bores 

(Sec. 1702) 463 

4. Limitation on Use of Investment Tax Credit for Airline 

Property (Sec. 1703) 465 

Q. International Trade Amendments 468 

1. United States International Trade Commission (Sec. 1801) _ 468 

2. Trade Act of 1974 Amendments (Sec. 1802) 469 

R. "Deadwood" Provisions 470 



XI 

III. General Explanation of the Act — Continued Pajre 

S. Estate and Gift Taxes 525 

1. Unified Rate Schedule for Estate and Gift Taxes; Unified 

Credit in Lieu of Specific Exemptions (Sec. 2001) 525 

2. Increase in Limitations on Marital Deductions; Fractional 

Interest of Spouse (Sec. 2002) 532 

3. Valuation for Purposes of the Federal Estate Tax of Certain 

Real Property Devoted to Farming or Closely Held 
Business Use (Sec. 2003) 536 

4. Extension of Time for Payment of Estate Tax (Sec. 2004) _ _ . 543 

5. Carryover Basis (Sec. 2005) 551 

6. Generation-Skipping Transfers (Sec. 2006) 564 

7. Orphans' Exclusion (Sec. 2007) 583 

8. Administrative Changes (Sec. 2008) 584 

9. Miscellaneous Provisions (Sec. 2009) 588 

T. Miscellaneous Provisions 598 

1. TaxTreatmentof Certain Housing Associations (Sec. 2101). 598 

2. Treatmentof Certain Crop Disaster Payments (See. 2102)-. 604 

3. Tax Treatment in the Case of Certain 1972 Disaster Loans 

(Sec. 2103) 605 

4. Tax Treatment of Certain Debts Owed by Political Parties 

to Accrual Basis Taxpayers (Sec. 2104) 607 

5. Tax-Exempt Bonds for Student Loans (Sec. 2105) 608 

6. Personal Holding Company Amendments (Sec. 2106) 610 

7. Work Incentive (WIN) and Federal Welfare Recipient 

Employment Incentive Tax Credits (Sec. 2107) 613 

8. ExciseTaxonPartsfor Light-Duty Trucks (Sec. 2108) 614 

9. Exclusion From Manufacturers' Excise Tax for Certain 

Articles Resold After Modification (Sec. 2109) . __ 615 

10. Franchise Transfers (Sec. 2110) 616 

11. Employer's Duties to Keep Records and to Report Tips 

(Sec. 2111) 617 

12. Treatment of Certain Pollution Control Facilities (Sec. 

2112) 619 

13. Clarification of Status of Certain Fishermen's Organiza- 

tions (Sec. 2113) 621 

14. Innocent Spouse (Sec. 2114) 622 

15. Rules Relating to Limitations on Percentage Depletion in 

Case of Oil and Gas Wells (Sec. 2115) 624 

16. Federal Collection of State Individual Income Taxes (Sec. 

2116) 628 

17. Cancellation of Certain Student Loans (Sec. 2117) 630 

18. Simultaneous Liquidation of Parent and Subsidiary 

Corporations (Sec. 2118) 631 

19. Prepublication Expenses (Sec. 2119) 633 

20. Contributions to Capital of Regulated Public Utilities in 

Aid of Construction (Sec. 2120) 635 

21. Prohibition of Discriminatory State Taxes on Production 

and Consumption of Electricity (Sec. 2121) 638 

22. Deduction for Cost of Removing Architectural and 

Transportation Barriers for Handicapped and Elderly 
Persons (Sec. 2122) 639 

23. Reports on High-Income Taxpayers (Sec. 2123) 640 

24. Tax Treatment of Certified Historic Structures (Sec. 2124). 643 

25. Supplemental Security Income for Victims of Certain 

Natural Disasters (Sec. 2125) 645 

26. Net Operating Loss Carryovers for Cuban Expropriation 

Losses (Sec. 2126) 645 

27. Outdoor Advertising Displays (Sec. 2127). . _ ._ _ _ 646 

28. Tax Treatment of Large Cigars (Sec. 2128) 648 

29. Treatment of Gain from Sales or Exchanges Between 

Related Parties (Sec. 2129) 651 

30. Application of Section 117 to Certain Education Programs 

for Members of the Uniformed Services (Sec. 2130) 654 

31. Exchange Funds (Sec. 2131) _. _ 656 



xn 

III. Greneral Explanation of the Act — Continued 
T. Miscellaneous Provisions — Continued 

32. Contributions of Certain Government Publications (Sec. rage 

2132) 667 

33. Study of Tax Incentives by Joint Committee (Sec. 2133) __ 667 

34. Prepaid Legal Services (Sec. 2134) 668 

35. Certain Charitable Contributions of Inventory (Sec. 2135). 672 

36. Tax Treatment of Grantor of Certain Options (Sec. 2136). 673 

37. Exempt-Interest Dividends of Regulated Investment 

Companies (Sec. 2137) 678 

38. Common Trust Fund Treatment of Certain Custodial 

Accounts (Sec. 2138) 679 

39. Support Test for Dependent Children of Separated or 

Divorced Parents (Sec. 2139) 680 

40. Deferral of Gain on Involuntary Conversion of Real 

Property (Sec. 2140) 681 

41. Livestock Sold on Account of Drought (Sec. 2141) 681 



I. SUMMARY AND REASONS FOR THE ACT 

The Tax Reform Act of 1976 will serve six major purposes. First, 
it will improve the equity of the tax system at all income levels without 
impairing economic efficiency and gi'owth. Second, the Act effects im- 
portant simplifications of the tax system by modifying certain deduc- 
tions and credits affecting individuals, by increasing the standard de- 
duction to encourage taxpayers to switch from itemizing their deduc- 
tions to using the standard deduction, and by redrafting complex 
provisions of the tax law and deleting obsolete and little used provi- 
sions. Third, the Act extends the fiscal stimulus provided by the Tax 
Reduction Act of 1975 and extended by the Revenue Adjustment Act 
of 1975, and makes permanent part of these tax cuts foi- individuals. 
Fourth, the Act encourages capital formation by extending the in- 
creased investment credit for four years, by modifying the application 
of the credit, by extending and revising the incentive for investing in 
employee stock ownership plans, and by liberalizing the net operating 
loss carryover. Fifth, it improves the administration of the tax laws by 
making it more efficient and strengthening taxpayers' rights. Sixth, the 
Act makes a major revision in the estate and gift taxes. It reduces the 
estate and gift tax for small- and medium-sized estates and at the same 
time eliminates tax avoidance possibilities. 

In addition, the Act makes certain changes in the operation of the 
U.S. International Trade Commission as well as the withholding of 
preferential trade treatment for countries who aid or abet interna- 
tional terrorists. 

(1) 



A. TAX REVISION 

While no one contends that our income tax system does not need 
improving, it is still widely acknowledged to be the best in the world. 
The difficulty faced in improving the system is that the American 
people want different things from their tax system. On the one hand, 
they want every individual and corporation to pay a fair share of 
the overall income tax burden. In a system that depends heavily on 
voluntary compliance with the tax laws, as ours does, tax equity is 
especially important. However, at the same time, Americans do not 
want the income tax system to interfere with economic efficiency and 
growth. This implies that tax changes to promote equity should not 
retard either the current recovery from what has been the worst reces- 
sion since the 1930's or impede the long-run growth of the economy. The 
tax revisions in the Act represent a careful balance between these some- 
times conflicting objectives. 

The Act contains many tax revisions, described in more deta,il below, 
designed to eliminate tax abuses and make the tax system more equi- 
table. 

Tax shelter provisions 

Congress believed that changes were needed to end the excessive tax 
deferrals provided by tax shelters, as well as the opportunity they 
provide to, in effect, convert ordinary income into capital gains. 
Too many investments have been motivated by excessive con- 
cern with the tax benefits associated with them, not their economic 
merits. In some cases, the manner in which the tax shelters were con- 
trived was questionable even under prior law. In others, individuals 
were combining provisions of the law, or leveraging them through non- 
recourse borrowings, in a way which multiplied severalfold any 
possible advantages intended by Congress. Such activities reduce 
citizens' respect for the income tax and represent an inefficient alloca- 
tion of resources. The Act contains a number of provisions designed to 
curb these abuses without interfering with economically worthwhile 
investments. 

The Act expands the use of the so-called "recapture" rules to prevent 
conversion of ordinary income into capital gains in the case of real 
estate, oil and gas drilling and sports franchises. For oil and gas drill- 
ing, farm operations, equipment leasing, and film purchases and pro- 
duction, losses from accelerated deductions are limited to the amount 
for which the individual is "at risk." This is designed to prevent 
leveraging of tax shelter benefits through the use of nonrecourse loans. 
There is also an "at risk" rule for limited partnerships in areas not 
specifically dealt with by the Act, which should discourage develop- 
ment of new leveraged tax shelters. In addition, in the case of farm 
syndicates (or passive farm partnerships) and motion picture produc- 
tion companies (and companies producing books, records, etc.), 
certain costs are required to be capitalized and written off over the 

(2) 



productive period of the related assets, or the writeoff is delayed until 
the items involved are used. For real estate, the Act also requires 
capitalization of interest and taxes during the construction period. 

The provisions relating to various deductions and exclusions in 
the case of partnerships are tightened so that the deductions or ex- 
clusions cannot be allocated among the various partnei*s according to 
whomever can maximize the tax benefits unless such allocation 
has substantial economic effect. Also, limits are placed on the amount 
of "bonus" first-year depreciation deductions of the partners. The 
Act requires prepaid interest to be deducted over the period to which 
it relates and requires use of accrual accounting by many farm corpo- 
rations. Also, it tightens the existing limit on deductions of excess 
investment interest. 

Minimum and maximum taxes 

Congress believed that high-income people and corporations should 
not be able completely to escape liability for income tax. Prevent- 
ing this is a major feature of the Act. It greatly reduces the incidence 
of tax avoidance by high-income people through two related provi- 
sions — a stiffer minimum tax on tax-preferred income and a revision 
in the maximum tax designed to discourage use of tax preferences. 

Mininiufn fax 

The prior minimum tax for individuals was inadequate. In 1974 it 
raised only $130 million, down from $182 million in 1973, which is 
only a small fraction of total tax-preferred income. Also, the minimum 
tax for individuals was largely a tax on one preference — the excluded 
half of capital gains. The Act amends the minimum tax both to in- 
crease its revenue yield and to broaden the tax preferences covered 
by it. 

The Act raises the minimum tax rate from 10 percent to 15 percent. 
In place of the existing $30,000 exemption and the deduction for regu- 
lar income taxes, the Act has an exemption for individuals equal to 
one-half of regular income taxes or $10,000, whichever is greater. These 
changes reflect Congress' view that the effective tax rate on tax pref- 
erences should be higher. 

Two new minimum tax preferences are added. To reduce the tax 
benefit of shelters in oil and gas drilling and to ensure that oil drillers 
pay some minimum income tax, the Act adds a preference for intangi- 
ble drilling costs. To impose some tax in cases where there is excessive 
use of itemized personal deductions, there is a new preference for item- 
ized deductions (other than medical expenses and casualty losses) in 
excess of 60 percent of adjusted gross income. 

Congress also believed that the minimum tax on corporations should 
be strengthened in order to raise the effective tax rate on corporate tax 
preferences. However, because corporate income is subject to both the 
individual and corporate income taxes, Congress felt it was appropriate 
to retain in full the deduction for regular taxes for corporations. 

Mammum tax 
In 1969, Congress enacted a 50-percent maximum marginal tax rate 
on income from personal services. To reduce the incentive to invest in 
tax shelters, the law provided that income eligible for this maximum 



rate be reduced by tax preferences (as defined under the minimum 
tax) in excess of $30,000. The Act extends this 50-percent maximum 
rate to deferred compensation (including pensions and annuities). 

The " preference offset" in the maximum tax has not l)cen as effective 
in discouraging investment in tax shelters as originally planned. The 
expanded list of minimum tax preferences will make the preference 
offset more effective. Also, the Act repeals the existing $30,000 floor 
on preferences that reduce personal service income eligible for the 
maximum tax. 

Business expenses under the individual income tax law 

Many individuals are now claiming deductions for the business use 
of their home, for expenses related to the rental of their vacation 
homes for a brief part of the year, or for expenses of attending foreign 
conventions. While in theory there is nothing wrong with appropriate 
deductions for business or investment expenses, in ])ractice it is often 
extremely difficult to allocate between deductible business expenses 
and nondeductible personal expenses. The result is that many people 
have been deducting amounts as business expenses which in part 
actually represent personal expenses. To deal with this problem, the 
Act places strict limitations on these deductions. 

The Act also repeals the special tax treatment for qualified stock 
options. With personal service income subject to a maximum rate of 
50 percent. Congress decided that there is no reason for not taxing 
this form of compensation as ordinary income. 

Tax treatment of foreign income 

The Act makes several important changes in the tax treatment of 
forei.^rn i'^come. Congress believed that it is necessary to strike a deli- 
cate b'hince between encouraging the free flow of capital across na- 
tional b-^rders and making sure that the tax laws do not provide exces- 
siv^e incentives for foreign investment instead of investment in the 
United States. Congress decided to retain the basic structure of the 
taxation of foreign income— namely, a foreign tax credit for income 
earned abroad and deferral of tax on income of foreign subsidiaries 
(except in the case of "tax haven" income) until returned to this 
country. However, the Act eliminates virtually all other tax-related 
incentives for investment abroad. 

An important change made by the Act is the repeal of the per- 
country limitation on the foreign tax credit. The per-country limit 
enables a firm with a loss in one country and a profit in another to 
deduct the loss against U.S. income and still avoid U.S. tax on the 
profit through the foreign tax credit. Its repeal will eliminate this 
possibility and will also greatly shnplify this part of the tax law. The 
Act also provides for recapture of foreign losses deducted from U.S. 
income when foreign profits are earned in subsequent years. 

The Act repeals numerous tax incentives which favor investment 
in some foreign areas over others— those which favor investment in 
less-developed country corporations, China Trade Act corporations 
and Western Hemisphere trade corporations. It also substantially re- 
vises and improves the tax provisions relating to U.S. possessions. Ex- 
cept in the case of U.S. possessions, Congress felt that there was no 
longer any good reason for favoring investment in one of these 
foreign areas over another. 



The Act, while retaining an exchision for income earned abroad by 
individuals, eliminates special features of this provision enabling those 
with income above the basic exemption levels to obtain additional tax 
benefits from the exclusion and reduces the maximum amounts eligible 
for the exclusion. Congress did not feel that the tax preference for 
income earned abroad should be as large as it was under prior law. 

Another area of concern is the DISC provision that permits defer- 
ral of tax for one-half of export income. To make this incentive more 
efficient, the Act limits DISC treatment to the excess of a firm's exports 
above a moving base period level. 

Congress did not believe that multinational corporations should 
benefit from tax incentives when they engage in misconduct. Thus, 
the Act denies the foreign tax credit, tax deferral, and DISC treat- 
ment for income earned in connection with participation in interna- 
tional boycotts, such as the Arab boycott o,f Israel. Similarly, it pro- 
vides that amounts paid as bribes by foreign subsidiaries will be taxed 
to the U.S. parent corporation. 

To eliminate the possibility that oil companies which operate abroad 
gain undue advantage from the characterization of their payments 
to foreign governments as creditable taxes, the Act further limits the 
extent to which foreign tax credits from oil extraction can be used 
while continuing the requirement that these taxes may not reduce the 
tax on other foreign oil income. 

The Act also makes several technical corrections that were consid- 
ered necessary resulting from the changes in the taxation of foreign 
income made by the Tax Reduction Act of 1975. 

Capital gains and losses 

The Act makes three important changes in the tax treatment of 
capital gains and losses. The holding period defining long-term capital 
gains, which receive preferential tax treatment, is raised (over a period 
of two years) from six months to one year. This should encourage 
longer term investments as contrasted to short-term speculative invest- 
ments. Also, the Act (over a period of two years) increases the amount 
of ordinary income against which capital losses can be deducted from 
$1,000 to $3,000. This change is designed to provide relief to those who 
have capital losses in excess of capital gains, which is not only fair but 
also should encourage individuals to make equity investments. Finally, 
the Act increases the exemption level for capital gains on the sale of a 
principal residence by a taxpayer age 65 or over. 

Other tax revisions 

The Act makes a large number of other relatively minor revisions 
in the tax law. These deal with inequities or technical problems that 
have come to the attention of the Congress. 

There are several provisions relating to tax-exempt organizations. 
Among these is one which sets the payout requirement (if larger than 
actual earnings) for foundations at 5 percent of asset value (instead 
of a minimum of 6 percent) and provides that this limit is not to be 
varied as interest rates generally change. A second provision sets up 
a court review procedure where the IRS holds that an organization 
does not qualify for exempt status. A third change makes more specific 
the rules for lobbying by charitable and educational organizations. 



234-120 O - 77 - 2 



6 

The Act includes a number of provisions relating to pensions. Prob- 
ably the most, important of these is one which expands the existing 
provision for individual retirement accounts (IRAs) to permit a work- 
ing spouse to set up an IRA for a nonworking spouse. This change 
recognizes the contributions to the family made by nonworking 
spouses. If an IRA is set up for both spouses, a $1,750 contribution 
limit applies. Contributions can be made, subject to that limit, to a 
single IRA with separate subaccounts or two separate IRAs. Another 
pension provision permits an amount of up to $750 to be set aside each 
year in an H.R. 10-type plan where income is $15,000 or under without 
the amount set aside being limited to 25 percent of an individual's 
earnings. 

There also are a number of changes relating to the taxation of 
insurance companies. Among these is one which, after a period of five 
years, will permit casualty insurance companies to file consolidated 
returns with life insurance companies but in a manner which does 
not permit the losses of the casualty companies to remove more than a 
limited amount of the life insurance income .from taxation. 

There are technical changes in the tax treatment of real estate invest- 
ment trusts, housing cooperatives and condominiums, certain franchise 
transfers, authors and publishers, creditors of political parties, sub- 
chapter S corporations, the work incentive (WIN) tax credit, personal 
holding companies, oil and gas producers, losses from disasters, simul- 
taneous liquidation of parent and subsidiary corporations, gain from 
sales or exchanges between related parties, and deductions for remov- 
ing architectural and transportation barriers for handicapped and 
elderly people. 

The Act makes revisions in depreciation rules designed to encourage 
rehabilitation of historic structures. 

Several tax provisions that have recently expired are extended in 
the Act. These include rapid amortization provisions for pollution con- 
trol facilities and rehabilitated low-income housing. Pollution control 
facilities are also given half of the normal investment credit, which 
differs from the prior provision under which 5-year amortization was 
an alternative to the investment credit. Congress believed that since 
Federal re^ilations require installation of pollution contix>l equipment, 
it is equitable to reduce the cost of capital for sii.l. equipment. Also, the 
exclusion from income for certain forgiven student loans is extended 
through 1978. Further, the Act extends for a limited period the exclu- 
sion for certain health -related scholarships for members of the uni- 
formed services for those participating in 1976. 

Tax exemption is provided for contributions by employers to quali- 
fied group legal services plans, designed to encourage use of this fringe 
benefit. 

To broaden the market for State and local government bonds, mutual 
funds are allowed to pass through tax-exempt interest on such bonds 
to shareholders. 

Also, the Act redefines income or loss from writing options as short- 
term capital gain or loss in order to limit the tax shelters that have 
developed in recent years in stock option hedges. 

In addition, the Act makes certain small changes in the excise tax 
treatment of truck modifications and truck parts and accessories, and 
simplifies and revises the excise tax treatment of cigars. 



B. TAX SIMPLIFICATION 

Tax simplification is the second major goal of the Act. Simplifi- 
cation must be an ongoing process, and the individual provisions of the 
tax law must be reexamined periodically to see how they contribute 
to the complexity of the tax law. Unless this reexamination occurs, the 
tax law will grow gradually more complicated as new provisions are 
added to achieve new goals of society. The Act repeals or restructures 
several provisions of the tax lav,', and directs that a Congressional 
study be made regarding further simplification of the tax system. 

One such provision concerns the use of the income tax tables. The 
Act eliminates the existing tax tables based on adjusted gross income, 
which have been a major source of taxpayer error, and substitutes a 
simpler set of tables based on taxable income. It also raises to $20,000 
the taxable income level where these tax tables may be used. 

A second simplification concerns the retirement income credit. This 
was originally designed to give those who retire without social security 
a tax benefit similar to that accorded social security benefits. As a 
result, eligibility for the credit and its computation were designed to 
follow as closely as possible eligibility for, and computation of, social 
security benefits. This required a complex form that filled a whole 
page, and it is estimated that a large fraction of the people eligible 
for the credit either did not claim it or made errors in computing it. 
In response to this problem, Congress restructured the credit to elimi- 
nate virtually all the complexity, even though this means breaking 
the close link between the retirement income credit and social security 
eligibility. This new credit for the elderly also will be fairer than the 
retirement income credit under prior law since it will also be applicable 
to earned income for taxpayers age 65 or over. 

Another complicated provision has been the sick pay exclusion. In 
this case. Congress concluded that the exclusion should be allowed only 
for persons who are permanently and totally disabled, since for other 
people there is no reason why sick pay should be treated more favorably 
than wage income, particularly in view of the deductibility of 
medical and drug expenses. For those still eligible for the sick pay 
exclusion, the provision has been considerably simplified and coordi- 
nated with the new credit for the elderly. 

The Act makes major changes in the treatment of child and depend- 
ent care expenses. Formerly, these were allowed as an itemized deduc- 
tion, subject to some complicated limitations. The Act converts the 
deduction into a 20-percent credit, so that it will be available to those 
who use the standard deduction as well as to itemizers and so that it 
will provide the same tax relief to taxpayers in low brackets as to those 
in high brackets. The child care deduction in prior law was worth, 
for exampV, 70 cents for each dollar of child care expenses for a tax- 
payer in the 70-percent bracket, but only 14 cents to a low-bracket tax- 
payer who itemized deductions and nothing to someone who used the 
standard deduction. The new credit will be worth 20 cents for each dol- 
lar of qualified child care expenses for all taxpayers. In addition, the 
Act significantly simplifies the child care provision and broadens eli- 
gibility for it. 

The Act makes several other changes that will simplify the law or 
make it more equitable, including a revision of the rules relating to 



8 

accumulation trusts and the moving expense deduction. The alimony 
deduction is moved from an itemized deduction to a deduction in deter- 
mining adjusted gross income, so that it can be used by people who 
take the standard deduction. 

There are some cases where it is possible to achieve tax simplifica- 
tion without changing the substance of the law. The Act includes the 
so-called "deadwood provisions" which deletes obsolete and rarely used 
parts from the Internal Revenue Code and makes many other changes 
to shorten and simplify the language of the Code. 

These provisions are only the beginning of what must be a continual 
process of tax simplification. Congress plans further tax simplication 
measures and has directed the Joint Committee on Taxation to conduct 
a comprehensive study of ways to simplify the tax system (with a le- 
port to the House "Ways and Means and Senate Finance Committees 
due by June 30, 1977). ' 

C. EXTENSION OF TAX REDUCTIONS 

Economic conditions 

A third major purpose of the Tax Reform Act of 1976 is to ex- 
tend the fiscal stimulus provided by the Tax Reduction Act of 1975 
and subsequently extended for the first half of 1976 by the Revenue 
Adjustment Act of 1975. The Tax Reduction Act of 1975 provided a 
tax cut, a tax rebate and increased expenditures totaling $23 billion in 
1975.1 

The 1975 tax cut included a temporaiy increase in the standard 
deduction and a $30 nonrefundable tax credit for each taxpayer and 
dependent, which reduced tax liability by $8 billion and was reflected 
in lower withheld and estimated tax payments over the last 8 months 
of 1975. There was also an earned income credit involving $1.4 billion 
and a home purchase credit amounting to about $0.6 billion. Finally, 
there were business tax reductions — an increase in the investment tax 
credit and a corporate rate cut for small businesses — amounting to $5 
billion. 

The 1975 increase in the standard deduction and the $30 credit, which 
reduced tax liability by $8 billion, were reflected in lower withheld 
and estimated tax payments over the last 8 months of 1975 at the 
rate of $1 billion per month, or $12 billion per year. In the Revenue 
Adjustment Act of 1975, Congress decided to extend these same with- 
holding rates for the first half of 1976 and to provide a cut in tax lia- 
bility for 1976 approximately equal to this $6 billion reduction in with- 
holding. Also, that Act extended the small business tax cuts and the 
earned income credit for the first half of 1976. (The increase in the 
investment credit had been put into effect for 1975 and 1976 in the 
Tax Reduction Act.) 

Congress analyzed economic conditions again in 1976 and believed 
it was inappropriate to withdraw the economic stimulus provided by 
the 1975 tax reductions. Due in no small part to the 1975-76 tax reduc- 



1 This included a rebate on 1974 individual Income taxes of $8.1 billion plus a $50 one- 
time .payment to social security recipients and increased unemployment compensation 
amounting to $2 billion. 



9 

tions, there has been an overall economic recovery from the 1974-75 
recession in the past 18 months. Output has grown at a rate of more 
than 6 percent, and we have exceeded the level of income and produc- 
tion that existed at the end of 1973, prior to the recession. Since then, 
however, the capacity of the economy has grown and will continue to 
grow, and the economic forecasts examined by Congress indicated 
that there is likely to be excess capacity in the economy for at least 
the next year. While the unemployment rate had fallen from 9 percent 
to 7.8 percent (at the time of passage of the Tax Reform Act), the 
existing unemployment rate was still considered to be unacceptably 
high. For these reasons. Congress agreed to extend the existing tax 
cuts at least through 1977 and to make part of the tax cuts permanent. 

Congress did not believe that a permanent extension of the entire 
$20 million in tax reductions then in effect was appropriate. There 
was imcertainty about just how much excess capacity there was (or was 
likely to be) in the economy, how serious the inflation problem would 
be in the years ahead, as well as what budgetary requirements would be 
necessary for the rest of the decade. 

In view of the uncertain economic and budgetary situation, Congress 
agreed to make part of the $20 billion tax reduction permanant but 
to extend the rest only temporarily. This will afford Congress and 
the Administration an opportunity in 1977 to review economic 
conditions and the fiscal requirements to see what, if any, further 
extensions or enlargements of these tax cuts should be made. 

Individual tax reductions 

The Act makes permanent $4 billion of individual tax reductions. 
These result from the increases in the standard deduction. The Act 
extends through 1977 the general tax credit adopted in the Revenue 
Adjustment Act and the earned income credit, which together involve 
a tax cut of $11 billion for 1977. 

The Act permanently increases the minimum standard deduction 
(or low-income allowance) from $1,300 to $1,700 for single returns 
and to $2,100 for joint returns. It increases the percentage standard 
deduction from 15 percent to 16 percent. Also, it increases the maxi- 
mum standard deduction from $2,000 to $2,400 for single returns and 
to $2,800 for joint returns. This will reduce tax liability at an annual 
rate of $4.2 billion for 1977, and will lower budget receipts in fiscal 
year 1977 by $4.1 billion. This increase in the standard deduction rep- 
resents a major simplification of the individual income tax, since it 
will make it worthwhile for filers of 9 million tax returns to switch to 
the standard deduction. Also, this change creates greater tax equity, 
since itemized deductions have been free to rise with inflation, while 
the minimum and maximum standard deductions stay constant unless 
there is specific legislative action. 

There is also an extension of the earned income credit through 1977. 
This is a refundable credit equal to 10 percent of the first $4,000 of 
earnings, with a phaseout as income rises between $4,000 and $8,000. 
It is available only to people with dependent children. It involves a 
cut in tax liability in 1977 at a rate of $1.3 billion, and a reduction in 
fiscal year 1977 budget receipts of $0.7 billion. The earned income 
credit provides a work incentive for those with jobs that pay relatively 



10 

low wages. It provides desperately needed tax relief to a hard-pressed 
group, who are faced with high food and energy prices and are sub- 
ject to the payroll tax. 

The Act extends through 1977 the general tax credit for individuals 
adopted in the Revenue Adjustment Act, which reduces tax liability in 
1977 at an annual rate of $10.1 billion. The extension of this credit will 
reduce fiscal year 1977 receipts by $9.5 billion. This credit equals the 
greater of $35 for each taxpayer and dependent or 2 percent of the 
first $9,000 of taxable income. 

Together, the individual tax cuts amount to a cut in tax liability in 
1977 at an annual rate of $15.6 billion. They will reduce budget receipts 
in fiscal year 1977 by $14.4 billion. 

Business tax reductions 

In order to provide sufficient economic stimulus and to encourage 
businesses to invest, the Act extends the business tax cuts provided by 
the Tax Reduction Act of 1975. These reduce tax liability in 1977 at an 
annual rate of $5.4 billion and will reduce tax receipts in fiscal year 
1977 by $3.0 billion. 

As discussed later under Capital Fcnvnation, the Act extends 
through 1980 the current 10-percent investment credit (applicable 
previously through 1976). This represents an increase from the 
previous 7-percent rate for most businesses and from the 4-percent 
rate for public utilities. These changes will reduce tax liability by $3.3 
billion in 1977, and will lower budget receipts by $1.3 billion in fiscal 
year 1977. 

The investment credit has proven an effective way to stimulate in- 
vestment in equipment. Its enactment in 1962 and its reenactment in 
1971 were followed by investment booms, and its suspension in 1966 
and repeal in 1969 were followed by sharp declines in investment. 
Increased investment in the U.S. economy is needed to improve our 
standard of living and to achieve energy, environmental and other 
goals ; and under these circumstances. Congress believed an extension 
of the 10-percent investment credit was appropriate. The credit for 
utilities is increased to the same rate as that for other businesses because 
Congress believed they should be able to compete for capital on the 
same basis as other industries. 

The Act also extends through 1977 the small business tax cuts enacted 
in 1975. These increase the corporate surtax exemption from $25,000 to 
$50,000 and reduce the tax rate on the initial $25,000 of corporate 
income from 22 percent to 20 percent. The reduction in tax liability is 
$2.1 billion in 1977, and the reduction in budget receipts is $1.7 billion 
in fiscal year 1977. This change will improve the competitive position 
of small business, 

D. CAPITAL FORMATION 

A fourth major aspect of the Act is the encouragement of capital 
formation through the continuation and modification of certain in- 
vestment-related tax incentives. Congress was concerned that the U.S. 
economy faced a severe shortage of capital. In 1973 and early 1974, 
there were capacity shortages in many majoi- industries because invest- 
ment in them had been inadequate in the previous five years. Also, the 



11 

growth rate of labor productivity has slowed, again partly because of 
inadequate capital investment. We have had the most success in stim- 
ulating capital investment in recent years by the use of the investment 
tax credit. There appears to be a close correlation since 1962 between 
the presence of the investment credit and purchases of equipment. As 
a result, the Act extends the 10-percent investment credit for four 
years (or through 1980). 

The Act extends and expands a provision enacted in 1975 allowing 
an additional one- percent investment credit if an equivalent amount 
is placed in an employee stock ownership plan. These changes should 
significantly increase the extent to which the provision is used by 
business. Under the new law, a credit of an additional one-half per- 
centage point is also allowed if it is matched with employee contribu- 
tions. This option is considered desirable in order to broaden em- 
ployees ownership in business and thereby increase their interest in 
improving productivity. It will also serve the twin goals of increasing 
capital accumulation and creating a more equal distribution of 
wealth. To make the investment credit available to less profitable busi- 
nesses, the Act makes it available on a first-in, first-out basis. 

Another provision to promote capital accumulation, which will be 
especially important for new business, is one that extends the net 
operating loss carryforward period to 7 years. By allowing more flexi- 
bility in averaging profits and losses, this will encourage risktaking. 
It will also encourage investment in new businesses. The Act tightens 
the existing rules to prevent "trafficking" in losses in order to reduce 
any tax incentives toward business mergers. In addition, the capital 
loss carryover period for mutual funds is extended from 5 years to 
8 years. 

For railroads and airlines, industries which have had trouble gener- 
ating internal funds as a result of the recession, the Act provides (for 
a limited period of time) a tax reduction through changes in the 
investment credit and in amortization rules. For similar reasons, at 
least half investment credit is made available to the domestic merchant 
marine for funds withdrawn from their tax-deferred ship construc- 
tion fund to purchase ships. 

Finally, the Act, in order to encourage domestic production, makes 
the investment credit available in the future for motion picture pro- 
ductions only where they are predominantly American-produced films. 
For the past, a compromise between the Internal Revenue Service and 
the industry is worked out as to the appropriate investment credit 
intended under the relatively uncertain provisions of prior law. 

E. ADMINISTRATIVE PROVISIONS 

A fifth major goal of the Act is to improve the administration of the 
tax laws. It contains several provisions to improve efficiency of tax 
administration through changes in withholding provisions and better 
regulation of tax return preparers. It also makes significant admin- 
istrative changes designed to strengthen taxpayers' rights. 

The Act provides definitive rules relating to the confidentiality of 
tax returns, an area where there has been abuse in the past. It 
strictly limits disclosure of information from tax returns. The ability 



12 

of the Internal Revenue Service to use jeopardy and termination assess- 
ments and to issue administrative summons also is limited by providing 
better court review in these cases. 

At the same time, rules are provided for the publication of pri- 
vate letter rulings so everyone will have an equal opportunity to know 
the view of the IRS on the proper interpretation of the tax law. New 
rules are also added to aid the Service in reviewing the way in which 
tax return preparers carry out their duties. 

In the case of withholding tax provisions, a number of changes are 
made, including provision to withhold at the rate of 20 percent on 
income from most wagering wliere the amount won is $1,000 or over. 
Further, in the case of fishing vessels where the catch is shared, stern- 
men are classified as independent contractors for tax purposes. The 
Act also provides mandatory withholding of State and local income 
taxes for members of the Armed Forces. 

F. ESTATE AND GIFT TAX PROVISIONS 

The estate and gift tax provisions provide a comprehensive revision 
of these taxes. In this area, the Act provides substantial relief for 
moderate-sized estates, farms and other closely-held businesses, allevi- 
ates the liquidity problem for estates comprised largely of farms and 
other closely-held business, while at the same time it removes tax 
avoidance devices from the present system. This is accomplished with 
a balanced set of provisions which in the long run will at least main- 
tain the present level of revenues. 

The Act substantially reduces estate taxes for medium-sized estates. 
The existing $60,000 estate tax exemption was enacted in 1942 and 
since that time the percentage of decedents whose estates have been 
subjected to the Federal estate tax has increased from 1 percent to 8 
percent. This increase has resulted from inflation and the greater 
ability of people to accumulate wealth because of the unprecedented 
economic prosperity in the post-war era. The Act increases from 
$60,000 to $175,000 the level at which the taxation of estates begins. 
It also changes the exemption into a tax credit in order to confer the 
maximum possible tax relief on the small and medium-sized estates. 

In addition, the prior estate tax imposed acute problems when the 
principal asset of the estate was equity in a farm or small business. 
Because assets are valued at their "highest and best use" for estate 
tax purposes, rather than on the basis of the specific use to which the 
assets were being put (and also because these assets are illiquid), 
family members have often been forced to sell farms and small busi- 
nesses in order to pay the estate tax. To deal with these problems the 
Act allows farms (and other family businesses) to be valued (to the 
extent of $500,000) at the value for farming purposes (or other small 
business use) , if they remain in the family for a period of ten to fifteen 
years after the death of the decedent, rather than being valued at the 
"highest and best use" market value. Also, in these cases, the Act ex- 
tends the time for payment of estate tax liability and provides for 
a low 4-percent interest rate on the tax on up to $1 million of farm 
or small business value. These changes are intended to preserve the 
family farm and other family businesses — two very important Ameri- 
can institutions, both economically and culturally. 



13 

The estate and gift tax structure is an important part of the Federal 
tax system and as such needs to be as nearly equitable as possible in 
its application. Tax liability should not depend on the method used to 
transfer the property from one generation to the next. Because of this, 
a number of steps Avere taken to reform the estate and gift tax provi- 
sions. This reform provides assurance that in the long run these pro- 
visions will not lose revenue. 

Two features of prior law which give rise to considerable variations 
in estate and gift tax burdens for people who transfer the same amount 
of wealth were the separate rate schedule and exemption provision for 
estates and gifts. There were several tax advantages to lifetime gifts. 
The gift tax rates were 75 percent of estate tax rates ; and, unlike the 
estate tax, the amount of the gift tax itself was not included in the tax 
base. Also, someone who split his total transfers between gifts and 
bequests achieved the advantage of "rate splitting," since the first 
dollar of taxable bequests was taxed at the bottom estate tax rate even 
where there had been substantial lifetime gifts. These opportunities 
for reducting the overall burden by lifetime giving were inequitable, 
especially since many people are not wealthy enough to make lifetime 
gifts. The Act unifies the estate and gift taxes — both the exemptions 
(which have been converted into a credit) and the rates — to deal with 
these inequities. 

Another cause of unequal treatment of taxpayers with the sa,me 
amount of wealth transfers has been the ability to use "generation 
skipping" trusts. Wlien weath is bequeathed from the parent to his 
child, then from the child to a grandchild and finally from the grand- 
child to a great-grandchild, the estate tax is imposed three times. 
However, if the parent places the wealth in a trust in which the child 
and then the grandchild has the right to the income from the trust, 
with the principal going to the great-grandchild, the parent will 
achieve virtually the same result and, in effect, skip two generations 
of estate tax. In these cases, the estate tax could be avoided for 100 
years or more under prior law. Since such trust arrangements have 
been used largely by wealthier people, this failure to tax generation- 
skipping trusts has undermined the progressivity of the estate and 
gift taxes. The Act significantly limits estate tax avoidance through 
generation-skipping trusts by imposing a tax at the time of the 
death of the child or grandchild, in the example cited above, of 
substantially the same size as would be imposed had the property 
passed directly from the child to the grandchild and to the great- 
grandchild, although the additional tax in this case is payable by the 
trust. However, an exception to this rule is provided for up to $250,000 
passing from a child to one or more grandchildren. 

Still another inequity in the prior law resulted from the fact that 
when appreciated property was transferred at death, the basis of the 
property for the heirs (on which any capital gain or loss is computed) 
was the fair market value at the time of death rather than the basis of 
the decedent. This contrasted with the rule for gifts, where the donee 
must carry over the basis of the donor. One unfortunate result of the 
prior law has been that people were reluctant to sell appreciated prop- 
erty in anticipation of the step-up in basis at death. Another result has 
been that assets accumulated out of savings from ordinary income bore 



14 

a heavier total tax burden than, those resulting from appreciation in 
value where the gain had not been realized. To reduce the inefficiency 
and inequity of the prior system, the Act generally provides for a 
carryover basis at death but provides, however, that there will continue 
to be a step-up in basis for appreciation which has occurred througli 
the end of the calendar year 1976. 

G. INTERNATIONAL TRADE AMENDMENTS 

Another area of the Act involves changes in the operation of the 
U.S. International Trade Commission and amendments to the Trade 
Act of 1974 regarding tariff treatment of countries aiding or abetting 
international terrorists. , , 

The Congress concluded that, the voting procedures of the Interna- 
tional Trade Commission, needed reyising in order to facilitate the 
functioning of the Congressiorial override mechanism in cases where a 
plurality of three commissioners reached agreemeiiit on a particular 
remedy but, because a majoi'ity of the commissioners voting did not 
agree on a remedy, there was no "recommendation"' by the Commis- 
sion which Congress could implement under the override provisions 
(contained in the Trade Act of 1974). Thus, the Act provides that if a 
majority of the Commissioners voting on an escape clause or market 
disruption case cannot agree on a remedy finding, the remedy finding 
agreed upon by a plurality of not less than three Commissioners is to 
be treated as the remedy finding of the Commission for the purposes 
of the Congressional override mechanism. The Act also modifies the 
rule for the term of office for a member of the Commission so that a 
Commissioner may continue to serve after the expiration of the term 
of office until the successor is appointed and qualified. 

In addition, the Act amends the Trade Act of 1974 to add a new 
category of reasons for denying preferential tariff treatment to "bene- 
ficiary developing countries.'' The new provision would prohibit pref- 
erential tariff treatment to such countries that aid or abet any indi- 
vidual or group which has committed an act of international terrorism. 
The President, however, could waive this prohibition (as he may for 
certain of the other categories for denial of preferential treatment) if 
a waiver is determined to be in the national economic interest of the 
ITnited States. 



11. REVENUE EFFECTS 

Table 1 gives the revenue effects of the tax reform, estate and gift 
tax, and tax cut provisions of the Act, and lists the revenue impact of 
each title of the Act. As the table indicates, the tax reform provisions 

are estimated to raise about $1.6 billion in revenues in fiscal year 
1977 and $2.5 billion by 1981. The tax cut extension amounts to $17.3 
billion in 1977. The title-by-title analysis of the table indicates that 
$417 million of revenue will be raised from tax shelter provisions in 
1977, a figure which rises to $527 million by 1981. 

Table 2 lists the revenue effect of each section of the Act by title. 

Tables 3 and 4 give the estimated decreases in individual income tax 
liability for calendar year 1977 and 1978 under the tax cut extensions 
contained in the Act. 

TABLE l.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX, AND TAX CUT PROVISIONS OF THE ACT, 

SUMMARY AND BY TITLE i 

(In millions of dollars; fiscal years] 

1977 1978 1979 1980 1981 

SUMMARY 

Tax reform -. - 1,593 1,719 2,038 2,118 2,470 

Estate and gift tax _ -728 -921 -1,134 -1,449 

Extension of tax cuts -17,326 -13,776 -7,966 -8,348 -7,212 



Total -15,733 -12,785 -6,849 -7,364 -6,191 



BY TITLE 

I l-Tax shelters 417 395 501 488 527 

III— Minimum and maximum tax 1,095 1,283 1,464 1,603 1,758 

IV— Extension of individual income tax reductions -14,350 -9,293 -4,506 -4,731 -4,968 

V-Tax simplification in the individual income tax —409 -442 -457 -478 -499 

VI— Business related individual income tax provisions 215 231 273 306 315 

Vll-Accumulation trusts (2) (2) (2) (2) (2) 

VIII— Capital formation -1,457 -3,593 -3,796 -4,000 -2,499 

IX— Small business provisions —1,676 —1, 177 .._ 

X— Changes in the treatment of foreign income 150 108 182 197 198 

XI— Amendments affecting DISC 468 553 559 598 728 

XII— Administrative provisions 88 55 55 55 55 

XIII— Tax exempt organizations -5 -5 (>) (') (2) 

XIV— Treatment of certain capital losses; holding period for 

capital gains and losses... —6 10 79 73 58 

XV— Pension and insurance taxation -18 -29 -29 —31 -30 

XVI— Real estate investment trusts (2) (2) <2) (2) (2) 

XVII— Railroad provisions -87 -139 -118 -98 -80 

XVIII— International Trade Amendments 

XX-Estate and gift taxes..-. -728 -921 -1,134 -1,449 

XXI— Miscellaneous provisions -158 -14 -135 -212 -305 

Total -15,733 -12.785 -6,849 -7,364 -6,191 



> Does not include Title I— Short Title and Title XIX— Repeal and Revision of Obsolete, Rarely Used, Etc., Provisions. 
2 Less than $5,000,000. 

(15) 



16 

TABLE 2.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX, AND TAX CUT PROVISIONS OF THE ACT 

BY TITLE AND SECTION' 

PART I. TAX REFORM 

|ln millions of dollars; fiscal years] 



1977 1978 1979 1980 1981 
TITLE II ~~ 

Tax Shelters 
Real estate provisions: 

Sec. 201— Amortization of real property construction period 

interest and taxes. _ 102 126 190 152 149 

Sec. 202— Recapture of depreciation on real property 9 is 28 38 56 

Sec. 203—5 year amortization of low income housing. —1 —4 _» —8 —7 

Farming provisions: 

Sec. 204— Limitation on deductions to amount at risk m m n) (2) (i\ 

Sec. 206— Termination of additions to excess deductions 
account _ __ (2) n\ /« m px 

Sec. 207— Limitation on deductions for farming syndicates.. 86 32 32 33 34 

Sec. 207— Accrual accounting for farm corporations 8 18 18 18 18 

Sec. 214 — Scope of waiver of statute of limitations In case 

of activities not engaged In for profit 

Oil and gas provisions: 

Sec. 204— Limitation on deductions to amount at risk 50 18 6 3 

Sec. 205— Gain from disposition of an interest in oil and 

. gas property 7 14 42 51 65 

Movie provisions: 

Sec. 204— Limitations on deductions to amount at risk 3 10 14 17 18 

Sec. 210— Capitalization rules.. 29 19 9 4 4 

Sec. 211— Clarification of definition of produced film rents O) (2) (2) (2) m 

Equipment leasing provision: Sec. 204— Limitation on deduc- 

tions to amount at risk 4 14 17 17 14 

Sports franchise provisions: 

Sec. 212— Allocation of basis to player contracts 14 6 6 8 

Sec. 212— Recapture of depreciation on player contracts... 7 6 7 7 7 

Partnership provisions: 

Sec. 213— Partnership syndication and organization fees... (2) (2) (2) (2) (2) 

Sec. 213— Retroactive allocations of partnership income or 

loss (2) (2) (2) (2) (2) 

Sec. 213— Partnership special allocations (2) (2) (2) (2) (2) 

Sec. 213— Limitation on deductible losses of limited 

partners (2) (2) (2) (2) (2) 

Sec. 213— Limitation on additional first year depreciation 

for partnerships 12 10 10 10 10 

Interest provisions: 

Sec. 208— Prepaid interest (2) (2) (2) (2) (j) 

Sec. 209— Limitation on deduction of nonbusiness interest... 100 110 130 140 145 
Other provisions: Sec. 214— Scope of waiver of statute of lim- 
itations in case of hobby loss elections (2) (2) (2) (2) (2) 

Total 417 395 501 433 "527 

TITLE III ~~ ======== 

Minimum Tax and Maximum Tax 

Sec. 301— Minimum tax for individuals.- 1,032 1,135 1,249 1,373 1511 

Sec. 301— Minimum tax for corporations 59 124 185 194 '204 

Sec. 302— Maximum tax 4 24 30 36 43 

Total 1,095 1,283 1,464 1,603 1,758 

TITLE V === 

Tax Simplification in the Individual Income Tax 

Sec. 501— Revision of tax tables for individuals 

Sec. 502— Deduction for alimony allowed in determining adjusted 

gross income —7 —44 —49 -54 -59 

Sec. 503— Revision of retirement income credit -391 -340 -340 -340 -340 

Sec. 504— Credit for child care expenses —384 —368 —404 —444 —488 

Sec. 505— Changes in exclusion for sick pay and certain military, 

etc., disability pensions 380 357 387 417 450 

Disability payments for civilian Government em- 
ployees for injuries resulting from acts of terrorism.. (2) (2) (2) (2) (») 

Sec. 506— Moving expenses —7 —47 —51 —57 —62 

Sec. 507— Tax revision study by Joint Committee 

Total _409 -442 -457 -478 -499 

See footnotes at end of table. 



17 

TABLE 2.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX, AND TAX CUT PROVISIONS '- OF THE ACT 
BY TITLE AND SECTION i— Continued 

(In millions of dollars; fiscal years] 



1977 1978 1979 1980 1981 



TITLE VI 
Business-Related Individual Income Tax Provisions 

Sec. 601— Deductions for expenses attributable to business use 

of homes, rental of vacation homes, etc 207 206 235 268 305 

Sec. 602— Deductions for attending foreign conventions 0) O 0) 0) (') 

Sec. 603— Change in tax treatment of qualified stock options... 7 20 33 33 5 

Sec. 604— State legislators' travel expenses away from home... (') 0) (') (') (') 
Sec. 605— Deduction for guarantees of business bad debts to 

guarantors not involved in business 15 5 5 5 

Total 215 231 273 306 315 

TITLE VII 
Accumulation Trusts 

Sec. 701-Accumulation trusts 0) (?) 0) P) C) 

TITLE VIII 
Capital Formation 

Sec. 802— First-in first-out treatment of investment credit 
amounts (for extension of 10-percent credit see 
Part III of this table) (0 (') -5 -20 -40 

Sec. 803— Modifications in employee stock ownership plans —107 —257 —303 -332 -189 

Employee stock ownership plan regulations 

Study of expanded stock ownership - - 

Sec. 804— Investment credit in the case of movie and television 

films *-37 4-18 4-13 * -13 -3 

Sec. 805— Investment credit in the case of certain ships —13 —12 —15 —18 —23 

Sec. 806— Additional net operating loss carryover years; limita- 
tions on net operating loss carryovers (0 (0 (2) y) y) 

Sec. 807— Small fishing vessel construction reserves (») (0 (') (?) P) 

Total - - -157 -287 -336 -383 -255 

TITLE IX 
Smalt Business Provisions 

3 

Sec. 902— Liberalization of subchapter S rules governing num- 
ber of shareholders (?) (2) (') (') (*) 

Liberalization of other subchapter S shareholder 

rules 0) (») (9 (') 

Distributions by subchapter S corporation (') (') (') (*) (?) 

TITLE X 

Changes in the Treatment of Foreign Income ' 

Part I— Foreign tax provisions affecting individuals abroad: 

Sec. 1011— Income earned abroad by U.S. citizens living 
or residing abroad -- 44 38 38 38 38 

Sec. 1012— Income tax treatment of nonresident alien 
individuals who are married to citizens or residents of 
the United States. -1 -5 -5 -5 -5 

Sec. 1013— Foreign trusts having one or more U.S. bene- 
ficiaries to be taxed currently to grantor 12 10 10 10 10 

Sec. 1014— Interest charge on accumulation distributions 
from foreign trusts...- (2) 0) « (») 0) 

Sec. 1015— Excise tax on transfers of property to foreign 

persons to avoid Federal income tax O Q) 0) v) (v 

Part II— Amendments affecting tax treatment of controlled 
foreign corporations and their shareholders: 

Sec. 1021— Amendment of provision relating to investment 
in U.S. property by controlled foreign corporations Q) Q) (') (v (V 

Sec. 1022— Repeal of exclusion for earnings of less devel- 
oped country corporations for purposes of section 1248.. 14 10 10 10 10 

Sec. 1023— Exclusion from subpart F of certain earnings of 
insurance companies.. —14 —10 —10 —10 —10 

Sec. 1024— Shipping profits of foreign corporations. P) C^) (v (v (?) 

Limitation on definition of foreign base company sales 
income in the case of certain agricultural products 

See footnotes at end of table. 



18 



TABLE 2.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX. AND TAX CUT PROVISIONS • OF THE ACT 
BY TITLE AND SECTION i— Continued 

[In millions of dollars; fiscal years] 



Total, title X. 



TITLE XI 

Amendments affecting DISC 

Sec. 1101— Amendments affecting DISC 

TITLE XII 

Administrative provisions 

Sec. 1207— Withholding: 

Withholding of Federal tax on gambling winnings 

Withholding of Federal tax on certain individuals engaged in 

fishing'. 

Sec. 1212— Abatement of interest vKhen return is prepared for 
Taxpayer by the International Revenue Service 



Total. 



TITLE XIII 

Tax Exempt Organizations 

Sec. 1301— Disposition of private foundation property under 

transition rules of Tax Reform Act of 1969 

Sec. 1302— New private foundations set-asides 

Sec. 1303— IVIinimum distribution amount for private foundations. 
Sec. 1304— Extension of time to amend charitable remainder 

trust governing instrument 

Sec. 1305— Unrelated trade or business income of trade shows, 
State fairs, etc.: 
Charitable organizations not subject to an unrelated busi- 
ness income tax on rental income from trade shows 

County fairs not subject to an unrelated business income 

tax _ 

1306— Declaratory judgments with respect to section 

501(cX3) status and classification 

Sec. 1307— Lobbying by public charities 

Sec. 1308— Tax liens, etc., not to constitute acquisition indebted- 
ness 

See footnotes at end of table. 



Sec. 



1977 



TITLE X— Continued 

Changes in the Treatment of Foreign Income— Continued 

Part III— Amendments affecting treatment of foreign taxes: 
Sec. 1031— Requirement that foreign tax credit be deter- 
mined on overall basis _ 

Sec. 1032— Recapture of foreign losses 

Sec. 1033— Dividends from less developed country corpora- 
tions to be grosses up for purposes of determining United 
States income and foreign tax credit against that income. . 
Sec. 1034— Treatment of capital gains for purposes of 

foreign tax credit 

Sec. 1035 -Foreign oil and gas extraction income......... 

Sec. 1036— Underwriting income 

Sec. 1037— Third-tier foreign tax credit when section 951 

applies.. 

Part IV— Money or other property moving out of or into the' 
United States: 
Sec. 1041— Portfolio debt investments in United States of 

nonresident aliens and foreign corporations 

Sec. 1042— Changes in ruling requirements under section 

367; certain changes in section 1248 _. 

Sec. 1043— Continguous country branches of domestic life 

insurance companies 

Sec. 1044— Transitional rule for bond, etc., losses of foreign 

banks.. 

Part V— Special categories of foreign tax treatment: 

Sec. 1051— Tax treatment of corporations conducting trade 
or business in Puerto Rico and possessions of the United 

States. 

Sec. 1052— Western Hemisphere trade corporations.. 

Sec. 1053— Repeal of provisions relating to China Trade Act 

corporations _ _ 

Part VI— Denial of certain tax benefits on internationai boycotts 
and bribe-produced income 



-4 



468 



88 



-5 



1978 



1979 



-10 



-10 



553 



559 



101 68 

-13 -13 

0) Q) 



55 



55 



0) 


(n 


(■') 


p) 


(2) 


(2) 



(?) 



-5 



1980 



51 
2 


35 
8 


39 
14 


45 
22 


80 


55 


55 


55 


14 
-6 
0) 


10 
23 
(?) 


10 
50 


10 
50 
(2) 



-10 



598 



68 68 

-13 -13 

Q) (2) 



55 



(2) 



(') 


(0 


(0 


(') 


o 


o 


(') 


Q) 


0) 


(2) 


o 


0) 








Q) 


(') 



1981 



10 
50 

-10 



-55 


-115 


-125 


-135 


-145 


0) 


Q) 


0) 


O 


P) 


-12 


-8 


-8 


-8 


-8 


(S) .. 










6 
19 


10 
25 


10 
34 


10 
45 


10 
50 


(') 


O 


0) 


(0 


P) 


(2) 


32 


70 


70 


70 


150 


108 


182 


197 


198 



728 



68 
-13 

55 



(0 



0) 
(») 



0) 
(2) 



19 

TABLE 2.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX. AND TAX CUT PROVISIONS » OF THE ACT 
BY TITLE AND SECTION i— Continued 

(In millions of dollars; fiscal years) 

1977 1978 1979 1980 1981 

TITLE XI 1 1— Continued 
Tax Exempt Organizations— Continued 

Sec. 1309— Extension of self-dealing transition rules for private 

foundations 0) 0) Q) (') 0) 

Sec. 1310-lmputed interest _.- (») (') (») 0) (?) 

Sec. 1311— Certain hospital services . (0 (J) 0) 0) 

Sec. 1312— Clinical services of cooperative hospitals Q) Q} (?) C) (") 

Sec. 1313— Exemption of certain amateur athletic organizations 

from tax P) P) 0) (?) 

Total -5 -5 (') (') 

TITLE XIV 

Treatment of Certain Capital Losses; Holding Period for Capital 
Gains and Losses 

Sec. 1461 — Increaseinamountof ordinary income against which 

capital loss may be offset -22 -162 -248 -260 -273 

Sec. 1402— Increase in holding period required for capital gain 

or loss to be long term 33 218 377 392 407 

Sec. 1403— Allowance of 8-year capital loss carryover in case of 

regulated investment companies —13 —21 —25 —34 —51 

Sec. 1404— Sale of residence by elderly -4 -25 -25 -25 -25 

Total -6 10 79 73 58 

TITLE XV 

Pension and Insurance Taxation 

Sec. 1501— Retirement savings for certain married individuals.. —2 —14 —15 —17 —17 

Sec. 1502— Limitation on contributions to certain pension, etc., 
plans 0) (2) (2) (2) (2) 

Sec. 1503— Participation by members of reserves or national 

guard in individual retirement accounts, etc —6 —5 —5 —5 —5 

Participation by certain volunteer firemen in individual re- 
tirement accounts, etc (?) (2) (2) (2) (2} 

Sec. 1504- Certain investments by annuity plans 0) (2) (2) (2) (2) 

Sec. 1505— Segregated asset accounts 

Sec. 1506— Study of salary reduction pension plans 

Sec. 1507— Consolidated returns for life and other insurance 
companies 

Sec. 1508— Treatment of certain life insurance contracts guar- 
anteed renewable (3) (S) (») (s) (>) 

Sec. 1509— Study of expanded participation in IRA's 

Sec. 1510— Taxable status of Pension Benefit Guaranty Cor- 
poration 

Sec. 1511— Level premium plans covering owner-employees (2) (2) (?) (?) (') 

Sec. 1512— Lump-sum distributions from qualifiea pension, 
etc., plans -10 -10 -9 -9 -3 

Total -18 -29 -29 -31 -30 

TITLE XVI 

Real Estate Investment Trusts 

Sees. 1601— 1608— Real estate investment trusts (2) (2) (2) (2) (2) 

TITLE XVII 

Railroad and Airline Provisions 

Sec. 1701— Certain provisions relating to railroads —29 —66 —65 —53 —41 

Sec. 1702 — Amortization over 50-year period of railroad grading 

and tunnel bores placed in service before 1969 —26 —18 —18 —18 —18 

Sec. 1703— Certain provisions relating to airlines -32 -55 -35 —27 —21 

ToUl -87 -139 -118 - 98 -80 

TITLE XVIII ~ 

International Trade Amendments 

Sec. 1801— United States International Trade Commission 

Sec. 1802— Trade Act of 1974 Amendments 

See footnotes at end of table. 



20 

ABLE 2.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX, AND TAX CUT F RCVISICNS i OF THE ACT 
BY TITLE AND SECTION i— Continued 

|ln millions of dollars; fiscal years] 



1977 1978 1979 1980 1981 



0) 
—48 
-60 


0) 

-42 
-15 


0) 

—42 
-15 _-. 


0) 

-42 


—42 


{') 

—3 
-3 


o 

-7 
—3 


(?) 

41 

-3 


(2) 

—14 
—3 


(') 
—3 


(?) 




0) 


0) 




0) 


0) -- 








59 


102 


18 


—70 


-160 


(?) 


(') 


(2) 


C) 


(?) 


(?) 


(?) ... 








-24 


-10 


—10 


-10 


—10 


(?) 


(') 


e) 


e) 


C) 


(') 


0) 


e) 


C) 


e) 


(2) 


0) 


(2) 





(') 



TITLE XXI 
Miscellaneous Provisions 

Sec. 2101— Tax treatment of certain housing associations 

Sec. 2102— Treatment of certai n disaster Payments 

Sec. 2103— Tax treatment of certain 1972 disaster losses 

Sec. 2104— Tax treatment of certain debts owned by political 
parties, etc., to accrual basis taxpayers 

Sec. 2105— Tax-exempt bonds for student loans. 

Sec. 2106— Personal holding company income amendments 

Sec. 2107— Work incentive program expenses 

Sec. 2108— Repeal of excise tax on light-duty truck parts 

Sec. 2109— Exclusion from excise tax on certain articles resold 
after modification _ _ 

Sec. 2110— Franchise transfers.. _ 

Sec. 2111 — Employers' duties in connection with the recording 
and reporting of ti ps _ _ 

Sec. 2112— Treatment of certain pollution control facilities 

Sec. 2113 — Clarification of status of certain fishermen's organi- 
zations 

Sec. 2114— Application of section 6013(e) of the Internal 
Revenue Code of 1954 

Sec. 2115— Amendments to rules relating to limitation on 

percentage depletion in case of oil and gas wells 

Transfers of oil and gas property within the same controlled 
groupor family.. 

Sec. 2116— Implementation of Federal- State Tax Collection Act 
of 1972 

Sec. 2117— Cancellation of certain student loans.. 

Sec. 2118— Treatment of gain or loss on sales or exchanges in 
connection with simultaneous liquidation of a parent and 
subsidiary corporation 

Sec. 2119— Regulations relating to tax treatment of certain pre- 
publication expenditures of publishers _ 

Sec. 2120— Contributions in aid of construction for certain 
utilities —16 —11 —11 —11 — U 

Sec. 2121 — Prohibition of discriminatory State taxes on produc- 
tion and consumption of electricity 

Sec. 2122— Allowance of deduction for eliminating architectural 
and transportation barriers for the handicapped — 4 — 10 — 10 — 6 

Sec. 2123— H igh-income taxpayer report. 

Sec. 2124— Tax incentives to encourage the preservation of 
historic structures —1 —3 —8 —12 —16 

Sec. 2125 — Amendment to Supplemental Security Income pro- 
gram 

Sec. 2126— Extension of carryover period for Cuban expropria- 
tion losses (2) (2) (2) (2) (2) 

Sec. 2127— Outdoor advertising displays 

Sec.2128— Tax treatmentof large cigars.. —7 —7 —7 —7 —7 

Sec. 2129— Treatment of gain from sales or exchanges between 

related parties... (2) (2) (2) (2) (2) 

Sec. 2130 — Application of section 117 to certain education pro- 
grams for members of the uniformed services' — 10 — 8 — 8 — 2 

Sec. 2131— Exchange funds (2) (2) (2) (2) (2) 

Sec. 2132— Contributions of certain Government publications (2) (2) (') (2) (2) 

Sec. 2133 — Tax i ncenti ves study 

Sec. 2134— Prepaid legal expenses —5 —8 —16 —21 —33 

Sec. 2135— Special rule for certain charitable contributions of 

inventory and other property — 19 — 22 —22 —24 —24 

Sec. 2136— Tax treatment of the grantor of options of stock, 

securities, and commodities 3 10 10 10 10 

Sec. 2137— Exempt-interest dividends of regulated investment 

companies 

Sec. 2138— Common trust fund treatment of certain custodial 

accounts 

Sec. 2139— Support test for dependent children of divorced, etc., 

parents - 

Sec. 2140— Involuntary conversionsof real property (2) (2) (2) (2) (2) 

Sec. 2141— Livestock sold on account of drought —20 20 

Total —158 —14 —135 —212 —305 

Total for Parti, Tax Reform T^S V7i9 2^038 2,118 2,470 

See footnotes at end of table. 



21 

TABLE 2.-REVENUE EFFECT OF TAX REFORM, ESTATE AND GIFT TAX, AND TAX CUT PROVISIONS i OF ACT 
BY TITLE AND SECTION— Continued 

PART II. ESTATE AND GIFT TAX 

[In millions of dollars; fiscal years] 

1977 1978 1979 1980 1981 

TITLE XX 
Estate and Gift Taxes ? 

Unified rates and credit -541 -756 -1,012 -1,380 

Marital deduction -153 -162 -171 -181 

Valuation -14 -15 -16 -17 

Extension of time -20 -24 -28 -33 

Unification (*) (•) (•) (•) (•) 

Generation skipping (*) (*) 

Carryover of basis (•) (•) 36 93 162 



Total -728 -921 -1,134 -1,449 

PART Ml. ETXENSION OF TAX REDUCTIONS 

TITLE IV 

Extension of Individual Income Tax Reductions 

Sec. 401 — Extensions of individual income tax reductions: 

(a) General tax credit -9,509 -3,462 

(b) Standard deduction -4,146 -4,481 -4,506 -4,731 -4,968 

(c) Earned income credit —695 —1,350 

Sec. 402— Refunds of earned income credit disregarded in the 

administration of Federal programs and federally assisted 

programs 

Total... -14,350 -9,293 -4,506 -4,731 -4,968 

TITLE VIII 

Capital Formation 

Sec. 801 — Extension of $100,000 limitation on used property for 

the investment credit -38 -142 -149 -156 -118 

Sec. 802-Extension of 10-percent investment credit -1,262 -3,164 -3,311 -3,461 -2,126 

Total _. -1,300 -3,306 -3,460 -3,617 -2,244 

TITLE IX 

Small Business Provisions 

Sec. 901— Extension of certain corporate income tax rate 
reductions —1,676 —1, 177 



Totalfor Part III, Extension of Tax Reductions -17,326 -13,776 -7,966 -8,348 -7,212 



Grandtotal, Partsl.ll.and III -15,733 -12,785 -6,849 -7,364 -6,191 

' This table has omitted Title I— Short Title and Title X IX— Repeal and Revision of Obsolete, Rarely Used, Etc., Provisions. 

2 Less than $5,000,000. 

3 The revenue impact of this provision will not be very great; its magnitude, however, is not determinable because of 
lack of information regarding the practices of the State legislators during the period covered by the provision. 

* Reflects liability of prior years. 

^ It is estimated that this provision will decrease budget receipts by $65,000,000 in the aggregate over the next 5 fiscal 
years. 

6 There is also an estimated $2,000,000 decrease in budget receipts for fiscal year 1976 under this provision. 

'The long-run estimates are as follows: unified rates and credit, —$1.23 billion; marital deduction, —$153 million; 
valuation, —$14 million; extension of time, less than $500,000; unification, $300 million; generation skipping, $280 million; 
carryover of basis, $1.08 billion; and total, $263 million. 



234-120 O - 77 - 3 



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III. GENERAL EXPLANATION OF THE ACT 

A. TAX SHELTER PROVISIONS 

1. Real Estate 

a. Capitalization and Amortization of Real Property Con- 
struction Period Interest and Taxes (sec. 201 of the Act and 
sec. 189 of the Code) 

Prior law 
Prior to the Act, amounts paid for interest and taxes attributable 
to the construction of real property were allowable as current deduc- 
tions except to the extent the taxpayer elected to capitalize these 
items as carrying charges (sec, 266).^ If an election was made to 
capitalize these items, the amount capitalized was deductible over the 
useful life of the building. The deduction for taxes (sec. 164) includes 
sales and real estate taxes paid or accrued on real or personal property 
during the construction period. The deduction for interest during the 
construction period includes amounts designated as "'points" or loan 
processing fees so long as these fees were paid by the borrower prior 
to the receipt of the loan funds and were not paid for specific services.^ 
(Generally, construction period interest is not treated as investment 
interest for purposes of the limitation on investment interest (sec. 
163(d) ).3 

Reasons for change 
Prior to the Act, the tax provisions relating to real estate construc- 
tion were used by taxpayers in high marginal income tax brackets to 
avoid payment of income tax on substantial portions of their economic 
income. This was principally achieved by allowing current deductions 
for costs which many believe are attributable to later years. For ex- 
ample, during the construction period the interest paid on the con- 
struction loan and the real estate taxes were immediately deducted 
even though there was no income from the property. These deductions 
resulted in losses which were used by taxpayers to offset income from 
other sources, such as salary and dividends. In effect, a taxpayer was 
allowed to defer or postpone the payment of tax on current income, 
either by offsetting current income with loss deductions attributable 
to real estate or by receiving a tax-free cash flow from the real estate 



1 Interest paid or accrued during the construction period was deductible under the 
provisions dealing with the deductibility of interest in general (sec. 163). 

2 See Rev. Rul. 68-643 (C.B. 1968-2, 76), Rev. Rul. 69-188 (C.B. 1969-1, 54) and 
Rev. Rul. 69-582 (C.B. 1969-2, 29). 

3 Construction period Interest also was not treated as a tax p °ference for purposes of 
the minimum tax in computing the preference for excess invest, lent interest which was 
subject to the minimum tax until 1972 when the excess investment interest limitation 
provision became applicable. 

(25) 



26 

project, or both. This deferral was the equivalent of an interest-free 
loan from the government, the economic benefits of which could be 
very significant. 

The allowance of a deduction for construction period interest and 
taxes is contrary to tlie fundamental accounting principle of matching 
income and expenses. Generally, a current expense is deductible in full 
in the taxable year paid or incurred because it is necessary to produce 
income and is usually consumed in the process. However, some expendi- 
tures are made prior to the receipt of income attributable to the ex- 
penditures and, under the matching concept, these expenditures should 
be treated as a future expense when the income "resulting" from the 
expenditure is received and the original investment is gradually 
consumed. 

In the case of an individual who constructs a building and subse- 
quently receives income in the form of rents from that building, the 
accounting concept of matching income against expenses should re- 
quire that the expenses incurred during the construction period be 
deducted against the rental income which is received over the life of 
the building, to the extent the expenses are attributable to a depreci- 
able or wasting asset. The genei-al construction costs of the building 
are trejited this way, being capitalized and subsequently deducted as 
depreciation expenses. (Similarly, certain pre-opening or start-up 
expenses for a new trade or business are required to be capitalized for 
tax accounting purposes.) The interest and taxes paid during the con- 
struction period, however, were not capitalized under prior law except 
to the extent that the taxpayer elected to treat these items as carrying 
charges chargeable to capital account. 

The allowance of a deduction for construction period interest and 
taxes contributed to the development of tax shelters in the real estate 
industry. Real estate ventures which were formed primarily to obtain 
tax shelter benefits essentially represent a misuse of intended tax in- 
centives of longstanding and major importance. In addition, many 
feel that tax shelters may cause serious distortions in real estate values 
and construction costs, resulting in investments being made in projects 
that are economically unsound, and interfering with the efficient allo- 
cation of the nation's resources. Although it has been argued that the 
provisions of prior law providing incentives are essential to attract 
investment in an industry already suffering from a shortage of capital. 
the Congress concluded that allowing the full, immediate writeoff of 
construction period interest and taxes in these cases was not compatible 
with the objectives set out above. 

As a result of the concern over the tax sheltering in real estate, the 
Congress decided, after a transition period, to require the capitaliza- 
tion of construction period interest and taxes and provide for the 
amortization of these items over a 10-year period, which deals directly 
with tlie preference providing the shelter while retaining some of the 
tax incentives for real estate investment by providing a shorter 
amortization period (10-years) than the useful life of the building. 

Explanation of provision. 
lender the Act, in the case of a taxpayer other than a corporation 
which is not a subchapter S corporation or a personal holding com- 



27 

pany,* real property construction period interest and taxes are to be 
capitalized in the year in which they are paid or accrued and amortized 
over a 10-year period. A portion of the amount capitalized may be 
deducted for the taxable year in which paid or accrued. The balance 
must be amortized over the remaining years in the amortization period 
beginning with the year in which the property is ready to be placed 
in service or is ready to be held for sale. 

The prepaid interest rules provided under the Act are to be applied 
first to determine the period to which the interest relates. If under that 
provision, interest is treated as allocable to the constiniction period, 
the 10-vear amortization rule is then to apply to tliat portion of the 
interest (in effect, for the purposes of this provision the interest is 
treated as paid or incurred in the year to which it is allocated under 
the prepaid interest rules) .■' 

Construction period interest includes interest paid or a-ccrued on 
indebtedness incurred or continued to acquire, construct, or carry 
real property to the extent attributable to the construction period 
for such property. The construction period commences with the date 
on which the construction of a, building or other improvement begins 
and ends on the date that the building or improvement is ready to be 
placed in service or is ready to l)e held for sale. For this purpose, the 
construction period is not to be considered to have commenced solely 
because drilling is performed to determine soil conditions, architect's 
sket^'hes or plans are prepared, or a building permit is obtained. Gen- 
erally the construction period will be considered to have commenced 
when land preparations and improvements, such as clearing, grading, 
excavation, and filling, are undertaken. However, the construction 
period will not be considered to have commenced solely because clear- 
ing or grading work is undertaken, or drainage ditches are dug, if such 
work is undertaken primarily for the maintenance or preservation of 
raw land and existing structures and is not an integral part of a plan 
for the construction of new or substantially renovated buildings and 
improvements. In the case of the demolition of existing structures 
where the construction period has not otherwise commenced, the con- 
struction period is considered to commence when demolition begins if 
the demolition is undertaken to prepare the site for construction. The 
construction period will not be considered to commence solely because 
of the demolition of existing structures if the demolition is not under- 
taken as part of a plan for the construction of new or substantially 
renovated buildings or improvements.^ 

The provision is not to apply to any amount that is capitalized at 
the election of the taxpayer as a carrying charge (sec. 266). In addi- 
tion, the provision is not to apply to interest or taxes paid or accrued 

* Since, except for subchapter S corporations and personal holding companies, this 
provision does not limit the deductibility of amounts p'ald or incurred by corporations, the 
provision is not to apply to corporations (other than subchapter S corporations and per- 
sonal holding companies) which are partners in any partnership. 

s However, in anv case where construction period interest is also Investment interest, 
(i.e.. where the exception under sec. 163(d)(4)(D) for construction period interest does 
not apply), the construction period Interest rules are to be applied first. Amounts allow- 
able under the construction period rules for a taxable vear are thus not to be subject to the 
investment Interest provision until that year ; if disallowed for that year unde rthe invest- 
ment interest provision, these amounts can be deducted in succeeding years in accordance 
with the carryover rules of the investment interest provision. 

8 For purposes of this provision the growing of trees or other crops is not to be con- 
sidered an improvement in real property. 



28 

with respect to property that is not held (or will not be held) for busi- 
ness or investment purposes (e.g., the taxpayer's residence) . 

Separate transitional rules are provided for non- residential real 
estate, residential real estate, and government-subsidized housing. In 
the case of nonresidential real estate, this provision is to apply to 
property where the construction period begins after December 31, 1975, 
with respect to amounts paid or accrued in taxable years beginning 
after 1975. In the case of residential real estate (other than certain 
low-income housing), this provision is to apply to construction pe- 
riod interest and taxes paid or accrued in taxable years beginning 
after December 31, 1977, and, in the case of low-income housing, to con- 
struction period interest and taxes paid or accrued in taxable years 
beginning after December 31, 1981. For this purpose, low-income hous- 
ing means government housing entitled to the special rules relating to 
recapture of depreciation (under sec. 1250(a) (1) (B) ). 

In addition, the length of the amortization period is to be phased-in 
over a 7-year period. The amortization period is to be 4 years in the 
case of interest and taxes paid or accrued in the first year to which 
these rules apply. The amortization period increases by one year for 
each succeeding year after the initial effective date until the amortiza- 
tion period becomes 10 years (i.e., the 10-year period is fully phased-in 
for construction period interest and taxes paid or acciiied in taxable 
years beginning in 1982, in the case of non-residential real estate ; 1984, 
in the case of residential real estate ; and 1988, in the case of govern- 
ment subsidized low-income housing). As a special transition rule for 
1976 only, 50 percent of the amount paid or incurred may be deducted 
currently but, the remaining 50 percent is to be amortized over a 3-year 
period beginning in the year the property is ready to be placed in 
service or is ready to be held for sale. 

The application of the general transitional rules and the phase-in 
of the amortization period can be illustrated by the following exam- 
ple. Assume that $120,000 of interest and taxes are paid or accrued in 
1980 with respect to the construction of residential real estate (other 
than government subsidized low-income housing) and that the prop- 
erty is ready to be placed in service in 1982. For taxable year 1980, the 
$120,000 must be capitalized under this provision, but a deduction is 
to be allowed for $20,000 (i^ of the amount capitalized). The remain- 
ing $100,000 (i.e., % of the total) is to be deducted ratably over a 5- 
year period beginning in 1982 (the year in wliich the property is ready 
to be placed in service). Thus, $20,000 is to be allowed as a deduction 
for taxable year 1982 and in each of the next succeeding 4 years. 

In the case of a sale or exchange of real property, the unamortized 
balance of the construction period interest and taxes is to be added to 
the basis of the property for purposes of determining gain or loss on 
the sale or exchange. In the case of nontaxable transfer or exchange 
(i.e., a transfer to a partnership or controlled corporation, a like-kind 
exchange, or a gift), the transferor is to continue to deduct the un- 
amortized balance allowable over the amortization period remaining 
after the transfer. 

E-ffective date 
In the case of nonresidential real estate, this provision is to apply 
only to property where the construction period begins after Decern- 



29 

ber 31, 1975, and only with respect to amounts paid or accrued in tax- 
able years beginning after 1975. In the case of residential real estate 
(other than certain low-income housing) , this provision is to apply to 
construction period interest and taxes paid or accrued in taxable years 
beginning after December 31, 1977, and, in the case of low-income 
housing to construction period interest and taxes paid or accrued in 
taxable years beginning after December 31, 1981. In each of these cases, 
phase-in rules of the amortization period are provided, as indicated 
above. 

Revenue effect 
The revenue gain from this provision is estimated to be $102 million 
for fiscal year 1977 and $149 million for fiscal year 1981. 

h. Recapture of Depreciation on Real Property (sec. 202 of the 
Act and sec. 1250 of the Code) 

Prior laio 

Generally, net gains on the sale of real property used in a trade or 
business (with certain exceptions) are taxed as capital gains, and 
losses are generally treated as ordinary losses. However, gain on the 
sale of depreciable real property (buildings) is generally "recaptured" 
and taxed as ordinary income rather than capital gain to the extent 
that the gain represents accelerated depreciation allowed or allowable 
in excess of the amount computed under the straight-line method of 
depreciation. 

The provisions relating to depreciation recapture were first enacted 
in 1962 to prevent deductions for accelerated depreciation from con- 
verting ordinary income into capital gain. In general, the 1962 recap- 
ture provision (sec. 1245 of the code) provided that gain on a sale of 
most personal property would be taxed as ordinai-y incoine 
to the extent of all depreciation taken on the property after December 
31, 1962. In 1964, recapture rules were extended to real property 
(buildings) to provide, in general, that gain on a sale would be taxed 
as ordinary income to the extent of the depreciation (in most cases only 
the accelerated depreciation) taken on that property after Decem- 
ber 31, 1963. This provision (sec. 1250 of the code), however, had a 
gradual reduction of the amount to be recaptured. If the property 
had not been held for more than 12 months, all of the depreciation was 
recaptured. However, if the property had been held over 12 months, 
only the excess depreciation over straight-line was recaptured and the 
amoimt recaptured was reduced after an initial 20-month holding 
period at the rate of one percent per month. Thus, after 120 months 
(10 years) there was no recapture of any depreciation. 

In the Tax Reform Act of 1969, the recapture rules on real property 
were further modified as to post-1969 depreciation. In the case of 
residential real property and property with respect to which the rapid 
depreciation for rehabilitation expenditures has been allowed, post- 
1969 depreciation in excess of straight-line was fully recaptured at 
ordinary income rates (to the extent of gain) if the property has been 
held for more than 12 months ^ but less than 100 months (8 years and 4 

''There was no change In the rule providing for recapture of all depreciation (including 
straight-line) if the property Is not held for more than 12 months. 



30 

months). For each month the property was held over 100 months, 
there was a one percent reduction in the amount of post-1969 deprecia- 
tion that was recaptured. Thus, there was no recapture of any deprecia- 
tion if the property was held for 200 months (16 years and 8 months) . 

In the case of non-residential real property, all post-1969 deprecia- 
tion in excess of straight-line depreciation is recaptured (to the extent 
there is gain) regardless of the length of time the property is held. 

In addition, in the case of certain Federal, State, and locally assisted 
housing projects constructed, reconstructed, or acquired before Janu- 
ary 1, 1976, such as the FHA 221(d) (3) and the FHA 236 programs, 
the pre-1969 recapture rules on real property were retained.* How- 
ever, if the property was constructed, reconstructed, or acquired after 
December 31, 1975, the regular post-1969 rules previously discussed 
above with respect to residential property were to apply (i.e., a one 
percent reduction per month after 100 months) . 

Reasons for change 

Generally, deductions for accelerated depreciation exceed the actual 
decline in the usefulness of the property. Further, accelerated methods 
of depreciation make it possible for taxpayers to deduct amounts in 
excess of the those required to service the mortgage during the early 
life of the property. 

When the property is sold, the excess of the sales price over the 
adjusted basis was treated as capital gain to the extent that the 
recapture provisions did not apply. Under prior law, by holding 
residential rental property for 16% years before sale, the taxpayer 
could arrange to have all gain resulting from excess depreciation 
(which was previously offset against ordinary incx^me) taxed at the 
capital gain rates without any recapture.'' The tax advan- 
tages for converting ordinary income into capital gain increase as the 
taxpayer's marginal income tax rate increases. 

To reduce the opportunities to avoid income taxes as a result of 
allowing accelerated depreciation for real property to convert ordi- 
nary income into capital gain, the Congress decided that it is appro- 
priate to extend the application of the present recapture rules on 
residential real estate. Under the Act, when residential real estate is 
sold, any gain will be recognized as ordinary income to the extent of 
accelerated depreciation previously allowed or allowable. In the case 
of low-income housing, however, the Congress decided that it is not 
desirable to require full recapture. In this way, in incentive is pro- 
vided for owners of such housing to retain their ownership and opera- 
tion of the properties for longer periods of time. 

In addition, it came to the attention of the Congress that certain 
taxpayers have taken dilatory action to postpone foreclosure (or simi- 
lar proceedings) on real property for the principal purpose of reduc- 
ing the applicable percentage of accelerated depreciation that will be 
recaptured upon foreclosure (or similar proceeding). As a result of 

^ That is, with respect to these projects, accelerated depreciation will be fully recaptured 
at ordinar.v income rates onl.v if the property has been held for not more than 20 months. 
(If the property is sold within 12 months, all of the depreciation is recaptured.) For each 
month the property is held over 20 months, there is a 1 percent per month reduction in 
the amount of accelerated depreciation recaptured. Thus, there will be no recapture if the 
property is held for a period of 120 months (10 years). 

8 In the ci\T.Q of certain Federal. State, and locally assisted housing projects constructed, 
■ reconstructed, or acquired before January 1, 1976, there will be no recapture if the prop- 
erty is held for 10 years before sale. 



31 

this, the Congress decided to make the recapture rules apply in the 
case of real property from the date foreclosure proceedings are com- 
menced. 

Explanation of provisimi 

In the case of residential real estate (other than certain low-income 
rental housing), the Act provides for the complete recapture of all 
post-1975 depreciation in excess of straight-line depreciation. (This 
rule already applies in the case of nonresidential, i.e., commercial prop- 
erty.) As under prior law, all of the depreciation taken, including 
straight-line depreciation, is recaptured as ordinary income if the 
property is not held for more than 12 months. Under the Act, all ac- 
celerated depreciation (depreciation in excess of straight-line) at- 
tributable to periods after December 31, 1975, will be fully recaptured 
to the extent of any depreciation in excess of straight -line regardless 
of the date the property was constructed. Special rules are provided 
in the case where a portion of the gain from the sale or exchange of 
property is subject to recapture under both the former recapture rules 
and the new recapture rules. Under these special rules, first, accelerated 
special rules, first, accelerated depreciation attributable to periods 
after December 31, 1975, will be recaptured (to the extent of any 
gain) ; second, accelerated depreciation attributable to periods after 
December 31, 1969, and before January 1, 1976, will be recaptured 
(to the extent of any additional gain not recaptured under the new 
rules) ; and third, accelerated depreciation attributable to periods 
after December 31, 1963, and before January 1, 1970 (to the extent of 
any remaining gain not recaptured). 

The new rules providing for complete recapture of accelerated 
depreciation do not apply to 4 categories of low-income rental hous- 
ing: (1) Federally assisted housing projects with respect to which a 
mortgage is insured under section 221(d) (3) or 236 of the National 
Housing Act (or housing financed or assisted by direct loan or tax 
abatement under similar provisions of State or local laws) ; (2) low- 
income rental housing held for occupancy by families or individuals 
eligible to receive subsidies under section 8 of the United States Hous- 
ing Act of 1937, as amended, or under the provisions of State or local 
law authorizing similar levels of subsidy for lower income families ; 
(3) low-income rental housing with respect to which a depreciation 
deduction for rehabilitation expenditures was allowed imde'r section 
167 (k) ; and (4) Federally assisted housing with respect to which a 
loan is made or insured under title V of the Housing Act of 1949. 
As to these 4 categories of real property, all depreciation will be 
recaptured if the property has not been held for more than 12 months. 
However, if the property has been held for more than 12 months, no 
more than the excess depreciation over straight-time will be recap- 
tured. For each month the property is held over 100 months, there will 
be a one percent per month reduction in the amount of accelerated 
depreciation attributable to periods after December 31, 1975. which is 
recaptured. Thus, after 200 months (16% years) there will be no re- 
capture. 

Special rules similar to those discussed above are provided for 
Federally assist^ housing projects with respect to whicih a mortgage 
is insured under section 221 (d) (3) or 236 of the National Housing Act 



32 

(or housing financed or assisted by direct loan or tax abatement un- 
der sdmilar provisions of State or local laws) where a portion of the 
gain from the sale or exchange of such proj^erty is subject to recapture 
under both the prior recapture rules and the new recapture rules. 

In addition, the Act provides that where real property is disposed of 
by reason of foreclosure or similar proceedings, the monthly pei"cent- 
age reduction of the amount of accelerated depreciation subject to 
recapture are to terminate as of the date on which such proceedings 
were begun. The application of this provision can be illustrated by the 
following example: 

Example. — Assume that on June 1, 1976, the taxpayer acquired cer- 
tain low-incx)me rental property which qualified for the special recap- 
ture treatment discussed above (i.e., a one percent per month reduction 
after 100 months). On April 1, 1987 (130 months after the property 
was placed in service) foreclosure proceedings were instituted with 
respect to the property and on December 1, 1988 (150 months after 
the property was placed in service) the property was disposed of pur- 
suant to the foreclosure proceedings. The applicable percentage reduc- 
tion will be 30 percent rather than 50 percent since the percentage 
reduction would cease to apply on April 1, 1987 (the date that fore- 
closure proceedings were instituted). 

Effective date 
The provisions relating to the complete i"ecapture of depreciation 
apply to accelerated depreciation attributable to taxable years begin- 
ning after December 31, 1975. The provisions relating to the percent- 
age reduction in the case of dispositions pursuant to foreclosure or 
similar proceedings shall apply with respect to proceedings which 
begin after December 31, 1975. 

Revenue effect 
It is estimated that this provision will result in an increase in budget 
receipts of $9 million for fiscal year 1977, and $56 million for 1981. 

c. Five-Year Amortization for Low-Income Rental Housing (sec. 
203 of the Act and sec, 167 of the Code) 

Prior lm(y 

Under the code, special depreciation rules are provided for ex- 
penditures to rehabilitate low income rental housing (sec. 167 (k) of 
the code). Low-income rental housing includes buildings or other 
structiires that are used to provide living accommodations for families 
and individuals of low or moderate income. Under current Treasury 
regulations occupants of a dwelling unit are considered families and 
individuals of low or moderate income only if their adjusted income 
does not exceed 90 percent of the income limits described by the Secre- 
tary of Housing and Urban Development (HUD) for occupants of 
projects financed with certain mortgages insured by the Federal Gov- 
ernment. The level of eligible income varies according to geographical 
area.^" 

Under the special depreciation rules for low income rental property, 
taxpayers can elect to compute depreciation on certain rehabilitation 

!« Tlie current Income limits prescribed by the Secretary of HUD for a family of four 
are $15,400 In WashlnRton, D.C., $13,700 In Chicago, and $11,900 In Los Angeles. Thus, 
00 percent of these limits are $13,800, $12,330, and $10,710 respectively. 



33 

expenditures under a straight-line method over a period of 60 months 
if the additions or improvements have a useful life of 5 years or more. 
Under prior law, only the aggregate rehabilitation expenditures as to 
any housing which do not exceed $15,000 per dwelling unit qualified 
for the 60-month depreciation. In addition, for the 60-month deprecia- 
tion to be available, the sum of the rehabilitation expenditures for two 
consecutive taxable years — including the taxable year — ^must erceed 
$3,000 per dwelling unit. 

Reasons for change 
In the Housing and Community Development Act of 1974, the Con- 
gress expressed its desire to stimulate construction in low-income 
rental housing to eliminate the shortage in the area. However, the 
special tax incentive for rehabilitation expenditures for low-income 
rental housing under present law expired on December 31, 1975. With- 
out this incentive the remodeling of many high-risk low-income proj- 
ects would have been curtailed. In order to avoid discouraging this 
rehabilitation, the Congress believed that the special depreciation pro- 
vision for low-income housing should be extended. 

Explanation of provision 

The Act provides a two-year extension of the special 5 -year deprecia- 
tion rule for expenditures to rehabilitate low-income rental housing 
and increases the amount of rehabilitation expenditures that can be 
taken into account per dwelling unit from $15,000 to $20,000. 

Under the Act, rehabilitation expenditures that are made pursuant 
to a binding contract entered into before January 1, 1978, would qual- 
ify for the 5-year depreciation rule even though the expenditures are 
actually made after December 31, 1977. 

In addition, the Act modifies the definition of families and individ- 
uals of low and moderate income by providing that the eligible income 
limits are to be determined in a manner consistent with those pres- 
ently established for the Leased Housing Program under Section 8 
of tiie United States Housing Act of 1937, as amended. 

Effective date 
The provisions relating to the 2-year extension apply to expenditures 
paid or incurred with respect to low-income rental housing after 
December 31, 1975, and before January 1, 1978 (including expenditures 
made pursuant to a binding contract entered into before January 1, 
1978). The provisions increasing the amount of expenditures that can 
be depreciated under the special 5-year rule apply to expenditures 
incurred after December 31, 1975. 

Revenue effect 
It is estimated that the provision will result in a decrease in budget 
receipts of $1 million for fiscal year 1977, and $7 million for 1981. 

2. Limitation cf Loss to Amount At-Risk (sec. 204 of the Act and 
sec. 465 of the Code) 

Prior laio 
Generally, the amount of depreciation or other deductions which 
a taxpayer has been permitted to take in connection with a property 
has been limited to the amount of his basis in the property. Similar 



34 

statutory limitation rules are found in sections 704(d) and 1374(c) (2) 
for owners of partnership interests and shareholders in subchapter S 
corporations where the partners and shareholders, rather than the 
entity, are taxed on the income or loss of the entity. 

The starting point for determining a taxpayer's adjusted basis in 
a productive activity or enterprise is generally the taxpayer's cost 
for the assets used in the activity or enterprise (sees. 1011, 1012). In 
the case of a productive activity engaged in through a partnership or 
subchapter S corporation, the investor's adjusted basis in his stock or 
partnership interest is generally based on the amount of money and 
his adjusted basis in other property contributed to the enterprise (sees. 
722, 358). The investor's basis in a partnership interest or subchapter 
S corporation stock is increased by his portion of the income of these 
entities, and decreased by his portion of their losses, in recognition of 
the fact that the income and losses are flowed through to the investor 
for tax purposes, rather than being taxed to the entity. 

The liabilities of a productive activity may also have an effect upon 
an investor's adjusted basis in the activity. Thus, a taxpayer's basis in 
a property includes the portion of the purchase price which is financed 
even if the taxpayer is not personally liable on the loan and the lender 
must look solely to the financed property for repayment of the loan. 

However, in the case of a subchapter S corporation, liabilities of 
the corporation increase a shareholder's adjusted basis in the stock 
only to the extent that the liability is owed to that particular share- 
holder (sees. 1374(c)(2), 1376). 

In the case of partnerships, in general, a partner's share of the lia- 
bilities of the partnership is considered to be a contribution of money 
by him to the partnership (sec. 752). Since a partner's contributions 
to the partnership increase the adjusted basis of his partnership inter- 
est (sec. 705), the partner's adjusted basis reflects not only his contri- 
butions in money and other property, but also his share of partnership 
liabilities. This rule applies regardless of whether the particular lia- 
bility is owed to one or more of the partners or to an unrelated party. 

The rule is premised upon the assumption that the partner may be 
held pei-sonally liable for the debts of the partnership and since he 
may be called on to, in effect, make additional contributions of money 
to cover these liabilities, the adjusted basis of his partnership interest 
should reflect this potential risk of additional liability. 

However, a limifed partner in a limited partnership may not be 
held responsible for partnership debts, and his potential personal 
liability is confined to any additional amount he is required to con- 
tribute to the partnership by the partnership agreement. Since a 
limited partner does not have unlimited personal liability, the basis 
of his partnership interest is not usually increased to reflect borrow- 
ing by the partnership. There has been, however, an exception to this 
rule. The regulations provide that where none of the partners have 
personal liability for a partnership obligation, all of the partners, 
including limited partners share in the liability (Reg. § 1.752-1 (e)). 
Since a limited partner is deemed to have a share of such nonrecourse 
liabilities, the adjusted basis of his partnership interest is increased 
under the generally applicable partnership provisions. 

This approach to nonrecourse partnersnip liabilities ai-ose from a 
judicially developed principle known as the Crane rule. The Crane 



35 

rule was derived from the Supreme Court's reasoning in Crane v. Com- 
missioner^ 331 U.S. 1 (1947), where it was held that an owner's ad- 
justed basis in a parcel of real property included the amount of a non- 
recourse mortgage on the property, under which the mortgagee-lender 
could seek a recovery of its loan oiily from the property. (It is because 
of the Crane rule that nonrecourse indebtedness has generally been in- 
cluded in an investor's adjusted basis, as indicated above, in a business 
or productive property.) 

Also, in general, the existence of protection against ultimate loss by 
reason of a stop-loss order, guarantee, guaranteed repurchase agree- 
ment or similar arrangement does not generally impose a limitation 
on the amount of losses a taxpayer may deduct in the early taxable 
years of an activity. 

Reasons for change 

The typical tax shelter has operated as a limited partnership with 
individual investors participating as limited partners. Virtually all of 
the equity capital for the activity has been contributed by the limited 
partners with the major portion of the remaining operating funds 
(generally 75 percent or more of the total capital) for the partner- 
ship financed through nonrecourse loans. 

When an investment had been solicited for a tax shelter activity, it 
had been common practice to promise the prospective investor sub- 
stantial tax losses which could be used to decrease the tax on his in- 
come from other sources. The opportunity to deduct tax losses in ex- 
cess of the amount of the taxpayer's economic risk had arisen under 
prior law primarily through the use of nonrecourse financing not only 
by limited partnerships, but also by individuals and subchapter S cor- 
porations. The ability to deduct tax losses in excess of economic risk 
had also arisen through guarantees, stop-loss agreements, guaranteed 
repurchase agreements, and other devices used by the partnerships, in- 
dividuals and subchapter S corporations. 

Nonrecourse leveraging of investments and other risk limiting de- 
vices which produce tax savings in excess of amounts placed at risk 
substantially alter the economic substance of the investments and 
distort the workings of the investment markets. Taxpayers, ignoring 
the possible tax consequences in later years, can be led into investments 
which are otherwise economically unsound and which constitute an 
unproducti ve use of investment funds. 

Congress believed that it was not equitable to allow individual in- 
vestors to defer tax on income from other sources through losses gen- 
erated by tax sheltering activities. One of the most significant prob- 
lems in tax shelters was the use of nonrecourse financing and other 
risk-limiting devices which enabled investors in these activities to 
deduct losses from the activities in amounts which exceeded the total 
investment the investor actually placed at risk in the activity. The 
Act consequently provides an "^at risk" rule to deal directly with this 
abuse in tax shelters. 

Explanation of provision 
To prevent a situation where the taxpayer may deduct a loss in ex- 
cess of his economic investment in certain types of tax shelter activi- 
ties, the Act provides that the amount of any loss (otherwise allow- 
able for the year) which may be deducted in connection with one of 



36 

these activities cannot exceed the a^^re^ate amount with respect to 
which the taxpayer is at risk in eacli such activity at the close of the 
taxable year. This "at risk" limitation applies to the follovvino^ activi- 
ties: (1) farming^; (2) exploring for, or exploiting, oil and gas re- 
sources; (3) the holding, producing, or distributing of motion picture 
films or video tapes; and (4) equipment leasing. The limitation ap- 
plies to all taxpayers (other than corporations which are not sub- 
chapter S corporations or personal holding companies) including 
individuals and sole proprietorships, estates, trusts, shareholders in 
subchapter S corporations, and partners in a pai-tnei-ship which con- 
ducts an activity described in this provision.^ 

The at risk limitation is to apply on the basis of the facts existing at 
the end of eacli taxable year. The at risk limitation applies regard- 
less of the method of accounting used by the taxpayer and regardless 
of the kind of deductible expenses which contributed to the loss. 

The amount of any loss which is allowable in a particular year re- 
duces the taxpayer's at risk amount as of the end of that year and in 
all succeeding taxable yeai-s with respect to that activity.'' 

Tosses which are suspended under this provision with respect to a 
taxpayer because they are greater than the taxpayer's investment 
which is "at risk"" are to be treated as a deduction with respect to the 
activity in the following year. Consequently, if a taxpayer's amount 
at risk increases in later years, he will be able to obtain the benefit of 
previously suspended losses to the extent that such increases in his 
amount at risk exceed his losses in later yeare. 

The at risk limitation is only intended to limit the extent to which 
certain losses in connection with the covered activities may be deducted 
in the year they would otherwise be allowable to the taxpayer. The 
rules of this provision do not apply for other purposes, such as the 
determination of basis. Thus, a partner's basis in his interest in the 
partnership will generally be unaffected by this provision of the com- 
mittee amendment.* However, for ]iurposes of determining how much, 
if any, of his share of a partnei-ship loss from the enumerated activi- 
ties a partner may deduct in any year, this provision of the Act over- 
rides the existing partnership rules of section 704(d) and related 
provisions, iiicludino; regulations section 1.752-1 (e).^ 

For purposes of this provision, a taxpayer is generally to be con- 

1 For purposes of this section, the definition of "farming" Is the definition used In the 
farming syndicate rules (discussed below). Thus, the at risk provision does not apply to 
forestry or the growing of timber. 

- Since, except for subchapter S corporations and personal holding companies, this 
provision does not limit the deductibility of amounts paid or incurred by corporations, 
the provision would not apply to a partnership in which all the partners are corporations 
(other than subchapter S corporations or personal holding companies). Similarly. If a 
partnership is comprised of both individiml partners and corporate partners (other than 
subchapter S corporations and personal holding companies), the at risk provision ap- 
plies to the individual partners but not the corporate partners. 

' The at ri.^k limitation does not affect a taxpayer's utilization of the Investment credit. 
.\lso. the amount of investment tax credit claimed by a taxpayer with respect to an 
activity does not reduce the amount the taxpayer is at risk with respect to the activity. 

* For example, the basis of a partner's interest in a partnership Is rpduce<l by the full 
amount of any losses which would be allowable but for this provision. However, upon 
disposition of his interest in a partnership, a partner is to be treated as becoming at risk 
with respect to the amount of any gain from the disposition. As a result, a partner will 
be able to deduct nny suspended losses at the time of disposition. 

" If no partner is personally liable to repay any part of a debt obligation Incurred bv 
the partnership, no partner may treat such part of the debt as part of his capital at risk 
in the partnership for purposes of this provision. Similarly, even if one or more partners 
is personally liable on part or all of a partnership debt, other partners who have no 
personal liability may not treat any part of the debt as part of their risk capital. In 
the case of a partnership, special allocations of deductions by agreement among the 
partners may not increase the amount of a loss deduction allowable to any partner for a 
taxable year beyond the amount which that iiartner is "at risk" in the partnership for the 
same vear. 



37 

sidered "at risk" with respect to an activity to the extent of his cash 
and the adjusted basis of other property contributed to the activity, 
as well as any amounts borrowed for use in the activity with respect 
to which the taxpayer has pereonal liability for payment from his per- 
sonal assets. 

A taxpayer's at risk amount is also generally to include amounts 
borrowed for use in the activity which are secured by property other 
than property used in the activity. For example, if the taxpayer act- 
ing as a sole proprietor (or partner or shareholder in a subchapter S 
corporation) uses personally-owned real estate to secure nonrecourse 
indebtedness, the proceeds from which are used in an equipment leas- 
ing activity, the proceeds may be considered part of the taxpayer's 
at risk amount. In such a case, the portion of the proceeds which in- 
creases the taxpayer's at risk amount is to be limited by the fair market 
value of the property used as collateral (determined as of the date the 
property is pledged as security), less any prior (or superior) claims to 
which the collateral is subject. 

The Act contains a special rule which prevents a taxpayer from in- 
creasing his at risk amoimt through collateral in cases where the col- 
lateral was financed directly or indirectly by indebtedness which is 
secured by any property used in the activity. The intent of this rule 
is to prevent a taxpayer from increasing his at risk amount by cross- 
collateral izing property used in the activity with other property not 
used in the activity. 

Except where the indebtedness is secured by property not used in 
the activity, a taxpayer is not to be considered at risk with respect to 
the proceeds from his share of any nonrecourse loan used to finance the 
activity or the acquisition of property used in the activity. In addi- 
tion, if the taxpayer borrows money to contribute to the activity and 
the lender's only recourse is either the taxpayer's interest in the activ- 
ity or property used in the activity, the amount of the proceeds of the 
borrowing are to be considered amovmts financed on a nonrecourse 
basis and do not increase the taxpayer's amount at risk. 

Also, under these rules, a taxpaj^er is not to be "at risk," even as 
to the equity capital which he has contributed to the activity, to the 
extent he is protected against economic loss of all or part of such capi- 
tal by reason of an agreement or arrangement for compensation or 
reimbursement to him of any loss which he may suffer." Under this 
concept, a taxpayer is not "at risk" if he arranges to receive insurance 
or other compensation for an economic loss after the loss is sustained, 
or if he is entitled to reimbursement for part, or all of any loss by 
reason of a binding agreement between himself and another person.^ 



8 The normal buy-sell afrreement between partners which is carried out when a partner 
retires or dies is not the kind of agreement which prevents a partner from being at risk. 

■' In livestock feeding operations, for example, some commercial feedlots have offered to 
reimburse Investors against any loss sustained on sales of the fed livestock above a stated 
dollar amount per bead. Under such "stop loss" orders, the investor is to be considered 
"at risk" (for nurposes of this nrovision) only to the extent of the portion of his capital 
agfainst which he Is not entitled to reimbursement. Similarly, in some livestock breeding 
Investments carrie'l on through a limited partnership, the partnership agrees with n 
limited partner that, at the partner's election, it will repurchase liis partnership Interest 
at a stated minimum dollar amount (usually less than the Investor's original capital 
contribution). In situations of this kind, the partner is to he considered "at risk" only to 
the extent of the portion of the amount otherwise at risk over and above the guaranteed 
repurchase price. 

In addition a limited partner who assumes personal liability on a loan to tht^ partnership 
(made by a bank or other lender) but who obtains the general partner's ugreement to 
Indemnify him against some or all of any loss arising under such personal liability, is at 
risk only with respect to the excess of the amount of the Indebtedness over the maximum 
amount covered by the indemnity agreement. 

234-120 O - 77 - 4 



38 

Similarly, if a taxpayer is personally liable on a mortgage but sepa- 
rately obtains insurance to compensate him for any payments which 
he nnist actually make under such pei"Sonal liability, the taxpayer is 
at risk only to the extent of the uninsured portion of the personal lia- 
bility to Avhicli he is exposed.* The taxpayer will be able to include in 
the amount which he has at risk any amount of nondeductible pre- 
mium which he has paid from his pei-sonal assets with respect to the 
insurance. However, a taxpayer who obtains casualty insurance or 
insurance protecting himself against tort liability will not be con- 
sidered "not at risk"' solely because of such hazard insurance protection. 

In the ca,s(^ of a pai"tnershii), a }>aitiier is generally to be treated as 
at I'isk to the extent that his basis in the partnership is increased by 
his share of partnership income.'' The fact that partnership income is 
then used to reduce the partnership's nonrecourse indebtedness would 
have no etl'ect on the partner's amount at risk. (The reduction of non- 
recoui-se indebtedness would still, of course, reduce his basis in his 
partnership interest for purposes other than the at risk limitation.)^" 
If the j)artnership, instead of retaining the income, makes actual dis- 
tributions of the income to a partner in the taxable year, the amount 
distributed, like any cash distribution, reduces the partner's amount at 
risk. 

In general, in the case of an activity engaged in by an individual, 
each motion picture film or video tape, item of leased equipment, fai-m, 
or oil and gas property is treated as a separate activity. However, in 
the case of a partnership, personal holding company, or subchapter S 
corporation, all of the activities of the same type (e.g., all motion 
picture films and video tapes) are to be treated as one activity." Thus, 
where the partnership is engaged in oidy one type of activity the loss 
from the activity for any partner is that partner's loss from the part- 
nership and (assuming no stop loss orders, etc.) his at risk amount is 
generally the amount of his cash or other contribution to the partner- 
ship, plus his share of any indebtedness with respect to which the 
partner has no limitation on liability. 

The at risk limitation applies only to losses produced by deduc- 
tions which are not disallowed by reason of some other provision 
of the Code. For example, if a prepaid interest expense is suspended 
under the prei)aid interest limitation (sec. 208 of the Act and sec. 
461 of the Code) that expense will not enter into the computation 

? For purposes of this rule, it will be nssnnied that ft loss-protection guarantee, repurchase 
acroonieiit or insurance policy will be fully honored and that the amounts due thereunder 
will be fully paid to the taxpayer. The possibility that the party making the guarantee 
to the taxpayer, or that a partnersliip whidi agrees to repurchase a partner's Interest at an 
agn'od price, will fail to carry out the agreement (because of factors sucli as Insolvency or 
other financial difficulty) is not to be material unless and until the time when the taxpayer 
becomes unconditionally entitled to payment and. at that time, demonstrates that he 
cannot recover under the agreement. 

" However, bis at rislv amount must be reduced by any personal nonrecourse indebtedness 
reflected in his basis and any other appropriate stop-loss orders, etc., which affect his 
ri'slc or that of his partnership. 

'"For example, assume partner A's basis in the partnership is .$60X (consisting of $10X 
whidi is "at risk" aTid .f.'iflX wldch represents tlie portion of the partnersliip's nonrecourse 
loan \v.hlch is allocated to partner A's basis). If the partnership has S.'SX of taxable income 
for the taxable year which is allocated to partner A. his total basis is increased to .^fi.'iX (his 
at Tisl< l)asis increases to .$ir)X while his l>asis which is not at rislc remains at .f.'iOX). 
If the partnership then makes a .f.^X payment to the bank on its loan, the partner's basis 
is reduced to .fSfiOX (bis at risk basis remains at .fl.'iX while his basis which is not at risk !s 
reduced to .'?45X). 

" Partnersliips engaged in two or more different types of activities, such as movies and 
equipment leasing, or movies and farming are to be treated as liaving that number of 
activities, and the at risk limitation is determined separately for each activity. 



39 

of the loss subject to the at-risk limitation. When the interest ac- 
crues and becomes deductible, the expense may at that time be subject 
to this provision. Similarly, if a deduction is deferred pursuant to 
the farming syndicate rules (described below), that deduction will 
enter into the computation of the tax loss subject to the at risk limita- 
tion only when it becomes deductible under the farminjr syndicate 
rules. 

The Act specifically requires that a taxpayer not be considered at 
risk with respect to amounts borrowed for use in an activity (or 
which are contributed to the activity)^'- where the amounts are bor- 
rowed from any pei-son who lias an interest in the activity (other 
than that as a creditor) or who is related to the taxpayer (as de- 
scribed in sec. 267(b)). Persons having an interest in the activity 
include, in the case of a partnership, all other partners and any other 
person (such as a promoter or selling agent) who stands to receive 
financial gain from the activity or from the sale of interests in the 
activity. Those persons considered to be related to the taxpayer 
include the taxpayer's spouse, ancestors and lineal descendants, broth- 
ers and sisters, and corporations and other entities in which the tax- 
payer has a nO-percent or greater interest.^^ 

E-ffective dates 

In general, the at risk provision applies to losses attributable to 
amounts paid or incurred (and depreciation or amortization allowed 
or allowable) in taxable years beginning after December 31, 1975. 
However, with respect to equipment leasing activities, the at risk rule 
generally does not apply where the i)roperty was subject to a net op- 
erating lease and binding contracts weiv finalized on or l)efore 
December 31, 1975, and similarly to operating lease transju'tions under 
binding contracts finalized on or before A])i-il 80, 1976. 

With respect to motion i)icture activities, the at risk provision does 
not apply to a film purchase shelter if the principal photography began 
before September 11, 1975, there was a binding written contract for the 
purchase of the film on that date, and the taxpayer held his interest in 
the film on that date. The at risk rule also does not apply to production 
costs, etc., if the principal photography began bixfore September 11, 
1975, and the investor had acquired his inter-est in the film l.»efore that 
date. In addition, the at risk provision does not apply to film ])roduced 
in the United States if the principal photogr-aphy began l)efore Jan- 
uary 1, 1976, if certain commitments with respect to the film had been 
made by September 10, 1975. 

In applying the at risk provisions to activities which were begim in 
taxable years beginning before January 1, 1976 (and not exempted 
from this pr-ovision by the above transition rules), amounts paid or in- 
curi-ed in taxable years beginning prior to that date and deducted in 
such taxable years will generally be treated as reducing first that por- 



12 Til p (imoiints borrowed by tlie taxpayer and then contributed to the activity (or used 
to purfhnsc property which is contributed to the activity) are "amounts borrowed with 
respect to" the activity (as referred to in section 465(b) (l)fB)) and therefore are sub- 
ject fo the rules of section 465(b)(3) ei^en though such amounts (or property) are also 
described In section 465 (b) (1) (A). 

" While this rule applies to loans from a partner to the partnership for purposes of 
determining the at rlsic amount of the iitlier partners (resulting from the increase in 
partnership liabilities), it is not to affect any possible allocation of basis and at risk amounts 
which otherwise might be made to a specific partner in cases where that partner has 
borrowed funds from the partnershp (or is otherwise obligated to the partnership). 



40 

tion of the taxpayer's basis which is attributable to amounts not at 
risk. (On the other hand, withdrawals made in taxable years begin- 
ning before Januaiy 1, 1976, will be treated as reducing the amount 
which the taxpayer is at risk.) ^* 

Reverviie effect 
The provision will increase budget receipts by $57 million in fiscal 
year 1977, $42 million in fiscal year 1978, and $38 million in fiscal 
year 1981. 

3. Farm Operations 

a. Farming Syndicates (sec. 207 (a) and (b) of the Act and sees. 278 
and 464 of the Code) 

Prior law 

Under the tax laws, farm operations are governed by special tax 
rules, many of which confer tax benefits on fai'ming activities and on 
persons who engage in farming. The special tax rules available to 
farmers have been utilized by both full-time farmers and by high- 
bracket taxpayers who participated in farming as a sideline. Part-time 
farmers have been entitled to use the special farm rules even if they 
were absentee owners who paid agents to operate their farming activi- 
ties and regarded their own participation (such as being limited 
partners in a nationwide syndicate) as a completely passive investment. 

Taxpayers engaged in farming have been allowed to report their 
income and expenses from farm operations on the cash method of 
accounting, which does not require the accumulation of inventory costs. 
Fanners have also been allowed to deduct the cost of seed and young 
plants purchased in one year which would be sold as farm products in 
a later year.^ These rules contrast with the tax rules applicable to non- 
farm taxpayers engaged in the business of selling products, who must 
report their income using the accrual method of accounting and must 
accumulate their production costs in inventory until the product is sold. 

The special inventory exception for farmers was adopted by admin- 
istrative regulation more than fiftv years ago. The primary justifica- 
tion for this exception was the relative simplicity of the cash method of 
accounting which, for example, eliminates the need to identify specific 
costs incurred in raising particular animals. 

The Treasury has also long permitted farmers to deduct currently 
many of the costs of raising or growing farm assets (such as costs 
related to breeding animals, orchards and vineyards) wliich are used in 
the trade or business of farming.- (In similar nonf arming businesses, 
such as manufacturing, these costs generally are treated as capital 
expenditures and are depreciated over their useful lives.) These assets 



"Increases in basis occurinij after December 31, 1975. as a result of income from the 
discharge of indebtedness attributable to property used in an activity with respect to which 
substantial deductions were taken in taxable years beginning before January 1, 1976, are 
not to increase a taxpayer's at rislc amount with respect to that activity. 

1 However, a farmer has not been allowed to deduct the purchase price of livestock, such 
as cattle, which he intended to fatten for sale as beef. 

2 Not all costs relating to development of farm assets have been currently deductible. A 
farmer has been required to capitalize costs of water wells, irrigation pipes and ditches, 
reservoirs, dams, roads, trucks, farm machinery, land and buildings. 

Thus, even prior to the changes made by the Act. section 27S of prior law speclfleally 
required caoitalization of all amounts attributable to the planting, cultivating, maintain- 
ing or developing of an almond or citrus grove during the first four years after the grove 
was planted. 



41 

are used in a taxpayer's business and may eventually be sold at a gain 
which is taxed at the lower capital gain tax rate. Since development 
costs could be deducted before the income is realized from the sale of 
livestock or crops, the development costs would offset a farm investor's 
income from other sources such as salaries, interest, professional fees, 
etc. 

Certain other statutory provisions allow specific types of capital 
improvements to farmland to be deducted when the taxpayer pays 
them. These costs include soil or water conservation expenditures (sec. 
175), fertilizer costs (sec. 180), and land clearing expenses (sec. 182). 
Similar capital expenditures in a nonfarm business would be added to 
the basis of the property and, since land is nondepreciable, could be 
rex3overed only out of the proceeds when the land is sold. 

Capital gain treatment is generally available on the sale of depre- 
ciable assets used in farming (as well as on the sale of the underlying 
farmland itself), even though these assets or land may have been 
developed or improved by expenditures which were deducted against 
ordinary income.^ In effect, a farm investor's income which has been 
initially sheltered by accelerated farm deductions has been trans- 
formed into added capital value of the farm asset and taxed as part of 
that value when the farm capital assets (vineyard, breeding animal, 
farmland, etc. ) are later sold. 

After breeding animals, vineyards or orchards reach maturity and 
are held for the production of annual crops, farmers and farm inves- 
tors continue to receive tax benefits through deductions for accelerated 
depreciation.* 

Capital gain treatment on the sale of farm asests held for the pro- 
duction of income or used in a taxpayer's farm business is not avail- 
able to the extent that various recapture rules of present law are 
applicable. For example, section 1251 requires a limited recapture as 
ordinary income (rather than capital gain) of previous farm tax 
losses whenever assets used in a farming business are sold or disposed 
of. (This section of prior law was amended by section 206 of the Act.) 

Section 1252 recaptures amounts previously deducted as soil and 
water conservation and land clearing expenses if farmland is sold 
within 5 years after acquisition. If the land is held for a longer period, 
the amount recaptured is reduced by 20 percent for each year over 
5 years that the property is held. Thus, if the land is held more than 
10 years, no recapture is required on a sale of farmland. 

The holding period for long-term capital gain treatment of cattle 
and horses held for draft, breeding, dairy, or sporting purposes (such 
as horse racmg) is 24 months (sec, 1231(b) (3) ). The minimum liold- 

3 Under section 1231. a taxpayer who sells property used in his trade or business obtains 
a special tax treatment. All gains and losses from section 12.'>1 property are afrpreRated 
for each taxable year and the gain, if any, is treated as capital gain. The loss, if any. 
Is treated as an ordinary loss. Machinery, equipment, buildings and land used by a taxpayer 
In his business are examples of section 12.31 property. 

* For example, an investor or rancher can use 200 percent declining balance depreciatiori 
on the purchase price of breeding animals which he originally purchased for the herd. If 
the rancher purchased cattle which had been used for breeding by a previous owner, the cat- 
tle can be depreciated on the 150 percent declining balance method. 

The offspring of purchased animals cannot be depreciated, however, since the owner is 
considered to have no cost basis in such animals. (As indicated earlier, however, the cost 
of raising such offspring can be expensed.) 

Accelerated depreciation under a 150-percent declining balance method is also avail- 
able for new farm buildings and for the costs of purchased vineyards and orchards. The 
capitalized costs of vineyards and orchards planted by the taxpayer may be depreciated 
on a 200-percent declining balance method. 



42 

ing period for other livestock held for such purposes is 12 months. 
(One effect of this rule is that many sales of "culls" from a breeding 
herd, i.e., animals regarded as unsuitable, are taxable at ordinary in- 
come rates, since many culls are sold within 24 months.)^ 

Section 183 limits the current deduction of expenses in an activity 
which a taxpayer conducts other than "for profit." Although not lim- 
ited to farming, this provision may affect a variety of farm operations. 
If an activity is found not to be engaged in for profit, expenses can 
be deducted only to the extent that income derived from the activity 
exceeds deductible interest, taxes and casualty losses. 

Reasons for change 

Farm investments have offered an opportunity to defer taxes on non- 
farm income where investors were able to take advantage of the special 
farm tax rules to deduct farm expenses in a year or years prior to the 
years when the revenue associated with such expenses was earned. This 
type of deferral could occur regardless of whether the proceeds from 
the later sale of the underlying products were taxed at ordinary income 
or capital gain rates. Generally, in farming operations tax losses were 
shown in early years of an investment because of (1) the opportunity 
to deduct, when paid, costs which in nonfarm businesses would be in- 
ventoried and deducted in a later year, (2) the ability to deduct, when 
paid, costs which under general accounting principles should have 
been capitalized, and (3) the ability to claim depreciation deductions 
which exceeded straight-line depreciation. 

These tax losses were used to offset income from a taxpayer's other 
nonfarm occupations or investments on which he would otherwise have 
been required to pay tax currently. ^Vhen the income which was re- 
lated to these deductions was reported, it was not reduced by the 
amount of the deductions attributable to it (and was thus greater 
in net amount than it otherwise would be). This lack of match- 
ing resulted in deferral of taxes from the years when the initial de- 
ductions were taken. If the related farm income was eventually real- 
ized as capital gain (as it might have been where breeding animals or 
orchards were sold), conversion of ordinary income (against which 
the expenses were deducted) into capital gain also resulted. Even 
without the possibility of conversion, however, the tax advantages of 
deferral alone were frequently sufficient to motivate high-income tax- 
payers to engage in certain types of farming activities. 

Even after the Tax Eeform Act of 1969, high-bracket taxpayers 
continued to use farm tax rules to shelter nonfann income because (ex- 
cept for citrus and almond groves) the restrictions in prior law 
did not prevent the initial deferral of taxes on nonfarm income by 
means of accelerated deductions incurred in farm activities. Prior law 
focused largely on recapturing deductions which otherwise would 
be used to convert ordinary income into capital gain, and on limiting 
capital train treatment by increasing the holding periods for farm 
assets. However, under the cash method of accoimting, farm expenses 

s The statute also prevents tax-free exchanges of livestock of different sexes (sec. 1031 
(e)). Prior to the Tax Reform Act of 1969. such exchanges had been used to enable a 
rancher (or ranch investor) to build up his herd free of current tax by exchancinp bull 
calves, most of which are not used for breeding purposes, for female calves which could 
be used to increase the size of the herd. 



43 

are still deductible as they are paid. The time value of deferring taxes 
on nonfami income remained a strong attraction for outside investors 
to invest in farming and to use as much borrowed money as possible 
to create farm "tax losses." 

Since 1969, the number and volume of publicly syndicated 
investments in almost all areas of agriculture increased substan- 
tially. Farm tax benefits were eifectively packaged and sold to high- 
bracket taxpayers through limited partnerships (and management 
contracts) for investments in cattle feeding and breeding, tree crops, 
vegetable and other field crops, vineyards, dairy cows, fish, chickens, 
and egg production. 

Table 1 sets forth the average farm loss reported for tax purposes 
since 1969 by individual taxpayers in different income brackets. This 
table shows that average farm losses increased as taxpayers' income 
levels increased, and that this trend remained consistent during the 
four years covered by the table. The fact that the largest farm losses 
were concentrated in income levels over $100,000 suggests that high- 
bracket taxpayers continued to make use of the special farm tax rules 
to shelter their nonf arm income. 

TABLE 1.— NET FARM LOSSES BY SIZE OF ADJUSTED GROSS INCOME 



1970 



Adjusted gross income 



Returns 

showing 

farm loss 



Average 
farm loss 



1971 



Returns 

showing 

farm loss 



Average 
farm loss 



1, 234, 092 


($2, 350) 


1, 290, 203 


($2, 540) 








(2,899,513).- 




(3, 277, 548) 







All returns— total 

Total net farm loss (thousands) 

Under $5,000 485,531 (2,659) 

$5,000 under $10,000 - 379,947 (1,576) 

$10,000 under $20,000 284,652 rl,669) 

$20,000 under $50,000 -- 63,949 (4,202) 

$50,000 under $100,000 14,697 (9,473) 

$100,000 under $500,000 5,012 (21,016) 

$500,000 under $1,000,000 210 (43, 143) 

$1,000,000 or more 94 (128,149) 



475, 983 

385, 338 

327, 808 

78, 358 

16, 575 

5,787 

252 

102 



(2, 969) 

(1, 664) 

(1,822) 

(4, 087) 

(9, 527) 

(20,903) 

(52, 516) 

(134, 069) 



1972 



Adjusted gross income 



Returns 

showing 

farm loss 



Average 
farm loss 



1973 



Returns 

showing 

farm loss 



Average 
farm loss 



All returns-totai 1,171,591 ($2,758) 1,218,962 ($3,343) 

Total netfarm loss (thousands) (3,230,956) (4,074,998) 

Under$5,000 363,492 (3,821) 371,489 (4,323) 

$5,000 under $10,000 325,492 (1,879) 290,056 (2,365) 

$10,000 under $20,000 354,754 (1,852) 397,588 (2,123) 

$20,000 under $50,000 100,840 (3,894) 126,567 (3,907) 

$50,000 under $100,000 19,642 (9,607) 24,494 (8,970) 

$100,000 under $500,000 - 6,941 (21,784) 8,390 (23,108) 

$500,000 under $1,000,000 301 (50,296) 268 (70,451) 

$1,000,000 or more 129 (170,418) 110 (110,018) 



Source: U.S. Treasury Department, Statistics of Income— Individual Income Tax Returns, 1970, 1971, 1972, 1973 (pre- 
liminary). 



Deferral shelters. — Some of the more popular types of farming oper- 
ations which have been used as deferral shelters are set out below. 



44 

Cattle feeding has offered one of the best known and, until recent 
downturns in the farm economy, most widely used deferral shelters. 
Typically, the investment has been organized as a limited partnership 
or as an agency relationship (under a management contract) in which 
a commercial feedlot or a promoter has agreed to act as an agent for 
the investor in buying, feeding and managing cattle. After being fed a 
specialized diet for four to six months, the fattened cattle were sold 
at public auction to meat packers or food companies. A cattle feeding 
venture of this kind has typically been formed in November or De- 
cember, using leveraging and the cash method of accounting to per- 
mit taxpayers with income from other sources to defer taxes other- 
wise due on that income in that year by deducting expenses for pre- 
paid feed, interest, and other costs incurred in the feeding venture. 
Income was realized in the following year when the fattened cattle 
were sold. At that time, the bank loans were repaid and any unpaid 
fees due the feedlot (or promoter) were deducted. The balance was 
distributed to the investors. Since feeder cattle are held for sale to 
customers, sales of the animals produce ordinary income. If the in- 
vestors were to reinvest their profit from one feeding cycle into an- 
other one, they could theoretically defer taxes indefinitely on the 
nonfarm income which they sheltered originally. 

Since most investors in cattle feeding shelters have typically bought 
in at the end of the calendar year, deductions for prepaid feed for the 
cattle have been central to the creation of tax losses in that year." 

Another deferral shelter involved the production and sale of eggs. 
In egg shelters, almost the entire amount invested and borrowed was 
spent on items for which deductions were claimed in the first year. 
These items included poultry flocks, prepaid feed, and (to some extent) 
management fees to the persons who operated the program for the in- 
vestors. Under prior law, amounts paid for egg-laying hens, which are 
commonly kept for one year from the time they start producing, have 
been treated as allowable deductions in the year the poultry was 
purchased.^ 

Deferral and conversion shelters. — A deferral and conversion shelter 
has offered an investor an opportunity both to defer taxes and also to 
convert ordinary income into capital gain. The manner in which 
these benefits were obtained was by deducting development costs of 
section 1281 property (breeding cattle, orchards, vineyards, etc.) and 
capital gain property (farmland) from ordinary nonfarm income and 
by later selling the developed assets after the investor had held them 
long enough to qualify for long-term capital gain rates. Since the re- 
capture rules which apply to deducted development expenses (e.g., 
section 1251) are much more limited in scope than depreciation re- 
captui'e rules generally, many farm operations can be structured so 
that there will be little or no recapture of previously deducted develop- 
ment costs. 



* In recent years, the Internal Revenne Service questioned deductions for prepaid feed 
claimed by taxpayers usinp the cash method of accountinff. The Service (in Rev. Rul. 
7.1-152) prescribed several technical criteria and relied on its general antliority to recom- 
pute a taxpayer's income if deductions materially distort his Income. However, investors 
In cattle feeding shelters, in some cases, had still been able to circumvent the administra- 
tive criteria in order to instifv deductions for prepaid feed. 

'Rev. Rul. 60-191, 1960-1 C.B. 78. The purchase cost of this poultry may be deducted 
currently if the farmer consistently does so and if the deductions clearly reflect his 
income. 



45 

Livestock breeding has offered taxpayers the opportunity to defer 
taxes over a period of two or more years and also to convert ordinary 
income into capital gain. In general, breeding operations have relied 
on current deductions for prepaid expense items; current deductions 
for expenses of raising young animals to be used for breeding, dairy, 
draft or sporting purposes ; the investment credit ; accelerated depre- 
ciation and additional first-year depreciation on purchased animals and 
equipment; and capital gain when the mature animals are eventually 
sold. 

Although cattle has been the most widely used breeding shelter, 
there have also been investments offered for the purchase, breeding 
and sale of horses, fur-bearing animals (such as mink and chinchilla) , 
other types of farm animals (such as hogs), and some kinds of fish 
and shellfish. 

An investment in an orchard, vineyard or grove involves a "tree 
crop" as distinct from a "field" crop such as vegetables. The list of 
tree crop partnerships has covered virtually anything grown in an 
orchard or vineyard in the form of trees or vines which produce 
annual crops of fruits (e.g., grapes, apples or avocados) or nuts (e.g., 
pecans, pistachios or walnuts) .® 

During the development period of trees or vines, the owners have 
deducted costs of spraying, fertilizing, irrigating and cultivating the 
tree or vine to its crop-producing stage. They have also depreciated 
farm machinery, irrigation equipment, sprinkler systems, wells and 
fences w^hich they installed on the property. They have also obtained 
the investment credit; and deductions were often available for interest, 
fees and some prepaid items. After the trees start producing fruit or 
nuts, the owner has depreciated the c^sts of the seedlings and their 
original planting. (These costs were capitalized when incurred.) Such 
depreciation has been used partly to shelter the annual crop income. 
Income from the crop sales is ordinary income. Capital gain is avail- 
able, however, when the underlying land and the orchard are sold 
(except to the extent that recapture rules come into play). 

Use of farming syndicates. — These special farm tax rules have been 
utilized not only by taxpayers who were actively engaged in farming 
enterprises with the intention of making a profit, but also by passive 
investors whose motivation, in large part, consisted of a desire to use 
these farming rules to shelter income from other sources. These pas- 
sive investors were frequently members of "farming syndicates" 
formed by a promoter or operator. In order to offer attribution of 
losses and limited liability to the investor, a farming syndicate has 
generally been structured as either a limited partnership or as an agen- 
cy relationship with a management contract (and with limited liability 
generally provided for by nonrecourse indebtedness, insurance, stop- 
loss guarantees, etc.). During the 51/^ years betw^een January 1, 1970, 
and July 1, 1975, the dollar amount of tax shelter offerings in partner- 
ship form registered with the National Association of Securities 
Dealers was $942,424,000 in cattle feeding and breeding ventures and 
$166,575,625 in vineyards and other farming shelters. (There have 
been many more private syndications which were not required to be 
registered.) 



■'' Citrus fruits and almonds were generally not suited to tax shelter because of the 
cost capitalization rule of section 278. 



46 

Congress believed that the special farm tax rules should be 
continued for most farmers who are actively engaged in farm opera- 
tions, but that such special farm tax rules should be severely curtailed 
for farming syndicates in which a substantial portion of the interest 
is held by taxpayers who are motivated, in very large part, by a desire 
to shelter other income, rather than by a desire to make a profit in the 
particular farming operation. 

CongTess also believed that reducing tax incentives for high-bracket 
taxpayers who invest in syndicated farming operations will improve 
the competitive position of full-time farmers who must look to the 
income generated from farm operations for all or most of the return 
on their investment in farm operations. 

Explanation of provisiotis 

In general, the Act requires farming syndicates to deduct expenses 
for feed, seed, fertilizer, etc., only when used or consumed, to deduct 
expenses of purchased poultry only over their useful life (or, in the 
case of inventory, only when disposed of) and to capitalize certain 
cultivation, maintenance, etc., expenses of groves, orchards and vine- 
yards to the extent such expenses are incurred before the grove, or- 
chard or vineyard becomes productive.^ 

DefnifioTi of farming sj/ndicafe. — For purposes of these provisions, 
a "farming syndicate" is defined as including (1) a partnership ^° or 
other enterprise (other than a corporation wliich is not a subchapter S 
corporation) engaged in farming if, at any time, any interest in the 
partnership or other enterprise has been offered for sale in an offering 
required to be registered with a Federal or State agency having 
authority to regulate the offering of securities for sale, (2) a partner- 
ship or other enterprise (other than a corporation which is not a sub- 
chapter S corporation) engaged in the trade or business of farming 
if more than 35 percent of the losses during any period are allocable 
to limited partners or limited entrepreneurs.^^ 

These categories include as farming syndicates many forms of orga- 
nization of farm enterprises such as general partnerships, sole pro- 
prietorships involving agency relationships created by management 
contracts, trusts, and interests in subchapter S corporations.^^ If an 
interest in any such enterprise has been offered for sale in an offering 
required to be registered, it is a farming syndicate. Similarly, unless 
excepted by the five specific exceptions described below, if more than 

' Also, as a general limitation on the use of the farm tax rules. Congress provided that 
tax losses incurred in farming are to be allowable in any year only to the extent of the 
amounts for which the taxpayer is at risk in the business. This rule applies to all types 
of taxpayers engaged in farming operations (sec. 204 of the Act). 

10 The term "partnership" is used in the farming syndicate provisions only in a de- 
scriptive sense ; it is not intended that this definition of farming syndicate operate to pre- 
clude the Internal Revenue Service from applying the regulations under section 7701 to 
an organization described in such definition to determine its proper classification (as a 
partnership or corporation) for Federal tax purposes. 

11 Thus, the first category of farming syndicates includes limited partnership and other 
tax shelter offerings required to be registered with the Securities and Exchange Commis- 
sion or with a State securities or real estate office. The second category includes partner- 
ships or other enterprises with respect to which there is no registration requirement. 
T^nregistered offering.^ made through a dealer who is a member of the National Association 
of Securities Dealers, through an intrastate broker-dealer, or througli a real estate compan.v, 
as well as interests in private enterprises which are not sold by a broker-dealer, or similar 
jiarty are included in the second category, if the loss allocation requirements are satisfied. 

12 Corporations other than subchapter S corporations are not treated as farming syndi- 
cates since tax losses in such corporations cannot be passed through to its shareholders. 



47 

35 percent of the losses during any year are allocable to limited part- 
ners or limited entrepreneurs, the enterjDrise will be treated as a 
farming syndicate. 

In general, a limited entrepreneur means a person who has an in- 
terest, other than a limited partnership interest, in an enterprise and 
who does not actively participate in the management of the enterprise. 
The determination of whether a person actively participates in the 
operation or management of a farm depends upon the facts and cir- 
cumstances. Factors which tend to indicate active participation 
include participating in the decisions involving the operation or man- 
agement of the farm, actually working on the farm, living on the farm, 
or hiring and discharging employees (as compared to only the farm 
manager). Factoi-s which tend to indicate a lack of active participa- 
tion include lack of control of the management and operation of the 
farm, having authority only to discharge the farm manager, having a 
farm manager who is an independent contractor rather than an em- 
ployee, and having limited liability for farm losses." 

With respect to farming activities othar than those conducted by 
enterprises in which securities have been registered or were required 
to be registered, the provision specifies five cases where an individ- 
ual's activity with respect to a farm will result in his not being treated 
as a limited partner or limited entrepreneur. These cases cover situa- 
tions where an individual — 

(1 ) has an interest in a trade or business of farming attributable 
to his active participation for a period of not less than 5 yeai-s 
in the management of the trade or business of farming ^* ; 

(2) lives on the farm on which the trade or business of farming 
is being carried on (but only with respect to farming activities on 
such farm) ; 

(3) actively participates in the management of a trade or busi- 
ness of fanning which involves the raising of livestock (or is 
treated as being engaged in active management pursuant to one 
of the first two exceptions set forth above), and the trade or 
business of the partnership or any other enterprise involves the 
further processing of the livestock raised in the trade or business 
with respect to which he is (actually or constructively) an active 
participant ; 

(4) actively participates, as his principal business activity, in 
the management of a trade or business of fanning, regardless of 
whether he actively participates in the management of the ac- 
tivity in question ; or 

(5) is a member of the family (within the meaning of section 
267(c) (4) ) of a grandparent of an individual who would be ex- 

1' In determining whether a person has lliniteil liability for farm losses, all the facts 
and circumstances are tu he taken into account. Generally, for purposes of this definition, 
a person will be considered to have limited liability for farm losses if he is protected 
against loss to any significant degree by nonrecourse financing, stop-loss orders, guaran- 
tees, fixed price repurchase (or purchase) agreenients. insuranc«». or other similar arrange- 
ments. A iierson with limited liability for farm losses might include, in appropriate cir 
cumstancGs, (1) a general partner who has obtained a guaranty or other protection against 
loss from another general partner or an agent, and (2) a principal who has given authority, 
in fact, to another party to conduct hia operations (such as an Investor who agrees to 
allow a feedlot to manage feeder cattle which he has purchased) and who utilizes non- 
recourse financing, stop-loss orders insurance, etc., to limit his risk. 

"This e.xception (and the fifth exception to the extent it applies this exception to 
family members of a person qualifying under this exception) will continue to apply where 
one farm is substituted for or added to another farm. 



48 

cepted under any of the first four cases listed above and liis inter- 
est is attributable to the active participation of such individual. 

The first exception listed above (and its application to family mem- 
bers by the fifth exception) is designed to insure that the term "farm- 
ing sj^ndicate" does not include an enterprise in which a limited part- 
nership interest (or other passive interest) is held by a person who 
has actively participated in the management of the enterprise for 
not less than five years merely by reason of his holding such a limited 
partnership interest (or other passive interest). Also, a member of 
the family of such a person, such as one of his heirs, would not be 
treated as a limited partner or limited entrepreneur for purposes of 
making the farming enterprise a farming syndicate. Thus, for ex- 
ample, if A, an individual who has owned and operated a farm for 
more than five years, wishes to retire and foiTns the AB limited part- 
nership with B, an unrelated individual, and more than 35 percent 
of the losses are allocated to A, the limited partner, the AB partner- 
ship will not be treated as a farming syndicate because A's interest 
is not treated as a limited partnei-ship interest for purposes of de- 
termining whether losses are allocated to limited partners. Similarly, 
if A later dies and the partnership is continued by B and C, A's son, 
the BC partnerehip will not be treated as a farming syndicate. 

Definition of farming. — For purposes of these farming syndicate 
rules, the term "farming" is defined to mean cultivation of land or the 
raising or harvesting of any agricultural or horticultural commwlity, 
including the raising, shearing, feeding, caring for, training, and man- 
agement of animals. Thus, for example, a syndicate engaged in the 
raising of livestock, fish, poultry, bees, dogs, flowers, or vegetables is 
engaged in farming and, thus, is a farming syndicate. 

For purposes of the farming syndicate rules, activities involving 
the growing or raising of trees (other than fruit or nut trees) are not 
considering farming. Thus, this provision does not apply to forestry or 
the growing of timber. 

Deduction of prepaid items. — The Act adds a new section (sec. 
464(a) ) to the Code to provide in general, that, in the case of farming 
syndicate^s, deductions for amounts paid for feed, seed, fertilizer, or 
other similar farm supplies are allowed only in the taxable year in 
which the feed, seed, fertilizer or other supplies are used or consumed. 
This provision jjrevents a farm syndicate from obtaining current de- 
ductions for prepaid feed, seed, fertilizer, etc., except in situations 
where the feed, seed, fertilizer, or other supplies are on hand at the 
close of the taxable year solely tecause the consumption of such items 
during the taxable year was prevented on accoimt of fire, storm, flood, 
or other casualty, or on account of disease or drought. 

Costs of poultry. — Under prior law. taxpayers engaged in farming 
have not been allowed to deduct the cost of purchased livestock ; rather, 
they must inventory the livest(X^k held for sale and deduct the cost only 
upon disposition, and they must capitalize the cost of purchased live- 
stock used in the trade or business (such as cattle held for breeding 
purposes) and depreciate them over their useful lives. However, this 
has not been the case with respect to poultry. A ruling bv the Internal 
Revenue Service (Rev. Rul. 60-101, 1960-1 'C. B. 78) has allowed cash 
basis taxpayers to deduct when paid the costs of both poultry held for 



49 

sale and poultry used in the trade or business. These deductions were 
allowable, in general, because the poultry purchased for resale has a 
relatively small cost, and the poultry purchased for use in the trade or 
business, such a,s laying hens, has a useful life of less than one year. 
Some syndicates, however, have taken advantage of these rules and, 
coupled with the prior rules relating to prepaid feed, have utilized 
the deductions for poultry to create tax shelters. 

The Act adds a new Code provision (sec. 464(b)) which does not 
allow a farming syndicate to deduct when paid costs of acquiring 
poultry. Rather, it requires that the cost of poultry acquired for resale 
not be deducted until the poultry is sold or otherwise disposed of. Also, 
in the case of poultry acquired for use in the trade or business (such 
as laying hens) or acquired both for use in trade or business and for 
later resale, the costs must be capitalized and (taking into account sal- 
vage value) deducted ratably on a monthly basis over the lesser of 
twelve months or their useful life in the trade or business.^^ 

Capitalization of development costs of groves^ orchards^ and vine- 
yards. — The Act amends section 278 to provide that, in the case of a 
farming syndicate, any amount otherwise allowable as a deduction 
which is attributable to the planting, cultivation, maintenance, or 
development of a grove, orchard, or vineyard, and which is incurred 
prior to the taxable year in whi€h the grove, orchard, or vineyard 
begins to produce crops in commercial quantities is required to be 
capitalized. Such expenditures can thereafter be recovered by deprecia- 
tion of the grove, orchard, or vineyard. A limited exception to this 
capitalization rule is provided for amounts allowable as deductions 
(without regard to section 278) which are attiibutable to a grove, 
orchard, or vineyard, which is replanted after having been lost or 
damaged while in the iiands of the taxpayer by reason of freezing 
temperatures, disease, drought, pests, or casualty. 

Where these new rules apply to a situation in which section 278(a) 
(relating to capitalization of certain expenses of citrus and almond 
groves) requires capitalization but for a different period (4 years 
instead of the preproductive period), the rules of capitalization of 
section 278(a) apply prior to the capalization rules with respect to 
farming syndicates. Also, if an amount is incurred as a cost of fertil- 
izer, or other prepaid supplies, which is generally subject to the rules 
of new section 464(a), such amount is nonetheless subject to the 
farming syndicate capitalization rules of section 278(b). Thus, in 
such a case, no deduction would be allowed upon consumption of the 
fertilizer, but rather such amount would have to be charged to capital 
account. 

Effective dates 
The provisions of the Act relating to prepaid feed and other farm 
supplies and poultry expenses apply generally to amoimts paid or 
incurred in taxable years beginning after December .SI, 1975. In the 
case of farming syndicates in existence on December 31, 1975 (but 
only if there is no change in membership in the farming syndicate 



-s since the only basin for deducting the cost of the laying hens currently was that they 
have an expected useful life of less than one year, the requirement that deductions be 
taken over the lesser of 1 year or the useful life should not result in the acceleration of such 
deductions. 



50 

throughout its taxable year beginning in 1976) , these provisions apply 
to amounts paid or incurred in taxable years beginning after Decem- 
ber 31, 1976.^^ The provisions relating to orchards, groves and vine- 
yards do not apply where the trees or vines were planted or purchased 
for planting prior to December 31, 1975, or where there was a binding 
contract to purchase the trees or vines in effect on December 31, 1975. 

Revenue effect 
This provision will increase budget receipts by $86 million in fiscal 
year 1977, $32 million in fiscal year 1978, and $34 million in fiscal 
year 1981. 

h. Limitation of Loss With Respect to Farms to the Amount for 
Which the Taxpayer Is at Risk (sec. 204 of the Act and sec. 
465 of the Code) 

Prior lm.0 

Generally, the amount of depreciation or other deductions which a 
taxpayer has been permitted to take in connection with a property has 
been limited to the amount of his basis in the property. Likewise, in 
the case of a partnership, the amount of loss a partner may deduct is 
limited to the amount of his adjusted basis in his interest in the part- 
nership. However, basis in a property lias included nonrecourse indebt- 
edness (i.e. a loan on which there is no personal liability) attributable 
to that property. Wliere a partnership incurs a debt obligation, and 
none o,f the partners has personal liability on the loan, all of the part- 
ners have been treated for tax purposes as though they shared the 
liability in proportion to their profits interest in the partnership (i.e. 
each partner's share in the nonrecourse indebtedness is added to his 
basis in the partnership) . (See regulations § 1.752-1 (e) ) . 

Also, there has been generally no limitation on deductions which 
take into account a taxpayer's protection agamst ultimate loss by rea- 
son of a stop-loss order, guarantee, guaranteed repurchase agreement, 
insurance or otherwise. 

Reasons for change 
Taxpayers have combined the special farm tax rules (discussed 
under the farm syndicate section above) with nonrecourse indebted- 
ness, and stop-loss orders, etc., to deduct losses in a taxable year which 
are substantially in excess of the maximum amounts they could ulti- 
mately lose with respect to their investments in farming. Although 
some of these situations may be limited by the restrictions on deduc- 
tions imposed on syndicates (as described above), some farming shel- 
ters may not involve syndicates. Also, the limitations on syndicates 
do not affect all types of farming operations. For instance, winter 
vegetables, rose bushes and other nurserj^ plants are not restricted by 
the restrictions on farming syndicates, except to the extent that such 
syndicates utilize prepaid seed, fertilizer, and other farm supplies. 
(The utilization of such prepaid items is not necessary for the creation 
of substantial tax shelter in these types of operations.) 



1* A change in membership which disqualifies a farming- syndicate from this transitional 
rule does not include substitutions occurring by operation of law, gifts, or withdrawals 
by existing members. 



51 

Expl-anation of provisions 

To prevent a situation where a taxpayer may deduct a loss in ex- 
cess of his economic investment in farming operations, the Act pro- 
vides that the amount of any loss (otherwise allowable for the year) 
which may be deducted in connection with a trade or business of farm- 
ing, cannot exceed the aggregate amount with respect to which the 
taxpayer is at risk in each such activity at the close of the taxable year. 
(For more detail as to the application and scope of the at risk rule, 
see section 2, above.) 

In applying the at risk provision to farming operations,^" Congress 
intends that the existence of a governmental target price program 
(such as provided by the Aginculture and Consumer Protection Act of 
1973) or other governmental price support program with respect to 
a product grown by a taxpayer does not, in the absence of agreements 
limiting the taxpayer's costs, reduce the amount which such taxpayer 
is at risk. 

In the case of farming activities carried on by an individual, the 
"at risk" provision applies separately to each farming activity. 
Whether a taxpayer is engaged in one or more farming activities de- 
pends on all the facts and circumstances of the case. Generally, some of 
the significant facts and circumstances in making a determination are 
the degree of organizational and economic interrelationship of various 
a/ctivities in which the taxpayer is engaged, the business pui"pose whicJi 
is (or might be) served by carrying on the various activities separately 
or together, and the similarity of the various activities. Thus, for in- 
stance, if a rancher engaged in cattle raising on his own ranch also 
purchases cattle which he has placed in a commercial feedlot, he will 
generally be treated as being in two separate fanning activities. How- 
ever, if such a rancher were, as a consistent business practice, to take 
cattle raised on his own ranch and place them in a commercial feedlot, 
he might well be treated as engaged in only one farming activity. 

All farming activities engaged in by a partnership or subchapter S 
corporation will be treated as one activity for purposes of applying 
this provision.^^ 

Effective date 

In the case of farm operations, the at risk limitation applies to losses 
attributable to amounts paid or incurred in taxable years beginning 
aft^er December 31, 1975. 

Revenue estimate 

It is estimated that this provision will result in an increase in budget 
receipts of less than $5 million annually. 

c. Method of Accounting for Corporations Engaged in Farming 
(sec. 207(c) of the Act and new sec. 447 of the Code) 

Prior lato 

Under prior law, a taxpayer engaged in farming activities was al- 
lowed to report the results of such activities for tax purposes on the 

" For purposes of the at risk provision, the term "farming" has the same meaning as 
it does in the farming syndicate provisions discussed above. 

1* This ajrgregation approach is adopted because of the difficulties of allocating a 
partner's at rislc amount between different activities. 



52 

cash method of accounting, regardless of whether the taxpayer was an 
individual, a corporation, a trust, or an estate. As indicated in the 
discussion of the farming syndicate rules, the availability of the cash 
method for farmers has contrasted with the tax rules which govern non- 
farm taxpayers engaged in the business of selling products. Such non- 
farm taxpayers must report their income using the accrual method of 
accounting and must accumulate their production costs in inventory 
until the product is sold.^^ TTnder the accrual method of accounting as 
applied to farming, if crops are harvested and unsold at the end of the 
taxaJble year, the costs atti-ibutable to such crops cannot be deducted in 
the taxable year but must be treated as inventory. However, even under 
the accrual method, it has been a longstanding Treasury practice to per- 
mit a farmer to deduct expenses paid in the taxable year so long as the 
crops to which these expenses relate are unharvested at the end of the 
taxable year. (I.T. 1368, 1-l C.B. 72(1922).) 

The Internal Revenue Service has recently ruled that, for taxable 
years beginning on or after June 28, 1976, an accrual method taxpayer 
engaged in farming is required to inventory growing crops (unless the 
taxpayer uses the crop method of accounting).^" 

Furthermore, except with respect to citrus and almond groves, a 
taxpayer engaged in farming has generally been allowed to deduct 
currently costs of developing certain assets used in the trade or busi- 
ness of farming (such as cultivation expenses of orchards and groves) 
even if an accrual method of accounting was used : however, tax- 
payers in other businesses are generally required to capitalize the 
costs of constructing or developing assets used in the trade or 
business.^^ 

Reasons for change 
Under the cash method of accounting, all items which constitute 
gross income are reported in the taxable year in which actually or con- 
structively received, and expenses are deducted in the taxable years 
in which they are actually paid. The primary advantage of the cash 
method is that it generally requires a minimum of recordkeeping; 
however, it frequently does not match income with related expenses. 
Consequently, the cash method can be used to create tax losses which 
defer current tax liabilities on both farm and nonfarm income. Cor- 
porations, as well as individuals, can benefit by the time value of such 
deferral of taxes. 



19 A primary goal of the accrual method of accounting is a matching of Income and ex- 
penses. Under this method, income is included for the taxable year when all the events 
have occurred which fix the right to receive such income and the amount can be deter- 
mined with reasonable accuracy. Under such a method, deductions are allowable for the 
taxable year in which all the events have occurred which establish the fact of the lia- 
bility giving rise to the expense and the amount can be determined with reasonable accu- 
racy. Also, under the accrual method, where the manufacture or purchase of items which 
are to be sold is an income-producing factor, inventories must be kept and the costs of 
the merchandise must be accumulated in inventory (rather th.'in deducted when incurred). 
These costs may be deducted onlv in the year the merchandise is sold. Regs. § 1.446-1 
(a)(4) and (c). 

'"'Rev. Rul. 76-242. 1976-26 I.R.B. 9. This ruling also specifically requires an accrual 
method taxpayer operating a nursery to inventory growing trees and an accrual method 
florist to inventory growing plants (unless the taxpayer uses the crop method of 
accounting). 

Under the crop method of accounting, where a farmer is engaged in producing crops 
and the process of gatherings and disposal of the crops is not completed in the taxable 
year in which the crops were planted, expenses of producing, gathering and disposing of 
the crop are taken only in the taxable year in which the gross income from the crop is 
realized. Regs. § 1.162-12 (a). 

^ See, e.g.. Commissioner v. Idaho Power Co., 418 U.S. 1 (1974). 



63 

The opportunity for farmers generally to use the cash method of 
accounting, without inventories and with current deduction of certain 
expenses which are properly capitalizable, was granted over 50 years 
ago by administrative rulings. These rulings were issued at a time 
when "most agricultural operations were small operations carried on 
by individuals. The primary justification for the cash method of ac- 
counting for farm operations was its relative simplicity which, for 
example, eliminates the need to identify specific costs incurred in rais- 
ing particular crops or animals. 

In recent years, however, many corporations have entered farming. 
While some of these corporations involve relatively small business 
operations owned by a family or a few individuals, other corporations 
conduct large farm businesses which have ready access to the skilled 
accounting assistance often required to identify specific farm costs. In 
addition, sophisticated farm operations have often been carried on by 
fann syndicates or partnerships consisting of high-income investors 
and a corporation representing a promoter of a farm "tax shelter." 

In view of this, Congress believed it was appropriate to require that 
certain corporations, and certain partnerships, engaged in farming to 
this requirement small or family corporations in order to continue the 
cash basis method of accounting essentially for all those but the larger 
corporations engaged in f arming.^^ 

Explanation of provisions 

In general. — The Act adds a new provision to the Code (sec. 447) 
which requires that corporations (other than nurseries, certain "family 
owned" corporations, subchapter S corporations, and certain corpora- 
tions with annual gross receipts of less than $1,000,000) and certain 
partnerships to use the accrual method of accounting for farm opera- 
tions and also to capitalize their preproductive period expenses of 
growing or raising crops or animals. 

For purposes of this provision, farming is intended to be defined 
in the same manner as it is defined in the farming syndicate rules.^' 
Since under this provision, a corporation engaged in forestry or the 
growing of timber is not thereby engaged in the business of farming,^* 
this provision does not affect the method of accounting (or treat- 
ment of preproductive period expenses) of corporations engaged in 
forestry or the growing of timber. 

Certain excepted corporations. — The Act provides a series of excep- 
tions to the rule that farming corporations must use the accrual ac- 
counting method. One exception to the required accrual accounting 
rules is provided for nurseries. Thus, a corporation which is engaged 

'2 Since the new rules for cornorations enjrased In farming do not apply to subchaoter S 
corporations, anv corporation eligible to elect subchaoter S status may so elect and thus be 
exemnt'from being rennired to use the accrual method of accounting. 

^^ For purposes of this provision, income derived from the personal services of em- 
plovees who are engaged in the operation of machinery used in connection with farming 
activities of other taxpayers is not income from the trade or business of farming. Conse- 
ouentlv. unless otherwise reouired by nrlor law. a corporation will not be reauired to 
compute taxable income from such activities on an accrual method of accounting. For 
example, if a corporation owns a combine and trucks which are operated by its employees 
in contract harvesting operations, the taxable income of such corporation need not be 
computed on an accrual method of accounting, unless otherwise required. 

"*This exclusion of forestrv or the growing of timber from "farming" is consistent with 
the distinction drawn in regulations relating to provisions of the Code allowing taxpavers 
engaged in the trade or business of farming to deduct currently expenditures for soil or 
water conservation, fertilizer for land used in farming, and land clearing (sees. 175, 180, 
182 and Regs. §§ 1.175-3, 1.180-1 (b), and 1.182-2). 



234-120 O - 77 



54 

in the business of operating; a nursery will not be required to utilize 
the accrual method of accounting by reason of this provision of the 
Act. No inference is intended, however, with respect to any business 
operation which is required to utilize the accrual method of accounting 
under provisions of prior law. 

Subchapter S corporations, which by definition can have no more 
than 15 shareholders, and certain family owned corporations are also 
excepted from the requirement of accrual accounting. A shareholder 
of a subchapter S corporation, however, is to be subject to the at risk 
provisions of the Act, and the corporation itself may also be farming 
syndicate. 

A family corporation (excerpted from the requirements of section 
447) includes a corporation in which at least 50 percent of the total 
combined voting power of all classes of stock entitled to vote, and 
at least 50 percent of the total number of shares of all other classes 
of stock, are owned by members of the same family. For purposes 
of this provision, the members of a family are an individual, his 
brothers and sisters, the brothers and sisters of such individual's 
parents and grandparents, ancestors and lineal descendants of any of 
the above, a spouse of any of the above, and the estate of any of these 
individuals. Ownership of stock by a trust or partnership is to be pro- 
portionately attributed to its beneficiaries or partners, as the case may 
be. "^^ Also, stock ownership is to be attributed proportionately through 
a corporate shareholder (in a farm corporation) to the owne.s of the 
corporate shareholder if 50 percent or more in value of the corporate 
shareholder is owned by members of the same family.-" In applying 
these rules, individuals related by the half-blood or by legal adoption 
are treated as if they were related by the whole blood. 

Since a principal justification for use of the cash method of ac- 
counting in agriculture is that small enterprises should not be required 
to keep books and records on the accrual method of accounting, 
a fourth exception to required accrual accounting covers small cor- 
porations. The provision exempts any corporation whose gross receipts 
(when combined with the gross receipts of related corporations) do 
not exceed $1,000,000 per year. However, once this level of receipts is 
exceeded for a taxable year beginning after December 31, 1975, the 
corporation must change to the accrual method of ac<x)unting for sub- 
sequent taxable years and may not change back to the cash method of 
accounting for subsequent taxable years even if its receipts subse- 
quently fall below $1,000,000.^^ 



^ In determining family ownership under this provision, Congress beUeves that, if the 
trustee of a trust has discretion to distribute income or principal to family members or 
charities and if the trustee has made no distributions lor taken deductions for set-asides) 
to charities, family beneficiaries should be treated as the sole beneficiaries of the trust. 
However, Congress does not intend that such beneficiaries should be treated as the sole 
beneficiaries of the trust for other purposes by reason of the preceding sentence. 

28 Also, if a farming corporation is a wholly-owned subsidiary of another corporation 
(the "parent corporation"), stock of the subsidiary may be attributed from the parent 
corporation to another corporation (the "grandparent corporation") and through such 
grandparent corporation to its shareholders, if .50 percent or more in value of the stock 
of the grandparent corporation is owned, directly or through a trust or partnership, by 
members of the same family. 

^ Amounts received from the sale of farmland and improvements, farm machinery and 
equipment would not be included in "gross receipts" under this provision. With respect to 
its farming activities, a taxpayer would include only the receipts received from the sale 
of farm products including livestock held for breeding, draft, dairy or sporting purposes— 
unless the sale of livestock is not in the ordinary course of business and involves the 
disposition of a substantial portion of the taxpayer's livestock. In the case of nonfarm 
items, the taxpayer would include receipts from those items which produce ordinary 
income as contrasted with those which produce capital gains. 



55 

Application to partnerships. — Under this provision, a partnership 
is also required to use an accrual method (and to capitalize preproduc- 
tive period expenses) if a corporation is a member of a partnership 
and the corporation itself would be required under this provision to use 
the accrual method for its farm operations. (Without a rule of this 
kind, a corporation directly engaged in farming could escape the gen- 
eral rule of this provision by becoming a partner in a partnership 
which could still elect the cash method of accounting for the benefit of 
its partners.) Where the rules of this provision apply to a partner- 
ship, noncorporate partners will be affected by the accounting method 
required to be used by the partnership.^^ 

Preproductive penod expenses. — The term "preproductive period 
expenses" (required to be capitalized under this section) means, in 
general, any expenses which are attributable to crops, animals, trees, or 
to other property having a crop or yield, during the preproductive 
period of such property and which are allowable as deductions for the 
taxable year but for the application of this provision (and the farming 
syndicate rules, if applicable) .^^ 

In the case of property having a useful life of more than one year, 
which will have more than one crop — such as an orchard or vineyard — 
the preproductive period extends until the disposition of the first 
marketable crop or yield. Thus, costs attributable to the cultivation, 
maintenance or development of an orchard or vineyard in a taxable 
year before the first year in which a marketable crop or yield is sold 
(and which are currently deductible under prior law) are preproduc- 
tive period expenses.^" 

In the case of other farm property, such as annual crops (and 
animals with useful lives of less than one year), the preproductive 
period includes the entire period before the crop (or animal) is dis- 
posed of. For example, amounts paid for laying hens with a useful 
life of less than one year are "preproductive period expenses" if the 
hens are purchased in one year and sold in the following year. 
Similarly, in the case of winter vegetables which are planted in 
December of one year and harvested in January or February of the 
following year, a calendar year taxpayer would treat the cost of seeds, 
planting, cultivating, etc., of the vegetables in December as preproduc- 
tive period expenses which must be capitalized and deducted only 
when the crop is sold. 

The term "preproductive period expenses" does not include taxes 
and interest, and also does not include any amount incurred on account 

28 A partnership with a corporate general partner may be required to use the accrual 
method of accounting and may also be a farming syndicate subject to limitations on 
deductible expenses for prepaid feed and other farm supplies, expenses for poultry, and 
certain expenses of orchards, groves and vineyards. However, feed and other farm supplies 
are required to be inventoried under the accrual method of accounting, and the expenses 
(of poultry, orchards, groves and vineyards) that must be capitalized under the farming 
syndicate rules are also capitalizable preproductive period expenses under the accrual 
method of accounting (as required by this provision). Consequently, the application of 
both provisions is not inconsistent ; the farming syndicate rules do not appear to impose 
any additional requirements for an organization subject to this provision. 

29 Soil and water conservation expenditures, as defined in section 175. and land-clearing 
expenditures, as defined in section 182, are preproductive period expenses if they are in- 
curred in a preproductive period of an agricultural or horticultural activity and if the 
taxpayer elects to deduct these expenditures rather than capitalize them. 

3" This provision applies to preproductive period expenses of a citrus or almond grove 
even though under section 278 of the Code, all preproductive expenses of planting, cul- 
tivation, maintenance, or development during the first four taxable years beginning with 
the taxable year in which the tree is planted must be capitalized. The result of this inter- 
action is that, if the preproductive period is greater than four years in any of these cases, 
the preproductive period expenses in later years will have to be <'apitalized. 



56 

of fire, storm, flood, or other casualty, or on account of disease or 
drought. 

AVith respect to preproductive expenses, there is a special dis- 
position nde for home-grown supplies. This nile provides that, in 
the case of deductions whicli arise because feed is grown on a farm, 
and is fed to the farmer's chickens, cattle or other animals, the 
consumption of the feed by the animals transforms the deductions 
incurred in raising the feed into ordinary deductions in the year the 
feed is consumed. Such deductions are thus not required to be treated 
as preproductive period expenses, even though the animals may not 
be disposed of during that taxable year. 

Annual accr-vnl Tnefhod of accounfhig. — The Act adds special rules 
which provide, in general, that, if a corporation (or its predecessors) 
has, for a 10-year period ending with its first taxable year beginning 
after December 31, 1975, used an "annual accrual method of account- 
ing" and if the corporation raises crops which are harvested not less 
than 12 months after planting, the corporation may continue to use 
this method of accounting for its farming operations. An "annual 
accrual method of accounting" means a method of accounting under 
which revenues, costs, and expenses are computed on an accrual method 
of accounting and the preproductive period expenses incurred during 
the taxable year are either charged to crops harvested during that year 
or are currently deducted. To qualify to continue to use this method of 
accounting, substantially all of t\\Q crops grown by the corporation 
must be harvested not less than 12 months after planting. Also, the 
corporation (and its predecessors) must haA'e used this method of 
accounting for at least 10 years. In order for a corporation to utilize 
the period another corporation has used the annual accrual method, 
the first corporation must have acquired the assets of a farming trade 
or business from the second corporation in a transaction in which no 
gain or loss was recognized to the transferor or transferee corporation. 

In general, this 10-year requirement is designed to insure that the 
method can not be used by new or growing taxpayers to achieve sub- 
stantial future deferrals, while permitting taxpayers who have had a 
substantial history of use of this method to continue its use. 

If a corporation has used an annual accrual method of accounting 
together with a static value method of accounting for deferred costs 
of growing crops for a 10-year period prior to the first year to which 
these new provisions apply, it may elect to change to the annual 
accrual method of accounting without the static value method of 
accounting for deferred costs. 

Period for taking adjustments into account. — A taxpayer who is 
required to change to the accrual method of accounting (or to revise 
his accrual method of accounting to capitalize preproductive period 
expenses) pursuant to this provision will be allowed to spread the 
accounting adjustments required by this method over a period of 10 
years unless the Secretary of the Treasury by regidations prescribes 
different periods in certain types of cases. The corporation Avill also be 
treated as having made the change with the consent of the Secretary 
of the Treasury. Such a change will be treated as not having been 
initiated by the taxpayer (for purposes of the rule which prohibits 
adjustments resulting from changes in a taxpayer's method of ac- 
counting if the taxpayer initiates the change (sec. 481(a)). 



57 

The provision which states that the Secretary of the Treasury may 
prescribe regulations settinfj forth exceptions to the general rule that 
a corporation (or partnership) may spread the adjustments required 
by the change of accounting method over a 10-year period, is, in gen- 
eral, intended to give the Internal Revenue Sei-vice discretion to set 
forth standards as to when a different period for taking the adjust- 
ments into account would be appropriate.^^ 
Effective Bate 

This provision will apply to taxable years beginning after Decem- 
ber 31, 1976. 

Revenue effect 
It is estimated that this provision will result in an increase in budget 
receipts of $8 million in fiscal 1977 and $18 million annually thereafter. 

d. Termination of Additions to Excess Deductions Accounts Un- 
der Sec. 1251 (sec. 206 of the Act and sec. 1251 of the Code) 

Prior laio 

Under prior law (sec. 1251), individuals who reported their farm 
operations on the cash method of accounting, and who have more than 
$50,000 of nonfarm adjusted gross income during a year, have been 
required to maintain an "excess deductions account" (EDA) for a net 
farm loss sustained in the same year to the extent the loss exceeds 
$25,000. (It is immaterial what specific farm deductions produced the 
farm loss.) The EDA account is a cumulative account adjusted from 
year to year take into account net farm income or loss. For the most 
part, when the farm assets used in the taxpayer's business (except de- 
preciable real property) are sold or otherwise disposed of, the portion 
of the gain on the sale or other disposition equal to the balance in the 
excess deductions account must be reported as ordinary income, rather 
than capital gain. Any gain recaptured in this manner is then, sub- 
tracted from the balance in the EDA account as of the end of the same 
taxable year.^^ 

In the case of dispositions of farm land, another provision (sec. 1252) 
requires recapture of deductions allowed for soil and water conserva- 
tion expenditures (sec. 175) and for land clearing expenditures (sec. 
182) on a gradually reducing scale depending on how long the land 
is held. However, if recapture is required as a result of an EDA ac- 
count, this recapture is to occur in the case of a gain or disposition even 
though the property is subject to a lesser recapture as a result of prior 
soil and water expenditures or prior land clearing expenditures. 

Under prior law, if a corporation had a balance in an EDA account, 
an otherwise tax free reorganization in which farm recapture property 
was transferred to another corporation in exchange for its stock and 
the stock was then distributed would result in EDA recapture unless 



^ It is contemplatPd that the Internal Revenne Service mijjht, for example, believe that a 
shorter period would be appropriate where the taxpayer has been in existence fewer than 
10 years prior to the year of change or where the taxpayer is a partnership with a limited 
life which, as of the year of change, is less than 10 additional years. 

^^Corporations (other than subchapter S corporations) and trusts have been required 
to establish an KDA account for the full amount of their farm losses regardless of size 
and regardless of the amount of their nonfarm income. A subchapter S corporation has 
been governed by the same dollar limitations that apply to individuals, except that the 
corporation has been required to Include in its nonfarm income the largest amount of 
nonfarm income of any of its shareholders. 



58 

substantially all of the assets of the first corporation were transferred 
to the second corporation. 

Reasons for change 

Prior law allowed a farm investor who used the cash method of 
accounting to defei' current taxes on his nonfarm income. It merely 
placed a potential limit on the amount of ordinary nonfarm income 
which might be converted to capital gain in a future year. Thus, even 
where an EDA account was required to be maintained, this provision 
reduced the conversion of ordinary income into capital gain but did 
not affect the time value of deferring taxes on nonfarm income or on 
annual farm crop income. 

The experience with this provision since it was enacted in 1969 also 
suggested that the dollar floors which must be reached before farm 
losses were subject to recapture are quite high, and that the applica- 
tion of the provision was very limited. Treasury statistics of income 
since 1969 show that the number of tax returns which show nonfarm 
income of $50,000 and higher and a net farm loss of $25,000 or more 
has generally been less than one percent of all returns which report 
both nonfarm income and farm losses. Treasury statistics also show 
that the provision affects no more than 8 percent of the dollar amount 
of all farm losses reported on returns which show both nonfarm in- 
come and farm losses. Furthermore, it appears that the provision is 
difficult to apply and susceptible of varying interpretations. 

Congress concluded that an approach which focused solely on pre- 
venting conversion of ordinary nonfarm income to capital gain, with- 
out limiting the initial deferral of current taxes on nonfarm income, 
did not deal effectively with the use of farm tax rules by high income 
taxpayers to "shelter" nonfarm income, particularly in some of the 
more flagrant abuses of the farm tax rules in publicly syndicated 
farm tax shelters which have been carefully structured to avoid or 
minimize the effects of section 1251. 

Since the new provisions limiting the deductions in the case of farm 
syndicates, providing an at risk limitation for farm operations, and 
requiring certain corporations to use the accrual method of account- 
ing, will prevent the deferral of taxes on nonfarm income in many 
cases. Congress did not believe that it was desirable to continue a 
complex iide of limited applicability in the statute which recaptures 
income previously offset by certain farm losses. 

Also, Congress believed that it was inappropriate for EDA recap- 
ture to be triggered by a divisive "D" reorganization so long as the 
amounts in the EDA account would remain subject to recapture 
(under rides which are at least as stringent as if the reorganization 
had not occurred) when farm recapture property is disposed of by a 
corporation which survived the reorganization. 

Explanation of provision 
The Act limits the future anplicability of the EDA provision (sec. 
1251) by providing that no additions to an excess deductions account 
need be made for net farm losses sustained in any taxable year begin- 
ning after December 81, 1975. Farm losses incurred during any such 
taxable year or years will instead be governed by other limitations 
under the Act. 



59 

If property which is "farm recapture property" (within the mean- 
ing of section 1251(e)(1)) is disposed of during a taxable year be- 
ginning after December 31, 1975, however, the recapture rules of pres- 
ent law will continue to apply, but only with respect to EDA accounts 
required to be maintained for one or more years beginning before 
December 31, 1975. 

The Act allows divisive "D'' reorganizations without triggering 
EDA recapture. In these reorganizations, the entire EDA account 
is applied to both the transferor corporation and the transferee 
corporation. 

Effective date 

The amendments to section 1251 will not affect any recapture of 
farm losses by reason of a disposition of farm recapture property 
during a taxable year beginning on or before December 31, 1975. 

In the case of dispositions of fann land, the termination of the pro- 
vision described here for farm losses incurred in taxable years be- 
ginning after December 31, 1975. will mean that deductions taken 
under sections 175 and 182 in years beginning after December 31, 1975, 
will continue to be subject to recapture, but only to the extent required 
by section 1252. In such cases, section 1251 will cease to apply to any 
deductions under sections 175 and 182. 

The provisions relating to "D" reorganizations apply to reorganiza- 
tions occurring after December 31, 1975. 

Revenue estimate 
It is estimated that these provisions will result in a decrease in tax 
liability of less than $5 million annually. 

e. Scope of Waiver of Statute of Limitations in Case of Activi- 
ties Not Engaged in for Profit (sec. 214 of the Act and sec. 
183(e) of the Code) 

Prior Jaw 

The tax law distinguishes between activities engaged in "for profit" 
and activities which are not engaged in for profit (sec. 183). In the 
case of an activity engaged in for profit, a taxpayer may deduct all 
expenses attributable to the activity even though they exceed the in- 
come from the activity. In the case of an activity not engaged in for 
profit, a taxpayer can deduct the allowable expenses attributable to 
the activity only to the extent that income derived from the activity 
exceeds amounts allowable for interest, taxes and casualty losses attrib- 
utable to the activity. A taxpayer thus cannot utilize an operating 
loss incurred in an activity of this kind to offset his other income. 
Activities which raise issues of this kind include horse breeding, cattle 
breeding, the racing or showing of horses, and vacation homes. 

In determining whether an activity is engaged in for profit, the 
facts and circumstances must be examined to determine whether the 
taxpayer entered the activity and continued it with the objective of 
making a profit. However, the tax law contains a provision under 
which an activity is presumed to be engaged in for profit if the activ- 
ity shows a profit in at least 2 out of 5 consecutive taxable years ending 
with the taxable year in question. (In the case of raising, breeding, 
training or showing horses, the requirement is a profit in at least 2 of 7 
consecutive years.) 



60 

If, at the end of a given year, the taxpayer has not conducted the 
activity for 5 (or 7) years, a special provision allows the taxpayer to 
elect to postpone a determination as to whether he can benefit by this 
presumption until he has conducted the activity for 5 (or 7) years 
(sec. 183(e) ). This election was added to the Code in 1971. The com- 
mittee reports at that time expressed an intent that a taxpayer who 
made the election should be required to waive the statute of limita- 
tions for the 5 (or 7) year period and for a reasonable time thereafter. 
The aim was to prevent statute of limitations (3 years, in the usual 
case) from running on any year in the period. The taxpayer, it was 
believed, should have time to claim a refund of tax paid by him during 
the period, and the Internal Revenue Service should also have time to 
assess any deficiency owned by the taxpayer for any year in the period. 

In carrying out this legislative intent, the Service has issued tempo- 
rary regulations which require a taxpayer who makes an election 
under section 183(e) to agree to extend the statute of limitations 
for each taxable year in the 5 (or 7) year period to at least 18 months 
after the due date of his return for- the last year in the period. Such 
an extension must apply to all potential income tax liabilities arising 
during the period, including issues unrelated to deductions subject to 
section 183 issues. 

The reason for requiring such a broad waiver stems from a pro- 
vision under prior law which, in certain circumstances, allows only 
one notice of deficiency to be sent to a taxpayer with respect to a tax- 
able year. If a taxpayer receives a notice of deficiency and then files a 
petition with the Tax Court relating to that notice, the Service can- 
not (as a general rule) determine an additional deficiency for the same 
taxable year (sec. 6212(c)). Therefore, if, within the present limita- 
tions period, the Sendee sends a deficiency notice to a taxpayer relat- 
ing to an i^Sue other than section 183 and the taxpayer petitions the 
Tax Court as to one or more of those issues, the Service cannot later 
assess a separate deficiency under section 183. In order to prevent such 
a result, the temporary regulations require the waiver to cover all tax 
issues during the presumption period and not just the potential sec- 
tion 183 issues. 

Reasons for change 

Tlie requirement that all items on a taxpayer's returns for the early 
years of a 5 (or 7) year period be kept open creates several problems. 
The taxpayer must retain all records for those years for a substan- 
tially longer period of time than otherwise would be the case. Leaving 
the statute of limitations open for the entire return because of an item 
which may well be relatively minor is also contrary to the policy of 
prompt, resolution of tax disputes. A taxpayer may also want a prompt 
resolution of other items on his return in order to limit his potential 
interest cost as to any deficiency arising from items not related to the 
section 183 issues on his return. 

In order to accomplish the purposes which Congress sought when it 
enacted the look- forward presumption of section 183(e), it is not 
necessary to keep the statute of limitations open for all issues on the 
taxpayer's return during the 5 (or 7) year period. Tlie only issues 
on which the statute of limitations need's to remain open concern the 



61 

deductions which will be tested as to whether they are mcurred in an 
activity which the taxpayer engaged in for profit. Congress believes 
that a taxpayer should be able to take full advantage of a statutory 
presumption which was intended for his benefit, without unnecessarily 
extending the statute of limitations for items on his return which are 
unrelated to deductions which might be disallowed imder section 183. 

Exfla/naUon of provision 

The Act revises prior law (sec. 183(e)) to provide that if a tax- 
payer elects to postpone the determination of his conduct of an activ- 
ity under the presumption provisions, the statutory period for the 
assessment of any deficiency specifically attributable to that activity 
during any year in the 5 (or 7) year jx^riod shall not expire until at 
least two years after the due date of the taxpayer's income tax return 
for his last taxable year in the period. 

If a taxpayer makes an election under section 183(e) and postpones 
a determination whether he engaged in a particular activity for profit, 
the making of this election automatically extends the statute of limita- 
tions, but only with regard to deductions which might be disallowed 
under section 183. The taxpayer would not have to agree to extend the 
statute of limitations for any other item on his return during the 5 
(or 7) year period. On the other hand, even if the taxpayer has peti- 
tioned the Tax Court with regard to an unrelated issue on his return 
for any year in the same period, the Service will be able to issue a sec- 
ond notice of deficiency relating to a section 183 issue as to any taxable 
year in i\\& period. 

In order to assure the Service adequate time to reexamine the section 
183 issue after the suspension period has ended, tliis new provision al- 
lows the Service two years after the end of the period in which to con- 
test the taxpayer's deductions. The making of the election extends the 
statute of limitations on any year in the susi^ension period to at least 
two years after the due date of his return for the last year in the pe- 
riod.^^ (The due date is to be determined without regard to extensions 
of time to file his return for the last year.) 

The taxpayer's limited waiver of the statute of limitations would 
include not only the section 183 issue itself but also dedudtions, etc., 
which depend on adjusted gross income and which might be affected 
if the deductions are disallowed in accord with section 183. 

The provision for this limited waiver is not intended to affect the 
scope or duration of any general waivers of the statute of limitations 
which taxpayers have signed (or sign) before the date of enactment 
of this Act (October 4. 1976) .^^ 

^^ The Act does not shorten the usual 3-year statute of limitations as to any taxable year 
in the 5 (or 7) year period. Rather, it requires that the normal limitations period be ex- 
tended as to any year in the 5 (or 7) year period as to which the normal 3-year limitation 
period would otherwise expire while the potential section 183 issues are held in suspense. 

■■^ The provision is not designed to affect existing general waivers of the statute of 
limitations, because to do so would allow taxpayers who have previously signed such 
waivers to escape an examination of issues not related to section 183 even though the 
Internal Revenue Service had attempted to make a timely audit of them. Thus, for example 
if, before the date of enactment of this bill, in examining a taxpayer's income tax returns for 
1970, a revenue agent had proposed adjustments to a taxpayer's allegedly unsubstantiated 
charitable contributions and to his horse breeding activities, and if the taxpayer made an 
election under section 183 (e), and signed a general waiver of the statute of limitations 
until October 15, 197S (i.e., until 18 months after the due date of his 1976 return), the 
agent could issue the taxpayer a deficiency notice for both items at any time prior to that 
date. After that date, however, the statute of limitations would continue to be open for 
issues relating to horse breeding activities conducted in 1970 until April 15, 1979. but 
would be closed for issues relating to the proper substantiation of charitable contributions 
after October 15, 1978. 



62 

Similarly, the bill does not affect general waivers of the statute of 
limitations which may be signed after enactment, since in order to 
avoid two controversies relating to overall income tax liability for the 
same year, a taxpayer may wish to postpone a resolution of non- 
section 183 issues until the information relating to the section 183 
presumption is available. 

Effective date 
This provision generally applies to taxable years beginning after 
December 31, 1969. However, it w^ill not permit a reopening of the stat- 
ute of limitations for any taxable year ending before the date of enact- 
ment of the bill and as to which the statute of limitations has expired 
before such date of enactment. Further, since this provision does not 
limit general waivers of the statute of limitations, a taxpayer who has 
previously signed a general waiver will not be able to take advan- 
tage of this new provision (and to argue that the statute of limitations 
has run on issues unrelated to section 183) until his general waiver 
expires. 

Revenue effect 
This provision is not expected to have any revenue effect. 

4. Oil and Gas 

a. Limitation of Loss to Amount at Risk (see sec. 204 of the Act 
and sec. 465 of the Code) 

Prior laiD 

Under the tax law, an owner of an operating interest in an oil or gas 
well is allowed the option (under sec. 263(c)) to deduct as a current 
expense the intangible drilling and development costs connected with 
that well. Intangible drilling costs include amounts paid for labor, 
fuel, repairs, hauling and supplies which are used in drillLig oil or 
gas wells, the costs of clearing of ground in preparation for drilling, 
and the intangible costs of constructing derricks, tanks, pipelines and 
other structures and equipment necessary for the drilling of the wells 
and the preparation of the wells for production. But for the statutory 
election to deduct these costs currently, they would, in the case of a 
successful well, be added to the taxpayer's basis and recovered through 
depletion and depreciation; in the case of a dry hole, the intangible 
costs would be deducted at the time the dry hole is completed. 

In the case of an oil and gas drilling venture, which is most often a 
limited partnership, the Service has ruled (in Rev. Rul. 68-139, 1968-1 
C.B. 311) that a limited partnership may earmark a limited partner's 
contribution to expenditures for intangible drilling costs, thereby al- 
lowing the allocation of the entire deduction to the limited partnei*s 
(if the principal purpose of such allocation is not the avoidance of 
Federal taxes). 

The Service has also ruled (Rev. Rul. 71-252, 1971-1 C.B. 146) 
that a deduction may be claimed for intangible drilling costs in the 
year paid, even though the drilling is performed during the following 
year, so long as such payments are required to be made in the first year 
under the drilling contract in (..uestion. 



63 

Generally, the amount of losses which a taxpayer is permitted to 
take in connection with a business or investment in an oil or gas prop- 
erty is limited to the amount of his basis in the property. In the case 
of a partnership investing in oil and gas properties, the amount of 
losses a partner may deduct is limited to the amount of his adjusted 
basis in his interest in the partnership. However, under prior law, 
basis in a property could include nonrecourse indebtedness (i.e., a loan 
on which there is no personal liability) attributable to that property. 
Where a partnership incurred a debt and none of the partners had 
personal liability on the loan, then all of the partners were treated for 
tax purposes as though they shared the liability in proportion to their 
profits interest in the partnership (i.e., each partner's share in the 
nonrecourse indebtedness was added to his basis in the partnei-ship). 

Reasmhs for change 

The use of leverage through nonrecourse loans in an oil or gas drill- 
ing fund expanded the tax shelter potential of these investments to 
the extent that the leveraged amounts are used for intangible drilling 
and development costs. In these cases investors could deduct amounts to 
produce losses sufficiently in excess of their cash investment so that 
the tax savings in the year of investment coidd exceed the amount in- 
vested. For example, an investor contributing $100,000 to a partner- 
ship for a 10 percent profits interest could have added to his basis 
another $100,000 if the partnership obtained a nonrecourse loan for 
$1,000,000. If all of the partnership's capital ($2,000,000) were spent 
on drilling costs and the partnership had no income, the investor could 
deduct all of his share of those costs, or $200,000. If the investor were in 
the 70 percent tax bracket, that deduction would reduce his taxes in 
that year by $140,000, or $40,000 more than his investment. 

This leveraging of investments to produce tax savings in excess of 
amounts invested has substantially altered the economic substance of 
the investments and distorted the working of the investment markets. 
Taxpayers could be led into investments which were otherwise eco- 
nomically unsound and which constituted an unproductive use of the 
taxpayer's investment funds. 

Explanation of provisions 
To prevent a taxpayer from deducting a loss in excess of his economic 
investment in an oil or gas property, the Act provides that the amount 
of any loss incurred in connection with an oil or gas property may not 
exceed the aggregate amount with respect to which the taxpayer is at 
risk at the close of the taxable year. (The detailed provisions of the 
at risk rule have been discussed in section 2 above.) The limitation 
applies to all taxpayers (other than corporations which are not sub- 
chapter S corporations or personal holding companies) including in- 
dividuals and sole proprietorships, estates, trusts, shareholders in 
subchapter S corporations, and partners in a partnership which con- 
dividuals and sole proprietorships, estates, trusts, shareholders in 

1 Since, except for subchapter S corporations and personal holding companies, this pro- 
vision does not limit the deductibility of amounts paid or incurred by corporation, the 
provision would not apply to partners in a partnership which are corporations (other 
than subchapter S corporations and personal holding companies). 



64 

In general, in the case of an activity engaged in by an individual 
other than through a partnership, each oil and gas property (deter- 
mined on a property-by-property basis, as defined for purposes of 
computing depletion under section 614) is treated as a separate ac- 
tivity. However, in the case of a partnersliip or subchapter S corpora- 
tion, all oil and gas properties are to be treated as one activity. 

For purposes of the 65 percent of net income limitation (under sec- 
tion 613A(d) ), and the 50 percent of income from the property limi- 
tation (under section 613(a)), the deduction for intangible drilling 
and development costs is to be taken into account without regard to the 
at risk provision (i.e., on the assumption that the intangible drilling 
and development costs are fully deductible) . 

As discussed above, where the taxpayer has no personal liability 
with respect to a loan, he is to be considered at risk with respect to any 
indebtedness where the loan is secured by the taxpayer's personal or 
partnership assets (oth»r than assets which are used in the same ac- 
tivity) which have an established value, to the extent of the value of 
the assets (net of any other nonrecourse indebtedness secured by these 
same assets) . In the case of oil and gas wells, a property is not con- 
sidered to have an established value unless sufficient drilling has taken 
place to establish proven reserves on the property. 

Effective date 
This provision is to apply to losses attributable to amounts paid 
or incurred with respect to oil and gas properties after December 31, 
1975, in taxable years beginning after that date. 

Revenue effect 
This provision will increase budget receipts by $50 million in fiscal 
year 1977, $18 million in fiscal year 1978, and $6 million in fiscal year 
1981. 

b. Gain From Disposition of an Interest in Oil and Gas Property 
(sec. 205 of the Act and sec. 1254 of the Code) 

Prior law 

Under the tax law, the operating interest in an oil or gas property 
is considered to be either a capital asset or real property used in a trade 
or business. As a result, where the operating interest is sold after being 
held for more than six months,^ the income from the sale will qualify 
for treatment as long-term capital gain. Similarly, an interest in a 
partnership is generally treated as a capital asset the sale of which 
will qualify for long-term capital gain treatment. 

Prior law provided for the recapture of any deductions upon the sale 
of oil or gas property only to the extent that any deductions taken 
(under sec. 167) for the depreciation of tangible personal property 
(sec. 1245). Amounts deducted currently for intangible drilling and 
development costs (under sec. 263 (c) ) were not subject to recapture. 

General reasons for change 
The provision allowing gain from the sale of oil or gas property to 
be treated as capital gain without any significant recapture of deduc- 

2 Thp required holding period is Increased to nine months for taxable years beginning 
in 1977 and to one-year for years beginning after 1977 under section 1402 of the Act. 



65 

tions taken against ordinary income increases the value of an oil and 
gas tax shelter investment because it permits an investor, who has 
(Obtained a deferral of tax through the deduction of intangible drilling 
and development costs, to convert amounts which would in later years 
be taken into account as ordinary income into capital gains subject to 
the lower capital gains tax rates. The opportunity to convert these 
amounts into capital gains by selling the property occurs in all cases 
of producing wells where the option to deduct intangible drilling costs 
has been made. Even apart from tax shelter considerations, the Con- 
gress sees no 7'eason why the principle which applies to other areas of 
the tax law (i.e., that deductions attributable to property should be 
subject to recapture if that property is sold or disposed of) should not 
also apply here. 

Exjdanation of pravisions 

The Act provides for the recapture of certain intangible drilling 
and development costs upon the disposition of oil and gas properties 
if the disposition takes place after December 31, 1975. The amount sub- 
ject to recapture is the amount deducted for intangible drilling and 
development costs (paid or incurred after December 81, 1975), re- 
duced by the amounts which would have been deductible had those 
intangible costs been capitalized and deducted through cost depletion. 
However, the amount recaptured cannot exceed the amount of gain 
realized from the dispositioji. The amount recaptured is to be treated 
as gain which is ordinary income and is to be recognized upon the 
disiiosition of the property, regardless of anj^ other provision of the 
Code which would otherwise provide for nonrecognition. 

The recapture provision applies to all intangible drilling and devel- 
opment costs which, but for the option to deduct these costs under 
section 263(c) , would be reflected in the adjusted basis of the property 
at the time the costs are paid or incurred. Amounts subject to recap- 
ture are to be reduced by the amount of cost depletion attributable to 
those intangible drilling and development costs actually deducted or 
permitted to be deducted under cost depletion (under sec. 611) . 

Costs which, but for the election to deduct intangibles, would be 
added to basis and recovered through depreciation (rather than to 
cost, depletion) are to be recaptured under this provision.^ 

This net amount of intangible drilling and development costs over 
the amount allowable under cost depletion is to be treated as ordinary 
income only to the extent of any gain realized (or to the extent of the 
excess of the fair market value of the property transferred over the 
basis in the property). This limitation on the amount recaptured to 
the amount of gain (or the excess of fair market value over basis) is 
the same limitation applied (under sec. 1245) for the recapture of 
certain depreciation or amortization expenses relating to personal 
property. The computation of the amount realized, the fair market 
value of any intercvst, and the adjusted basis of the property are to be 
made under substantially the same rules which apply to that provision. 

The rules of this provision are to be applied separately to the in- 
tangible costs attributable to each oil and gas property. A property is 

'These amounts were not, of course, previously subject to recapture under sec. 1245. 
since they are deducted under sec. 26.3(c) and not under sees. 168, 169, 184, 185. 187, or 
188, as is required under sec. 1245(a) (2). 



66 

defined for purposes of these rules in the same way as under the exist- 
ing rules (under sec. 614) for purposes of computing the amount of 
depletion allowable. Thus, each different taxpayer's interest in a tract 
or parcel of land is generally to constitute a separate property, but all 
of a single taxpayer's operating interests in one tract or parce^l of 
land are generally to be combined. However, if one or more taxpayers 
combine their interests for depletion purposes under a pooling or 
unitization agreement (as described in sec. 614(b) (3)), the property 
is to include all of the interests as so combined. 

A property is to be considered an oil or gas property only if intan- 
gible drilling and development costs are properly chargeable to that 
property (either in the hands of the taxpayer or his predecessor in 
interest). Thus, an interest in a tract or parcel of land which is not 
an operating interest does not constitute an oil or gas property. 

The recapture rule is to apply to all taxpayers who own oil or gas 
properties, including citizens and residents, "trusts and estates, and 
corporations. 

The recapture rule applies to the disposition of all or any portion 
of an oil or gas property. In the case of a disposition of a portion of 
an oil or gas property other than an undivided interest, the entire 
amount of intangible costs attributable to that property are to be 
allocated to the portion of the property which is first disposed of. Any 
excess of intangible costs not recaptured in the first disposition of a 
portion of an interest other than an undivided interest (because, for 
example, the gain realized from the disposition was less than the 
amount of costs subject to recapture) is to be subsequently allocated 
to the remaining portions of the oil or gas property. However, in cases 
of dispositions of a portion of an oil or gas propertv which are not 
subject to recapture under this provision (such as gifts), a propor- 
tionate part of the intangible costs subject to recapture is to be treated 
as allocable to the portion of the property transferred and is to be 
treated in the hands of the transferee as a transfer of a separate oil 
or gas property. 

In the case of a disposition of an undivided interest in an oil or gas 
property or in a portion of an oil or gas property, a proportionate part 
of the intangible costs attributable to that property are to be allocated 
to the undivided interest and recaptured to the extent of the gain from 
the disposition of the undivided interest. For purposes of this rule 
(as well as for purposes of the rule relating to gifts and other non- 
recapture dispositions as discussed in the next paragraph), it is in- 
tended that the expenditures are to be allocated in proportion to the 
rights to income from the property. 

The recapture rule is to apply to all dispositions ffenerally except 
those which are not treated as dispositions under tl^e existin<r recapture 
provisions relating generally to gains from the disposition of depre- 
ciable personal property (sec. 1245). This provision excepts from 
recapture dispositions by gift, transfers at death, transfers in certain 
tax-free reorganizations, like-kind exchanges and involuntary conver- 
sions in certain circumstances, and certain sales or exchauires required 
by order of Federal agencies. These same exceptions are to be applied 



67 

under regulations in the appropriate manner to the recapture of intan- 
gible drilling and development costs from oil or gas properties. 
Also, for purposes of this provision a unitization or pooling arrange- 
ment (within the meaning of section 614(b) (3) ) is not to be treated as 
a disposition.* 

In addition, the rules relating to the distribution of property by a 
partnership to a partner which are applied (under sec. 617(g) ) to dis- 
tributions of any property or mine with respect to which mining ex- 
ploration expenditures have been deducted are to be applied in a 
similar manner to the distribution of oil or gas property to a partner 
and to the distribution of other property to a partner by a partner- 
ship which, after the distribution, continues to hold oil or gas property. 

For purposes of these rules, where a partner sells or exchanges his 
interest in a partnership holding an interest in oil or gas property, 
intangible drilling costs which would be subject to recapture under 
these provisions (should the partnersliip dispose of its interest in the 
property) are to be treated as an unrealized receivables (within the 
meaning of section 751). Thus, any gain realized by the partner upon 
the sale or exchange of his interest would be subject to ordinary income 
treatment to the extent of his share of these costs. Similar rules are 
to apply upon the sale or exchange of stock in a subchapter S corpo- 
ration (in accordance with regulations to be prescribed by the Secre- 
tary or his delegate). 

Effective date 
The rules providing for the recapture of deductions for intangible 
drilling and development costs are to apply to dispositions of oil and 
gas properties in taxable years ending after December 31, 1975, with 
respect to intangible drilling and development costs paid or incurred 
after December 31, 1975. 

Revenue effect 
It is estimated that this provision will result in an increase in budget 
receipts of $7 million for fiscal year 1977, $14 million for 1978, and 
$65 million for 1981. 

5. Motion Picture Films 

a. At Risk Rule and Capitalization of Production Costs (sees. 204 
and 210 of the Act and sees, 280 and 465 of the Code) 

Prior law 
Under prior law, motion picture shelters generally had two basic 
forms. In one format, a limited partnership was formed to purchase 
the rights to an already completed film. The purchase price was heavily 
leveraged (and often unrealistically inflated) and the partners claimed 
substantial depreciation deductions. The principal features of the 
shelter was deferral and leverage. This format was sometimes referred 
to as a "negative pick-up" or "amortization purchase" transaction. 



* Also, arrangements under which the interests of two or more parties in a drilling 
venture (such as a leaseholder and a driller) shift after a certain amount of production 
is obtained are not generally to be considered a disposition where the shift in interests 
occurs under an agreement "made prior to the time that the intangible drilling expenses 
were paid or incurred. 



68 

In the second type of format, the limited partnership was formed 
to produce a film (rather than to buy a completed film). The partner- 
ship entered into an agreement with a studio, with a distributor or 
with an independent producer to produce a particular film. The part- 
nership used the cash method of accounting and wrote off the costs of 
production as they were paid. Typically the partnership was heavily 
leveraged and significant costs were paid with borrowed funds. The 
principal elements of this form of motion picture shelter were also 
deferral and leverage. The partnership in this type of shelter was 
sometimes referred to as a "service company" or "production 
company." 

Another variation of this shelter was the film distribution partner- 
ship. In this shelter, the partnership also did not own an interest in 
the film., but obligated itself to distribute the film. By writing off the 
costs of distribution, the deferral occurred for the partners because 
the partnership's income from its distribution services was not realized 
until later years. 

The basic principles of partnership tax law which benefited the 
motion picture tax shelter (and other shelters as well) included the 
use of the partnership form to allow limited partners to take into in- 
come their distributive share of the partnership's income or losses 
(which are generally determined under the partnership agreement). 
Also, the amount of partnership loss which the partner may deduct 
included not only his own equity contributions to the partnership, but 
also his share of any nonrecourse debt which the partnership has 
incurred (see regulations § 1.752-1 (e) ) . There were also several aspects 
of prior law, however, which relate particularly to motion picture 
shelters. 

(/) Film purchase shelter 

The income forecast method. — Motion pictures were usually (and 
may continue to be under the Act) depreciated on the "income forecast" 
method. (Rev. Rul. 60-358, 1960-2 C.B. 68: Rev. Rul. 64-273, 1964-2 
r.B. 62.) This method is used because, unlike most other depreciable 
assets, the useful life of a motion picture is difficult to ascertain. Under 
the income forecast method, the taxpayer computes depreciation by 
using a fraction, the numerator of which is the income received from 
the film during the year and the denominator of which is the total esti- 
mated income which the film is expected to n-enerate over its remain- 
ing lifetime. This fraction is then multiplied bv tlie cost of the film. 
For example, if the taxpayer has a basis of 5f;500,000 in liis interest in 
the film, the income from the film throuo-h the end of tlie first vear is 
^750,000, and the total estimated income from the film over its lifetime 
is $1,000,000, the taxpaver would be allowed to depreciate 75 percent of 
his basis, or $375,000. (If the income forecast increases or decreases as a 
result of changed circumstances, this change is tnken into account for 
later periods. Thus, in the second year, depreciation under the income 
forecast method might be ba^^-ed on an income forecast denominator 
which was more or less than the amount used for the fii-st year.) 

The film purchase transaction worked as a tax shelter onlv where 



69 

the purchase price of the film (inchiding nonrecourse indebtedness) 
exceeded its economic value. ^ 

However, there was a substantial question even under prior law 
whether taxpayers in a film-purchase shelter were legally entitled to 
claim depreciation based on nonrecourse indebtedness where the "pur- 
chase price'" of the film was in excess of the income forecast on the film. 

While the authorities in this area have not been uniform, there are 
several cases which have disallowed the depreciation deduction based 
on nonrecourse liability where there was no substantial prospect that 
this liability would be discharged. In Leonard Marcus, 30 T.C.M. 1263 
(1971) , the court held that where the taxpayer purchased two bowling 
alleys for a 5 percent down payment, with a 20-year nonrecourse note 
for the balance, the taxpayer could depreciate only the basis repre- 
sented by his down payment, and that the note could be taken into 
account for purposes of increasing the taxpayer's basis only to the 
extent that payments were actually made. The court held that the 
liability represented by the note was too contingent to be included 
in basis until payments were made.^ 

In Marvin M. May. 31 T.C.M. 279 (1972), the Tax Court held that 
a transaction in which the taxpayer purchased 13 television episodes 
for $35,000, and obligated himself to pay an additional $330,000 on a 
nonresource basis was a sham, because this amount was far in excess 
of the fair market value of the films and there was no realistic prospect 
(or intention) that the debt would ever be paid. Therefore the court 
disallowed the depreciation deduction claimed with respect to the film. 
See also Rev. Rul. 69-77, 1969-1 C.B. 59.^ 

It would seem that some of these same principles could often be 
applied in the case of a film purchase shelter, where the purchase 
price of the film consists largely of nonrecourse indebtedness and sub- 
stantially exceeds the film's income forecast. 

Depreciation recapture. — There is some question as to whether a 
movie film in the hands of a limited partnership, such as those de- 
scribed here, constitutes a capital asset (within the meaning of sec. 
1221), or "property used in the trade or business" of the taxpayer 

1 Assume, for example, that a limited partnership pays $1,000,000 for a film (consisting 
of $200,000 in cash and a 10-year nonrecourse note for $800,000). After the film is 
released, it becomes apparent that the film mav not be successful and an income forecast of 
$200,000 is made for the film. Assuming $160,000 of this revenue (or 80 percent of the 
predicted total) were realized in the first year, the partners would depreciate 80 percent 
of their basis in the film, or $800,000 for a net tax loss (after taking account of the 
$160,000 of income from the film) of $640,000. 

On the other hand, where the income stream is equal to or greater than the purchase 
price there was no shelter. For example, if the film is purchased for $2 million (and has 
this as its basis), but has an estimated income stream of $4 million, $3 million of which is 
earned during the first year, the result would be as follows. The partners would be allowed 
to take 75 percent of their $2 million basis as depreciation in the first year under the 
income forecast method (or a $1,500,000 deduction). However, the film would be also 
generating $.3 million of income which the partners would have to recognize. Thus, the net 
tax effect would be positive taxable income to the partners of $1,500,000. Where the pur- 
chase price of the film and its estimated income stream are exactly equal, the depreciation 
deduction and the amount of income from the film should exactly offset each other. 

=2 In Marcus, the 20-year term of the note was substantially in excess of the useful life 
of the bowling alleys. 

3 As indicated above, under the partnership provisions, the partner could add to his basis 
in the partnership his share of the nonrecourse liabilities. However, section 752(c) pro- 
vides that "a liability to which property Is subiect" shall be considered as a liability of the 
owner of the property "to the extent of the fair market value of such property . . ." Since 
the "fair market value" of a movie film ordinarily will not exceed its total projected 
lifetime earnings, this suggests that a partner's basis could not, even under prior law. 
Include his share of nonrecourse indebtedness to the extent that this indebtedness (plus 
the partner's down payment) exceeded the income forecast for the film. 



234-120 O - 77 



70 

which is neither "inventory," nor "propert}' held by the taxpaper 
primarily for sale to customers in the ordinary course of his trade or 
business" (within the meaning of sec. 1231) . 

If the film is not a capital asset (or section 1231 property), any 
income received with respect to the film would be ordinary income. 
Assuming that the film is found to be a capital asset, income realized 
on the sale or exchange of the film would be subject to the depreciation 
recapture rules of section 1245. Thus, the proceeds of the sale in excess 
of the taxpayer's adjusted basis would constitute ordinary income to 
the extent of any depreciation previously allowable with respect to the 
film.* 

Even if the film is not sold, there should eventually be recapture of 
the depreciation attributable to the unpaid balance of a nonrecourse 
note which entered into the depreciable basis of the film. If the film is 
successful and the loan is repaid out of the partnership income, each 
partner must take into income his distributive share of the amounts 
used for repayment; the partner's basis would not be affected. (The 
partner's basis would increase to the extent that his distributive share 
of the partnership income was used for partnership purposes, such 
as repayment of the loan, but his basis would decrease in an equal 
amount because his share of the nonrecourse partnership liability was 
being reduced by the repayment, ) If the film is not successful and the 
nonrecourse debt becomes worthless, a default, foreclosure or abandon- 
ment of the debt generally constitutes income to the partnership be- 
cause such events are treated as a "sale" of the movie film, which is 
subject to the recapture rules of section 1245.^ 

The rules on depreciation recapture are essentially the same under 
prior law and under the Act. 

(2) Production company shelter 

OasJi method of accounting. — Under prior law, obtaining tax de- 
ferral through a production company transaction depended on whether 
the partnership could properly deduct its costs of producing the film 
as it paid them. This in turn depended on whether proper tax ac- 
counting practices permitted the partnership to treat these costs as 
an item of expense or required the partnership to capitalize these ex- 
penditures and amortize them over the life of the asset. (In this case, 
the asset was the partnership's rights under the contract with the 
distributor-owner of the film.) 

Under prior law (and present law), a taxpayer is generally per- 
mitted to select his own method of accounting (sec. 446(a)) imless 
the method selected "does not clearlv reflect income" (sec. 446(b)). 
If it does not, the law permits the IRS to compute the taxpayer's in- 
come in a way that will clearly reflect his income. 

One problem with the motion picture service partnership's use of 
the cash method under prior law was the possibility that a particular 
partnership is really engaged in a joint venture with the distributor or 
with an independent producer, i.e., the investors provided financing 

* If the partner sold hif? interest in tlie partnership, the depreciation would be recap- 
turerl as an "unrealized receivable" under section 751. 

^ Likewise, if the partnership discontinues its operations, this should constitute a con- 
structive distribution of the partnership assets (includinjr. for this purpose, the unpaid 
portion of the nonrecourse note) to the partners, whicli in turn triggers the recapture rules 
of section 1245. 



71 

and the studio/distributor or producer supplied personnel, production 
skills and also loan guarantees. As part owners of the film, the partner- 
ship would then have to capitalize its production costs.^ 

In such circumstances the question is whether failure to capitalize 
the expenses of producing the film (and thus, of the partnership's 
rights under the contract) results in a material distortion of income. 
There is a strong argument, even under prior law, that a material dis- 
tortion of income does occur under these circumstances. See Commis- 
sioner V. Idaho Power Co., 418 U.S. 1 (1974), holding that "accepted 
accounting practice" and "established tax principles" require the 
capitalization of the cost of acquiring a capital asset, including costs, 
such as depreciation on equipment, which would generally be deducti- 
ble if they were not allocable to the construction of the asset. (The 
production company's contract rights are not a capital asset, but these 
rights are an asset with a long useful life, so there is a strong argu- 
ment that the capitalization principle should apply.) 

On the other hand, there is one case relied on heavily in the past 
by the investors in movie production partnerships which held that a 
building contractor's income was not distorted where the company 
constructed apartments and shopping centers under long-term con- 
struction contracts and deducted its costs on the cash method, while 
receiving payments over a five-year period after each project was com- 
pleted. C. A. Hunt Engineering Co., 15 T.C.M. 1269 (1956). Produc- 
tion company investors have argued that the same result should be 
allowed in their situation. 

A related question under prior law is whether a limited partner- 
ship producing a motion picture is engaged in selling or delivering a 
product (the film) and is therefore required to maintain an inventory. 
If this were the case, the labor costs paid in producing the inventory 
could not be deducted until the inventory item was sold. The argu- 
ment against that view is that the production company was selling 
services (i.e. production services) rather than a product. 

Another question under prior law is whether the funds supplied 
by the limited partners were merely part of a financing transaction in 
which the investors were basically only loaning money to the distrib- 
utor or other party who would own the completed film. As creditors, 
the financing parties would not be entitled to tax deductions for the 
amounts which they are lending. 

(S) IRjS rulings position 

The Service has issued several revenue rulings with respect to the 
use of limited partnerships and nonrecourse loans.'^ Although these 
rulings have applicability outside the area of movie shelters, they 
also impose some limitations, at least insofar as the position of the 
Service is concerned, which apply both to the film purchase type trans- 
action, and the production company arrangement. 



* In some cases, the personnel hired by the partnership to make the film were not in 
reality the investors' own employees but were supplied by the studio/distributor. In other 
cases, the investors' partnership subcontracted actual production work to the studio/ 
distributor (or to its agents). Factors such as these, along: with the sharing of profits 
and risks of loss, the distributor's day-to-day involvement in production and budget changes, 
etc.. would tend to supnort treatment of the partnership as a participant in a ioint venture. 

Still another difficult question under prior law for the motion picture "service com- 
l>any" was whether the partnership was conducting a trade or business if it made only one 
picture or did not operate with regularity. 

'Rev. Proc. 74-17, 1974-1 C.B. 438; Rev. Rul. 72-135, 1972-1 C.B. 200; Rev. Rul. 
72-350, 1972-2 C.B. 394. 



72 

These rulings suggest that many forms of nonrecourse loans may, in 
substance, be equity investments by the lender, which cannot be used by 
the limited partners to increase their bases in the film or in a produc- 
tion partnership. Purchase money loans by the seller of a film (in 
a negative pickup transaction) might be included in this categoiy. 
The logic of these rulings might well apply also to the case where a 
loan is made to the investors' partnership by a bank, but is guaran- 
teed by the studio which is selling the film (or for whom the film is 
being made, in the case of the production company shelter) . 

Reasons for change 

The two formats commonly employed in connection witli movie 
films, the film purchase shelter and the production company shelter, 
had the same basic elements, i.e., tax deferral and the use of leverage. 
In the case of the film purchase shelter, deferral occurred because of 
the rapid depreciation which is allowed in connection with movie films, 
and which is passed through to the limited partners, particularly in 
cases where the film is not economically successful. In the case of the 
production company, the mismatching of expenses and income occurred 
because the partnership deducts the full cost of producing the film be- 
fore the film is released and because the contract which the limited 
partnership enters with the "owner" of the film (usually a studio- 
distributor) often provided that payments to the production company 
for its "services-' will be spread over a relatively long time period. 

Both types of investments involved the use of leverage (i.e., non- 
recourse loans) which allow the limited partners to receive tax de- 
ductions for amounts in excess of their economic investment. This 
result distorted the economic substance of the transaction b}^ permit- 
ting the taxpayer to deduct money which he has neither lost nor placed 
at risk. In the case of movie shelters, the use of very heavy leverage 
factors was not uncommon. 

As indicated above, questions existed under prior law as to whether 
investors in certain cases were entitled to the deductions they are claim- 
ing in connection with movie shelters. Thus, many participants in 
these shelters may have claimed deductions which will later be dis- 
allowed by the Service.^ 

In addition, the Congress was informed that the production com- 
pany shelter may be expanding into other areas, such as the publishing 
field. 

For these reasons, under the Act, the film purchase shelter is to be 
subject to an at risk rule, to prevent taxpayers from writing off more 
than their economic investment in this type of transaction. In the case 
of the production company shelter (including the use of a service 
company to produce books, recordings and similar property as well 
as films) , the Act requires capitalization of the expenses of production, 
not only for movies, but also for similar types of service company 
shelters. In addition, the production company movie shelter is also to 
be subject to the at risk rule. 



' In the case of the film purchase shelter, the principal issue in potential abuse situa- 
tions is whether the taxpayers have used an inflated basis for purposes of depreciation. In 
the case of the production company, the issue is whether the partnership has failed to 
reflect income properly by not capit.i'lizing the production costs of the film. In both shelters, 
the use of leverage to increase the partners' bases might be subject to question, at least 
under certain facts and circumstances. 



73 

Explanation of provisions 

The '■''at risk'''' rule 

Under the xlct, as indicated above, both the fihn purchase shelter 
and the production company shelter are to be subject to the at risk 
limitation. (The provisions of the at risk rule have already been 
explained in detail in section 2 above.) 

In the case of movie films activities engaged in by an individual 
(other than through a partnership) each film in which the taxpayer 
has an ownership interest, and each film which the taxpayer pro- 
duces or distributes, is to be considered a separate activity for pur- 
poses of the at risk rule. However, in the case of a partnership (or 
subchapter S corporation), all films in which the partnership (or 
subchapter S corporation) has an ownership interest, and all films 
which the partnership (or subchapter S corporation) produces or 
distributes, are to be treated as part of one activity. 

Amortization of production costs of motion pictures, hooks, records, 
and, other similar property 

To prevent a situation where a taxpayer may attempt to accelerate 
his deductions in connection with the production costs of a motion 
picture film (or other property), thus producing a mismatching of in- 
come and expenses attributabie to the income, the Act provides that a 
taxpayer is to be required to capitalize his share of the production costs 
and deduct them over the life of the income stream generated from the 
production activity. This rule is to apply to persons (other than cor- 
porations which are neither subchapter S corporations nor personal 
holding companies) engaged in the service of producing a film (in- 
cluding the costs of making prints of the film for distribution), sound 
recording (including discs, records, tapes, etc.) book, or similar prop- 
erty ( such as a play, etc. ) . 

Generally, it is anticipated that taxpayers who are subject to this 
capitalization requirement will (in effect) depreciate their capitalized 
expenses (in accordance with regulations to be prescribed by the Sec- 
retary) under a method analogous to the income forecast method. Thus, 
the production costs will be written off by the taxpayer over the useful 
life of the asset which he has acquired as a result of his investment. 
In the case of a service company shelter, the asset will be the taxpayer's 
contract rights under his contract with the motion picture distributor, 
publisher, etc. 

For purposes of these rules, the numerator of the income forecast 
fraction will be the income which the taxpayer has received under the 
contract. The denominator of the fraction is to be the total income 
which the taxpayer may reasonably expect to receive under the con- 
tract. Thus, in the case of a film service partnership, for example, the 
denominator of the fraction is to include the partnership's share of 
any anticipated income from the film (where the partnership is com- 
pensated by a percentage of income from the film), as well as any 
guaranteed payments which the partnership is to receive under the 
contract, and any income from the discharge of indebtedness. Of course 
each item of anticipated income is to be taken into account only once ; 
thus, where a partnership is entitled to 10 percent of gross income from 
the film, with a guaranteed payment of $1 million, the denominator of 



74 

the income forecast fraction would be the greater of ( 1 ) 10 percent of 
the anticipated gross revenues from the fihn, or (2) $1 million (so as 
to avoid double counting) . 

Effective dates 

Under the Act, the at risk rule is to apply to losses attributable to 
amounts paid or incurred (or amounts allowable as depreciation or 
amortization) in taxable years beginning after December 31, 1975. 
The at risk provision does not apply to a film purchase shelter if 
the principal photography began before September 11, 1975, there 
was a binding written contract for the purchase of the film on that 
date, and the taxpayer held his interest in the film on that date. The 
at risk rule also does not apply to production costs, etc., if the principal 
photography began before September 11, 1975, and the investor had 
acquired his interest in the film before that date. 

Under a second transition rule in the Act, this provision will not 
apply to costs of producing, displaying or distributing a film, in 
the case of a film production partnership, if (1) the principal photog- 
raphy begins before January 1, 1976, (2) the picture is to be pro- 
duced within the United States,^ and (3) there was binding written 
agreement in effect on Sei:)tember 10, 1975 (and at all times there- 
after) between a director (or a principal star) for the picture and the 
partnership which w^ill produce the film. An alternative to the third 
of these requirements may also be satisfied : under this alternative, on 
September 10, 1975, there must have been expended, or irrevocably 
committed, to the film the lower of (1) $100,000 or (2) 10 percent of 
the reasonably estimated total production costs of the film. This 
second transititon rule applies, however, only to taxpayers who held 
their interests in the film (or in a partnership which will produce the 
film) on or before December 31, 1975. 

In applying the at risk provisions to activities which were begun in 
taxable years l)eginning before January 1, 1976 (and not exempted 
from this provision by the above transition rules) , amoimts paid or 
incurred in taxable years beginning prior to that date and deducted in 
such taxable yeai-s will be generally be treated as reducing first that 
portion of the taxpayer's basis which is attnbutable to amounts not at 
risk. (On the other hand, withdrawals made in taxable years begin- 
ning before January 1, 1976, will be treated as reducing the amount 
which the taxpayer is at risk.) 

The capitalization requirement applies to costs of producing a film 
(i.e. a production partnership) or other similar property, if such costs 
are paid or incurred after December 31, 1975, and the principal pi'o- 
duction of the property began after that date. In the case of a film, 
principal production means principal photography; in the case of a 
sound recording, principal production is the date of the recording ; in 
the case of a book, principal production begins with the preparation of 
the material for publication ; in the case of other similar property, the 
commencement of principal production is to be determined in ac- 
cordance with regulations. 

9 For purposes of this rule, a film is to be treated as bein^ produced in the United 
States if at least 80 percent of the "direct production costs" of the film are paid or 
incurred for U.S. production (see discussion of this issue in connection with the "Invest- 
ment Credit in the Case of Movies and Television Films," infra). 



75 

As indicated above, in the case of both the film purchase shelter and 
the "production company" shelter there are some substantial ques- 
tions under prior law as to whether the deductions which are claimed 
in connection with some of these shelters are allowable. ( Such questions 
include the amount of depreciation which may be claimed, whether 
the deduction or capitalization is the appropriate treatment with 
respect to costs o.f production, and whether nonrecourse loans should 
be treated as debt or equity, etc.) In establishing transition rules with 
respect to the new restrictions on the deductibility of these items as 
added by the Act, the Congress intends to make clear that these transi- 
tion rules are not to be read as implying that deductions not otherwise 
allowable under prior law are to be allowable until the capitalization 
requirement and at the risk rule take effect. No inference is intended 
that such deductions were allowable under prior law and, quite to 
the contrary, it appears that, at least under certain facts and circum- 
stances, the questions as to the nonallowability of certain of these 
deductions under prior law are very substantial. 

Revenue ejfect 
It is estimated that the provisions with respect to the at risk re- 
quirement will result in an increase in budget receipts of $3 million 
for fiscal year 1977, $10 million for 1978, and $18 niillion for 1981. It is 
estimated that the capitalization requirement will result in an in- 
crease in budget receipts of $29 million for fiscal year 1977, $19 million 
for 1978, and $4 million for 1981. 

h. Clarification of Definition of Produced Film Rents (sec. 211 
of the Act and sec. 543 of the Code) 

Prior law 

Under prior law (and under the Act) , a corporation which is a per- 
sonal holding company is taxed on its undistributed personal holding 
company income at a rate of 70 percent (sec. 541). A corporation is a 
personal holding company w^here five or fewer individuals own more 
than 50 percent in value of its outstanding stock and where a/t least 60 
percent of the corporation's adjusted ordinary gross income comes 
from specified types of income. 

One income category treated as personal holding company income is 
"produced film rents." Generally, this category covere payments re- 
ceived by the corporation from the distribution and exhibition of 
motion picture films if these rents arise from an "interest" in the film 
acquired before its production was substantially completed (sec. 543 
(a) (5) (B) ). Produced film rents are not treated as personal holding 
company income, however, if such rents constitute 50 percent or more 
of the corporation's ordinary gross income. The qualifying rental in- 
terest under this category is one which arises from participation in the 
production of the film. In such cases Congress has regarded production 
activities as an active business enterprise. 

Amounts received pursuant to a contract under which the corpora- 
tion is to fuiTiish pei^onal services ma.y be classified, under certain 
conditions as personal holding company income (sec. 543(a) (7)). 

These statutory rules affect, among others, independent motion pic- 
ture and television producers, actors, directors, writers, etc. (or persons 
possessing more than one of these skills), who form corporations 



76 

through which they participate in making motion picture or television 
fihns. 

Reasons for change 

A question concerning the proper definition of produced film rents, 
for purposes of the personal holding company rules, has resulted from 
a recent decision by the Tax Court ^° which denied depreciation deduc- 
tions to an independent production company which produced an 
original motion picture with nonrecourse financing supplied by a 
major studio-distributor under an agreement that, on completion, all 
rights to the picture except a share in distribution profits vested in the 
distributor. The court held that, in these circumstances, the produc- 
tion company had no ownerehip interest in the film after it was com- 
pleted and therefore could not depreciate the costs of producing film. 

Although this case involved depreciation rather than personal hold- 
ing company issues, it appears that the Internal Revenue Service has 
interpreted the decision to require that an "interest" in a film, for 
purposes of the definition of produced film rents in sec. 543(a)(5), 
must be a depreciable interest. If a production company has only a 
profit participation after the picture is completed and released, but 
legally does not have an ownership interest sufficient to claim deprecia- 
tion, some revenue agents have treated all of the company's income as 
personal service contract income (under sec. 543(a) (7) of the Code). 

Congress decided that a production company does not have to have 
a depreciable interest in a picture it makes in order for its profits inter- 
est to qualify as produced film rents. The test under section 543 (a) (5) 
should be whether i\\e, company in fact produced the film. 

Explcmation of provision 

In order to avoid ambiguities, the Act (sec. 543(a)(5)(B)) sets 
forth more clearly the nature of the qualifying "interest" in a film. In 
the case of a producer who actively participates in producing a film, 
the term "produced films rents" will include an interest in the proceeds 
or profits from the film, but only to the extent that this interest is 
attributable to active participation in production activities.^^ 

Under this provision, a production company will be considered a 
"producer" if it engages in production activities and is involved in 
principal photography or taping of the production. The term "pro- 
ducer" also includes participation in qualifying production activities 
as a co-producer. 

Qualifying production activities cover preproduction activities, 
principal photograph}^ or taping, and postproduction functions neces- 
sary to produce a film or television tape. Preproduction activities in- 
clude acquiring literary rights on which the film is to be based; 
developing a shooting script, supervising writers, preparing budgets, 
scouting locations and employing crews to be involved in the produc- 
tion. Activities during principal photography (or taping) include 
administration of budgeted items, contracting for production facil- 
ities, actual filming or taping and reviewing rough cuts. Postproduc- 

10 Carnegie Productions, Inc.. 50 T.C. 642 (1973). 

" Other requirements in the existing: definition of produced film rents must also be sat- 
isfied, namely, that the payments received by the producer are for the use of, or right to 
use, the film and that the interest must be acquired before substantial completion of pro- 
duction of the film. 



77 

tion activities include film editing, dubbing, musical scoring, synchro- 
nizing, showings to exhibitors or other previewers, re-editing and 
delivering the completed film (or tape) for showing to the public. 

If the income of a corporation qualifies as produced film rents under 
this provision, as amended, the Congress believes that such income 
should not be subject to being treated as income from personal service 
contracts (for purposes of section 543(a) (7) ). 

On the other hand, if all or part of the conduct of production activi- 
ties lacks substance or is otherwise not bona fide (such as a corporation 
which primarily provides the services of an actor or actress who is 
nominally named "producer"), the Service is not to be precluded 
from attributing part of the company's income to personal service con- 
tracts (if the requirements of sec. 543(a) (7) are otherwise present). ^^ 

Congress does not intend the amendment made by this provision to 
affect depreciation questions, e.g.^ whether a production company 
owns a depreciable interest in a film financed by nonrecourse loans. 

Effective date 
This amendment applies to taxable years ending on or after Decem- 
ber 31, 1975. The Congress intends that no inference should be drawn 
from this change as to whether, before the effective date of this amend- 
ment, the definition of produced film rents required the corporation 
to have a depreciable interest in the film under production. 

Revenue effect 
It is estimated that this provision will result in a reduction in 
budget receipts of less than $5 million annually. 

6. Equipment Leasing — ^Limitation on Loss to Amount At Risk 
(sec. 204 of the Act and sec. 465 of the Code) 

Prior law 

Accelerated depreciation. — The owner of personal property used for 
the production of income may generally claim annual deductions for 
depreciation to reflect the approximate decline in the value of the prop- 
erty over the period of the owner's use of the property. These deprecia- 
tion deductions are also available where the owner is not the actual user 
of the property, such as in a leasing transaction where the owner leases 
the depreciable property to another party who has possession and use 
of the property. In certain cases where title to the depreciable property 
is held for the benefit of individual investors by a legal entity, such as 
a partnership or grantor trust, the depreciation deductions are passed 
through them to the individual taxpayers who own the actual beneficial 
interests in the property and are deducted on these taxpayer's income 
tax returns. 

There are a number of depreciation methods. One depreciation 
method for tangible personal property is the straiglit-line method, 
under which an exjual portion of the property's depreciable basis is 
deducted each year of the property's useful life. 

'^^ A corporation which "loans out" the services of an actor, writer, director, or Individual 
producer employed by It to another company which produces the picture should also 
not be considered to receive produced film rents. In that type of case, the loaned-out em- 
ployee does not assume the business risks involved in producing the picture. 



78 

Equipment leasing transactions have often characterized, however, 
by use of one of the accelerated methods of tax depreciation which 
allow large deductions initially, with gradually reduced deductions for 
each successive year of the asset's useful life. The accelerated deprecia- 
tion methods allowed for productive equipment include the double- 
declining balance method and the sum-of-the-years-digits method. 

Additional -first-year depreciation. — An owner of equipment may 
also elect, for the first year the property is depreciated, a deduc- 
tion for additional first-year depreciation of 20 i)ercent of the cost of 
property which has a useful life of six years or more (sec. 179). The 
amount of cost on which this "bonus" depreciation is calculated is 
limited to $10,000 per taxable year ($20,000 for an individual who 
files a joint return). The maximum bonus depreciation in any taxable 
year is as a result limited to $2,000 ($4,000 for an individual filing a 
joint return). 

Where the lessor is a partnership, the election for bonus deprecia- 
tion is made by the partnership. However, the dollar limitation de- 
scribed above was, under prior law, applied to the individual partners 
rather than the partnership entity. For example, each one of 40 indi- 
vidual investors who contribtued $5,000 to an equipment leasing limited 
partnership, which purchased a $1 million executive aircraft on a 
leveraged basis, would be entitled to $4,000 of bonus depreciation if he 
filed a joint return. In this case, additional first-year depreciation 
would have provided a total deduction to the partners of $160,000. 
(This provision in prior law has been changed by sec. 213(a) of the 
Act.) 

The additional first-year depreciation reduces the depreciable basis 
of the equipment. However, the partnership is still entitled to claim, 
and the partners to deduct, accelerated depreciation on the reduced 
basis in the property both for the first year and for the later years of 
the property's useful life. 

Asset depreciation range {ADR). — The ADR system for deprecia- 
tion was authorized by the Congress in the Revenue Act of 1971 in 
order to bolster a lagging economy and to eliminate a number of diffi- 
cult interpretative problems pertaining to depreciation which had 
arisen under prior law. The ADR system operates under regulations 
issued by the Treasury Department, and became effective in 1971. 
(Reg. § 1.167(a)-ll.) 

One of the important features o.f ADR is that taxpayers are allowed 
to depreciate tangible personal property, including leased property, 
over useful lives which may vary up to 20 percent from the guide- 
line lives which are otherwise authorized for use under the ADR 
system. 

This means, for example, that an asset with a depreciable useful life 
of 10 years under the ADR guidelines may instead be depreciated 
over a period of 8 years, giving the taxpayer a type of "accelerated" 
depreciation deduction even with straight-line depreciation.^ 

1 In computing depreciation under the ADR system, a taxpayer also is entitled to use 
one of two first-year "conventions," or methods, on all assets first placed in service during 
any one tax year or period. Under the first of these conventions, the taxpayer may elect to 
claim a half-year's depreciation on all assets put into service at any time during the year. 
The other convention allows a full year's depreciation for all assets placed in service during 
the first half of the tax year and no depreciation (for the first year) on assets placed in 
service during the last half of the tax year. 



79 

Rapid amortization. — Certain categories of assets which are subject 
to equipment leasing transactions have been eligible for rapid amorti- 
zation. Under the rapid amortization provisions, the costs for qualify- 
ing categories of property may be amortized over a period of 60 months 
in lieu of depreciation deductions otherwise allowable for these assets. 
Rapid amortization has been allowed for pollution control facilities 
(sec. 169), railroad rolling stock (sec. 184), and coal mine safety 
equipment (sec. 187). These provisions expired at the end of 1975.^ 

Depreciation recapture. — The equipment leasing venture does not 
give rise to the "conversion" characteristic common in many other 
types of tax shelters because of the full recapture rules that apply to 
dispositions of depreciated personal property. When personal prop- 
erty is disposed of at a gain, the gain is "recaptured" as ordinary in- 
come to the extent of all previous depreciation or amortization deduc- 
tions claimed on the property (not just accelerated deductions). The 
recapture treatment for depreciable personal property thus differs 
from that accorded depreciable nonresidential real property, which 
is limited to a recapture of the amount by which accelerated depreci- 
ation deductions claimed exceed those allowable on a straight-liup 
basis. 

In the case of a partnership, the individual partners are generally 
allocated a share of the partnership's depreciation recapture in accord- 
ance with the provisions of the partnership agreement concerning the 
allocation of partnership gains. The recognition of depreciation re- 
capture by a partner may be triggered directly by a sale of the de- 
preciated partnership property or indirectly by a disposition of the 
partner's interest in the partnership itself. Also, if a lender forecloses 
on the debt used to finance the partnership's purchase of the equip- 
ment, this is treated as a disposition which will trigger recapture. 
The amount "received" in a foreclosure will include the unpaid non- 
recourse debt. If this amount exceeds the undepreciated basis in the 
equipment, there will be so-called "phantom gain" which is taxed as 
ordinary income to the partners. 

Limfiitation on deduction of losses. — Generally, the amount of deduc- 
tions or of losses which a taxpayer was permitted to claim in connec- 
tion with a business or investment property was limited to the amount 
of his basis in the property. Likewise, in the case of a partnership, the 
amount of losses a partner may deduct was limited to the amount o.f 
his adjusted basis in his interest in the partnership. However, basis in 
a property may include nonrecourse indebtedness (i.e., a loan on which 
there is no personal liability) attributable to that property, and where 
a partnership incurs a debt and none of the partners have personal 
liability on the loan, then all of the partnere are treated for tax pur- 
poses as though they shared the liability in proportion to their profits 
interest in the partnership (i.e., each partner's share in the nonrecourse 
indebtedness is added to this basis in the partnership). As a result, 
prior law enabled investors in an equipment leasing activity to deduct 
losses from the activity in excess the total amount of economic risk the 
investor had from the activity. 

3 However, amortization for pollution control facilities was extended under Sec. 2112 of 
the Act. 



80 

Also, there was generally no limitation on the amount of deductions 
that can be taken in situations where the taxpayer is protected against 
ultimate loss by reason of a stop-loss order, guarantee, guaranteed re- 
purchase agreement, insurance or otherwise. 

Reasons for change 

A business may acquire productive equipment in a variety of ways, 
including an outright purchase or a lease of the equipment. Although 
an outright purchase remains the most common form of acquiring the 
use of equipment, recent years have shown a substantial growth in 
the leasing alternative. Some of the more common types of property 
and equipment which have been leased include computers, aircraft, 
railroad rolling stock, ships and vessels, and oil drilling rigs. Also, 
utility companies have begim to lease the nuclear fuel assemblies used 
in their generating plants. 

There are several reasons for the growth in equipment leasing. 
From the standpoint of the business lessee who uses the equipment, 
one factor, for example, is the opportunity to acquire use of the equip- 
ment in a manner which, in comparison with the purchase alternative, 
places less strain upon the available cash of the business. Another 
important advantage for the lessee is that leasing provides greater tax 
benefits through the ability to deduct its rental costs. There are also 
significant tax benefits to the lessor in an equipment leasing trans- 
action (such as accelerated depreciation deductions, as discussed 
above) which attract the participation of individual investors. 

The equipment leasing tax shelter generally operates through the 
limited partnership f omi of business organization, with the individual 
investors participating as limited partners. All, or virtually all, of 
the equity capital of the venture is contributed by the limited partners 
and non-recouse financing is obtained for 75-80 percent of the cost of 
the equipment w^hich is purchased by the partnei-ship and leased to a 
business user. The partnership generally leases the equipment to the 
lessee at a rental rate which, over the initial term of the lease, will 
enable the partnership to repay the loan, plus interest, fees and other 
expenses, and generate a modest positive cash flow. 

In most leasing shelters, the limited partnership elects the method 
of depreciation or amortization which will generate the largest capital 
recovery deductions allowable in the early years of the lease. The 
partnership may, in addition, prepay some of its interest charges, and 
often, during the first year of operation, pays the promoter for man- 
agement and syndication fees. The large depreciation, fees, interest, 
and other expenses generally exceed the partnership's receipts from 
rental of the equipment during the first 8-7 years of the lease (depend- 
ing upon i\\e estimated useful life of the leased equipment), and this 
generates sizable losses for the partnership. 

Partnership losses are allocated to the investor-limited partners 
under the partnership agreement and are used by the individual in- 
vestors to offset income from other sources (and thus defer taxes on 
this income for a number of years) . The individual investor may also 
obtain an apportioned share of the investment credit if the equipment 
is eligible for the credit and the lease is of a type which enables an 
individual investor to claim the credit. 



81 

Because of these tax advantages under prior law, when an invest- 
ment was solicited in an equipment leasing venture, it was common 
practice to promise a prospective investor substantial tax losses which 
could be used to decrease the tax on his incx)me from other sources. 
The Congress believed that is was not equitable to allow these individ- 
ual investors to defer tax on income from other sources through the 
losses generated by equipment leasing transactions, to the extent the 
losses exceed the amount of his resources the investor has actually 
placed at risk in the transaction. 

This leveraging of investments to produce tax savings in excess of 
amounts invCvSted substantially alters the economic substance of the 
investment and distorts the workings of the investment markets. Tax- 
payers, ignoring the possible tax consequences in later years, can be 
led into investments which are otherwise economically unsound and 
which constitute an unproductive use of the taxpayer's (and the fed- 
eral government's) investment funds. Because of these considerations, 
the Act applies the "at risk" rules to equipment leasing activities. 

Explanatimi of provision 

The Act provides that where an individual taxpayer may otherwise 
be entitled to deduct a loss in excess of his economic investment in an 
equipment leasing activity, the amount of the loss deduction is limited 
to the aggregate amoimt with respect to which the taxpayer is at risk 
in this trade or business at the close of the taxable year. This "at risk" 
limitation applies to all individual taxpayers who invest in an equip- 
ment leasing activity, including individuals who invest for their 
own account and those who do so through another entity such as a 
partnership, personal holding company, or subchapter S corporation. 
In addition, the limitation extends to trusts and estates, which are 
taxed like individuals. ( For more detail as to the application and scope 
of the risk rule, see section 2, above.) 

Under the at risk rule as it applies to equipment leasing, the tax- 
payer is considered to be in a leasing activity if he has an ownership 
interest, either direct or indirect, in section 1245 property (as defined 
in sec. 1245(a) (3)) which is leased or held for leasing.^ In the case 
Avhere equipment leasing activity is conducted by an individual, the 
at risk limitation applies separately to each property leased or held 
for leasing. (However, where several properties, such as parts of a 
computer, comprise one unit under the same lease agreement and are 
neither separately financed nor are subject to different lease terms, 
the properties are to be considered one property for purposes of the 
at risk rule.) 

All equipment leasing activities engaged in through a partnership 
or subchapter S corporation will be treated as one activity under this 
provision. However, if the partnership or corporation engages in more 
than one type of activity covered by the at risk rule, then each type of 
activity is treated as a separate activity. For example, if a partnership 
has one farm and a number of equipment leasing transactions, it will 
be considered to have two activities, farming and equipment leasing, 

» Since the at risk rule does not apply to real estate activities, in a situation where 
section 1245 property is leased as a minor incident of a lease of real property (such as 
where an unfurnished rental apartment is equipped with a stove or refrigerator), the 
at risk rules for equipment leasing will not be considered to apply. 



82 

and a separate application of the at risk limitation must be made for 
each of the two activities. 

Effective date 

The at risk rule for equipment leasing will apply generally to losses 
attributable to amounts paid or incurred (including depreciation or 
amortization allowed or allowable) after December 31, 1975. Special 
transitional rules are provided however for pre-existing leasing trans- 
actions.* In the case of leasing transactions where the property is leased 
under an operating lease, the at risk rule will not apply if the property 
was either subject to a binding lease before May 1, 1976 or subject to a 
binding purchase order by the lessor or lessee before this date. How- 
ever, this grandfather rule will apply only to those taxpayers who 
owned their interests in the leased property on April 30, 1976.^ The 
at risk rule will not apply to any type of leasing transaction where 
the property was either leased or ordered (by the lessor or lessee) be- 
fore January 1, 1976, but only for those taxpayers who owned their 
interests in the property on JDecember 31, 1975. In those situations 
where the eventual lessee has executed a binding purchase order for 
property by the relevant effective date and an investor has similarly 
Acquired (or has irrevocably committed himself to acquire) an interest 
in the partnership or other entity which becomes the eventual lessor of 
the property by that date, the investor will be considered to have 
acquired an interest in the property for purposes of these transitional 
rules even though the assumption of the lessee's purchase order by the 
lessor entity actually occurs after the relevant date under these rules. 

For purposes of these transitional rules, an order, a lease, and the 
acquisition of an interest in the property will not be considered to have 
occurred luitil they are evidenced by binding and legally enforceable 
agreements which are complete as to all relevant terms. However, a 
lease agreement will be considered binding on the relevant dates under 
the above provisions even though it is later modified to increase (but 
not decrease) the lease term. 

Revenue effect 
This provision will increase budget receipts by $4 million in fiscal 
year 1977, $14 million in fiscal year 1978, and $14 million in fiscal year 
1981. 

7. Sports Franchises and Player Contracts (sec. 212 of the Act and 
sec. 1245 and new sec. 1056 of the Code) 

Prior law 

Generally, the cost of tangible property used in a taxpayer's trade 

or business may be depreciated and deducted over the useful life of 

the property. In the case of a sports franchise, players' contracts 

(contracts for the services of athletes) are intangible assets and usually 

* These transitional rules In the Act erroneously refer to actiivtles "described in [Code] 
section 465(c)(1)(B)", that is, farming activities. Congress intends, however, that these 
transitional rules apply to equipment leasing activities described in section 46.t(c) (1) (C). 

° An operating lease for purposes of this transitional rule is defined in Code section 
46(e)(3)(B) as generally one where the lease term is less than 50 percent of the 
property's useful life and the lessor's unreimbursed ordinary and necessary business 
deductions^ (under section 162) from the property are greater than 15 percent of Its 
rental income during the first 12 months the property Is held by the lessee. 



83 

represent one of the important costs incurred in connection with the 
acquisition of the franchise. It is the position of the IRS (as described 
below) that player contracts have a useful life of more than one 
year and therefore the cost of acquiring a player's contract is to be 
capitalized and depreciated over the life of the contract. While the 
terms of players' contracts vary with the type of sport involved, the 
typical contract will provide employment for one year and give the 
employer (the team) a unilateral option to renew the contract for an 
additional year at a specified percentage of the player's previous 
salary.^ 

In 1967, the Commissioner of Internal Revenue ruled that the cost 
of a player's contract must be capitalized and depreciated over the use- 
ful life of the contract. (Rev. Rul. 67-379, 1967-2 C.B. 127.) In adopt- 
ing this position, the IRS noted that by reason of the reserve clause, 
a player contract has a useful life extending beyond the taxable year 
in which the contract was acquired. In Rev. Rul. 71-137, 1971-1 C.B. 
104, the same result was reached with respect to football contracts by 
virtue of the option clause under the contract. Although the useful life 
varies from sport to sport, sports teams typically adopt a maximum 
life ranging between three and six years. The cost to be capitalized in- 
cludes amounts paid or incurred upon purchase of a player contract 
and bonuses paid to players for signing contracts. 

The depreciable basis of player contracts also affects the current 
capitalization and depreciation of bonus payments to be made in the 
future under the terms of the contract. Generally, an accrual basis 
taxpayer is entitled to deduct an unpaid expense for the taxable year 
in which all the events have occurred which determine the fact of 
liability and the amount can be determined with reasonable accuracy 
(Treas. Reg. § 1.461-1 (a) (2)). Under this general rule, accrued sal- 
aries would ordinarily be deductible expenses for the taxable year in 
which earned by the employees even if paid in the following taxable 
year. However, any expenditure which results in the acquisition of an 
asset having a useful life which extends substantially beyond the close 
of the taxable year may not be deductible for the taxable year in which 
the liability for the expenditure was incurred. This limitation would 
generally apply to amounts required to be capitalized with respect to 
a liability for future payments u^.der a player contract. 

In addition, another specific limitation would also apply in the case 
of such a contract if it is treated as a nonqualified deferred compensa- 
tion plan. An employer is not entitled to deduct contributions made to 
or under a nonqualified deferred compensation plan, usually a trust, 
until the taxable year in which an amount attributable to the con- 

1 Baseball and hockey contracts contain a specific "reserve clause" in whicli the right 
to renew the contract Is Itself renewed. Although the team obligates Itself for only one 
year, the effect of this reserve clause in the contract, and certain league rules, is to 
f-lnd the player to play only for the team which owns the contract. Under league rules, if 
the player refuses to sign a new contract or play for an additional year under the terms 
contained In the original contract, the team can prevent the player from playing for 
another team. Basketball and football player contracts purport to be less restrictive in that 
although they provide an option for an additional year's contract, they do not contain a 
reserve clause per «e. Neither the contract nor the league rules prevent the player from 
"playing out his option" and becoming a "free agent." However, in the case of football, if a 
player becoming a free agent signs a contract with a different team in the NPL, then unless 
mutually satisfactory arrangements have been reached between the two league teams, the 
Commissioner of the NFL can assert the right to award to the former team one or more 
players (including future draft choices) of the acquiring team. This right is currently being 
litigated. 



84 

tribution is includible in the gross income of the employee, (sec. 404 
(a)(5)). The employee-beneficiary must generally include amounts 
paid on his behalf in his taxable year in which there is no substantial 
risk of forfeiture (sees. 83, 402(b), and 403(c)). In addition, the 
Internal Eevenue Service has ruled that if compensation is paid by 
an employer directly to a former employee, under an unfunded plan, 
such amounts are deductible when actually paid in cash or other 
property (Rev. Rul. 60-31, 1960-1 C.B. 174). Thus, the deferred 
compensation rules would preclude the allowance of a deduction under 
an unfunded plan before the team makes the payment where the useful 
life of the player contract is shorter than the actual payout period. 

When there is a sale or exchange of a sports franchise, both the 
buyer and the seller must generally make an allocation of the consid- 
eration for the sale or exchange between the various assets acquired or 
sold. Franchise rights are not usually depreciable because these rights 
exist for an unlimited period of time. Therefore, a purchaser of a 
sports team will benefit from larger depreciation deductions if he is 
able to allocate more of the aggregate purchase price to player con- 
tracts and less to franchise rights. Under prior law, there was no spe- 
cific rule relating to the allocation of a portion of the total considera- 
tion paid to acquire a franchise, players' contracts and other assets 
which might be acquired at the time of acquisition of a franchise. 
Generally, this allocation was made on the basis of the fair market 
values (or relative fair market values) of the various assets. The 
allocation to players' contracts was also necessary when a new franchise 
is acquired through the expansion of an existing league or the forma- 
tion of a new league. 

Generally, depreciable property that is used in a trade or business 
is not treated as a capital asset. However (under section 1231), a tax- 
payer who sells property used in his trade or business benefits from 
special tax treatment. All gains and losses from section 1231 property 
are aggregated for the taxable year and any gain is treated as capital 
gain. If the losses exceed the gains, the loss is treated as an ordinary 
loss. Thus, gains from the sale of player contracts will be treated as 
capital gain and taxed at the more favorable long-term capital gain 
rates if the contracts were held for the requisite holding period, to 
the extent such gains are not "recaptured" as ordinary income under 
section 1245.^ 

Reasons for change 

In many cases, the tax benefits which can be derived from mvesting 
in a sports franchise combine to transform an otherwise unprofitable 
investment into a very profitable one. In addition, the tax benefits to 
some extent may have increased the price of sports franchises. 

One practice that increased the tax benefits resulting from the opera- 
tion of a sports franchise was the allocation of a large part of the 
amount paid for the acquisition of a sports team to player contracts. 
Typically, a purchaser of a sports franchise attempted to allocate 
most of the aggregate purchase price of the franchise to player con- 

2 The Internal Revenue Service has ruled that gains from the disposition of depreciable 
professional baseball and football player contracts which are owned by teams for more 
than 6 months are subject to recapture as ordinary income. [Rev. Rul. 67-380, 1967-2 C.B. 
291 : Rev. Rul. 71-137, 1971-1 C.B. 104.] 



85 

tracts because the cost of a player contract could be deprecia.ted over 
the life of the contract.^ Amounts that were allocated to other assets 
such as the franchise rights or to good Avill could not be depreciated 
because these assets have an indeterminate useful life. 

On the othei- hand, the seller attempted to allocate most of the aggre- 
gate sales price to franchise rights. In this way, a greater amount of 
any gain was tiTiated as capital gain and a lesser amount was treated 
as gain attributable to depreciable assets (e.g., players' contracts) sub- 
ject to recapture as ordinary income. 

Since under prior law, depreciation with respect to player contracts 
was recaptured on a contract by contract basis, a substantial amount 
of lepreciation allowed was not recaptured since Uiany of the original 
players had retired or had been "cut" and replaced by new players. In 
addition, an abandonment loss is allowed for the adjusted basis of the 
player contract in the year a player retired or was cut. To the extent 
that gain attributable to player contracts was not recaptured, it can be 
argued that the taxpayer has converted an ordinary deduction into 
capital gain. Since the amount allocated to player contracts was usual- 
ly a large portion of the acquisition cost of a sports franchise and may 
be depreciated ov^er a short life, the amount allowed as a deduction in 
the early years in most cases was in excess of the income generated by 
the sports franchise for that year and produced a tax loss to shelter 
other income. 

The Congress believed it was appropriate to deal directly with the 
tax treatment of player contracts in these cases since the concern has 
been with the allocation of basis to player contracts in the case of a 
sale or exchange of a sports franchise and the conversion of ordinary 
income into capital gain upon a subsequent sale. As a result, the Act 
in general provides that the purchase price allocated to player con- 
tracts by the purchaser cannot exceed the amount of the sales price allo- 
cated to those contracts by the seller. Also upon the subsequent sale 
of the franchise by the })urchaser, the Act generally provides for the re- 
capture of the depreciation taken (or any abandonment of losses) on 
the player contracts which were initially acquired with the original 
acquisition of the franchise by the seller. 



3 Of the total cash consideration paid for an expansion major league football team, the 
Atlanta Falcons, the purchaser (a subchapter S corporation) treated $7,722,914 as the 
cost of player contracts and options, $727,08t5 as deferred interest and the remaining 
$50,000 as the cost of the franchise. This resulted in tax losses to the corporation of 
$506,.329 in 1967 and $581,047 in 1968 which was passed through to the shareholders on 
a proportionate basi.s. TTpon audit, the IRS determined that onl.v .fl, 050,000 should be 
allocated to the player contracts and options, and $6.72'.i,914 should be allocated to the 
nondepreciable cost of the National Football League franchise. The taxpayer paid the 
additional assessment, submitted a claim for refund, and after its disallowance, filed a 
suit for refund. The court rejected both the taxpayer's initial allocation of $7,722,914 and 
the Commissioner's allocation of $1,050,000 and "concluded that the amount that should 
have been allocated to the players' contracts and options was $3.0.'^5,0O0. (Laird v. U.S., 
391 F. Supp. 656, 75-1 U.S.T.C. Par. 9274 (N.D. Ga. 1975)), The court further concluded 
that $4,277,04.3 represented the value of the television rights granted to the Atlanta 
Falcons under a 4-year contract between the NFL and the CBS television network and that 
this amount was not amortizable because the useful life of the television rights was for an 
Indefinite period. The case is presently on appeal in the Fifth Circuit. 

Questions have been raised as to the method used by the District Court in allocating 
the purchase price to the various assets acquired in the Laird case. Although the court held 
rhat the right to participate in receipts from television contracts could not be depreciated 
since it "had no defiinite limited useful life the duration of which could be ascertained with 
reasonable accuracy," the court relied upon the existing 4-year contract in valuing this 
risrht for purposes of allocating the purchase price. Concern has been expressed as to 
whether, it the television contract had only 1 year left at the time of acquisition, the court 
would have deterniiued the contract's value to be the present value of the right to receive 
television receipts for only 1 year. 



234-120 O - 77 - 7 



86 

Explanation of provision 

The Act provides that in the case of the sale, exchange, or other 
disposition of a sports franchise (or the creation of a new franchise), 
the amount of consideration allocated to a player contract by the trans- 
feree shall not exceed the sum of the adjusted basis of the contract in 
the hands of the transferor immediately before the transfer and the 
gain (if any) recognized by the transferor on the transfer of the 
player contract. In this way, a more appropriate allocation will be 
achieved since, to a substantial extent the buyer and seller will be 
adverse parties with respect to the allocation (i.e., to the extent that 
the amount of gain attributable to player contracts will be fully re- 
captured as ordinary income, the buyer and seller will be operating 
at arms-length with respect to the allocation). This limitation is not to 
apply to a like-kind exchange under section 1031 of the code. In addi- 
tion, the provision is not to apply with respect to the determination of 
basis of the player contract in the hands of a person acquiring the con- 
tract from a decedent. 

Under this provision, th^ transferor must provide both the Secre- 
tary and transferee with information stating the amount which the 
transferor believes to be the adjusted basis in the player contract, the 
amount which the transferor believes to be the gain (if any) recog- 
nized on the transfer of the player contract and any subsequent modi- 
fication to either amount. The time and manner for furnishing this 
information is to be provided by regulations prescribed by the Secre- 
tary. Further, these amounts are to be binding on both the transferor 
and the transferee to the extent provided in such regulations. 

The Act also provides that in the case of the sale or exchange of 
a sj>orts franchise, it is presumed that not more than 50 percent of 
the consideration is allocable to player contracts unless the taxpayer 
can satisfy the Secretary of the Treasury that under the facts and cir- 
cumstances of the particular case, it is proper to allocate an amourt in 
excess of 50 percent. However, the Act provides that the presumption 
does not mean that an allocation of less than 50 percent of the consid- 
eration to player contracts is proper. The proper allocation is to de^yend 
upon the facts and circumstances of each particular case. Facl:>rs to 
be taken into account by the Secretary are to include the amount of 
gate receipts received by the past owner of the franchise (as well as 
the amount expected to be received in the future) , the amount of radio 
and television receipts that were received by the past owner of the 
franchise (as well as the amount expected to be received in the future) , 
etc. It is recognized that there are differences among the various sports 
which ai-e relevant to the proper allocation and, therefore it is intended 
that factors peculiar to each sport (and to each team) be taken into 
account. For example, in the case of baseball, revenues from television 
and radio contracts are to a substantial degree derived from individual 
team contracts rather than, as in the case of football, from leaarue 
contracts. 

The Act provides special rules for the recapture of depreciation 
and deductions for losses taken with respect to player contracts. The 
special recapture rules apply only in the case of the sale, exchange, or 
other disposition (other than a disposition under vihich the trans- 



87 

feree has a carry-over basis) of the entire sports franchise. In the case 
of the sale or exchange of individual player contracts recapture will 
continue to be determined on a contract-by-contract basis. Under these 
special rules, to the extent of any gain attributable to plaj^er contracts, 
the amount recaptured as ordinary income will be the greater of (1) 
the sun\ of the depreciation taken plus any deductions taken for losses 
(i.e., abandonment losses) with respect to those player contracts which 
are initially acquired as a part of the original acquisition of the fran- 
chise or (2) the amount of depreciation taken with respect to those 
player contracts which are owned by the seller at the time of the sale of 
the sports franchise. To the extent that depreciation taken on player 
contracts which were acquired as part of the original acquisition of the 
franchise has previously been recaptured, the amount so recaptured 
will reduce the aggregate amount of depreciation and losses attributa- 
ble to player contracts initially acquired for purposes of determining 
the recapture amount under (1) above. The amount determined under 
(2) above with respect to player contracts held at the time the fran- 
chise is sold will be equal to the aggregate depreciation allowed or 
allowable for all such contracts. Thus, the amount subject to recapture 
will be determined for player contracts on a consolidated basis and 
may exceed the sum of the amounts which would otherwise be sub- 
ject to recapture if determined on a contract-by-contract basis, e.g., 
the aggregate gain is ecpial to or greater than the aggregate depre- 
ciation deductions, but the gain attributable to one or more of the con- 
tracts is less than the applicable depreciation. 

Effectme dates 
The provision relating to the allocation of basis to player contracts 
applies to sales or exchanges of franchises after December 31, 1975, in 
taxable years ending after that date. The provision relating to the 
recapture of depreciation applies to transfers of player contracts in 
connection with any sale or exchange of a franchise after December 31, 
1975. 

Revenue efect 
It is estimated that the provision relating to allocation of basis to 
player contracts will result in a revenue gain of $1 million for fiscal 
year 1977, and $8 million for fiscal year 1981. In addition, it is esti- 
mated that the provision relating to depreciation recapture will result 
in a revenue gain of $7 million for fiscal year 1977 and 1981. 

8. Partnership Provisions 

o. Partnership Additional First-Year Depreciation (sec. 213(a) of 
the Act and sec. 179(d) of the Code) 

Prior Imii 
An owner of tangible personal property is eligible to elect, for the 
first year the property is depreciated, a deduction for additional first- 
year depreciation of 20 percent of the cost of the property (sec. 179). 
The cost of the property on which this "bonus" depreciation is calcu- 
lated is not to exceed $10,000 ($20,000 for an individual who files a 



88 

joint return). The maximum bonus depreciation deduction is thus 
Rmited to $2,000 ($4,000 for an individual filing a joint return). Bonus 
depreciation is available only for property that has a useful life of six 
years or more. 

Wliere the owner is a partnership, the election for bonus deprecia- 
tion is made by partnership. However, under prior law, the dollar 
limitation described above was applied to the individual partners 
rather than to the partnership entity. For example, each one of 40 
individual investors who contributed $5,000 to an equipment leasing 
limited partnership, which purchased a $1 million executive aircraft, 
would have been entitled to $4,000 of bonus depreciation if he filed a 
joint return. In this case, additional first-year depreciation would have 
provided total deductions to the partners of up to $160,000. 

A corporation, however, under present law, is allowed to deduct only 
$2,000 of additional first-year depreciation. Thus, in the case of the 
purchase of an aircraft, as described above, a corporation would be 
limited to $2,000 of additional first-year depreciation, whereas the 
partnership, under prior law, could have passed through to the part- 
ners total first-year additional depreciation of up to $160,000. 

RemoTis for change 

Allowing each individual partner in a partnership to have the full 
$2,000 first-year depreciation deduction (or $4,000, in the case of a 
married partner filing a joint return) inflates the amount of "bonus 
depreciation" which should be allowable in the year the property is 
placed in service. 

The provision for bonus depreciation (sec. 179) was enacted to 
provide a special incentive for small businesses to make investments in 
depreciable property. The limitations on the dollar amount of property 
with respect to which a taxpayer can take additional first-year de- 
preciation were intended to insure that this provision allow only a 
very limited dollar benefit to any enterprise, regardless of size. The 
dollar limitation was thus intended to insure that the allowance for 
additional first-year depreciation would be of significance primarily 
for small businesses. In practice, however, the lack of a dollar limita- 
tion on the amount of depreciable basis with respect to which a part- 
nership could calculate the bonus depreciation — even though there 
is a dollar limitation which applies to each partner — had enabled 
partnerships with many partners, especially tax-shelter partnerships, 
to pass through amounts of bonus depreciation very substantially in 
excess of what was intended to be allowed. 

Explanation of provision 

The Act provides that, with respect to a partnership, the dollar 
limitation is first applied at the partnership level. Thus, the cost of the 
property on which additional first-year depreciation is calculated for 
the partnership as a whole is not to exceed $10,000, However, this pro- 
vision does not affect the dollar limitation which is applicable to the 
individual partners. Thus, for example, if a single individual is a 
member of a partnership and also owns a sole proprietorship, the total 
amount of the cost basis of property on which he can calculate addi- 
tional first-year depreciation is $10,000. 



Ejfecti/ve date 
This provision is effective for partnership taxable years beginning 
after December 31, 1975. 
Revenue effect 
It is estimated that this provision and the three following partner- 
ship provisions will result in an increase in budget receipts of $12 mil- 
lion in fiscal year 1977 and $10 million annually thereafter. 

6. Partnership Syndication and Organization Fees (sec. 213(b) 
of the Act and sees. 707(c) and 709 of the Code) 

Prior law 

Prior law (sec. 707(c)) provided for the deduction by a part- 
nership of so-called "guaranteed payments" made to a partner for 
services or for the use of capital to the extent the payments were deter- 
mined without regard to the income of a partnership, "but only for the 
purposes of section 61(a) (relating to gross income) and section 162 
(a) (relating to trade or business expenses)." However, present law 
(sec. 263) generally provides that no current deduction shall be 
allowed for capital expenditures. Nonetheless, it has been contended 
that these payments under section 707(c) were automatically deducti- 
ble by the partnership without regard to the "ordinary and necessary" 
requirements of section 162 (a) or section 263. 

Thus, until recently, it has been the common practice for limited 
partnerships to deduct the payments made to the general partner for 
the services he rendered in connection with the syndication and orga- 
nization of the limited partnership. However, in recently issued Rev. 
Rul. 75-214 (1975-1 C.B. 185), the Internal Revenue Service ruled 
that payments made by a partnership to a general partner to reim- 
burse^ him for costs of "organizing the partnership and for selling the 
limited partnership interests were not automatically deductible by 
virtue of section 707(c), but rather were capital expenditures under 
section 263. The ruling stated that: "For purposes of either section 
707(a) or section 707(c) of the Code, payments to partners for serv- 
ices on behalf of the partnership may be deducted by the partnership 
only if such payments would otherwise be deductible (under section 
162) if they had been made to persons who are not members of the 
partnership." 

Similarly, the Tax Court, in Jaclcson E. Cagle. Jr., 63 T.C. 86 ( 1974) 
a.fd, 539 F. 2d 409 (5th Cir. 1976), disallowed deductions for part- 
ners' shares of payments made by a partnership to another partner for 
services rendered in conducting a feasibility study of a proposed oifice- 
showroom facility, obtaining financing:, and developing a building for 
the partnership. In this decision, the Tax Court expressly rejected the 
contention that Congress, in enacting section 707(c), had intended 
to make guaranteed payments to partners automatically deductible to 
the partnership without regard to sections 162(a) and 263. 

Reasons for change 
The correct interpretation of section 707(c) is the interpretation 
given that subsection by the Internal Revenue Service and the Tax 



90 

Court, as discussed above. However, despite this court decision 
and Revenue Ruling, prior law was not entirely clear that, to be de- 
ductible, guaranteed payments must meet the same tests under section 
162(a) as if the payments had been made to a person who is not a 
member of the partnership. A contrary conclusion would allow part- 
nerships to treat capital expenditures as current deductions, while a 
corporation incurring these expenditures would not be entitled to simi- 
lar treatment. 

While section 263 requires these expenditures of a corporation to 
be capitalized, section 248 allows the corporation to elect to amortize 
the organizational expenditures (as opposed to syndication-type ex- 
penditures) over a period of not less than 60 months. Under the regula- 
tions, the costs incurred by a corporation in marketing and issuing its 
stock are capital expenditures under section 263, but are not subject 
to the 60-month amortization provisions of section 248. (Regs. 
§ 1.248-1 (b) (3) (i)i 

Explanation of provisions 

The Act adds a new provision (sec. 709) which provides that, sub- 
ject to the special amortization provision described below, no deduc- 
tion shall be allowed to a partnership or to any partner for any 
amounts paid or incurred to organize a partnership or to promote the 
sale (or to sell) an interest in the partnership. The Act also amends 
section 707(c) to make it clear that, in determining whether a guar- 
anteed payment is deductible by the partnership, it must meet the same 
tests under section 162 (a) , as if the payment had been made to a person 
who is not a member of the partnership, and the normal rules of sec- 
tion 263 (relating to capital expenditures) must betaken into account.^ 

The Act provides that a partnership may elect to deduct ratably, 
over a period of not less than 60 months, amounts paid or incurred 
in organizing the partnership.^ The organizational expenses subject 
to the 60-month amortization provision are defined as those expendi- 
tures which are incident to the creation of the partnership, chargeable 
to the capital account, and of a character which, if expended in con- 
nection with the creation of a partnership having an ascertainable life, 
would be amortized over that period of time. 

The capitalized syndication fees, i.e., the expenditures connected 
with the issuing and marketing of interests in the partnership, such as 
commissions, professional fees, and printing costs, are not to be sub- 
ject to the special 60-month amortization provision. 

E-ffective date 
The provisions relating to guaranteed payments and the capitaliza- 
tion of partnership syndication and organization fees apply to taxable 
years beginning after December 31, 1975. The provision pertaining to 
the amortization of organization fees applies to amounts paid or in- 

' For cases supportlne: this position, see Davis v. Cotnmiaaioner, 151 F. 2d 441 (8th Clr. 
1945), cert, den., 327 U.S. 783; United Carlton Company. ^'1 B.T.A. 1000 (1935). 

"The Act is not Intended to adversely affect the deductibility to the partnership of a 
payment described in section 736(a)(2) to a retiring partner or to a deceased partner's 
successor in Interest. 

' If the partnership were liquidated before the end of the 60-month period, the remaining 
organizational expenses would be deductible to the extent provided under the provision 
relating to lo.sses (sec. 165). 



91 

curred in partnership taxable years beginning after December 31, 
1976. 

Revenue effect 
The revenue impact of these provisions is included in the estimate 
under a above. 

c. Retroactive Allocations of Partnership Income or Loss (sec. 
213(c) of the bill and sees. 704(a) and 706(c) of the Code) 

Prior I'T'n 
Investments in tax shelter limited partnerships have commonh^ been 
made toward the end of the taxable year. It has also been common for 
the limited partnership to have been formed earlier in the year on a 
skeletal basis with one general partner and a so-called "dummy" 
limited partner. In many cases, the limited partnerships incurs sub- 
stantial deductible expenses prior to the year-end entiy of the limited 
partner-investoi-s. 

In these cases, a full share of the partnership losses for the entire 
year had usually been allocated to those limited partners joining at the 
close of the year. These are referred to as "retroactive allocations." 
For example, in the case of a limited partnership owning an apart- 
ment house which had been under construction for a substantial part 
of the year, where construction interest and certain deductible taxes 
had been paid during that time, such deductions might have been retro- 
actively allocated to investors entering the partnership on, say, Decem- 
ber 28th of that year. 

Prior law was not clear whether retroactive allocations were per- 
missible under the Code.* Essentially, there are four partnership Code 
provisions which had a direct or indirect bearing on this issue — sections 
704(a), 761 (c), 704(b) (2) and 706(c) (2) (B). 

Section 704(a) of prior law provided, in effect, that except as other- 
wise provided in section 704, the partnership agreement would govern 
the manner of allocation of "income, gain, loss, deduction, or credit." 
With respect to a particular taxable year, section 761(c) of present 
law treats a partnership agreement as consisting of any amendment 
made up to and including the time for which the partnership's tax 
return must be filed for such year. It was argued that sections 704(a) 
and 761(c), particularly when read together, allowed retroactive al- 
locations. On the other" hand, it was argued that sections 704(b) (2) 
and/or 706(c) (2) (B) of prior law, discussed below, prohibited some 
or all retroactive allocations. 

Section 704(b) (2) prohibited the allocation of items of income, de- 
duction, loss or credit (such as capital gains and depreciation) where 
the principal purpose of the allocation was the avoidance or evasion of 
tax. This pi'ovision, it was argued, prohibited any retroactive alloca- 
tion having tax avoidance as its principal purpose. The counter-argu- 
ment to this claim was that section 704(b) (2) was inapplicable to re- 
troactive allocations of taxable income and loss, since, by its own terms, 



*Two primary cases dealing with thp issue of retroactive allocations are Smiih v. Com- 
mif,f<ioner. 331 F. 2d 29,S {7th Clr. 1964). and Rodman v. Commissioner, --F^ 2d — (2d 
rir. 1076) [CPH U.S. Tax Cases. H No. 9710], reversing and remanding 32 T.C.M. JiOl 
(1973). 



92 

it only pertained to allocations of particular iteTns of income, deduc- 
tion, loss, or credit.^ 

Section 706(c) (2) (B) provides that where a partner disposes of less 
than his entire interest in a partnership, Or his interest is reduced, the 
partnership taxable year does not close as to such partner, but that his 
distributive share of partnership income and loss is determined '^by 
taking into account his varying interests in the partnership during the 
taxable year." Wliile not specifically stated in this provision or the 
relevant regulations (Regs. § 1.706-1 (c) (4)), it is implicit that the 
transferee of less than the entire interest of a transferor-partner would 
necessarily be subject to the same rule, i.e., his distributive share of 
partnership income and loss would be determined by taking into ac- 
count his varying interests in the partnership during the taxable year. 
For example, if, on July 1, a person, who was not previously a partner, 
were to acquire from an existing partner a 25 percent interest in a cal- 
endar year reporting partnership, which had a loss for the year of 
$1,000, then, by taking into account his varying interests of zero during 
the first half of the year and 25 percent during the second half, $125 
of the loss would be allocable to the transferee-partner under section 
706(c)(2)(B). 

As previously stated, section 706(c) (2) (B) also applies where the 
interest of a partner is reduced. Under prior law, it was unclear 
whether this provision pertained to the situation where a partner's 
proportionate interest in the partnership was reduced as the result of 
the purchase of an interest directly from the partnership. Conse- 
quently, it was unclear whether an incoming partner, who purchased 
his interest directly from the partnership, would be subject to the rule 
of including partnership income and loss according to his varying 
interests during the year. Some argued that the varying interests rule 
of section 706(c) (2) (B) was inapplicable to this situation. 

It was further argued that, even if section 706(c) (2) (B) imposed 
the varying interests rule in the above situation, a timely amendment 
to the partnership agreement providing for a retroactive allocation of 
the entire year's losses would, pursuant to sections 704(a) and 761(c), 
override this provision. 

Section 706(c) (2(A) of present law provides that where a partner 
retires or sells his entire interest in a partnership, the taxable year of 
the partnership will close and the partner's distributive share of vari- 
ous income and deduction items will be determined under the income 
tax regulations. Essentially, the regulations (Regs. § 1.706-1 (c) (2) 
(ii) ) provide the alternatives of either an interim closing of the part- 
nership books or the determination of a partner's distributive share 
of income and deductions by a proration of such items for the taxable 
year, the proration being based either upon the portion of the taxable 

5 The main case dealing; with the Interpretation of section 704(b)(2) with respect to 
this Issue Is Jean V. Kresser, 54 T.C. Ifi21 (1970). In Kresser, the retroactive allocation 
involved was disallowed upon the court's flndinjjs that the partnership agreement was 
not amended to provide for the allocation and the allocation of Income was, in fact, 
nothing more than a paper transaction lacking in economic substance. One of the argu- 
ments of the Government was that section 704(b) (2) precluded the retroactive allocation. 
The court dealt with this contention in a footnote (supra, at p. 1631). which indicated 
support for the interpretation of section 704(b) (2) as applying only to allocations of par- 
ticular items of income, deductions, or credit, and not to allocations of the composite of the 
partnership's income or loss. However, because of the court's initial findings (i.e., the 
absence of both an amendment to the partnership agreement and a bona fide reallocation 
of Income), it did not resolve this Issue. 



93 

year that had elapsed prior to the sale or retirement or under any 
other method that is reasonable. These alternative methods of com- 
putation were not specifically provided, however, with respect to the 
sale or exchange of, or a reduction in, a partnership interest under sec- 
tion 706(c) (2) (B). As previously mentioned, in cases to which sec- 
tion 706 (c) (2) (B) applied, the only guidance provided was that in- 
come and loss allocations should take into account a partner's "vary- 
ing: interests in tlie partnership during the taxable year." 

Reasons for change 

Under prior law, it was unclear whether section 706(c) (2) (B) re- 
quired the inclusion of income and loss according to a partners varying 
interests during the year where the partner's interest was acquired di- 
rectly from the partnershi]). Even if section 706(c)(2)(B) imposed 
the varying interests rule in this situation, there was the further am- 
biguity whether a retroactive allocation provided in a partnership 
agreement would, under the authority of sections 704(a) and 761(c), 
override any allocation provided under section 706(c) (2) (B). More- 
over, even if it were established that section 706(c) (2) (B) was not 
overridden by a retroactive allocation pursuant to sections 704(a) and 
761(c), no clear method was provided in the Code or regulations for 
taking into account the varying intei-ests of the partners during the 
partnership year. 

In essence, the consequence of allowing retroactive allocations was 
that new partners investing in the partnership toward the close of 
the taxable year were allowed to deduct expenses which were incurred 
prior to their entry into the paitnership. Some argued that these retro- 
active allocations were proper because the funds invested by the new 
partners served to reimburse the origiiuil partners for their expendi- 
tures and that, as an economic matter, the new partners had incurred 
the costs for which they were claiming deductions. However, this argu- 
ment loses its persuasiveness when the new partner in a partner- 
ship situation is compared to that of an investor who directly pur- 
chases property which had previously generated tax losses during the 
taxable year. It is clear that in the latter case the investor would not 
be entitled to deduct the losses incurred prior to his ownership of the 
property, notwithstanding the fact that he, in effect, may be reim- 
bursing the seller of the property for losses already incurred. 

In order to deal with the problem of retroactive allocations and 
clarify the treatment of a partner's interest where the partner ac- 
quired the interest directly from the partnership, the Act specifically 
provides that the present varying interests rule is to apply to a part- 
ner's interest acquired directly from the partnership. 

Explanation of provision 
The Act amends section 706(c)(2)(B) to make it clear that the 
varying interests rule of this provision is to apply to any partner 
whose interest in a partnership is reduced, whether by entry of a new 
partner who purchased his interest directly from the partnership, par- 
tial liquidation of a partner's interest, gift, or otherwise. Correspond- 
ingly, the provision is to apply to the incoming partner so as to take 
into accoimt his varj'ing interests during the year. In addition, regu- 
lations are to apply the same alternative methods of computing al- 



d4 

locations of income and loss to situations falling under section 706(c) 
(2)(B) as those now applicable to section 706(c)(2)(A) situations 
(sale or liquidation of an entire interest). As under section 706(c) 
(2) (A), these rules will permit a partnership to choose (1) the easier 
method of prorating items either according to the portion of the 
year for which a partner was a partner or under any other method 
that is reasonable or (2) an interim closing of books (as if the year 
had closed). However, any proration or interim closing of the books 
under section 706(c) (2) (B), unlike that under section 706(c) (2) (A), 
would not result in the actual closing of the partnership taxable year. 

The interim closing of the books or proration is to relate to the time 
of the reduction (and corresponding increase) in partnership interest. 
To alleviate the undue accounting complexity that may result with 
respect to reductions in interest occurring over several days in the 
same month, the regulations may provide, for example, that the in- 
terim closing of the books could relate to the fifteenth and last day 
of each month. Thus, an interim closing of the books as of the close 
of December 15th would be suflficient, for example, with respect to 
new partners entering on the 16th, 19th, 20th, and 21st of December. 

In addition, section 704(a) (relating to the effect of a partnei*ship 
agreement) is amended to provide that it is overridden by any con- 
trary income tax provisions of the Code. Thus, a partnership agree- 
ment, amended (pursuant to section 761(c) ) to provide for a retroac- 
tive allocation, will not override an allocation required under section 
706(c)(2)(B). 

Ejfective date 
These provisions are effective for partnership taxable yeai-s that 
begin after December 31, 1975. The Congress does not intend that 
any inference be drawn as to the propriety or impropriety of a retro- 
active allocation under prior law. 

Revenue effect 

The revenue impact of this provision is included in the revenue 
estimate under a above. 

d. Partnership Special Allocations (sec. 213(d) of the Act and 
sec. 704(b) of the Code) 

PHor law 

A limited (or a general) partnership agreement mav allocate in- 
come, gain, loss, deduction, or credit (or items thereof) among the 
partners in a manner that is disproportionate to the capital contribu- 
tions of the partners. These are sometimes referred to as "special 
allocations" and, with respect to any taxable year, may be made by 
amendment to the partnership agreement at any time up to the initial 
due date of the partnership tax return for that vear (sec. 761 (c) ) . 

A special allocation was not recognized under prior law (sec. 704 
(b) (2) ) if its principal purpose was to avoid or evade a Federal tax. 
In determining whether a special allocation had been made princi- 
pally for the avoidance of tax, the regulations focused upon whether 
the special allocation had "substantial economic effect," that is, 
whether the allocation may actually affect the dollar amount of the 



95 

partner's share of the total partnership income or loss independently 
of tax consequences (Regs. § 1.704-1 (b) (2)). The reflations also 
inquired as to whether there was a business purpose for this special 
allocation, whether related items from the same source were subject to 
the same alloccition, whether the allocation ignored normal business 
factors and was made after the amount of the specially allocated item 
could reasonably be estimated, the duration of the allocation, and the 
overall tax consequences of the allocation. 

By its terms, the tax avoidance provisions of prior law section 704 
(b) (2) applied to allocations of ite7-m of income, gain, loss, deduction, 
or credit. It was thus argued that these provisions did not apply to and 
would not preclude allwations of taxable income or loss, as opposed to 
specific items of income, gain, deduction, loss, or credit. 

The main case dealing with the interpretation of section 704(b) (2) 
with respect to this issue is Jean V. Kressei\ 54 T.C. 1621 (1970). In 
Kresser, a purported allocation of all a partnership's taxable income 
for one taxable year to one partner who had a net operating loss cari-y- 
forward expiring in that year was disallowed upon the court's findings 
that the partnei-ship agreement was not amended to provide for the 
allocation and the allocation of income was, in fact, nothing more than 
a paper transaction lacking in economic substance. One of the argu- 
ments of the Government was that section 704(b) (2) precluded the 
allocation. The court dealt with this contention in a footnote {supra, at 
p. 1631), which indicated support for the interpretation of section 704 
(b) (2) as applying only to allocations of particular items of income, 
deduction, or credit, and not to allocations of the composite of the part- 
nership's income or loss. However, because of the court's initial find- 
ings (i.e., the absence of both an amendment to the partnership agree- 
ment and a bona fide reallocation of income), it did not resolve this 
issue. 

Reasons for change 

Congress believed that an overall allocation of the taxable income 
or loss for a taxable year (described under section 702(a) (9) ) should 
be subject to disallowance in the same manner as allocations of items 
of income or loss. 

Also, allocations of special items and overall allocations should be 
restricted to those situations where the allocations have substantial eco- 
nomic effect. 

ExplaThation of provisions 
The Act provides that an allocation of overall income or loss (de- 
scribed under section 702 (a) (9) ) , or of any item of income, gain, loss, 
deduction, or credit (described under section 702(a) (l)-(8)), shall 
be controlled by the partnership agreement if the partner receiving the 
allocation can demonstrate that it has "substantial economic effect", 
i.e., whether the allocation may actually affect the dollar amount of 
the partners' share of the total partnership income or loss, independ- 
ent of tax consequences." Other factors that could possibly relate to 



* The determination of whether an allocation may actually aflfect the dollar amount of 
the partners' shares of total partnership Income or loss, independent of tax consequences, 
will to a substantial extent involve an examination of how these allocations are treated 
in the partners' capital accounts for financial (as opposed to tax) accounting purposes ; 
this assumes that these accounts actually reflect the dollar amounts that the partners 
would have the rights to receive upon the liquidation of the partnership. 



96 

the determination of the validity of an allocation are set forth under 
the present regulations (Regs. § 1.704r-l(b) (2) ). 

If an allocation made by the partnership is set aside, a partner's 
share of the income, gain, loss, deduction or credit (or item thereof) 
will be determined in accordance with his interevSt in the partnership. 

In determining a "partner's interest in the partnership", all the 
relevant facts and circumstances are to be taken into account. Among 
the relevant factors to be taken into account are the interest of the 
respective partners in profits and losses (if different from that in 
taxable income or loss), cash flow, and their rights to distributions of 
capital upon liquidation. 

Effective date 
The provision applies to partnership taxable years beginning after 
December 31, 1975. No inference is to be drawn as to the propriety or 
impropriety of a special allocation under prior law. 

Revenue e-ffect 

The revenue impact of this provision is included in the revenue 
estimate under a above. 

e. Treatment of Partnership Liabilities Where a Partner Is Not 
Personally Liable (sec. 213(e) of the Act and sec. 704(d) of 
the Code) 

Prior law 
Under both prior and present law, a partner may deduct his distribu- 
tive share of all the deductible items of the partnership, but not more 
than the amount of the adjusted basis of his interest in the partner- 
ship (sec. 704(d)). Under the income tax regulations, a partner's 
adjusted basis in his partnership interest is increased by a portion 
of any partnership liability with respect to which there is no per- 
sonal liability on the part of any of the partners (Treas. Reg. § 1.752- 
1(e)). 

Reasons for change 
Under prior law, a partner was allowed to substantially increase 
the adjusted basis in his partnership interest, and thus the amount of 
partnership losses he could deduct, by a portion of the partnership 
liabilities with respect to which he had no personal liability. This rule 
enabled partners to deduct amounts for tax purposes exceeding the 
amount of investment that they had economically at risk in the 
partnership. 

Explarvation of provision 

The Act amends section 704(d) by providing that, for purposes of 
fhe limitation on allowance of partnership losses, the adjusted basis of 
a partner's interest will not include any portion of any partnership 
liability with respect to which the partner has no personal liability. 

It is intended that in determining whether a partner has personal 
liability with respect to any partnership liability, rules similar to the 
rules of section 465 (relating to the limitation on deductions to 
amounts at risk in case of certain activities) will apply. Thus, for 
example, guarantees and similar arrangements may be taken into 
account in determining whether there is personal liability. 



97 

This provision will not apply to the extent that a partnership 
activity is subject to the provisions of section 465 (relating to the 
limitation on deductions to amounts at risk in case of certain activ- 
ities) nor will it apply to any partnership the principal activities of 
which involve real property (other than mineral property).^ 

This provision will not apply to a corporate partner (other than a 
subchapter S corporation or a personal holding company) with respect 
to liabilities incurred in an activity to the extent that the activity is 
subject to the provisions of section 465. Thus, if two corporations form 
a partnership for an equipment leasing activity, this provision will 
not apply; but, if in addition to equipment leasing, the partnership 
invents in an activity not specified under section 465 and which does 
not involve real property (other than mineral property), then this 
provision will apply to the extent of liabilities incurred wtih respect 
to that other activity. 

It is contemplated that this provision and the specific at-risk rules 
of section 465 could apply to a partnership carrying on more tJhan one 
activity. For example, a partnership involved in equipment leasdng 
to which the 'at-risk provisions of section 465 would apply, may also 
be indebted on a nonrecourse basis with respect to activities which 
are mirelated to the equipment leasing ac'ti\^ty of the partnership. 
In this instance, separate computations for purposes of allowance 
of losses would have to be made under both sections 465 and 704(d). 

Also, for example, if a partnership engages in the raising of trees, 
some of which bear fruit and nuts, this provision will not apply to 
the extent that the tree-raising activity is subject to the provisions of 
section 465. 

Effect'we date 
This provision applies to liabilities incurred after December 31, 
1976. 

Revenue ejfect 

The revenue impact of this provision is included in the revenue 
estimate under a. above. 

9. Interest 

a. Treatment of Prepaid Interest (sec. 208 of the act and sec. 461(g) 
of the Code) ) 

Prior l^aw 
A taxpayer may generally claim deductions in the year which is 
proper under the method of accounting which he uses in computing 
his taxable income (sec. 461). Under prior law, a taxpayer using 
the cash receipts and disbursements method of accounting has gen- 
erally been able to claim a deduction for interest paid within his 
taxable year (sec. 163(a)). However, if the taxpayer's method of 
accounting does not clearly reflect income, the Internal Revenue 

■^ Generally, the principal activities of a partnership would Involve real property if 
substantially all of its activities involve the holding of real property for sale, for invest- 
ment, or for deriving rental-type Income. The holding of real property for sale, for Invest- 
ment, or for deriving rental-type income would include the investment in a partnership or 
joint venture where substantially all of the activities of the partnership or joint venture 
involve the holding of real property for sale, for investment, or for deriving rental-type 
Income. 



98 

Service may recompute the income using the method which the 
Service believes clearly reflects income (sec. 446(b)). The income 
tax regulations also provide that, even under the cash method of 
accounting, an expense which results in the creation of an asset hav- 
ing a useful life which extends substantially beyond the close of the 
taxable year may be deducted only in part in the year in which pay- 
ment is made. 

No specific statutory provision has expressly permitted prepaid 
interest to be deducted in full when paid by a cash method taxpayer. 
The authority for deducting prepaid interest rested on court cases 
and on administrative rulings by the Service. Until the late 1960's, 
tax-oriented investors were able to prepay as much as five years' 
interest with apparent approval by the courts and the Service. 

In 1968, however, the Service published a revenue ruling holding 
that an interest prepayment by a cash-basis taxpayer for a period ex- 
tending for more than 12 months beyond the end of the current tax- 
able year would be deemed to create a material distortion of income. 
In such a case the interest would be allocated over the taxable years 
involved. Deductions for interest paid in advance for a period not in 
excess of 12 months after the last day of the taxable year of payment 
wei'e considered on a case-by-case basis to determine whether a 
material distortion of income resulted.^ Recent Tax Court cases 
have disallowed prepaid interest deductions of taxpayers in situations 
where the Internal Revenue Service has relied on this ruling as 
authority to disallow the deduction. The Tax Court has indicated, 
however, that under prior law it might not be willing to disallow pre- 
paid interest in all cases where the prepayment relates to periods 
extending more than 12 months beyond the end of the current taxable 
year. 

The tax treatment of a loan re^juiring prepaid interest or points has 
contrasted with the tax treatment of a discount loan under present law, 
although in many situations the economic substance of both transac- 
tions is similar. In a discount loan, the lender delivers to tlie borrower 
an amount which is smaller than the face amomit of the loan. The dif- 
ference between the fac« amount and the amount delivered to the 
borrower is the charge for his use of the borrowed funds. Under prior 
law, a borrower on the cash method could not deduct the entire interest 
element in the year in which he received the loan proceeds. He could 
deduct the interest element only when and as he actually repaid the 
face amount of the loan.' 

Reasons for change 
Prepaid interest has been extensively used in many types of tax 
shelters to defer tax on income which would otherwise be taxable in 
higlier marginal tax brackets. The deduction for prepaid interest has 
become highly important to investors seeking year-end tax losses 
who acquire their interests in a property (such as land, an apartment 
building, cattle, computers, motion pictures and the like), or in a 

1 The ruling (Rev. Rul. 68-643. 1968-2 C.B. 76) sets forth several factors which may be 
considered in determining' whether there is a material distortion of income : the amount 
of the taxpayer's income in the taxable year of payment ; his Income in previous years ; 
the amount of prepaid interest : the time of payment ; the reason for the prepayment ; and 
the presence of a varying rate of interest over the term of the loan. 

* See Rev. Rul. 75-12, 1975-1 C.B. 62. 



99 

partnership which will own the property, toward the end of the calen- 
dar year. In such cases, the investors may not have been able to operate 
the property long enough in that taxable year to generate either in- 
come or a large amount of ordinary and necessary business expenses: 
Therefore, deductions arising from prepaying as much of the financing 
costs as possible have been central to the creation of year-end tax 
losses. If the investors had income from other sources, the interest 
deductions were used to offset this other income (rather than off- 
setting income from the property itself, which would be realized in a 
later year). Prepaid interest thus has given a taxpayer the time value 
of deferring taxes on his other sources of income.^ 

The advantages of prepaying interest have been especially attractive 
to persons who have unusually high income in a particular year and 
who are in a higher effective tax bracket that year than they expect to 
be in during later years. 

In many cases a deduction for prepaid interest was generated with- 
out adverse cash flow consequences by borrowing more than was 
needed and promptly repaying the excess as "prepaid interest." * 

A recent technique used to justify larger amounts of prepaid in- 
terest within the Service's present guidelines than could be obtained 
under conventional financing is the "wraparound'' mortgage (some- 
times referred to as an all-inclusive deed of trust). Often, a farm, 
shopping center or other property whicli investors are purchasing 
is encumbered by an existing first mortgage. In a situation involving 
a wraparound mortgage, the investors would execute to the seller a 
new purchase money obligation whose face amomit included both the 
unpaid balance of the first mortgage and the new financing supplied 
by the seller (which would ordinarily take the form of a second 
mortgage). The buyere would agi-ee to pay (and to prepay) interest 
on the face amount of the "wraparound" note, while the seller would 
agree to continue paying the interest on the first mortgage out of 
the interest payments which he would receive from the buyers. Since a 
wraparound mortgage usually bears a higher rate of interest than the 
first mortgage (and in some cases the additional prepaid interest 
which the buyers have claimed on the note has been negotiated as a 
substitute for a larger downpayment), this type of arrangement has 
been widely used to increase the amount of interest which could be 
prepaid in the initial year of a purchase of property and claimed as a 
deduction for one year's prepaid interest within the Service's 
guidelines.^ 



3 In some cases the investors (or their partnership) execute a purchase money mortgage 
note to the person who is selling the property to them. Although most sellers would ordi- 
narily desire to receive a larger purchase price (capital gain) and less interest (ordinary 
income), many sellers are not adversely affected by receiving ordinary income. Some sellers 
may have expiring loss carryovers to absorb the interest income. Others are dealers who 
would realize ordinary income on the sale in any event ; other sellers are pension funds, 
charities or other tax-exempt organizations. 

* In some cases an interest prepayment reduces the taxpayer's cash flow (net of tax 
savings). However, as long as the deduction lowers the taxpayer's eBfectlve tax rate by 
more than the market rate of interest which he could earn on the cash he invests, the tax- 
payer will find It to his advantage to shelter his income by prepaying interest. (Generall.v, 
the largest reductions in effective tax rate will accrue to taxpayers in the higher mar- 
ginal tax brackets.) 

5 The seller of property has been motivated to use a wraparound mortgage because he 
is relending the balance of the first mortgage to the investor at a higher rate of interest 
than he pays to his lender. Thus, the amount received as a result of the difference between 
the interest rates is additional profit to him. 

A wraparound mortgage is also often used as a refinancing device by an owner of mort- 
gaged property who desires to receive a new loan from a third party, who agrees to pay 
oflf the existing lien out of the payments which he receives from the borrower. 



100 

Congress believed that the creation of a tax shelter with prepaid 
interest could not be justified even under the cash method of ac- 
counting. The policies underlying the cash method, namely, simplicity 
and avoidance of complex recordkeeping or computations, do not 
apply to prepaid interest, which can be allocated over the term of a 
loan. 

Under prior law there has been considerable uncertainty as to the 
deductibility of prepaid interest. Under the Tax Court's holdings, the 
deductibility of prepaid interest depends on a case-by-case deter- 
mination. Even under the Internal Revenue Service position, a case- 
by-case deteiTnination must be made in all c^ses where interest is 
prepaid for a period which does not extend more than 12 months 
beyond the taxable year in which the prepayment is made. Conse- 
quently, a deduction of prepaid interest by the same taxpayer might 
have been allowed in one year and perhaps not in another year. Also, 
prepaid interest might have been deductible by one taxpayer who has 
a large amount of income in a given year after the deduction (so that 
the deduction arguably has not "distorted" his income) but possibly 
not have been deductible by another taxpayer who had little or no tax- 
able income after taking the deduction. In the case of prepaid interest, 
the clear reflection of income test should focus less on comparing the 
interest deduction with the taxpayer's general income stream from 
year to year than on matching interest and other costs of carrying a 
particular property against its income or loss over the term of the loan, 

ExplanMion of provision 

The Act permits a cash method taxpayer to deduct prepaid interest 
no earlier than in the taxable year in which (and to the extent that) 
the interest represents a charge for the use or forbearance of borrowed 
money during that period. 

Under this provision, if a taxpayer uses the cash receipts and dis- 
bursements method to compute his taxable income, interest which he 
pays and which is properly allocable to any later taxable year must 
be charged to capital account and treated as paid by him in the periods 
in which (and to the extent that) the interest represents a charge for 
the use or forbearance of borrowed money during each such taxable 
year. In determining whether an interest prepayment is properly al- 
locable to one or more taxable years after the year of payment, the 
allocation is to be made to the period or periods in which the interest 
represents a cost of using the borrowed money in that period, re- 
gardless of whether allowing prepaid intere-vSt to be deducted when 
paid would materially distort the taxpayer's income in the year of 
payment (or the income of a partnership of which the taxpayer may 
be a member) . 

This rule applies to all types of taxpayers, including individuals, 
corporations, estates and trusts and covers interest paid for personal, 
business or investment purposes. 

The new statutory rule relates to interest prepayments by a cash 
method taxpayer. It is intended to conform the tax deductibility of 
prepaid interest by cash method taxpayers to the rule which Congress 



101 

understands to be proper under prior law for interest prepayments by 
an accrual method taxpayer.** 

Once prepaid interest has been allocated to the proper periods, the 
interest allocable to a given taxable year will then become subject to 
other limitations. For example, interest allocated to a taxable year 
under this provision of the Act is then subject, in turn, to the rules 
relating to the capitalization of certain construction period interest 
(sec. 189 of the Code, added in sec. 201 of this Act), the limitations 
on the deductibility of investment interest (sec. 163(d), as amended 
by sec. 209 of this Act), and to the limitation on activities not en- 
gaged in for profit (sec. 183), in each of the taxable year or years 
in which interest is treated as paid under this provision. 

In adopting the new rule. Congress does not intend to change 
prior law with regard to defining "interest." 

Congress also does not intend to prevent the Treasury or the tax- 
payer from continuing to be entitled to recharacterize a purported 
"interest" payraent as not true interest in the circumstances.^ Con- 
versely, the Treasury will have full authority under new section 
461(g) to recharacterize as "interest" a payment made by a taxpayer 
and labeled otherwise than is interest on a loan. Wliere this reclassify- 
ing is appropriate, it may also be appropriate to treat the payment 
as being a prepayment of interest, thereby making the payment 
subject to section 461(g). 

In certain cases, the Treasury is authorized to treat interest pay- 
ments under a variable interest rate as consisting partly of interest 
computed under an average level effective rate of interest and partly 
of an interest prepayment allocable to later years of the loan.^ 

The Act does not contemplate that interest is to be treated as paid 
in level payments over the term of every loan. Thus, interest paid as 
part of a level constant payment (including principal and interest) 
is not to be subject to this provision merely because the payments con- 
sist of a larger interest portion in the earlier years of the loan than in 
the later years. 

Prepaid interest on an indebtedness secured by a "wraparound mort- 
gage" will be subject to the general rule of this provision.^ 

Congress does not intend the new rule to change the treatment of 
a discount loan by a cash method taxpayer. Nor does the new rule 
prevent the Treasury from treating interest as paid under the terms 
of a discount loan rather than as prepaid interest under a conventional 
loan. 



• An accrual method taxpayer can deduct prepaid Interest only In the period In which 
the use of money occurs and only to the extent of tht? interest cost of using the bor- 
rowed funds during that period. It is not material when actual payment occurs, nor is 
the existence of a fixed liability to make a prepayment of interest sufficient to justify a 
deduction. Rev. Rul. 68-643, 1968-2 C.B. 76. 

^ It may thus be appropriate In some cases to treat a payment denominated "interest" 
as. In substance, additional purchase price of property, as a dividend, as payment for an 
option, etc. 

' Congress does not intend, however, that a loan calling for interest at a stated 
rate tied to the "prime rate" necessarily involves prepaid interest, or that variations 
in the rate of interest as the prime rate (or some other objective measurement) varies 
necessarily subjects the interest payments to disallowance under this provision. 

» Since the provision focuses on the fact of prepayment as such, it is immaterial whether 
the borrower prepays interest (either voluntarily of contractually^ to a third-party 
lender under the first mortgage rather than to the seller of the property. In appropriate 
cases, however, the Congress does not intend to prevent the Service from recharacterlziug 
part or all 6t a buyer's (or borrower's) "interest" payment on a wraparound mortgage 
as, in substance, an additional down payment of principal or as a nondeductible deposit 
of interest with a third party. See Rev. Rul. 75-99, 1975-1 C.B. 197. 



234-120 O - 77 - i 



102 

Points are additional interest charges which are usually paid when a 
loan is closed and which are generally imposed by the lender in lieu 
of a higher interest rate. Where points are paid as compensation for 
the use of borrowed money (and thus qualify as interest for tax pur- 
poses) rather than as paj^ment for the lender's services, the points are 
substituted for a higher stated annual interest rate. As such, points are 
similar to a prepayment of interest and under the Act are generally 
to be treated as paid over the term of the loan. This rule also applies 
to charges similar to points, whether called a loan-processing fee or 
a premium charge (if such fee or charge is compensation for the use 
of borrowed money) . 

The Act permits points paid by a cash method taxpayer on an 
indebtedness incurred in connection with the purchase or improve- 
ment of (and secured by) his principal residence to be treated as 
paid in the taxable year of actual payment. A loan will not qualify 
under this exception,, however, if the loan proceeds are used for pur- 
poses other than purchasing or improving the taxpayer's principal 
residence, or if loan proceeds secured by property other than fiis 
principal residence are used to purchase or improve his residence. The 
exception applies only to points on a home mortgage, and not to other 
interest costs on such a mortgage. However, in order to qualify 
under this exception, the charging of points nmst reflect an 
established business practice in the geographical area where the 
loan is made, and the deduction allowed under this exception may not 
exceed the number of points generally charged in the area for this type 
of transaction. 

E-ffective dates 

The rules in this provision apply generally to any prepaj'^ment of 
interest (including points) after December 31, 1975. However, a 
transition rule excepts interest paid before January 1, 1977 (even ff 
the taxpayer's taxable year ends after that date) if there existed on 
September 16, 1975, and at all times thereafter, either (1) a binding 
written contract for a prepayment of interest by the taxpayer, or (2) a 
written loan commitment for a loan to the taxpayer and if the con- 
tract or loan commitment required the prepayment of this amount of 
interest. In either of these situations, however, if the interest is paid 
on or after January 1, 1977, the payment will be subject to this 
provision. 

Congress intends that no inference should be drawn concerning 
the deductibility of prepaid interest paid before the effective dates of 
the new rule. It is expected that deductions for such prepayments will 
be determined according to the criteria of prior law. 

ReveTwe e-ffect 
It is estimated that this provision will result in an increase in budget 
receipts of less than $5 million annually. 

6. Limitation on the Deduction for Investment Interest (sec. 209 
of the Act and sec. 163(d) of the Code) 

Prior law 
Section 163 of the Internal Revenue Code provides, in oeneral, that 
a taxpayer who itemizes his deductions may deduct all interest paid 
or accrued within the taxable year on his indebtedness. A limitation 



103 

is imposed under section 163(d) on interest on investment indebted- 
ness. Under prior law the deduction for such interest was limited to 
$25,000 per year, plus the taxpayer's net investment income and his 
long-term capital gain, plus one-half of any interest in excess of these 
amounts. Any remaining amount could be carried over to future years. 

Reasons for change 
As indicated above, in connection with the discussion of problems 
which occur with tax shelters, there is a question as to the extent to 
which a taxpayer should be permitted to shelter or reduce tax on in- 
come from the taxpayer's professional or income-producing activities 
by incurring an unrelated deduction. The Congress felt that the lim- 
itation on the deductibility of investment interest should be strength- 
ened, in order to reduce the possibility that this deduction could be 
used to shelter noninvestment types of income. It was also felt that 
this provision may have some economic benefits by encouraging tax- 
payers to focus on the economic viability of particular investments 
(rarher than possible tax advantages resulting from the interest deduc- 
tion) before borrowing funds in order to make those investments. 

Explanation of provisions 

Under the Act, interest on investment indebtedness is limited to 
$10,000 per year, plus the taxpayer's net investment income. No offset 
of investment interest in permitted against long-term capital gain. An 
additional deduction of up to $15,000 more per year is permitted for 
interest paid in connection with indebtedness incurred by the taxpayer 
to acquire the stock in a corporation, or a partnership interest, where 
the taxpayer, his spouse, and his children have (or acquired) at least 50 
percent of the stock or capital interest in the enterprise. Interest de- 
ductions which are disallowed under these rules are subject to an 
unlimited carryover and may be deducted in future years (subject to 
the applicable limitation). Under the Act, no limitation is imposed 
on the deductability of personal interest or on interest on funds bor- 
rowed in connection with the taxpayer's trade or business. 

As under prior law, investment income (against which investment 
interest may be deducted) means income from interest, dividends, 
rents, royalties, short-term capital gains arising from the disposition 
of investment assets, and any amount of gain treated as ordinary in- 
come pursuant to the depreciation recapture provisions (sees. 1245 
and 1250 of the Code), but only if the income is not derived from the 
conduct of a trade or business. 

As indicated above, interest on funds borrowed in connection with a 
trade or business is not affected by the limitation. In this connection, 
rental property is (as under prior law) generally considered an invest- 
ment property subject to the limitation, rather than as property used 
in a trade or business, if the property is rented under a net lease 
arrangement. The determination of whether property is rented under 
a net lease arrangement is made separately for each year. For this 
purpose, a lease is considered to be a net lease for a taxable year either 
if the taxpayer's trade or business expenses with respect to the property 
which are deductible solely by reason of section 162 of the code are 
less than 15 percent of the rental income from the property, or if the 
taxpayer is guaranteed a specified return, or is guaranteed, in whole or 
in part, against loss of income. 

In determining net investment income, the investment expenses 



104 

taken into account are real and personal property taxes, bad debts, 
depreciation, amortizable bond premiums, expenses for the production 
of income, and depletion, to the extent these expenses are directly 
connected with the production of investment income. For purposes of 
this determination, depreciation or depletion with respect to any 
property is taken into account on a straight-line or cost basis, 
respectively. 

In the case of partnerships, the limitation on the deduction of inter- 
est is applied only at the partner level. In other words, each partner 
separately takes into account his share of the partnership's investment 
interest and other items of income and expense taken into account for 
purposes of the limitation. Similar treatment is provided in the case 
of subchapter S corporations. In this case, each shareholder of the 
corporation takes into account the investment interest of the corpora- 
tion and the other items of income and expense w^hich are taken into 
account for purposes of the limitation on a pro-rata basis in a manner 
consistent with the way in which the shareholders of the coi-poration 
take into account a net operating loss of the corporation. 

Generally, these rules are applicable to taxable years beginning after 
December 31, 1975. However, under a transition rule, prior law (sec. 
163(d) before the amendments made under the Act) continues to 
apply in the case of intei-est on indebtedness which is attributable to 
a specific item of projDerty, is for a specified term, and was either in- 
curred before September 11, 1975, or is incurred after that date under 
a binding written contract or commitment in eifect on that date and at 
all time^ thereafter (hereinafter referred to as "pre-1976 interest"). 
As under prior law, interest incurred before December 17, 1969 ("pre- 
1970 interest") is not subject to a limitation. 

Under the Act, carryovers are to retain their character. Thus, 
carry ovei-s of pre-1976 interest will continue to be deductible under 
the limitation of prior law. Cai-ryovers of post-1975 interest will be 
subject to the new rules adopted imder the Act. 

In a case where the taxpayer has interest which is attributable to 
more than one period (pre-1970, pre-1976, and post-1975), the tax- 
payer's net investment income is to be allocated between (or among) 
these periods. For example, assume a taxpayer has $30,000 of pre-1976 
interest and $60,000 of post-1975 interest ;' also assume that the tax- 
payer has $45,000 of investment income. Under the Act, one-third 
of the investment income ($15,000) is to be allocated to the pre-1976 
mterest, which would be fully deductible (the $25,000 allowance, plus 
the $15,000 of net investment income— exceeds the $30,000 of pre-1976 
interest, wliich is therefore fully deductible). Two-thirds of the net 
m vestment income ($30,000) is allocated to the post- 1975 interest; this 
amount, added to the $10,000 allowance provided under the Act, would 
result in a total deduction of $40,000 for the post-1975 interest. The 
remaining amount, ($20,000) could be carried forward. 

Effective date 
Generally, these rules apply to taxable years beginning after De- 
cember 31, 1975, subject to certain transition rules discussed above. 
Revenue effect 
It is estimated that tliese provisions will result in a revenue gain of 
$100 million for fiscal year 1977, $110 million for fiscal year 1978, and 
$145 million for fiscal j^ear 1981. 



B. MINIMUM AND MAXIMUM TAX 

1. Minimum Tax for Individuals (sec. 301 of the Act and sees. 56- 
58 of the Code) 

Prior law 
Under prior law, individuals and corporations paid a minimum tax, 
in addition to their regular income tax, equal to 10 percent of their 
items of tax preference, reduced by a $30,000 exemption and their 
regular tax liability. The tax preferences subject to the minimum tax 
were : ( 1 ) the excluded one-half of capital gains ; (2) the excess of per- 
centage depletion over the basis of the property; (3) accelerated de- 
preciation on real property; (4) the bargain element of stock options; 
(5) accelerated depreciation on personal property subject to a net 
lease; (6) the excess of amortization of on-the-job training and child 
care facilities over regular depreciation ; (7) the excess of amortization 
of pollution control facilities over regular depreciation; (8) the excess 
of amortization of railroad rolling stock over regular depreciation; 
and (9) excess bad debt reserves of financial institutions. Regular taxes 
not used to offset preferences in the current year could be carried 
over for up to 7 additional years. 

Reasons for change 

The minimum tax was enacted in the Tax Reform Act of 1969 in 
order to make sure that at least some minimum tax was paid on tax 
preference items, especially in the case of high-income persons who 
were not paying their fair share of taxes. However, the previous mini- 
nmm tax did not adequately accomplish these goals, so the Act con- 
tains a substantial revision of the minimum tax for individuals to 
achieve this objective. 

Congress intended these changes to raise the effective tax rate on tax 
preference items, especially for high-income individuals who are pay- 
ing little or no regular income tax. 

Explanation ^f pi^avision 

The Act raises the minimum tax rate from 10 percent to 15 percent. 
The Act replaces the $30,000 exemption and deduction for regular 
taxes allowed under prior law with an exemption equal to the greater 
of $10,000 or one-half of regular tax liability. In addition, the Act 
repeals the carryover of regular taxes paid. These changes are intended 
to raise the effective rate of the minimum tax on tax preferences. 

The Act also adds two new items of tax preference to the minimum 
tax base for individuals and modifies one existing preference item. 
The new preferences are excess itemized deductions and intangible 
drilling costs. 

The new preference for excess itemized deductions equals the amount 
by which itemized deductions (other than medical and casualty deduc- 
tions) exceed 60 percent of adjusted gross income. (Itemized deduc- 

(105) 



106 

tions in excess of 100 percent of adjiisted gross income are not taken 
into account in this computation.) This preference is intended to. re- 
duce the number of situations in which a person with a large adjusted 
gross income is able to avoid paying any income tax. Medical and 
casualty deductions are excluded from this preference item because 
they are limited to expenses that are beyond the control of the 
taxpayer. 

The new preference for intangible drilling costs applies to those 
expenses in excess of the amount which could have been deducted had 
the intangibles been capitalized and either (1) deducted over the life 
of the well as cost depletion or (2) deducted ratably over 10 years; 
the taxpayer may choose whichever of these two methods of capitaliza- 
tion is most favorable. The calculation of the amount which could have 
been deducted under capitalization in a taxable year is to be made 
for those intangible drilling costs which were paid or incurred in the 
taxable year. This preference does not apply to taxpayers wlio elect 
to capitalize their intangible drilling costs. 

The new preference does not apply to nonproductive wells. For this 
purpose, nonproductive wells are those which are plugged and aban- 
doned without having produc^ed oil and gas in conunercial quantities 
for any substantial penod of time. Thus, a well which has been plugged 
and abandoned may have produced some relatively small amount of oil 
and still be considered a non-productive well, depending on the amount 
of oil produced in relation to the costs of drilling. 

In some cases it may not be possible to determine whether a well is 
in fact nonproductive until after the close of the taxable year in 
question. In these cases, no preference is included in the minimum tax 
base with respect to any wells which are subsequently determined to be 
nonproductive. Thus, if a well is proved to be nonproductive after the 
end of the taxable year but before the tax return for the year in ques- 
tion is filed, that well can be treated as nonproductive on that return. 
If a well is not determined to be nonproductive by the time the return 
for the year in question is filed, the intangible expenses with respect 
to that well are to be subject to the minimum tax. However, the tax- 
payer may later file an amended return and claim a credit or refund 
for the amount of any minimum tax paid with respect to that well 
if the well subsequently proves to be nonproductive. 

The preference for accelerated depreciation on personal property 
is expanded in two ways. Under prior law, it applied only to net leases : 
the Act expands it to all leases. Also, the definition of accelerated 
depreciation is expanded to include the acceleration that results from 
the 20-percent variance under the Asset Depreciation Range (ADR) 
system. The preference for accelerated depreciation on personal prop- 
erty is not intended to apply to personal property which is leased as 
an incidental part of a real property lease. For example, the inclusion 
of a refrigerator in the lease of an unfurnished apartment is not to be 
treated as a lease of personal property. 

There are certain cases in which a person derives no tax benefit from 
an item of tax preference because, for example, the item is disallowed 
as a deduction under other provisions of the Code or because the 
taxpayer has sufficient deductions relating to nonpreference items to 



107 

eliminate his taxable income.^ To some extent, the Internal Revenue 
Service has been able to deal with this issue through regulations. To 
deal with this problem specifically, the Act instructs the Secretary of 
the Treasury to prescribe regulations under which items of tax pref- 
erence (of both individuals and corporations) are to be properly ad- 
justed when the taxpayer does not derive any tax benefit from the 
preference. For this purpose, a tax benefit includes tax deferral, even 
if only for one year. Congress, by adding this provision to the Act, does 
not intend to make any judgment about the authority of the Treasury 
to issue these regulations under prior law. 

The minimum tax is not imposed on tax preferences that make up 
a net operating loss that is carried forward to a succeeding taxable 
year. Instead, the minimum tax is imposed on those preferences when 
the net operating loss reduces taxable income. For preferences from 
taxable years prior to January 1, 1976, this tax rate will continue at 
10 percent even if the net operating loss is deducted in a taxable year 
beginning after December 31, 1975. For preferences for taxable years 
beginning after December 31, 1975, the tax rate will be 15 percent. 
Thus, the year of the preferences, not the year when the net operating 
loss is deducted, is to determine whether the 10-percent or the 15- 
percei;it rate applies. 

These changes all apply to individuals, estates, trusts, subchapter 
S corporations and personal holding companies. 

Effective date 
These changes are eflPective for taxable years beginning after De- 
cember 31, 1975. Carryovers of regular taxes from taxable years 
beginning before January 1, 1976, will not be allowed in years be- 
ginning after December 31, 1975. 

Revenue effect 
The changes in the minimum tax for individuals will raise $1.0 
billion in fiscal year 1977, $1.1 billion in fiscal year 1978 and $1.5 bil- 
lion in fiscal year 1981. 

2. Minimum Tax for Corporations (sec. 301 of the Act and sees. 56- 
58 of the Code) 

Prior law 

The minimum tax for corporations was the same as that for indi- 
viduals except that the capital gains preference equalled 18/48 of net 
long-term capital gains (rather than one-half of such gains) and the 
preference for accelerated depreciation on personal property subject 
to a net lease did not apply. 

Rea^^mis for chwnge 
Congress believed that, as in the case of individuals, it was appro- 
priate to raise the effective tax rate on corporate tax preferences sub- 
ject to the minimum tax. Howev^er, because corporate income is already 
subject to two taxes — ^the corporate income tax and the individual 
income tax — Congress felt that it was appropriate to retain the deduc- 
tion for regular taxes in computing the corporate minimum tax. 



1 For example, preference items giving rise to losses which are suspended under at risk 
provisions (see. 465 or sec. 704(d) of the Code) are not to be considered to give rise to 
a tax benefit until the year in which the suspended deduction is allowed. Similarly, in- 
vestment interest which Is disallowed (under sec. 163(d)) Is to be treated as an itemized 
deduction for purposes of that preference only in the year in which it is allowed (under 
sec. 163(d)). 



108 

Explanation of provision 

The Act raises the minimum tax rate for corporations to 15 percent. 
In place of the $30,000 exemption and deduction for reg:ular taxes 
under prior law, it substitutes an exemption equal to the greater of 
$10,000 or reo^ilar taxes. It also eliminates the carryover of regular 
taxes. The "tax 'benefit" rule applies to corporations as well as to other 
taxpayers. 

Personal holding companies are generally treated as individuals 
under the minimum tax, and generally where the Act makes a change 
in the minimum tax that is different for individuals than for corpora- 
tions, the rule for individuals is used for personal hokling companies. 
Preferences of subchapter S corporations are generally attributed to 
shareholders under the minimum tax. However, the preference ,for 
itemized deductions will, of course, not apply to personal holding com- 
panies or to subchapter S corporations since these entities have no 
adjusted gross income from which to calculate their prefei-ence. 

The Act provides special rules for timl>er income of corporations, 
including both gains from the cutting of timb(^r and long-term gains 
from the sale of timber. These rules have the effe-ct of exempting tim- 
ber income from the increase in tlie minimum tax for corporations. 
These rules provide that the item of tax preference for timber gains 
is to be reduced by one-third and then fui-ther reduced by $20,000. 
Also, tlie deduction for regular taxes is to bo i-educed by the lesser of 
(a) one-third or (b) the preference reduction described alx)ve. In ef- 
fect, the adjustments compensate for the general minimum tax rate 
increases fi'om 10 percent to 15 percent by scaling down the entire 
minimum tax base, as it i-elates to timber, by one-third and then sub- 
jecting that lower base to a 15-percent rate. This gives the same result 
as subjecting the normal tax base to a 10-percent rate. The reduction 
in timber preferences by $20,000 (two-thirds of $80,000), in effect, 
compensates timber for the loss of the $30,000 exemption. 

The Act also retains a regular tax carryover for timber. Taxpayers 
will first have to determine how much of their corporate income tax 
is attributable to timber income (including both gains from the cutting 
of timber and long-teiTn gains from the sale of timber). This alloca- 
tion is to be made under regulations prescribed by the Secretary of 
the Treasury. This allwation must be made for vears prior to 1976 
as well as futui-e years, in order to deteiTnine how much of a corpora- 
tion's existing regular tax carryover remains available for use in 1976 
and subsequent years. Congress does not intend that there be a carry- 
over of regidar taxes not attributable to timl>er income. To the extent 
that regular corporate income taxes attributable to timber exceed the 
items of tax preference in a taxable year, they may be carried forward 
for up to 7 additional years. The amount of the carryover that may 
be deducted in a subseouent year is limited to timber tax pi-eferences 
in that year, reduced b}^ the timber preference reduction desci'ibed 
above, minus the regular tax deduction for the vear (as ivduced by 
the regular tax adjustment described above) . This has the effect of per- 
mitting a cam'forward of timber-related regular taxes that are not 
used in the current year and limiting the use of that carryforward to 
the part of the minimum tax base tliat is attributable to timber-related 
capital gains income. 



109 

E-ffectwe date 

Generally, the minimum tax changes are effective for taxable years 
beginning after December 31, 1975. However, for taxable years be- 
ginning in 1976, corporations are to compute their minimum tax under 
both prior law and the new law and pay the average of the two 
minimum taxes. Also, regular tax carryovers from prior years can be 
deducted in taxable years beginning before July 1, 1976 (as changed 
by later legislation).^ 

For financial institutions who are eligible for excess bad debt reserve 
deductions, the effective date is delayed until December 31, 1977. 

Revenue effect 
The increases in the minimum tax for corporations will increase 
budget receipts by $59 million in fiscal year 1977, $124 million in fiscal 
year 1978 and $204 million in fiscal year 1981. 

3. Maximum Tax Rate (sec. 302 of the Act and sec. 1348 of the 
Code) 

Prior la/w 

Under prior law, the maximum marginal tax rate on taxable 
income from personal services was 50 percent. For this purpose, 
income from personal services (in the past this was referred to as 
"earned income") included wages, salaries, professional fees or com- 
pensation for personal services (including royalty payments to au- 
thors or inventors) and, for an individual engaged in a trade or busi- 
ness where both personal services and capital are material income- 
producing factore, a reasonable amount (not to exceed 30 percent) of 
his share of the net profits from the business. Personal service income 
for this purpose did not include deferred compensation, penalty 
distributions from owner-employee plans, lump-sum distributions 
from pension plans or distributions from employee annuity plans. 

The amount of personal service income eligible for the 50-percent 
maximum tax was reduced in three ways. First, it was reduced by trade 
or business deductions allowable under section 62 (which excludes most 
trade or business deductions of employees) properly allocable to per- 
sonal service income. Second, it was reduced by a pro rata share of 
deductions from adjusted gross income used in computing taxable 
income (including all itemized deductions, the standard deduction 
and the deduction for personal exemptions). Third, it was reduced by 
the taxpayer's items of tax preference (as defined under the minimum 
tax) or the average of the taxpayer's tax preferences over the current 
year and the four preceding vears, whichever is greater, in excess of 
$30,000. 

For married couples, the maximum tax only applies if they file 
a joint return, and taxpayers cannot use the maximum tax provision 
if they use income averaging. 

Reasons for change 
Congress lielieved that one way to reduce the incentive for making 
use of tax preferences was to continue the lower top bracket rate (i.e., 

1 The Tax Reform Act of 1976 included an effective date of January 1. 1976, for the repeal 
of the carryover, but H.R. 1144 (P.L. 94-568) amended this to July 1, 1976. 



no 

50 percent) on personal service income but to reduce the amount of 
personal service income eligible for this benefit to the extent that the 
taxpayer uses tax preferences. This "preference offset" in prior law, 
however, was considerably weakened by the $30,000 exemption. 

Also, Congress thought it was appropriate to extend the benefits 
of the 50-percent maximum tax rate to deferred compensation. Under 
prior law, there were cases where an individual could retire on a pen- 
sion ; and, even though his before-tax income would fall, his after-tax 
income would rise because he would lose the benefit of the maximum 
tax. 

Explanation of provision 

The Act eliminates the $30,000 exemption to the preference offset 
and the five-year averaging provision. These changes will make the 
maximum tax a more effective deterrent to use of tax preferences and 
also will considerably simplify it. 

Also, the Act extends the benefits of the maximum tax to deferred 
compensation including pensions and annuities. This extension applies 
to pensions and annuities that are personal services income. For exam- 
ple, it excludes those pensions and annuities in which an individual 
buys the pension or annuity for himself wher-e there is no connection 
with earning income with personal services. Income deferred under 
individual retirement accounts will also qualify for the maximum tax. 
Lump-sum distributions which are taxed under special rules and cer- 
tain distributions from H.R. 10 pension plans or Individual Retire- 
ment Accounts (IRA's) do not qualify for the maximum tax. 

Effective date 
The changes in the maximum tax are effective for taxable yeare 
beginning after December 31, 1976. 

Revenue effect 
The changes in the maximum tax will increase revenues by $4 mil- 
lion in fiscal year 1977, $24 million in fiscal year 1978 and $43 million 
in fiscal vear 1981. 



C. EXTENSION OF INDIVIDUAL INCOME TAX 
REDUCTIONS 

(Sees. 401-402 of the Act and Sees. 42, 43, and 141 of the Code) 

Prior l^w 

The Tax Reduction Act of 1975 (Public Law 94-12) enacted thre^ 
individual income tax cuts for the first six months of 1975. These 
were an increase in the standard deduction, a general tax credit and an 
earned income credit. The Revenue Adjustment Act of 1975 (Public 
Law 94-164) enacted somewhat larger tax cuts for the first six months 
of 1976. 

Prior to the 1975 tax reduction, the minimum standard deduction 
(or low-income allowance) was $1,300. The Tax Reduction Act in- 
creased it to $1,600 for single returns and to $1,900 for joint returns for 
the year 1975. The tax reduction in the Revenue Adjustment Act of 
1975, on a full-year basis, would have increased the minimum standard 
deduction to $1,700 for single returns and to $2,100 for joint returns. 

The percentage standard deduction was 15 percent prior to 1975. 
The Tax Reduction Act of 1975 and the Revenue Adjustment Act in- 
creased it to 16 percent for 1975 and the first half of 1978, respectively. 

The maximum standard deduction was $2,000 before 1975. The Tax 
Reduction Act of 1975 increased it to $2,300 for single returns and to 
$2,600 for joint returns for 1975. On a full-year basis, the Revenue 
Adjustment Act of 1975 would have increased it to $2,400 for single 
returns and to $2,800 for joint returns for 1976. 

The Tax Reduction Act of 1975 also provided a nonrefundable credit 
of $30 for each taxpayer and dependent for 1975. The Revenue Adjust- 
ment Act of 1975, on a full-year basis, would have increased this credit 
to the greater of $35 per capita or 2 percent of the first $9,000 of tax- 
able income. 

In addition, the Tax Reduction Act of 1975 included a refundable 
tax credit equal to 10 percent of the first $4,000 of earned income, 
phased out as adjusted gross income rises from $4,000 to $8,000. This 
earned income credit applied only to families who maintained a house- 
hold for at least one dependent child for whom they were entitled to 
claim a personal exemption. The earned income credit was extended 
for the first six months of 1976 in the Revenue Adjustment Act of 1975. 
Also, the credit for 1975 was modified to provide that it be disregarded 
in detennining eligibility for, or benefits under. Federal or federally- 
assisted aid programs, as long as the individual was a recipient of bene- 
fits under the program in the month before receiving a tax re,fund 
resulting from the earned income credit. 

The Tax Reduction Act of 1975 provided that the changes in the 
standard deduction and the general tax credit be reflected in lower 
withheld and estimated taxes for the last eight months of 1975. The 
Revenue Adjustment Act of 1975 extended those same withholding 

(111) 



112 

rates and estimated tax requirements through June 30, 1976. Subse- 
quent leoislation extended the withholding rates through Septem- 
ber 30, 19t6. 

The Revenue Adjustment Act of 1975 reduced taxes only for the 
first half of 1976. This was achieved by enacting a reduction in tax 
liability approximately equal to one-half of the full-year reduction de- 
scribed above and by providing that this tax cut be entirely reflected 
in lower withheld and estimated tax payments in the first six months 
of 1976.1 

Reasons fm' change 

Without new legislation, income tax withholding rates would have 
risen by $13 billion on October 1, 1976. Congress believed that eco- 
nomic conditions did not warrant this tax increase. Wliile the recovery 
from the 1974—75 recession has proceeded far enough that we have now 
exceeded the level of output that existed prior to the recession, which 
began at the end of 1973, there is still a large gap between what the 
economy is capable of producing and what it actually produces. The 
unemployment rate was 7.8 percent in September 1976, as compared to 
its pre recession level of less than 5 percent, while capacity utilization 
in manufacturing was onlv 73 percent, as compared to 83 percent in 
1973. 

An extension of the expiring 1975 income tax cuts at least through 
1977 is needed to permit a continuation of the economic recovery. 
This extension does not provide any new fiscal stimulus to the econ- 
omy; it only prevents the withdrawal of existing stimulus. In 1977, 
Congress plans to review the economic situation to see if a further 
income tax cut extension is appropriate. 

The extension of the tax cuts also serves purposes other than eco- 
nomic stimulus. The increase in the standard deduction represents a 
major simplification of the tax law because it will encourage taxpayers 
who file over 9 million tax returns to switch from itemizing their 
deduction to using the standard deduction. Also, the increase in the 
standard deduction creates greater equity between users of the stand- 
ard deduction and itemizers, since itemized deductions have risen in 
recent years as a result of inflation while there has been no comparable 
increase in the standard deduction. For these reasons, Congress be- 
lieved the increases in the standard deduction should be made 
permanent. 

The income tax cuts also raised the income level at which people 
begin to pay income taxes (the tax threshold) above the current pov- 
erty level. If taxes were allowed to rise after September 30, the income 



1 For the minimum standard deduction, the half-year tax cut for 1976 involved an 
increase from ?1,S00 to $1,500 for single returns and to $1,700 for joint returns (compared 
with increases to $1,700 and $2,100 respectively in the full-year version of the tax cuts). 
T'he maximum standard deduction was increased in the half-year version from $2,000 to 
$2,200 for single returns and to $2,400 for joint returns (compared with increases to 
$2,400 and $2,800 respectively in the full-year version). The percentage standard deduc- 
tion was increased from 1-5 percent to 16 percent in the half-year version, which is the same 
level as in the full-year version. 

For the general tax credit, the half-year variant was a credit equal to the greater of 
$17..50 per capita or one percent of the initial $9,000 of taxable income (compared with 
a credit equal to the greater of $3,'i per capita or 2 percent of the first $9,000 of taxable 
income In the full-year version). 

For the earned "income credit, the half-year version was 5 percent of the initial $4,000 
of earnings (compared with a 10-percent rate in the full-year version) with the same 
income phaseout as mentioned above. 



113 

tax threshold would have fallen substantially below the poverty level. 
This is shown in Table 1, which compares the poverty level in 1976 
with the income tax threshold with and without the tax cuts. If the 
tax cuts had expired, the poverty level would be $1,550 above the 
threshold for a family of four; thus, such a family could be liable 
for a Federal income tax burden as high as $222. 

TABLE 1.— POVERTY LEVELS AND FEDERAL INCOME TAX THRESHOLDS, 1976 





Income lax 


threshold 


1976 poverty 


Without tax 


With tax 


level 


cuts' 


cuts' 


$2, 970 


12, 050 


$2, 700 


3,840 


2,800 


4,100 


4,570 


3,550 


5,100 


5,850 


4,300 


6,100 


6,900 


5,050 


7,083 


7,770 


5,800 


8,067 



Family size: 

1 

2.... - 

3 

4.. 

5 

6 

» Personal exemption of $750 and minimum standard deduction of $1,300. 

'Personalexemptionof $750, minimum standard deduction of $1,700 for single returns and $2,100 for joint returns, and 
$35 tax credit for each taxpayer and dependent. 

Congress also decided to extend the earned income credit. This pro- 
vides needed tax relief to a hard-pressed group in the population — 
the lower income worker. It also provides a work incentive, since the 
credit is based on the amount of earned income. In effect, it offsets the 
social security payroll taxes payable with respect to those who are 
working but whose incomes are slightly, if any, above the levels of 
those on welfare. This is designed to improve the financial position 
of those who work relative to those remaining on welfare. 

Ex'ptanation of provisions 

(a) Standard deduction. — The Act makes permanent the increases 
in the standard deduction from the Revenue Adjustment Act of 1975, 
thus, making the increases effective for 1976 and subsequent years. It 
increases the minimum standard deduction (or low-income allowance) 
to $1,700 for single returns and $2,100 for joint returns; increases 
the percentage standard deduction to 16 percent; and increases the 
maximum standard deduction to $2,400 for single returns and $2,800 
for joint returns. It also modifies the income tax filing requirements to 
reflect the increases in the minimum standard deduction. 

(b) General tax credit. — The Act continues the general tax credit 
from the Revenue Adjustment Act of 1975 through the last 6 months 
of 1976 and for all of 1877. This credit is the greater of $35 per tax- 
payer and dependent or 2 percent of the initial $9,000 of taxable 
income. 

(c) Ean}^d income credit. — ^The Act extends the earned income 
credit through 1977, and also extends the provision that the credit be 
disregarded in determining eligibility for benefits under Federal or 
federally-assisted aid programs. Also, the eligibility for the credit is 
broadened in two ways. The Act makes the credit available to a parent 
who maintains a household for a child who is either under 19 or a 
student even though the parent is not entitled to a personal exemption 



114 

for the child. Also, it extends the credit to a parent who maintains a 
household for an adult disabled dependent for whom he is entitled to 
claim a pereonal exemption. 

(d) Withholding rates. — The Act extends the income tax withhold- 
ing rates that have been in use since May 1975 through the end of 
1977. After that, it insti*ucts the Secretary of the Treasury to issue new 
withholding tables that are to be the same as those which were in effect 
prior to May 1975, except that they are to be adjusted to reflect the 
permanent increases in the standard deduction made by the Act. 

Effective dates 
The changes in the standard deduction are effective for taxable years 
beginning after December 81, 1975. The general tax credit and changes 
in the earned income credit are effective for taxable years beginning 
after December 81, 1975, and before Januar}^ 1, 1978. The "disregard" 
applies to refunds received after December 81, 1975. The extension of 
the withholding rates is effective for wages paid after September 14, 
1976. 

Revenue effect 
These tax reductions will reduce receipts by $14.4 billion in fiscal 
year 1977, $9.3 billion in fiscal year 1978, and $5.0 billion in fiscal 
year 1981. 



D. TAX SIMPLIFICATION IN THE INDIVIDUAL 
INCOME TAX 

1. Revision of Tax Tables for Individuals (sec. 501 of the Act 
and sees. 3, 4, 36, 144, 1211, 1304 and 6014 of the Code) 

Prior Jaiv 
Under prior law, a taxpayer whose adjusted ^oss income was under 
$10,000 ($15,000 for 1975 only) and who claimed the standard deduc- 
tion was required to use the optional tax tables. These tables had AGI 
brackets as horizontal row^ designations ; marital status and number of 
exemptions as vertical column headings; and the amount of tax in the 
resulting cell, xl taxpayer whose income was greater than $10,000 
($15,000 for 1975 only) or who itemized his deductions was required to 
compute his tax using the tax rates. 

Reasons for change 
The optional tax table set-up which provided a diiferent table for 
each number of exemptio-.s claimed by the taxpayer just to cover up 
to $10,000 of AGI resulted in 6 pages of fine print, representing 12 
optional tax tables in the instructions accompanying the income tax 
return. The 1975 tables extending up to $15,000 of AGI covered 10 
pages in the instructions. In addition, a separate publication was 
required for taxpayers claiming 13 or more exemptions. This system 
was a considerable source of taxpayer error since taxpayers were not 
always sure which table to use or, because of the necessarily small size 
of the print, which was the proper tax figure to enter on their returns. 
In the interest of taxpayer compliance and simplification of the in- 
structions as well as increased accuracy in the determination of the 
proper tax by taxpayers, the Congress believed it desirable to elim- 
inate the existing optional tax table system and to adopt a table based 
on taxable income. This should make it possible to print the tax table 
on three pages. 

Explanation of provision 

The Act revises the existing optional tax tables by providing that 
taxpayers with taxable incomes of $20,000 or less are to use a tax table 
based on taxable income which is to be prescribed by the Secretary of 
the Treasury on the basis of the existing tax rates. This table is to be 
used by individuals, estates, and trusts. 

In construc<-ing such a taxable income table, the Secretary has the 
authority to design a bracket system analogous to that in the prior 
optional tax table (including a zero-tax bracket for rounding pur- 
poses). In order to limit the taxable income bracket table to three 
pages and to have the tax table run to $20,000 of taxable income, 
the tax liability of an individual may have to be several dollars 
higher at the bottom of one bracket than at the top of the next lower 

(115) 



116 

bracket. (This was the case with the optional tax table under prior 
law.) However, the amount involved is only a small portion of the 
existing tax. This chan<ire is necessary to achieve the simplification 
and taxpayer accuracy that is oenerally believed to be desirable. 

In order to use the tax table, the taxpayer must subtract from his 
adjusted g:ross income the amount of his personal exemptions and 
itemized deductions oi- standard deduction (either percentage or mini- 
mum standard deduction). The amount of tax deteimined from the 
table is tax before credits and is to be reduced by any tax credits 
(such as the $3i5 per capita or 2 j^ercent of taxable income credit pro- 
vided by the Act as well as other credits). This will entail additional 
computations for some taxpayers but should, on balance, result in 
improved taxpayer compliance and greater accuracy than was 
achieved under the prior system. (It is estimated that over 90 percent 
of taxpayers will use the new tables.) 

The cojnputation of the 16-pei-cent standard deduction is not ex- 
pected to cause significant difficulty because it applies at an income 
level where (prior to 1975) taxpayers would not have been able to 
use the optional tax table. They would have had to use the tax rates 
for a computation which involves the same type of multiplication as 
the standard deduction computation. 

In the case of a taxpayer with a short taxable year, the taxpayer 
still annualizes as he did under section 448 (b) . 

Effective date 

This provision applies to taxable years beginning after December 31, 

1975. 

Revenue effect 
This provision will not have any revenue effect. 

2. Alimony Payments (sec. 502 of the Act and sees. 62 and 3402(m) 
(2) of the Code) 

Prior law 
Under prior law, a deduction for alimony could be taken as an 
itemized deduction from adjusted gross income in the year paid 
in arriving at taxable income. The recipient of alimony Avas re- 
quired to include such payments in his or her income and to pay tax 
on them. Payments for the support of a spouse which were not re- 
quired by a divorce or separation agreement and payments for the 
support of children were considered normal living expenditures on 
the part of a taxpayer. Such expenditures wei-e not deductible and 
were not included in the income of the recipients. 

Reasons for change 
The Congress believes that the splitting of income or assignment 
of income through the payment of alimony was not properly treated 
under prior law which permitted only an itemized deduction for ali- 
mony. Instead, the Congress believes it is more appropriate to take 
the payment of alimony into account as a deduction in arriving at 
adjusted gross income, rather than as one of the itemized deductions 
which are generally limited to personal expenses. As a deduction from 



117 

gross income, the alimony deduction would be available to taxpayers 
who elect the standard deduction as well as to those taxpayers who 
elect to itemize their deductions. 

Exflanation of provision 

The Act takes the payment of alimony into account in determining 
adjusted gross income. 

The Act moves the deduction of alimony payments from an itemized 
deduction to a deduction from gross income to arrive at adjusted gross 
income (sec. 62). The Act also makes a conforming change in the sec- 
tion providing a withholding allowance for itemized deductions (sec. 
3402 (m) (2) ). This change includes the deduction for alimony as one 
of the deductions taken into account for determining withholding al- 
lowances in order to avoid overwithholding. Previously such allow- 
ances, which were based on estimated itemized deductions, could not 
take alimony into account. 

Effective date 
This provision is to apply to taxable years beginning after Decem- 
ber 31, 1976. 

Revenue effect 
This provision Avill reduce budget receipts by $7 million in fiscal 
year 1977, $44 million in fiscal year 1978, and^$59 million in fiscal 
year 1981. 

3. Retirement Income Credit (sec. 503 of the Act and sec. 37 of 
the Code) 

Prior law 

Under prior law, individuals who were 65 years of age or over 
could receive a tax credit based on the first $1,524 of retirement 
income. The credit was 15 percent of this retirement income. Each 
spouse who was 65 or over could compute his tax credit on up to $1,524 
of his own retirement income (whether the couple filed separate or 
joint returns) . Alternatively, spouses 65 or over who filed joint returns 
could compute their credit on up to $2,286 of retirement income (one 
and one-half times $1,524) even though one spouse received the entire 
amount of the retirement income. 

To be eligible for the credit an individual had to receive more than 
$600 of earned income in each of 10 prior years. (A widow or 
widower whose spouse had received such earned income was con- 
sidered to have met this earned income test) . 

Retirement income, for purposes of this credit, included taxable 
pensions and annuities, interest, rents, dividends, and interest on Gov- 
ernment bonds issued especially for the self-employed setting aside 
amounts under "H.R. 10" retirement-type plans. 

The maximum amount of retirement income which an individual 
could claim ($1,524, or $2,286 for certain married couples) had to be 
reduced by two broad categories of receipts. First, it was reduced on 
a dollar-for-dollar basis by the amount of social security, railroad 
retirement, or other exempt pension income received by the taxpayer. 



234-120 O - 77 - 9 



118 

Second, the maximum amount of retirement income eligible for the 
credit was further reduced by one-half of the annual amount of earned 
income over $1,200 and under $1,700 and by the entire amount of 
earned income in excess of $1,700. This reduction for earned income 
did not apply to individuals who had reached age 72. 

Individuals under age 65 also were eligible for tax credits for retire- 
ment income but only with respect to pensions received under a public 
retirement system. Only income from a pension, annuity, retirement, 
or similar fund or system established by the United States, a State, 
or a local government, qualified under this provision. This resitriction 
of retirement income for purposes of the credit to income from a public 
retirement system applied only until the individual reached the age 
of 65 ; thereafter, he was entitled to take the credit on the same basis 
as other individuals who had reached that age. 

Reasons for change 

The Congress concluded that there was a need to redesign the retire- 
ment income credit for several basic reasons. One reason was that the 
credit needed updating. Most of the features of the credit had not been 
revised since 1962 when the maximum level of income on which the 
credit was computed was set and when the earnings limits were estab- 
lished.^ Since then, there have been numerous revisions of the social 
security law which substantially liberalized the social security benefits. 
As a result, the maximum amount of income eligible for the credit was 
considerably below the average annual social security primary benefit 
received by a retired worker and the average social security primary 
and supplementary benefit that could be received by a retired worker 
and spouse (one and one-half times the primary benefit). 

In addition, the complexity of the retirement income credit pre- 
vented it from providing the full measure of relief it was intended 
to grant to elderly people. This complexity stemmed from an attempt 
to pattern the credit after the social security law. For example, to 
claim the credit on his tax return, a taxpayer had to show that he 
met the test of earning $600 a year for 10 years ; he also had to segre- 
gate his retirement income from his other income; he had to reduce 
the maximum amount of retirement income eligible for the credit by 
the amount of his social security income and by specified portions of 
his earned income under the work test ; a credit of one and one-half 
times the basic credit was available for a man and his wife ; and a credit 
was available for each spouse separately if each spouse independently 
met the eligibility tests. 

The purpose of all these provisions was to treat taxpayers who re- 
ceived little or no social security benefits on as equal a basis as possible 
to that provided for recipients of tax-exempt social security benefits. 
However, the result was to impose severe compliance burdens on large 
numbers of elderly people, many of whom are not skillful in filing tax 
returns. Such individuals had to compute their retirement income 
credit on a separate schedule, which occupied a full page in the tax re- 
turn packet, with 19 separate items, some of which involved computa- 

1 One other feature of the credit was adopted in the 1964 Revenue Act. This provision 
allowed spouses 65 and over who file joint returns to claim a credit on up to $2,286 of 
retirement income (one and one-half times the $1,524 maximum base for single people) 
even If one spouse received the entire amount of the married couple's retirement income. 



119 

tions in three separate columns (see the form shown below) . It is these 
complexities which undoubtedly accounted for the fact that some of the 
organizations representing retired people estimated that as many as 
one-half of all elderly individuals eligible to use the retirement income 
credit did not claim this credit on their tax returns. 



sch.duiM E«.R (Form 1040) >»75 Schedule R — Retirement Income Credit Computatton 



)>•(• 2 



«(s) •» shown on Form 1040 (Do not ent0r i 



I and •odal vecuri^ numbv If shown on other side) 



Your social saciiil^ numbar 



If you received earned income in excess of $600 In each of any 10 calendar years before 1975, 
you may be entitled to a retirement income credit. If you elect to have the Service compute your 
tax (see Form 1040 instructions, page 5), answer the question for coJumns A and B below/ and 
fill in lines 2 and 5. The Service will figure your retirement income credit and allow it In com* 
puting your tax. Be sure to attach Schedule R and write "RIC" on Form 1040, lino 17. If you 
compute your own tax, filj out all applicable lines of this schedule. 
Married residents of Community Property States see Schedule R instructions. 



Joint return filers use column A for wife and column B for husband. Atl other filers 
use coK*mn B only. 

Did you receive earned Income In excess of $600 In each of any 10 calendar yeare 
before 1975? (Widows or widowers see Schedule R Instructions.) If "Yes" In either 
column, furnish all Information below In that column. Also furnish the combined 
information called for in column C for both husband and wife If Joint return, both 65 
or over, even if only one answered "Yes" In column A or B. 



n Yes a No 



B 



D Yes D No 



Inrorrtatlon of 



both 65 or ovar) 



1 Maximum amount of retirement Income for credit computation 



}1.624 



Deduct; 

(a) Amounts received as pensions or annuities under the Social Security Act, 
the Railroad Retirement Acts (but not supplemental annuities), and certain 
other exclusions from gross Income , 



(b) Earned Income received (does not apply to persons 73 or over): 

(1) If you are under 62, enter the amount In excess of $900 

(2) If you are 62 or over but under 72, enter amount determined as follows: 

If $1,200 or less, enter zero 

if over $1,200 but not over $1,700, enter Vi of amount 
$1,200; or If over $1,700, enter excess over $1,450 

Total of lines 2(a} and 2(b) 



tovar . \. 



Balance (subtract line 3 from line 1) 

If column A, B, or C is more than zero, complete this schedule. If all'Of these 
columns are zero or less, do not file this ecliedule. 
Retirement income: 

(a) If you are under 65: 

Enter only Income received from pensions and annuities under public retire- 
ment systems (e.g. Fed., State Govts., etc.) Included on Form 1040, 
line 15 

(b) If you sre-SS or olden 

Enter total of pensions and annuities. Interest, dividends, proceeds of retire 
ment bonds, and amounts received from individual retirement accounts 
and individual retirement annuities that are Included on form 1040, line 
15. and gross rents from Schedule E, Part II, column (b). Also Include your 
share of gross rents from partnerships and your proportionate share of 
taxable rents from estates and trusts 



6 Line 4 or line 5, whichever Is smaller . . . . 

7 (a) Total (add amounts on line 6, columns A and 8) 
(b) Amount from line 6, column C, If applicable . 



00 



tl.624 



00 



(3.286 



00 



Q 




8 Tentative credit Enter 15% of line 7(a} or 15% of line 7(b), whichever Is greater 

9 Amount of tax shown on Form 1040, line 16e... 



10 Retirement Income credit. Enter here end on Form 1040, line 48, the amount on line 8 or One 9, wtilchever Is 
smaller. Note: If you claim credit for foreign taxes or tax free covenant twnds, skip line 10 and complete lines 11, 
12, and 13, below 



11 Credit for foreign taxes or tax free covenant bonds . . 

12 Subtract line 11 from line 9 (if less than zero, enter Zero) 



■trV.B. GOTIERNIIENT PEINTINa OmCII I UTI— O-iTC-TIi IS4M-I119 



Moreover, the retirement income credit discriminated among indi- 
viduals depending on the source of their income. As indicated above, 
the credit was avaihible onlv to those with retirement income — that is, 



120 

some form of investment or pension income. Elderly individuals who 
had to support themselves by earning modest amounts and who had no 
investment or pension income were not eligible for any relief undei- 
the prior credit. This gave rise to considerable criticism as to the 
fairness of the tax law: many elderly individuals who relied entirely 
on earned income maintained that they should have been allowed the 
same retirement income credit as those who lived on investment income. 
Under the prior credit, elderly people who relied entirely on earned 
income were required to pay substantially higher taxes than the taxes 
paid by individuals who were comparable in every respect except that 
they had significantly larger incomes which came from investments. 
Another criticism was that higher taxes on earnings than on retirement 
income served as a disincentive to work. 

Explanation of provision 

To deal with the problems above, the Congi-ess first updated the 
amount on which the credit is based. Then it simplified the credit to the 
extent practicable by eliminating complicating, substantive features 
of the credit which previously were included in order to parallel social 
security treatment. Thus the $600 for ten-years earnings test is elimi- 
nated, as is the requirement that the taxpayer have "retirement in- 
come" (that is, pension or investment income) in order to be eligible 
for the credit. In addition, the variation in treatment of married cou- 
ples depending on whether they are separately eligible for the credit 
is eliminated. 

The Congress has increased the equity of the provision by making 
the credit more generally available to those age 65 or over. The major 
change in this area is the elimination of the cutback of the credit for 
earned income. The Congress concluded, however, that in view of 
the broadening of the credit generally and the change in its nature 
to focus relief on low- and middle-income taxpayers, it is not necessary 
to provide the credit to higher income taxpayers. Consequently, the 
maximum amounts of the base for the credit are reduced by one-half 
of the adjusted gross income in excess of $7,500 for a single person and 
$10,000 for a married couple filing a joint return ($5,000 for a married 
taxpayer filing a separate return) . Thus, for a single person, the credit 
would no longer be available when his adjusted gross income reaches 
$12,500 ($7,500 plus two times $2,500). For a joint return the credit 
would be available up to an income level of $15,000 if only one spouse 
is age 65 or over and up to $17,500 if both spouses are age 65 or over. 

The most significant extension of the credit provided by this Act 
is that it will for the first time benefit low-income earners age 65 or 
over regardless of whether they receive retirement income or earned 
income. Since the credit is no longer limited to retirement income, it 
has been renamed the "credit for the elderly." 

Taxpayers age 65 and, over. — More specifically, the credit for the 
elderly provided by the Act liberalizes the retirement income credit 
available under prior law for those age 65 and over in four respects. 
First, the amount of income with respect to which the 15-percent credit 
may be claimed is increased to $2,500 for a single person and for a 
married couple filing jointly if only one spouse is 65 or over, and to 
$3,750 in the case of a married couple filing a joint return where 
both are 65 or over. 



121 

Second, all types of income, including earned income, are to be 
eligible for the credit. Third, the maximum amounts on which the 
credit is based are reduced by one-half of adjusted gross income in 
excess of $7,500 for a single person and $10,000 for a married couple 
filing a joint return ($5,000 for a married individual filing a separate 
return) . Because of the cutback based on the couple's combined income, 
the credit is available to married couples only if they file a joint return, 
except in the case of a husband and wife who live apart at all times 
during the taxable year, which is treated as a "nonlegal" separation 
and is evidence that filing a joint return might not be possible. Fourth, 
the credit is to be available regardless of whether the individual has 
had work experience (i.e., has received earned income) in prior years. 

Under the Act, the amount with respect to which the 15-percent 
credit may be claimed (referred to in the Act as the "section 37 
amount") may not exceed a maximum amount (referred to in the Act 
as the "initial amount") of $2,500 in the case of a single individual 
age 65 or over or a married couple filing a joint return where only one 
spouse is age 65 or over. In the case of a married couple filing a joint 
return where both spouses are age 65 or over, the maximum amount is 
$3,750 and if a married individual age 65 or over files a separate return 
the maximmn amount is $1,875. (As under prior law, the age of an 
individual is to be determined as of the close of the taxable year in 
question.) This credit is available whether or not the individual (or 
his spouse in the case of a joint return) has received $600 of earned 
income in ten prior years. 

One feature of the prior law parallel to social security recipients is 
retained, however. As under prior law, the maximum base for the 
credit is reduced by amounts received by the individual (and by his 
spouse in the case of a married couple filing a joint return) as a pension 
or annuity under the Social Security Act, the Railroad Retirement 
Acts, or as a pension or annuity which is otherwise excluded from gross 
income. 

In conjunction with the minimum standard deduction of $1,700 for 
single persons and $2,100 for joint returns and the $35 per capita or 
two percent of taxable income up to $9,000 tax credit, the credit for the 
elderly will permit a single elderly person to receive approximately 
$5,800 of earned income or pension income before becoming taxable. 
For a joint return with one spouse age 65 or over, the tax-free level is 
about $7,300. With both spouses age 65 or over, the tax-free income 
level is about $9,200. 

The change in the retirement income credit to a tax credit for the 
elderly and the increase in the base for the credit will increase the 
number of returns with at least one taxpayer age 65 or over benefiting 
from about 400 thousand to about 2.4 million. 

An example of the type of simplified tax credit form for taxpayers 
age 65 and over which these changes make possible is shown below. 
This form is less than one-third as long as the prior form and in- 
volves only one column instead of three. It requires the taxpayer to 
select the appropriate amount on which to compute the credit and to 
deduct from this amount his social security or certain other tax-exempt 
income. It also requires the taxpayer to reduce the base for the credit 
by one-half the adjusted gross income above specified levels. On the 
balance, the credit is computed at a 15 percent rate, and this is then 
entered on the basic form 1040 as a tax credit. 



122 

ScHEDUXE R. — Credit far taxpajfers age 65 or over 



MAXIM0M AMOUNTR FOR CREDIT COMPUTATION 

Then your maximum' 

amount for credit 

If you are : (check one box) : computation %» — 

D Single $2,500 

Q Married filing jointly and only one spouse is 65 or over 2, 500 

□ Married filing jointly, both age 65 or o%-er 3, 750 

□ Married filing a separate return and age 65 or over 1, 875 

1. Enter (from above) your maximum amount for credit computat'on. 



2. Amounts received as pensions or annuities under the Social Security 

Act, the Railroad Retirement Acts (but not supplemental annui- 
ties) and certain other exclusions from gross income 

3. Adjusted gross income reduction. Enter one-half of adjusted gross 

income (line 15 form 1040) in excess of $7,500 if single; $10,000 if 
married filing jointly ; or $5,000 married filing separately 

4. Total of lines 2 and 3 

5. Balance (subtract line 4 from line 1) ; if more than zero complete 

this form; if zero or less, do not file this form 

6. Amount of credit; enter (here and on form 1040, line 48) 15 percent 

of line 5 but not more than the total income tax on form 1040, 
line 18 



Public retirees under age 65. — The Act makes three changes in the 
retirement income credit for taxpayers who are public retirees under 
age 65 ; otherwise, the credit for public retirees age 65 is left generally 
the same as prior law. First, the maximum base for the credit is in- 
creased (as in the case of taxpayers over age 65) to $2,500 for a single 
taxpayer, $3,750 for a married couple filing a joint return, and $1,875 
for a married individual filing a separate return. Because of the re- 
tention of the earnings cutback of prior law, the Congress did not 
believe it necessary to apply the adjusted gross income phaseout in 
order to limit the benefits of the credit to the low- and middle-income 
taxpayer generally. Second, the $600 a year of earnings for 10 years 
test is also eliminated for taxpayers under age 65. Third, in the case 
of joint returns where one spouse is age 65 or over and therefore 
eligible for the elderly credit and the other spouse is under age 65 
with public retirement income, the couple must elect for the taxable 
year whether to use the prior law retirement income credit or the new 
elderly credit. This election procedure was adopted principally to 
avoid the serious complexity that would result from a combination 
of the retirement income credit for public retirees and the new elderly 
credit (especially the application of the adjusted gross income 
phaseout) . 

Under this procedure, if the prior law public retirement provision 
is elected, the provisions restricting the base of the retirement income 
to retirement income as defined under prior law for taxpayers over 
age 65 apply. The computation of the credit in these situations where 



123 

a couple elects to have essentially the prior law procedure apply is 
modified by peraiitting the spouses to allocate the maximum base of 
the credit, $3,750, between them in any way they wish so long as no 
more than $2,500 is allocated to one spouse. After the allocation, the 
regular reductions provided by prior law are to apply and any re- 
maining credit base of either spouse is to be aggregated as the base 
for the final credit computation in essentially the same manner as the 
dual computation under prior law. 

Miscellaneous provisions. — As mider prior law, the Act provides 
that the credit for the elderly may not exceed the individual's (or the 
married couple's, in the case of a joint return) tax for the year. For 
this purpose, however, the Act provides that the credit for the elderly 
is to be taken before the foreign tax credit. In other words, the tax 
for the year is to be computed before reduction for the foreign tax 
credit. A correlative change is made by the Act in the limitation on 
the foreign tax credit to reflect this reordering of the priority of 
these two credits. Thus, the limitation on the foreign tax credit is to 
be computed with respect to the tax for the year after i-eduction for 
the retirement income credit. 

In addition, although the credit is not available to nonresident aliens 
generally, it is available to nonresident aliens who are married to 
citizens or residents of the United States who agree to be taxed on 
their worldwide income and to make records of their combined income 
available for inspection to the IRS (i.e., those nonresident aliens 
treated as residents by section 1012 of the Act) . 

Effective date 
This provision is to apply to taxable years beginning after Decem- 
ber 31, 1975. 

Revenue effect 
This provision will reduce receipts by $391 million in fiscal year 
1977, $340 million in fiscal year 1978, and $340 million in fiscal year 
1981. 

4. Credit for Child Care Expenses (sec. 504 of the Act and sees. 
44A, 214 and 3402(m)(2) of the Code) 

Prior law 

Under prior law, taxpayer were permitted an itemized deduction 
for expenses for the care of a dependent child, incapacitated depend- 
ent or spouse, or for household services when the taxpayer maintained 
a household for any of these qualifying individuals. An eligible de- 
pendent child had to be under age 15 and the taxpayer had to be able 
to claim a personal exemption for the child. These expenses had to be 
related to employment ; that is, they had to be incurred to enable the 
taxpayer to be gainfully employed. 

Eligible expenditures were limited to a maximum of $400 a month. 
Services provided for children outside the taxpayer's home were fur- 
ther limited to $200 a month for one dependent, $300 for two, and 
$400 for three or more. (No deduction was allowed for the care of an 
incapacitated dependent over age 14 or spouse outside the taxpayer's 
home.) The amount of the eligible expenses which could be deducted 
was also reduced by one-half of adjusted gross income in excess of 



124 

$35,000 a year. No deduction was allowed, however, for payments to 
relatives. 

To claim this deduction, a husband and wife were generally required 
to file a joint return. Both had to be employed substantially full time, 
that is, three-quai'ters or more of the normal or customary workweek 
or the equivalent on the average. However, a spouse who had been 
deserted for an entire year could file as a single person. 

In the case of a disabled dependent, the deductible expenses were 
reduced by the dependent's adjusted gross income plus disability 
income in excess of $750. 

Reasons for change 

The Congress believed that the availability of the child and depend- 
ent care deduction under prior law was unduly restricted by its classifi- 
cation as an itemized deduction and by its complexityo 

Treating child care expenses as itemized deductions denied any 
beneficial tax recognition of such expenses to taxpayers who elected 
the standard deduction. The Congress believed that such expenses 
should be viewed more as a cost of earning income thai) as personal 
expenses. One method for extending the allowance of child care 
expenses to taxpayers generally and not just to itemizers was to replace 
the itemized deduction with a credit against income tax liability for a 
percentage of qualified expenses. While deductions favor taxpayers 
in the higher marginal tax brackets, a tax credit provides relatively 
more benefit to taxpayers in the lower brackets. 

Because there was a $400 a month limit on the deduction under prior 
law, a complex child care deduction form was necessary. The child 
care allowance could be made simpler and the form simplified if it 
were computed on an annual instead of a monthly basis. The Congress 
also believed that additional unnecessary complications resulted from 
the distinction between expenses for care of children incurred inside 
and outside the home and from the requirement that the allowable 
deduction be reduced by the dependent's disability income. Allowing 
the same amount for the expenses of caring for children whether inside 
or outside the home and replacing the $200, $300 and $400 monthly 
maximum deductions for such outside expenses for the care of one, 
two, or three children, with annual ceilings based on one and two or 
more dependents, would further reduce the complexity of the pro- 
vision. 

The rule allowing the deduction in the case of joint returns only 
where both spouses work full time seemed unduly restrictive. The 
full-time earnings test was intended to prevent one spouse from 
working part time, perhaps in a nominal capacity, in order to obtain 
the benefits of a deduction which could amount to $4,800 a year. The 
Congress believed this type of abuse could be prevented by an alterna- 
tive rule limiting the allowable expenses to the earnings of the spouse 
with the smaller earnings. Such a limitation would enable a married 
or single taxpayer with a qualifying dependent to treat child care 
expenses as a cost of earning income. 

The Congress also believed that child care expenses should be al- 
lowed when one spouse works and the other is a full-time student. 
The spouse attending school cannot reasonably be expected to provide 



125 

child care to enable the other spouse to work. In these circumstances, 
the expenses incurred to pay for child care are, in fact, necessary for 
the taxpayer to be gainfully employed. 

The Congress believed that the one-year waiting period before a 
deserted spouse could claim child care expenses was too long and 
adopted a shorter qualifying period to mitigate haixiships. 

Limiting the deduction of child care expenses to parents who claim 
a child as a dependent denied the deduction to a divorced or separated 
parent with custody of a child, who did not supply more than half of 
the child's support and could not claim the child as a dependent, but 
who nevertheless incurred child care expenses in order to work. The 
Congress believed that the parent who has custody of the child for 
the greater period of the year should be allowed to treat the child 
care expenses as a cost of earning income, provided the parent who has 
custody for the shorter period does not claim such expenses. 

The Congress also viewed the bar on deducting payments to rela- 
tives for the care of children as overly restrictive. Relatives generally 
provide superior attention. In order to cover the child oare expenses 
paid to relatives and also to limit the risks of abuse (such as splitting 
or transferring income by gift to relatives who are in lower brackets 
or have incomes below taxable levels) the Congress has provided the 
child care allowance only for those payments made to a relative who 
is not the taxpayer's dependent and whose sei-vices constitute employ- 
ment for social security purposes. 

The Congress views qualified child care expenses principally as a 
cost of earning income, but believes that in view of the disparity of 
benefits between high-income and low-income taxpayei*s and the large 
revenue cost of a deduction (in determining adjusted gross income) 
that a tax credit is more appropriate. It also believes that an income 
ceiling on those entitled to the allowance has minimal revenue impact 
if the allowance is in the fonn of a credit. Therefore, it considered it 
appropriate and feasible to eliminate the income phaseout and to allow 
all taxpayers to claim such expenses regardless of their income level. 

Explanation of provision 

The Act replaces the itemized deduction for household and depend- 
ent care expenses with a nonrefundable income tax credit. Taxpayers 
with qualified expenses may claim a credit against tax for 20 percent 
of the expenses incurred (up to certain limits) for the care of a child 
under age 15 or for an incapacitated dependent or spouse, in order to 
enable the taxpayer to work. The prior income limit of $35,000 
beyond which the deduction was phased out is removed. 

Although the A.Q,t changes the nature of a claim for child care 
expenses to a credit, it retains the basic rules for determining quali- 
fied expenses with some modifications and extensions. 

Several changes simplify the child care tax form. One such change 
replaces the present monthly maximum allowance for expenses for 
children outside the home ($200 for one dependent, $300 for two de- 
pendents, and $400 for three or more dependents) with an annual 
credit of 20 percent of a maximum of $2,000 for one dependent and 
$4,000 for two or more dependents whether the expenses are for services 
inside or outside the home. (No credit, however, is allowed for the 



126 

expenses for the care of a dependent over age 14 or of a spouse outside 
the home.) With a 20-percent credit, the maximum credit would be 
$400 for one dependent and $800 for two or more. 

The Act also extends the credit to married couples where the hus- 
band or wnfe, or both, work part-time. (Previously, both were required 
to work full-time.) The eligible expenses are limited to the amount 
of earnings of the spouse earning the smaller amount or, in the case 
of a single person, to his or her earnings. The deduction also is made 
available to married couples where one is a full-time student and the 
other spouse works. For purposes of the earnings limitation only, the 
Act treats a student as if he or she earns $166 a month if there is one 
dependent and $333 a month if there are two or more dependents at 
any time during the year. 

The credit is available to married couples only if they file a joint 
return. The credit is extended to a divorced or separated parent who 
has custody of a child under age 15 even though the parent may 
not be entitled to a dependency exemption for the child, provided the 
parent claiming the credit has custody of the child for a longer period 
during the year than the other parent and maintains (i.e., provides 
over half the cost of maintaining) a household which includes the 
child. A deserted spouse is eligible for the credit when the deserting 
spouse is absent for the last 6 months of the taxable year instead of 
an entire year. Finally, the requirement that the allowable expenses be 
reduced by disability income received by the dependent is eliminated. 

The entire allowance of $2,000 or $4,000 a vear is available to a tax- 
payer who has one or two qualifying dependents, respectively, at any 
time during the course of the taxable year. However, only those ex- 
penses incurred on behalf of a qualifying individual during the period 
when the individual was a qualifying individual are eligible. For 
example, a taxpayer whose child reaches age 15 in April would be 
eligible for the entire $2,000 limit and no prorating would be required. 
However, only those expenses incurred prior to the child's fifteenth 
birthdav would be eligible. 

The Act repeals the disqualification of any amounts paid to rela- 
tives. The Act allows a credit for child care expenses paid to relatives 
who are not dependents of the taxpayer even if they are members of 
the taxpayer's household, provided the relative's services constitute 
emplovment within the meaning of section 3121(b), that is, for social 
security purposes.^ 

The Act also makes a conforming chance to allow the credit to be 
considered for purposes of additional withholdinR allowances. Under 
prior law (sec. 3402 (m) (2) ), additional withholding allowances were 
permitted to be claimed for itemized deductions. Changing the child 
care provision from a deduction to a tax credit would have made it 
impossible for an employee to avoid i\u\ overwithholdinff attributable 
to the child care expenses. To avoid this overwithholding, the Act 
gives the Secretary of the Treasury the authority to provide withhold- 



^Fcr social security purposes, the following services are considered employment: (a) 
services in tbe taxpayer's home if performed by the taxpayer's son or daughter age 21 or 
over, but not the taxpayer's spouse: (b) domestic service by the taxpayer's mother or 
father if (i) the taxpayer has in his home a son or daughter Tvho is under age 18 or who 
has a physical or mental condition requiring the personal care of an adult for at least 
four continuous weelcs In the quarter, and (il) the taxpayer is a widow or widower or is 
divorced, or the taxpayer has a spouse in his home who, because of a physical or mental 
condition, is incapable of caring for his son or daughter for at least four continuous weeks 
In the quarter ; (c) services of all other relatives. 



127 

ing allowance tables which take into account tax credits to which 
employees are entitled. It is intended that these tables may take into 
account the credit for child care expenses, the new tax credit for the 
elderly, and such other tax credits as the Secretary may find appro- 
priate. Because the credit for child care expenses is 20 percent of the 
eligible expenses, the tables may be designed to reflect the approximate 
tax value of the credit rather than the total expenses (as is the case with 
itemized deductions) to make the withholding change closely approxi- 
mate the reduction in tax liability. (Similarly, the full amount of the 
tax credit for the elderly might not be reflected in such tables, particu- 
larlj'^ where the income phaseout is operative.) 

It is estimated that the number of returns benefiting from the child 
care provision will approximately double from about 2 million to 
nearly 4 million. Of the 4 million, approximately ^5 million will benefit 
compared to prior law and about 1 million will lose relatively small 
amounts because of the change from an itemized deduction to a 20- 
percent credit. 

Effective date 
This provision is to apply to taxable years beginning after Decem- 
ber 31, 1975. 

Revenue effect 
This provision will reduce tax receipts by $384 million in fiscal 
year 1977, $368 million in fiscal year 1978, and $488 million in fiscal 
year 1981. 

5. Sick Pay and Certain Military, etc. Disability Pensions (sec. 505 
of the Act and sees. 104 and 105 of the Code) 

a. Sick Pay 

Prior I^w 

Under prior law, gross income did not include amounts received 
under wage continuation plans when an employee was ''absent from 
work" on account of personal injuries or sickness. The payments that 
were received when an employee was absent from work were generally 
referred to as "sick pay" (under sec. 105 (d) ) . 

The proportion of salary covered by the wage continuation pay- 
ments and any hospitalization of the taxpayer determined whether or 
not there was a waiting period before the exclusion applied. If the sick 
pay was more than 75 percent of the regular weekly rate, the waiting 
period before the exclusion became available was 30 days whether or 
not the taxpayer was hospitalized during the period. If the rate of sick 
pay was 75 percent or loss of the regidar weekly rate and the taxpayer 
was not hospitalized during the period, the waiting period was 7 days. 
If the sick pay was 75 percent or less of the regular weekly rate and 
the taxpayer was hospitalized for at least 1 day during the period, there 
was no waiting period and the sick pay exclusion applied immediately. 
In no case could the amount of "sick pay" exclusion exceed $75 a week 
for the first 30 days and $100 a week after the first 30 days. 

During the period that a retired employee was entitled to the sick 
pay exclusion, lie could not recover any of his contributions toward any 
annuity under section 72.^ 

iReg. sec. 1.72-15 (b) and (c)(2) and 1.72-4(b) (2) (iv). 



128 

jReasons for change 

Section 105 (d) , which provided the exclusion for "sick pay," was ex- 
tremely complex. The provision's complexity required a separate 28- 
line tax form which was so difficult that many taxpayers had to 
obtain professional assistance in order to complete it and avail them- 
selves of the exclusion. The Congress believed that elimination of 
the complexity in this area was imperative. 

In addition, the sick pay provision caused some inequities in the 
tax treatment of sick employees compared to working ones and the 
treatment of lower-income taxpayers compared to those with higher in- 
comes. Excluding "sick pay" payments (received in lieu of wages) 
from income when an employee was absent from work, while taxing the 
same payments if made as wages while he was at work, was not justi- 
fied. A working employee generally incurs some costs of earning in- 
come not incurred by a sick employee who stays at home. The latter 
may incur additional medical expenses on account of his sickness, but 
he may deduct such medical expenses if they exceed the percentage of 
income limitations. 

Under prior law, low- and middle-income taxpayers received on a 
percentage basis less benefit from the sick pay exclusion than did tax- 
payers in higher marginal tax brackets because of the progressivity of 
tax rates. Taxpayers who received no sick pay, of course, received no 
benefit at all. The Congress believed that the exclusion allowed under 
section 105 should not have a regressive effect and that the provision 
should direct a fairer share of its tax benefits to low- and middle- 
income taxpayers. 

Explanation of provision 

The Act repeals the prior sick pay exclusion and continues the 
maximum exclusion of $100 a week ($5,200 a year) only for taxpayers 
under age 65 vi/ho have retired on disability and are permanently and 
totally disabled. For this purpose permanently and totally disabled 
means unable to engage in any substantial gainful activity by reason of 
any medically determinable physical or mental impairment which can 
be expected to result in death or which has lasted or can be expected to 
last for a continuous period of not less than 12 months. A taxpayer is 
considered to be "retired" even if not fonnaJly placed on retirement 
but receiving some other form of income in lieu of wages, such as ac- 
cumulated leave, provided he is not expected to return to work. The 
Congress expects that proof of disability must be substantiated by the 
taxpayer's employer, who is to certify this status under procedures ap- 
proved in advance by the Tntornal Revenue Service. The Service may 
also issue regulations requiring the taxpayer to provide proof from 
time to time that he is disabled. If, at the time an individual retires 
on disability, a qualified physician is not certain that the retiree's 
disability will in fact be permanent, the Service may accept subsequent 
evidence that his disability was permanent and qualified him as of 
the time of his retirement for ^his provision. (At age 65, taxpayers 
become ineligible for this exclusion but are entitled to claim the 
revised elderly credit.) 

The maximum amount excludable is to be reduced on a dollar-for- 
dollar basis by the taxpayer's adjusted gross income (including dis- 
ability income) in excess of $15,000. Thus, if a taxpayer receives 



129 

$5,200 in disability income and $15,000 (or more) in other income 
which together equal $20,200 (or more), he would not be entitled to 
any exclusion of his disability payments. 

In order to claim this exclusion, a taxpayer who is married at the 
close of a taxable year must file a joint return with his or her spouse, 
unless they have lived apart at all times during that year. Each spouse 
is entitled to a separate, maximum $5,200 exclusion, but the phaseout 
for adjusted gross income in excess of $15,000 applies on a per-retum 
basis. 

The Act also provides a transitional rule allowing persons who, 
before January 1, 1976, retired on disability or who were entitled to 
retire on disability, and on January 1, 1976, were permanently and 
totally disabled (though they may not have been permanently and 
totally disabled on their retirement date) to claim a disability income 
exclusion if they otherwise qualify. Another transitional rule allows 
taxpayers who retired on disability before January 1, 1976, and who 
were entitled to a sick pay exclusion on December 31, 1975, also to 
benefit from the section 72 amiuity exclusion before age 65, if they 
make an irrevocable election not to claim the disability exclusion. 

The Act provides that when a taxpayer reaches age 65, he can begin 
to recover his investment in an annuity contract (if any) under section 
72. A special rule enables certain permanently and totally disabled tax- 
payers who determine that they will not be able to claim any (or little) 
sick pay exclusion to benefit from the section 72 exclusion before age 
65. Under this rule, the taxpayer may make an irrevocable election not 
to seek the benefits of the disability income exclusion for that year or 
subsequent years. ^ 

The new rules apply both to civilians and to military personnel. 
However, Veterans' Administration payments remain completely ex- 
empt from tax. 

Effective date 
This provision applies to taxable years beginning after December 31, 
1975. 

6. Disability Pensions of the Military, etc. 

Prior law 
Prior law excluded from gross income amounts received as a pen- 
sion, annuity, or similar allowance for pei-sonal injuries or sickness 
resulting from active service in the armed forces of any country, as 
well as similar amounts received by disabled members of the National 
Oceanic and Atmospheric Administration (NOAA, formerly called 
the Coast and Geodetic Survey), the Public Health Service, or the 
Foreign Service (sec. 104(a) (4)).^ 

2 At age 65 the taxpayer then becomes eligible for the elderly credit rather than having 
to wait until mandatory retirement age as was the case under prior law. Public retirees who 
retired on disability and malte this election must wait until minimum retirement age to use 
the retirement Income credit (rather than the mandatory age of prior law). Otherwise, 
public retirees who retired on disability would be eligible for the retirement income credit 
at a substantially earlier time than under prior law. Congress did not intend this sub- 
stantial liberalization of the retirement income credit for public retirees. 

"Under Treasury regulations (Reg. sec. 1.105— 4(a) (3) (i) (a) ), the portion of a dis- 
ability pension received by a retired member of the Armed Forces which was In excess 
of the amount excludable under this provision was excluded as sick pay under a wage 
continuation plan subject to the limits of section 105(d) if such pay was received before the 
member reached retirement age. This Act repeals the .sick ipay provision and substitutes 
a maximum annual exclusion of $5,200 for persons who are permanently and totally 
disabled. (See Explanation of provisions under a. Sick Pay above.) 



130 

Reasons for change 

The Congress was concerned with two somewhat conflicting aspects 
of the exclusion of disability payments from gross income : on the one 
hand, the abuse of the exclusion in certain instances, particularly by 
retiring members of the armed forces, and on the other hand, the ex- 
pectation and reliance cf present members of the affected government 
services, especially the armed forces, on the government benefits avail- 
able to them when they entered government employment or enlisted in 
or were draft/cd into the milit/ary. 

Criticism of the exclusion of armed forces disability pensions from 
income focused on a number of cases involving the disability retire- 
ment of military personnel. In many cases, armed forces personnel 
have been classified as disabled for military service shortly before they 
would have become eligible for retirement principally to obtain the 
benefits of the special tax exclusion on the disability portion of their 
retirement pay. In most of these cases the individuals, having retired 
from the military, earn income from other employment while receiving 
tax-free "disability" payments from the military. The Congress ques- 
tioned the equity of allowing retired military personnel to exclude the 
payments which they receive as tax-exempt disability income when 
they are aible to earn substantial amounts of income from civilian work, 
despite disabilities such as high blood pressure, arthritis, etc. 

However, in order to pro/ide benefits to any present personnel who 
may have joined or continued in the government or armed services in 
reliance on possible tax benefits from this program, the Congress be- 
lieved any changes in the tax treatment of military disability payments 
should affect only future members of the armed forces, NOAA, Public 
Health Service and Foreign Service. The Congress also believed that 
the risks borne by some civilian employees of the United States Gov- 
ernment are similar to those faced in combat by the military. It thus 
decided to extend tax exclusion benefits to civilian government em- 
ployees who receive disability pay for injuries resulting from acts of 
terrorism. 

Explanation of provisions 

The Act eliminates the exclusion of disability payments from income 
for those covered under section 104(a)(4), that is, members of the 
armed forces of any country, NOAA, the Public Health Service and 
the Foreign Service. This change applies only prospectively to per- 
sons who join these government services after September 24, 1975. 
Specific exceptions continue the exclusion in certain cases for future 
disability payments for injuries and sickness resulting from active 
service in the armed forces of the United States. 

At all times, Veterans' Administration disability payments will con- 
tinue to be excluded from gross income. In addition, even if a future 
serviceman who retires does not receive his disability benefits from the 
Veterans' Administration, he will be allowed to exclude from his gross 
income an amount equal to the benefits he could receive from the Vet- 
erans' Administration. Otherwise, future members of the armed forces 
will be allowed to exclude military disability retirement payments 
from their gross income only if the payments^ are directly related to 
"combat injuries." A combat-related injury is defined as an injury or 



131 

sickness which is incurred as a result of any one of the following activi- 
ties: (1) as a direct result of armed conflict; (2) while engaged in 
extra-hazardous service, even if not directly engaged in combat; (3) 
under conditions simulating war including maneuvers or training ; or 
which is (4^ caused by an instrumentality of war, such as weapons. 
This definition of com bat -related injuries is meant to cover an injury 
or sickness attributable to the special dangers associated with armed 
conflict or preparation or training for armed conflict. 

In addition, the Act provides an exclusion for disability payments 
to civilian employees of the United States Government for injuries 
which result from acts of terrorism and which are incurred while the 
employees are performing official duties outside the United States. 

All persons who were members of the armed forces of any country 
(or a military reserve unit), the National Oceanic and Atmospheric 
Administration, the Public Health Service and the Foreign Service 
as of September 24, 1975, or Avho as of that date were subject to a 
written binding commitment to enter these Government services or 
were retirees from these sei-vices receiving disability retirement pay- 
ments which were excluded from their gross income under prior law, 
will continue to exclude such payments from gross income under the 
Act. In addition, all disability benefits paid by the Veterans' Ad- 
ministration will continue to be exempt from tax, as under prior law. 

Effective date 
This provision relating to members of the armed forces of any 
country, the National Oceanic and Atmospheric Administration, the 
Public Health Service and the Foreign Service applies to persons 
who joined these services after September 24, 1975. The exclusion for 
disability payments for injuries resulting from acts of terrorism ap- 
plies to taxable years beginning after December 31, 1976. 

Reveiiue effect 
The change in the sick pay provision will increase tax receipts by 
$380 million in fiscal year 1977, $357 million in fiscal year 1978, and 
$450 million in 1981. The changes in the disability exclusion will have 
no revenue impact until substantial numbers of persons entering gov- 
ernment service after September 24, 1975, retire. The new exclusion 
for disability payments for injur-ies resulting from acts of terrorism 
will cause a negligible revenue loss. 

6, Moving Expenses (sec. 506 of the Act and sees. 217 and 82 of the 
Code) 

Prior law 

An employee or self-employed individual may claim a deduction 
from gross income for certain expenses of moving to a new residence 
in coimection with beginning work at a new location (sec. 217). Any 
amount received directly or indirectly as a reimbursement of moving 
expenses must be included in a taxpayer's gross income as compensa- 
tion for services (sec. 82), but he may offset this income by deducting 
expenses which would otherwise qualify as deductible items. 

Deductible moving expenses are the expenses of transporting the 
taxpayer and members of his household, as well as his household goods 
and personal effects, from the old to the new residence; the cost of 



132 

meals and lodging enroute; the expenses for premove househunting 
trips; temporary living expenses for up to 30 days at the new job 
location; and eei'tain expenses related to the sale or settlement of a 
lease on the old residence and the purchase of a new one at the new job 
location. 

Tlie moving expense deduction was subject to a number of limitations 
under prior law. A maximum of $1,000 could be deducted for premove 
househunting and temporary living expenses at the new job location. A 
maximum of $2,500 (reduced by any deduction claimed for househunt- 
ing or temporary living expenses) could be deducted for certain quali- 
fied expenses for the sale and purchase of a residence or settlement of a 
lease. If both a husband and w ife began new jobs in the same general 
location, the move was treated as a single commencement of work. If a 
husband and wife filed separate returns, the maximum deductible 
amounts were halved. 

Also, under prior law in order for a taxpayer to claim a moving 
expense deduction, his new principal place of w^ork had to be at least 
50 miles farther from his former residence than was his former prin- 
cipal place of work (or his former residence, if he had no former place 
of work). During the 12-month period following his move, the tax- 
payer had to be a full-time employee in the new general location for 
at least three- fourths of the following year, that is, 39 weeks during 
the next 12-month period. A self-employed pei-son was required, dur- 
ing the 24-month period follow ing his arrival at his new work location, 
to perform services on a full-time basis for at least 78 weeks, with at 
least 39 weeks of full-time work falling within the first 12 months. 
Even if the 39- or 78-week requirement had not been fulfilled at the end 
of a taxable year (but could still be fulfilled), the taxpayer could elect 
to deduct any qualified moving expenses which he had paid or incurred 
provided he met all the other requirements. If he failed to meet the 
full-time employment period requirement in a subsequent taxable 
year, he had to include the amounts previously deducted in his gross 
income for the subsequent year.^ 

Pursuant to statutory autorization,^ the Secretary of the Treasury 
had entered into agreements with the Secretary of Defense for mem- 
bei-s of the Army, Navy, and Air Force, and with the Secretary of 
Transportaion for members of the Coast Guard to allow special treat- 
ment tor servicemen's moving expenses for taxable years ending before 
January 1, 1976. 

As a result, the Secretaries of Defense and Transportation were not 
required to report or withhold tax on moving expense reimbursements 
made to members of the armed forces, nor were membei-s of the armed 
forces required to include in income the value of in-kind moving serv- 
ices provided by the military. However, members of the armed forces 
could deduct moving expenses to the extent they exceeded military re- 
imbursements, and would otherwise qualify as deductible expenditures 
under section 217, without counting any military in-kind reimburse- 
ments against the dollar limitations. This special legislative morato- 
rium on the application of the moving expense provision to mem- 
bers of the military lapsed as of January 1, 1976. 

1 The 39- and 78-week tests were waived if the employee was unable to satisfy them as 
a result of death, disability, or Involuntary separation (other than for willful miscon- 
duct), 

3 Public Law 93-490, sec. 2, 88 Stat. 1466. 93d Cong., 2d sess., October 26, 1974. 



133 

Reasons for change 

The prior provisions for moving expenses reflected significant revi- 
sions made by the Tax Reform Act of 1969. Generally, the Congress 
believes that the basic rationale and requirements of these provisions 
remain sound. 

The mobility of labor continues to be important to the economy of 
the United States. Frequently, employers must transfer employees 
from one location to another and workers must change their residence 
in order to obtain better employment opportunities. The substantial 
moving expenses incurred by many taxpayers in connection with em- 
ployment-related moves may be viewed as a cost of earning income. 
Allowing a tax deduction for certain moving expenses helps achieve 
a more accurate account of a taxpayer's net income. 

Despite inflation between 1969 and 1975, there had been no adjust- 
ment of the $1,000 and $2,500 ceilings on moving expense deductions. 
The Congress believed that these ceilings should be set at higher 
dollar levels. However, the Congress did not believe that the two 
ceilings had to be increased proportionately. 

The 50-mile test restricted the deduction of expenses to a move to a 
new job location which was at least 50 miles farther from the tax- 
payer's former residence than was his former principal place of work. 
For example, if a taxpayer's former residence was 30 miles from his 
former job, his new job location had to be at least 50 miles farther 
from his former residence; that is, it had to be a total of at least 80 
miles, if his moving expenses were to be deductible. Recognizing the 
increasing cost of commuting, the growing concern for gasoline con- 
servation, and the continuing inadequacy of mass transportation in 
most areas of the country, the Congress decided that some reduction 
of the 50-mile test was appropriate. 

Certain changes made in the 1969 Act created unforeseen adminis- 
trative difficulties for the military. The Department of Defense and 
the Department of Transportation (with respect to the peacetime 
Coast Guard) apparently have no economically feasible procedure 
for identifying or valuing the in-kind reimbui-sements provided for 
each serviceman where the military pays a mover for the moving ex- 
penses, or does the moving itself. The Department of Defense, acting 
on behalf of all the military services, indicated in discussions with 
the Internal Revenue Service that establishing such a system for 
identifying reimbursed moving expenses and in-bound services would 
involve substantial administrative burdens for the Department, as well 
as increasing its expenses, at no revenue gain to the Treasury. As a 
result of these administrative problems, the Internal Revenue Service 
in 1971 agreed to a moratorium for the reporting and reimbursement 
rules (except for cash reimbursements) in the case of the military. The 
Service extended this administrative moratorium through 1972 and 
1973. As indicated above, in 1974 the armed forces were exempted from 
these requirements by legislation effective through December 31, 1975. 

The Congress agreed that requiring the military to report and with- 
hold tax on reimbursed in-kind moving expenses and requiring service- 
men to include reimbursements or allowances for moving expenses in 
income would entail needless, costly administration by the military 
services. 



234-120 O - 77 - 10 



134 

In addition, the military had found the mileage limitation (the 50- 
mile limit) and the 39- week rule a hardship for military personnel 
because many mandatory personnel moves are for less than 39 weeks 
and for less than 50 miles. The Congress believed that servicemen 
who are required to change their residence incident to a permanent 
change of station should not be required to include in income the 
in-kind moving assistance, allowances, or reimbursements provided 
by the military and should not be denied a deduction for otherwise 
deductible expenses involved in a mandatory move only because they 
fail the time and mileage tests. Therefore, the Congress exempted 
members of the armed forces from the time and mileage limitations for 
moves incident to a permanent change of station when the military 
authorizes in-kind moving assistance. The Congress also believed it 
appropriate to exclude from income the in-kind moving services and 
assistance provided to move servicemen's spouses and dependents in 
connection with moves required by the military. 

Explanation of provision 

The Act modifies the prior treatment of job-related moving ex- 
penses in a number of respects. It increases the maximum deduction 
for premove househunting and temporary living expenses at the new 
job location from $1000 to $1500 and increases from $2500 to $3000 the 
maximum deduction for qualified expenses for the sale, purchase or 
lease of a residence (reduced by any deduction claimed for premove 
househunting or temporary living expenses). As with the existing 
limitations, the new amounts are halved if a husband and wife file 
separate returns. The Act also reduces the 50-mile rule to 35 miles. 

With regard to military moves, the Act also exempts military moves 
from the time and mileage requirements and excludes from income 
cash reimbursements or allowances to the extent of expenses actually 
paid or incurred, as well as all in-kind services provided by the mili- 
tary. The Armed Services are exempted from the reporting require- 
ments under section 82 with regard to in-kind moving services (includ- 
ing storage), reimbursements and allowances provided to members 
on active duty for moves pursuant to military orders and incident 
to a permanent change of station. In addition, the Act provides that 
when a military member is required to relocpte and the member's 
spouse and dependents move to a different location, all in-kind moving 
and storage expenses, and reimbursements and allowances (to the ex- 
tent of moving expenses actually paid or incurred) provided by the 
military to move the member and the spouse and dependents to 
and from their separate locations are excluded from income. In cases 
where the military moves the member and the member's spouse and 
dependents to or from separate locations and they incur unreimbursed 
expenses, their moves are treated as a single move to a new principal 
place of work for purposes of section 217. 

Ejfective date 
This provision is to apply generally to taxable years beginning after 
December 31, 1976, except that the military provisions are to apply 
for years beginning after 1975. 



135 

Revenue effect 
This provision will reduce budget receipts by $7 million in fiscal 
year 1977, $47 million in fiscal year 1978, and $62 million in fiscal year 
1981. 

7. Tax Simplification Study by Joint Committee (sec. 507 of the 
Act) 

Prior law 
Prior law contained no provision requiring a specific report on tax 
simplification by the Joint Committee. However, the law (sec. 8022 
of the Code) provides that the Joint Committee on Taxation is to 
investigate the operation and effects of the Federal system of internal 
revenue taxes, including studies for the simplification of the income 
tax. The Joint Committee is to publish its proposals and report the 
results and any recommendations to the Senate Finance and House 
Ways and Means Committees. 

Reasons for change 
The Congress believes that simplification of the Code is urgent and 
that the Joint Committee should make a specific study involving ways 
of simplifying and indexing the tax laws. 

Explanation of provision 
The Act requires the Joint Committee to conduct a study on "sim- 
plifying and indexing the tax laws" (including whether tax rates can 
be reduced by repealing any or all tax deductions, exemptions or 
credits). A report of its study and investigation together with its rec- 
ommendations, including recommendations for legislation, is to be 
submitted to the Senate Finance and House Ways and Means Com- 
mittee by June 30, 1977. 

Revenue effect 
T his provision will not have any revenue effect. 



E. BUSINESS-RELATED INDIVIDUAL INCOME TAX REVI- 
SIONS 

1. Deductions for Expenses Attributable to Business Use of 
Home (sec. 601 of the Act and new sec. 280A of the Code) 

Prior law 

Under the code, no deductions are allowed for personal, living, and 
family expenses except as expressly allowed under the code (sec. 262). 
Generally, under this provision, expenses and losses attributable to a 
dwelling which is occupied by a taxpayer as his personal residence are 
not deductible. However, deductions for interest, certain taxes, and 
casualty losses attributable to a personal residence are expressly 
allowed under other provisions of the tax laws (sees. 163, 164 and 165). 
Under prior law, if a portion of the residence was used in the tax- 
payer's trade or business or for the production of income, a deduction 
would be allowed for an allocable portion of the expenses incurred in 
maintaining such personal residence. 

In any case involving the business use of a personal residence, it 
must first be established that the expenses were incurred in carrying on 
a trade or business (sec. 162) or for the production of income (sec. 
212). Thus, there must be some relatively clear connection between the 
activities conducted in the home and a trade or business or the pro- 
duction of income. Under the regulations (Reg. § 1.262-1 (b) (3) ) , the 
expenses of maintaining a household are treated as nondeductible per- 
sonal expenses if the taxpayer only incidentally conducts business in 
his home. However, under prior law, if a part of the housa is used as 
the taxpayer's place of business, the allocable portion of the expenses 
attributable to the use of the home as a place of business was allowed 
as a deduction. 

For this purpose the expenses attributable to the office or business 
use of the home were deductible if they were "ordinary and necessary" 
expenses paid or incurred in carrying on a trade or business or for the 
production of income. These expenses were claimed as deductions by 
self-employed individuals who used portions of their residences for 
trade or business purposes, employees who maintained offices in con- 
nection with the performance of their duties as employees, or investors 
who maintained offices in connection with investment activities. Typi- 
cally, the expenses for which a deduction was claimed included an allo- 
cable portion of the depreciation or rent, maintenance, utility, and in- 
surance expenses incurred in connection with the residence. 

With respect to the maintenance of an office in an employee's home, 
the position of the Internal Revenue Service iwas that the office must be 
required by the employer as a condition of employment and regularly 
used for the performance of the employee's duties. (Revenue Ruling 
62-180, 1962-2 C.B. 52, set forth these standards as they applied to the 
deductibility of expenses attributable to an office maintained in an em- 

(136) 



137 

ployee's home.) Certain courts had decided that a more liberal stand- 
ard than that urged by the Internal Revenue Service was appropriate. 
Under these decisions, the expenses attributable to an office maintained 
in an employee's residence were deductible if the maintenance of the 
office was "appropriate and helpful" to the employee's business: 
George H. Neioi, T.C. Memo. 1969-131, aff'd 432 F. 2d 998 (2d Cir. 
1970) ; Jay R. Gill, T.C. Memo. 1975-3; Hall v. U7iited States, 387 F. 
Supp. 612 (D.C. N.H., 1975). 

In Stephen A. Bodzin, 60 T.C. 820 (1973) , the Tax Court, in a deci- 
sion allowing a deduction for an office in an employee's residence, 
held that "the applicable test for judging the deductibility of home 
office expenses is whether, like any other business expense, the main- 
tenance of an office in the home is appropriate and helpful under all 
the circumstances." However, the court cautioned that no deduction 
would be allowable if personal convenience were the primary reason 
for maintaining the office notwithstanding any conclusion as to the 
"appropriateness" and "helpfulness" of the office. On appeal, the 
Fourth Circuit reversed the decision of the Tax Court (509 F.2d 679). 
The Appellate Court held that, as a factual matter, the expenses attrib- 
utable to the taxpayer's residence were nondeductible personal ex- 
penses and that it was therefore unnecessary to decide if the mainte- 
nance of the office was appropriate and helpful in carrying on his 
business. Thus, it was not clear which standard would be applied 
in the Fourth Circuit in a case in which the court found both personal 
and business use of a residence. However, the court suggested that 
to obtain a deduction, an employee would have to show that the office 
provided by the employer is not available at the times the employee 
uses the office in his residence or that the employer's office is not suit- 
able for the purposes for which the taxpayer is using the office in his 
residence.^ 

The Tax Court had also applied the "appropriate and helpful" st-^nd- 
ard to determine the deductibility of expenses attributable to the main- 
tenance of an office in the home of an investor. {Lena M. Anderson, 
TC Memo 1974-49.) In that case, the taxpayer was allowed a portion 
of the expenses attributable to a family room which was partially used 
to conduct investment activities which consisted of keeping records 
with respect to rental properties, preparing the taxpayer's income 
tax returns, and writing lettei-s to brokers and taxing authorities. 

With respect to an apartment or residence used by a taxpayer while 
in a travel status, the expenses attributable to the maintenance of the 
apartment or residence are treated as lodging expenses subject to 
certain other rules relating to deductibility (sec. 162). As such, the 
expenses are deductible only if they are reasonable and necessary in 
the conduct of the taxpayer's business and directly attributable to it. 
"Lavish or extravagant" expenses are not allowable deductions. The 
expenses attributable to the apartment or house are deductible as 
lodging expenses if properly allocable to the taxpayer's trade or busi- 
ness even though the transportation expenses are not deductible be- 
cause the trip was undertaken primarily for personal purposes. 

Additional requirements also apply with respect to a residence where 
the business use consists of entertainment of clients, customers, or 



1 The Supreme Court denied certiorari in the Bodzin case on October 6, 1975 (44 
U.S.L.W. 3201). 



138 

business associates. In such cases, the residence is treated as an enter- 
tainment facility, and no deduction is allowed for any expenditure 
unless the taxpayer establishes that the facility was used primarily 
for the furtherance of the taxpayer's trade or business and that the 
items of expense were directly related to the active conduct of such 
trade or business (sec. 274). 

In determining whether or not an entertainment facility was used 
prim.arily for the furtherance of the taxpayer's trade or busine^ss, the 
taxpayer must establish that the primary use of the facility was for 
ordinary and necessary business use based upon the facts and circum- 
stances considered on a case-by-case basis. Generally, the actual use of 
the facility is controlling, and not its availability for use. The factors 
to be considered include the nature of each use, the frequency and 
duration of business use and the amount of expenditures incurred for 
business purposes. 

The regulations provide that with respect to an entertainment facil- 
ity, a taxpayer shall be deemed to have established that an entertain- 
ment facility was used primarily for the fuitherance of his trade or 
business if more than 50 percent of the total calendar days of use of 
the facility during any taxable year were business use days. 

An expenditure is considered directly related to the active conduct 
of the taxpayer's trade or business if four requirements are met: (1) 
the taxpayer had more than a general expectation of deriving income 
or benefit (other than goodwill) at some indefinite future time; (2) the 
taxpayer actually engaged in, or reasonably expected to engage in, 
business meetings, negotiations, etc., for the purpose of obtaining in- 
come or other benefits; (3) in light of all the facts and circumstances, 
(111' ])rincipal function of the combined business meeting, etc., and en- 
tertainment was the active conduct of the taxpayer's trade or business, 
and (4) the expenditure was allocable to the taxpayer and person or 
persons with whom the taxpayer engaged in the active conduct of 
trade or business during the entertainment. 

In determining the deductible amount attributable to the business 
use of the home, the general rule is that any reasonable method of allo- 
cation may be used. In all cases involving the dual use of a home, the 
allocation of expenses attributable to the portion of the residence used 
for business purposes will take into account the space used for those 
purposes, e.g., a percentage of the expenses based on the square feet of 
that portion compared to the total square feet of the residence. In addi- 
tion, a further allocation based on time of use is required when the 
portion of the residence is not exclusively used for business purposes. 
In Rev. Rul. 62-180, 1962-2 C.B. 52, 54, the Internal Revenue Service 
held that, after allocating expenses attributable to a den used for busi- 
ness and personal purposes on the basis of space, a further allocation 
must be made on the basis of time of use to reflect the dual use. For 
purposes of the latter allocation, the Service ruled that the allocation 
should be made on the basis of availability for use rather than actual 
use, i.e., the ratio of time actually used for business purposes to the 
total time it is available for all uses. Plowever, in Goerge W. Gino^ 
60 T.C. 304, 314 (1973) (followed in Lena M. Anderson, T.C. Memo, 
1974r-i9), the Tax Court held that such expenses should be allocated 
on the basis of actual business use as compared with actual total use. 



139 

In another case where the allocation could not clearly be determined, 
the Cohan rule was applied to estimate the approximate space of an 
apartment which was used for business purposes. George H. Newi^ 
T.C. Memo. 1969-131, aff'd., 432 F.2d 998 (2d Cir. 1970). The Cohan 
rule provides, generally, that where there is evidence that the tax- 
payer incurred certain deductible expenses but the exact amount can- 
not be determined, a close approximation would be acceptable and, 
therefore, the deduction would not be entirely disallowed. Under pres- 
ent law, however, because of certain substantiation requirements, no 
deduction is allowed for certain expenditures relating generally to 
travel or entertainment on the basis of a Cohan approximation or on 
the basis of unsupported testimony of the taxpayer. 

Reasons for change 

The Congress believed that there was a great need for definitive 
rules to resolve the conflict that existed between several court decisions 
and the position of the Internal Revenue Service as to the correct 
standard governing the deductibility of expenses attributable to the 
maintenance of an office in the taxpayer's personal residence. 

With respect to the "appropriate and helpful" standard employed 
in the court decisions, the determination of the allowance of a deduc- 
tion for these expenses was necessarily a subjective determination. In 
the absence of definitive controlling standards, the "appropriate and 
helpful" test increased the inherent administrative problems because 
both business and personal uses of the residence were involved and sub- 
stantiation of the time that the space was used for each of these activi- 
ties was clearly a subjective determination. In many cases the applica- 
tion of the appropriate and helpful test appeared to result in treating 
personal living; and family expenses which are directly attributable 
to the home (and therefore not deductible) as ordinary and necessary 
business expenses, even though those expenses did not result in addi- 
tional or incremental costs incurred as a result of the business use of 
the home. Thus, expenses otherwise considered nondeductible personal, 
living, and family expenses might be converted into deductible busi- 
ness expenses simply because, under the facts of the particular case, 
it was appropriate and helpful to perform some portion of the tax- 
payer's business in his personal residence. For example, if a university 
professor, who was provided an office by his employer, used a den or 
some other room in his residence for the purpose of grading papers, 
preparing examinations or preparing classroom notes, an allocable 
portion of certain expenses might have been claimed as a deduction 
even though only minor incremental expenses were incurred in order 
to perform these activities. 

Explanation of 'provision 

The Act adds a new section to the Code (sec. 280A) which provides, 
in part, that no deductions shall be allowed with respect to a dwelling 
unit which is used by the taxpayer as a residence, unless specifically 
excepted from this new section and otherwise allowable. The provi- 
sions of this section apply to individuals, trusts, estates, partnerships, 
and electing small business corporations. This provision does not apply 
to a corporation (other than an electing small business corporation). 

The general disallowance provision, however, does not apply with 



140 

respect to certain expenses which are otherwise allowable as deduc- 
tions; for example, the deductions allowable for interest (sec. 163), 
certain taxes (sec. 164) and casualty losses (sec. 165) may still be 
claimed as deductions without regard to their connection with the 
taxpayer's trade or business or income producing activities. 

In the case of a taxpayer (other than an employee) who exclusively 
uses a portion of a dwelling unit on a regular basis as his principal 
place of business, as a place of business which is used by patients, 
clients, or customers in meeting or dealing with the taxpayer in the 
normal course of his trade or business, or in the case of a separate 
structure which is not attached to the dwelling, in connection with the 
taxpayer's trade or business, an allocable portion of ordinary and 
necessary trade or business expenses paid or incurred in connection 
with such trade or business use will be allowed as a deduction. How- 
ever, the amount of the deduction is subject to a limitation discussed 
below. 

Exclusive use of a portion of a taxpayer's dwelling unit means that 
the taxpayer must use a specific part of a dwelling unit solely for the 
purpose of carrying on liis trade or business. The use of a portion of a 
dwelling unit for both personal purposes and for the carrying on of a 
trade or business does not meet the exclusive use test. Thus, for 
example, a taxpayer who uses a den in his dwelling unit to write legal 
briefs, prepare tax returns, or engage in similar activities, as well for 
personal purposes, will be denied a deduction for the expenses paid or 
incurred in connection with the use of the residence which are allocable 
to these activities. 

Under the Act, an exception to the exclusive use test is provided in 
the case of a taxpayer whose trade or business is selling products at 
retail or wholesale and whose dwelling unit is the sole fixed location 
of such trade or business. Under this exception, the ordinary and 
necessary expenses allocable to space (within a dwelling unit) which 
is used as a storage unit for inventory will not be disallowed. How- 
ever, the space must be used on a regular basis and must be a separately 
identifiable space suitable for storage. 

In addition to the exclusive use test, the Act requires that the por- 
tion of the residence used for trade or business purposes must be used 
by the taxpayer on a regular basis in order for the allocable portion 
of the expenses to be deductible. Expenses attributable to incidental 
or occasional trade or business use of an exclusive portion of a dwelling 
unit would not be deductible. 

The provision does not permit a deduction for any portion of ex- 
penses paid or incurred with respect to the use of a dwelling unit 
which is used by the taxpayer both as a residence and in connection 
with income producing activities (sec. 212). For example, no deduction 
will be allowed if a taxpayer who is not in the trade or business of 
making investments uses a portion of his residence (exclusively and 
on a regular basis) to read financial periodicals and reports, clip bond 
coupons and perform similar activities because the activity is not a 
trade or business. 

In the case of an employee, a deduction for the portion of the 
ordinary and necessary business expenses attributable to the use of a 
residence which are paid or incurred in connection with the per- 



141 

formance of services as an employee will be allowable only if, in addi- 
tion to satisfying the exclusive and regular use tests, the use is 
for the convenience of his employer. If the use is merely appropriate 
and helpful, no deduction attributable to such use will be allowable. 
The Act also provides an overall limitation on the amount of deduc- 
tions that a taxpayer may take for the business use of the home. The 
allowable deductions attributable to the use of a residence for trade 
or business purposes may not exceed the amount of the gross income 
derived from the use of the residence for that trade or business reduced 
by the deductions which are allowed without regard to their connection 
with the taxpayer's trade or business (e.g., interest and taxes). In the 
case where gross income is derived both from the use of the residence 
and from the use of facilities other than the residence, a reasonable 
allocation (based on the facts and circumstances of each case) is to 
be made to determine that portion of the gross income derived from 
the use of the residence. With respect to the deductions which are 
allocable to the trade or business use of the residence, deductions 
allowable without regard to whether the activity is a trade or business 
are to be deducted first. Any remaining gross income may then be 
reduced (but not below zero) by the remaining allowable deductions 
which are allocable to such use. 

Effective date 
This provision applies to taxable years beginning after Decem- 
ber 31, 1975. 

Revenue effect 
The revenue effect of this provision is combined with that of the 
following vacation home provisions. 

2. Deduction for Expenses Attributable to Rental of Vacation 
Homes (sec. 601 of the Act and sec. 280A of the Code) 

Prior law 

A taxpayer is allowed a deduction for the ordinary and necessary 
expenses paid or incurred during the taxable year in carrying on a 
trade or business (sec. 162), or for the management, conservation, or 
maintenance of property held for the production of income (sec. 212). 
In order to be entitled to a deduction under these provisions, it is 
necessary that the activity be engaged in by the taxpayer for profit 
(i.e., for the purpose of or with the intention of making a profit.)^ 
The determination of whether an activity is engaged in for profit is to 
be made on the basis of objective standards, taking into account all 
facts and circumstances of each case. Although a reasonable expecta- 
tion of profit is not required, the facts and circumstances (without 
regard to the taxpayer's subjective intent) must indicate that the tax- 
payer entered into or continued the activity with the objective of mak- 
ing a profit. No deduction is allowed under section 162 or 212 if the 
activity is carried on primarily as a sport, hobby, or for recreation. 

Even though an activity is not engaged in for profit (and therefore 
no deduction is allowed under section 162 or 212), certain deductions 



iSee Morton v. Commissioner, 174 F. 2d 302. 304 (2d Clr.), cert, denied, 338 U.S. 828 
(1949) ; Schley v. Commissioner, 375 F. 2d 747 (2d Cir. 1967) ; and George W. Mitchell, 
47T.C. 120 (1966). 



142 

are allowed under other provisions of the tax law. Subject to specific 
limitations discussed below, a deduction is allowed under section 183 
for expenditures which are of the type that may be deducted without 
regard to whether they are incurred in connection with a trade or 
business or for the production of income. These items include the de- 
ductions which are allowed for interest (sec. 163), certain State and 
local property taxes (sec. 164), and casualty losses (sec. 165). 

Section 183 further provides that, in the case of an activity not 
engaged in for profit, a deduction is allowed for expenses which could 
be deducted if the activity were engaged in for profit, but only to the 
extent these expenses do not exceed the amount of gross income de- 
rived from the activity reduced by the deductions which are allowed 
in any event (e.g., interest and certain State and local taxes). In other 
words, as to expenses such as depreciation, insurance, and maintenance, 
a taxpayer is allowed a deduction but only to the extent of income 
derived from the activity. The taxpayer is not allowed to use these 
deductions to create losses which can be used to offset other income. 

A taxpayer is presumed to be engaged in an activity for profit for 
a taxable year if, in two or more years of the period of five consecutive 
taxable years (seven consecutive taxable yeai-s in the case of an activ- 
ity which consists in major part of the breeding, training, showing, 
or raising of horses) ending with such taxable year, the activity was 
in fact carried on at a profit. For purposes of this presumption, the 
activity is treated as being carried on for a profit in a given taxable 
year if the gross income fi*om the activity exceeds the deductions at- 
tributable to the activity which would be allowable if it were engaged 
in for profit. 

The rules for determining whether an activity is a trade or business 
or engaged in for the production of income are the same as those used 
for determining whether an activity is engaged in for profit. As a 
result, except for the presumption discussed above, if deductions with 
respect to the activity are not allowable as a trade or business expense 
(sec. 162) or as expenses incurred for the production of income, etc. 
(sec. 212) , then the activity will be treated as an activity not engaged 
in for profit under section 183. 

The Regulations provide a list of relevant factors which should 
normally be taken into account in determining whether the activity is 
engaged in for profit. Among other factors, the presence of personal 
motives must be considered, especially where there are recreational or 
personal elements involved.- By way of illustration, the regulations 
provide tliat a taxpayer will be treated as holding a beach house pri- 
marily for personal purposes if, during a three-month season, the 
beach house is personally used by the taxpayer for one month and 
used for the production of rents for the remaining two months (Regs. 
§ 1.183-1 (d) (3) ). However, except for this example, there are no 

2Treas. Reg. § 1.183-2(b). These factors Include: (1) The manner in which the tax- 
payer carries on the activity, (2) the expertise of the taxpayer or his advisers, (3) the 
time and effort expended hy the taxpayer in carrying on the activity, (4) the expectation 
that assets used in the activity may appreciate in value, (5) the success of the taxpayer 
in carrying on other similar or dissimilar activities, (6) the taxpayer's history of income 
or losses with respect to the activity, (7) the amount of occasional profits, if any, which 
are earned, (8) the financial status of the taxpayer, and (9) the elements of personal 
pleasure or recreation. 



143 

definitive rules relating to how much personal use of vacation prop- 
erty will result in a finding that the rental of the vacation property 
is an activity not engaged in for profit. 

Generally, no deduction is allowed for personal, living, and family 
expenses except as otherwise expressly provided under the tax laws 
(sec. 262). Deductions that are expressly allowable, even though they 
are attributable to personal use, include items of interest, certain taxes, 
and casualty losses. However, no deduction is allowed for such items 
as depreciation, maintenance, insurance, and utilities to the extent 
these items are attributable to personal use. As a result, under prior 
law, where property was used for both personal and business use, the 
total amount of maintenance, insurance, and utilities expenses and 
depreciation incurred during a taxable year had to be allocated on a 
reasonable and consistently applied basis. 

Reasons for change 

Where expenses attributable to a residence are treated as deductible 
business expenses, an opportunity exists to convert nondeductible per- 
sonal, living and family expenses into deductible expenses. In the case 
of so-called "vacation homes" that are used both for personal purposes 
and for rental purposes, it would appear that frequently personal 
motives predominate and the rental activities are undertaken to inini- 
mize the expenses of ownership of the property rather than to make 
an economic profit. 

In marketing vacation homes, it has become common practice to em- 
phasize that certain tax benefits can be obtained by renting the prop- 
erty during part of the year, while reserving the remaining portion 
for personal use. In addition, certain an-angements have been devised 
whereby an individual owner of a condominium unit is entitled to 
exchange the time set aside for the personal use of his own unit (typi- 
cally three to six weeks) for the use of a different unit under the same 
general management at another location. 

Under many of these arrangements, it is extremely difficult under 
existing law to determine when an activity is engaged in for profit. 
The present regulations provide that in making this determination 
a number of factors shall be taken into acxjount. These factors include 
the presence of "personal motives", especially where there are recrea- 
tional or personal elements involved. However, except for the example 
mentioned above, no objective standards are set forth in the regula- 
tions. The Congress concluded that definitive rules should be provided 
to specify the extent to which personal use would result in the disal- 
lowance of certain deductions in excess of gross income. In a case 
where personal use is the controlling faxitor to be considered, this ap- 
proach would obviate the need for subjective determinations to 
be made concerning the taxpayer's motive and the primary purpose 
for which the vacation home is held. 

In addition, if there is any personal use of a vacation home, the 
portion of expenses allocable to rental activities should be limited 
to an amount determined on the basis of the ratio of time that the 
home is actually rented for a fair rental to the total time that the 
vacation home is used during the taxable year for all purposes (i.e., 
rental, business, and personal activities). 



144 

Explanatio7t of provision 

The Act adds a new provision (sec. 280A) which, in general, pro- 
vides a limitation on the amount allowable to a taxpayer for the deduc- 
tions attributable to the rental of a dwelling unit if the taxpayer per- 
sonally uses the unit in excess of specified periods of time during a 
taxable year. This new limitation only applies if the taxpayer's use of 
the dwelling unit for personal purposes during his taxable year exceeds 
the greater of fourteen days or ten percent of the number of the days 
during the year for which the vacation home is rented. (Rules for deter- 
mining personal use and rental days are discussed below.) The Act also 
provides that in the case where the taxpayer rents a dwelling unit 
used as a residence for less than 15 days, neither operating gain nor loss 
would be recognized for tax purposes. 

The provisions of this section apply to an individual, a trust, estate, 
partnership, and an electing small business corporation. The provisions 
do not apply to corporate taxpayers (other than shareholders of sub- 
chapter S corporations). However, no inference should be drawn 
from this section in the case of a corporation, as to whether or not 
expenses incurred for the maintenance of a residence are connected 
with its trade or business for purposes of the tax laws. 

If a taxpayer exceeds the pereonal use limitations for the dwelling 
unit for a taxable year, the deductions attributable to the rental activity 
are limited to the amount by which the gross income derived from 
the rental activity exceeds the deductions otherwise allowable without 
regard to such rental activities (e.g., interest and certain taxes). For 
this purpose, deductions attributable to the rental activities are those 
items which are of a type allowable only as expenses incurred in con- 
nection with a trade or business or the production of income (e.g., 
sec. 162 or 212). 

If the personal use limitation applies, the allowable deductions 
would be determined after first determining the expenses of the dwell- 
ing unit which are allocable to the rental activities (in accordance 
with the new allocation rules). Grenerally, the amounts allowable as 
deductions would be determined in the same manner as provided in 
the regulations prescribed under section 183 of the Code. 

The applicability of this new limitation on allowable deductions 
would be determined solely by reference to the taxpayer's personal use 
of the dwelling unit during his taxable year rather than, as under sec- 
tion 183, by reference to the profits or losses during any consecutive 
period of taxable years or on the basis of a facts and circumstances 
determination of the taxpayer's objectives. Generally, application of 
section 183 of the code would not be affected by these new provisions. 
Thus, if the rental of a dwelling unit is treated as an activity not 
engaged in for profit after consideration of the relevant objective 
standards prescribed by the regulations under section 183, deductions 
attributable to the rental activity would be limited under that provi- 
sion (sec. 183) even though the new provisions did not apply because 
there was little or no personal use of the dwelling unit, i.e., the unit 
was not used for personal purposes for more than 14 days. 

As indicated above, where the dwelling unit is rented for less than 
15 days during the taxable year, neither operating gain nor operat- 
ing loss would be recognized for Federal income tax purposes. Thus, 



145 

where a dwelling unit is rented for less than 15 days, neither the 
new limitation under this new section nor the provisions of section 183 
(pertaining to activities not engaged in for profit) are applicable. In 
tlhis case, expenses which would be allowable if the taxpayer were in a 
trade or business or subject to the provisions of section 183 (e.g., main- 
tenance, utilities, insurance and depreciation) will not be allowed as a 
deduction and any revenue received from the rental of a dwelling unit 
for less than 15 days will not be includible for tax purposes. How- 
ever, a deduction for expenses otherwise allowable (e.g., interest, cer- 
tain taxes and casualty losses) will be allowed as a deduction. 

This new limitation, as indicated above, will not apply unless the 
taxpayer uses the dwelling unit for personal purposes during his 
taxable year for more than fourteen days or ten percent of the number 
of the days during such year for which the dwelling unit is rented, 
whichever is greater. For this purpose, a dwelling unit would not 
be treated as rented (at a fair rental) for any day for which it is 
treated as used for personal purposes. In the case of a dwelling unit 
owned by a partnership, trust, estate, or subchapter S corporation, ^he 
number of days of personal use by a taxpayer shall be determined by 
reference to the total number of days of personal use by the partners, 
beneficiaries, or stockholders, as the case may be. However, if two or 
more partners, beneficiaries, or stockholders personally use the dwell- 
ing unit during the same day, that day would constitute only one 
day of personal use. If a taxpayer owns a dwelling unit during only 
a portion of the taxable year, no reduction of the personal use specified 
under the provision would be required by reason that the dwelling 
unit was owned for less than a full year. 

The taxpayer generally would be deemed to have used a dwelling 
unit for personal purposes for a day if, for any part of the day, the 
unit is used for personal purposes by (1) the taxpayer or any other 
person who owns an interest in the home; (2) their bix)thers and sis- 
ters, spouses, ancestors, or lineal descendants; (3) any individual who 
uses the unit under a reciprocal arrangement (whether or not a fair 
rental is charged) ; or (4) any other individual who uses the dwelling 
unit during a day unless for that day the unit is rented for a fair 
rental. With respect to use by a person other than the taxpayer who 
also owns an interest in the dwelling unit, the taxpayer would be 
deemed to have used the dwelling unit for personal purposes for a 
day if, for any part of the day the unit is used by a co-owner or a 
holder of any interest in the unit (other than a security interest or an 
interest under a lease for a fair rental) for personal purposes. For this 
purpose, any other ownership interest existing at the time the tax- 
payer has an interest in the unit shall be taken into account even if 
there are no immediate rights to possession and enjoyment under such 
other interest. 

A taxpayer would not be considered to have personally used a 
dwelling unit with respect to a use by his employee, even if it is 
I'ented for less than a fair rental, if the value of such use is excludable 
from income by the employee under section 119 of the code (relating 
to meals and lodging furnished for the convenience of an employer). 
Further, if the taxpayer spends a normal work day cleaning, painting, 
repairing or otherwise maintaining the dwelling unit, such use shall 
not be treated as personal use. 



146 

For purposes of this new provision, the term "dwelling unit" in- 
cludes a house, apartment, condominium, house trailer, boat, or similar 
property. The term would include any environs and outbuildings, 
such as a garage, which relate to the use of the dwelling unit for 
living accommodations. However, the term would not include that 
portion of a dwelling unit that is used exclusively as a hotel, motel, 
inn, or similar establishment. 

In any case where there is any personal use of a dwelling unit dur- 
ing the taxpayer's taxable year (whether or not that pei'sonal use 
constitutes use as a residence), the expenses allocable to the rental of 
the vacation home will be limited to an amount which bears the same 
ratio to such expenses as the number of days the unit is actually 
rented out for the year bears to the total number of days the unit is 
actually used for all purposes during the year. However, the limita- 
tion upon allocable expenses would not apply to expenses such as 
interest or taxes which are allowable even if not attributable to the 
rental activity. 

For purposes of this limitation, the personal use of a dwelling unit 
would be determined in accordance with the rules described above. 
However, for purposes of determining the relationship of rental days 
to total days of use, the number of rental days would include any day 
for which the dwelling unit is rented for a fair rental even if the 
taxpayer is deemed to have personally used the unit for that day. The 
period during which the unit is merely held out for rent would not 
be considered in determining the number of rental days for a taxable 
year. 

Effective date 

This provision applies to taxable years beginning after December 31, 
1975. 

Reveniie effect 

This provision and the provision relating to business use of the 
home will increase revenues by $207 million in fiscal year 1977, $206 
million in fiscal year 1978, and $305 million in fiscal year 1981. 

3. Deductions for Attending Foreign Conventions (sec. 602 of the 
Act and sec. 274(h) of the Code) 

Prior law 

Generally, the deductibility of traveling expenses paid or incurred 
to attend a foreign convention, seminar, or similar meeting while 
away from home is governed by the ordinary and necessary standard 
under sections 162 and 212 of tlie code and, in certain cases, the special 
disallowance rules provided under section 274(c). 

Generally, to be deductible, traveling expenses must be reasonable 
and necessary in the conduct of the taxpayer's business and directly 
attributable ito the trade or business. If a trip is primarily related to 
the taxpayer's business and the. sjjecial foreign travel allocation rules 
do not apply, the entire traveling expenses (including food and lodg- 
ing) to and from a destination are deductible. If a trip is primarily 
personal in nature, the traveling expenses to and from the destination 
are not deductible even if the taxpayer engages in business activities 



147 

while at the destination.^ However, expenses incurred while at the des- 
tination which are allocable to the taxpayer's trade or business are 
deductible even if the transportation expenses are not deductible. 

With respect to expenses incurred in attending a convention or 
other meeting, the test under section 162 is whether there is a suffi- 
cient relationship between the taxpayer's trade or business and his at- 
tendance so that he is benefiting or advancing the interests of his trade 
or business. Generally, deductibility depends upon the facts and cir- 
cumstances of each particular case. (Reg. § 1.162-5(e) (1) ). If the 
convention is for political, social, or other purposes unrelated to the 
taxpayer's business, the travel expenses are not deductible. The Inter- 
nal Revenue Service has ruled that the test for allowance of deduc- 
tions for convention expenses is met if the agenda of the convention 
or other meeting is so related to the taxpayer's position as to show that 
attendance was for business purposes. (Rev. Rul. 63-266, 1963-2 
C.B.88). 

If an individual travels away from home primarily to obtain edu- 
cation for which the expenses are deductible as trade or business ex- 
penses, the expenses for travel, meals, and lodging incurred while 
away from home are deductible. However, the portion of the travel 
expenses attributable to personal activities, such as sightseeing, is 
treated as a nondeductible personal or living expense. If the travel 
away from home is primarily personal, only the meals and lodging 
incurred during the time spent in participating in educational pur- 
suits are deductible. Further, in the case of foreign travel to obtain 
education, deductions are subject to special allocation rules. 

Under section 274(c) of the code, expenses of travel outside the 
United States are deductible only to the extent allocable to the tax- 
payer's trade or business or income-producing activities if such travel 
is for more than one week or the time of travel outside the United 
States which is not attributable to the pursuit of the taxpayer's trade 
or business is 25 percent or more of the total time on such travel. In 
the case of foreign travel to which section 274(c) applies, this alloca- 
tion requirement overrides the general rule that the entire expenses 
of travel are deductible if the primary purpose of the trip was related 
to a trade or business. 

General reasons for change 
Serious administrative problems have arisen because of the recent 
proliferation of conventions, educational seminars, and cruises which 
were ostensibly held for business or educational purposes, but which 
were held at locations outside the United States primarily because of 
the recreational and sightseeing opportunities. In Technical Informa- 
tion Release 1275 (February 14, 1974), the Internal Revenue Service 
announced that it intended to scrutinize deductions for business trips, 
conventions, and cruises which appear to be vacations in disguise. The 
Service noted that a number of professional, business and trade orga- 
nizations have been sponsoring cruises, trips and conventions during 
which only a small portion of time is devoted to business activity and 
that the practice seemed to be growing. In cases where there were indi- 

iSee Patterson v. Thomas. 289 F. 2d 108 (5th CIr., 1961) ; Espandiar Kadivar, T.C. 
Memo 1973-95 ; Rev. Rul. 74-292, 1974-1 C.B. 43. 



148 

cations of abuse, the Service intended to request lists of the names 
and addresses of the participants on cruises and other trips. However, 
under prior law, allowance of deductions claimed by participants con- 
tinued to depend upon the facts and circumstances, including the re- 
lationship of the meeting to a particular taxpayer's trade or business. 

As indicated above, the basic test that has been applied by the Inter- 
nal Revenue Service was whether the convention or other meeting was 
primarily related to the taxpayer's business or whether it was pri- 
marily personal in nature. Thus, in administering this test, the Inter- 
nal Revenue Service was required to make a subjective determination 
as to the motives and intentions of the taxpayer after taking into 
account all the facts and circumstances in a particular case. One of the 
important factors considered by the Service in making this subjective 
detennination was the amount of time spent on business activities as 
compared to the amount of time spent on personal activities. There 
were no specific guidelines or formulae in the statute or regulations 
that specified when this factor would weigh in the favor of or against 
the taxpayer. The taxpayer was not required to keep detailed records 
relating to the amount of time spent on each of these activiites. Upon 
audit, the taxpayer frequently attempted to substantiate the business 
nature of his trip by providing the Service with the agenda from the 
meeting or a certificate of attendance which was furnished by the 
organization sponsoring the meeting.^ 

The administrative problems created by the lack of specific guide- 
lines were substantial. The pix)cess of trying to ascertain all the facts 
and circumstances was extremely time consuming both for the taxpayer 
and the Service. Further, additional importance was placed on the sub- 
jective judgment of the IRS because of the basically "all or nothing" 
approach under prior law. If the primary purpose was determined to 
be pleasure, no amount of the travel expense could be deducted. Since 
reasonable and competent auditors differed in evaluating all the facts 
and circumstances, the deduction of one taxpayer could be totally dis- 
allowed while another taxpayer (perhaps with slightly different facts) 
could obtain a complete deduction for travel expenses. This disparity 
of treatment resulted in complaints that the Service did not treat 
taxpayers equally. 

The Congress was concerned that the lack of specific detailed 
requirements has resulted in a proliferation of foreign conventions, 
seminars, cruises, etc. which, in effect, amounted to Government-sub- 
sidized vacations and served little, if any, business purpose. It was 
indicated that the promotional material often highlight the deduct- 
ibility of the expenses incurred in attending a foreign convention or 
seminar and, in some cases, describe the meeting in such terms as a 
"tax-paid vacation" in a "glorious" location. In addition, it was 
pointed out that there were organizations that advertised that they 
could find a convention for the taxpayer to attend in any part of the 
world at any given time of the year. This type of promotion had an 
adverse impact on public confidence in the fairness of the tax laws. 

Explanation of provision 
The act limits the deductions allowable for the expenses of indi- 

2 A few organizations maintained attendance records and required participants to "sign 
in" at each session of the convention or seminar. 



149 

viduals attendin<j foreign conventions. The term "foreign convention" 
means an}^ convention, seminar or similar meeting held outside the 
United States, its })ossessions, and the Trust Territory of the Pacific. 

Generally, under the act, no deduction will be allowed for expenses 
paid or incurred by an individual in attending more than two foreign 
conventions in any taxable year. In addition, with respect to the two 
conventions for which a deduction is allowable, the act limits the 
amount of expenses that can be deducted for transportation and sub- 
sistence. If an individual attends more than two foreign conventions 
in a year, he must select which two of the foreign conventions are to 
be taken into account for purposes of determining the allowable 
deductions. 

The provisions apply to any person, whether or not such person is 
the individual attending the foreign convention. For example, if an 
employee is reimbursed for attending a foreign convention on behalf 
of his employer corporation (or if the corporation directly pays 
the expenses), the corporation will be allowed a deduction for the ex- 
penses of attending the foreign convention only to the extent that the 
employee is (or would be) allowed a deduction. Thus, the corporation 
would be allowed a deduction for the reimbursement (subject to the 
transportation and subsistence limitations) only if the employee se- 
lects the convention as one of the two conventions to be taken into 
account for the taxable year. In applying these provisions to a cor- 
poration, it is intended that the two convention rule be applied on an 
employee-by-employee basis. 

With respect to subsistence expenses incurred to attend a foreign 
convention, no deduction will be allowed unless: (1) a full day or 
half-day of business activities are scheduled on each day during the 
convention and (2) the individual attending the convention attends 
at least two-thirds of the hours of the daily scheduled business activ- 
ities or, in the aggregate, attends at least two-thirds of the total hours 
of scheduled business activities at the convention. A full day of sched- 
uled business activities means a day during which at least 6 hours of 
business activities are scheduled and a half -day means a day during 
which at least 3 hours of business activities are scheduled. Thus, if 6 
hours of business activities are scheduled for a day, the individual 
must attend at least 4 hours for it to be counted as a full day. However, 
if the individual attends only 2 of the 6 hours scheduled, the day will 
not count either as a full day related to business activities or as a half- 
day related to business activities. If a convention has scheduled more 
than 6 hours of business activities (or more than 3 hours and less than 
6 hours in the case of half-days) on a day, then the actual hours of 
scheduled business activities will be taken into account in computing 
whether or not the individual has attended at least two-thirds of the 
hours of the daily scheduled business activities. Similarly, in deter- 
mining whether the two-thirds aggregate test is met, all scheduled 
hours of business activities will be taken into account. 

In no event will time spent at parties, receptions, or similar social 
functions be taken into account for purposes of determining whether 
the required 3 or 6 hours of business activities were scheduled. Further, 
where there is a banquet at which there is a speaker or lecturer, only 
the time attributable to the speech or lecture (if business related) will 
be taken into account. 



234-120 O - 77 - U 



150 

In the case where subsistence expenses are allowed under the Act, 
the amount allowable as a deduction while at the convention or travel- 
ing to or from the convention is not to exceed the dollar per diem rate 
for the site of the convention which has been established for United 
States civil servants under section 5702(a) of title 5 of the United 
States Code and which is in effect for the calendar montli in which 
the convention begins. For purposes of this provision, "subsistence 
expenses" means lodging, meals, and other necessary expenses for the 
personal sustenance and comfort of the traveler, including tips and 
taxi and similar transportation expenses. 

With respect to transportation expenses outside the United States, 
the amount allowable as a deduction may not exceed the lowest coach 
or economy rate charged by any commercial airline for such trans- 
portation during the caleiidar month the convention is held. However, 
where the taxpayer travels coach or economy class on a regularly 
scheduled flight of a common carrier, the cost of that economy or 
coach fare is to be allowed as a deduction (subject to the special 
foreign travel allocation rules if applicable). If there is no coach or 
economy rate, the deduction allowable would be limited to the lowest 
first class rate charged by any commercial airline for such transpor- 
tation. Transportation expenses for travel within the LTnited States 
are deductible to the extent the cost is reasonable. 

A deduction for the full expenses of transportation (subject to the 
coach or economy rate limitation) to and from the site of a foreign 
convention will be allowable only if one-half or niore of the total days 
of the trip are devoted to business-related activities. In determining 
whether a day is devoted to business-related activities, the same rules 
for counting full days and half-days for purposes of su]>sistence ex- 
penses are to be applied. 

If less than one half of the total days of the trip are devoted to busi- 
ness-related activities, then only a proportionate amount of the trans- 
portation expenses will be allowable as a deduction. The amount allow- 
able is to be determined by multiplying the transportation expenses 
paid or incurred (after the application of the coach or economy rate 
rule) by a fraction, the numerator of which is the total days of the 
trip devoted to business-related activities and the denominator of 
which is total days of the trip. For purposes of this provision, the 
travel days to and from the site of the convention shall not be taken 
into account in determining the total days of the trip or of business 
related activities. 

In any case where the transportation and subsistence expenses are 
either not separately stated or under the facts and circumstances there 
is reason to believe that the allocation of expenses between transporta- 
tion and subsistence expenses is not properly reflected, all amounts paid 
for such expenses shall be treated as having been paid solely for sub- 
sistence expenses subject to the subsistence expense per diem limita- 
tion. 

The Act provides that no deduction is to be allowed unless the tax- 
payer complies with certain reporting requirements in addition to the 
substantiation requirements of present law. Under these reporting re- 
quirements, the taxpayer must furnish information indicating the total 
days of the trip (exclusive of the transportation days to and from 



151 

the convention), the number of hours of eacli day that he devoted 
to business activities (and a brochure describing the convention, if 
available), and furnish any other information required by regula- 
tions. In addition, the taxpayer must attach a statement signed by 
an appropriate officer of the sponsoring organization to his income 
tax return which must include a schedule of the business activities of 
each convention day, the nvnnber of hours of business-related activities 
that the taxpayer attended each day and any other information re- 
quired by regulations. 

Effective date 
This provision shall apply to conventions beginning after Decem- 
ber 31, 1976. 

Revenue effect 
It is estimated that this provision will result in an increase in fiscal 
year receipts of less than $5 million annually. 

4. Qualified Stock Options (sec. 603 of the Act and sees. 422 and 
424 of the Code) 

Prior law 

An employee stock option is a right, which is limited in time, granted 
by a corporate employer to one or more employees to purchase a stated 
amount of stock in the corporation at a stated price. An option is a 
relatively low risk means of acquiring an equity interest in a corpora- 
tion, since the option need not be exercised unless the value of the stock 
increases during the option period. If the value of the stock drops 
below the price at which the stock may be purchased (i.e., below the 
option price), .the employee can allow the option to lapse (although 
ordinarily the employee would lose the amount which he may have 
originally paid for the option, if any) . 

Under prior law, employee stock options fell broadly into two cate- 
gories: "qualified" and nonqualified options. The former category was 
governed by statutory rules which set forth conditions which the 
option must meet in order to receive the fa\^orable tax treatment ac- 
corded "qualified" stock options under prior law. Employee options 
which do not satisfy these requirements (often called "non-qualified" 
or "nonstatutory" options) are gov^emed by rules set forth in the in- 
come tax regulations (Regs. § 1.421-6) and by certain statutory rules 
which apply generally to property transferred to employees in connec- 
tion with their performance of services (sec. 83) . 

Under prior law, no income was recognized on the grant to a cor- 
porate employee, or on his exercise of, a "qualified" option to receive 
stock in the employer corporation (sec. 421). The stock acquired by 
the exercise of the option is a capital asset in the hands of the employee 
and the income realized from the eventual sale of the stock is ireiierallv 
treated as long-term capital gain or loss.^ 

No deduction was available to the employer, as a business expense 
(under sec. 162) with respect to either the granting of a qualified stock 
Option or the transfer of stock to the employee when he exercised a 
qualified option. 



1 Generally similar tax treatment was also avaUable in the case of "restricted" stock 
options, which were the predecesscs to qualified options, but restricted stock options are 
no longer being granted, and most restricted options which were granted in the past have 
now been exercised or have lapsed. 



152 

A qualified option (meeting the requirements in sec. 422) must be 
granted pursuant to a plan approved by the shareholders of the corpo- 
ration. The option must, by its terms, be exercised within 5 years from 
the date it is granted and the purchase price of the shares (option 
price) may not be less than the fair market value of the company's 
stock on the date when the option is granted to the employee. In addi- 
tion, any stock acquired under a qualified option may not be disposed 
of within 3 years after it is transferred to the employee. The option 
must also be exercised while the option holder is an employee of the 
corporation, or within three months after the termination of his 
employment. 

By contrast, nonqualified stock options were (and remain) generally 
subject ot the rules of section 83. Generally, under section 83, the value 
of a nonqualified stock option constitutes ordinary income to the em- 
ployee if the option itself had a readily ascertainable fair market value 
at the time it was granted to the employee. If the option did not have 
a readily ascertainable value when granted, it would not constitute 
ordinary income at the time it was granted; when the option is exer- 
cised, however, the spread between the option price and the value of 
the stock at that time constitutes ordinary income to the employee. 

As can be seen from the above description, qualified options had 
the advantage that an executive was not required to pay any ordinary 
income tax on the value of the option as such when the company grants 
it to him, or on any "bargain element" which may exist if '^nd when 
he decided to exercise the option and purchase stock in the company. 
(The bargain element is the excess of the fair market value of a share 
of stock over its purchase price.) The employee was only required to 
pay tax when he sold the shares purchased under the option. Further, 
if he held the shares for at least 3 years (as required for the option 
to remain qualified) he was entitled to pay tax at capital gain rates on 
the full amount of his gain (if any) over the price which he originally 
paid to buy the shares. 

Although an employee did not have to pay tax under the qualified 
stock option rules at the time he exercised the option and received 
stock worth more than he paid for it, the bargain element was treated 
as an item of tax preference. (This rule remains in effect for qualified 
options granted and exercised under certain transition rules described 
below.) This means that the excess of the fair market value of the 
share at the time of exercise over the purchase price paid by the em- 
ployee was subject to the minimum tax. 

ReasoTis for change 
The principal reason for the prior tax treatment of qualified stock 
options was said to be that such treatment allowed corporate employers 
to provide "incentives" to key emploj'ees by enabling these employees 
to obtain an equity interest in the corporatioii. However, it seems 
doubtful whether a qualified stock option gives key employees more 
incentive than does any other form of compensation, especially since 
the value of compensation in the form of a qualified option is subject 
to the uncertainties of the stock market. Moreover, even to the extent 
a qualified option is an incentive, it still represents compensation and 
the Congress believes that as such it should be subject to tax in much 
the same manner as other compensation. Moreover, to the extent that 



153 

there was an incentive effect resulting from stock options, it could be 
argued that prior law discriminated in favor of corporations (which 
were the only kind of employers who could grant qualified options) as 
opposed to all other forms of business organization. 

Explanation of provisions 

Under the Act, prior law will not apply to qualified stock options 
granted after May 20, 1976, except in the case of an option granted 
under a written plan adopted and approved on or before that date, or 
under a plan adopted by a board of directors on or before May 20, 
1976 (even if the plan is approved by the shareholders after that date) . 

Thus, generally, stock options granted after May 20, 1976, whether 
or not otherwise qualified (under the requirements of section 422) will 
be subject to the rules which apply in the case of most nonqualified 
options granted after June 30, 1969 (sec. 83 of the code). Under these 
rules, if an employee receives an option which has a readily ascer- 
tainable fair market value at the time it is granted, this value (less 
the price paid for the option, if any) constitutes ordinary income to 
the employee at that time.- 

On the other hand, if the option does not have a readily ascertain- 
able fair market value at the time it is granted, the value of the option 
does not constitute income to the employee at that time, but would be 
taxable to the employee when the option is exercised. The ordinary 
income recognized at that time is the spread between the option price 
and the value of the stock (unless the stock is nontransferable and 
si'bject to a substantial risk of forfeiture) . 

Any option which is subject to the provisions outlined above (sec. 
83) is not treated as a tax preference for purposes of the minimum tax. 

To illustrate these rules, consider the case of a qualified option 
granted to a corporate executive to buy 100 shares at $10 per share. 
The employee exercises the option in full when the shares are selling 
at $15 per sliarc in the open market. ITuder the act, this transaction 
would be treated (under sec. 83) as follows: 

(a) At the time that the company grants the option to the execu- 
tive, if the option as such has a readily ascertainable fair market value, 
the value of the option (less any amount which he may have been paid 
for it) is taxable to the executive as ordinary income. 

(b) If the option itself does not have a readily ascertainable market 
value, the executive will be subject to tax when he exercises the option 
and acquires the shares under option to him. In this example, the 
employee will be taxable on the $5 per share bargain element (or a 
total of $500) at the time he exercises his option. This income will be 
treated as comjiensation taxable at oi-dinary income rates.'' 



2 Howpvpr. if thp option is nontransferable and Is also subject to a substantial risk of 
forfeiture, recognition of income would be postponed until one or both of these en- 
cumbrances is removed. 

^As indicated above, recognition of income could be postponed if the stoclc is not trans- 
ferable and if it is subject to a substantial risk of forfeiture. In this case, the tax is 
im|)osed (at ordinary income rates) at the time when either of these two restrictions is 
removed and the tax base is the exces.? of the fair marlcet value of the shares at the time 
when eltlier of these two restrictions is removed over the amount which the employee 
originally paid for the property. However, under section 83, an employee who receives 
stock (or other property) in liis employer corporation burdened by restrictions which 
would free him from paying a tax at that time may, nevertheless, elect to pay tax on the 
bargain element existing at that time. If the employee makes this election and pays tax 
when he exercises the option, any later increase in value of the shares will generally be 
taxable to him as capital gain (rather than compensation income) when he disposes of 
the shares. 



154 

Income recognized by the employee under these rules would gen- 
erally constitute earned income for purposes of the maximum tax on 
earned income (sec. 1348). 

(c) Aft«r the executive pays tax at ordinary income rates on the 
compensation portion of the transaction, he would be entitled to add 
the amount of ordinary income recognized to his basis in the shares. 
Any further gain (realized when the employee sells the shares) would 
generally be taxable as a capital gain. 

(d) The employer corporation is entitled to a deduction (under 
sec. 83) in an amount equal to the ordinary income realized by an 
employee under the above rules. The employer's deduction accrues at 
the time that the employee is considered to have realized compensa- 
tion income. 

The Congress intends that in applying these rules for the future, 
the Service will make every reasonable effort to determine a fair mar- 
ket value for an option (i.e., in cases where similar property would be 
valued for estate tax purposes) where the employee irrevocably elects 
(by reporting the option as income on his tax return or in some other 
manner to be specified in regulations) to have the option valued at the 
time it is granted ( particularly in the case of an option granted for a 
new business venture) . The Congress intends that the Service will pro- 
mulgate regulations and rulings setting forth as specifically as pos- 
sible the criteria which will be weighed in valuing an option which the 
employee elects to value at the time it is granted. 

Of course, merely because the option is difficult to value does not 
mean that the option has no value. The Congiess intends that under 
these rules, the value of an option would be determined under all the 
facts and circumstances of a particular case. Among other factoi-s that 
would be taken into account would be the value of the stock underlying 
the option (to the extent that this could be ascerained), the length of 
the option period (the longer the period, the greater the chance the 
imderlying stock might increase in value) , the earnings potential of the 
corporation, and the success (or lack of success) of similar ventures. 
Corporate assets, including patents, trade secrets and knowhow would 
also have to be taken into account. 

The Congress anticipates that under the Service's rules, certain 
options, such as those traded publicly, would be treated as having a 
readily ascertainable fair market value, regardless of whether the 
employee makes an election. However, the regulations could provide 
that in certain other cases the option would ordinarily not be valued 
at the time it is granted unless the employee so elects. 

The rules outlined above are not to apply to employee "stock pur- 
chase plans'* (described in sec. 423 of the Code) under which the 
rank and file employees of a corporation (as well as the executives) 
are afforded an opportunity to purchase corporate stock on a non- 
discriminatory basis. The prior Federal tax treatment of this type of 
plan is not affected by this provision of the Act. 

The Act also provides certain transition rules so as not to disturb 
arrangements which were entered into in reliance on prior law. Under 
the transition rules, prior law will continue to govern qualified stock 
options granted pursuant to a written qualified stock option plan which 
was adopted by the board of directors of the corporation before May 21, 



155 

1976. For purposes of this rule, it is immaterial whether the share- 
holders approve the plan before, on, or after the date, although in order 
to be a qualified plan the shareholders must approve the plan within 
12 months before or after its adoption b}' the board (sec. •122(b) (1) ). 
In order to retain its qualification the option must be exercised by the 
employee before May 21, 1981 (i.e., within five years of the May 20, 
1976 cutoff date). However, this requirement does not have to be 
spelled out inider the terms of the option ; it is sufficient if the option 
is actuall}^ exercised on or before May 20, 1981. 

In general, a plan is to be treated as having been "adopted" by the 
board of directors of the corporation by May 20, 1976, only if all of the 
action required for adoption has been completed by that date. For 
example, if the plan had been adopted by the directors of a corpora- 
tion under procedures which were valid under State law, the plan 
would generally be treated as having been "adopted" within the mean- 
ing of the statute. For purposes of these iiiles, any amendment of an 
existing plan to increase the number of shares which ma}' be granted 
under the plan is to be treated as a new plan. Thus options granted as 
a result of a plan amendment adopted after May 20, 1976, would not 
be qualified options. It is not necessary, however, in the case of a plan 
adopted by May 20, 1976, for options to have been granted under the 
plan by that date or for the directors or shareholders to have author- 
ized the specific grant of options under the plan to specific individuals. 

If qualified options are granted under the transition rule, but the 
options are not exercised until after May 20, 1981, the Congress intends 
that the option is to be treated as an option which did not have a read- 
ily ascertainable fair market value at the time it was granted (w'ithin 
the meaning of sec. 83 (e) (3) ) . Thus, the value of the option in this case 
would not constitute income to the employee when granted (or at a 
time the transition rule expires), but if the option subsequently is 
exercised, and if the fair market value of the stock exceeds the option 
price, this excess will constitute ordinary income to the employee at 
the time of exercise. 

The Act also requires that all outstanding restricted stock options 
(sec. 424) must be exercised on or before May 20, 1981, in order to 
receive the Federal tax treatment previously accorded these options. 

As under prior law, in the event of a corporate merger, consolida- 
tion or other reorganization, the employer corporation may substitute 
a new option for an old option, as long as the new option and the old 
option are substantiall}' equivalent (sec. 425). Thus the surviving 
corporations in a corporate merger could substitute options on its stock 
for options on the stock of the nonsurviving corporation, so long as the 
options were of equivalent value and the new option did not provide 
for any additional benefits for the employee which he did not have 
under the old option. These substitutions can occur after May 20, 1976. 
on the same basis as before that date. (Of coui*se, "old options" could 
not be granted after May 20, 1976, by the acquired corporation, except 
as provided under the transition rules. Hovrever, if a corporation 
adopted an option plan in 1974 and is reorganized in 1977 into a hold- 
ing compan}'^ with one or more operating subsidiaries, the holding 
company may adopt the 1974 option plan and continue to grant 



156 

qualified stock options to the extent permissible had the reorganiza- 
tion not occurred.) 

Ejfective date 
The amendments with respect to qualified stock options apply to 
taxable years ending after May 20, 1976. 

Reverme effect 
This program will increase budget receipts by $7 million in fiscal 
year 1977, $20 million in fiscal year 1978, and $5 million in fiscal year 
1981. 

5. Treatment of Losses From Certain Nonbusiness Guaranties 
(sec. 605 of the Act and sec. 166 of the Code) 

Prior Jaws 

Under prior law (which remains in effect), in the case of a 
noncorporate taxpayer, "business" bad debts are deductible as ordi- 
nary losses for the year in which the debt becomes worthless or par- 
tially worthless. On the other hand, "nonbusiness" bad debts are 
treated as short-term capital losses, which means that the losses ai-e 
offset first against the taxpayer's capital gains (if any) , and may then 
be deducted against ordinary income to the extent of $1,000 per year. 

On the other hand, where the noncorporate taxpayer's loss results 
from a situation where he guaranteed the debt of a noncorporate 
person, and was required to make good on that guaranty because the 
borrower defaulted, section 166(f) of the code provided that the 
guarantor could treat the payment under the guaranty as a business 
bad debt (even though the guaranty did not arise in connection with 
the gviaran tor's trade or business) if the proceeds of the loan were 
used by the borrower in his trade or business, and the debt was worth- 
less when payment was made by the guarantor (i.e., the borrower was 
insolvent). The deduction is allowed for the year in which the pay- 
ment is made. 

However, the guarantor of a corporate obligation which becomes 
worthless must treat the guaranty payment as a nonbusiness bad debt 
(Reg. § 1.166-8 (b) ). Also, if the loan was not used in the borrower's 
trade or business, the provisions of section 166(f) did not apply. How- 
ever, the guarantor's payment was still deductible as a nonbusiness 
bad debt (short-term capital loss) if the debt was worthless when paid 
and the guarantor had a right of reimbursement (subrogation) 
against the borrower.^ 

Where the guarantor had no right of subrogation, there was some 
uncertainty as to whether, and under what circumstances, the guar- 
antor was entitled to deduct his guaranty payment. For some time it 
was believed that the payment could not be deducted as a bad debt on 
the theory that unless there is a right of recovery against the borrower, 
there is no "debt" which might become worthless in (lie hands of the 
guarantor. However, if the guaranty transaction was entered into in 
connection with the taxpayer's trade or business, or the agreement was 
part of a transaction entered into for profit on the part of the tax- 
payer, then the payment was claimed to be deductible as a loss under 

1 If the debt is not worthless, no deduction Is j^nerally allowed (on the theory that pay- 
ment by the guarantor was voluntary). 



157 

section 165.^ More recently, courts have held that there was a bad 
debt on the grounds that there was an implied promise on the part of 
the borrower to reimburse the guarantor for his payments.^ 

General reasons for cliange 

As discussed above, where a taxpayer makes a loan which is not 
connected with his trade or business, and the debt becomes worthless, 
he is generally required to treat the loss as a short-term capital loss. 
On the other hand, where a third party made the loan, which was 
guaranteed by the taxpayer, and the proceeds of the loan were used by 
the borrower in his trade or business, any loss which results could 
generally be deducted by the taxpayer against ordinary income. The 
Congress concluded that this distinction made little sense and gave a 
tax advantage to guaranteeing loans over making them directly. 

Explanation of provisions 

To provide for more consistent treatment in the area of bad debts 
and guaranties, the Act repeals section 166(f) of the Internal Revenue 
Code, effective for taxable years beginning after December 31, 1975. 
Thereafter, when a taxpayer has a loss arising from the guaranty of 
a loan, he is to receive the same treatment as where he has a loss from 
a loan M^iich he makes directly. Thus, if the guaranty agreement arose 
out of the guarantor's trade or business, the guarantor would still be 
permitted to deduct the loss resulting from the transaction against 
ordinary income. If the guaranty agreement was a transaction entered 
into for profit by the guarantor (but not as part of his trade or busi- 
ness), he Avould be able to deduct the resulting loss as a nonbusiness 
debt. 

Also, in the case of a guaranty agreement which is not entered into 
as part of the guarantor's trade or business, or as a transaction for 
profit, no deduction is to be available in the event of a payment under 
the guarantee. 

Generally, in the case of a direct loan, the transaction is entered 
into for profit by the lender, who hopes to realize interest on the loan. 
However, this may not be true in the case of loans made between 
friends or family members, and in these cases the Internal Revenue 
Service will generally treat any loss resulting from such a "loan" as a 
gift, with respect to which no bad debt deduction is available. (Reg. 
§ 1.166-1 (c)) 

In the case of a guaranty agreement, however, it is not always easy 
to tell whether the transaction has been entered into for profit on the 
part of the guarantor. It is not uncommon for guaranty agreements 
to provide for no direct consideration to be paid to the guarantor. 
Often this may be because the guarantor is receiving indirect consid- 
eration in the form of improved business relationships. On the other 
hand, many other guaranties are given without consideration as a 
matter of accommodation to friends and relatives. 

The Congress believes that a bad debt deduction should be avail- 



2 The legal theory led to attempts on the part of some taxpayers to take themselves out 
of the general rules relating to guaranties of debts by taking steps to Insure that they 
would have no right of subrogation against the borrower if he defaulted. (This was par- 
ticularly true in the case of guaranties by taxpayers of corporate obligations where the 
taxpayer was a shareholder In a closely held corporation.) The taxpayer would then 
attempt to claim an ordinary loss deduction under section 165, instead of receiving non- 
business bad debt treatment under section 166. 

'See e.g.. Bert W. Martin. .52 T.C. 140 (reviewed by the Court), aflf'd per curiam, 
424 F.2d 1368 (9th Cir.) cert, denied, 400 U.S. 902 (1970). 



158 

ablo in the cnse of a guaranty related to the taxpayer's trade or busi- 
ness, or a guaranty transaction entered into for profit. However, no 
deduction should be available for a "gift'' type of situation. Thus, the 
Congress intends that for years beginning in 1976 (in the case of 
guaranties made after 1975) and thereafter, the burden of substanti- 
ation is to be on the guarantor, and that no deduction is to be available 
unless the guaranty is entered as part of the guarantor's trade or busi- 
ness, or unless the transaction has been entered into for profit, as evi- 
denced by the fact that the guarantor can demonstrate that he has re- 
ceived reasonable consideration for giving the guaranty. For this pur- 
pose, consideration could include indirect consideiation; thus, where 
the taxpayei- can substantiate that a guaranty was given in accordance 
with normal business practice, or for hona-fde business purposes, the 
taxpayer would be entitled to his deduction even if he received no 
direct monetary consideration for giving the guaranty. On the other 
hand, a father guaranteeing a loan for his son would ordinarily not 
be entitled to a deduction even if he received nominal considei-ation 
for giving the guaranty. 

The Congress also wishes to make it clear that in the case of a 
guarantor of a corporation obligation, any payment under the guar- 
anty agreement must be deducted (if at all) as a nonbusiness bad debt, 
regardless of whether there is any right of subrogation, unless the 
guaranty was made pursuant to the taxpayer's trade or business. Of 
course, if the payment under the guaranty by a corporate shareholder 
constitutes a contribution to capital, under the facts and circumstances 
of the particriar case, the paym> i*t would not be deductible but would 
increase tlu- sto.- ^diolder's basis in his shares in the corporation. This 
rule is consistent with Congress' understanding of present law. 

The (^ongress further wishes to resolve for the future the appro- 
priate timing of the deduction for a payment under a guaranty agree- 
ment. If the guaranty agreement (including for this purpose a guar- 
anty, indemnity or endorsement) requires payment by the guarantor 
upon default by the maker of the note (i.e., the borrower), and the 
guarantor has a right of subrogation oi other right against the maker, 
no deduction will be allowed to the guarantor until the year in Avhich 
the right over against the maker becomes worthless (or partially 
worthless, where the guaranty occurs in connection with the guaran- 
tor's trade or business) . If the guarantor has no right over agaijist the 
maker of the obligation, the payment under the guaranty is deductible 
as a bad debt for the year in which the payment is made. Of course, if 
the payment is voluntary in the sense that there is no legal obligation 
to make the payment,* or a guai-anty agreement is entered after the 
debt has become worthless, no deduction is to be available. 
Effective date 

The provisions of this amendment are to be effective for taxable 
years beginning after December 81, 1975 in connection the guaranties 
made after that date. 
Revenue e-ffect 

It is estimated that this provision will result in an increase in budget 
receipts of $1 million in fiscal year 1977 and of 5 million annually 
thereafter. 



* It is not intpnrtpd that legal action must have been brought against the guarantor 
in order to entitle him to take an otherwise available deduction ; but there must be an en- 
forceable legal obligation on his part to make the payment. 



F. ACCUMULATION TRUSTS 

(Sec. 701 of the Act and sees. 644 and 665-669 of the Code) 

Prior law 

A trust is generally treated as a separate entity wliich is taxed in tlK- 
same manner as an individual. However, there is one important dif 
fercnce: the trust is allowed a special deduction for any distributions 
of income to beneficiaries. The beneficiaries then include these distri- 
butions in their income for tax purposes. Thus, in the case of income 
distributed currently, the trust is tieated as a conduit through which 
income passes to the beneficiaries, and the income so distributed re- 
tains the same character in the hands of the beneficiaries as it possessed 
in the hands of the trust. 

If a grantor creates a trust under which the trustee is either re- 
quired, or is given discretion, to accumulate the income for the benefit 
of designated beneficiaries, however, then, to the extent the income is 
accumulated, it is taxed at individual rates to the trust. An important 
factor in the trustee's (or grantor's) decision to accumulate the income 
may be the fact that tlie beneficiaries are in highei- tax brackets than 
the trust. 

Beneficiaries are taxed on distributions of previously accundated 
income from trusts in substantially the same manner as if the income 
had been distributed to the beneficiaries currently as earned, instead of 
bein^ accumulateil in the trust. This is accompfislied through the so- 
called "throwback rule,'* under which distributions of accumulated 
income to beneficiaries are thrown back to the yoar in which the income 
would have be«n taxed to the beneficiary^ if it had been distributed 
currently. The Tax Reform Act of 19(59 revised the prior throwbacii 
rule to provide an unlimited throwback rule with respect to accumula- 
tion distributions. 

Under prior law, the tax on accumulation distributions was com- 
puted in either of two ways. One method was the "exact'' method, and 
the other was a "sliortcut" method which did not require the more ex- 
tensile computations required by the exact method. Under the exact 
niethod of computation, the tax on an accuuiulation distribution could 
not exceed the aggregate of the taxes that would have been payable 
if the income had actually been distributed in the prior years when 
earned. This method i-equired complete trust and beneficiary records 
for all past years so that the distributable net income of the trust and 
the taxes of the beneficiary could be determined for each year. The 
beneficiarv's own tax tiien was recom])uted foi- these years, including 
in his income the appropriate amount of trust income for each of the 
years (including his share of an}^ tax paid by the trust). Against the 
additional tax computed in this manner, the beneficiary was allowed 
a credit for his share of the taxes paid by the trust. Any remaining 
tax then was due and payable as a part of the tax for the current year 
in which the distribution was received. 

(159) 



160 

The so-called shortcut method in effect determined the tax attribut- 
able to the acciinuilation distribution by avenigin^ the distribution 
over a number of years (hirin<2: which the income was earned 
by the trust. This was accomplished by including, for purposes of 
tentative computations, a fraction of the income received from the 
trust in the beneficiary's income of each of the 3 immediately prior 
years. The fraction of the income included in each of these years was 
based upon the number of years in which the income was accumulated 
by the trust. 

Prior law also provided an unlimited throwback rule for capital 
gains allocated to the corpus of an accumulation trust. Tliis provision 
normally did not apply to '"simple trusts" (any trust which is required 
by the terms of its governing instrument to distribute all of its income 
currently) or any other trusts, which in fact distribute all their income 
currently, until the first year they accumulated income. For purposes 
of this provision, a capital gains distribution was deemed to have been 
made only when the distribution was greater than all of the accumu- 
lated ordmary income. If the trust had no accoumulated ordinary in- 
come or capital gains, or if the distribution was greater than the ordi- 
nary income or capital gain accumulations, then to this extent it was 
considered a distribution of corpus and no additional tax was imposed. 

Reasons for change 

The progressive tax rate structure for individuals is avoided if a 
grantor creates a trust to accumulate income taxed at low rates, and 
the income in turn is distributed at a future date with little or no 
additional tax being paid by the beneficiary, even when he is in a high 
tax bracket. This result oc^iurs because the trust itself is taxed on the 
accumulated income rather than the grantor or the beneficiary. 

The throwback rule (as amended by the Tax Eeform Act of 1969) 
modifies this result by taxing beneficiaries on distributions they receive 
from accumulation trusts in substantially the same manner as if the 
income had been distributed to the beneficiaries currently as it was 
earned. The 1969 Act made a number of significant revisions in the 
treatment of accumulation trusts. In applying the throwback rule to 
beneficiaries with respect to the accumulation distributions they re- 
ceive, the 1969 Act provided two alternative methods, as indicated 
above, the exact method and the shortcut method. A number of admin- 
istrative problems have resulted in the application of these alternative 
methods for both the Internal Revenue Service and the beneficiaries. 

For example, taxpayers are under an obligation, as a practical 
matter, to compute the throwback under the rule which results in 
the least tax ; thus, the shortcut method, which was intended to sim- 
plify calculations and eliminate recordkeeping problems involved with 
the exact method has not achieved this result because taxpayei-s nnist 
compute the tax under both methods. As a i-esult, the Congress believed 
it was more desirable to have one simplified inemod rather than hav- 
ing two alternative methods in applying the throwback mle. In the 
case of multiple trusts, however, the Congress was concerned about 
the potential tax avoidance use of such trusts. As a result, the Act 
provides a special rule in the case of accumulation distributions re- 
ceived by any beneficiary from three or more trusts. 

In addition, a number of questions were raised as to whether the 
capital gains throwback rule, which was enacted in the 1969 Act, 



161 

presented more complexity in its application than was warranted by 
the concerns raised in 1969 with respect to capital gains. The Congress 
believed it was appropriate to repeal the capital gains throwback rule 
and provided instead a rule to deal more directly with the transferring 
of appreciated assets by grantoi-s into trusts. 

The Congress also reviewed other aspects of the tax treatment of 
accumulation trusts and provided modifications to make the rules 
easier to apply and ]>e administered. For example, the Act provides an 
exemption for the income accumulated in a trust during the minority 
of a beneficiarv, as was provided in the law under the throAvback rule 
before 1969. 

Explanation of provisions 

The Act substitutes for the two alternative methods used in com- 
puting the throwback rule for accumulation distributions a single 
method, which is a revision of the present "shortcut" method. The new 
shortcut method provided under the Act determines (in etfect) the 
tax attributable to the distribution by averaging the distribution over 
a number of years equal to the number of years over which the income 
was earned by the trust. This is accomplished by including, for pur- 
poses of tentative computations, a fraction of the income received from 
the trust in the beneficiary's income for each of the 5 preceding years 
(rather than the 3 preceding years under present law).^ The fraction 
of the income included in each of these years is based upon the number 
of years in which the income was accumulated by the trust (as deter- 
mined under prior law). This average amount is added to the bene- 
ficiary's taxable income for these years (rather than requiring the re- 
computation of his tax returns as under prior law).^ 

Of these 5 preceding years, the j-ear with the highest taxable income 
and the year with the lowest would not be considered; m effect, then, 
the computation of the additional tax on the accumulation distribution 
under this shortcut method is based, as under prior law, on a 3-year 
average basis. 

In general, except as indicated below, the rules under the shortcut 
method continue to apply. Thus, if the accunudated income is attribu- 
table to 10 different years (although the trust may have been in exist- 
ence longer than 10 years), then one-tenth of the amount distributed 
would be added to the beneficiary's taxable income in each of the 3 
years. The additional tax is then computed with respect to these 3 
years and the average yearly additional tax for the 3-year period is 
determined. This amoinit is then nndtiplied by the iiumber of years to 
which the trust income relates (10 in this exauiple). The tax so com- 
puted may be offset by a credit for any taxes previously paid by the 
trust v/ith respect to this income and any remaining tax liability is 
then due and payable in the same year as the tax on the beneficiary's 
other income in the year of the distribution. Tender the Act, unlike 



^ The accunuilated Income which is to be Included in the beneficiary's Income for any year 
under the shortcut method is the income of the trust which v/ould have been included 
in the beneficiary's income if the trust had made the distributions currently rather than 
accumulating the income. As a result, the character of any tax-exempt interest would be 
carried with the accumulated income and, thus, would not be subject to tax to the 
beneficiary. 

" For purposes of adding the accumulated income to the taxable income of a beneiciary 
for a year, the beneficiary's taxable income may not be less than zero. Thus, if in any 
year to which the shortcut method applies a beneficiary has a net operating loss, the 
beneficiary's taxable income for that particular year will be treated as being zero. 



162 

under prior law, no refunds or credits are to be made to any bene- 
ficiary or a trust as a result of any accumulation distributions. 

The Act provides a special rule to deal with multiple trusts where a 
beneficiary receives an accumulation distribution from more than two 
trusts with res2:>ect to the same year. Under this rule, in tlie case of a 
distribution from the third trust (and any additional trusts) , the bene- 
ficiary is to recompute his tax under the revised shortcut method in the 
same manner as indicated above except that no credit is to be given 
for any taxes previously paid by the trust with respect to this income. 
The xVct provides a de Tninlmw rule under which this special nmltiple 
trust rule is not to apply. Under this de minimis rule, the special mul- 
tiple tinist rule is not to apply where an accumulation distribution from 
a trust (including all prior accumulation distributions from the trust 
to the beneficiary for that same year) is less than $1,000. 

The Act provides that the throwback rule is not to apply to any 
distributions of income accumulated for a beneficiary while he was 
a minor ; that is, before the birth of such beneficiary or before the bene- 
ficiary is 21 years of age. This exception for minors, however, is not 
to apply in the case of distributions covered mider the multiple trust 
rule. 

The Act also modifies the rules for determining when an accumula- 
tion distribution is made. Under prior law, if a trust had deductions 
taken into account in determining distributable net income, for ex- 
ample, fees which are chargeable to corpus, the trust accounting in- 
come (as defined under section 643(b) ) exceeded the distributable net 
income of the trust. In this case, a distribution of the current ^^ear's 
trust income to a beneficiary, which otherwise is technically the ac- 
counting income of the trust for the year, was treated as constituting 
an accmnulation distribution of the trust. To deal with this situation, 
the Act provides a rule that a distribution made or required to be made 
by a trust to a beneficiary in a year which does not exceed the income of 
the tnist for the year is not to be treated as an accumulation distribu- 
tion for that year. 

The Act also repeals the capital gain throwback rule under prior 
law. The Act, however, provides a special nile to cover the possible 
abuse where the grantor places in trust property which has unrealized 
appreciation in order to shift the payment of tax to the trust at its 
lower progressive rate structure (sec. 644). I"rnder this rule, where 
the fair market value of property which is placed in trust exceeds 
the price paid (if any) for the property by the trust (i.e.. where there 
is any bargain element in connection with the transfer) and where 
the ti-ust seils the property within two years of its transfer to the 
trust, the tax on the gain (called the "includible gain") to the trust 
will be equal to the amount of additional tax the transferor would 
have paid (including any minimum tax ^) had the gain been included 
in the gross income of the transferor for his taxable year in which 
the sale occurred. In essence, the Act treats such gains as if the trans- 
feror had realized the gain and then transferred the net proceeds from 
the sale aftertax to the trust as corpus. 

»For purposes of computing the minimum income tax portion of tlie section 644 tax, 
the amount of tax paid by the transferor shall be deemed to include the tax determined 
under section 644 other than the portion attributable to the application of the minimum 
Income tax. 



163 

However, where the transferor dies before the sale within the two- 
year period, so that it would not be possible to use the rate brackets of 
the transferor, the Act makcvS the provision inapplicable. Consequently, 
in such a case, the tax on the gain would be taxed at the trust's rates. 
In addition, in order to prevent circumvention of the two-year period 
through a short sale during such period, the Act contains a rule which 
extends two-year period to the closing of tlie short sale. 

For purposes of determining whether the property is a capital asset 
subject to favorable capital gains treatment, the Act contains a rule 
under wliich the character of the property is to be determined by 
looking to the character of that property in the hands of the trans- 
feror. Consequently, where section 644 applies, the gain on the sale 
of the property will not be eutitled to capital gains treatment if the 
property would not have been a capital asset in the hands of the trans- 
feror even if the property is a capital asset in th.e hands of the trust. In 
addition, the Act contains a i-ule which attributes the activities of the 
trust with respect to the property to the transferor for this purpose. 
In effect, the provision treats the trust as the agent of the transferor 
so that the trust's activities are attributed to the transferor. 

The "includible gain" is the lesser of the amount of gain recognized 
by the trust or the amount of gain that the trust would have realized 
had the property been sold immediately after it was transferred to 
the trust.^ Therefore, the transferor cannot use the trust's lower pro- 
gressive rate structure to tax gain that occurred while he owned the 
property. Any additional gain that occurs after the property is trans- 
ferred to the trust is subject to the normal rules for gains idealized by 
the trust. 

In order to prevent double taxation of the "includible gain", the 
Act excludes the includible gain from the taxable income of the trust. 
Thus, the tax on the remaining income of the trust (including addi- 
tional gain on the property occurring after the transfer to the trust) 
will be computed without i-egard to that includible gain. Similarly, 
since the includible gain is excluded from the trust's taxable income 
that gain is not included in the trust's distributable net income and, 
consequently, the includible gain also will not be taxed to the bene- 
ficiary if the gain is currently distributed to him. Moreover, since the 
includible gain is not in the trust's distributable net income, that gain 
will not be subject to tlie accumulation distribution rules (under sub- 
part D) where the gain is first accumulated and then distributed m a 
subsequent year. 

Where the trustee of the trust does not have sufficient information 
about the transferor to compute the tax on the includible gain, it is 
expected that the Internal Revenue Service will issue regulations 
under which the trustee will state in tlie tax return that he does not 
have sufficient information and that, in such a case, the Service will 
computi^ (he tax attributable to that gain. It is also expected that the 



* TTnder the Act. the basis of the property for purposes of determining tlie amount of 
the "incluclii)le sain'' is tiie trusts basis immediately after its transfer to the trust. Con- 
seqiiently. this basis includes any increases in basis under section 101.5(d) (relating to 
Increased basis for gift tax paid). The bill also contains special rules -n-here the trust sells 
the propertj within the two-year period and elects to report the gain on the installment 
sales method of accoiinting (sec. 453). In such a case, the provision is intended to treat 
each installment as if it were a separate sale or exchange subject to the special two- 
year rule. 



164 

Service will issue regulations providing rules where the transferor has 
capital or net operating losses and where the transferor's taxable in- 
come or tax is affected by subsequent events such as a loss cany- 
back or adjustment by the Internal Revenue Service. The special 
rale on transfers of appreciated property is not to apply to property 
placed in charitable remainder trusts or pooled income funds or to 
property acquired by a trust from a decedent. 

There will be some cases where, because the trust is on a fiscal year, 
it will not be ix)ssible for the trustee to ascertain the tax that the trans- 
feror would have paid had the transferor realized the gain because the 
sale occurs within a taxable year of the transferor which ends after the 
end of the taxable year of the trust in which the sale occurs. For ex- 
ample, assume that the transferor uses a calendar year and the trust 
uses a fiscal year ended June 30, the transferor transfers appreciated 
property to the trust in 1977, and the trustee sells the property during 
the fii-st six months of calendar year 1978. In such a case, the tax re- 
turn of the trust for the year in which the sale occurred (fiscal year 
ending June 30, 1978) is due on October 15, 1978. However, the tax re- 
turn of the transferor for the year in which the sale occurred (calen- 
dar year 1978) is not due until April 15, 1979. In such a case, the Act 
provides a rule under which the trust will report the gain in its tax 
return due Octi)ber 15, 1979, but the tax on the gain will be increased 
by an additional amount representing, in effect, the interest on the one- 
year delay in reporting the gain. Where the trust terminates during 
this one-year period, it is contemplated that the Treasury will issue 
regulations making such gain reportable in the return of the trust for 
its last taxable year. 

Effective date 
The amendments made by this provision to the acxiumulation dis- 
tribution rules are to apply generally to distributions made in trust 
taxable years beginning after December 31, 1975. The amendment 
made with respect to the taxation of gain arising from sales of prop- 
erty within two years of its transfer in trust are to apply to transfers 
made after May 21, 1976. 

Revenue effect 
It is estimated that this provision will not have a significant effect 
on budget receipts. 



G. CAPITAL FORMATION 

1. Investment Tax Credit — Extension of 10-Percent Credit and 
$100,000 Limitation for Used Property (sees. 801 and 802 of the 
Act, sec. 46 of the Code, and sec. 301(c)(2) of the Tax Re- 
duction Act of 1975) 

Prior law 

Prior to the Tax Reduction Act of 1975, a 7-percent credit was avail- 
able for qualified property (4 percent in the case of certain public 
utilities). Inv^estnient in qualified used property eligible for the credit 
was limited to $50,000 per taxable year. 

The Tax Reduction Act of 1975 temporarily increased the rate of the 
investment tax credit for all taxpayers (including certain public utili- 
ties) to 10 percent for the period beginning January 22, 1975, and end- 
ing December 31, 197G. A corporate taxpayer could elect an 11-percent 
credit during this period if an amount equal to 1 percent of the quali- 
fied investment was contributed to an employee stock ownership plan. 
xA.lso, in the case of public utilities, the limitation on the amount of tax 
liability that could be olFset by the investment tax credit in a year was 
increased from 50 percent to 100 percent during 1975 and 1976, and 
then reduced gradually (by 10 percentage points per year) back to 
the 50-percent level in 5 subsequent years. In addition, the limitation 
on qualified investment in used property was temporarily increased 
to $100,000 until January 1, 1977. 

Reasoi^s for change 
Real investment in plant and equipment declined severely in 1975, 
grew rather modestly in 1976, and prospects for a substantial increase 
in investment in 1977 did not appear to be strong. Real nonresidential 
fixed investment has fallen from a high of $131 billion in 1973 to an 
annual rate of $117.7 in the third quarter of 1976. Provision of the 
10-percent investment credit over a longer period of time is essential 
to permit business to properly plan their investment projects without 
a substantial bunching of projects, which could, in the short run, bid 
up the price of capital goods. Encouraging investment in new equip- 
ment and modernization of existing equipment will improve the long- 
run ability of the economy to achieve economic growth consistent with 
past rates of gi'owth without inflationary pressures. Also, increasing 
aggregate demand by increased investment incentives constitutes an 
important element in a balanced program of economic recovery. 

Explanation of provinon 
The Act extends the temporary increase in the investment credit to 
10 percent for four additional years, through 1980, and similarly ex- 
tends the increase to $100,000 in the litnit on used property through 
1980. Under the Act, the credit will reveit to 7 percent (4 percent in 



(165) 

234-120 O - 77 - 12 



166 

the case of certain public utilities) and tlie used property limit will 
drop to $50,000 in 1981. 

Effective date 
These provisions are effective for taxable years beginning after 
December 31, 1975. 

Revenue effect 
It is estimated that these provisions will reduce budget receipts by 
$1,300 million in fiscal year 1977, $3,306 million in fiscal year 1978, 
and $2,444 million in fiscal year 1981. 

2. First-In-First-Out Treatment of Investment Tax Credits (sec. 
802 of the bill and sec. 46 of the Code) 

Prior law 

In general, the amoimt of investment credit used in any year camiot 
exceed $25,000 of tax liability plus 50 percent of any liability in excess 
of $25,000, (In the case of public utilities, the Tax Reduction Act of 
1975 raised the percentage to 100 percent in 1976, 90 percent in 1977, 
and so forth, dropping back to 50 percent by 1980.) A 3-year carryback 
and 7-year carryforward is then applied to credits which are not 
used l>ecause of the tax liability limitation. (A 10-year carryforward 
is available for pre-1971 credits.) Generally, under prior law, invest- 
ment credits earned in a particular year beginning with 1971 were 
applied first to the tax liability for that year, after which caiTyovers 
and carrybacks of unused credits from other years were applied. 

In the case of carryovers of unused investment credits earned in 
pre-1971 tax years, prior law provided that these credits were to bo 
used before current year credits were used. 

Reasons for cJiange 

It was brought to the attention of the Congress that many taxpay- 
ers with substantial amounts of investment credit carryovers which 
arose in the pavSt would not l>e able to use these credits because low 
levels of taxable income or net operating losses incurred in recent 
years have prevented use of the credits. Credits arising in the future 
would completely absorb the limitation and thus prevent the use of 
the carryovers. The Congress was concerned that the desire of tax- 
payers to use investment credit carryovers as (juickly as possible 
could significantly dampen the stimulative effect of the investment 
credit on new investments because these taxpayers may be less likely 
to make new investments while they have carryover credits which the 
new in^'estments might cause them to lose. 

As a result, the Act changes the genei-al oi'dering scheme for absorb- 
ing investment tax credits to better facilitate the use of cariyover 
credits. 

ExflanatioTi of froxnsions 
The Act extends the approach adopted for prc'-1971 credits (by 
the Revenue Act of 1971) to require generally that investment credits 
earned first are to be utilized first regardless of whether the credits 
were eaiiied in the current year or are carryback or carryover credits. 
In determining the application of investment credits for a taxable 



167 

year under this first-in-first-out (P'IFO) method, carrj'over credits 
from prior taxable years are used first, up to the amount of the tax 
liability limitation. To the extent the limitation exceeds the amount of 
cai'ryover credits, current year and then carryback credits may be 
applied. 

An exception to this general rule is provided to reflect Congress' 
concern that taxpayers be permitted a maximum utilization of their in- 
vestment ci-edit carryovers under the first-in-first-out method. It was 
noted that the converee of the general rule, that investment credits 
earned first will also expire first, while generally applicable, does not 
result for tax years ending in 1978, 1979, and 1980. This dichotomy 
arises because pre-1971 credits receive a 10-year carryover while 
credits earned in later years may be carried over for 7 years. It results, 
for example, in the expiration of 1971 investment credits at the end 
of the 1978 taxable year (assuming there are no short taxable periods) 
while credits earned in 1969 could be carried over not only to 1978 but 
also to 1979. In order to better enable the earlier expiring (but later 
earned) inv^estment credits to be used, the Act provides that a carryover 
of a pre-19Tl credit will be postponed to the extent its applicati(m in a 
carryover year will cause all or part of an investment credit from a 
}X)st-1970 year to expire unused at the end of that carryover year. 
In the above example, if the limitation for 1978 will not enable both a 
1969 credit carryover and a 1971 credit carryover to be absorbed, the 
1971 carryover is to l)e used first after which the 1969 carryover may 
be used. This provision does not in any way extend the number of 
carryover years available for investment credits earned under either 
the 10-year or 7-year rules. 

Effective date 
These provisions are effective for taxable j'ears beginning after 
December 31, 1975. 

Revenue effect 
It is estimated that these provisions will result in a decrease in 
budget receipts by less than $5 million in fiscal year 1977 and 1978, $5 
million in 1979, aiid $20 million in 1980. 

3. ESOP Investment Credit Provisions (sec. 803 of the Act; 
sees. 46(f), 401(a), 415(c), and 1504(a) of the Code; sees. 
301(d) and 301(e) of the Tax Reduction Act of 1975; and sec. 
3022(a) of the Employee Retirement Income Security Act of 
1974) 

Prior law 

Employee compensation paid in the form of employer contributions 
under an employee stock ownership plan (ESOP) is treated as de- 
ferred compensation for tax purposes; that is, the employee generally 
is not taxed on these employer contributions until they are distributed 
under the plan. 

ESOPs are generally designed to be tax-qualified plans. In order 
to qualify, a plan nuist, for example, satisfy rules prohibiting discrim- 
ination in favor of highly paid employees, and it must meet standards 



168 

relatin<i: to employee participation, vesting, benefit and contribution 
levels, the form of the benefits, and the security of the l)enefits. Al- 
though, in limited circumstances a contribution to a plan can be with- 
drawn by the employer if it is made by mistake, the tax law does not 
permit withdrawal of a contribution merely because it is not deducti- 
ble. 

Under the tax law, if a plan meets these requirements, in addition 
to deferral ot employee tax on employer contributions the employer 
is allowed a deduction (within limitations) for his contributions for 
the year the contributions are made, the income earned on assets held 
imder the plan is generally not taxed until it is distributed, special 
10-year income averaging rules and nonrecognition of gain rules apply 
to distributions made in a lump sum, and estate and gift tax exclu- 
sions may be provided. 

An E80P uses a tax-qualified stock bonus plan ^ or a combination 
of a qualified stock bonus plan and a qualified stock money pension 
plan.^ It IS a technique of corporate finance designed to Iniild beneficial 
equity ownership of shares in the employer corporation into its em- 
ployees substantially in proportion to their relative incomes, without 
requiring any cash outlay on their part, any reduction in pay or other 
employee benefits, or the surrender of any rights on th.e part of the 
employees. 

Under an ESOP, an employee stock ownership trust generally 
acquires stock of the employer with the proceeds of a loan made to it 
by a financial institution. Typically, the loan is guaranteed by the 
employer. The employer's contributions to the employee trust are 
applied to retire the loan so that, as the loan is retired, and as the 
value of the employer stock increases, the beneficial interest of the 
employees increases. Of course, if the employer fails to make the 
required contributions, or if the value of the employer's stock declines, 
the beneficial interest of the employees declines. 

Under prior law, if a qualified investment were made before January 
1, 1977, an extra percentage point of investment credit (11 percent 
rather than 10 percent) was allowed where the additional credit 
amount was contributed to an ESOP which satisfied the requirements 
of the Tax Reduction Act of 1975. Under that Act, the ESOP, wliether 
or not tax-qualified, must satisfy special rules as to vesting,'- employee 
participation,* allocation of employer contributions,^ l)enefit and con- 
tribution limits," and voting of stock held by a trust under the 
plan.'^ The vesting, allocation, and voting rules are generally con- 

' A quaUfled stock bonus plan Is required to distribute benefits in the form of employer 
stock. 

' A pension plan which Invests In employer securities, and under which employer con- 
tributions are credited to the separate accounts of employees. An employee's benefits 
under such a plan are based upon the balance of his account. 

' Each participant's right to stock allocated to his account under these rules must be 
nonforfeitable.. 

* The ESOP must satisfy the same participation rules applicable to qualified plans. 

5 An employee who participates in the plan at any time during the year for which an 
employer contrilnition is made is entitled to a share of the employer contribution, based 
upon the amount of compensation paid to him l)y the employer. Only the first .$100,000 
of employee compensation is considered for purposes of the plan. 

'The ESOP is subject to the same benefit and contribution limitations applicable to 
qualified plans. 

■^ Employees must be entitled to direct the voting of employer stock allocated to their 
(iccount^i under the employee trust. The plan need not permit employees to direct the 
voting of unallocated employee stock held by the trust. 



169 

sidered more favorable to rank and file employees than those which 
have been required for tax qualification. 

Reasons jov change 

Several problems arose under the prior investment tax credit rules 
designed to encourage the adoption of ESOPs, For example, because 
the additional investment tax credit was only available for a short 
period, many employers did not become aware of it in time to establish 
an ESOP. This lag in recognition of the new provisions and uncer- 
tainty as to how they would be applied probably accounts for the 
modest number of ESOPs established under the prior investment 
tax credit rules. Also, because of the short period during which in- 
vestments could qualify for the additional credit, some employers 
found that the cost of establishing an ESOP under the investment 
tax credit rules was unreasonably high in relation to the benefits of 
the plan. 

Tlie investment tax credit recapture and redetermination rules were 
another factor which discouraged the adoption of ESOPs. Under 
those rules, if a portion of the additional investment tax credit was 
recaptured or the credit was redetermined by the Internal Revenue 
Service to be a smaller amount than claimed, the employer had to bear 
the cost of repaying the excess credit; it coidd not recover that cost 
directly or indirectly from an employee trust under an ESOP. 

Special problems discouraged the adoption of ESOPs by regulated 
utilities. Publicly regulated utilities were reluctant to establish ESOPs 
under the investment tax credit rules because they were concerned that 
regulatory commissions would require that the additional investment 
tax credit be "flowed-through" to customers. If the regulatory com- 
missions took that position, the utilities would be required, in effect, 
to pay out the additional investment tax credit twice — once to the 
ESOP and then again to the customers. 

Explanation of provislo7is 

(a) General Rules 

Effective for years beginning after 1976, the Act extends the addi- 
tional one-percent credit program to qualified investments made before 
January 1, 1981. x\lso, if an employer supplements its contributions 
under the one percent credit program by matching employee contiibu- 
tions to the P]SOP, beginning in 1977 the Act allows an extra invest- 
ment credit (up to an extra one-half percentage point of qualified in- 
vestments) for the employer's supplementary contributions which are 
matched by employee contributions. Under the Act, separate accoimt- 
ing is required for matching employee and employer contributions. 
Uontinuing prior law treatment, an employer contribution for a tax- 
able yeai- in excess of the amount attributable to the additional credit 
allowed for tbat year is deductible for that year, subject to the usual 
rules for deduction of contributions to employee plans. 

ITnder the Act, employer and employee contributions are subject to 
the overall benefit and contribution limitations applicable to employee 
plans. (The Act continues prior law under which employer contribu- 
tions to investment credit ESOPs were subject to these limitations.) 



170 

The limitations may restrict the amount of the additional one-half 
percent investment credit allowable. 

Tlie Congress intends that employee contributions can be taken into 
account for the additional credit it' they are contributed to the plan 
before the end of the year in which the credit is allowed or if the 
contributions are pledged bj' the employees to be paid within 2 years 
after the close of that year and the j)ledgo is made before the return 
for the year is filed. If employee contributions are made in excess of 
the amount pledged and are matched with employer contiibutions. 
additional credit can be claimed by the emi>loyer for the year the 
(|ua]ified investment was made. Under the Act, employee contributions 
made under the matching rules are to l)e invested in employer securities 
under the same rules that apply to employer contributions. 

Also, under the Act, emploj^ee contributions to an investment credit 
ESOI^ are subject to the same antidiscrimination ndes as apply to 
employee contributions imder a tax-qualified pension plan, and matche'l 
emploj^ee contributions are subject to the same lestrictions on distribu- 
tion as employer contributions of investment credit (generally, no 
withdrawal is permitted for 84 months). 

Under the Act, em.ployee contributions cannot be compulsory ; that 
is, employee contributions may not be made a condition of employment 
or a condition of participation in the plan. Of couise, the level of 
employer-derived benefits under the matching rules depends u})on 
employee contributions. 

FJoic-fhrough of investment tax credit. — Because the entire addi- 
tional investment tax credit is intended to go to the employees partic- 
ipating in an ESOP, the Act provides that the entire investment ( redii 
is not available to a company if a public service commission requires 
a utility to flow through any part of that additional credit (claimed 
for taxable years ending after 1075) to the consumer. 

Recapture and redetermimitimi of tax credit. — Where, an invest- 
ment credit is subject to recapture or a company's income or investment 
is redetermined with the result that the investment tax credit is de- 
creased, ur^der the Act, the amount v)f decrease can be applied to off- 
set employer contributions for other years. Alternatively, the Act 
allows a deduction for disallowed or recaptured credit which was con- 
tributed to an ESOP. As a further alternative, the Act permits an 
employer to recover recaptured credit from an ESOP. (See ^''With- 
drawal of contrihutions''' below.) 

Time of contrihution. — Where the full amount of investment tax 
ciedit is not allowed for a year because the ci'edit is limited on the 
basis of the tax for the year, the Act provides that the additional 
credit can be contributed to the plan as it is allowed. Also, the Congress 
intended that if the investment credit is carried back from the year 
of investment in qualifying property to a prior year, the additional 
investment credit wliich is allowed as a result of the carryback is to 
be contributed to the ESOP for the year of the investment and is to 
be allocated to plan participants in the same manner as if it had been 
allowed in the year of investment. 

Administrative expenses. — Limited amounts of "start up" and ad- 
ministrative expenses for establishing an ESOP can be charged against 
the additiona,! investment credit contributed to an ESOP. The maxi- 



171 

mum amount of stait up costs which may be charged is 10 percent of 
the first $100,000 of the amount required to be transferred to the ESOP 
for the taxable year for which tlie plan is established, and 5 percent of 
any additional amount for such year. In addition, under the provision, 
on'-<::oino: costs of administration (up to 10 percent of the first $100,000 
of the trust's dividend income plus 5 percent of the remaining dividend 
income, but in no evont move than $100,000) may also be charged to an 
ESOP. 

Definition of employer securities. — In order to extend the benefits 
of employee stock ownership to •'brother-sister" corporations and "sec- 
ond-tiei--' parent-subsidiary groups, the provision permits the stock of 
a member of a controlled group of corporations to be used as employer 
securities for another ]neml>er of the group. This rule also permits the 
stock of a parent corporation to be used as employer securities with re- 
spect to a subsidiary where the parent owns 80 percent or more of the 
subsidiary's voting stock but does not own at least 80 percent of the 
subsidiary's non^ oting stwk which is limited and preferred as to div- 
iilends. In this situation, the subsidiary's stock could also be used as 
employer securities. 

Consolidated returns. — The Act provides that the rules for deter- 
mining whether there is a sufficient affiliation between corporations 
to permit the filing of a consolidated return are applied without regard 
to employer securities held by an ESOP. 

C oinpensation. — Under the provision, a participant's compensation 
is defined to be the same as under rules of the Code which limit con- 
tributions to qualified plans (sec, 415). 

Perm/inent plan. — The Act makes clear that an ESOP which satis- 
fies the investment tax credit rules does not fail to be a permanent pro- 
gram merely because employer contributions are not made for a year if 
the additional investment tax credit is not available for the year (for 
reasons other than the employer's failure to make the contribution). 

Other provisions. — In situations where the value of employer stock 
can be expected to increase rapidly, the rule of prior law limiting 
the annual addition to the account of a participant in a defined con- 
tribution plan to $25,000 (plus a cost-of-living adjustment) may dis- 
courage the establishment of an ESOP designed to acquire employer 
stock from a present shareholder by causing the shareholder to suffer 
an unacceptable level of dilution of his interest in the company. In 
order to remove this barrier to ESOPs, the Act doubles the dollar 
limitation provided by present law in the case of defined contribution 
plans but the additional amount may only consist of employer securi- 
ties. Also, under the Act, the limitation on benefits which may be pro- 
vided under a defined benefit plan would be reduced where the 
additional defined contribution limitation is allowed for an ESOP. In 
order to assure that the doubled allowance is not available to a plan 
unless rank-and-file employees are the chief beneficiaries of the plan, 
however, under the Act the doubled allowance is not available for a 
plan if more than one-third of the employer contributions to plan for a 
year are allocated to employees who are officers or shareholders, or 
whose compensation for the year exceeds twice the amount of the 
dollar limitation ordinarily applicable to the annual addition to the 
account of a paiticipant in a defined contribution plan. (This is not 
intended to aifect any determination of which employees are consid- 



172 

ered highly compensated for purposes of the coverage and nondiscrini- 
ination requirements applicable to qualified plans generally.) For 
this purpose, employees who hold 10 percent or less (determined with 
attribution rules) of the employer's stock (outside of the ESOP) are 
not considered shareholders. 

Withdrawal of contrihiitions. — If the plan provides, the Act per- 
mits funds contributed by the employer to be withdrawn from an in- 
vestment credit ESOP (1) to refund employer contributions which 
are not matched by employee contributions within the period specified, 
or (2) to permit the employer to recover from the ESOP any portion 
of the employer's contribution which is recaptured from the employer 
under the investment credit rules (for example, where the property 
for which the credit is claimed is disposed of prematurely). The Act 
provides that the withdrawal of employer contributions made under 
the one-half percent credit rules because they are not matched by em- 
ployee contributions, or a recovery of employer contributions under 
the recapture rules, will not cause the plan to be considered as other 
than for the exclusive benefit of employees and that employee rights 
to employer-derived benefits under the plan Mill not be considered 
forfeitable merely because employer contributions of investment 
credit may be withdrawn under the matching or recapture rules. The 
Act does not permit an employer to recover recaptured investment 
credit unless the employer contributions for each year are separately 
accounted for (all contributions made before enactment of the Act 
can be aggregated for this purpose) . 

Under the Act, employee funds contributed to an investment credit 
ESOP are subject to employee withdrawal unless they are matched by 
employer contributions under the one-half percent credit rules. For 
example, if matching employer or employee contributions cannot be 
made because of the overall limitations on benefits and contributions 
(sec. 415 of the Code), the unmatched employee contributions would 
be refunded to the employee (unless he instructs the plan to the 
contrary). 

(h) Employee Stock Ownership Plan Regulations 

The Act reaffirms Congressional intent with respect to employee 
stock ownership plans and expresses concern that administrative niles 
and regulations may frustrate Congressional intent. In this connec- 
tion, it has come to the attention of the Congress that proposed regu- 
lations issued by both the Department of the Treasury and the Depart- 
ment of Labor on July 30, 1976, may make it virtually impossible 
for ESOPs, and especially leveraged ESOPs, to be established and 
function eflfectively. The following areas are of specific concern to the 
Congress. 

(1) Independent third party. — The proposed rules would prohibit 
loans (or loan guarantees) by fiduciaries to employee stock ownership 
plans unless the loans are arranged and approved by an independent 
third party. These rules would, for example, prevent a bank which 
serves as trustee for an ESOP from making a loan to the plan and 
would prevent the employer-fiduciary who established the plan from 
providing a loan guarantee. 

In view of other rules presently in effect, which require that the 
interest rate for any such loan be reasonable, that the loan be primarily 



173 

for the benefit of participants or their beneficiaries, and that the only 
collateral the plan can give the lender is the employer's stock pur- 
chased with the loan proceeds, the requirement of an independent 
third party is unduly burdensome. Consequently, the Congress believes 
that the regulations should deal directly with possible abuses which 
may occur in the administration of plans rather than attempting to 
require a plan to incur the burden of dealing through an independent 
third party. Similarly, the Congress believes that an independent third 
party should not be required to arrange and appi'ove a sale of stock 
between an employer (or shareholder of the employer) and an ESOP. 
The Congress has not considered whether the principles applicable to 
ESOPs in connection with loans to the plan or sales of employer stock 
vshould apply in the ease of other exemptions fi'om the prohibited 
transaction rules and, accordingly, no inference, should be drawn 
regarding those other exemptions. 

(2) Put option. — The proposed regulations would require that an 
emploj'er provide each employee who receives stock from a leveraged 
ESOP or an investment credit ESOP with a 2-year "put option'' if 
the stock is not listed on an exchange. 

Although the Congress agrees that a mai-ket should be provided 
for employer stock distributed by an ESOP to an employee, the Con- 
gress believes that a put option for a period considerably shorter tiian 
two years will properly protect emploj^ees and that a put under which 
the employer must pay for tendered stock over too short a period would 
effectively deny the employer the benefits of capital formation the 
Congress sought to provide under an ESOP. On the contrary, the 
Congress believes that the payment by the employer could be made 
in substantially equal installments over a reasonable periovl, taking 
into account the need to protect the interests of employees and the need 
of the employer for capital. 

(3) Stock pureh/is-ed with loan jn^oceeds. — Under the proposed regu- 
lations, if an ESOP holds employer stock which it purchased with 
the proceeds of a loan, the stock is to be placed in a suspense account 
from which it is to be released under a formula. The fonnula provided 
b}^ the proposed regulations, however, is not in accordance with the 
common business practice under which the stock is released from the 
account as loan principal is amortized. 

The Congress believes that the regulations should allow the stock to 
be released as the loan principal is repaid if (a) the principal is 
amortized over a reasonable period (taking into account the facts and 
circumstances, including the interests of plan participants and the 
employer's need for capital), and (b) the employees are adequately 
informed regarding their rights to employer stock held by the plan. 

(4) Allocation of stock. — Under the proposed regulations, employer 
stock acquired by an ESOP with loan proceeds must be allocated to 
plan participants as it is released from the suspense account discussed 
in (o) above. The Congress believes that the regulations should permit 
the allocation of stock to be made in accordance with a formula more 
similar to that provided for ESOPs in the Trade Act of 1974 (19 
U.S.C.§ 2373(f) (4)). 

(5) Voting rights. — The proposed regulations would require that 
employees be permitted to direct the voting of employer stock alio- 



174 

cated to their accounts under a leveraged ESOP even though other 
types of employee plans need not provide employees with these rights. 
(The Tax Reduction Act of 1975 requires that employees be permitted 
to direct the voting of employer stock allocated to their accounts under 
an investment credit ESOP but not under other ESOPs.) The Con- 
gress believes that the regulations should not distinguish between lev- 
eraged ESOPs and other employee plans in this regard. 

(6) Dividend restrictions. — Under the proposed regulations, em- 
ployer stock held by an ESOP must have unrestricted dividend rights. 
However dividend restrictions are comuKmly required in connection 
with loans. Consequently, the Congress believes that such restrictions 
should be permitted if they are required in connection with a loan \o 
the ESOP for the purchase of employer securities (but only if the 
restrictions terminate when the loan is repaid) or if they apply also to 
a significant portion of the employer stock not held by the ESOP. 

(7) Right of first refusal. — The proposed regulations prohibit a 
leveraged ESOP from acquiring, with the ]>roceeds of a loan, employer 
stock subject to a right of first refusal. Because the shareholders of 
many corporations (especially smaller businesses) believe that a right 
of first refusal is necessary to protect their interests, the Congress be- 
lieves that the prohibition will have a chilling effect upon the estab- 
lishment of ESOPs and that a right of first refusal should not be 
proscribed. 

(8) Treatment of sah as redemption. — Under the proposed regula- 
tions, the sale of stock by a corporate shareliolder to the corporation's 
ESOP could, depending upon the facts and circumstances, be treated 
as a redemption of the stock by the corporation. If the sale is treated 
as a redemption, the proceeds of the sale could be considered dividend 
income rather than capital gain. The Congress believes that if such a 
rule is authorized and proper, its application should not be restricted 
to ESOPs and that it should be applied only where the stock sold by 
the shareholder inures to his benefit (or the benefit of related parties) 
under the plan. 

(9) Nonvoting common stocky etc. — The proposed regulations im- 
pose special rules on ESOPs which limit the extent to which the plan 
can acquire employer securities, other than voting common stock with 
unrestricted dividend rights, with the proceeds of a loan. (The Tax 
Reduction Act of 1975 does not allow the additional investment credit 
for nonvoting employer stock.) The Congress believes that the usual 
rules applicable to employee plans properly protect the interests of 
plan ]>articipants and that these s[>ecia] lules are not needed. 

(10) Prepayment penalty. — The i)i-o[)ose(l regulations si)ecifically 
prohibit any loan made to an ESOP from containing a i)rovision for 
a prepayment penalty. The ("ongress believes that the (|ue^stion of such 
penalties should be a matter of negotiation between the ESOP and the 
lender and that prepayment penalties should not be i)ro]iibited in all 
cases. (They should not be allowed of coui-se if, for example, payment 
of a penalty would be imprudent.) 

(11) No calls or other options. — The proposed regulations prohibit 
stock acquired with an ESOP loan f lom being subject to any calls or 
options (other than the put option described in (2) above). There is no 
prox'ision for restrictions which may be requir-ed by State or Federal 



175 

law. The Congress believes that in the limited situation where restric- 
tions are imposed by law, stock in an ESOP should be permitted to 
have restrictions necessary to comply with the law. 

(12) Comparability. — Tlie proposed regulations do not permit an 
ESOP and another plan to be considered a single plan for purposes of 
determining whether the jjlans meet the anti-discrimination require- 
ments of the tax law. Although the Congress agrees that an ESOP and 
another type of plan sliould not be considered a single plan for this 
purpose, the Congress believes that this rule should not be applied to 
disqualify a plan already in existence and that two or more ESOPs 
can be considered as a single plan in testing the coverage and con- 
tril?utions or benefits under the pi ans. 

As stated in the Report of the Senate Finance Committee on the 
bill, an ESOP is designed to "build equity ownership of shares in 
the emplover corporation into i+s employees substantially in propor- 
tion to their relative incomes." (S. Kept. No. 94-938, p. 180.) The 
Congress understands that, under the proposed regulations, an ESOP 
could be integrated with the social security system so that employer 
stock would not be allocated to employees substantially in proportion 
to their compensation. The Congress believes that social security inte- 
gration is not consistent with the purposes of an ESOP. The Con- 
gi-ess believes, however, that a prohibition on integration should not 
apply to ESOPs which were integrated at the time the Act was 
enacted. 

(13) Inferences. — Although the Congress has commented on the 
merits of the proposed regulations, these comments should not be 
taken as inferring approval or disapproval of the provisions not com- 
mented upon. 

(c) Study of Expanded Stock Ownership 

The Act changes the name of the existing Joint Pension Task 
Force to the Joint Pension, Profit-sharing and Emplo^/ee Stock Owner- 
ship Plan Task Force, and provides that the Task Force is to study 
employee stock ownersliip plans. The Task Force, which may con- 
sult others who have information concerning employee stock owner- 
ship plans, is to report its findings to the Committee on Ways and 
Means and the Committee on Education and Labor of the House and 
the Committee on Finance and the Committee on Labor and Public 
Welfare of the Senate by March 31, 1978. 

Effective date 
The additional one-half percent investment tax credit applies for 
taxable years beginning after December 31, 1976. The investment 
credit "flow through" provisions apply for taxable years beginning 
after December 31, 1975. The special limitation on contributions for 
ESOPs applies for taxable years beginning after December 31, 1975. 
The other provisions generally apply for taxable years beginning 
after December 31, 1974. 

Revenue effect 
The general provisions for the one and one-half percent investment 
credit ESOPs are expected to decrease revenue by $107 million in 
fiscal 1977, $257 million in fiscal 1978, $303 million in fiscal 1979, $332 



176 

million in fiscal 1980, $189 million in fiscal 1981. The regulations and 
study provisions have no effect on revenue. 

4. Investment Credit in the Case of Movies and Television Films 
(sec. 804 of the Act and sec. 48 of the Code) 

Prior law 

Under the tax law, taxpayers are entitled to receive an investment 
credit for tangible personal property (i.e., section 38 property) which 
is placed in service by the taxpayer. In order to receive the full credit, 
the property placed in service by the taxpayer must have a useful life 
of at least 7 years. If the property has a useful life of at least 5 years 
(but less than 7 years) the taxpayer is entitled to two-thirds of the 
full credit. If the property has a useful life of at least 3 years (but 
less than 5 years) the taxpayer is entitled to a one-third credit. In ad- 
dition, there cannot be any predominant foreign use of the property 
during any taxable year, or the property will cease to qualifj^ as sec- 
tion 38 property. 

Prior to 1971, it was not clear whether (and if so, under what con- 
ditions) the investment credit was available for movie or television 
films. However, a court case had held that movie films were tangible 
personal propert}^ eligible for the investment credit. During the legis- 
lative consideration of the Kevenue Act of 1971, it was made clear that 
motion pictures and television films are to be treated as tangible per- 
sonal property eligible for the investment credit (i.e., section 
38 property). However, this issue was still being litigated for years 
prior to 1971, and there were still a number of other unsettled issues, 
such as how to determine the useful life of a film, the basis on which the 
credit is to be computed, and how to determine whether tliere has been 
a predominant foreign use of the film. 

Reasons for change 

Due to the uncertainties of prior law with respect to the questions 
of useful life and predominant foreign use, it was often difficult to 
determine whether a film was entitled to a full credit, a partial one- 
third or two-thirds credit, or possibly no credit. Congress felt that it 
was desirable to clarify these issues, in order to avoid costly litigation 
with respect to the past, and to allow accurate investment planning for 
the movie industry in future years. 

To achieve the objective set out above, the Act, for past years, allows 
taxpayers to determine their investment credit on a film-by-film basis 
in accordance with certain statutory rules prescribed under the Act 
with respect to useful life and predominant foreign use, or to elect to 
take a 40-percent compromise credit for all their films, regardless of 
the actual useful life or foreign use of any particular film. The Con- 
gress believes that this 40-percent figure represents a fair compromise 
between the litigating position of the Internal Kevenue Service, on 
the one hand, and members of the industrv, on the other hand. 

In addition, since the major purpose of the investment credit is to 
create jobs in the United States, the Act provides that for the future 
the amount of the investment credit in the case of movie films is to de- 
pend on the plac^ of production of the film (i.e.. United States or 
foreign), rather than on the place where revenues are received for 
showing the film. Thus, the foreign use test will not apply to movie 



177 

films for the future. As a further incentive to encourage U.S. produc- 
tion of films, the Act provides that where 80 percent or more of the 
direct production costs of the film are U.S. costs, the credit base for 
the film is to include certain indirect costs (such as general overhead 
costs, the cost of screen rights, etc.) , but that otherwise the credit base 
will be limited to direct U.S. production costs. 

As to the issue of useful life, taxpayers may take a two-thirds credit 
on all their films (regardless of the useful life of particular films), or 
they may elect to determine useful life on a film-by-film basis. Under 
this latter method of computing the credit, the useful life of the film 
will be treated as having ended when 90 percent of the basis of the film 
has been recovered through depreciation. 

Explanation of provisions 
As outlined above, the Act provides somewhat different rules in this 
area with respect to the past than it does for the future, because the 
rules for the past are intended to be a compromise of the litigating 
positions of the Internal Eevenue Service and members of the film 
industry, based on transactions which have already occurred. Also, the 
rules are different for the future because the emphasis for the future is 
to be on providing jobs in the United States. 

Films placed in service in future years 

General rule. — For the future, as a general rule, under the Act, tax- 
payers are to receive two-thirds of a full credit for all their films re- 
gardless of the actual useful life (or foreign use) of any particular 
film. This rule will applv to all films placed in service (i.e., initially 
released for public exhibition in any medium) in taxable years begin- 
ning after "December 31, 1974, regardless of whether any particular 
film had a useful life of 7 years or more (so that it would be entitled 
to a full credit if judged on an individual basis), or less than 3 years 
(so that it would not be entitled to any credit if judged separately). 
The credit is to be available only for "qualified films", i.e., motion 
picture films or television films or tapes created primarily for use as 
public entertainment, and educational films, i.e., generally films used 
in nrimarv or secondary schools, colleges and universities, vocational 
and post -secondary educational institutions, public libraries and gov- 
ernment asrencies (thus, for example, excluding industrial training 
films'^. Also, the credit would be available for TV pilot films 
and dramatic or comedv series, such as "Mod Squad" or "Tlie Mary 
Tvler Moore ShoAv." However, the credit would not be available for 
films which were topical or transitory in nature, such as news shows, 
interview shows such as "Johnnv Carson" or "Firing Line", or films 
or tapes of sports events, eveii though some of these shows misrht be 
shown in subseoaent years. Also, the credit would not be available for 
used films (i.e., filnis shown previously in any market) . 

Th^ 90-vercent method, — Under the Act, as an alternative to the 
general rule, taxpayers mav elect to have the investment credit deter- 
miiied for all of their nualified films placed in service in the future on 
a film-by-film basis. Thus, if a particular film had a useful life of 
7 years or more, the taxpayer would be entitled to a full credit for 
that film. On the other hand, if a film had a useful life of less than 
3 years the taxpayer would not be entitled to anv credit for that film. 
For purposes of these rules, the film's useful life is to be treated as 
ending at the close of the year by the end of which the aggregate 



178 

allowable deductions for depreciation equal at least 90 percent of the 
basis of the film (adjusted for any partial dispositions, but determined 
without regard to any otlier adjustments) . 

For example, assimie that a taxpayer who is on a calendar year basis 
releases (i.e., places in service) a film Avith a basis of $100 on Febru- 
ary 1, 1975. The film is depreciated undei* the income forecast method 
and $50 of depreciation is allowable witli respect to this film for 1975, 
$30 for 1976 and $10 is for 1977. Thus. $90 of depreciation is allowable 
by the close of 1977, and since this represents 90 percent of the basis 
of the film the useful life of the film is to be treated as having ended 
on December 31, 1977, or less than three years after the film was placed 
in service ; therefore, no credit would be available with respect to this 
film, and any credit or partial credit which had been claimed would be 
subject to recapture. 

On the other hand, if less than $90 of basis had been recovered by 
the close of 1977, the film would be eligible for at least a partial credit.^ 

Of course, films of a transitory or topical nature would not be eli- 
gible for the investment credit, no matter when their basis was recov- 
ered through depreciation. 

If the actual useful life of a film is less than its anticipated useful 
life in the case of a taxpayer using the 90-percent method, the credit 
is to be subject to recapture under essentially the same rules which 
appl}^ in the case of any other section 38 property where the actual 
useful life proves to be shorter than the anticipated life. Also, in the 
case of a disposition or partial disposition of rights in the film before 
the end of the anticipated useful life of the film, there would be a full 
or partial recapture.^ 

A partial disposition includes the sale of commercial exploitation 
rights in any medium (television, for example) or in any geographic 
area (such as Great Britain, or any other foreign countiy). On the 
other hand, an ordinary commercial license for less than the full rights 
of exploitation in a particular medium or area generally does not con- 
stitute a disposition or partial disposition for purposes of these rules. 

Also, a sale of exploitation rights to a member of an "affiliated 
group" does not constitute a partial disposition. For example, U.S. film 
distributors commonly exploit the foreign rights to a U.S. -made film 
through use of a foreign affiliate. For purposes of these rules, the term 
"affiliated group" is to have the same meaning as it does for purposes 
of section 1504, but with a 50-percent control test (instead of 80 per- 
cent), and with no exclusion of corporations (such as foreign affiliates) 
described in section 1504(b). Also where stock in a foreign film dis- 
tributor is held by the trust of a pension ])lan which benefits the em- 
ployees of that foreign distributor, any U.S. corporation holding stock 
in the foreign distributor may add the stock held by the nension trust 
to its own stock holdings for purposes of determining if the foreign 
film distributor is an "affiliate" of the U.S. corporation. For example, 
if two American distributors each hold 49 percent of the stock in a for- 
eign distributor, and the pension tiaist of the foreign distributor holds 
the remaining 2 percent, the foreign distributor would be an affiliate 



1 For purposes of these cnlnilations. salvace value would not bo taken in^o account: 
th"s. If ?» f'm has a hasls of $100, and a salvage value of .$10. the useful life would not 
end until $90 of depreciation w-^s recoverable (i.e.. 90 percent of the «100 basis, not 90 
percert of the $100 basis minus the $10 salvapre value, which would eoual $811. 

= This ru'e Is not to apply to a taxpayer usinir the jrenernl mlp Cthe two-thirds method), 
however, since the amount of the credit under this method does not depend on the useful 
Ufe of any particular film. 



179 

of both the American corporations (l^ecause each would add the 2 per- 
cent interest held by the pension trust to its own 49-pereent intere.st). 

Some of the principles above may be illustrated as follows. A film 
distributor having a 100-percent ownership interest in a television 
dramatic series, consisting of 24 weekly episodes, elects to use the 90- 
percent method of determining its investment credit for movie films. 
The distributor estimates the useful life of the series will be 7 years 
or more and claims a full credit. The distributor licenses a United 
States television network; under the agreement the network acquires 
first-run U.S. television rights for $100, with the right to repeat each 
episode over the network one time for an additional fee of $25, 

In the following year,^ the American distributor sells the exclusive 
rights to exhibit the series in Great Britain to a British coi'poration 
which is not affiliated with the American distributor. This constitute^ 
a partial disposition of the series which triggers a partial recapture of 
the credit. 

If, on the other hand, the American distributor entered into a limited 
licensing agreement with the foreign corporation (similar to the agree- 
ment which it had entered with the American network) , or sold the 
British rights to the series to a member of an affiliated group, there 
would be no partial disposition, and consequently, no recapture. 

Films placed in service for taxable yeai*s beginning after Decem- 
ber 31, 1974, are not subject to the foreign use rule. This is because, 
in the case of a movie film, jobs are created where the film is produced, 
not where it is shown. To use the 90-percent method, the taxpayer 
would have to make an election, in a time and manner to be prcvscribed 
in regulations. 

Once the taxpayer (or any related business entity) has operated 
under the general rule for the future, or has elected to use the 90-per- 
cent method, he cannot change his method of operation without the 
consent of the Internal Revenue Service, The Congress intends that 
permission will be granted where the taxpayer undergoes a substantial 
transformation in its operations, but generally will not be granted 
otherwise. For example, it might be appropriate to grant permission 
if a film studio using the 90-percent method merged with a studio 
using the two-thirds method ; or in cases where a studio sliif l.ed from 
the production of short-lived gi'ade B westerns to long-lived classic 
films. 

For purposes of these rules, related business entities include all com- 
ponent members of a controlled group of corporations (within the 
meaning of section 1563(a), without regard to subsection 1563(b) (2) ) 
but subject to a 50-percent control test. Also classified as "related 
business entities" are any corporations, partnerships, trusts, estates, 
proprietorships, or other entities, if "related persons", each of whom 
have at least a 10-percent interest in each entity, also have, in the ag- 
gregate, at least 50 percent of the beneficial interests in those entities,* 

Thus, for example, if individuals A, B, C, and D each have a 25- 
percent interest in studio 1 (which uses the two-thirds method in 1975) , 



* Where a TV series Is Involved, each weekly segment Is placed In service when It Is 
first shown. Thus, the various segments of the series will not necessarily be placed In 
service in Che same year. 

* The term "benefi''.al Interest" means voting stock In the case of a corporation, profits 
or capital interest In the case of a partnership, and beneficial Interest in the case of a 
trust or estate. "Related persons" are generally as described In section 267 or 707(h), 
but for purposes of these rules members of a family consist only of the Individual, his 
spouse, and his minor children. 



180 

studio 2, formed in 1976, with A and B each having a 50-percent prof- 
its interest, cannot elect the 90-percent method for 1976 without the 
permission of the Internal Ilevenue Service. Studio 1 and studio 2 are 
related, because A and 13 each have at least a 10-percent interest in both 
studios and together A and B have at least 50 percent of the beneficial 
interest of both studios. Since studio 1 used the two-thirds method 
in 1975, studio 2 must have permission to use a different method in 
1976. 

Credit hose. — Since the primary purpose of the investment credit is 
to create jobs, the Act is designed to encourage the production of films 
in the United States. Thus, the credit base for motion picture films 
includes the direct costs which are allocable to production of the film 
in the United States (including Puerto Rico and the possessions) and, 
in addition, if at least 80 percent of the direct production costs are 
allocable to United States production, the credit base also includes 
certain indirect "production costs." 

Direct production costs include compensation payable to the actors 
and other production personnel. However, under the Act certain spe- 
cial rules apply in the case of participations (described below in con- 
nection with indirect production costs) . 

Direct production costs also include expenses for costumes, props, 
scenery, and similar items, as well as the cost of the film, and the cost 
of preparing the first distribution of prints (i.e., prints placed in 
service within 12 months after the film is first released). 

Where the film is produced partly in the United States and partly 
abroad, the direct production costs must be allocated between the U.S. 
and foreign production of the film. Under the Act, compensation for 
services is to be allocated to the country where the services are per- 
formed. However, compensation paid to United States citizens is to 
be allocated to the United States, even if the services are performed 
outside of the United States. Also, payments to a subchapter S cor- 
poration or to a partnership are t-o be treated as United States pro- 
duction costs if (and to the extent) that the payments are includable 
in gross income by a U.S. citizen or any other United States person 
(which is not a partnership or subchapter S corporation). Amounts 
paid for equipment and supplies are to be allocated to the country in 
which the materials are predominantly used (where this can be estab- 
lished for particular materials). Subject to these guidelines, allocation 
of direct production costs is to be determined under regulations. The 
Congress intends that generallv (in the absence of better evidence as 
to the actual place of predominant use of personnel and materials) 
direct production costs are to be allocated in accordance with the shoot- 
ing time of the film. 

If 80 percent or more of the direct production costs are allocable to 
U.S. production, then the credit base for the film is to include all "pro- 
duction costs" of the film (other than the direct foreign production 
costs, if anv) . These would include not only the direct production costs, 
as outlined above, but also certain capitalized costs, including a reason- 
able allocation of the general overhead of the taxpaver, the cost of 
obtaining the screen ri*rhts to the film, as well as the cost of developing 
the screenplay, and "residuals" (whether or not capitalized) paid 
under agreements with labor organizations, such as the Actor's Guild. 



181 

Generally, residuals are amounts paid under a collective bargaining 
agreement to all members of tlie union involved (or in some cases to a 
guild or union pension, health, or welfare fund). The collective bar- 
gaining agreement generally covers all films produced over a period of 
several years. Eesiduals may be a percentage of gross receipts from 
nontheatrical uses of a theatrical film, or a percentage of the minimum 
salary payable (i.e., scale) to the union member. 

Under the Act, particii)ations may be included in the credit base 
of an 80 percent or more U.S. produced film subject to certain limita- 
tions. First, participations may be included in the credit base only to 
the extent that i^articipations paid to any one person in connection 
with any one film do not exceed $1 million.^ Subject to this rule, par- 
ticipations are includible in the investment credit tax base to the extent 
of the lesser of: (1) 25 percent of participations qualifying under the 
$1 million limitation, or (2) 121^ percent of the production costs of 
the taxpayer's films for the year (i.e., his investment credit tax base 
determined without regard to participations or residuals). These lim- 
itations are to be applied on a vintage year basis (i.e., participations in 
films released in the same year are to be considered in the aggregate 
for purposes of determining whether the 12i/^-percent limitattion with 
respect to those films has been exceeded) . 

If less than 80 percent of the direct production costs of a film are 
allocable to U.S. production, then the credit base with respect to that 
film includes only the direct U.S. production costs. 

Some of the principles discussed above may be illustrated as follows. 
Assimie that the total production costs of a film equal $150. Of this 
amount, $50 are indirect production costs, including $30 for general 
overhead, $10 for the screen rights and $10 of residuals. The direct 
production costs include $75 of salary and $25 for supplies and ma- 
terials. Fifty dollars of compensation are paid to United States citi- 
zens, and S25 of compensation are paid to non-U.S. actors and pro- 
duction crew, and these invdividuals perform services both in the U.S. 
and abroad. Of the $25 used for costume and supplies, $10 are paid for 
supplies used only in the United States, $5 are paid for costumes used 
only in a foreign country, and $10 worth of supplies are used both in 
domestic and foreign shooting. Sixty percent of the shooting time for 
the film occurs in the U.S., and 40 percent occurs abroad. The calcula- 
tion is as follows : 



U.S. COSTS 

Compensation paid to U.S. citizens_ $50 
60 pet. of compensation paid to non- 
U.S. citizens 15 

Supplies used onl.v in United States 10 
60 i)ct. of the cost of supplies used 
in the United States and abroad_ 6 

Total 81 



FOREIGN COSTS 



$00 

40 pet. of compensation paid to non- 
U.S. citizens 10 

Supplies used only abroad 5 

40 pet. of the cost of supplies used 

in the United States and abroad- 4 

Total 19 



Since 81 percent of the direct cost of production is allocable to United 
States production, the credit base also includes the $50 of indirect pro- 



■^ These rules affecting participations apply only for purposes of the investment credit 
tax base and no inference is intended that similar rules should be applied for other 
purposes under the tax law (i.e., the taxpayer's basis for depreciation). The Congress 
intends that .such questions be determined under the rules of the tax law without regard 
to this provision. 



182 

duction costs. However, the $10 cost for residuals is not to be eligible 
for the credit until the year in which these amounts are actually paid. 

Of course, under the Act, where a hhn is purchased before it is placed 
in service in any medium, the credit base cannot exceed the purchase 
price of the film (if this is less than the credit base for the film as com- 
puted under the rules outlined above). 

Under certain circumstances, it may be possible for the rights to the 
film to be leased under section 18(d) before the film is placed in service. 
However, it is intended that the credit is to be available to the lessee 
only where the lessee acquires full rights to exploit the movie or film 
for its estimated useful life through a particular medimn or in a 
particular geographic area ; it is not to be available where the lessee is 
precluded (by law, regulation or governmental action) from acquiring 
all rights to exploit the him or tape comnif rcialiy. Also, in the case of 
the transfer of a him to a lessee (under section 48(d) of the Code), the 
lessee is generally to be treated as having acquired the hhn for an 
amount equal to the lessor's credit base with respect to that him (rather 
than its fair market value) . 

The rules outlined above concerning the credit base apply regar-dless 
of whether the taxpayer uses the general rule (two-thirds method) or 
the 90-percent method. 

Who is entitled to the credit. — Under the Act, a taxpayer is to be 
entitled to the investment credit for a movie film if, and to the extent, 
that he has an "ownership interest" in the film at the time it is placed 
in service. For purposes of these rules, a taxpayer will be treated as 
having an ownership interest to the extent that his capital is at risk. 

Thus, if the expenses of producing a movie are incurred by the pro- 
ducer, but are reimbursed by the distributor, either by means of a 
nonrecourse loan or otherwise, the distributor would be entitled to 
the credit, because the distributor's capital is at risk. Also, if the pro- 
duction costs are paid from the proceeds of a nonrecourse loan sup- 
plied by a bank but guaranteed by the distributor, then the distributor 
would be entitled to the credit because its capital was at risk in con- 
nection with the film. A similar result would follow if the producer 
was liable to the bank on the loan, but the distributor had contracted 
to pay at least the amount of the loan to the producer in connection 
with the film. 

The determination as to whose capital is at risk in connection with 
the film (and, therefore, as to who is entitled to the credit) is to be 
made as of the time the film is first placed in service (i.e., released). 
Thereafter, the film would be considered used property, wliich is not to 
be eligible for the credit under the Act. 

Generally, where the distributor has borne the cost of producing 
a film, and first releases it through the medium of movie houses, it is 
the distributor who is entitled to the credit. In the case of a film or 
series which is made for television, the producer-distributor will also 
generally be entitled to the credit where the film is exhibited over the 
network pursuant to a licensing agreement. On the other hand, if the 
network purchased all rights to the film or series before it was placed 
in service, the network would be entitled to the credit. 

It is possible that more than one taxpayer may be entitled to a share 
of the credit for the same film as, for example, where several investors 



183 

put up a portion of the capital needed to produce the film pursuant to 
a joint venture agreement. Generally, where more than one party bears 
the risk of loss with respect to a particular film, the Secretary of the 
Treasury or his delegate may establish procedures for determining 
who is entitled to the credit, or partial credit. (Of course, where there 
are several parties to a transaction involving a movie film, and one 
party is entitled to the investment credit with respect to that film 
under these rules, whereas the other party is not, the Congress antici- 
pates that the availability of the investment credit may often be taken 
into account by the parties in determining their contract arrange- 
meiits,) 

It is also possible that more than one taxpayer may be entitled to 
the credit for a particular film where the film is placed in service in 
more than one medium or more than one geographic area. For example, 
siij^pose that a producer creates a U.S. -produced film having a credit 
base of $100. A distributor acquires exclusive perpetual distribution 
rights witliin the United States in exchange for a lump-sum payment 
of $50 and the film is subsequently placed in service. The distributor 
is entitled to a credit with respect to the film based on his cost of $50 
in acquiring the U.S. rights. The producer, who retains the other 
rights to the film, would also be entitled to a part of the credit based 
on his capital at risk. The producer's credit base would be computed 
by subtracting the cost borne by the U.S. distributor ($50) from the 
credit base whicli the producer would otherwise be entitled to (i.e., the 
$100 cost of production). Thus, the producer's credit base would equal 
$50 in this case. 

Filnos Placed in Service in the Past 

For the past {i.e.^ for taxable years beginning before January 1, 
1975), in general, taxpayers will come under one of two rules, either 
the "90-percent method," as described above, with certain modifica- 
tions to deal with the foreign-use problem, or a "40-percent method," 
under which a taxpayer would be entitled to receive 40 percent of a 
full credit for all of his films, regardless of the useful life or predomi- 
nant foreign use of any particular film. However, taxpayers may elect 
to come under the genei-al rule for the future (the two-thirds method, 
as described above) for all section 50 propert}^ placed in service after 
the restoration of the investment credit under the Revenue Act of 1971. 

Finally, certain taxpayers, who have already filed suit for a determi- 
nation as to their entitlement to the investment credit for past years, 
may elect the application of the rules of prior law, rather than the 
provisions of this Act, in determining their entitlement to the credit 
for all past periods. 

General rule for past. — Under the Act, as a general rule, the invest- 
ment credit for films placed in service in taxable years beginning 
before January 1, 1975, is to be computed on a film-by-film basis. In 
determining the useful life of the film, taxpayers would use the 
90-percent method as described above. However, an additional rule 
is necessary for the past to determine whether or not there was pre- 
dominant foreign use of the film. 

Under the Act, a film is to be treated as having a predominant 
foreign use in the first taxable year in which 50 percent or more of 



184 

the gross revenues received or accrued from the fihn were received 
or accrued from showing the tihn outside the United States. This is a 
year-by-year test (not a cumulative test). For example, assume a fihn 
was released on P'ebruary 1, 1972, and revenues of $100 were received 
that year from showing the film in the United States (with no foreign 
revenues), while in 1975 there were $75 of income from U.S. showings, 
and $25 of income from foreign exhibitions, and in 197-1 there were 
$40 of U.S. revenues, and $60 of revenue fi-om foreign exhibitions. 
In this case, there would be a predominant foreign use of the film in 
1974, and as a result the film would cease to qualify as section 38 
property in that year. This would mean that the taxpayer would not 
be entitled to an investment credit with respect to the film because the 
disqualifying event would have occurred less than 3 years after the 
property had been placed in service.® 

Films of a transitory or topical nature would not be eligible for an 
investment credit.^ 

The JfO-percent Tnethod. — Under the Act, the taxpayer can elect to 
receive 40 percent of a full credit for all of his films placed in service 
in taxable years beginning before January 1, 1975.^ If the taxpayer 
makes this election, he is to receive the 40-percent credit, regardless 
of the actual useful life or predominant foreign use of any particular 
film. This 40-percent method is offered as a way of avoiding costly 
litigation with respect to past years. It is believed that this method 
achieves, for the average member of the film industry, about the same 
size credit which he would receive for all his films, on the average, 
were he actually to litigate. 

A taxpayer is not to receive a credit for any films of a transistory or 
topical nature (because almost all of these films have a useful life of 
less than three years). Also, a taxpayer using the 40-percent method 
for the past is not entitled to credits for any films which were produced 
and shown exclusively abroad. 

The election to use the 40-percent method is to be made by the tax- 
payer within six months after the date of enactment (October 4, 1976) 
in a manner to be prescribed in regulations. Any such election, once 
made, is to apply to all the taxpayer's films placed in service in the past 
(except those, if any, covered under the general rule for the future), 
and can be revoked only with the consent of the Internal Revenue 
Service. 

To prevent a situation where two different taxpayers may attempt 
to claim the credit for the same film, the Act provides that any tax- 
payer making the 40-percent election nuist consent to join in a judicial 
proceeding to determine which o.f the competing claimants was entitled 
to the credit, or whether each of the parties was entitled to part of the 

• For this limited purpose, gross foreign revenues from showing films in future yars 
must also be taken into account. In other words, if a t.^xpayer uses the 90-peroent method 
for 1974, and 50 percent or more of the reventies from showing the film in 1075 are from 
foreign exhibitions, this would constitute a predominant foreign use of the film placed In 
service In 1974, and the taxpayer would not be entitled to an Investment credit with 
respect to that film. 

"> The Congress intends that no Inference should be drawn from this report or this 
legislation as to what constitutes useful life, predominant foreign use, the basis on which 
the credit is to be computed, or any other aspect of the application of the investment 
credit under iirior l^w. 

8 As described below, the taxpayer can also use this method for films placed in service 
on or before August 15, 1971, but elect to use the general rule for the future for all of his 
section 50 films. 



185 

credit.^ The rules with respect to entitlement to tlie credit (i.e., the 
capital at risk rules, etc.) are the same for the past as for the future. 

Credit hase. — In general, under the Act, the rules as to the size of 
the credit base for the past (including those with respect to partici- 
pations) are similar to the rules which are to apply for the future. 
However, for the past there has not been a U.S. production test in 
connection with movie films, and the Congress does not believe it 
would be appropriate to impose such a test retroactively. (The Act 
does impose a U.S. production test for the future, in order to 
encourage the U.S. production of movie films.) Thus, for the past, 
taxpayers may include in the credit base all the direct and indirect 
expenses of production, as described above, regardless of whether the 
film would have satisfied the 80-percent United States direct produc- 
tion expenses test and regardless of whether some of the expenses 
(actors' pay, costumes, etc.) included in the credit base were paid 
for services performed abroad, or for equipment and supplies which 
were used abroad. 

The rules described above with respect to the credit base would 
apply both to taxpayers using the 90-percent method for the past, and 
to taxpayers using the 40-percent method. 

ApplHation of the general rule for the future to certain past years. — 
In connection with the Eev'enue Act of 1971 Congress nuide clear that 
it intended the investment credit to be available for movie films 
(whereas this question has not been completely resolved prior to that 
time) even though, as described above, certain subsidiary issues were 
not settled in that Act. For this reason, the Act provides that those 
taxpayers who wish to do so are to be allowed to use the general rule 
for the future with respect to all of their section 50 property (generally 
property placed in service after. August 15, 1971). Thus, the Act pro- 
vides that taxpayers may elect to use the general rule for the future 
for all of their section 50 movie films. (Taxpayers making this election 
could still use either the 90-percent method or the 40-percent method 
for all films placed in ser\'ice in the past which do not qualify as 
section 50 property.) 

Taxpayers who make this election are to be covered under the gen- 
eral rule for the future for all purposes, including, for example, the 
rules with respect to the size of the credit base, which include an 
80 percent U.S. production test and exclude expenses of foreign pro- 
duction from the credit base. 

The election to use the general rule for the future for section 50 
films would have to be made within one year after the date of enact- 
ment of this Act, in a manner to be prescribed in regulations. The 
election would have to apply to all of the taxpayer's section 50 films, 
and the election, once made, could not be revoked without the consent 
of the Internal Revenue Service. Other rules with respect to use of 
this method for the past may also be prescribed b}' regulations. 



8 Thp Concress is concerned, however, that this procedure should not unnecessarily 
delay the allowance of the credit in cases where it is reasonably clear that there is only 
one "lausible person who has a ripht to claim the credit. The Congress intends that the 
Service will develop such reporting and other procedures as it deems necessary to deter- 
mine whether there is a like'ihood that several persons ma.v claim a credit with re5;peet to 
the same film, and that where there is no such likelihood, allowance of the credit will not 
be unduly delayed. 



186 

Taxpayers who have already litigated 

Some taxpayers have already litigated the issues outlined above for 
certain prior years. The Congress believes that these taxpayers should 
be entitled to the fruits of their litigation because of the substantial 
eifoit and expense which they have incurred in connection with their 
suits. Accordingly, the Act provides that any taxpayer who has filed 
a petition before any court before January 1, 1976, with respect to his 
entitlement to the investment credit for any prior year, may elect 
(within 90 days after the date of enactment) to have his right to the 
investment credit for all taxable years beginning prior to January 1, 
1975, determined under prior law, as interpreted by the courts, rather 
than under one of the methods prsecribed in this Act. (As an alterna- 
tive, taxpayei-s who have filed suit prior to January 1, 197G, may elect 
to have their credit determined under prior laAV for yeai-s prior to 1971, 
and elect the general rule for the future for all their section 50 prop- 
erty.) But, of course, issues which have not already been resolved by 
court proceedings (such as predominant foreign use, the size of the 
credit base, etc.) must be settled by further litigation, and it is intended 
that no inference be drawn from the provisions of this Act as to how 
such issues should be resolved under prior law. 

Generally, under this procedure, a taxpayer wishing to make an 
election under these provisions may do so by mailing a letter to this 
effect to the Commissioner of Internal Revenue within the 90-day 
period. Any such election is to be irrevocable. 

Taxpayers relying on litigation to determine their credits for past 
yeare still must use either the general rule for the future or the 90- 
percent method for all taxable years beginning after December 31, 
1974. 

Effective dates 
The effective dates of these provisions have been described above. 
In general, the rules with respect to the general rule for the future and 
the 90-percent method apply to films placed in service in taxable years 
beginning after December 31, 197-±. In general, taxpayers may use 
either the 90-percent or the 40-percent method for all prior years, but 
may alternatively elect to use the general rule for the future for all 
section 50 property. 

Revenue effect 
It is estimated that the f)rovisions of this section will result in a rev- 
enue cost of $37 million for fiscal year 1977, $18 minion for fiscal year 
1978, and $3 million for fiscal year 1981 and each year thereafter. 

5. Investment Tax Credit in the Case of Certain Ships (sec. 805 of 
the Act and sec. 46(g) of the Code) 

Prior law 
The tax on income deposited into a capital construction fund (estab- 
lished under section 21 of the Merchant Marine Act of 1970) for the 
construction of certain vessels is deferred until funds are withdrawn 
from the fund for certain purposes. When the funds are withdrawn to 
purchase, construct, or reconstruct a qualified vessel, there is no tax 
basis in the purcliased vessel to the extent of the withdrawal. Under 



187 

prior law, this reduced the amount of investment credit available on 
the purchased vessel. 

Reasons for change 

The Merchant Marine Act was amended and the tax treatment 
accorded domestic shipping was substantially revised when the in- 
vestment credit was not in effect (1970). As a result, the Congress 
did not at that time address itself to the question of whether the in- 
vestment tax credit should be available in the case of a vessel con- 
structed with funds withdrawn from the tax-deferred capital con- 
struction fund. In addition, since the tax jDrovisions relating to the 
capital construction fund are in the Merchant Marine Act of 1936 
rather than in the Internal Revenue Code, this question was not re- 
viewed wlien the investment credit was subsequently restored. 

The Congress believes that denying the investment credit in 
the case of ships built from monies taken from tax-deferred construc- 
tion funds has the effect of substantially reducing the inducement to 
set funds aside for ship construction rather than using them for other 
forms of capital formation for which the investment credit is available. 
It is the understanding of the Congress that, in fact, the funds set 
aside for this purpose since the restoration of the investment credit 
generally have been nuich more limited than was previously estimated. 
The Congress believes it is a matter of national concern that the U.S. 
shipping industry have a modern fleet and be competitive in world 
markets. This is necessary from the standpoint of our international 
trading position as well as from the standpoint of having a fleet in 
place upon which the United States can call in times of international 
crisis. As a result, the Congi-ess concluded that it was undesirable to 
limit the incentive of the capital construction fund by denying the 
full investment credit for monies Avitlidrawn from this fund for ship 
construction while the investment credit is available for many other 
forms of capital investment. 

Explanation of provisions 

The Act provides for an investment credit of one-half the regular 
credit on the tax-deferred amounts withdrawn from the capital con- 
struction fund which are used to purchase, construct, or reconstruct 
qualified vessels. In addition, Congress intends that taxpayers are to 
have the right to obtain a court determination as to whether they are, 
under already existing law, also eligible for the other one-half of the 
regular investment credit. Also, it is intended that no inferences be 
drawn either way on this issue from the action taken in this Act. 

If a taxpaj^er claims the full investment credit on its tax return, it 
is expected that the Internal Revenue Service will provide, by regula- 
tions, procedures which will require the taxpaj^er to indicate on its re- 
turn that the full investment credit is being claimed. This will alert 
the Internal Revenue Service to the position taken by the taxpayer 
on this point. If the IRS asserts a deficiency in this case, the taxpayer 
has the option of pursuing its claim for the full credit in the Tax 
Court. In addition, the taxpayer may fie a claim for a refund which 
w^ill allow the taxpayer to pursue its claim with the Court of Claims 
or in the District Courts. 

Where a taxpa3'er purchases a ship with borrowed funds and uses 
the capital construction fund to pay off the indebtedness, there ini- 



188 

tially will be allowed a full investment credit and then subsequently 
there is to be a recapture of no more than 50 percent of the amount of 
the investment credit taken on the purchase price of tire ship repre- 
senting the indebtedness which is bei g liquidated with tax deferred 
amounts from the capital construction fund. 

Ejfective date 
The Act applies to taxable years beginning after December 31, 1915. 
No inference is to be drawn from this provision legarding the applica- 
tion of law with respect to the availability of the credit for prior 
years. 

Revenue effect 
This provision will result in a reduction of $13 million in budget 
receipts in fiscal year 1977, $12 million in fiscal year 1978, and $:?3 
million in 1981. 

6. Net Operating Losses 

a. Net Operating Loss Carryover Years and Carryback Election 
(sec. 806(a)-(d) of the Act and sees. 172, 812, and 825 of the 
Code) 

Prior law 

Prior law provided that both individual and corporate tax- 
payers in general were allowed to carry a business net operatmg 
loss back as a deduction against income for the three taxable years pre- 
ceding the years in which loss occurred and to carry an}' remaining un- 
used losses forward to the five years following the loss year (sec. 172). 
Under this general rule, taxpayers could balance out income and loss 
over a moving 9-year period. Insurance companies were also allowed 
3-year carryback and 5-year carryover periods for their losses, either 
under the general rule (section 172) or under separate rules in sub- 
chapter L. Exceptions to the general 3-year carryback and five-year 
year carryover rule have been provided in the case of certain i]idus- 
tries or categories of taxpayers. One exception allowed certain regu- 
lated transportation corporations to carry baciv net operating losses 
for the usual 3 years and to carry over such losses for 7 years.^ 

A net operating loss is required to be applied against income from 
other taxable years, beginning with the earliest year to which the loss 
may be carried. For example, if a business taxpayer, subject to the 
general 3-year carryback and 5-year carryover rule, had a net operat- 
ing loss for 1976, the loss would be carried first to reduce or eliminate 
taxable income (if any) reported for 1973, and to the extent any of 
the loss remained unused, it would then be successively applied against 
any income reported for 1974 and 1975. Any of the 1976 loss unab- 
sorbed by these three carryback years would, then be used as a deduc- 

1 Another exception prohibits the carryback of a net operating loss to the extent the 
net oi)erating loss was attributable to a foreign expropriation loss. However, a 10-year 
carryover period is allowed for the foreign expropriation loss (15 years in the case of a 
Cuban expropriation loss under prior law, now 20 years under section 2126 of the Act). 
A third exception, applicable to financial institutions Tor taxable years beginning after 
December 31, 1975, lengthens the carryback period for net operating losses to 10 years 
and allows the usual 5-year carryover period. Similarly, a bank for cooperatives is allowed 
to carry net operating losses back for 10 years and forv^ard for 5 years. Finally, prior 
law al.so contained a provision designed for America Motors Corporation which permitted 
a 5 year carryback period and a carryover perior of 3 years for losses incurred for taxable 
years ending after December 31, 1966, and prior to January 1, 1969. 



189 

tion on the taxpayer's returns for the succeeding five years, begin- 
ning with 1977. Any loss remaining after it had been successively 
applied in these five years expires, and the taxpayer loses the benefit 
of this unused loss. 

Reasons for change 

Adverse economic conditions in recent years have caused many 
business taxpayers to incur sizable net operating losses. In many 
cases there is some doubt that, because of the severity of the losses 
and the delay in the economic recovery, these taxpayers will generate 
sufficient income during their existing carryover periods to enable 
them to use their large operating loss carryovers. In order to reduce the 
possibility that a similar situation will arise in the future, Congress 
decided to increase the loss carryover period by two additional years 
for taxpayers subject to the general carryback and carryover rules and 
for special category taxpayers with similarly short periods for absorb- 
ing operating losses. 

In addition, in some cases where net operating losses have been 
carried back to reduce or eliminate income reported in prior years, 
the loss carrybacks have caused investment and foreign tax credits 
carried over to these prior years to expire unused because of the 
limited carryover periods allowed for the tax credits. 

To alleviate this problem the Act provides an election for any tax- 
payer with a loss carryback period to relinquish the carryback period 
for any loss year. Because of the interaction of the net operating loss 
rules and other provisions of the Code, a net operating loss cai'i-ybnck 
can in some cases actuall}- increase a taxpayer's aggregate tax liability 
over the 9-year carryback and carryover period. For example, if a tax- 
payer has a loss to be carried back and if m the carryback year the tax- 
payer had foreign source income which resulted in no U.S. tax liability 
because of foreign tax credits, the net operating loss carrybacks would 
merely displace the foreign source income and accompanying foreign 
tax credits without providing any tax benefit.^ 

Explanation of provisions 
The Act makes two changes to prior law. First, the loss carryover 
period is increased by two years for taxpayers covered by the general 
rule (3-year carryback and 5-year carryover) and similarly situated 
taxpayers with relatively short, periods to which their losses may be 
applied. Specifically, the two additional loss carryover years are avail- 
able to taxpayers subject to the general 3-year carryback and 5-year 
carryover general rule, and regulated transportation corporations. 
In addition, the Act also extends the additional carryover years to 
insurance companies taxable under subchapter L of the income 
tax provisions (sees. 801-844), all of which had 3-year carry- 
back and 5-year carryover periods, either under the general rale (sec- 
tion 172) or under separate provisions in subchapter I. As a result, 
these taxpayers, except for regulated transportation corporations, will 
have a 7-year loss carryover period. Regulated transportation cori:)ora- 
tions will have a 9-year loss carryover period. The two additional 



2 Furthermore the foreign tax credits could be carried forward only five years from 
the carryback year ; under the Act the net operating losses could be carried forward for 
seven years from the current year. 



190 

carryover yenrs are not available to taxpayers with foreign expropria- 
tion losses or to real estate investment trusts, financial institutions, or 
banks for cooperatives. 

The second change made by these provisions of the Act concerns the 
net operating loss carr^'back period. An election is provided for any 
taxpayer with a loss carryback period under section 172 or under sub- 
chapter L to forego its entire carryback period for an operating Joss. 
The election may not be made to forego only part of the carryback 
period for an operating loss. 

The election is available for any taxable year for which there is an 
operating loss and must be made by the due date (including extensions 
of time) for filing tlie return for the taxable year of the operating loss. 
Once made, the election is irrevocable for that taxable year but has no 
effect on an operating loss reported for any other taxable year. 

Effective date 
These provisions are effective for losses incurred in taxable years 
ending after December 3il, 1975. 

Revenue, effect 
The provision is expected to have a negligible effect on revenues in 
years before 1982. 

6. Special Limitations on Net Operating Loss Carryovers (sec. 
806(e) of the Act and sees. 382 and 383 of the Code) 

Prior law 

Prior law (sec. 382(a) ^ provided that where new owners buy 50 
percent or more of the siock of a loss corporation during a 2-year pe- 
riod, its loss carryovers from prior years were allowed in full if the 
company continued to conduct its prior trade or business or substan- 
tially the same kind of business. It could add or begin a new business, 
however, and apply loss carryovers incurred by the former owners 
against profits from the new business (unless tax avoidance was the 
principal purpose for the acquisition). If the same business was not 
continued, however, loss carryovers were completely lost. In the case 
of a tax-free reorganization, loss carryovers were allowed on a de- 
clining scale (sec. 382(b) ). If the former owners of the loss company 
received 20 percent or more of the fair market value of the stock of 
the acquiring company, the loss carryovers were allowed in full. 
For each percentage point less than 20 which the former owners re- 
ceived, the loss carryover was reduced by 5 percentage points. It was im- 
material whether the business of the loss company was continued 
after the reorganization (sec. 382(b) ) . 

The former "purchase" rule of section 382(a) applied where one 
or more of the 10 largest shareholders increased their stock ownership, 
within a 2-year period, by 50 percentage points or more in a transac- 
tion in which the purchasers took a cost basis in their stock (except 
where the stock was acquired from "I'elated" persons within the con- 
sti-uctive ownership relationships described in section 318 of the 
Code.) The constructive ownership rules of section 318 applied, with 
some modifications, in determining the ownership of stock for pur- 
poses of section 382 ( a ) . 

Section 382(a) also became operative if a person's stock ownership 
increased by at least 50 percentage points by reason of a decrease in 



191 

total outstanding stock, such as occurs in a redemption of stock owned 
by other shareholders (except redemptions under sec. 303 to pay death 
taxes). 

Section 383 incorporates by reference the same limitations as are 
contained in section 382 for carryovers of investment credits, work in- 
centive program credits, foreign tax credits, and capital losses. 

The tax law also contains a general i)rovision which authorizes the 
Treasuiy to disallow a net operating loss carrj^over where any 
persons acquire stock control of a corporation foi' the principal pur- 
pose of evading or avoiding Federal income tax by obtainiug a bene- 
fit which such persons would not otherwise have obtained (sec. 269 
(a) (1)). A similar rule also applies to tax free acquisitions of one 
corporation's assets by an uni-elated corporation where the acquiring 
company takes a carryover basis in such assets (sec. 26D(a)(2)). 
For purposes of these rules, control means ownership of at least 50 
percent of the total combined voting power of voting stock or at least 
50 percent of the total value of all classes of stock. 

Reasons for change 

In genera], the limitations contained in sections 382, 383, and 269 
recognize that any rules which permit an operating loss (or other 
tax deductions or credits) to contiinie despite a substantial 
change in shareholders can be manipulated for tax avoidance pur- 
poses. For example, a free traffic in loss carryovers could result in 
large windfalls for buyers of stock or assets who could take advan- 
tage of the weak bargaining position of the existing owners of a loss 
business and acquii-e large carryovers for substantially less than their 
tax value. Such buyers are effectively buying a tax shelter for their ex- 
pected future profits, whereas if the same persons had used their 
capital to start a new business on their own, no such loss offsets would 
be available. 

On the othei hand, a going business may lose money for a variety 
of reasons, such as bad economic conditions, competition, location, or 
poor business judgments by its owners. In many cases the loss can be 
fairly well traced to an inability or unwillingness by the existing 
owners to see, or to make, needed changes. In situations such as these, 
tlie owners often seek out additional co-owners to help turn the busi- 
ness around with fresh ideas or better management. 

In several v.ays the former loss limitations did not deal adequately 
with the genuine concerns which taxpayers and the Government have 
in both kinds of situations described above. Generally, old 
section 382(a) covered stock acquisitions and section 382(b) covered 
asset acquisitions. These rules were not coordinated, however. They 
also failed to cover some transactions where "trafficking" in loss carry- 
overs could still occur, and there were se\ eral loopholes. For example, 
where enough stock of a loss corporation was purchased for cash, car- 
ryovers were lost if the corporation did not continue to carrj' on the 
same kind of business it had conducted previously. However, losses 
could still be carried ovei' after a taxfree I'eorganization whether or 
not the same trade or business was 'continued. Conversely, after a pur- 
chase of stock, losses could be carried over in full if the fonner busi- 
ness was continued even though a new profitable business could be 



192 

added to absorb the existing loss carryovers ; but after a reorganiza- 
tion, the loss carryover could be reduced even if the old business were 
continued. 

The former purchase rules required no continuity of interest by the 
former owners of a loss company, since a 100 percent change in stock 
ownership could preserve all the carryovers if at least the same 
kind of business was continued. By contrast, the reorganization rules 
required at least 20 percent continuity by former owners if carry- 
overs were to survive in full. Where the purchase limitations applied, 
the loss carryovers were completely disallowed. Where the reorganiza- 
tion rules applied, loss carryovers were merely reduced in proportion 
to the change in stock ownership. 

The rule that a loss company must continue the same business when 
new owners buy control of its stock presented special problems. Many 
critics of this test argued that it is uneconomic to compel new owners 
of a failing business to continue to operate that business if a new 
activity can be found in which to make profits. Besides running counter 
to normal business practice, this test was also difficult to apply in 
specific cases, i.e., it was difficult for taxpayers and for the courts to 
determine at what point a change in merchandise, location or size of 
the business, or a change in the use of its assets, should be treated as 
a change in the business. The tax law has also general!}^ permitted the 
continuing owners of a loss business to abandon that business entirely 
but still apply loss carryovers from the discontinued activity against 
profits from a new business. 

The reorganization limitations did not apply to a "B"-tvpe reorga- 
nization (stock for stock). This meant that a profitable company 
could acquire the stock of a loss company in exchange for the profit 
company's stock, liquidate the loss company after a reasonable interval 
(or transfer profitable assets into the loss company), and use its loss 
carryovers without limit acrainst the future income from profitable 
operations. Where a profitable company used a controlled subsidiary to 
acquire the assets of a loss company for stock in the profitable company, 
the reorganization rules could also be effectively avoided because the 
20 percent continuity of interest rule for the loss company's sharehold- 
ers was not applied by reference to the percentage interest which these 
shareholders received in the profitable company (sec. 382(b) (fi) ). 

Full preservation of loss carryovers could also be obtained under 
the prior rules by issuing limited preferred stock (voting or nonvoting) 
to the shareholders of a loss company, so long as the fair market value 
of the stock was at least 20 percent of the fair market value of all the 
acquiring company's stock immediately after the reorganization. 

Congress reviewed the circumstances under which limitations should 
be imposed on net operatinir loss carryovers, whether orio-inatiiiir with 
the same corporation or inherited fi^om an acquired corporation. Con- 
gress concluded that in light of the longer caiTjv^v'er period permitted 
by this Act (sec. 806(a)), it was important to correct defeats in the 
former rules of section 382. This meant closing loopholes and coordinat- 
ing the rules for stock purchases and reorganizations so that they 
operate in a more equitable (and economic) manner for both taxpayers 
and the Government. The basic decision was to tie the survival of loss 
carryovers (and section 383 items) to changes in the stock ownership 



193 

of a loss cojnpany, and to do so in a way that reduces the windfall to 
new^ owners who' did not uiciir the losses but also avoids hardship to 
the continuing former owners (which would occur if loss carryovers 
were eliminated entirely). 

Explanation of proinsions 

The Act amends sections 382 and 383 to provide more nearly paral- 
lel rules for acquisitions of stock and tax-free reorganizations involv- 
ing a loss company; to eliminate the test of business continuity and 
base the rules solely on changes in stock ownership; and to increase 
the amount and kind of continuity of ownership required under these 
rules. 

The increased ownership standard applies to the continuing interest 
in the loss company held by its former owners where its stock is 
acquired by new owners or where the loss company is the acquiring 
company in a reorganization. And, as under prior law, where the loss 
company is acquired in a reorganization, the new standard applies to 
the interest received by the former loss company owners in the com- 
pany which acquires the loss company. The Act also increases the 
types of reorganizations specifically covered by sec. 382 ; it covers in 
detail reorganizations in Avhich stock is transferred for stock ("B" 
reorganizations) and triangular reorganizations. 

For purposes of new section 382, the continuity required of the 
former shareholders of a loss company is now^ 40 percent. For each per- 
centage point (or fraction thereof) less than 40 but not less than 20 
which the loss shareholders retain (or receive) , the allowable loss carry- 
over is reduced by 3i/^ percentage points. For each percentage point 
(or fraction thereof) less than 20, the loss carryovers are reduced by 
11/2 percentage points.^ 

These rules are, in general, applied by reference to the ownershijj 
by the former owners of a loss company of the lesser percentage owner- 
ship of the fair market value of the "participating stock" or of the 
fair market value of all the stock of the loss company (or, in the case 
of a reorganization, of the acquiring company if that company is not 
the loss company).* These tests mean, in effect, that carryovers can sur- 
vive in full under the new rules only if a loss company's shareholders 
retain an interest in at least 40 percent of the continuing company's to- 
tal current value and at least 40 percent of its future gro-svth. This con- 
tinuing interest must be retained directly in the loss company or re- 



^ This weighted scfle reflects the fact that for many tax purposes, such as tax-free 
liquidations under sec. 332 and the filing of consolidated returns, an acquisition of SO 
percent ownership is virtually equivalent to total ownership, so that increases in owner- 
ship up to 80 percent are usually more significant than any particular ownership level 
ahove 80 percent. 

* For example, assume that profit company P (whose total value is $600) acquires the 
assets of loss company L (worth $400) in a statutory merger. The combined company 
LP's capital structure consists of common stock worth $900 and voting preferred stock 
worth $100. Assuming the common stock qualifies as participating stock, L's carryovers 
wi'l be preserved in full if L's former shareholders receive $400 worth of LP common 
stock (they will have received at least 40 percent of the value of participating stock and 
40 percent of the value of all stock combined). The same result will occur if these share- 
holders receive $360 worth of common stock and $40 worth of voting preferred stock (this 
will still constitute 40 percent of the value of participating stock and a total of 40 percent 
of the value of all stock) . 

If L's shareholders receive $300 worth of common stock and $100 worth of voting 
preferred stock, however, they will have received 40 percent of LP's total value but only 
3314 percent of its participating stock. Consequently, L's carryovers will be reduced by 
reference to the lower of these two figures, i.e.. the reduction here will be 23.3 percent 
(6% percentage point continuity below 40 times 3% =23.3 percentage point reduction). 



194 

tained indirectly through stock received in a company which acquires 
the loss company. 

These tests are to be applied, as under prior law, by disregarding 
unissued or treasury stock, except where option attribution under 
section 318(a)(4) is invoked with respect to a warrant, convertible 
debenture, or other right to acquire stock directly from the loss 
company. 

The new rules for both taxable and nontaxable acquisitions of a loss 
company apply to carryovers of operating losses incurred in the year 
in which an ownersliip change occurs and also to carryovers of earlier 
operating losses to that year and later years. The percentage reduction 
determined under the new rules is to be applied separately to each of 
these two categories. If, for example, the percentage reduction figiire 
is 35 percent, carryovers to the change of ownership year are to be 
reduced by 35 percent and the carryover of a loss incurred in that year 
is also to be reduced by 35 percent. 

Since section 383 incorporates the section 382 rules for capital loss, 
investment credit, work incentive program credit, and foreign tax 
credit carryovers, the Act also amends section 383 to adopt the same 
new rules for these items. 

Purchases^ etc. of stock. — The Act changes section 382(a) to focus 
on changes in stock ownership alone. The continuation of business rule 
is eliminated along with the former all-or-nothing eifect of section 
382(a). It will no longer be necessar^^ to make detailed factual in- 
quiries into the different degrees or ways that an existing business may 
have been changed. As a result, wlien a sufficient increase in stock 
ownership by new owners occurs, net operating loss carryovers will be 
limited even if the new owners continue the same trade or business. On 
the other hand, where carryovers are allowable under the new rules, the 
company may change, contract or abandon an existing business with- 
out affecting its loss carryovers. 

Section 382(a) continues to measure continuity by former owners 
indirectly by looking to the increase in new owners' percentage owner- 
ship of a loss company's stock. However, the Act raises the point at 
which a specified acquisition brings the limitations into play from 50 
to more than 60 percentage points. If the increase in a buyer's stock 
ownership is greater than 60 percentage points, the company's net 
operating loss carryovers are reduced by a percentage of the carry- 
overs equal l:o 31/0 percentage points for each percentage point increase 
by the buyer above 60 and up to 80 points. If the buyer's increase is 
more than 80 percentage points, loss carryovers are also reduced by 
11/^ percentage points for each 1 percentage point increase over 80 
and up to 100.-^ 

The shareholders taken into account under the new section 382(a) 
test to determine the increases in interest are those who hold the 15 



^ For exaniplo, if a buyer ir.vTeases his stork owuership during the applicable period 
by 80 percentage points, the loss carryover -will be reduced by 70 percent, i.e., 20 per- 
centage points abo\e the fiO percentaL'o point threshold times 3% =a 70 percent reduc- 
tion in net operating loss carryovers. This reduction will be made whether the new owners 
change the business or continue it. 

If the buyer Increases his ownership Of the applicable stock of a loss company by 90 
percentage paints, its loss carryovers will be reduced by 85 percent, i.e., a 70 percent re- 
duction attributable to the increase in stork ownership over 60 and up to 80 percentage 
points, pins another 1.5 percent reduction attributable to the increase in percentage points 
over 80 and up to 90 (10 percentage points times IM; =15). 



195 

largest percentages of the total fair market value of all the stock of 
the company on the last day of its taxable year. (''Participating stock" 
is not used for this determination.) Once this group is ascertained, the 
percentage point increase by the group is then determined, as discussed 
above, by reference to the increase in percentage point ownership of 
the fair market value of participating stock, or of all stock, of the 
company, whichever increase is greater. 

The relevant points for determining the extent of any ownership 
change as of the end of any taxable year are the beginning of the year 
under examination and the beginning of the first and second preceding 
taxable years. If one or more of these three taxable years is a short 
taxable year, an additional taxable year is added to the period for 
each such short j^ear. 

The new rules expand the list of transactions governed by section 
382(a). In all cases, the increase in percentage points must be attrib- 
utable to one or more of the following types of transactions : 

1. A purchase of stock of a loss company from an existing share- 
holder or from the company itself. The term "purchase" is defined as 
a cost-basis acquisition.^ 

2. A purchase of stock of a corporation which owns stock in a loss 
company ; or a purchase of an interest in a partnership or trust which 
owns such stock. 

3. An acquisition by contribution, merger or consolidation of an in- 
terest in a partnership which owns loss company stock, or an acquisi- 
tion of sucli s*-ock by a partnership by means of a contribution, merger 
or consolidation.^ 

4. An exchange to which section 351 applies, i.e., a transfer of prop- 
erty to a loss company after which the transferors own 80 percent or 
more of the company, or an acquisition by a corporation of loss 
company stock in an exchange in which section 351 applies to the 
transferor.^ 

5. A contribution to the capital of a loss company.^ 

6. A decrease in the total outstanding stock of a loss company (or 
in the stock of a corporation which owns such stock) . This category 
thus includes, but is not limited to, a redemption from other share- 
holders (except a section 303 redemption). In the case of a partner- 



8 This category InpUide^ n tavabV snle nf profitable assets to a loss company in exchange 
for its stock, since the seller's basis in the stock will be his cost (fair market value) for 
such stock. A "failed"' reorganization can thus also trigger section 382(a). 

'To illustrate the first clause it' partnership P-1, in w'nch individuals A and B are 
equal partners, merges into unrelated partnership P-2, which owns loss company stock, 
A and B will have acquired an interest in a partnership (P-2) which owns loss company 
stock. To illustrate the second clause, if P-2 merged into P-1, A and B will have acquired 
(through I'-l) a stock interest in the loss company. 

8 This category also includes an increase in percentage ownership of a loss company 
as a byproduct of a contribution to capital made by another person. For example, assume 
that unrelated individuals A and B own -■• and ^-'s. respectively, of the sole class of 
outstanding stock of corporation M. Separately, B also owns 100 percent of the sole class 
of stock of loss company L worth .$25,000. A and B then make pro rata contributions 
to the capital of M : A contributes .$50,000 cash and B contributes all of his L stock. As 
a result. A will constructively own 66% percent of the stock of L (by reason of his two- 
thirds stock ownership of M). See sec. 318(a)(2)(C). This increase in ownership of L 
stock by a new owner. A, requires under section 382 (a) a 23M! percent reduction in L's 
loss carryovers. 

9 For example, loss company L's total value is .$200. New investor N purchases all of 
the class A common stock worth 10 percent ($20) of L from its existing owners, who 
retain all of the class B common stock. N then contributes $800 of profitable assets to 
the company under a charter provision tying dividends to capital contributions made 
by the shareholders. The capital contribution, in this example, could increase N's per- 
centage ownership of the total value of L to 82 percent ($820/$1000). If so, there would 
be an increase of 72 percentage points attributable to the capital contribution. 



196 

ship which owns loss company stock, liquidation by a partnership of 
the partnership interest of one or more partners, so as to increase tlie 
ownei-ship interest of other partners in the partnership, is also covered. 

7. Any combination of these transactions. 

The above categories are also intended to cover acquisitions of an in- 
terest in a corporation, trust or partnership which does not own a 
loss company's stock at that time but acquires '■; later under a pre- 
existing plan. 

Exceptions are made for the following acquisitions : 

1. Stock acquired from a person if the stock is already attributed 
to the acquirer because of section 318's constructive ownership rules.^° 

2. Stock acquired by inheritpnce or by a decedent's estate from the 
decedent (regardless whether the basis is determined under section 
1014 or under tlie carryover basis rules of section 1023) ; by gift.; or 
by a trust from a grantor. 

3. Stock acquired by a creditor or security holder in exchange for 
relinquishing or extinguishing a claim against the loss company, un- 
less the claim was acquired for the purpose of obtaining such stock." 

4. Stock acquired by persons who were full-time employees of the 
loss company at all times during the 36 -month peiiod ending on the 
last day of the company's taxable year (or at at all times during its 
existence, if that period is shorter). This exception is not to apply, 
however, to an increase in the stock ownership of a person who is both 
an employee and has been a substantial shareholder of a loss company. 

5. Employer stock acquired by a qualified pension or profit-sharing 
trust or by an employee stock ownej-ship plan qualifying under Code 
section 4975(e) (7) or under section 301(d) of the Tax Reduction Act 
of 1975.^2 

6. Stock acquired in a tax-free recapitalization described in section 
368(a) (1)(E).^^ 

The Act brings under section 382(a) carryovers of operating losses 

i"As under prior law, the constructive ownership rules of section 318 are incorporated 
by i-eference into section 382(a), except that corporation to-shareholder attribution, and 
vice versa, operates without regard to the 50-per«?ent threshold rule of sections 318 (a) 
(2)(C) and 318(a)(3)(C). 

This exception operates only to the extent of stock attributed to the acquiring person 
under section 318. Thus, for example, if shareholder A owns 20 percent of the stock (by 
value) of corporation M, which in turn owns all the st /ck of loss companv L, A wiU be 
treated as owning constructively 20 percent (rather than 100 percent) of the stock of L 
pursuant to section 318(a) (2) (C>. ' 

As under prior law, stock acquired for the purpose of invoking this exception will be 
disregarded (see regulation sec. 1.382(a)-l(e) (2) ). 

The exception for actual transfers of loss company stock between related persons 
is also intended to apply if loss company stock is transferred to a newly formed corpora- 
tion in the initial transfer of property to the new corporation. Such a tran.saction should 
be treated as if the transferors had first become shareholders of the holding company 
and then transferred to 't the stock of the loss corporation. 

'1 A court-supervised insolvency proceeding is not required under this exception. The 
exception is also intended to be available if one or more creditors transfer their claims 
to a new corporation in a section 351 exchange for stock in the new corporation. On the 
other hand, this exception does not necessarily preserve loss carryovers following a dis- 
charge in a Bankruptcy Act proceeding if, under applicable judicial authority, such a 
discharge ipso facto eliminates any losses to be carried to future years. 

"This exception covers only the a.'quisition of stock of the emi)lover company (or a 
parent or subsidiary of such company) by the employee-beneficiaries of the b'-ne/it plan. 
The trust must also benefit such employees exclusively. However, this exception is not 
intended to apply to collectively bargained plans or multi-employer plans within the 
broadened meaning of "exclusive benefit" in sections 413(b)(3) and (c)(2) of the Code. 

"This exception may not apply to a recapitalization and acqiisition which together 
result in increased owne-ship bv outside investors. Tie Service may examine such 
a recapitalization and, if appropriate in the situation, treat it as 'pnrt of a sten 
transaction which is subject to the rules of section 382 without regard to this exception. 
This exception will also not apply if an outsider acquires stock for purposes of participat- 
ing in a recapitalization. 



197 

from earlier taxable years to the taxable year at the end of which an 
over-60 percentage point increase in stock ownership has occurred, and 
also carryovers of an operating loss incurred in the latter year itself. 
However, the Act also adopts a "minimum ownership" rule (sec. 
382(a)(3)), under which an operating loss incurred in the latter 
acquisition year can be carried over in full to later years if the persons 
who increased their ownership by over 60 percentage points owned 
at least 40 percent of the fair market value of the participating stock, 
and of all the stock, of the loss company during the entire last half 
of the acquisition year.^* 

If the company's stock ownership changes again before losses being 
carried over under the minimum ownership rule have expired, the 
furtlier change in o^^'nership must be separately tested under section 
382, As a result, losses being carried forward from a minimum owner- 
ship year may be reduced as further carryovers by reason of the later 
transaction. The mininuim ownership rule is also available with respect 
to an oj^erating loss incurred in the first or second taxable year 
preceding tlie acquisition year (these are other years in the "lookback 
period" from the end of the taxable year being tested under section 
382(a)). However, this rule does not prevent a reduction in loss 
carryovers from earlier years to a year when the minimum ownership 
rule is satisfied.^^ 

Operating losses of a corporation incurred in its first taxable year 
are also excepted from the carryover limitations of sec. 382(a). This 
exception will permit the organizens of a corpo^'ation to take in addi- 
tional investors during the course of its first year without adversely 
affecting the carryover of an operating loss incurred in that first year 
of the new venture. 

The Act contains a successive .application rule (sec. 382(a)(6)), 
providing that if a loss carryover has been once reduced under section 
38L(a), and if the new owners do not increase their interest further 
during the following two years, the same carryover will not be reduced 
again under section 382(a) at the end of either later year.^^ 
On the other hand, if the persons whose increase in ownership 



^» Since the general rule of section .S82(a)(l) is triggered by sliareholders whose stock 
ownership of a loss company increases, and the minimum ownership rule operates as a 
limited exception to the general rule, the minimum ownership rule is itself triggered only 
by those among the 15 largest shareholders whose increase in ownership would otherwise 
bring the general rule into effect. For example, assume that individual A owns 100 percent of 
the sole class of stock of a calendar year loss company during all of 1980. On January 2, 
1981, A sells 09 percent of his stock to unrelated individual B. In this case the company's 
loss carryovers vo 1981 will be reduced by 97 Vj percent. The reason is that B is the only 
shareholder in the group of 15 whose stock ownership increased during the three year period 
ending on December HI. 1981 a«d B did not have a 40 percent minimum ownership during 
the last half of 1980. The minimum ownership rule would, however, allow aan operating 
loss suffered in 1981 to be carried over in full to later years since B did own at least 
40 percent of the loss company's stock during at least all of the last half of 1981. 

IS poj. example, assnnie that an outside investor buys 40 percent of a loss company's 
stock during the first half of 1980 and then buys an additional 25 percent at any time dur- 
ing 1981. At the end of 198', loss carryovers to 1981 from before 1980 will be scaled down 
!)y 17 Vi percent. However, the minimum ownership rule will permit a loss incurred in 1981 
to carry over in full to 1982 and later years. The same rule also permits an operating loss 
Incurred in 1980 to carry over in full to 1981 and later years because the new owner will 
have owned a minimum 40 percent interest during all of the last half of 1980. 

i^To illustrate, assume that nn o"tside investor buys 65 percent of the sole class of a 
calendar year loss company's stock in March, 1980, and "stands still" for the n<^xt two 
years. At the end of 19S0. less crrvovers to 1980 will be reduced by 17 '^ percent. (A loss in 
19S0 could carry over in full, however, under the minimum ownership rule.) At the end of 
1981 and 1982, however, section .382(a)(1) would literally require more reductions in the 
unused balance of the same carryovers to those later years because a 65 percentage point 
increase in stock ownership would have cccurred during the lookback period from each of 
those lacer years. The successive application rule prevents such further reductions. 



234-120 O - 77 - 14 



198 

caused a reduction in carryovers (or other persons collaborating with 
them under a concerted plan) buy additional stock during; the first 
or second succeeding years, a further reduction in the unused carry- 
overs should be made, based on the total increase in ownership by the 
new owners during the three-year period. In order to deal with this sit- 
uation, the Service is authorized to provide regulations dealing with 
the computation of the further reduction in carryovers.^" 

Mergers and other tax-free reorgaalzations. — Where a profit com- 
pany acquires the stock or assets of a loss company (or vice versa) in 
a taxfree reorganization, section 382(b) measures continuity by the 
loss shareholders' collective percentage ownership of stock of the 
acquiring company as the result of the reorganization. As already in- 
dictated, the new continuity test for full survival of loss carryovers is 
40 percent, with a reduction of 31/^ percentage points in the allowable 
carryover for each percentage point of continuing stock ownership 
less than 40 and down to 20, plus a reduction of II/2 percentage points 
for each percentage point of continuing stock ownership less than 20. 
As discussed above, these percentage tests are applied separately to 
the ownership (by fair market value) of the participating stock and 
of all stock, respectively, of the acquiring company, and the carryovers 
are reduced by reference to the lower continuity figure. 

As under prior law, section 382(b) continues to apply to statutory 
mergers or consolidations and to C, D and F reorganizations (sec, 368 
(a)(1)(C), (D), (F), except spinoffs under section 355.^« The Act 
also brings under these rules stock acquisitions solely for voting stock, 
as described in section 368(a) (1) (B). The rules of section 382'(b) test 
the above reorganizations both where a loss company is the acquired 
or the acquiring (or surviving) company.^^ 

Tl|e new limitations apply both to operating loss carryovers from 
taxable years of the loss company preceding its taxable year in which 
a reorganization occurs, and to carrvovers of losses incurred in the 
acquisition year itself. However, a minimum ownershi]) rule allows an 
operating loss incurred in the acquisition year to be carried over in full 
if the other narty to the reorganization owned at least 40 percent of 
the fair market value of both participating stock and all stock of the 
loss company at all times during the last half of the acquisition year 

^' The Service is also authorized to prescribe rules relating to cases where a share- 
holder whose acquisition of stock caused a reduction In carryovers sells his stock to other 
new investors before the reduced carryovers are fully used or expire. It may be unfair, 
under some circumstances, to reduce again the carryovers which have already been 
reduced. 

'^ The inclusion of F reorganizations is not intended to atTect the question of whether 
an F reorganization can occur where two or more corporations are combined or, if so, 
whether an F reorganization can occur if complete identity of ownership does not exist 
(see Rev. Rul. 75-561, 1975-2 C.B. 129). 

As under prior law, a purchase of stock followed by a liquidation under conditions which 
give the buyer an asset basis determined under section 334(b)(2) does not allow carry- 
overs to the buyer («ec. 381(a)(1)). A liquidation of a less than wholly-owned loss sub- 
sidiary by a controlling parent corporation, in the form of an "upstream" statutory 
merger, must also be tested under section 382(b). Even though the parent's tax treatment 
wi'l ordinarily be governed by section 332, the transaction will ordinarily be tested (as 
under nrior law) as a reorganization as to the subsidiary's minority shareholders. The 
availabili+v of the loss carryovers to the parent will then depend on "the tests of section 
382(b). These tests will come into play because, for pnrnoses of section 3S2(b)(l). the 
trnns-'ction in this example will he a reorsranization "described in" section 3fi8(a) (1 ) ( A). 

^^ In the case of a C reorganization where the loss company does not distribute the 
stock it receives, the loss company's shareholders are treated as owning constructively 
the undistributed stock of the acquiring company in proportion to the value of their 
stock interest in the loss company (sec. 382(b) (4) (C)). 



199 

(sec. 382(b) (6) (B)). This rule may thus appl}- to a "creepmg" ac- 
quisition where the other party to the reorganization (the acquiring 
or acquired company, as the case may be) previously acquired stock in 
the loss company.-° 

A separate rule covers a situation where a holding company 
(or an operating company) which controls a loss company merges or 
otherwise reorganizes with a profit company (regardless which com- 
pany acquires the o^her). The Act requires, in effect, that the stock 
which the holding company's shareholders receive (or retain) will 
determine liow much of the actual loss company's carryovers survive 
the reorganization (nee. 3Si2(b) (3) (A) ).=^i 

The Act revises the prior ownership i-ule of former section 382(b) 
(5) without, however, intending any substantive change. This nile 
dealt with the situation where, before a merger or C reorganization, 
the other party to the reorganization (typically a profit company) 
already owned stock in the loss company. In this situation, whether the 
profit company acquires the loss company or vice versa, the profit com- 
pany's stock interest is converted into direct ownership of an equivalent 
portion of tlie loss company's assets and ceases to be a stock interest in 
the loss company. For this situation, the former rule deemed the pre- 
existing stock interest to remain outstanding after the exchange in 
order to give proper '"ci-edit" to the former owners of the loss company 
toward satisfying continuity of interest. The Act reaches the same re- 
sult more simply by adding to the stock actually received by the former 
shareholders of the loss company constructive ownership of an addi- 
tional amount of the value of the surviving company's stock equal 
to tho value of the preexisting stock interest in the loss company which 
was extinguished in the reorganization (sec. 382(b) (4) (B) ).-"- 

The prior ownership rule does not apply to an aa^uisition of a 
loss company's assets in a C reorganization where the loss company 
does not distribute some oj* all of the stock it receives. (See footnote 
17.) The i)rior ownership rule also does not apply to a B reorganiza- 
tion, for which special rules are provided (see below). 

=oTlie iiiinimum ownprslilp ruic Is not intendefl to apply where the actual loss company 
Is a third entity other than the acquired or acquiring company. The minimum ownership 
rule excepts a loss carryover unless and until another change in ownership of the loss 
company occurs. At any such later time, the rules of section 382 may require a further 
reduction in the continueil carryover of any remaining balance of the carryovers. 

^ In order for this rule to apply, the company with an operating loss carryover must 
be a corporation other than the actual acquired or acquiring company. This rule therefore 
does not apply to a statutory merger of a parent company with an SO percent or greater 
controlled subsidiary regardless which company In fact has loss carryovers and regardless 
which company is the acquiring company. 

The minimum ownership rule of sec. 382(b)(6)(B) is intended to apply only where the 
company which increases its ownership of the loss company owned the re(|uired miiiimum 
interest in the loss oompa' y before the reorganization. For example, assume fliat cori)o- 
ration HC owns 100 percent of the one class of stock of loss company L throughout calen- 
dar 19S0 and, in 1981, unrelated company I' acquires HC's stock in a "B" reorganization. 
Ij suffers an operating loss in 1980. The minimum ownership rule does not apply to permit 
L's 1980 loss to carry over in full after the exchange. 

--For example, assume that P, a profit company, owns 20 percent (wortli .SIO.OOO) 
of the one class of loss company L's stock whose total value is $50,000 and that 
unrelated persons own the remaining $40,000 in value of L's stock. The fair market 
value of P's one class of stock is $100,000. If P acquires L's assets by merger, the 
combined asset value after the mer:;er v 11 be .i;i40,000 ($10,000 of P's value is extin- 
.guished in the combination). L's former shareholders, other tlian P, will actually receive 
stock worth $40,000 in the combined entity. Under the revised credit rule, the .saiue group 
of former L shareholders will also own con.^^ructively an additional $1'>,000 lu value 
ol the surviving company. The total combined value, $G0,000, will represent a 35.7 percent 
eciuity ownership of tlie combined company (the same result reached by the former rule). 
This percentage, in turn, will require a 15.05 percent reduction in L's loss carryovers 
under the general rules of section 382(b) (4.3 percentage point continuity below 40 
times 314 = 15.05 percent reduction). 



200 

In order to discourage the owners of a profit company from arti- 
ficially satisfying the continuity rules by buying stock in a loss com- 
pany and then merging with it within a short period of time, a 
three-year rule disqualifies certain owners of a loss company from 
being included in the continuity test of section 382(b) (1) (sec. 382(b) 
(4) ( A) ) . This rule applies to stock acquired in the loss company witti- 
in 36 months before the reorganization by one or more shareholders 
who own more than 50 percent of the fair market value of the stock of 
another party to the reorganization, or by a controlled subsidiary of 
such other party. Any such stock must be disregarded in measuring 
continuity under section 382(b) (1).^^ 

A similar rule applies to disregard, in computing continuity of own- 
ership for purposes of section 382(b) (1), stock in the loss company 
acquired within 36 months before a reorganization by the other party 
to the reorganization (section 382(b) (4) (B) and (5) (B) ) .2* 

A liberalizing change is made in the common ownership exception 
of former section 382(b) (3), which preserved loss carryovers in full 
if the acquired and acquiring corporations were owned substantially by 
the same persons in the same proportions. Since constructive owner- 
ship rules did not apply under this exception, it was often difficult to 
combine second-tier subsidiaries witliin an affiliated group. The Act 
makes clear that the common ownership exception applies only to stock 
ownership, but also adds limited constructive ownership rules which 
permit certain controlled subsidiaries below a first tier to be combined 
with each other without loss of carryovers. If the acquired or ac- 
quiring company is a controlled subsidiary of a third company, the 
shareholders of the parent company will be considered to own the sub- 
sidiary's stock owned by the parent in proportion to the fair mar- 
ket value of their stock in the parent (sec. 382 (b) (6) ) .^^ 

If a loss company acquires the stock of a profit company in a "B" re- 
organization, the general rules of section 382(b) will apply to produce 
the proper results (that is, continuity of ownership will be determined 
by reference to the stock owned by the loss company's shareholders 
in their own company after the exchange). However, if a profit com- 
pany acquires the stock of a loss company, the Act contains special 

23 For example, assiii^e that In 1979 A, an over-50 percent Individual shareholder in 
profit company P, buys 55 percent of the sole class of stock of loss company L and that 
in 1980 L mertres into P for 40 percent of P's sole class of stock. Since L's shareholders 
other than A owned 45 percent of L, their ratable share of the ownership of P after the 
merger is 18 percent (45 percent of 40 percent). L's carryovers will therefore be reduced 
by 73 ttercent (20 percentage points below 40 times 314 =70 percent, plus 2 percentage 
points below 20 times 1 % =3 percent). 

-^ These .3(5-month rules in sections 3S2(b)(4) and (5) (B) apply to purchases 
and other acquisitions covered by section 382(a) other than acquisitions excepted from 
that subsection. The minimum ownership rule of section 382(b)(6)(B) overrides these 
36-month rules, but only as to the carryover of operating losses incurred in years in 
wh'ch the minimum ownership is satisfied. 

25 For example, if a common parent company, P. merges L. a wholly owned loss sub- 
sidiary, into S-2, a wholly owned second-tier profit subsidiary of P, the common ownership 
exception will apply because P will be treated as being the common owner of both L and 
S-2. Similarly, if P causes two second-tier subsidiaries in separate chains to be merged- 
together, P will also be treated as the common owner of both merging companies. 

The common ownership exception is intended to apply only to situations where 
neither the acquired nor acquiring company controls the other. Therefore, the exception 
will not apply to "upstream" or "downstream" mergers (or C reorganizations) of a 
parent company and its controlled subsidiary. The minimum ownership rule of sec. 
382(b) (6) (B) may apply, however, to a downstream merger of this kind. 



201 

provisions requiring the continuity rules of section 382(b) to be 
applied by direct reference to the stock ownership of the loss company 
after the exchange. Exchanging shareholders will be treated as owning 
a percentage of the loss company's stock acquired by the acquiring 
company equal to the percentage of the latter's stock which such share- 
holders received in the exchange.-^ This percentage will then be com- 
bined with the percentage (if any) of the loss company's stock which 
its shareliolders did not exchange. Where the acquiring company itself 
owned stock in the loss company before the exchange, such stock will 
also be counted toward satisfying the continuity rule (except, as dis- 
cussed earlier, for stock acquired wathin 36 months before the 
exchange) . 

Under a special rule in i:)rior law (former sec. 382(b) (6)), a prof- 
it company could arrange for a controlled subsidiary to acquire 
the assets of a loss company for stock of the parent company and a 
full carryover could be obtained if the fair market value of the loss 
company shareholders' stock in the parent equalled at least 20 percent 
of the fair market value of all the stock of the acquiring subsidiary. 
If the acquiring company were a newly created shell, this rule would 
almost always be satisfied, even though the loss company sharehold- 
ers' stock in the parent may have been less than a 20-percent interest 
in the parent (and thus less than a 20-percent indirect interest in their 
former company). 

The Act now requires that in this type of "triangular" reorganiza- 
tion, the continuity rules are to be applied by reference to the loss com- 
pany shareholders' actual percentage ownership of participating stock 
and of all stock, respectively, of the parent company (sec. 382(b) (3) 
(B).^" In the case of a triangular B reorganization, where a subsi- 
diary of a profit company acquires the stock of a loss company in ex- 
change for stock of the profit company, a special rule requires, in ef- 
fect, a two-step calculation converting the loss shareholders' percentage 
ownership in the parent of the acquiring company into an equivalent 
])ercentage ownership of the acquiring subsidiary and then, in turn, 
into an indirect percentage ownership of the loss company (sec. 382(b) 
(5)(C)).- 

Rifles relating to stock. — The statute narrows the exception in prior 

^This rule excludes stock of the acquiring company which shareholders of the loss 
company may have owned before the exchange 

'■''' This new rule also applies to "forward" and "revprse" triangular reorganiza- 
tions pursuant to section 368(a)(2) (D) and (E) of the Code. It applies to the situation 
existing immediately after the exchange and, at that point, the loss company's share- 
holders will own stock in a corporation which controls the loss company. 

^ Ti> illustrate, assu!i\e that pro'it company P funds a new wholly owned subsidiary 
S with shares of P stock, which S then uses to acquire all the stock of loss company L 
in a tax-free B reorganization in exchange for 20 percent of the participating stock and 
of all the stock of P. As a result, L becomes a second-tier subsidiary of P. Under the rule 
stated above. L's shareholders will be deemed to own 20 percent of the equivalent stock of 
S. In turn, this interest will be treated as a 20-percent ownership of L, so that 30 percent 
of L's carryovers will survive the exchange (20 percentage point continuity below 40 times 
314 = 70 percent reduction). 

If S had acqui d oniy 80 i)ercent of L's stock for, say, 17 percent of P's stock, evchang- 
ing shareholders would be considered, by reason of their receipt of P stock, to own 13.6 per- 
cent of L after the exchange (17 percent of S s 80 percent ownership of L). After adding 
the 20 percent of L stock not exchanged, a total of 33.6 percent continuity would result, so 
that 77.6 percent of L's carryovers would survive the exchange (6.4 percentage point con- 
tinuity below 40 times 3% =22.4 percent reduction). 



202 

law for nonvoting preferred stock which must be ignored for purposes 
of section 382. The new exception is limited to nonvoting stock which 
has fixed and preferred dividends and does not participate in corpo- 
rate growth to any significant extent, has redemption and liquidation 
rights which do not exceed paid-in capital or par value (except for 
a reasonable redemption premium), and is not convertible into another 
class of stock. 

The Act also defines "participating stock" to mean stock (including 
common stock) whicli represents an interest in the corporate eainings 
iind assets not limited to a stated amount of money or property or 
l)crcentage of paid-in capital or par value, or by any similar formula. 
The reorganization rules will thus not be fully satisfied by giving loss 
company sliareholders only conventional preferrred stock (whether 
looting or nonvoting) .^^ 

The new rules require the Service to determine by regulation 
vvhether a variety of instruments (however denoted) wliich may be 
difficult to classify undei* gc^neral definitions are to hv. considered 
stock or participating stock for purposes of this provision. For this 
{Hirposo, the Service v.ill deal by regulation Avith conversion and 
f-ali rights, rights iu earnings and assets, priorities and preferences, 
and similar factors (including collateral agreements and "puts" back 
to the issuing company) in determining whether or not a particular 
Distj-unicnt will be treated as "stock"' or as "participatirig stock."-'" 

The Libson Shops doctrine. — In Lihson Shops, Inc. v. Kochler., 35-" 
U.S- 3S-2 (1957), the Supreme Court, in a case decided under the 1939 
Code, adopted an approach to the loss carryover area under which loss 
carryovers would basically follow the specific business activities which 
gave rise to the losses. Some uncertainty existed after this decision as 
io vvhetiier the business continuity approach represents a separate, 
nonstatutory test for determining carryovei^ of net operating losses. 
As a result of the changes made by the Act, Congress intends that the 
so-called Lihson Shops test should have no application to determining 
net operating loss carryovers after stock purchases or reorganizations 
to tax years governed by the now rules. However, Congress intends 
•hat no inference should be drawn concerning the applicability or 



*' As Indicated earlier, section 382 Is applied In effect by reference to the lesser percentage 
ct participating stock or of all stock retained by former owners of a loss company. Under 
fiectiou .SS'ifa), for example. If a loss company recapitalizes by freezing the bulk (e.g., 95 
percent) of its current value Into voting preferred stock, and the balance into common stock 
which the owners then sell to outsiders, the iatters' purchase may cause a reduction In 
ca.-rycvers. Although the common (participating) stock represents only 5 percent of the 
company's current vi'.lue. it also represents 100 percent of Its future value. Since the former 
owners retained no share in this future value, the company's loss carryovers wUl be elimi- 
nated entirely. 

3" I'nrter some cirrunistances, fully participating preferred stock may properly be treated 
as participating stock la light of the practical economic effect of its preferential right 
tt) earnings. 

Under this delegation, the Service can also deal with contingent share reorganizations 
and with nonvoting preferred stock which obtains voting rights only if and when certain 
events occur (such as missing a stated number of dividends). The delegation will also 
permit the Service, on appropriate facts, to ignore stock held as security for a loan to 
the corporation (see regulation sec. 1.305-3(e), example (14)), or stock held in escrow 
(st>e G:oier I'uckmg Co. of Tewa-a v. U.S., 32S F. 2d 342 (Ci. CI. 1964). This delegation also 
gives the Service specific luithority under section 382 to treat convertible preferred stock 
br bonds, warrants and other options as equivalent to the underlying stock where appro- 
priate to prevent manipulations of stock structures designed to circumvent the basic 
policies underlying section 382. 



203 

nonapplicability of theLibson Shops case in determining net operating 
loss carryovers to tax years governed by prior law." 

The general tax avo? dance test. — Congress did not change the basic 
provisions of section 209 of the Code. Congress believes, however, that 
section 269 should not be applied to disallow net operating loss carry- 
overs in situations where part or all of a loss carryover is permitted 
under the sj)ecific rules of section 382, unless a device or scheme to 
circumvent the purpose of the carryover restrictions appears to be 
present.''- Congress also concluded that this general disallowance pro- 
vision should be retained for transactions not expressly within the 
fixed rules of section 382. Section 269 is retained, for example, to deal 
with "built-in-loss" transactions, other post-acquisition losses, ac(iiiisi- 
tions expressly excepted from section 382, and other exchanges or 
transfers which are apparent devices to exploit continuing gaps in the 
technical rules for tax avoidance purposes. 

Effective date 

In order to allow a reasonable time for the Internal Revenue Service 
to issue regulations under the new rules, the Act delays the effective 
date of the new rules generally for one year. The new rules apply 
to reorganizations pursuant to plans adopted by one or more of the 
parties on or after January 1, 1978. A reorganization plan will be 
considered adopted on the date tlie board of directors adopts the plan 
or recommends its adoption to the shareholders, or on the date the 
shareholders approve the plan, whichever is earlier. If the new limi- 
tations affect a reorganization occurring in 1978, net operating loss 
carryovers to 1977 from earlier years will not be affected by the new 
rules, but carryovers of operating losses to 1978 and later years may be 
limited. A loss occurring in 1977 (or in a fiscal year ending in 1978) 
may also be limited as a carryover to 1978 (or to a fiscal year ending in 
1979) and later years. 

In the case of purchases of stock of a loss company and other 
acquisitions subject to new sec. 382(a), the new rules take effect for 
taxable years of a loss corporation beginning after June 30, 1978. 



SI Congress does not Intend the changes In section 382 to af?ect the "continuity of busi- 
ness enterprise" requirement which the courts and the Service have long established as 
ii condition for basic nonrecognltlon treatment of a corporate reorganization (see sec. 
1.368-1 (b) of theregalatlons). 

Congress also does not Intend to deprive the Service of other weapons to attack trans- 
actions in which the benefits of loss carryovers are Improperly transferred In ways other 
than by transfers of stock, or transactions where section 382 is otherwise satisfied (In 
whole or part). For example, the new rules do not affect the principles of substance over 
form, step transaction (see, e.g., the examples In regulations sec. 1.382 (b)-l (c), corpo- 
rate entity, assignment of income, or the rules of Code sections 482 or 704(b) (relating 
to allocations). Nor do the new rules prevent the Service, in appropriate cases, from chal- 
lenging situations where a loss company pays more than fair market value for stock or 
assets of another company. 

*• For example, section 269 could still apply to a case where the capital structure of 
a company is arranged principally to avoid a "control" relationship under section 382, 
or where a permanent Interest by former owners of a loss company Is diluted for tax 
avoidance purposes. Thus, If a profit company buys less than all the stock of a loss company 
and then transfers in a short-term Income asset such as certain kinds of royalties or an 
installment note receivable (or liquidates the loss company Into a company which owns 
such assets), section 269 might still be Invoked If the after-tax benefits to the new owner 
exceed the price paid for the loss company's stock and If the company remains a shell 
after the last payment ou the receivable Is received. 



204 

However, the "lookback" period under these rules may include earlier 
taxable years. The earliest lookback point, liowever, is January 1, 1978. 
For example, section 382(a) as amended will take effect for a calendar 
year corporation during calendar 1979. The first "lookback" period for 
a calendar year corporation under the new rules will be a transitional 
24-month period from December 31, 1979, back to elanuarv 1, 1979. and 
then back to January 1, 1978. When the new rules become fully effec- 
tive, the lookback period will cover three years, so that for a corpora- 
tion whose taxable year ends on December 31, 1980, reference will be 
made back to the first day of that year and then back to January 1, 
1979, and then to January 1, 1978. 

In this example, the prior rules of section 382(a) will govern the 
allowance of loss carryovers of the company to its calendar years 1977 
and 1978. The new rules will govern loss carryovers from 1978 and 
earlier years to 1979 and later years. Although the new rules will thus 
not actually limit carryovers in this example until 1979, the new limi- 
tations may affect loss carryovers to 1979 from earlier years, as well as 
carryovers from 1979 to later years. Also, changes in stock ownership 
occurring during 1978 will be taken into account as part of the look- 
back period from December 31, 1979, for purposes of testing loss carry- 
overs to 1979 and later years. This means that changes in the stock 
ownership of a calendar year loss company during 1978 will be taken 
into account in applying former section 382(a) at the end of 1978 and 
also in applying ncAv section 382(a) at the end of 1979 and 1980 as 
pai"t of the lookback period from the end of each of those years."*^ 

For a fiscal year corporation whose taxable year begins, for ex- 
ample, on July 1, the rules of prior section 382(a) will govern loss 
carryovers to fiscal 1977 and 1978. The new rules will govern loss carry- 
overs to fiscal 1979, and for this purpose changes in stock ownership 
measured by reference back to stock ownership on July 1, 1978, and 
on January 1, 1978, will be taken into account.^* 

The statements above concerning the relationship between the new 
section 382 rules and section 269 of present law and the Lihson Shops 
case are intended to operate initially with respect to the first taxable 
year to which carryovers are governed by the new rules of section 382. 

Revenue effect 
It is estimated that, when fully effective in 1978 and later years, 
the provision will increase budget receipts in light of the reduced off- 

'2 For a calendar year company, chanpes in Its stock ownership during 1978 will thus 
be taken Into account under the "old" rules in testing loss carryovers to 1978. The same 
ownership changes will also be taken into account under the new rules in testing carryovers 
to 1979 and later years. If no change In the stock ownership of a calendar year company 
occurs during 1978, new section 382(a) will not reduce its loss carryovers to 1979 (unless 
ownership changes occur in 1979). If changes in stock ownership do occur during 1978. 
those changes may reduce (under the new rules) a carryover of prior losses to 1979 and 
Inter years. This reduction of carryovers to 1979 and later years may occur even If the 
old rules (applied at the end of 1978) did not limit carryovers to 1978. 

Similar principles also apply to fiscal year companies. 

^* For a fisf'nl year corporation whose tnxa^'le year begins before July 1. the rules of 
prior section 382(a) will govern loss carryovers to fiscal 1977, 1978 and 1979. The new 
rules will govern loss carryovers to fiscal 1980. and for this purpose changes in stock 
ownership measured by reference back to stock ownership on the first day of fiscal 1980 
and 1979 and on January 1, 1978, will be taken into account. 



205 

set of past losses against current profits. Howe vcr, the amount of tlie 
revenue increase is considered indeterminate because the amount of the 
reduction in the use of carryovers depends on the relative sizes of the 
companies imolved and also because some acquisitions of loss com- 
panies by })rofitable companis may not be made. 

7. Small Commercial Fishing Vessel Construction Reserves (sec. 
807 of the Act and sec, 607 of the Merchant Marine Act) 

Prior laio 
Under prior law, domestic shipping vessels had to weigh at least 5 
net tons in order to be eligible for the capital construction fund (under 
which the tax on shipping income can be deferred if placed in a capital 
construction fund for future use in obtaining additional ships). 

Reasons for change 
In reviewing the operation of the capital construction fund. Con- 
gress was concerned that the 5-ton limitation discriminated unfav- 
orably against small shipowners, especially those engaged in small 
scale commercial fishing- Accordingly, Congress concluded that a 
lower weight limitation would better achieve the general goal of re- 
vitalizing the U.S. commercial fleet. 

Explanation of provision 
The Act permits a commercial fishing vessel which is under 5 net 
tons, but not under 2 net tons, to be an eligible vessel under the capital 
construction fimd (sec. 607 of the Merchant Marine Act, 46 U.S.C. 
1177), if the vessel is constructed (or reconstructed) in the United 
States, is owned by a citizen of the United States, has a home port in 
the T"''nitod States, rnd is operated in the commercial fisheries of the 
United States. 

Effective daze 
The provision is effective upon the date of enactment (October 4. 
1976). 

Revenue effect 
It is estimated that this provision will reduce revenues by less than 
$5 million a year. 



H. SMALL BUSINESS PROVISIONS 

1. Extension of Certain Corporate Income Tax Rate Reductions 
(Sec. 901 of the Act and sees. 11 and 821 of the Code) 

Prior law 

Prior to the 1975 Tax Reduction Act, corporate income was subject 
to a 22-percent normal tax and a 26-percent surtax (for a total tax rate 
of 48 percent). However, the first $25,000 of corporate income was 
exempt from the surtax. As a result, the first $25,000 of corporate in- 
come was taxed at a 22-percent rate and the income in excess of $25,000 
was taxed at a 48-percent rate. 

In the Tax Reduction Act of 1975, the surtax exemption was in- 
creased to $50,000 and the normal tax was reduced to 20 percent on 
the initial $25,000 of taxable income. This resulted in a 20-percent rate 
on the first $25,000 of income, a 22-percent rate on the next $25,000 of 
income, and a 48-percent rate on income in excess of $50,000. These 
changes were extended by the Revenue Adjustment Act of 1975 
through June 30, 1976. 

Reasons for change 

The temporary changes in the corporate surtax exemption provided 
by the 1975 Tax Reduction Act were adopted for two reasons : First, to 
grant tax relief to small businesses which are not likely to derive sub- 
stantial benefits from the liberalizations in the investment credit be- 
cause they are not capital intensive ; and second, to provide temporary 
tax relief to small business as part of a program of tax reduction de- 
signed to help sustain the economy and promote economic recovery. 
These reasons for increasing the surtax exemption and lowering the 
normal corporate tax rate continue to apply in the current economic 
situation. 

The changes in the surtax exemption and the normal corporate tax 
rate made in the 1975 Tax Reduction Act did not apply to mutual 
insurance companies, because of a technical oversight [resulting from 
the fact that nuitual insurance companies' tax rates are determined 
under a different section of the Code (sec. 821)]. 

Explanation of provision 
The Act extends the increase in the surtax exemption and the 
reduction in the normal tax rates through December 31. 1977, and 
applies these changes to mutual insuranc^i companies. 

Effective date 
These provisions make the changes in corporate tax rates and the 
increase in the surtax exemption applicable in the case of all taxable 
years ending after December 31, 1975 and before January 1, 1978. 
They are made applicable to mutual insurance companies for taxable 
years ending after December 31, 1974 and before January 1, 1978. 

(206) 



207 

Revenite effect 

This provision will reduce budget receipts by $1,676 million in fiscal 
year 1977 and $1,177 million in fiscal year 1978. 

In accordance with the provision's objective, the larger part of the 
resulting tax reductions will accrue to small corporations. For ex- 
ample, about 63 perc^^nt of the aggregate tax reductions resulting 
from the liberalized surtax exemption and the decrease in the normal 
tax rate will accrue to corporations with incomes of less than $100,000, 

2. Changes in Subchapter S Rules 

a. Subchapter S Corporation Shareholder Rules (sees. 902 (a) and 
(c) of the Act and sec. 1371 of the Code) 

Prior Ioajo 

Subchapter S was enacted in 1958 in order to minimize the effect of 
Federal income taxes on businessmen's choices of the form of business 
organization in which they conduct their businesses, and to permit the 
incorporation and operation of certain small businesses without the 
incidence of income taxation at both the corporate and shareholder 
levels. The subchapter S rules allow corporations engaged in active 
trades or businesses an election to be treated for income tax purposes in 
a manner similar to that accorded partnerships. Where an eligible cor- 
poration elects under the subchapter S provisions, the income or loss 
(except for certain capital gains) is not taxed to the corporation, but 
each shareholder reports a share of the corporation's income or loss 
each year in proportion to his sliare of the corporation's total stock. 

An election under subchapter S is made by. and requires the consent 
of, all shareholders. It may be terminated either voluntarily or invol- 
untarily in certain circumstances. 

In order to be eligible for subchapter S treatment, the stock owner- 
ship of the corporation must meet certain qualifications. First, it must 
be a corporation with only one issued and outstanding class of stock. 
Under prior law the corporation was required to have 10 or fewer 
shareholders, all of whom were individuals or estates and none of 
whom were trusts or nonresident aliens.^ 

For purposes of determining the number of shareholders, stock 
which is community property of a husband and wife (or the income 
from which is community property income) under the law of a com- 
munity property St«<te is treated as owned by one shareholder. Sim- 
ilarly, a husband and wife are treated as one shareholder where they 
own the stock as joint tenants, tenants in common, or tenants by the 
entirety. 

Rea.'ions for change 
One of the most common uses of the subchapter S election has been 
in the situation of a family owned or controlled corix>ration. During 
the eighteen years that subchapter S has been in effect, many corpora- 
tions which have been electing corporations during much of this 
period, and their sliareholders, find that their subchapter S status is 
imperiled because of the 10-shareholder linvitation. This often occurred 



■ In addition to the stock ownership requirements, the corporation must be a domestic 
corporation and may not be a member (parent corporation) of an affiliated group of 
corporations ellgiole to file consolidated income tax returns. 



208 

where one of the original shareholders retires from the family busi- 
ness and transfers the stock to his children or leaves it to them in his 
will. The death of a spouse could also cause a problem under this rule. 
Although a husband and wife were treated as one shareholder, the 
deceased spouse's estate was considered to be a separate shareholder. 
Because of these difficulties and in order to maintain the viability of 
the subchapter S corporation for family o-svned businesses, Congress 
decided to make several changes in the subchapter S shareholder rules. 

Explanation of provimms 

The Act makes several changes in the stock ownership rules in the 
subchapter S provisions. First, the number of shareholders permitted 
in order for a corjwration to qualify for and maintain subchapter S 
status is increased from 10 to 15 after the corporation has been an 
electing subchapter S corporation for 5 taxable years. Under this 
rule, an electing corporation may have no more than 10 shareholders 
during the first 5 years of its subchapter S status, but may increase 
its number of qualifying shareholders to 15 after this period. The 
5-year period in this provision means 5 consecutive taxable years of 
the corporation. 

Congress intends that once the corporation has satisfied the 5-year 
rule under any subchapter S election, it qualifies for the additional 
5 shareholders even though this election has been terminated or revoked 
and it has subsequently made a new subcliapter S election. This is to 
prevent a potential problem, where an electing corporation's status 
is terminated or revoked after it has satisfied the 5-year rule and the 
number of sliareliolders has increased to more than 10. Under prior 
statutory rules, a corporation whose subchapter S status has been 
terminated or revoked is not eligible, without the permission of the 
Secretary, to make a new election for subchapter S treatment until 
the sixth taxable year following the last year the previous election was 
in effect. If the corporation were required to satisfy the 10-shareholder 
5-year rule after this new election, the rule could force divestitures 
(or encourage sham transactions) by as many as 5 of the shareholders. 
Since this rule avouM create hardships in some situations, such as a 
family-owned small business. Congress believes that the 5-year rule 
should not be required to be satisfied in conjunction with a subsequent 
election where it was previously satisfied under an earlier election 
and the corporation had in fact more than 10 shareholders on the last 
day of the last taxable year covered by the previous election. 

Othei" statutory changes relate to situations where ownership of a 
subchapter S corporation's stock changes as a result of the death of 
a shareholder. One change provides an exception to the 5-year thresh- 
old requirement to allow shareholders in excess of 10 (but in no event 
more than 15 total shareholders) during the 5-year period if the initial 
additional shareholders acquire their stock by inheritance. 

In order not to restrict the transferability of the shares (during the 
5-year period) by the inheriting shareholders, these shareholders may 
sell or otherwise transfer their shares during the 5-year period to a 
noninheriting shareholder without violating the 5-year requirement. 
However, the total number of shareholders during the 5-year period 
is not permitted to exceed the number of previous shareholders plus 



209 

the number of inheriting shareholders. For this ])urpose, the term 
"inheritance" is given a broad definition to inchide the passing of 
property by legacy, devise or intestate succession. 

Congi-ess also decided to mitigate potential adverse effects of the 
shareholder rules where husband and wife are treated as one share- 
holder and one or both of the spouses die. The Act provides that where 
either husband or wife, or both, die, the estate of the deceased will be 
treated as one shareholder with the surviving spouse (or that spouse's 
estate) if husband and wife were treated as one shareholder while botli 
were living and the stock continues to be held in the same proportions 
as before death. 

The final change to the shareholder rules concerns the eligibility of 
trusts as shareholders in subchapter S corporations. I'^nder the Act, 
grantor trusts and voting trusts may be shareholders in a subchapter 
S corporation. A grantor trust is defined as one treated as owned by 
the grantor under subpart E of part I of subchai:)ter J of the income 
tax provisions (Code sees. 671-678). In addition, each beneficial owner 
of stock in a voting trust will be considered the shareholder for pur- 
poses of determining the number of shareholders. Any type of trust 
may also be a shareholder where it acquires stock in a subchapter S 
corporation pursuant to the terms of a will. However, the eligibility 
of trusts as subchapter S sliareholders in this situation extends only 
for a period of 60 days beginning with the day on which the trust ac- 
quired the stock. Thereafter, the trusit becomes an ineligible share- 
holder and retention of the stock beyond the 60-day period will cause 
a termination of subchapiter S status. 

Effective, date 
These provisions are effective for taxable years beginning after 
December 31, 1976. 

Revenue ejfect 
The revenue loss from these provisions is estimated to be negligible. 

6. Distributions by Subchapter S Corporations (sec. 902(b) of the 
Act and sec. 1377 of the Code) 

Prioi' law 

The shareholders of a subchapter S corporation are taxed each year 
on the income of the corporation, regardless of whether this income 
is distributed currently as dividends to the shareholders. If the share- 
holders of a subchapter S corporation have been taxed on income of 
the corporation which has not been distributed to them, the corpora- 
tion in a subsequent year can distribute this previously taxed income 
without the shareholders incurring any additional tax liability. How- 
ever, before a distribution will constitute a distribution of previously 
taxed incoii.e, the corporation nmst first have distributed an amount 
o(jual to its current earnings and profits in tiie yera- of sucii distribution. 

An earnings and profits rule applicable generall)^ to corporations 
(sec. 312(m), enacted in 1969) requires that the earnings and profits 
of corporations, including subchapter S corporations, be computed 
using straight line depreciation, rather than the accelerated deprecia- 
tion methods taxpayei-s may use for computing taxable income. Thus, 
under prior law, where a corporation elects an accelerated deprecia- 



210 

tion method, the earnings and profits of the corporation could be 
greater than its taxable income. 

Reasons for change 
In tax years vhere a subchapter S corporation claimed an acceler- 
ated depreciation deduction which exceeded the amount allowable 
under the straight line method, the corporation had current earnings 
and profits which exceeded its taxable income. If the corix)ration made 
cash distributions for that year in amounts in excess of its current 
taxable income (which is taxed to the shareholders, whether dis- 
tributed or not), the oxcess distributions were considered dividend in- 
come to the stockholders to the extent that the corporation's current 
earnings and profits exceeded its taxable income. This (x*curred 
even though the corpoj-ation had undistributed taxable income which 
had previously been taxed to the shareholders. Congress decided that 
this unintended interplay between tlie subchapter S rules and section 
312 (m) should be changed so that a corporation can distribute pre- 
viously taxed income to the extent its distributions exceed its taxable 
income even though, as a result of section 312 (m), its current earn- 
ings and profits exceed its taxable income. 

E xplan/itiov. of jyrovision 

Under the Act, current year earnings and profits are to be computed 
without regard to section 312 (m) solely for purposes of determining 
whetlier a distribution by a subchapter S corporation is considered to 
come from the corporation's previously taxed income or from its cui- 
rent earnings and profits. As a result, where the current earnings and 
profits of a subchapter S corporation exceed its taxable income because 
of section 312 (m) for a year when it makes a cash distribution in excess 
of its taxable income, that excess will, to the extent of its undistrib- 
uted previously taxed income, be considered to be a distribution of 
this previously taxed income. Consequently, it will not be taxable to 
the shareholders and will not reduce earnings and profits of the corpo- 
ration. If the distribution exceeds the sum of the previously taxed in- 
come and the taxable income in the year of distribution, the excess 
will be considered a taxable dividend to the extent of the current and 
accumulated earnings and profits, in accordance with the rules gen- 
erally applicable to corporations. Accordingly, any such excess dis- 
tribution would be taxable as a dividend to the extent of current earn- 
ings and profits (determined with regard to section 312 (m)) even 
though the corporation had a deficit in accumulated earnings and 
profits. 

For example, assume a subchapter S corporation has $100 of tax- 
able income, $120 of current earnings and profits (the $20 difference 
between taxable income and current earnings and profits representing 
the accelerated portion of depreciation which is not deducted 
for purposes of current earnings and profits as a result of section 
312 (m) ), and $10 of undistributed taxable income previously taxed to 
shareliolders in a prior year. Assume further that in such year the 
corporation distributes $120 to its shareholders. lender the Act, solely 
for purpos?s of determining whether the corporation has distributed 
previously taxed income, the corporation's current earnings and profits 
are considered to be $100. Accordingly, $10 of the amount distributed 
is treated as a distribution of previously taxed income and is received 



211 

without additional tax liability by the shareholders, and $110 of the 
amount is treated as a distribution of current earnings and profits and 
is taxed to the shareholders as a dividend. The remaining $10 of undis- 
triimted current earnings and profits increases accumulated earnings 
and profits. The result of the above example would be the same even 
if the corporation had a deficit in accumulated earnings and profits. 

Effective date 
Tliis amendment applies to taxable years beginning after Decem- 
ber 31, 1975. 

Revenue effect 
It is estim.ated that this provision will result in a decrease in budget 
receipts of less than $5 million annually. 

c. Changes to Rules Concerning Termination of Subchapter S 
Election (sec. 902(c) of the Act and sec. 1372(e) of the Code) 

Prior lav 
Statutory rules provide generally that all shareholders of a corpora- 
tion must consent to either an election of subchapter S status or io a 
voluniary revocation of this election. However, prior law provided 
that an election of su]>chapter S status would be involuntarily termi- 
nated if any new shareholder of the corporation did not affirmatively 
consent to the election, generally within "a period of 30 days from the 
day he became a new shareholder. A consent for this purpose involved 
a formal filing with the Internal Revenue Service. 

Reason for change 
The requirement of a new shareholder's affirmative consent to a sub- 
chapter S election within a limited period of time could result in an 
inadveitent termination of the election if the new shareholder failed 
to file a timely consent or was not aware of the necessity of filing a 
consent, (congress was concerned that a termination of subchapter S 
status in these circumstances would cause a severe hardship not only 
to the new shareholder but to all shareholders of the corporation. It 
therefore decided to require that a new shareholder must affirmatively 
refuse to consent to a subchapter S election in order to terminate such 
an election. 

Explanation of provision 
Under the Act, in order for a subchapter S election to be terminated, 
a new shareholder must affirmatively refuse to consent to the election 
within 60 days from the time he acquired his stock in the corporation. 
In the case where a decedent's estate is the new shareholder, the 60- 
day period for filing an affirmative refusal will begin upon the earlier 
of either the day on which the executor or administrator of the estate 
qualifies or the last day of the corporation's taxable year during which 
the decedent's death occurred. The Secretary is authorized to issue reg- 
ulations prescribing the manner in which an affirmative refusal is to 
be filed. 

Effective date 
These jH'ovisirns are effective for tax years beginning after Decem- 
ber 31, 1976. 

Revenue effect 
This provision involves a negligible revenue loss. 



I. TAX TREATMENT OF FOREIGN INCOME 

1. Exclusion for Income Earned Abroad (sec. 1011 of the Act and 
sees. 36 and 911 of the Code) 

Prior law. 

U.S. citizens are generally taxed by the United States on their 
worldwide income with the provision of a foreign tax credit for 
foreign taxes paid.^ However, under prior law l^.S. citizens Avho were 
working abroad could exclude from their income up to $20,000 of 
earned income for periods during which they were present in a foreign 
country for 17 out of 18 months or during the period they were l)ona 
-fide residents of foreign countries (sec. 911). In the case of individuals 
who had been hona -fide residents of foreign countries for three years or 
more, the exclusion was increased to $25,000 of earned income. 

The above exclusions did not apply to employees of the U.S. Govern- 
ment working abroad. However, prior law provided that certain 
special governmental allowances given to these employees were exclud- 
ed from gross income and were not taxed by the United States (sec. 
912). These allowances, Avhich included liousing, cost-of-living, educa- 
tion and travel allowances (established by various statutes) were ex- 
empt under the tax laws. (Allowances received by members of the 
armed forces were exempted under provisions of law outside of the 
Internal Revenue Code.) Any employee was entitled to exclude from 
gross income lodging furnished by the employer on the business prem- 
ises if the em])loyee was required to accept it as a condition of employ- 
ment (sec. 119). 

Reasons for change 

The Congress believed that the exclusion for income earned abroad 
should be retained so that the competitive position of U.S. firms 
abroad is not jeopardized. Therefore, the Congress did not repeal the 
provision or phase it out. However, the Congress's attention had been 
called to the presence of unintended results under prior law. For 
example, compensation was excluded under section 911 even though 
it was not subject to tax by the foreign country where the employee 
was employed if the compensation was paid outside that foreign coun- 
try (e.c., if the salary is sent to a bank outside of that country). 

In those cases where a foreign tax was naid by the U.S. citizen, 
that tax was creditable directly asrainst any U.S. tax that niijrht other- 
wise exist on income above the $20,000 or $25,000 excludable limits. 
This combination of an exclusion of $20,000 or $25,000 of income, plus 
the allowance of tlie full foreign tax credit attributable to all income 
(including the excluded income) gave taxpayers who did pay tax to 
foreign governments in effect a double benefit, in that they could offset 

1 A foreign tax credit was not allowed under prior law to those Individuals who took the 
standard deduction. 

(212) 



213 

the foreign taxes paid on the excluded income against any U.S. tax 
which might be due on additional foreign income. The result "was that 
substantially more than $20,000 of earned income coukl be exempted 
from U.S. tax if tlie U.S. employee paid any significant income tax 
to the foreign government. 

In addition, compensation in excess of tlie excluded amount Avas 
taxed by the United States at a marginal rate that would apply to an 
employee who had not earned the excluded amount. The Congress 
felt that this treatment was inconsistent with our progressive tax 
system and that the marginal rate applicable to the employee having 
the advantage of the exclusion should take into account the excluded 
amount. 

Evi'plaimtion of fromsions 

The Act generally reduces the exclusion for earned income of in- 
dividuals abroad to $15,000, except that the Act retains a $20,000 
exclusion for employees of charitable organizations. If an individual 
performs services for an employer who was created or organized 
under the laws of the United States (or any State, including the Dis- 
trict of Columbia) Avhich meets the requirements of section 501 (c) (3) , 
the employee, if he otherwise meets the )-equirements of section 911, 
will be entitled to exclude earned income attributable to those services 
in an amount not in excess of $20,000 computed on a dail^^ basis. An 
individual is not entitled to full benefits of the charitable exclusion and 
the $15,000 exclusion provided to other individuals. Accordingly the 
amount of earned income entitled to be excluded by reason of the gen- 
eral $15,000 exclusion may not exceed $15,000 reduced by the amount of 
earned income excluded by reason of the fact that it is attributable to 
qualified charitable services. 

In addition, the Act makes three changes that deal with tlie amount 
eligible for the exclusion and the computation of tax liability for those 
individuals who claim the exclusion. 

First, the Act ])rovides tliat any individual entitled to the earned 
income exclusion is not to be allowed a foreign tax credit with respect 
to foreign taxes allocable to the amounts that are excluded from gross 
income under the earned income exclusion. Thus, foreign income taxes 
that are paid on excluded amounts are not to be creditable or 
deductible. 

Second, the Act provides that any additional income derived by 
individuals beyond the income eligible for the earned income exclusion 
is subject to I"^.S. tax at the higher rate brackets which would apply 
if the excluded earned income were not so excluded. For the purpose of 
determining the rate brackets applicable to the nonexcluded income, 
the taxpayer is entitled to subtract those deductions which woidd be 
otherwise disallowed by reason of being allocable to the excluded 
earned income. Thus, for example, if a tax[)ayer- has $15,000 of gross 
income Avhich is excluded under the earned income exclusion and also 
has $5,000 of deductions which are not allowable by reason of the 
deductions being allocable to the excluded earned incoiuo. the taxpayer 
is treated as having an additional $10,000 of taxable income for pur- 
poses of computing the tax rates on the nonexcluded income. 



234-120 O - 77 - 15 



214 

Since earned income is now subject to an exclusion with the other 
income being taxed at the higher brackets, any foreign tax credits dis- 
allowed by reason of being allocable to the excluded earned income are 
to be considered as those taxes paid on the first $15,000 of excluded 
income. P\)i-oign taxes are allocable to the amount excluded in the 
proportion that the tax on net excluded earned income bears to the tax 
on the net taxable income. Thus, the foreign taxes allocable to the ex- 
cluded amount and disallowed are those foreign laxes imposed on the 
first $15,000 (or other excluded amount) of income assuming a foreign 
effective tax rate as progressive as the IT.S. tax rate.- 

Third, the Act makes ineligble for the exclusion any income earned 
abroad which is received outside the counti-y in which earned if one of 
the purposes of receiving such income outside of the country is to avoid 
tax in that country. The tax avoidance purpose does not have to be 
the only purpose for receiving the money outside of the country in 
which earned, nor does it have to be the principal reason for receiving 
the money outside of that country. It is sufficient that it be one of the 
purposes. It is the Congress's intention that the fact that the country 
in which the income is earned does not tax amounts received outside 
of the country be viewed as a strong indication of a tax avoidance 
purpose. 

The Act provides an election to an individual not to have the earned 
income exclusion apply. To prevent shifting from an exclusion to a 
credit system from year to year, the Act provides that once an elec- 
tion is made not to have the exclusion apply, it is binding for all 
subsequent years and may be revoked only with the consent of the 
Internal Revenue Service. 

While the Act makes no change in the taxation of housing allow- 
ances provided to overseas employees, the Congress is aware that ques- 
tions have been raised as to the entitlement to the exclusion for hous- 
ing furnished to employees on the employer's premises when the 
employee is employed on a large construction project in a remote area. 
Quite often no housing other than that furnished by the employer 
is available. Congress expects that the Internal Revenue Service will 
administer the exclusion of existing law in as liberal a manner as 
possible given the confines and limitations of the existing provision so 
that as many employees as possible who are involved in construction 
projects in remote areas will be entitled to this exclusion. 

Finally, the Act provides that individuals taking the standard 
deduction are to be allowed the foreiirn tax credit. 



2 The Impact of these modifications may be illustrated by the following example (drawn 

from an example presented to the Senate Committee on Finance durilnp the mark-up session 

on the provision) of a family of four who files a joint return and whose income is all for- 
eign source income subject to foreign tax : 

(1) Gross income $32,000 

(2) Deductions 4,000 

(3) Personal exemptions 3, 000 

(4) Net taxable income 25,000 

(5) Earned income exclusion 15, 000 

(6) Deductions allocable to amount excluded 1, 000 

(7) Net excluded earned income 14, 000 

(S) Tax on net taxable income 6,020 

(9) Tax on net excluded ear':ed Income 2,760 

(10) Tax prior to foreign tax credit (No. 8 iess No. 9) 3, 260 

(11) Foreign tax paid 3,000 

(12) Foreign tax allocable to excluded amount ($3,000X2,760 divided 

by 6,020) 1, 375 

(13) Foreign tax credit (No. 11 less No. 12) 1, 625 

(14) U.S. tax (No. 10 less No. 13) 1,635 

(15) Aggregate U.S. and foreign tax (No. 14 and No. 11) 4,635 



215 

E-ffective date 
These provisioTis are effective for taxable years beg^inning after 
December 31, 1975. Tlie rule disallowing the credit for foreign taxes 
allocable to excluded amounts only applies to taxes paid on income 
excluded in taxable years beginning after that date. 

Revenue effect 
This pi-o\ ision will increase budget receipts by $44 million in fiscal 
year 1977, $38 million in fiscal year 1978, and $38 million in fiscal 
year 1981. 

2. U.S. Taxpayers Married to Nonresident Aliens (sec. 1012 of the 
Act and sees. 879, 891, 6013 and 6073 of the Code) 

Prior law 

Under prior law, a husband and wife could file a joint income tax 
return even though one of the spouses had no gross income or deduc- 
tions. However, a joint return could not be made if either the husband 
or the wife at any time during the taxable year was a nonresident 
alien. Under prior law, nonresident aliens were generally required to 
file estimated tax returns by April 15 of the year in question, although 
they had until June 15 to file the income tax return for the previous 
year. 

Reasons for cliange 

As a rule, a husband and wife find it desirable to file a joint return 
since it generally results in a lower aggregate tax liability than if they 
each filed separate returns of tlieir own income and deductions. Tax- 
payers are encouraged to file joint returns due to the fact that it 
eliminates the administrative problems of otherwise having to allocate 
income and deductions betw^een married taxpayers. 

The inability of a husband and wife to file a joint return where one 
of them is a nonresident alien has resulted in the possibility of a heavier 
tax burden being placed upon this group of taxpayers than other mar- 
ried taxpayers. For example, even though a joint return was not al- 
lowed, the spouse who filed a tax return was required to use the higher 
rate table for married individuals filing separately. In addition, these 
married individuals could not obtain the benefits of the 50-percent 
maximum tax on earned income because married taxpayers must file a 
joint return in order to obtain the benefits of that provision. There are 
approximately 10,000 U.S. taxpayers who are married to nonresident 
alien individuals. 

These disadvantages under the U.S. tax laws were, however, offset 
by a number of tax advantages for certain of these taxpayers. First, 
the foreign source income attributable to the nonresident alien spouse 
was not subject to any U.S. taxation if not effectively connected with 
a T'nited States trade or business. Second, if the taxpayers were sub- 
ject to community property rules, one-half of the earned income of the 
taxable spouse was treated as being the income of the nonresident alien 
spouse and was not subject to U.S. taxation if it was from foreign 
sources and not effectively connected with a TTnited States trade or 
business. 

A second problem involved the fact that certain nonresident 
alien individuals who were required to file declarations of esti- 
mated income tax for a taxable year were required to file two 



216 

months before the time required for filing a return of income for the 
previous taxable year, while domestic taxpayers could file the declara- 
tion at the time the return for the previous year was due. It is normally 
helpful to compute tax liability for the previous year before estimat- 
ing the income tax for the current year. 

Explanation of 'provisions 

The Act allows a U.S. citizen or resident married to a nonresident 
alien to file a joint return provided that an election is made by both 
individuals to be taxed on their worldwide income. The nonresident 
alien is treated, in effect, as a resident of the Unit^'d States for pur- 
poses of the income tax laws. A requirement of the election is that 
the husband and wife agree to supply all the necessary books and 
records and other information pertinent to the determination of tax 
liability ; failure to do so could result in termination of the election 
by the Secretary. 

The election applies for the taxable year for which made and for 
all subsequent years until tenninated. However, the election does not 
apply in a taxable year in which neither spouse is a U.S. citizen or 
resident at any time during the taxable year (i.e., one of the spouses 
must be a resident for the full taxable year). Only individuals who 
are residents under the normal rules of the Code are residents for 
purposes of satisfying the requirement that one spouse must be a citi- 
zen or resident who would otherwise be able to file a joint return. 

The election continues imtil terminated. Either spouse may revoke 
the election for any taxable year so long as the revocation is made 
prior to the prescribed time for the filing of the income tax return for 
such year. The election is terminated in the event of the death of 
either spouse or the legal separation of the spouses under a decree 
of divorce or of separate maintenance. In the event of the death of 
either spouse, the election will ordinarily terminate for the year of 
the surviving spouse following the year in which the death occurred. 
However, if the sui'A^iving spouse is a U.S. citizen or resident who, 
for years subsequent to the death of the spouse, is entitled to use the 
joint return rate^ (as provided under sees. 1(a) (2) and 2), the elec- 
tion will not terminate until the close of the last year for which joint 
return rates may be used. In the event of legal divorce or separation, 
the election terminates as of the beginning of the taxable year in 
which the divorce or separation occui*s. 

The Secretary may terminate an election if he deteiTnines that either 
spouse has failed to keep adequate tax records, to give the IRS ade- 
quate access to such records, or to supply such other information as 
may be reasonably necessary to ascertain the taxpayer's income tax 
liability for the taxable year. 

If an election is terminated for any two individuals for any of the 
reasons stated above, neither of them will be eligible to make the 
election for any subsequent taxable year. For example, if a divorced 
individual, who had previously made the election, were to remarry, 
he or she would not be eligible to make the election. 

The above rules apply in the case of a citizen or resident who is 
married to an alien individual who does not become a resident of the 
United States. The Act provides a special rule for a nonresident alien 



217 

individual who becomes a resident of the United States at the close of 
the taxable year if married to a citizen or resident of the United States 
at the close of the year. Prior law prevented this couple from filing a 
joint return, since they both were not citizens or residents of the 
United States for the entire taxable year. 

The Act provides that a nonresident alien who at the close of a 
taxable year is a U.S. resident and is married to a U.S. citizen or 
resident at the close of the year may elect with the other spouse to be 
eligible for the joint return provision. If both spouses were nonresi- 
dent aliens at the beginning of the year, they may make the election 
if both become residents by the close of the year. In that case, a 
spouse who was a nonresident alien for the first part of the year is 
treated as a resident of the United States for the entire taxable 
year for purposes of the income tax law and thus is taxable on his 
worldwide income. Since this provision is a limited exception for 
individuals when they first become residents of the ITnited States, the 
election does not apply to any subsequent taxable year, and the tax- 
payers are not eligible to make a second election for any such subse- 
quent year. 

The Act makes certain community property laws inapplicable for 
income tax purposes Avhere the election is not made. Earned income 
of a spouse, otlier than trade or business or partnership distributive 
share income, is treated as the income of the spouse whose services 
generated such income. Trade or business and partnership distribu- 
tive share income subject to community property laws Avill receive 
the same treatment as that provided under section 1402(a) (5) (defin- 
ing net earnings from self -employment.) Under section 1402(a)(5) 
(A), trade or business income (other than that derived by a partner- 
ship) which is treated as community income is treated as the income 
of the husband imless the wife exercises substantially all of the man- 
agement and control of such trade or business, in which case the income 
of the trade or business is treated as that of the wife. Under section 
1402(a) (5) (B), any portion of a partners distributive share of the 
ordinary income or loss from a trade or business carried on by a 
partnership which is community income or loss is treated as the 
income or loss of such partner, and no part of such distributive share 
is attributed to the other spouse. 

Community income derived from separate property of one spouse 
(and which is neither earned income, trade or business income, nor 
partnership distributive share income) is treated as the income of 
that spouse. All other community income is treated as provided by 
the applicable community property law% 

In addition, the Act provides for a delay in the time for filing a 
declaration of estimated tax for a taxable year by certain nonresident 
alien individuals until the time required for filing a return of income 
for the prior taxable year. The Act provides that in the case of non- 
resident alien individuals who are not subject to wage withholding, 
the due date for filing the estimated tax return is not to be anv earlier 
tlian the due date for the tax return. 

Effective dates 
The provisions of the Act pertaining to the election to be treated 
as residents of the United States apply to taxable years ending on 



218 

and after December 31, 1975. The provisions of the Act pertaining 
to the tax treatment of certain community income, and to the due 
date for filing estimated tax returns, apply to taxable years beginning 
after December 31, 1976. 

Revenue ejfect 
It is estimated that this provision will decrease budget receipts 
$1 million in fiscal year 1977, and $5 million in 1981. 

3. Income of Foreign Trusts and Transfers to Foreign Trusts 
and Other Foreign Entities (sees. 1013 to 1015 of the Act and 
sees. 643(a) (b), 668, 670, 679, 1056, 1491, 1492, 6048, and 6677 
of the Code) 

Prior law 

Under prior law, the income of a trust Mas taxed basically in the 
same manner as the income of an individual, with limited exceptions 
(sec. 642). Just as nonresident alien individuals are generally taxed 
only on their U.S. source income other than capital gains ^ and on 
their income effectively connected with a U.S. trade or business (and 
not on their foreign source income) , so any trust which could qualify as 
being comparable to a nonresident alien individual was generally not 
taxed on its foreign source income. 

If a trust is taxed in a manner similar to nonresident alien individ- 
uals, it is considered (under sec. 7701 (a) (31)) to be a foreign trust. 
The Internal Revenue Code does not specify what characteristics 
must exist before a trust is treated as being comparable to a nonresi- 
dent alien individual. However, Internal Revenue Service rulings and 
court cases indicate that this status depends on various factors, such as 
the residence of the trustee, the location of the trust assets, the country 
under whose laws the trust is created, the nationality of the grantor, 
and the nationality of the beneficiaries.- If an examination of these 
factors indicates that a trust has sufficient foreign contacts, it is 
deemed comparable to a nonresident alien individual and thus is a 
foreign trust. 

Under prior law, grantors and other persons were treated as the 
owners of that portion of a trust (under the grantor trust rules) as 
to which they had certain powers or interests. The grantor trust rules 
which tax the income of those trusts to the grantor (see sees. 671 to 
678) apply equally to foreign and domestic trusts. If a I".S. grantor 
establislies a foreign trust which comes within these provisions, the 
worldwide income attributable to him of that trust is taxed by the 
United States to the grantor. 

If a U.S. taxpayer was a beneficiary of a foreign trust, distributions 
to him were taxed in basically the same manner as were distributions to 
a beneficiary of a domestic trust. Distributions of ordinary income 
received from foreign trusts which could accumulate income were sub- 
ject to the same throwback rules (sec. 668) which applied to domestic 
trusts. Under these rules a beneficiary determined his tax on a dis- 
tribution of income earned by the trust in an earlier year either under 



1 Sec. 1041 of thp 4ct provides an exception to the rule that nonresident alien Individuals 
(and thus comparable trusts) are taxed on their U.S. source Income. That provision exempts 
certain U.S. source interest of nonresident aliens from U.S. taxation. 

2 For example, see Rev. RuL 60-lSl (C.B. 1960-1. 257) and B. ^y . Jones TruM v. 
Commissioner, 46 B.T.A. 531, aff'd 132 F. 2d 914. 



219 

the "exact method' or under the alternative three-year "shortcut 
method." Also distributions of capital gain income from a foreign 
trust were treated similarly to such distributions from domestic trusts 
(i.e., the income was excluded from distributable net income ^ and was 
taxed under the special capital gains throwback rules (sec. 669) ), but 
only if the foreign trust was created by a foreign person. If a foreign 
trust was created by a U.S. person, gains from the sale or exchange 
of capital assets were included in the distributable net income and 
thus were treated as received by a beneficiary proportionally with any 
ordinary income earned by the trust in the same year. This exception 
favored foreign trusts created by U.S. persons over domestic trusts 
because a beneficiary could receive a distribution of capital gain 
income, Avhich was' taxed at a lower rate, without requiring the 
trust first to distribute all of its ordinary income. Under prior 
law, any capital gains income retained its character in the hands of the 
beneficiary, thus being eligible for tlie capital gains deduction (under 
sec. 1202) upon the distribution of the income. 

In addition to the above provisions which governed the taxation of 
foreign trusts, prior law imposed (sec. 1491) an excise tax of 271/2 
percent on certain transfers of property to foreign trusts, as well as to 
foreign corporations (if the transfer was a contribution to capital) 
and to foreign partnerships. Under prioi- law the excise tax was im- 
posed on all transfers of stock or securities to such an entity by a 
U.S. citizen, resident, corporation, partnership or trust. The amount of 
the excise tax was equal to 271/2 percent of the amount of the excess of 
the value of the stock or securities over the adjusted basis in the hands 
of the transferor. 

Reasons por change 

The rules of prior law permitted U.S. persons to establish foreign 
trusts e-o that funds could be accumulated free of I^.S. tax. Further, the 
funds of these foreign trusts were generally invested in countries which 
did not tax interest and dividends paid to foreign investors, and the 
trusts generally were administered through countries which did not tax 
such entities. Thus, these trusts generally paid no income tax anywhere 
in the world. Although the beneficiaries were taxed (and the throwback 
rules were applied) upon any distributions out of these trusts, never- 
theless the use of foreign trusts permitted a grantor to jirovide a tax- 
free accumulation of income while the income remained in the trust. 
The Congress believed that allowing this tax-free accumulation of in- 
come was inappropriate and jn-ovided an unwarranted advantage to 
the use of a foreign trust over the use of a domestic ti'ust. Accordingly, 
the Act provides that where there is a U.S. grantor the income of a for- 
eign trust is taxable to him if the funds are being accumulated for a 
U.S. beneficiary. The Act also provides for an interest charge on the 
amount of any tax paid by a U.S. beneficiary in cases where the income 
of the trust is not taxable to a U.S. grantor. 

In addition, the Act has made a number of changes in the treatment 
of domestic ti-usl^s (see sec. 701 ). These changes. ])articularly the modi- 
fication of the throwback rules and the elimination of the cliai-acter of 
capital gains upon accumulation distributions to beneficiaries, are in- 

=> Tlip effppt of exclnclinc cnpitnl L'nins from distrihntnblo net inoomo was to treat such 
inponie as being received by a beneficiary only after all ordinary income for all years of the 
trust had been distributed. 



220 

tended to simplify the administration of the tax laws. Adjustments in 
the rules applicable to forei^rn trusts must be made in light of these 
changes in order to prevent foreign trust from receiving relatively 
advantageous tax treatment. 

A final problem that has come to the Congress's attention relates to 
the effectiveness of the provision in the Internal Revenue Code pro- 
viding for a 271^ percent excise tax on certain transfers to foreign 
entities, including foreign trusts. The excise tax was intended to pre- 
vent U.S. taxpayers from transferring appreciated property to 
foreign trusts or other foreign entities without payment of a capital 
gains tax. However, under prior law the excise tax of 27% percent of 
the amount of appreciation was less than the maximum capital gains 
tax on individuals (which can be as high as 35 percent). Furthermore, 
the excise tax provision had been interpreted by some tax advisors to 
exclude transfers to foreign entities to the extent that the entity pro- 
vides some consideration to the transferor. For example, a U.S'. tax- 
payer could transfer appreciated stock to a trust established by him 
and receive in return from the trust a private annuity contract or other 
deferred payment obligation.* The Congress believes it is appropriate 
to tax a transfer of assets in these situations. 

Explanation of provisions 

The Act includes three separate sets of provisions which revise the 
treatment of foreign trusts. First, a foreign trust, the corpus of which 
is, in whole, or in part, transferred to the trust by a U.S. person and 
which has a U.S. beneficiary, is made subject to a new grantor trust 
provision. This provision generally taxes the income of such a trust to 
the U.S. person transferring property to the trust. Second, in the case 
of a foreign trust the income of which is not taxed to the grantor, the 
taxation of any distribution to a U.S. beneficiary is revised by chang- 
ing the rules for taxing capital gains income and by adding an interest 
charge on accumulation distributions. Finally, the excise tax on trans- 
fers to foreign entities, such as foreign trusts, is expanded in its scope 
and iho, rate of the excise tax is increased. 

Grantor trust rules. — The Act contains a now grantor trust pro- 
vision undci" which, in general, any U.S. person transferring prop- 
erty to a foreign trust which has a U.S. beneficiary is treated as 
owner of the portion of the trust attributable to the property trans- 
ferred by the U.S. person.^ The Act specifically excludes trusts 
described in section 404(a) (4) (relating to employee trusts created 
or organized outside of the United States) from this new provision. 

* Since the contract is viewed as consideration for tlie assets transferred, section 1491 
had been interpreted by some tax advisers not to apply to the transfer. Under this view, 
the transferor could transfer an asset to a foreign trust and cause It to be sold without 
payment of tax and could receive, in return, annual payments which were taxed over a 
number of years. (But c.f. Rev. Rul. 68-18.3, 1968-1 Cum. Bull. 308.) The effect of this 
transaction was that the transferor deferred payment of a substantial amount of 
tax attributable to the sale of the appreciated asset and obtained the benefit of a 
tax-free accumulation of the proceeds of the sale. The Congress believes that 
.'inv policy in favor of permitting deferral of tax In private annuity trans- 
actions should not apply to a private annuity transaction with a foreijrn trust. These 
trusts have limited assets, so that if the transferor outlives his life expectancy the trust 
will often be unable to continue annuity payments, and if the transferor dies prematurely 
his beneficiaries receive the remaining trust assets. These facts make the transaction 
qiiite different from a conventional private annuity. 

" This provision does not affect the definition of a foreign trust provided in sec. 7701 
(a) (.31) of the Internal Revenue Code since the foreign source income of a grantor trust 
is taxed to the owner and not the trust itself. 



221 

Any U.S. person treated under this provision as owner of a portion 
of a trust is taxed on the income of that portion of the trust in the 
same manner as an owner of a trust is taxed under the existing grantor 
trust rules (part IE of subchapter J of the Internal Revenue Code). 
If another person would be treated as owner of the same portion 
of the trust under the grantor trust rule (sec. 678 which applies to 
persons other than the grantor), that other person is not to be treated 
as owner of that portion of the trust for tax purposes. For purposes 
of determining the portion of a trust over which the U.S. grantor is 
treated as owner, loans to the trust by the grantor may be treated as 
transfers of corpus." 

The new grantor trust provision applies to transfers of property by 
any U.S. person, as that term is defined in the Internal Revenue Code 
(sec. 7701(a) (30)). Thus, transfers by U.S. citizens or residents, by 
domestic partnerships, by domestic corporations, and by estates or 
trusts which are not foreign estates or foreign trusts are included. 
However, transfers by U.S. persons which take place b}^ reason of the 
death of the U.S. person are not included. For example, the income of 
a foreign testamentary trust created by a U.S. person is not taxed to 
the estate of the I"''.S. person. In addition, an inter vivos trust which is 
treated as owned by a TLS. person under this provision is not treated 
as owned by the estate of that person upon his death. 

These rules apply only for income tax purposes. Whether tlie corpus 
of the inter vivos trust is included in the estate of the U.S. person 
depends on the estate tax provisions of the Code. Such provisions, as 
well as the gift tax provisions of the Code, are unaffected by this 
amendment. 

The new grantor trust provision applies to transfers of property 
by U.S. persons whether the transfers are accomplished directly or 
indirectly. A transfer by a domestic or foreign entity in which a U.S. 
])erson has an interest may ])e regarded as an indirect transfer to the 
foreign trust by the T^.S. person if tlie entity merely serves as a conduit 
for the transfer by the I"^.S. person or if the T^.S. ])erson has sufficient 
control over the entit}- to direct the transfer by the entity rather than 
himself." Further, if a foreign trust borrows money or other ])roperty 
the repayment of which is guaranteed by a U.S. person, tliat U.S. per- 
son may be treated as having transferred to the ti'ust tlie property 
to which the guarantee applies. Foi- this purpose, a guarantee may 
consist of any understanding, formal or informal, ])y which payment 
of an obligation is assured. 

8 For example. If a U.S. person transfers $10 to a foreign trust having F.S. bene- 
ficiaries, and also lends $90 to that trust, he may he treated as the owner of trust income 
attributable to $100. For this purpose, if a U.S. person makes a deposit In a hank (or a 
contribution to another entity) and that deposit (or contribution) l.s followed (or pre- 
ceded) by a loan of a similar amount to a forelprn trust, the U.S. person may he considered 
to have made the loan directly to the trust. 

"For example If a T'.S. person transfcs property to a foreign person or entity and If 
that person transfers that property for Its equivalent) to a foreign trust that has U.S. 
beneficiaries, the U.S. person transferring the property to the foreign person or entity is 
treated as having made a transfer to a foreign trust unless It can be shown that the 
transfer of property to the trust was unrelated to the T\S. person's transfer of property to 
the foreign person or entity. A similar rule apnlles to tran.sfers Mnclnding certain deferred 
sales) through domestic entities or persons. For evnmnlp. if a I\S. person transfers prop- 
erty to a domestic trust or corporation and that entity subsequently transfers the .same or 
couivalent property to a foreign trust, the U.S. person may be treated as having made a 
transfer of property indirectly to a foreign trust. Moreover, transfers to a domestic trust 
which subsequently becomes a" foreign trust may be regarded as Indirect transfers to a for- 
eign trust. 



222 

Transfers by U.S. persons are subject to the grantor trust provision 
regardless of whether the transfers are made without receipt of con- 
sideration from the trust or whether the transfers constitute sales or 
exchanges (including tax-free exchanges) of the property to the trust. 

However, the Act provides an exception for transfers of property 
to a foreign trust pursuant to a sale or exchange of the property at 
its fair market value if, in the transaction, the transferor realizes and 
recognizes all of the gain at the time of the transfer or if the gain is 
taxed to the transferor as provided in section 453 (providing for 
installment reporting of gains under certain circumstances). If this 
exception applies, the transferor is not treated as owner of any portion 
of the trust by reason of that transfer. But the transferor is treated 
as an owner of the trust if gain is realized from the transaction and if 
the transferor reports the gain as an open transaction or as a private 
annuity. 

A U.S. person transferring property to a foreign trust is treated as 
an owner of the trust only if the trust has a l^.S. beneficiary. The Act 
provides that a trust is treated as having a U.S. beneficiary if the 
trust instrument includes existing U.S. persons as beneficiaries or 
if the trust instrument (taken together with any related written or 
oral agreements l3otween the trustee and persons transferring property 
to the trust) gives to any person the authority to distribute income or 
corpus to unnamed persons generally or to any class of pereons which 
includes XLS. persoiis. This authority exists, for example, if any person 
(wiu4her or not adverse to the grantor) has the power to appoint U.S. 
beneficiaries or to amend the trust instrument in such a way as to in- 
clude TLS. beneficiaries. A trustee (or other person) can have* authority 
to distribute income or corpus to unnamed persons and can avoid being 
treated as having a ILS. beneficiary if terms of the trust (which can- 
not be amended) provide that no part of income or corpus of the trust 
may be paid or accumulated for the benefit of a U.S. person. Of course, 
the fact that a named foreifrn beneficiary could become a U.S. person 
bv residency or citizenship does not cause a foreign trust to be treated 
as a grantor trust before the event actually occurs. 

In addition, the Act provides that a trust is treated as having a XLS. 
beneficiarv for any taxable year if, assuming the trust terminated in 
the taxable year, any part of the remaining income or corpus of the 
trust could be paid to or for the benefit of a U.S. person. Tlie same 
rules that apply to determine whether a trust has a U.S. beneficiary in 
any year during its existence are to apply to this tennination 
provision.^ 

The Act provides that a vear-by-year determination be made of 
whether or not a trust has a XLS. beneficiary. If a foreign beneficiary 
becomes a U.S. person (and thus becomes a U.S. beneficiary ^, the new 
grantor trust provision applies to th-^ transferor beginning with the 
transferor's first taxable year in which the foreign person becomes a 
U.S. beneficiary.^ 



* For example. If any person has a power to appoint a remainder beneficiary or to 
amend the triist provisions to name such a beneficiary, the trust Is treated as havlnjr a U.S. 
beneficiary. Also, if under the law applicable to the trust, distributions are required to be 
made to U.S. persons (notwithstanding the trust instrument), the trust Is treated as hav- 
inp a U.S. beneficiary. 

" For example, if a trust names X, a French cltiz'^n and resident, plus X's oifsprinq: as 
beneficiaries, the trust would have no U.S. beneficiaries until X's offspring or X himself 
became a U.S. person. 



223 

The Act provides a special rule for cases in which a foreign trust 
acquires a U.S. beneficiary in any taxable year and has undistributed 
net income (i.e., accumulated income which would be taxable to a 
beneficiary upon distribution) as of the close of the immediately pre- 
ceding taxable year. In such a case, the transferor of property to the 
trust is treated as having additional income in the first taxable year 
in which the taxpayer is treated as an owner of a portion of the trust. 
The amount of the additional income is equal to the undistributed net 
income for all prior taxable years to the extent that sucli undistributed 
net income remains in the trust at the end of the last taxable year before 
the trust had a U.S. beneficiary." 

The Act provides attribution rules for determining whether a 
trust lias a U.S. beneficiary. A trust having a foreign corporation as a 
beneficiary is treated as having a U.S. beneficiary if more than 50 
percent of the total combined voting power of all classes of stock is 
owned or considered to be owned by U.S. shareholders under the rules 
for determining stock ownership of controlled foreign corporations. 
Similarly, if a foreign trust has a foreign partnership as a beneficiary, 
the trust is treated as having a U.S. beneficiary if any U.S. person is a 
partner (directly or indirectly) of the partnership. Finally, if a for- 
eign trust has as a beneficiary another foreign trust or a foreign estate, 
the first trust is considered to have a U.S. beneficiary if the second 
foreign trust or the foreign estate has a U.S. beneficiary. 

The Act also provides that persons subject to the grantor trust rule 
are to file an annual information return with the Internal Revenue 
Service, setting out such information as is prescribed by the Secretary. 
A penalty equal to 5 percent of the corpus of the trust is provided for 
failure to file this return. 

Taxation of heneficiarifs of foreign trusts. — In those cases where the 
income of a foreign trust is not taxed to the grantor under the grantor 
trust rules,^^ the Act provides for an interest charge based on the 
length of time during which that tax was deferred because of the 
trust's accumulation of income. This charge is in addition to any tax 
which is incurred by beneficiai-ies receiving distributions from foreign 
trusts not taxed under the grantor trust rules. The interest charge is 
to equal 6 percent per year times the amount of tax imposed on the 
beneficiary (after reduction for any taxes paid by the trust). It is 
not compomided.^^ 

In cases where the distribution in one year consists of amounts 
earned in more than one year, the interest charije is calculated by aver- 
aging the years in which amounts were actually earned (even though 
the amount of income tax to be paid by the beneficiary is determined 



30 por example, if a trust Instrnment provides that income is to accumulate until dis- 
tributed to Swiss citizen X's offspring, the amount accumulated is not taxed to the 
transferor of the property as long as the oflfsprinp are not U.S. persons. However, if any 
of X's offsprinjr becomes a IT.S. person, the transferor of the property is treated as having 
income in the amount of the undistributed net income for all taxable years (attributable 
to the property transferred) remaining in the trust at the end of the last taxable year be- 
fore the year in which that offspring became a U.S. beneficiary. For this purpose any power 
over a trust (described by sees. 671-678) held by a nonresident alien shall be ignored. 

"For example. If the T'.S. grantor of the trust has died or if the trust has a foreign 
grantor, the new grantor trust rules do not apply. 

"For examnle, the tax on a distribution in year S of amounts earned in year 2 (and 
thus deemed to be distributed in year 2) is subject to an interest charge of 6 percent for 
6 years, or a total of 36 percent of the amount of tax. 



224 

under the new five-year throwback rules provided for under sec. 701 
of the Act) and computing the entire charge based on that average 
period.^^ 

The interest charge is to be calculated on an annual basis. Amounts 
deemed to be distributed to a beneficiary in year 1 but actually dis- 
tributed in year 2 carry one full year's interest charge, regardless of 
when in year 1 the amounts were earned by the trust or when in year 2 
the amounts were distributed. 

The total of the interest charge plus the tax incurred is limited by 
the amount of the distribution (not including any amounts deemed 
distributed as taxes paid by the trust). Thus, in no case can the in- 
terest charge plus the tax on the distribution exceed the amount actu- 
ally distributed. The amount of interest paid or assessed under the 
provision is not deductible as interest for Federal tax purposes and 
may itself be subject to interest charges in c'ases of late payment. 

The interest charge applies to distributions made in taxable years of 
beneficiaries beginning after December 31. 1976. Solely for purposes 
of the interest charge, undistributed net income existing in a foreign 
trust as of the beginning of the first taxable year beginning after 
December 81. 1976. is treated as having been earned b}- the trust in 
that taxable year. Thus, any distribution out of earnings deemed to 
have been distributed prior to taxable years beginning after Decem- 
ber 31, 1976. bears an interest charge beginning with the first taxable 
year beginning after December 31, 1976. 

Tender the provisions of the Act, U.S. beneficiaries receiving dis- 
tributions from foreign trusts not taxed under the grantor trust rules 
are subject to the new five-year throwback provisions established for 
beneficiaries of trusts generally (see sec. 701 of the Act). Thus, the 
exact throwback rules and the three-year shortcut method for taxing 
ordinary income, plus the capital gains throwback rules, no longer 
apply to distributions from foreign trusts. 

In addition, the new multiple trust rules (of sec. 701 of the Act) 
apply equally to foreign trusts as to domestic trusts. A beneficiary 
receiving distributions attributable to the same taxable year from 
three or more trusts is not permitted to gross up his distributions by 
the amount of trust tax paid or to receive a tax credit for distributions 
from any trust bevond the first two trusts. However, the Act limits to 
domestic trusts the provision permitting trusts to accumulate income 
for unborn children or children under the ago of twenty-one and to 
avoid the throwback rules upon later distribution of the accumulated 
income; the throwback rules apply to distributions from foreign trusts 
without regard to the age of any beneficiary. 

The Act provides (in Code sec. 667(a) as amended by sec. 701 of the 



" For exaninle. if anionnts distributed In year 8 were earned in jears 2. .3, and 4, the 
number of years for which Interest Is charged Is determined first by calculating the num- 
ber of years of accumulation for each year In which amounts distributed were originally 
earned (in this case 8—2 or 6 years for amounts earned in year 2, 8 — 3 or 5 years for 
p mounts earned in year 3. and S— 4 or 4 years for amounts earned in year 4). The total of 
these number of years of accumulation (here 6-1-5 + 4. or 15 years) is then divided by the 
number of different years from which the amounts distributed were earned (3 different 
years). The result (5 years) is the average number of years of accumulation and is multi- 
plied bv the 6 percent interest rate to produce the total percentage of interest (30 percent) 
which is applied against the amount of the tax. 



225 

Act) that the character of capital g:ains is to be disreofarded for pur- 
poses of taxing accumulation distributions to the beneficiary.Further- 
more, in the case of distributions of capital gain income from foreign 
trusts, the provision of prior law requiring that the capital gain be 
allocated to income and not to corpus if the foreign trust is created by 
a U.S. pei-son has been expanded to apply to all foreign trusts. The 
effect of ending the separate characterization of income from capital 
gain in the new throwback provisions and of allocating to income all 
capital gains in foreign trusts is to treat income from capital gains the 
same as ordinary income when it is distributed from a foreign trust as 
an accumulation distribution. No exclusion of 50 percent of net long- 
term capital gains is available to the beneficiary of a foreign trust upon 
such a distribution. However, if a foreign trust has undistributed net 
income at the end of the last taxable year ending before January 1, 
1976, which is attributable to income from capital gains from any prior 
taxable year, the trust is permitted to reduce undistributed net income 
as of the beginning of the next taxable year by the amount of the 50 
percent of lonaf-term capital ,<rain exclusion which would be permitted 
to any beneficiary upon the distribution of all undistributed net income. 
However, no reduction in undistributed net income is permitted for 
foreign trus*^s attributable to income from capital gains earned after 
the effective date of these provisions. 

Excise tax on transfers to foreign entities. — The Act increases the 
excise tax imposed under prior law (sec. 1491) on certain transfers of 
property to foreign trusts, foreign corporations, and foreign partner- 
ships from 271/^ percent to 35 percent. In addition, the scope of the tax 
has been altered. First, the tax is to apply to transfei-s of all types of 
property rather than onl v to transfers of securities. Second, the tax is to 
apply to the amount of irain which is not recognized by the trans- 
feror at the time of the transfer. 

Under prior law, it was not clear whether the provision applied to 
all transfers of appreciated securities regardless of whether gain is 
recognized. Some tax advisors have interpreted the provision to apply 
primarily to donative transactions. The excise tax as amended by the 
Act is to apply to all transfers (including tax-free exchanges) whether 
or not at fair market value and whether or not the transfer is made 
with donative intent. However, in the case of transfers to corporations, 
the provision is to apply only to transfers treated as paid-in surplus 
or as a contribution to capital. The amount against which the excise 
tax is applied is to be reduced by the amount of frain recognized bv 
the transferor upon the transfer of the property. Thus, all sales and 
exchanges (includinir tax free exchansres, installment sales, and private 
annuity transactions), regardless of how any gain on these transac- 
tions is reported, are within the scope of the excise tax provision. But 
to the extent the transferor immediately recogmizes gain in the trans- 
fer, the amount against which the tax is applied is reduced. 

The Act adds a new section to the Code imder which a taxpayer 
may elect (under remilations prescribed by the Secretary) to treat a 
transfer described above as a sale or exchan.cre of the property trans- 
ferred and to recognize as gain (but not loss) in the year of the 
transfer the excess of the fair market value of the property transferred 



226 

over the adjusted basis (for determining gain) of the property in the 
hands of the transferor. Thus, to the extent that gain is recognized 
pursuant to the election in the year of the transfer, the transfer is 
not subject to the excise tax, and normal rules will apply to increase 
the basis to the transferee by the amount of grain received. Since the 
objective of section 1491 is to prevent a transfer which is in pursuance 
of a plan having as one of its principal purposes the avoidance of 
Federal income taxes without payment of tax, the making of an 
election which has as one of its principal purposes the avoidance of 
Federal income taxes is not permitted. 

As under prior law, the excise tax does not apply if the transferor 
can establish to the satisfaction of the Secretary that the transfer 
is not in pursuance of a plan having as one of its principal purposes 
the avoidance of Federal income taxes. It is contemplated that 
ordinarv business sales or exchanges involving an unrelated foreign 
trust will normally be determined not to be in pursuance of a plan 
of tax avoidnnre.^* However, where the transferor of the property is 
directly or indirectly related in some way to the foreign entity receiv- 
ing the property, then under normal circumstances, the transfer could 
be one in pursuance of a plan having as one of its principal purposes 
the avoidance of Federal income taxes. Such a transfer would thus 
normally be subject to the excise tax. 

A final change in the excise tax made by the Act provides that 
transfers to foreign entities to which section 367 of the Code applies 
(dealing with reorganizations and transfers involving foreign cor- 
porations) are not to be subject to the new 35 percent excise tax. The 
taxation of any transfer to which section 367 applies, as that section 
is amended by the Act (see sec. 1042), is determined entirely by that 
section and the regulations and rulings of the Internal Revenue Service 
under that section. 

Ejfective dates 

The new grantor trust rule is to apply to transfers of property to 
existing foreign trusts after May 21, 1974, and to all new trusts created 
after May 21, 1974. However, the rule is to apply to income received in 
taxable years beginning after December 31, 1975. 

The interest charge on distributions to beneficiaries of foreign trusts 
is to apply to taxable years beginning after December 31, 1976. The 
provision applies to income from trusts whenever created. The change 
in the capital gains rule for foreign trusts not created by XLS. persons 
is to apply to taxable years beginning after December 31, 1975. 

The amendment to the excise tax on certain transfers to foreign 
entities is to apply to transfers of property after October 2, 1975. 

Revenue ejfect 
It is estimated that these provisions will result in an increase in 
budget receipts of $12 million in fiscal year 1977 and of $10 million 
thereafter. 



'♦ For example, a sale of real estate to an unrelated real estate trust In a case where 
the gain from the sale Is reported on the Installment basis should, under normal circum- 
stances, be considered not a transfer In pursuance of a plan of avoidance of Federal taxes 
and thus would not normally be subject to the 35 percent excise tax. 



227 

4. Amendments Affecting Tax Treatment of Controlled Foreign 
Corporations and Their Shareholders (sees. 1021 through 
1024 of the Act and sees. 951, %4, 956, 958, 963, and 1248 of the 
Code) 

Prior law 

The United States imposes its income tax upon the worldwide income 
of any domestic corporation, whether this income is derived from 
sources within or from witlioiit the United States. A tax credit (sub- 
ject to limits) is allowed for foreign income taxes imposed on its for- 
eign source income. 

Foreign corporations generally are taxed by the TTnited States only 
to the extent they are engaged in business in the United States (and 
to some extent on other income derived here). As a result, the United 
States generally does not impose a tax on the foreign source income 
of a foreign corporation even though it is owned or controlled by 
a U.S. corporation or group of U.S. corporations (or by U.S. citizens 
or residents). Such a corporation is subject to tax, if at all, by the 
foreign country or countries in which it operates. 

Generally, the foreign source income of a foreign corporation is 
subject to U.S. income tax only when it is actually i-emitted to the 
U.S. corporate or individual shareholders as a dividend. The tax in 
this case is imposed on the U.S. shareholder and not the foreign cor- 
poration. The fact that no U.S. tax is imposed in this case until (and 
unless) the income is distributed to the U.S. shareholders (usually 
corporations) is what is generally referred to as tax deferral.^ 

An exception is provided, however, to the general rule of deferral 
under the so-called subpart F provisions of the Code. Under these pro- 
visions income from so-called tax haven activities conducted by cor- 
porations controlled by U.S. shareholders is deemed to be distributed 
to the U.S. shareholders and currently taxed to them before they actu- 
ally receive the income in the form of a dividend. 

The rules generally apply to U.S. persons owning 10 percent or 
more of the voting power of a foreign corporation, if more than fifty 
percent of the voting power in the corporation is owned by U.S. per- 
sona owning 10 percent interests. 

The categories of income subject to current taxation as tax haven 
income are foreign pereonal holding company income, sales income 
from property purchased from, or sold to, a related person if the 
property is manufactured and sold for use, consumption, or dispo- 
sition outside the country of the corporation's incorporation, income 
from services performed outside the country of the corporation's 
incorporation for or on behalf of any related per-^on, and shipping 
income (unless reinvested in shipping assets). The statute refers 
to these types of income as "foreign base company income." In addi- 
tion, the income derived by a controlled foreign corporation from 
the insurance of U.S. risks is subject to current taxation. Foreign base 
company income and income from the insurance of T".S. risks are col- 
lectively referred to as subpart F income. 



iWhp'-p it is not nntioinatpfl t'lnt the incotnp will be hronc'^t back to tlip TTnited States, 
for financial accounting purposes (in accountinfr for tbe income of a consolidated group 
consisting of one or more domestic corporations and Its foreign subsidiaries) this income 
in effect Is often shown as income exempt from U.S. tax. 



228 

Also earnings of controlled foreign corporations are taxed cur- 
rently to U.S. shareholders if they are invested in U.S. property. Under 
prior law, U.S. property was generally defined as all tangible and in- 
tangible property located in the United States. 

In addition to denying deferral on certain categories of income un- 
der subpart F, the Code treats as a repatriation of tax-deferred earn- 
ings the gain realized on the sale, exchange or redemption of stock 
in a controlled foreign corporation (sec. 1248). If a U.S. shareholder 
owns 10 percent or more of the total combined voting stock of a for- 
eign corporation at any time during the 5-year period ending on the 
date of the sale or exchange (while the corporation was a controlled 
foreign corporation) , the recognized gain is treated as a dividend to the 
extent of the foreign corporation's post-1962 earnings and profits at- 
tributable to the stock during the time it was held by the taxpayer 
and was a controlled foreign corporation. Under prior law, however, 
this provision did not apply to earnings and profits accumulated by 
a foreign corporation while it was a less-developed country corpora- 
tion if the stock of that corporation was owned by the U.S. share- 
holders for at least 10 years before the date of the sale or exchange. 

a. Investment in US. property 

Reasons for change 

As indicated above, an investment in U.S. property by a controlled 
foreign corporation is treated as a taxable distribution to its U.S. 
shareholders. The reason why this provision was adopted was the be- 
lief that the use of untaxed earnings of a controlled foreign corpora- 
tion to invest in U.S. property was "substantially the equivalent of a 
dividend" being paid to the U.S. shareholders. Therefore, it was con- 
cluded that this sliould be the occasion for the imposition of a tax on 
those earnings to the XT.S. shareholders of the controlled foreign cor- 
poration making the U.S. investment. However, prior law was very 
broad as to the types of property which were to be classified as U.S. 
investments for purposes of this rule. For example, the acquisition by 
the foreign corporation of stock of a domestic corporation or obliga- 
tions of a U.S. person (even though unrelated to the investor) was con- 
sidered an investment in U.S. property for purposes of imposing a tax 
on the untaxed earnings to the investor's U.S. shareholders. 

The Congress believed that the scope of the provision was too broad. 
In its prior form it may, in fact, have had a detrimental effect upon 
our balance of ])ayments by encouraging foreign corporations to invest 
their profits abroad. For example, a controlled foreign corporation 
looking for a temporary investment for its working capital was, by 
this provision, induced to purchase foreign ratlier than U.S. obliga- 
tions. In the Congress's view a provision which acts to encourage, 
rather than prevent, the accumulation of funds offshore should be 
altered to minimize any hannful balance of payments impact while 
not permitting the U.S. shareholders to use the earnings of controlled 
foreign corporations without payment of tax. 

In the Con<rress's view, since the investment by a controlled foreign 
corporation in the stock or debt obligations of a related XT.S. person or 
its domestic affiliates makes funds available for use by the U.S. share- 
holders, it constitutes an effective repatriation of earnings which 



229 

should be taxed. The classification of other investments in stock or 
debt of domestic corporations as the equivalent of dividends is, in the 
Congress's view, detrimental to the promotion of investments in the 
United States. Accordingly, the Act provides that an investment in 
U.S. property does not result when the controlled foreign corporation 
invests in the stock or obligations of unrelated U.S. persons. 

In addition, the Congress believes that the inclusion of oil-drilling 
rigs used on the U.S. continental shelf acted as a disincentive to 
explore for oil in the United States. Since these rigs are movable, 
they can easily be used in a foreign countrv. Accordingly, the Act 
excludes these rigs from the definition of U.S. property. 

Explanation of provision 

The Act adds three exceptions to the types of U.S. property the 
investment in which by a controlled foreign corporation results in 
taxation to its U.S. shareholders (see sec. 951(a) (1) (B) ). It provides 
that the term "United States property" does not include stock or debt 
of a domestic corporation (unless the corporation is itself a U.S. 
shareholder of the controlled foreign corporation), if the U.S. 
shareholders of the controlled foreign corporation own or are con- 
sidered to own, in the aggregate, less than 25 percent of the total com- 
bined voting power of all classes of stock of such domestic corporation 
which are entitled to vote. Thus, under this provision, a controlled 
foreign corporation cannot buy the stock of, or lend money to, any of 
its U.S. shareholders. In addition, a controlled foreign corporation can- 
not buy the stock of, or lend money to, U.S. corporations who are not 
U.S. shareholders of that controlled foreign corporation if those U.S. 
shareholders own 25 percent or more of the stock of the U.S. corpora- 
tion. This 25 percent test is to be applied immediately after the invest- 
ment by the controlled foreism corporation. 

For purposes of determining who is a U.S. shareholder of a con- 
trolled foreign corporation, the constructive ownership rules apply 
(sec. 958 (^bU. Hnwpver, the exception to those rnles for certain per- 
sons other than U.S. persons (contained in sec. 958(b)(1) and (4)) 
do not apply. Thus, for example, stock owned by foreign persons is at- 
tributed to U.S. persons for purposes of determining whether U.S. 
shareholders of the controlled foreign corporation own 25 percent or 
more of a domestic corporation, the stock of which is acquired by the 
controlled foreign corporation, in determinina: whether there has been 
an investment in US. T>roperty. If at any time there is an investment 
in U.S. property, the U.S. shareholders of the controlled foreio^n cor- 
poration will be treated as having received a distribution under sec- 
tion 956 equal to the amount of the investment of the controlled for- 
eign corporation. It is intended that if the facts indicate that the con- 
trolled foreign subsidiarv facilitnted a loan to, or borrowing bv, a U.S. 
shareholder, the controlled foreign corporation is considered to have 
made a loan to (or acquired an obligation of) the U.S. shareholder 
(seo. 956(oU. 

The Act also excludes from the definition of U.S. property movable 
drilling rigs (other than a vessel or aircraft) and other oil and jras ex- 
ploration nnd exploitation equipment, including barges which are 
used for oil exploration and exploitation activities on the continental 
shelf of the United States. Basically, this exception includes that prop- 



234-120 O - 77 - 16 



230 

erty which is entitled to the investment credit if used outside the 
United States in certain geographical areas of the Western Hemis- 
phere (see sec, 48(a) (2) (R) (x) ). For this purpose, the definition of 
continental shelf as used in section 638 is to be applied. 

E-ffective dates 

The amendments relating to investment in U.S. property by a con- 
trolled foreign corporation apply to taxable years of foreign corpora- 
tions beginning after December 31, 1975, and to taxable years of U.S. 
shareholders within which, or with which, such taxable years of such 
foreign corporations end. 

For purposes of determining the increase in investment in U.S. 
property for years after 1975, the cumulative amount invested in 
U.S. property as of the close of the last taxable year of a corpora- 
tion beginning before January 1, 1976, is computed under the amend- 
ments made by this section. Consequently, in determining the increase 
in earnings invested in U.S. property (under sec. 951(a) (1) (B)) in 
years beginning after December 31, 1975, only the investment in 
U.S. property as defined in the Act as of the close of the last taxable 
year beginning before 1976 is considered.^ 

Revenue ejfect 

It is estimated that this provision will have little or no effect on tax 
liabilities. 

6. Exception for investments in less-developed countries 

Reasons for change 
As indicated above, prior law contained an exception to the rules 
providing for dividend treatment on the sale of stock of a subsidiary 
which is classified as a less-developed country corporation. The extent 
to which this exception provided an incentive to invest in less- 
developed countries is questionable. The size of the tax benefit to the 
U.S. investor depended on a variety of factors, such as the foreign 
tax rate in the country where the investment is made and in other 
countries, and the capital gains tax rate in the United States. Further, 
the relationship of the tax benefits to the investor to the benefits ob- 
tained bv the developing country was erratic since the size of the tax 
benefit could bear no relationship to the amount of development 
capital invested. While these factors might have occasionally combined 
to encourage investment in a certain less-developed country, the Con- 
gress believes that it would be preferable to provide Avhatever assist- 
ance is appropriate to less-doveloped coimtries in a direct manner 
where the economic costs can be accurately measured. 

Explanation of provision 
The Act repeals tl)e los«-developed country exception Avhich excludes 
earnings accumulated while a corporation was a less-developed coun- 
try corporation from those earnings and profits which are subject to 
tax as a dividend if there is gain from the sale or exchange of stock 

2 For pvamnlp. if for tlio Inst tnxable vear bpforo this Act applies a controlled 
foreign corporation Is considered to have $100 Invested in U.S. property under the law in 
effpct prior to the nmendmont and .?75 invested in U.S. property under the law as amended, 
$75 is the amount considered as invested in U.S. pronertv for purposes of determining 
whether there has been an increase in investment in the following year. 



231 

in the controlled foreign corporation (sec. 1248(d) (3) of the Code). 
However, the exclusion is still applicable with respect to those earn- 
ings of a controlled foreign corporation which were accumulated dur- 
ing any taxable year beginning before Januaiy 1, 1976, while the cor- 
poration was a less-developed country corporation (as defined in sec. 
902(d) as in effect prior to the enactment of this Act). The e:'"3lusion 
applies to pre-1976 earnings regardless of whether the U.S. share- 
holder owned the stock for ten years as of that date. 

Effective date 
The provision repealing the less-developed country exception under 
section 1248 applies to taxable years beginning after December 31, 
1975. 

Revenue effect 
It is estimated that this provision will result in an increase in 
budget receipts of $14 million in fiscal year 1977 and of $10 million 
thereafter. 

c. Exclusion from subpart F of certain earnings of insurance 
companies 

Reasons for change 

As indicated above, one of the principal categories of tax haven in- 
come subject to current taxation is foreign personal holding company 
income (sec. 954(c) ). This item of tax haven income consists of passive 
investment income such as dividends, interests, rents and royalties. 
Prior law provided an exception for income of a foreign insurance com- 
pany from its investment of unearned premiums or reserves which are 
ordinary and necessary for the proper conduct of its business. 

In order to write insurance and accept reinsurance premiums, for- 
eign insurance companies may be required by the laws of various juris- 
dictions in which they operate to meet various solvency requirements in 
addition to specified capital and legal reserve requirements. Many 
jurisdictions also employ an internal rule-of -thumb as to what the ratio 
of surplus to earned premiums should be. In the United States, the 
National Association of Insurance Commissioners employs a ratio of 
1 to 3 (surplus to earned premiums) as the guideline by which State 
regulatory agencies can measure the adequate solvency of companies 
insuring casualty risks. If Fuch a company's ratio were less than 1 to 
3, for instance 1 to 4, the State resfulatory agencv may question its 
ability to accept additional risks. Surplus maintained in compliance 
with the 1 to 3 ratio, althou.o-h not necessarilv required by law, has been 
considered as ordinary and necessary to the proper conduct of a 
casualty insurance business in the United States. 

Similar ratios often are employed in some foreign jurisdictions with 
respect to companies insuring casualty risks. Even where the foreign 
jurisdiction does not imnose reouirements as severe as those required 
in the United States, a foreiern insurance company participating: in a 
reinsurance pool composed princinally of companies doine: business 
in the United States must, for all practical purposes, maintain this 
ratio to satisfv the State insurance authorities involved. In these 
situations, the State regulatory a<Tencv, emplovinjr the relatively hiq^h 
ratio, will review the solvency of the foreign insurer before allowing 



232 

the placement of the reinsurance policy with such foreign insurer. 
This effectively causes any f oreifjn insurance company participating in 
a reinsurance pool to adhere to the high ratio. Those assets maintained 
by these insurance companies in order to meet this ratio test are neces- 
sarily in the form of investments, which, in turn, generate passive 
income such as dividend and interest income. Just as in the case of the 
maintenance and investment of unearned premiums or reserves, these 
insurance companies, in compliance w^ith the high ratio requirement, 
must maintain and invest a certain portion of their assets in connection 
with the active conduct of their trade or business. The Congress be- 
lieves that it is appropriate to provide the same type of exception from 
subpart F for surplus which is required to be retained as is provided for 
unearned premiums or reserves. 

Explanation of provision 

The Act adds a new exception to the definition of foreign personal 
holding company income (sec. 954(c) (3) (C)). Under the exception, 
foreign personal holding company income does not include dividends, 
interest, and gains from the sale or exchange of stock or securities 
derived from investments made by an insurance company of an amount 
of assets equal to one-third of its premiums earned (as defined under 
sec. 832 (b) (4) ) during the taxable year on insurance contracts (other 
than for life insurance and annuity benefits under life insurance and 
annuity contracts, to w^hich sec. 801 pertains) . 

The exception only applies to passive income received from a person 
other than a related person (as defined in sec. 954(d) (3)). Also, the 
exception only applies with respect to premiums which are not directly 
or indirectly attributable to the insurance or reinsurance of related 
persons. Where an insurance company participates in an insurance or 
reinsurance pool, it is not intended that the risk insured or reinsured 
by such company be treated as a risk of a related person merely because 
of the existence of the pooling arrangement, the existence of joint lia- 
bility on the risk, or because a related insurance company may jointly 
share in the risk on a policy issued by one member of the pool. 

Effective date 
The provision applies ilo taxable years of foreign corporations be- 
ginning after December 31, 1975, and to taxable years of U.S. share- 
holders within which or with v/hich the taxable years of the foreign 
corporations end. 

Revenue effect 
It is estimated that this provision will result in a decrease in budget 
receipts of $14 million in fiscal year 1977 and of $10 million per year 
thereafter. 

d. Shipping profits of foreign corporations 

Reasons for change 
As indicated above, one of the categories of tax haven income sub- 
ject to current taxation under the subpart F provisions of the Code is 
income derived from, or in connection with, the use of an aircraft or 
vessel in foreign commerce, except to the extent that the profits are 
reinvested in shipping assets. In general, foreign base company income 
is defined for purposes of the tax haven provisions to mean income 



233 

earned by a corporation outside the country of incorporation. In the 
case of foreigTi base company shipping income, however, no distinction 
was made under prior law for cases where a corporation derived ^ts 
shipping income in the same country where it was incorporated. As in 
the case of other tax haven income, the Congress believes that ship- 
ping activities should not be categorized as a base company activity 
when the corporation involved carries on its activities entirely in the 
country in which it is organized and the aircraft or vessel is registered. 

The Congress also is aware that the law^ is unclear as to what ship- 
ping profits are considered as reinvested in shipping assets and thus 
entitle a controlled foreign corporation to an exclusion from the 
subpart F provisions. The Congress wants to insure that in any case 
where a controlled foreign corporation discharges an unsecured lia- 
bility which constitutes a general claim against its shipping assets, 
the payment in discharge of that liability should be considered a pay- 
ment toward the acquisition of a shipping asset as much as the pay- 
ment on an obligation which constitutes a specific charge against a 
shipping asset. 

Explanation of provision 

The Act provides that base company income does not include ship- 
ping income derived by a controlled foreign corporation from the 
operation (or hiring or leasing for use) of a vessel or airplane between 
two points in the country in which the vessel or airplane is registered 
and the controlled foreign corporation is incorporated. Thus, income 
earned by a lessee from the operation of the vessel or aircraft between 
two points within the country of registration qualifies for this excep- 
tion if the lessee is incorporated in that country whether or not the 
owner of the vessel is incorporated there. Similarly, income derived 
by the owner from the hiring or leasing of a vessel or airplane for use 
between two points within the country of registration qualifies for the 
exception if the owner is incorporated in that country whether or not 
the lessee is also incorporated there. 

Effective date 
The changes made by the Act are applicable as of the date of the 
provisions which added the foreign-base company shipping rules and 
thus apply to taxable years of foreign corporations beginning after 
December 31, 1975, and to taxable years of U.S. shareholders within 
which or with which such taxable years of the foreign corporations 
end. 

Revenue effect 
It is estimated that this provision will decrease receipts by less than 
$5 million on an annual basis. 

5. Amendments to the Foreign Tax Credit (sees. 1031 to 1037 of 
the Act and sees. 78, 901, 902, 904, 908, and 960 of the Code) 

Prior law 
Taxpayers subject to U.S. tax on foreign source income may take 
a foreign tax credit for the amount of foreign taxes paid on income 
from sources outside of the United States. The credit is provided only 
for the amount of income, war profits or excess profits taxes paid or 
accrued during the taxable year to any foreign country or to a posses- 
sion of the United States. 



234 

This foreign tax credit system embodies the principle that the coun- 
try in which a business activity is conducted (or in which any income 
is earned) has the first right to tax the income arising from activities 
in that country, even though the activities are conducted by corpora- 
tions or individuals resident in other countries. Under this principle, 
the home country of the individual or corporation has a residual right 
to tax income arising from these activities, but recognizes the obliga- 
tion to insure that double taxation does not result. Some countries avoid 
double taxation by exempting foreign source income from tax alto- 
gether. For U.S. taxpayers, however, the foreign tax credit system, 
providing a dollar-for-dollar credit against U.S. tax liability for in- 
come taxes paid to a foreign country, is the mechanism by which double 
taxation is avoided. 

The foreign tax credit is allowed not only for taxes paid on income 
derived from operations in a specific country or possession of the 
United States, but it is also allowed for dividends received from for- 
eign corporations operating in foreign countries and paying foreign 
taxes. This latter credit, called the deemed-paid credit, is provided for 
dividends paid by foreign corporations to U.S. corporations which 
own at least 10 percent of the voting stock of the foreign corporation. 
Dividends to these U.S. corporations carry with them a proportionate 
amount of the foreign taxes paid by the foreign corporation. 

The computation of the amount of the foreign taxes allowed as a 
deemed-paid credit in the case of a dividend distribution differed de- 
pending upon whether or not the payor of the dividend was a less- 
developed country corporation. Initially, a question arose as to how 
much of the foreign taxes for purposes of this credit should be attrib- 
uted to the earnings out of which dividends were paid and how much 
should be attributed to the portion of earnings used to pay the foreign 
taxes. This was decided in the Supreme Court case, American Chide 
Company^ which required the foreign taxes paid for purposes of the 
credit to be allocated between the dividend distribution and the por- 
tion of the earnings used to pay the foreign taxes. The Congress in 
1962, however, recognized tliat this resolution obtained less than the 
full U.S. tax on the dividend income because it omitted from the U.S. 
tax base the portion of the earnings used to pay the foreign tax. A^Hiere 
the foreign tax was less than the U.S. tax (but above zero) , this gave 
an advantage to dividend income over income subject to the full 
United States tax. In 1962. the Congress corrected this problem for 
all coi-porations other than less-developed country corporations. 

The correction made in 1962 took the form of requiring the earn- 
ings used to pay the foreign tax to be included in the deemed distribu- 
tion base and then allowing the credit for foreign taxes paid to be 
based upon the earnings, including the amount paid as foreign taxes, 
and not merely the portion paid as a dividend. 

These rules for the deemed-paid credit apply to distributions to a 
domestic corporation from a first-tier foreign corporation in which 
the domestic corporation is a 10-percent shareholder and to distribu- 
tions from a second-tier or third-tier foreign corporation (through a 
firet-tier foreign corporation). However, distributions originating 

'■American Chicle Company v. United States, 316 U.S. 450 (1942). 



235 

from a foreign corporation that is more than three-tiers beyond the 
domestic corporate sliareholder do not carry with them any deemed- 
paid foreign tax credit. 

In order to prevent a taxpayer from using foreign tax credits to 
reduce U.S. tax liability on income from sources within the United 
States, two alternative limitations on the amount of foreign tax 
credits which could be claimed were provided by prior law. Under the 
overall limitation, the amount of foreign tax credits which a tax- 
payer can apply against his U.S. tax liability on his worldwide in- 
come is limited to his U.S. tax liability multiplied by a fraction the 
numerator of which is taxable income from sources outside the United 
States and the denominator of which is worldwide taxable income. 
Under this limitation, the taxpayer thus aggregates his income and 
taxes from all foreign countries; a taxpayer may credit taxes from 
any foreign country as long as the total amount of foreign taxes 
applied as a credit in each year does not exceed the amovmt of tax 
which the United States would impose on the taxpayer's income from 
all sources without the United States. 

The alternative limitation was the per-country limitation. Under 
this limitation the same calculation made under the overall limitation 
was made on a country -by-country basis. The allowable credits from 
any single foreign country could not exceed an amount equal to U.S. 
tax on worldwide income multiplied by a fraction the numerator of 
which was the taxpayer's taxable income from that country and the 
denominator of which was worldwide taxable income. Taxpayers were 
required to use the per-country limitation unless they elected the 
overall limitation. Once the overall limitation was elected, it could 
not be revoked except with the consent of the Secretary or his delegate. 

The Tax Eeduction Act of 1975 prohibited the limitation on the 
foreign tax credit on income from oil-related activities from being 
calculated under the per-country method. Instead, this income (and 
anj'' losses) is computed under a separate overall limitation which 
applies only to oil-related income. Any losses from oil-related activity 
are to be "recaptured" in future years through a reduction in the 
amount of allowable foreign tax credits which can be used to offset 
subsequent foreisrn oil -related income. 

In addition, the Tax Reduction Act of 1975 requires that the amount 
of any taxes paid to foreign governm^ents which will he allowed as a 
tax credit on foreign oil and gas extraction income be limited to 52.8 
percent of that income in 1975, 50.4 percent in 1976, and 50 percent 
in subsequent years. 

Finally, the Tax Reduction Act of 1975 requires that no tax credit 
at all be allowed with respect to payments to a foreign country in 
connection with the purchase and sale of oil or gas where the tax- 
payer has no economic interest in the oil or gas and the purchase or 
sale is at a price which differs from the fair market value. 

In computing taxable income from any particular country or from 
all foreign countries for purposes of the fractions used in the tax credit 
limitations, all types of income were included under prior law as well 
as the deductions which related to that income and a proportionate 
part of deductions unrelated to any specific item of income. Thus, 
for example, income from capital gains was included in the numerator 



236 

and denominator of the limiting fraction as well as the deductions 
allocable to those ffains (e.g., the 50-percent exclusion of capital gains 
for individuals). However, an exception was provided for interest in- 
come if that income was not derived from the conduct of a banking or 
financing business, or was not otherwise directly related to the active 
conduct of a trade or business in the foreign country. Such interest 
income and the taxes paid on it was subject to a separate per-country 
limitation to be calculated without regard to the other foreign income 
of the taxpayer. 

In cases where the applicable limitation on foreign tax credits re- 
duces the amount of tax which can be used by the taxpaj^er to offset 
U.S. tax liability in any one year, the excess credits not used may be 
carried back for two years and carried forward for five years. How- 
ever, if a person using the per-country limitation in any year elected 
subsequently to use the overall limitation, no carryovers were per- 
mitted from years in which the per-country limitation was used to 
yeare in which the overall limitation was elected. 

The prior foreign tax credit system, and in particular the alternative 
methods of computing the limitation on allowable foreign tax credits, 
contained a number of problems which resulted in inequities between 
taxpayers and which, in some cases, resulted in a reduction of U.S. tax 
on U.S. source income. 

a. Per-country limitation and foreign losses 

Reasons for change 

The use of the per-country limitation often permitted a U.S. tax- 
payer who had losses in a foreign country to obtain what was, in 
effect, a double tax benefit. Since the limitation was computed sep- 
arately for each foreign country, losses in any foreign country did not 
have the effect of reducing the amount of credits allowed for foreign 
taxes paid in other foreign countries from which other income was 
derived. Instead, such losses reduced U.S. taxes on U.S. source income 
by decreasing the worldwide taxable income on which the U.S. tax was 
based. In addition, when the business operations in the loss country 
became profitable in a subsequent tax year, a credit was allowed for 
the taxes paid in that country. Thus, unless the foreign country in 
which the loss occurred had a tax rate no higher than the U.S. rate 
and had a net operating loss carryforward provision (or some similar 
method of using prior losses to reduce subsequent taxable income) , the 
taxpaver received a second tax benefit when income was derived from 
that foreign country because no U.S. tax was imposed on the income 
from that country (to the extent of foreign taxes paid on that income) 
even tJiou<rh earlier losses from that country had reduced U.S. tax 
liability on U.S. source income. 

The Congress does not believe that taxpayers should be permitted 
to obtain the double tax benefits described above. Accordingly, the per- 
counti'v limitation was repealed. In addition, where a taxpayer on the 
overall limitation reduces U.S. tax on domestic income by means of a 
loss from foreign sources, the Congress believes that this tax benefit 
should be subiect to recapture by the United States wliere foreign 
source income is subsequently derived. 



237 

(1) Pe7'-country limitation 

Explanation of provisions 

The Act includes two provisions which prevent losses incurred 
from activities abroad from reducing U.S. tax on U.S. source income. 
The Act repeals the per-country limitation. Taxpayers will be re- 
quired to compute the limitation of the amount of foreign tax which 
can be used to reduce U.S. tax under the overall limitation. The effect 
of this provision is that losses from any foreign country will reduce 
income from other foreign countries for purposes of calculating the 
foreign tax credit limitation, and thus will reduce the amount of for- 
eign taxes which can be used from those countries as a credit against 
U.S. tax. Foreign losses will reduce U.S. tax on U.S. income only in 
cases where foreign losses exceed income from all foreign countries 
for the taxable year. The Act also provides that the separate limita- 
tion for interest income, w^hich under prior law was computed on a 
country-by-country basis, is to be computed on an overall basis. 

It is the Congress's understanding that the per-country limitation 
is not required under the provisions of any recent income tax treaty 
between a foreign country and the United States. It is the Congress's 
intent that all existing treaties are to be applied consistently with this 
provision by using the overall limitation in computing the allowable 
foreign tax credit.* 

Because the provisions of this Act require taxpayers to compute 
their tax credit limitation on the overall method, special rules are 
included for taxpayers previously on the per-country limitation to 
permit some excess credits to be carried over from years in which the 
per-country limitation applied to years in which the overall limita- 
tion applies; similarly, special rules are provided to permit carry- 
backs from overall years to per-country years. The Congress recog- 
nizes that the repeal of the per-country limitation may have a sub- 
stantial adverse impact on the consolidated tax liability of an affiliated 
group. It is anticipated that in these cases the Internal Revenue Serv- 
ice will permit these companies to discontinue filing consolidated 
returns. 

Carryovers from years beginning before January 1, 1976, during 
which the taxpayer was on the per-country limitation, to years begin- 
ning after December 31, 1975 (i.e., years during which the taxpayer is 
required to be on the overall limitation) are permitted if such carry- 
overs were created under the rules of prior law (i.e., if, under the 
per-country limitation, the taxpayer had excess credits from one or 
more countries which could be carried forward). lender the Act these 
excess credits are further limited in that they mav be used only to the 
extent they would be used had the per-country limitation continued 
to apply in the succeeding taxable years. This computation is to be 
made iii the following steps. If the excess credits attributable to any 
specific country from prior years could have been vised under the per- 
coimtry limitation in the current vear, the use of these credits in the 
current year is further restricted if the overall limitation produces a 
lower amount of total credits. If this limitation applies, the amount 



* Thp roncTPss f'Tthpr Intends that, as is the case with other recent letrlslatlon modi- 
fying the forelen tax credit, the changes made by the Act are to be used In computing 
the credit allowed under all treaties. 



238 

of the carryovers which may be used as credits are reduced to the 
amount allowed under the overall limitation. The amount of credits 
attributable to any country which are treated as being used in the 
current year is to be reduced by the amount of credits allowed under 
the per-country limitation that are not allowed under the overall 
limitation. This reduction in the credits to be available is allocated 
among the credits attributable to each of the foreign countries in the 
ratio of the credits allowable under the per-country limitation for each 
country to the aggregate of the credits allowable on this basis for all 
countries.^ The remaining ct edits from each country which cannot be 
used in the current year can continue to be carried forward until the 
end of the 5-year carryforward period. 

A slightly different rule is provided for foreign taxes which arise in 
taxable years beginning after December 31, 1975 (overall limitation 
years), which may be carried back to years beginning before Janu- 
ary 1, 1976, during which the taxpayer was on the per-country lim- 
itation. First, the taxpayer is to determine if, under the normal rules 
applying to the overall limitation, any excess credits arise in the cur- 
rent year which are available to be carried back. If such excess credits 
do arise, the taxpayer is to make a country-by-country computation 
for the current year to determine what, if any, excess credits would 
arise from each country in that year under the per-country limitation. 
If excess credits arise from any country, those credits can be carried 
back. The credits which are available to be carried back for each 
country can then be applied to the appropriate earlier years if these 
excess credits could have been used in those years under the per- 
country limitation. Credits which are not available to be carried back 
may be carried forward to subsequent yeai"S under the^-year carry- 
forward rules. 

Effective date 

The repeal of the per-country provision and the related carryback 
and carryover rules apply to taxable years beginning after De- 
cember 31, 1975. 

The Congress is aware of the fact that certain existing mining ven- 
tures were begun with substantial investments of capital under the 
assumption that the foreign tax credit could be computed under the 
per-country limitation. The Congress l)elieves that it is appropriate 
to provide a limited transitional rule for these cases. The Act provides 
that in the case of a domestic corporation (whether or not it joins in 
the filing of a consolidated return with other cor])orations) which as 



" The followlnj? example illustrates this reduction. Assume company X has operations in 
countries A, B, and C as follows : 





A 


B 


c 


Total 


Income . . 


40 


60 
30 


-40 



60 


Taxes (current plus carried forward) . - 


25 


55 









With a 50-percent U.S. tax rate, company X could use 50 credits under the per-country limitation 
(20 in A and 30 in B) and 30 under the overall. Thus the amount of the reduction is 20 (50 minus 30), 
and is allocated 8 to country A (20/50X20) and 12 to country B (30/.50X20). Tn this case, 13 credits 
will be carried forward to subsequent years from country A (.5 originally disallowed by the per- 
country limitation, plus 8 disallowed under the overall) and 12 credits will be carried forward from 
country B. 



239 

of October 1, 1975, has satisfied four conditions, the per-country lim- 
itation may be used for all taxable years beginning before January 1, 
1079. The four conditions are that the corporation has as of October 1, 
1975: (1) been engaged in the active conduct of the mining of hard 
minerals (of a character for which a percentage depletion deduction 
is allowable (under sec. 613) ) outside the United States or its posses- 
sions for less than 5 years ; (2) has had losses from the mining activity 
in at least 2 of the 5 years ; (3) derived 80 percent of its gross receipts 
since the date of its incorporation from the sale of the minerals that 
it mined ; and (4) made commitments for substantial expansion of its 
mining activities. 

A commitment for substantial expansion of mining activities means 
a commitment of additional capital for the purpose of substantially 
expanding mining production. For example, if the production of a 
mine for the period immediately before October 1, 1975, averaged 
less than 75 percent of designed capacity and if additional capital is 
required in order to increase production to reach designed capacity, 
the commitment of that additional capital, if substantial, would be a 
commitment for substantial expansion of mining activities. To the 
extent that any foreign loss was sustained on a per-country basis 
during the transition period the loss is to be subject to the general 
loss recapture on a per-country basis. 

The Congress is also aware that a similar problem exists with 
respect to certain ventures begun in Puerto Rico or other possessions. 
Therefore, the Act applies the special transition period developed 
for mining ventures to existing ventures in Puerto Rico or other 
possessions. Thus, a taxpayer may continue to use the per-country 
limitation for operations in Puerto Rico for 3 additional years, and 
any loss sustained in those years will be subject to recapture, but on a 
per-country basis. 

Revenue effect 
It is estimated that the repeal of the per-country limitation will re- 
sult in an increase in budget receipts of $51 million in fiscal year 1977, 
$35 million in fiscal year 1978 and $45 million in fiscal year 1981. 

(^) Foreign Joss recapture 

Explanation of provisions 
Repeal of the per-countrj^ limitation, as outlined above, will prevent 
a taxpayer who has foreign losses from reducing his U.S. tax on U.S. 
source income if the taxpayer also has foreign source income equal to 
or greater than the amount of losses. However, in a case where overall 
foreign losses exceed foreiffn income in a given year, the excess of the 
losses could still reduce U.S. tax on domestic source income. In this 
case, if the taxpayer later receives income from abroad on which he 
obtained a foreign tax credit, the taxpayer has received the tax benefit 
of having reduced his U.S. income for the loss year while not paying 
a U.S. tax for ih^, later profitable year. To reduce the advantage to 
these taxpayers, the Congress has included a provision which requires 
that in cases where a loss from foreign operations reduces U.S. tax on 
U.S. source income, the tax benefit derived from the deduction of these 
losses should, in effect, be recaptured by the United States when the 
company subsequently derives income from abroad. 



240 

In general, the recapture is accomplished by treating a portion of 
foreign income which is subsequently derived as income from domestic 
sources. The amount of the foreign income which is to be treated as 
income from domestic sources in a subsequent year is limited to the 
lesser of the amount of the loss (to the extent that the loss has not been 
recaptured in prior taxable years) or 50 percent of the foreign taxable 
income for that year, or such larger percent as the taxpayer may 
choose. Thus, in any taxable year the amount subject to recapture 
is not to exceed 50 percent of the taxpayer's foreign income (before 
recharacterization) unless the taxpayer chooses to have a greater per- 
centage of his foreign income so recharacterized. Since the amount 
that is recaptured represents a loss which in the previous taxable 
year reduced the U.S. tax on income from U.S. sources, the recaptured 
amoimt is to be treated as income from sources within the United 
States. 

For the purposes of this recapture provision the Act defines the 
term "overall foreign loss" to mean the amount by which the taxpayer's 
(or in the case of an affiliated group filing a consolidated return, the 
group's) gross income from sources without the United States is ex- 
ceeded by the sum of the expenses, losses, and other deductions prop- 
erly apportioned or allocated to foreign sources and a ratable part of 
any expenses losses or other deductions which cannot definitely be 
allocated to some item or class of gross income (under sec. 862(b) 
of the Code) . If no overall foreign loss has been sustained in the case of 
an affiliated group of corporations filing consolidated returns, then no 
loss is subject to recapture even if a member of the group had a 
loss and the member is subsequently sold or otherwise leaves the 
group (e.g., a section 936 election is made with respect to the member). 
In computing the amount of the foreign loss, the net operat- 
ing loss deduction (under sec. 172(a)) and any capital loss carry- 
back and carryover to that year (under sec. 1212 of the Code) are 
not to be taken into account. In addition, foreign expropriation losses 
(as defined in sec. 172(k) (1) of the Code) or a loss which arises from 
fire, storm, shipwreck, or other casualty, or from theft (unless the 
loss is compensated for by insurance or otherwise) are not subject 
to tlie recapture provision. A taxpayer is to be treated as sustaining 
a foreign loss whether or not he claims a foreign tax credit for the 
year of the loss. 

The Act also provides for the recapture of a loss where property 
which w^as used in a trade or business, and which was used predomi- 
nantly outside of the ITnited States, is disposed of prior to the time the 
loss hns been recaptured under the rules discussed above. These rules are 
to apply regardless o^^ whether gain would otherwise be recognized. In 
cases Avhere srain would otherwise not be recofrnized, the taxpaver is 
to be treated as having received gain which is to be reco^-ni/ed in the 
year the taxpayer disposes of the property. The grain is to be the excess 
of the fair market value of the prone rty disponed of over the taxpayer's 
adinsted basis in the pronertv. Of course, the crain to be recoirnized 
under this provision is to be limited to the amount of the foreign losses 
not vet recaT^tured. In the case of a recapture resulting from the dis- 
position of the property, 100 percent of the gain (to the extent of losses 
not previously recaptured) is recaptured. In such a case the 50-percent 



241 

of gain limit is not applied, and the amount (if any) to be recaptured 
in future years is reduced by the full amount of the gain. 

For purposes of the recapture provisions, the term "disposition" m- 
cludes a sale, exchange, distribution, or gift of property whether or 
not gain or loss would otherwise be recognized. 

If income is recognized solely because of this disposition rule, such 
income receives the same characterization that it would be given 
had the <^axpayer actually sold or exchanged the property. In such 
cases, the Secretary of the Treasury is given the authority to prescribe 
appropriate regulations to provide for any necessary adjustments to 
the basis of the property to reflect any taxable income so recognized. 
However, a disposition for this purpose only includes a transfer of 
property which is a material factor in the realization of taxable in- 
come by the taxpayer. A disposition for this purpose does not include 
a transfer of property to a domestic corporation in a distribution or 
transfer which has carryover attributes (sec. 381(a)). Property is to 
be treated as a material factor in the realization of income not only 
if it is or was a material factor in the production of income, but also 
if it would be in the future. 

In determining whether the predominant use of any property has 
been without the United States, the use of the asset during the 3 years 
immediately prior to the disposition (or during the entire period of 
use of the property, if less) is to be taken into account. 

E-ffective date 

The loss recapture provisions apply to losses sustained in taxable 
years beginning after December 31, 1975, with two exceptions. Since 
the new recapture provisions apply to all losses (oil-related and other- 
wise), the recapture of foreign oil-related losses is to be accomplished 
under the general recapture provisions of section 904. However, under 
the special limitation for foreign oil-related income, a separate recap- 
ture computation and reduction of the foreign tax credit limitation 
is made with respect to the recapture of foreign oil-related losses and 
other losses. Foreign oil-related losses which were subject to recapture 
under the provisions of section 907(f) which have not yet been recap- 
tured are to be recaptured under the new recapture provisions. 

The first exception applies to loss from a debt obligation of a foreign 
government. In the case of a loss from the disposition of a bond, note, 
or other evidence of indebtedness issued before May 14, 1976, by a 
foreign government or instrumentality thereof for property located 
in that country or stock or indebtedness of a corporation incorporated 
in such country, the loss recapture provision does not apply. This pro- 
vision is intended to provide relief where foreign subsidiaries of 
domestic corporations incur losses because they w^ere forced, under the 
threat of expropriation, to exchange their stock or assets for long-term 
debt obligations of a foreign government which yield very low interest. 

The second exception applies to cases where a loss sustained in 1976 
is from an investment which became substantially worthless prior to 
the effective date. The loss may be with respect to stock or indebtedness 
(including guarantees) of a corporation in which the taxpayer owned 
at least 10 percent of the voting stock. The termination may be by 
reason of sale, liquidation or abandonment of a single corporation or 



242 

a group of corporations which are operated in the same line of busi- 
ness. To take into account more than one corporation in computing the 
5-year tests, tlie taxpayer must terminate its operations by January 1, 
1977, in all of the corporations in the group. This exception applies 
where a corporation has suffered an operating loss in three out of the 
five years preceding the 5^ear in which the loss was sustained, has 
sustairicd an overall loss for those five years, and the termination 
takes place before January 1, 1977. 

In some cases, a corporation mav want to continue an investment 
beyond 1976 in an attempt to try to make the investment profitable, 
although it may ultimately fail'in that endeavor. The Act provides 
that if a loss would qualify for the exception to recapture but for the 
fact that the investment is not terminated in 1976, if the investment 
is terminated before January 1, 1979, there is to be no recapture of the 
loss to the extent there was on December 31, 1975, a deficit in earnings 
and profits. 

Revenue effect 
It is estimated that the loss recapture provisions will result in an 
increase in budget receipts of $2 million in fiscal vear 1977, $8 million 
in fiscal year 1978 and $28 million in fiscal year 1981. 

6. Dividends from less-developed country corporations 

Prior law 
Under prior law, the amount of a dividend from a less-developed 
country corporation included in income by the recipient domestic cor- 
poration was not increased (i.e., grossed up) by the amount of taxes 
which the domestic corporation receiving the dividend was deemed to 
have paid to the foreign erovernment. Instead, the amount of taxes was 
reduced by the ratio of the foreign taxes paid by the less-developed 
country corporation to its pretax profits. 

Reasons for change 
The failure to gross-up the dividend by tlie amount of the foreign 
taxes that were deemed paid resulted, in effect, in a double allowance 
for foreign taxes. The problem arose from the fact that the amount paid 
in foreign taxes not only was allowed as a credit in computing the I".S. 
tax of the corporation receiving the dividend, but also was allowed as 
a deduction (since the dividends could only be paid out of income re- 
maining after payment of the foreign tax). The result was that the 
combined foreign and U.S. tax paid bv the domestic corporation was 
less than 48 percent of the taxpayer's income in cases where the for- 
eign tax rate of the less-developed country corporation was lower 
than the 48 percent U.S. corporate tax rate (but above zero).^ In 

"For example, assume that a foreign country Imposes a 30-percent tax on $1,000 of 
Income. If the forelpn corporation earns .$1,000 as a less-developed country corporation In 
that country, a distribution by that corporation of the remalnlne $700 to Its U.S. parent 
corporation would result In $700 income to the U.S. parent. The parent's U.S. tax vould be 
S.T.^fi before allowance of a foreign tax credit. In calculntinir the foreign tax credit, the 
$300 amount of foreign taxes paid would be reduced bv .SOO/IOOO to $210. The S210 could 
then be credited against TT.S. tax liability of $,S.'?6, leavinc a net liability of $126. Thus, 
the combined T\S. tax and foreign tax Uahllitv on the oritrlnal $1,000 of income would be 
$426 ($300 foreign taxes plus $126 U.S. tax),' not the $480 which should be paid at a 48 
percent rate. 

If that same foreign corporation earning $1,000 were not a less-developed country 
corporation, the entire 1.000 would be Included In the parent corporation's Income If it 
received a dividend of $700 which would carrv with it foreign taxes of $300. In this case, 
the U.S. tax before credit would be $480. The entire $300 of foreign taxes would be 
credited, leaving a U.S. tax liability of $180. The combined U.S. tax and foreign tax liabil- 
ities would be $480. 



243 

cases where the foreign tax rate exceeded 48 percent, the dividend did 
not bring with it all the foreign taxes that were paid and thus the 
size of foreign tax credit carryover was reduced. 

The size of the tax diflferential which existed in the case of divi- 
dends from less-developed country corporations varied with the for- 
eign tax rate, as can be seen by the table below : 

TABLE 1— RATE DIFFERENTIAL ENJOYED WITH RESPECT TO DIVIDENDS FROM LESS-DEVELOPED COUNTRY 
CORPORATIONS WITH VARIOUS SELECTED FOREIGN INCOME TAX RATES AND PRESENT 48 PERCENT U.S. RATE 

















Rate 
















differential 
















enjoyed by 






Income 


U.S. tax 


Credit 






foreign 




Foreign 


available 


before 


against 






subsidiary 


Income before tax 


tax 


for dividend 


credit 


U.S. tax 


U.S. tax 


Total tax 


(percent) 


$100 





$100 


$48.00 





$48.00 


$48.00 





JlOO 


$10 


90 


43.10 


$9.00 


34.20 


44.20 


3.90 


JlOO 


20 


80 


38.40 


16.00 


22.40 


42.40 


5.60 


$100 .- 


24 


76 


36.48 


18.24 


18.24 


42.24 


5.76 


$100 


30 


70 


33.60 


21.00 


12.60 


42 60 


5.40 


$100 


40 


60 


28.80 


24.00 


4.80 


44.80 


3.20 


$100 


48 


52 


24.% 


24.96 





48.00 





$100 


55 


45 


21.50 


24.75 


•0 


55.00 






* Excess credits of 3.25 are generated. 

Further, the tax differential disappeared either when the foreign 
tax rate equaled or exceeded the U.S. tax or when there was no foreign 
tax imposed at all. The maximum tax differential, given a 48-percent 
U.S. tax rate, occurred when the foreign tax was half that, or 24 per- 
cent. The differential at this jDoint was 5.76 percentage points. 

The Congress believes that in the interest of uniform tax treatment 
between developed and less-developed country corporations and among 
all less-developed country corporations, this double allowance should 
be removed. Further, providing for identical treatment between all 
foreign corporations simplifies the foreign tax credit computation. 

Explaiiafion of proviswn 
Under the Act, dividends from less-developed country corporations 
are treated the same as dividends from other foreign corporations. 
Thus, the amount of the dividends is increased by the amount of taxes 
deemed paid with respect to that dividend. 

Effective date 
For distributions out of current income, the provision is effective 
for taxable years beginning after December 31, 1975. However, the 
Act provides that for distributions made by less developed country 
corporations in taxable years beginning after December 31, 1975. and 
received by domestic corporations before Januaiy 1, 1978, this provi- 
sion applies only to the extent that the distributions are made out of 
profits of the foreign corporation accumulated in taxable years (of 
such foreign corporation) beginning after December 31, 1975. Thus, 
during that period, distributions of a less-developed country corpo- 
ration out of profits accumulated in taxable years beginning before 
January 1. 1076, are taxed as under prior law. After January 1. 1978, 
however, the provisions of this Act apply to all distributions regard- 
less of the year in which the profits are accumulated. 



244 

Revenue effect 
It is estimated that this provision will increase budget receipts by 
$80 million in fiscal year 1977 and by $55 million thereafter. 

c. Treatment of capital gains 

Reasons for change 

The prior foreign tax credit limitation created a number of prob- 
lems in the treatment of capital gains stemming from the fact that 
capital gains are taxed dijfferently than ordinary income. In many 
cases the source of income derived from the sale or exchange of an 
asset is determined by the location of the asset, or, if the asset is per- 
sonal property, by the place of sale (i.e., the place where title to the 
property passes) . In the latter case, taxpayers could often exercise a 
choice of the country from which the income from the sale of personal 
property is to be derived. It has thus been possible, in some cases, for a 
taxpayer to plan sales of personal property (including stocks or se- 
curities) in such a way as to maximize use of foreign tax credits by 
arranging that the sale of that property take place in a certain country. 

Since most countries (including the United States) impose little, 
if any, tax on sales of personal property by foreigners if the sales 
are not connected with a trade or business in that country, the prior 
system permitted taxpayers to plan sales of their assets in such a way 
that the income from the sale resulted in little or no additional for- 
eign taxes and yet the amount of foreign taxes they could use as a 
credit against their U.S. tax liability was increased. 

Further prdblems in the treatment of income from the sale or ex- 
change of assets for purposes of the foreign tax credit limitation were 
presented because prior law included no explicit rules for netting long- 
term and short-term gains and losses in cases where some gains or 
losses are U.S. source income while other gains or losses are foreign 
source income. The Internal Revenue Service has held that if a tax- 
payer (in certain circumstances) had losses from sources within the 
United States and had gains from sources outside the United States, 
the domestic losses did not offset the foreign gains for purposes of 
determining taxable income from sources without the TTnited States 
in the limiting fraction of the per-country or overall limitation on 
foreign tax credits. For example, if a taxpayer had long-term gain 
from sources outside the United States, that gain would increase in- 
come from sources without the United States and thus would increase 
the amount of foreign tax credits allowed to reduce U.S. tax liability, 
even tho\igh that gain had no effect on the taxpayer's pre-credit U.S. 
tax liability because it was offset by U.S. source capital losses. The re- 
sult is that in a case of foreign gains and domestic losses the amount of 
foreign tax credits which could be used was increased without a com- 
mensurate increase in U.S. tax liabilitv: IT.S. tax on U.S. income was 
reduced. Where foreign losses reduced U.S. gains, the amount of the 
allowable credit was improperly reduced. 

A problem with the treatment of capital gains under the foreign 
tax credit system was also presented by the fact that the credit limita- 
tions were not adjusted to reflect the lower tax rate on capital gains 
income received by corporations.^ Under prior law, corporations hav- 



■^ A similar problem exists to a mvioh lesser extent for canital gains income of inrtividuals 
under the alternntive tax fsecs. 1201 (b) and {o>). However, since only a limited amount 
of Income is eligible for this treatment It was felt unnecessary to deal with this problem. 



245 

ing a net long-term capital gain in most instances pay only a 30-percent 
rate of tax on the gain. But for purposes of determining foreign source 
and worldwide income in the limiting fraction of the foreign tax credit 
limitation, income from long-term capital gain was treated the same as 
ordinary income (i.e., as if it were subject to a 48-percent rate of tax).^ 
Similarly, a corporation which had capital gain income from U.S. 
sources and had foreign source income that was not capital gain did not 
receive a full credit for the amount of U.S. tax attributable to foreign 
source income.^ 

Finally, in computing the foreign tax credit limitation, the numera- 
tor of the limiting fraction was reduced by the amount of the net 
capital losses from sources without the United States which were taken 
into account in computing the taxpayer's entire taxable income for the 
year (i.e., to the extent that they were deductible as offsets against 
capital gain net income from sources within the United States). How- 
ever, no adjustment was made under prior law to account for the lower 
rate where the net capital loss from sources without the United States 
offset long-term capital gains from sources within the United States, 
even thougli the gains would have only been subject to tax at a 30- 
percent rate if the foreign loss had not been sustained. Thus, while the 
foreign source capital losses reduced long-term capital gains for pur- 
poses of computing taxable income, the impact on the computation of 
the foreign tax credit limitation was for the foreign source capital 
losses to reduce foreign source ordinary income. Consequently, the 
loss reduced the taxpayer's foreign tax credit limitation by an amount 
greater than the tax which would have been imposed on the U.S. 
source gain in the absence of the loss, and the taxpayer's net U.S. tax 
after the foreign tax credit was higher than it would have been had it 
not sustained the loss. 

The Congress believes that adjustments should be made to the for- 
eign tax credit limitation to take into account the fact that capital gains 
are taxed differently from ordinary income. 

Explanation of provisions 

The Act includes three provisions altering the treatment of income 
from the sale of capital assets for purposes of computing the limita- 
tion on the foreign tax credit. The Act establishes specific rules for de- 
termining the extent to which income or loss from the sale or exchange 
of capital assets from sources outside the United States is to be in- 
cluded in the limiting fraction in calculating the foreign tax credit 
limitation. 

The amount of capital gain included in foreign source income is re- 
ferred to as "foreign source capital gain net income", defined as the 
lower of capital gain net income from sources without the United 
States or capital gain net income. (Capital gain net income is the ex- 

» For example, if a corporation had worldwide income of $20 million, $10 million of 
which was ordinary income from sources within the United States and $10 million of which 
was income from the sgile of a capital asset from sources without the United States, that 
corporation was allowed a foreign tax credit equal to one half (10/20) of its U.S. tax 
liability, even though only $3 million of the $7.8 million in U.S. tax liability was attribut- 
able to foreign source income. Prior law thus favored the taxpayer with foreign source 
capital gain since its U.S. tax on foreign income of $10 million was not treated as being 
$3.0 million but as $3.9 million. 

"For example. If such a taxpayer had $10 million of U.S. source capital gain and $10 
million of foreign ordinary Income, the foreign tax credit limitation would limit the credit 
to $3.9 million even though it would be liable for $4.8 million of U.S. tax on Its foreign 
source Income. 



234-120 O - 77 - 17 



246 

cess of the gains from sales or exchanges of capital assets over the 
losses from such sales or exchanges.) Thus, under this provision, for- 
eign source capital gain can oe used to increase the amount of tax 
credits available to oliset U.IS. tax liability only to the extent the for- 
eign source capital gain results in a foreign source capital gain nc 
income. In cases where foreign and net U.kS. losses equal or exceed 
foreign gains, the foreign gains will not be taken into acoomit for pur- 
poses of determining the limitation. 

The second adjustment for capital gains income of corporations 
under the foreign tax credit limitation provides that the foreign 
source capital gain net income taken into account is to be reduced by 
three-eighths of foreign source net capital gain. Foreign source net 
capital gain is defined as the lower of the net capital gain from sources 
without the United btates or net capital gain. (iSet capital gain is the 
excess of net long-term capital gain over net short-term capital loss.) 
In etfect a maximum of 80/48ths of the net long-term capital gain 
from sources without the United States is taken mto account.^** This 
reduction of income is made to prevent distortion in the amount of 
foreign tax credits allowable to foreign income which would result be- 
cause capital gams for corporations is taxed at a 30-percent rate 
rather than a 48-percent rate.^^ 

Further to the extent that a net capital loss from sources without 
the United States is taken into account in determining capital gain 
net income for the taxable year (i.e., to the extent that a net capital 
loss from sources without the United States is allowed as a deduction 
in computing taxable income for the taxable year because it offsets 
capital gain net income from sources within the United States) 
and thus reduces the numerator, the loss is reduced (and thus the 
numerator is increased) by three-eighths of the excess of net capital 
gain from sources within the United States over net capital gain. Since 
the amount of the deductible net capital loss from sources without the 
United States is not as such taken into account as a separate element m 
computing the denominator of the foreign tax credit limitation, no 
adjustment is made to the depominator of the fraction in this 
situation.^^ 



1" If a corporation has, for example, $100 of net long-term capital gain from sources 
without the United States, all of which is foreign source capital gain net income, that 
corporation Includes as foreign source income only a maximum of 30/48ths (or %ths) 
thereof. Assuming that all of the corporation's foreign source capital gain net income qual- 
ifies as foreign source net capital gain, the corporation is permitted only $30 In tax credits 
attributable to the $100 of foreign source Income, rather than the $48 in foreign tax credits 
which would be permitted without the reduction in capital gain Income. Similarly, a com- 
pany which has $100 in domestic capital gain income and $100 in foreign source ordinary 
Income includes as U.S. -source Income 30/48ths of its U.S. source net capital gain. Such a 
corporation has a $48 limitation on foreign tax redits attributable to the $100 of foreign 
income rather than $39 as would be permitted without the reduction in capital gains 
income. 

" A similar adjustment is not needed In the case of taxpayers other than corporations 
(even though the alternative tax might be used) since in computing taxable Income for 
purposes of the foreign tax credit limitation a deduction Is taken for long-term capital 
gains (sec. 1202). 

" This provision may be Illustrated by the following example. Assume a corporation has 
a U.S. source long-term capital gain of $50, a U.S. short-term capital gain of $25, a foreign 
source long-term capital gain of $100, and a foreign source long-term capital loss of $200. 
The taxpayer also had U.S. source ordinary income of $1,000 and foreign source ordinary 
Income of $100. Only $75 of the corporation's net foreign source capital loss is taken into 
account in computing its capital gain net inome of zero for the taxable year, and its net 
capital gain from U.S. sources of $50 exceeds its worldwide net capital gain of zero by $50. 
'J''ius, the numerator of the foreign tax credit limitation is reduced by $56.25 ($75 less 
than three-eighths of $50). Therefore, the numerator is $43.75 ($100 less $56.25), and 
the denominator is $1,100. On the basis of a tentative U.S. tax of $52.8, the foreign tax 
credit limitation is $21, and the U.S. tax after the credit is $507, the same amount of tax 
the corporation would be liable for if its foreign source income, gains and losses were 
disregarded. 



247 

The Act also provides a special rule which applies to personal prop- 
erty sold outside of the United States by a corporation or by an in- 
dividual (if sold or exchanged outside of the countiy of the individ- 
ual's residence) . In these cases, no income is included for purposes of 
calculating the numerator of tiie foreign tax credit limitation from 
such sales or exchanges if the country in which such property is sold 
does not impose an income, war profits, or excess profits tax at a rate at 
least equal to 10 percent of the gain from the sale or exchange as com- 
puted under U.S. tax rules. This is accomplished by treating the 
foreign source capital gain as U.S. source income. The purpose of this 
rule is to prevent taxpayei s from selling their assets abroad primarily 
to utilize any excess foreign tax credits which they may have available 
from other activities. It was concluded that if the foreign government 
significantly taxes a sale, that sale probably did not take place in that 
country purely for tax purposes. The Congress concluded that a tax 
of 10 percent of the gain was substantial for these purposes. 

The rules treating foreign source capital gain as U.S. source income 
do not apply in three situations, even though no foreign tax is paid 
on the gain. These cases involve situations where the sale is not made in 
a country purely for tax purposes and, thus, an exception to the gen- 
eral rule should be made. The three cases are : first, in the case of a 
sale by an individual, if the property is sold or exchanged within the 
individual's country of residence; second, in the case of a sale by a 
corporation of stock in a second corporation, if the stock is sold in a 
country in which the second corporation derived more than 50 percent 
of its gross income for the 3-year period ending with the close of the 
second corporation's taxable year immediately preceding the year dur- 
ing which the sale took place ; and third, in the case of a sale by a corpo- 
ration or an individual of personal property (other than stock in a cor- 
poration), if the property is sold in a country in which such property 
was used in a trade or business of the taxpayer or in which the tax- 
payer derived more than 50 percent of its gross income for the 3-year 
period ending with the close of its taxable year immediately preced- 
ing the 3'^ear during which the sale took place. 

The changes in capital gains income generally are to apply both 
to capital assets and to business assets if such assets are treated as 
capital assets under the applicable Code provision. The new rules for 
capital gains are to be applied before application of the rules dealing 
with the recapture of foreign losses. 

Effective dates 

These provisions are to take effect with respect to gains and losses 

recognized in taxable years beginning after December 31, 1975, except 

that the rule which treats certain foreign source gain as U.S. source 

gain only applies to sales or exchanges made after November 12, 1975. 

Revenue effect 
It is estimated that the capital gain provisions will result in an 
increase in budget receipts of $14 million in fiscal year 1977 and $10 
million thereafter. 



248 

d. Foreign oil and gas extraction income 

(1) Limitation on oil and gas extraction income 
Reasons for change 
Under prior law, the amount of foreign taxes paid with respect to 
foreign oil and gas extraction income which under U.S. law were cred- 
itable taxes with respect to foreign oil and gas extraction income was 
limited to 50 percent of that income on an overall basis for taxable 
years ending after 1976. For purposes of this limitation "foreign oil 
and gas extraction income" is the income derived by the taxpayer from 
extraction (by the taxpayer or any other person) of minerals from oil 
and gas wells. Income from extraction includes the purchase and sale 
of crude oil by the taxpayer in cases where the taxpayer is not per- 
forming the extraction operations. Also it includes cases where the 
taxpayer is performing extraction services within the country for the 
government of that country (whether or not the taxpayer may pur- 
chase the oil from tliat ffovernment) . Any extraction tax allowed could 
only be used to offset U.S. tax on oil-related income in that year. No 
carryback or carryforward on any excess tax was pennitted. 

Explanation of provision 

Under the Act, the limitation on foreign taxes on foreign oil and 
gas extraction income allowable as a foreign tax credit is reduced for 
taxable years ending after 1976 to 48 percent of the foreign oil and 
gas extraction income computed on an overall basis. The 48-percent 
figure is the sum of the normal tax rate and the surtax rate for the 
taxable year in which the credit is claimed. Thus, if either of these two 
rates should be increased or decreased, the 48-percent limitation would 
also be changed. Further, a definition of foreign oil and gas extraction 
taxes is provided in order to make clear that the term includes credita- 
ble taxes paid to a foreign country where there is no taxable income in 
that country under U.S. tax accounting rules. The term "foreign oil and 
gas extraction taxes" is defined to mean any income, war profits, and 
excess profits tax paid or accrued (or deemed to have been paid under 
sec. 902 or 960) with respect to foreign oil and gas extraction income. 
This determination of foreign oil and gas extraction income is to be 
made without regard to whether there was, under U.S. acxM)unting 
rules, a loss described in section 907(c) (4) from oil or gas extraction 
operations in the taxing country. The determination also includes any 
tax on foreign oil and gas extraction operations which would be taken 
into account as a tax in computing the foreign tax credit under section 
901 if section 907 of the Code did not so limit the allowability of that 
tax as a credit. 

The Act provides carryback and carryover rules for excess foreign 
oil and gas extraction taxes. Under the Act, foreign oil and gas ex- 
traction taxes paid in taxable years ending after the date of enact- 
ment which exceed the percentage limitation for the year can be carried 
back 2 years to taxable years ending after December 31, 1974, and 
can be carried forward for 5 years in a manner similar to the regular 
foreign tax credit rules. The amount of the tax which is entitled to this 
new carryback or carryforward treatment may not exceed 2 percent 
of the foreign oil and gas extraction income for the year. Thus, 



amounts in excess of 50 percent of the forei^ oil and gas extraction 
income for the year are not allowed as a creditable tax in the current 
or carryover year. For purposes of determining the amount of taxes 
which may be carried to a taxable year ending in 1975, 1976, or 1977, 
the Act provides a transition rule which permits a carryover of excess 
credits in addition to the 2 percent allowed under the general new 
carryover rule. 

Special rules are provided which are designed to prevent the carry- 
over of credits disallowed under section 907 for extraction taxes paid 
or accrued in a year (the "unused credit year") to any year in which 
the credits could not be used because they would exceed either the 
section 907 limitation for that year or the section 904 limitation on 
oil-related taxes for that year. Under the special rules, the amount of 
extraction taxes which can be carried to a year under section 907 
cannot exceed the lesser of two limits. The first limit prevents the 
carryover of taxes to a year if they would exceed the section 907 
limitation for the year. The limit is the amount by which the section 
907 limitation for the year to which the taxes are to be carried exceeds 
(i) the sum of the extraction taxes actually paid in that year plus 
(ii) the amount of extraction taxes carried to that year from years 
prior to the unused credit year. The second limit prevents the carry- 
over of taxes which would exceed the section 904 limitation on foreign 
oil-related income for the year to which the taxes are carried. The 
limit is the amount by which the section 904 limitation exceeds the sum 
of (i) the amount of foreign oil-related taxes paid or accrued (or 
deemed paid under sec. 902 or 960) during the year, (ii) the amount 
of foreign oil-related taxes carried to that year under section 904(c) 
from years preceding the unused credit year, and (iii) amount of oil 
extraction taxes carried to that year under section 907 from years 
preceding the unused credit year. 

Where a taxpayer's extraction taxes exceed the section 907 limita- 
tion for a year and its oil-related taxes exceed the section 904 limita- 
tion for the year, the carryover under section 907 is to be made before 
the carryover under section 904(c). In determining the amount of oil- 
related taxes which can be carried to a year from the unused credit 
year under section 904(c), an overlap of carryovers to that year is 
prevented by treating the extraction taxes carried to that year from 
the unused credit year as actually having been paid during that year 
(thereby reducing the amount which could be carried to that year 
under sec. 904(c) bv the amount of extraction taxes carried to that 
year under sec. 907). 

Effective dates 
The reduction in the percentage limitation of the foreign tax credit 
for foreign oil and gas extraction taxes applies to taxable years ending 
after December 31, 1976. The new carrvover provisions are to apply 
to taxes paid or accrued during taxable years ending after the date of 
enactment of the Act, 

Revenue effect 
It is est 'mated that the provisions dealing with limitation and 
carryover of foreign oil and gas extraction taxes will result in an 
increase in budget receipts of $23 million in fiscal year 1977, and $50 
million thereafter. 



250 

(2) Foreign oil-related income earned hy individuals 
Reasons for change 

As indicated above, the foreign tax credit that can be claimed for 
foreign oil and gas extraction income is limited by a percentage of that 
income, and the amount of U.S. taxes that can be offset by these taxes 
in any year is subject to a separate overall limitation based on foreign 
oil-related income. 

Foreign oil-related income includes (in addition to extraction in- 
come) income from processing, transportation, and distribution activi- 
ties. These items are not included in foreign oil and gas extraction in- 
come. Under prior law, individuals and corporations were subject to the 
same percentage limitation. However, it is believed that individuals 
seldom have foreign oil-related income which is not also included in 
foreign oil and gas extraction income. In addition, limiting the amount 
of creditable taxes to the corporate rate is unfair or unduly generous 
in the case of certain individuals. For example, if an individual has a 
high effective rate of tax (in excess of the corporate rate), his dis- 
allowed foreign tax credit will cause him to pay U.S. tax on his 
foreign extraction income, while a corporation would owe no U.S. tax. 

Expla7Mtio7i of provision 
The Act limits the allowable foreign tax credit on foreign oil and 
gas extraction income to an amount equal to the average U.S. effective 
rate of tax on that income. Thus, in any case there will be sufficient 
tax credits to offset the U.S. tax on the foreign oil and gas extrac- 
tion income but no excess credits to offset U.S. tax on other for- 
eign source income. The Act achieves this result by limiting the tax- 
payer to a separate overall foreign tax credit limitation for foreign oil 
and gas extraction income. 

Effective date 

This provision is effective for taxable years ending after Decem- 
ber 31, 1974. 

ReveniLe effect 

It is estimated that this provision will decrease revenues by less 
than $5 million on an annual basis. 

(J) Production-shanng contracts 
Reasons for change 
A problem concerning the allowance of a foreign tax credit for 
payments to a foreign government in connection with mineral extrac- 
tion arose in the case of production-sharing contracts. These arrange- 
ments between the foreign government and oil companies which are 
becoming increasingly popular involve government ownership of all 
oil and gas reserves. Under these arrangements, the oil company 
operates as a contractor furnishing services and know-how. All man- 
agement and control of production is retained by a government- 
owned entity which has the exclusive right to explore and develop 
the government's mineral property. All tangible property is owned 
by the government-owned entity. Ordinarily, the contractor is com- 
pensated for its costs in the form of a share (not to exceed a given 
percentage each year) of the production from a contract area. The 



251 

remainder of the production is divided between the contractor and 
the government-owned entity according to negotiated percentages. 
(Any unrecovered costs are recovered in subsequent years.) The law of 
the foreign country generally provides that the government-owned oil 
company is to pay to the government each year a i)ortion of its produc- 
tion share. This payment is said to constitute (among other things) the 
payment of tlie contractor's tax liability on its beliaif so that the con- 
tractor does not directly pay any income taxes under the country's gen- 
eral corporation tax. 

The Inteiiv;! Revenue Service issued Revenue Ruling 76-215, 1976 
I.R.B. No. ii;>, Holding tliat the contractor under a production-sharing 
contract in Indonesia is not entitled to a foreign tax credit for pay- 
ments made by the government-owned company to the foreign govern- 
ment. The grounds for this holding were, in part, that since the 
foreign government already owns all of the oil and gas, there is no 
payment to the government by the contractor. Furthermore, even if 
a payment by, or on behalf of, the contractor could be identified, the 
IRS views such a payment as in the nature of a royalty, rather than 
a tax. 

In 1969, the Internal Revenue Service issued Revenue Ruling 69- 
388, 1969-2 C.B. 154, which held that certain payments made pur- 
suant to a contract to explore for, develop, and produce oil in Indo- 
nesia are creditable. The contracts to which that Ruling applied were 
not production-sharing contracts but the Ruling was apparently relied 
on by oil companies entering into production-sharing contracts. In 
view of the fact that the scope of the prior Ruling was not clear, the 
Internal Revenue Service exercised its discretion to apply Revenue 
Ruling 76-215 only prospectively to claims for credits for taxes paid 
in taxable years beginning after June 30, 1976. 

While tlie Congress takes no position on the correctness of the IRS 
ruling, the Congress feels that oil companies operating under existing 
production-sharing contracts should have a reasonable time to re- 
negotiate their contracts with the foreign government. Thus, assum- 
ing the ruling is sustained, if challenged, generally the companies 
should continue to be allow^ed the foreign tax credit for another year. 
In the meantime, however, the oil companies should not be allowed 
to generate excess foreign tax credits under the contracts that can be 
used to offset tax on other income. 

Explanation of provision 

The Act allows a limited foreign tax credit for a limited period in 
the case of certain production-sharing contracts to which Revenue Rul- 
ing 76-215 applies. Under this provision, amounts which are desig- 
nated by a foreign government under certain production-sharing 
contracts as income taxes are treated as creditable income, war profits, 
and excess profits taxes even though the amounts would not other- 
wise be treated as creditable taxes. Moreover, the provision only applies 
to taxes not creditable by reason of that ruling. Thus, to the extent that 
payments are treated as taxes, this provision does not apply to those 
payments. 

However, the total amount treated as creditable taxes under this 
provision is not to exceed the lesser of two amounts. The first amount 



252 

is the total foreio:n oil and gas extraction income with respect to pro- 
duction-sharino; contracts coxered under the rule multiplied by the 
U.S. corporate tax rate (presently 48 ])ercent) less the otherwise allow- 
able (if any) foreig^i tax credits attributable to income from those 
contracts. The second amount is the total foreign oil and gas extrac- 
tion income multiplied by the U.S. corporate tax rate (generally 
48 percent) less the total amount of the otherwise allowable foreign 
tax credits (if any) attributable to the total foreign oil and gas extrac- 
tion income. 

The production-sharing contracts covered by this provision are those 
contracts for which the IRS has published a ruling disallowing for- 
eign tax credits for taxes paid in taxable years beginning on or after 
June 30, 1976, but has not disallowed claims for tax credits for taxable 
years beginning before that date. 

Thus, for example, assume that the taxpayer for 1977 derives a 
total of $100 of foreign oil and gas extraction income; that $10 of 
that amount is derived from production-sharing contracts to which 
this provision applies ; that the taxpayer pays a total of $45 in foreign 
taxes on the foreign extraction income (not including any amounts 
claimed as taxes under production-sharing contracts to which this 
provision applies) ; and that $6 of tax credit was disallowed on the 
income from the production-sharing contracts. Under these facts, the 
taxpayer is allowed a foreign tax credit for amounts under the pro- 
duction-sharing contract equal to $3, the lesser of (48 percent of $10) 
or ( (48 percent of $100) minus ^5) . 

The special rule applies only with respect to production-sharing con- 
tracts for which the Internal Revenue Service will disallow claims 
for a foreign tax credit for taxes paid in taxable years beginning on or 
after June 30, 1976, but will not disallow claims for taxes paid for tax- 
able years beginning on or after June 30, 1976. 

Effective date 
The special rule for production-sharing contracts is to apply for tax- 
able vears beginning on or after June 30, 1976. This provision will 
apply only to production-sharing contracts entered into before April 8, 
1976, and will apply only with respect to taxable yeare ending before 
January 1, 1978. 

Revenuue effect 
It is estimated that this provision will decrease budget receipts by 
$23 million in fiscal year 1977 and $27 million in fiscal year 1978. 

e. Third-tier foreign tax credit under subpart F 

Prior law 
Under existing law, when amounts which are foreign base company 
income are included in the income of a domestic corporation under 
subpart F with respect to the undistributed earnings of a controlled 
foreign corporation, a proportionate part of the foreign taxes paid 
by the foreign cor^wration are deemed paid by the domestic corpora- 
tion, and a foreign tax credit is available to the domestic corporation 
with respect to those taxes. These rules are substantially parallel to the 
foreign tax credit rules on actual distributions. However, this deemed 
paid credit was available under prior law for subpart F income only 



253 

if tlie controlled foreign corporation was a first-tier foreign corpora- 
tion (which must be at least 10 percent owned by a domestic corpora- 
tion) or a second-tier foreign corporation (which must be at least 50 
percent owned by a first-tier foreign corporation). 

Reasons for change 

The rules with respect to second- and third-tier corporations were in- 
consistent with the foreign tax ciedit rules applicable with respect to 
dividends actually distributed. Actual dividends carry with them a 
proportionate part of the foreign taxes paid by third-tier foreign cor- 
porations, as well as first- and second-tier foreign corporations. More- 
over, in order to qualify as a second-tier corporation with respect to di- 
vidends actuall}^ distributed, only 10 percent of the stock need be held 
by a first-tier foreign corporation. 
' The Congress believes that the foreign tax credit rules with respect 
to amounts included in income under subpart F should be consistent 
with the rules applicable to dividends actually distributed. Taxpayers 
tend to structure their business operations in accordance with the rules 
applicable with respect to actual distributions. The rules of subpart F 
were overly harsh when they denied a foreign tax credit to a taxpayer 
who would have been entitled to a credit had there been an actual 
distribvition. 

When subpart F was added in 1962, the rules for computing the 
deemed-paid foreign tax credit with respect to dividends were appli- 
cable only with respect to foreign taxes paid by a first-tier foreign 
subsidiary (definerl as being at least 10 percent owned by a domestic 
corporation) or a second-tier foreign subsidiary (defined as being at 
least 50 percent owned by a first-tier foreign corporation). The foreign 
tax credit rules under subpart F were made applicable under the same 
circumstances as actual dividends. In 1971, the deemed-paid foreign 
tax credit with respect to dividends actually distributed was expanded 
to apply to foreign taxes paid by a larger class of second-tier corpora- 
tions and by third-tier foreign corporations. The Act conforms the 
subpart F foreign tax credit rules to the 1971 change in the deemed- 
paid foreign tax credit rules for actual dividend distributions. 

Exphinatlon of 'provision. 

The Act makes two changes to the rules for computing a foreign tax 
credit with respect to amounts included in income under subpart F. 
First, the Act provides that the foreign tax credit is applical)le with 
respect to foreign taxes paid by a third-tier foreign corporation whose 
undistributed income is taxed to the shareholder. Second, the Act lib- 
eralizes the stock ownership test applicable to second-tier foreign 
corporations. 

Under the Act, a foreign corporation qualifies as a second-tier for- 
eign corporation if at least 10 percent of its voting stock is owned by a 
first-tier foreign corporation, at least 10 percent of the voting stock of 
which must be owned by a domestic coi-poration. A foi-eign corporation 
qualifies as a third-tier foreign corporation if at least 10 percent of its 
voting stock is owned by a second-tier foreign corporation. 

However, with respect to a second-tier foreign corporation, the for- 
eign tax credit \:, not available unless the percentage of voting stock 
owned by the domestic corpoi-ation in the first-tier foreign corpora- 
tion and the percentage of voting stock owned by the first -tier foreign 



254 

corporation in the second-tier foreign corporation when multiplied 
together equal at least 5 pei'cent. With respect to a third-tier foreign 
corporation, the foreign tax credit is not available unless the percent- 
age of voting stock in the first-tier foreign corporation owned by the 
domestic corporation and the percentage of voting stock in the second- 
tier foreign corporation owned by the first-tier foreign corporation 
and the percentage of voting stock in the third-tier foreign corpora- 
tion owned by the second-tier foreign corporation w4ien multiplied 
together equal at least 5 percent. 

E-ffective date 
The Act applies with respect to earnings and profits of a foreign 
corporation included in gross income after December 31, 1976. 

Revenue effect 
This provision will reduce budget receipts by $4 million in fiscal 
year 1977, $10 million in fiscal year 1978, and $10 million in fiscal 
year 1981. 

/. Source of underwriting income 

Prior law 
Under prior law, the source of insurance underwriting income was 
imclear. Neither the Internal Revenue Code nor the Income Tax Reg- 
ulations set forth a specihc rule for determining the source of insur- 
ance underwriting income. It was apparently the position of the Inter- 
nal Revenue Service, how^ever, tliat the source of such income was to be 
determined on the basis of where the incidents of the transaction which 
produced the income occurred. Under this rule, income produced from 
insurance underwriting contracts negotiated and executed in the 
United States, regardless of tlie location of the insured risks, was gen- 
erally deemed to be from sources within the United States. This rule 
apparently applied even though the insurance contract was actually 
written by a foreign company. 

Reasons for change 
The prior source rule applicable to insurance underwriting income 
was vulnerable to artificial manipulation by taxpayers. By simply 
changing the place wdiere a contract was negotiated and executed, a 
taxpayer could clumge the source of the underwriting income produced 
by the contract. The prior source rule in some situations also could 
result ill double taxation. It is not uncommon for United States 
corporations doing business abroad through foreign subsidiaries to 
negotiate and execute insurance contracts in the United States; which 
cover Its overseas operations. The insurance policies, however, fre- 
quently must be issued in the foreign jurisdiction in which the in- 
sured's risk is located in order to comply with local insurance laws or 
for other business reasons. Although the underwriting income in these 
circumstances generally would be subject to foreign taxation, the in- 
come w^ould be deemed Ignited States source income, which in turn 
would reduce the amount of the foreign tax credit available to the 
taxpayer. 

Explanation of provision 
The Act clearly establishes a source rule applicable to insurance un- 
derwriting income under which underwriting income derived from 



255 

the insurance of U.S. risks will be income from sources within the 
United States. All othei- underwritiufj income will be considered in- 
come from sources without the United States. The source rule is not in- 
tended to chano-e the law with respect to the determination of whether 
foreign source income is effectively connected with the conduct of a 
trade or business within the United States. 

Effective date 
The provision applies to taxable years beginning after December 
31, 1976. 

Revenue effect 
It is estimated that this provision will decrease receipts by less 
than $5 million annually. 

6. Exclusion From Gross Income and From Gross Estate of Port- 
folio Investments in the United States of Nonresident Aliens 
and Foreign Corporations (sec. 1041 of the Act and sec. 861 
of the Code) 

Prior law 

Interest, dividends and other similar types of income of a non- 
resident alien or a foreign corporation are generally subject to a 30- 
})ercent tax on the gross amount paid ^ if the income or gain is not 
effectively connected AA'ith the conduct of a trade or business within 
the United States (sees. 871(a) and 881).^ Prior law provided a 
temporary exemption from the tax for interest earned on deposits with 
banks, savings and loan institutions, and insurance companies (sees. 
861(a) (1) (A) and 861 (c) ). Under prior law that temporary exemp- 
tion would have expired for interest paid or credited after Decem- 
ber 31, 1976. 

Bank deposits owned by nonresident aliens are exempt from Federal 
estate tax if interest on the deposits, were it received by the decedent 
at the time of his death (sees. 210-1 and 2105) , would be exempt under 
the Code from the 30-percent withholding tax. 

In addition to the exemption from tlie 30-percent withholding tax 
provided in the Internal Revenue Code for interest on bank deposits, 
various income tax treaties of the United States provide for either 
an exemption or a reduced rate of tax for interest paid to foreign 
persons if the income is not effectively connected with the conduct of 
a trade or business within the United States. 

Reasons for change 
Interest on bank deposits paid to nonresident aliens and foreign 
corporations has been exempt from U.S. tax continuously since 1921. 
The exemption was permanent prior to 1966. In the Foreign Investors 
Tax Act of 1966, the exemption was put on a temporary basis because 
Congress felt there was some question Avhether it was appropriate 
that foreign investors should receive more favorable treatment with 
respect to bank account interest than citizens and residents of the 
United States, but it wished to retain the exemption temporarily so 

^ This tax is generally collected by means of a withholdinc by the person making the 
pavpient to the foreijrn recipient of the income (sees. 1441 and 1442). 

- If the interest, dividend or other similar income is effectively connected with a U.S. 
trade or business, that income is included in the normal income tax return which must be 
filed for the business. 



256 

that it could determine whether the elimination of exemption would 
have a substantial adverse balance of payments effect. 

Congress has concluded that the elimination of the exemption would 
result in a significant decline in the substantial deposits by nonresident 
aliens and foreign corporations in banks in the United States. Since 
a possible shortage of investment capital presently exists in the United 
States, Congress concluded further that it would not be advisable at 
this time to permit the exemption to expire at the end of 1976 with 
the resultant outflow of investment capital. 

Moreover, it was decided to retain the exemption on a permanent 
basis. It is believed that the temporary nature of the exemption in 
recent years may have discouraged foreign investors from investing 
in fixed term bank deposits such as certificates of deposit where those 
obligations were due to mature after the dates the exemption was due 
to expire. Although the exemption had in the past l)een extended each 
time it was due to expire, some foreign investors (as the expiration 
came near) who desired to invest in fixed-term obligations because 
they tend to bear a relatively high interest rate apparently felt that 
they could not take the risk that the exemption would not be extended, 
and thus they invested their funds elsewhere. 

Explanation of proiusion 
The Act continues without any termination date the exemption in 
prior law for interest earned by nonresident aliens and foreign cor- 
porations on deposits with banks, savings and loan institutions, and 
insurance companies where the interest is not effectively connected 
with the conduct of a trade or business within the United States, 
The Act makes the exemption for interest on deposits permanent by 
eliminating the language of prior law which would have terminated 
the provision for interest paid or credited after December 31, 1976. 

Effective date 
The provision is effective upon enactment. 

Revenue effect 
It is estimated that this provision will reduce budget receipts by 
$55 million in fiscal year 1977, $115 million in fiscal year 1978, anil 
$145 million in fiscal year 1981. 

7. Changes in Ruling Requirements Under Section 367 and 
Changes in Amounts Treated as Dividends (sec. 1042 of the 
Act and sees. 367, 1248, and 7477 of the Code) 

Prior laio 
Certain types of exchanges relating to the organization, reorganiza- 
tion, and liquidation of a corporation can be made without recognition 
of gain to the corporation involved or to its shareholders. lender prior 
law, howev^er, when a foreign corporation was involved in certain of 
these types of exchanges, tax-free treatment was not a\ailable unless 
prior to the transaction the Internal Revenue Service had made a 
determination that the exchange did not have as one of its principal 
purposes the avoidance of federal income taxes. Under prior practice 
this determination was made by issuing a separate ruling for each. 



257 

transaction. The required deteniiination had to be obtained before the 
transaction began in all cases unless the transaction involved only a 
change in the form of organization of a second (or lower) tier foreign 
subsidiary with no change in ownership. 

The advance i-uling requirement of section 367 applied to exchanges 
involving contributions of property to controlled corporations (sec. 
351), all tax-free corporate reorganizations (sees. 154, 355, 356 and 
361), and liquidations of subsidiary corporations (sec. 3^2). In de- 
termining the extent to which gain (but not loss) was recognized in 
these exchanges, a foreign corporation was not considered a corporation 
unless it was established to the satisfaction of the Internal Revenue 
Service that the exchange was not in pur-suance of a plan having as 
one of its principal purposes the avoidance of Federal income taxes. 
Since corporate status is essential to qualify for the tax-free organiza- 
tion, reorganization and liquidation provisions, failure to satisfy the 
Commissioner under section 367 could result in the recognition of gain 
to the participant corporations and shareholders. Furthermore, there 
was no effective way a taxpayer could appeal an adverse decision bj^ the 
Commissioner to the courts because the statute re(|uired the Commis- 
sioner's, not the court's, satisfaction. 

In 1968, the Internal Revenue Service issued guidelines (Rev. Proc. 
68-23, 1968-1 Cum. Bull. 821) as to when favorable rulings "ordi- 
narily" would be issued. As a condition of obtaining a favorable ruling 
with respect to certain transactions, the section 367 guidelines required 
the taxpayer to agree to include certain items in income (the amount 
to be included was called the section 367 toll charge). For example, if 
a domestic corporation transferred property to a foreign subsidiary 
(a transaction otherwise accorded tax-free treatment under section 
351) , the transaction was given a favorable ruling only i " the domestic 
corporation agreed to include in its gross income for its taxable year 
in which the transfer occurred an ajjpropriate amount to i-eflect realiza- 
tion of income or gain with respect to certain types of assets {e.g., in- 
ventory, accounts receivable, and certain stock or securities) trans- 
ferred to the foreign corporation as part of the transfer. If the 
transaction involved the liquidation of a foreign corporation into a 
domestic parent, a favorable ruling was issued if the domestic parent 
agreed to include in its income as a dividend for the taxable vear in 
which the liquidation occurred the portion of the accumulated earn- 
ings and profits of the 'oreign corporation which were jyroperly 
attributable to the domestic corporation's stock interest in the foreign 
corporation. These two cases illustrate that the statutory stand- 
ard for determining that a transaction did not have as one of its 
principal purposes tax avoidance had evolved through administrative 
internretation into a renuirement o-enerally that tax-free treatment 
would be permitted only if the ILS. tax on accumulated earnino-s and 
profits (in the case of transfers into the Ignited States bv a foreijrn 
corporation) or the I^.S. tax on the notential earnin.o-s from liouid 
or passive investment assets (in the case of transfers of pronerty 
outside the United States) was paid or was preserved for future 
payment. 

In addition to section 367, section 1248 provided for the imposition 



258 

of a full U.S. tax on accumulated profits earned abroad when they 
were repatriated to the United States in cases where gain was recog- 
nized on the sale or exchange (or liquidation) of stock of a controlled 
foreign corporation held by a U.S. person owning 10 percent or more 
of the voting stock. In these cases, the gain was included in the gross 
income of the U.S. person as a dividend to the extent of the earnings 
and profits of the foreign corporation attributable to the period the 
stock was held by the U.S. person while the foreign corporation was 
a controlled foreign corporation. Tliis provision applied to post-1962 
accumulated earnings. 

Reasons for change 

Several pix)blems developed insofar as section 367 and the related 
provisions of section 12-18 were concerned. First, the advance ruling 
requirement often resulted in an undue delay for taxpayers attempting 
to consummate perfectly proper business transactions. Second, a num- 
ber of cases had arisen where a foreign corporation was involved in 
an exchange within the scope of the section 367 guidelines without the 
knowledge of its U.S. shareholdei-s, and thus no request for prior 
approval had been made. In a case of this type, an otherwise tax-free 
transaction became a taxable transaction, and if a second or lower tier 
foreign subsidiary was involved, the U.S. shareholders of the controlled 
foreign corporation might have been taxed under the subpart F rules. 
This could have occurred under the Service's section 367 guidelines 
despite the fact that a favorable ruling would clearly have been issued 
by the Internal Revenue Service had it been requested prior to the 
transaction. 

The third area of difficulty in the administration of section 367 under 
prior law concerned situations where the IRS required a U.S. share- 
holder to include certain amounts in income as a toll charge even 
though there was no present tax avoidance purpose but, rather, only 
the existence of a ix)tential for future tax avoidance. This occurred 
under the section 367 guidelines because of limitations in the carryover 
of attribution rules (sec. 381). The Internal Revenue Service in some 
cases had the option either of collecting an immediate tax or of 
collecting no tax at all since in those cases it had no authority to defer 
payment of the tax until the time that the avoidance actually arose, 
except by entering into closing agreement with the taxpayer. 

The fourth problem concerned the fact that since the law required 
the satisfaction of the Commissioner, a taxpayer was unable to go 
through with a transaction and litigate in the courts the question of 
whether tax avoidance was one of the ]nirix)ses of the transaction. 
While the Congress generally approves the standard applied by the 
IRS, there may have been cases where these standards were inappro- 
priate or were not being correctly applied. Congi-ess believes it is fair 
to permit taxpayers to litigate these questions in the courts. 

The Congress further believes that the interpretation of the rules 
governing exchanges described in section 367 should not be done in in- 
dividual rulings but should be provided by clear and certain regula- 
tions. "\Miile it is recognized tliat the prior rules were necessarily 
highly technical and largely procedural and while it is essential to pro- 



259 

tect against tax avoidance in transfers to foreign corporations and 
upon the repatriation of previously untaxed foreign earnings, unneces- 
sary barriers to justifiable and legitimate business transactions shoiild 
be avoided. The Congress believes that U.S. taxpayers participating 
in certain types of transactions involving foreign corporations should 
he able to determine the tax effects of the transaction from the statute 
and accompanying regulations rather than being required to apply to 
the Internal Revenue Service for a determination in advance of the 
transaction. Only in those types of transactions where the amount of 
tax, if any, which must be paid to protect against tax avoidance can 
only be determined by judging the specific facts of the case should 
the taxpayer be required to obtain a determination from the Internal 
Revenue Service. Moreover, in cases where such a ruling is to be 
required, taxpayers should be permitted to obtain the ruling within 
some limited time after the transaction has begun. 

A problem also existed with the provision which imposes a tax 
at ordinary income rates to the extent of post-1962 accumulated earn- 
ings and profits upon certain sales or exchanges of stock in a controlled 
foreign corporation (sec. 1248). In some situations other than those 
covered by section 367, a domestic corporation is entitled to nonrecog- 
nition of any gain if it sells, exchanges, or distributes its property. 
When transactions coming within the scope of these non recognition 
provisions involve the sale or distribution of stock in a controlled for- 
eign corporation, section 1248 did not apply since that provision 
applied only when gain was recognized. Thus, any ordinary income tax 
on the repatriation of accumulated earnings and profits of the con- 
trolled foreign corporation was lost. For example, a U.S. parent cor- 
poration was able to avoid ordinary income tax on foreign earnings 
if it sold the stock in a controlled foreign subsidiary as part of a plan 
of complete liquidation (pursuant to sec. 337). The U.S. corporation 
was entitled to nonrecognition of gain (or loss) on the sale or exchange 
of the stock and was not requii-ed to recognize any gain when it dis- 
tributed its property (including the sales proceeds) to its shareholders 
in complete liquidation. The shareholders would pay a capital gains 
tax on the difference between the value of the property received in 
liquidation and their basis in the stock of the liquidating corporation, 
but no ordinary income tax was paid on the foreign earnings. 

A similar problem was involved, for example, if a U.S. corporation 
distributed stock in a controlled foreign corporation as a dividend. 
The distributing corporation would not recognize gain on the distribu- 
tion and the distributee shareholders (if they were individuals) would 
acquire a fair market value basis in tlie distributed stock and would 
not be treated as holdinc: the stock for the period it was held by the cor- 
poration (sec. 1223). Thus, although the shareholders would be taxed 
on the dividend out of the domestic corporation's earnings, there was 
no corporate tax on the earnings of the foreip-n corporation. 

The Congress believed that the availability of nonrecoo-nition 
treatment for distributions or exchanges of stock of controlled foreign 
corporations in situations not covered under section 367 or 1248 de- 
tracted substantially from the principle of taxing accuinulated earn- 
ings and profits of foreign corporations upon repatriation. In Con- 



260 

gress's view, nonrecognition should not be available to the selling or 
distributing corporation but, rather, it should be required to include 
in income, as a dividend, its share of post-1962 foreign earnings and 
profits. 

Explanation of provisions 

The Act approaches the problems outlined above first by amending 
section 367 to establish separate rules for two different groups of trans- 
actions: (i) transfers of property from the United States, and (ii) 
other transfers (this latter group including transfers into the United 
States and those which are exclusively foreign). Transactions in the 
first group generally include those transactions where the statutory 
aim is to prevent the removal of appreciated assets or inventory from 
U.S. tax jurisdiction prior to their sale, while transactions in the second 
group include those where the statutory purpose in most cases is to 
prepare for taxation the accumulated profits of controlled foreign 
corporations. 

Transfers from the United States. — With respect to the first group 
(sec. 367(a)), it is provided that if in connection with an exchange 
described in section 332, 351, 354, 355, 356, or 361, there is a trans- 
fer of property (other than stock or securities of a foreign corpora- 
tion which is a party to the exchange) by a U.S. person to a foreign 
corporation, the foreign corporation will not be considered a corpora- 
tion (for purposes of determining gain) unless, pursuant to a request 
filed not later than the close of the 183rd day after the beginning of 
the transfer, the taxpayer establishes to the satisfaction of the Inter- 
nal Revenue Service that the exchange did not ha^•e as one of its 
principal purposes the avoidance of Federal income taxes. The term 
"party to the exchange" as used in this provision includes a party to 
the reorganization (as defined in sec. 368(b)) and the transferor and 
transferee in an exchange other than a reorganization. Types of "out- 
bound" transfers falling within this categor}' include exchanges involv- 
ing transfers of property to a foreign corporation, the liquidation of a 
U.S. subsidiary into a foreign parent, the acquisition of a U.S. corpo- 
ration's assets by a foreign corporation in a qualified reorganization 
and the acquisition of stock in a U.S. corporation by a foreign cor- 
poration in a type "B" reorganization.^ Exchanges where the only 
transfer of property out of the United States is stock of a foreign 
corporation which is a party to the exchange are treated as transfers 
into the T'nited States, since the princi]^al concern in that case is the 
avoidance of taxation on the accumulated earnings of the foreign 
corporation. The rules for outbound transactions apply only to trans- 
fers of property by U.S. persons; thev do not apply to transfers 
which are between two foreign corporations or between a foreign cor- 
poration and a foreign individual. 

The Act thus provides that for transfers of property out of the 
United States the requirement of an advance ruling is replaced by a 
I'equirement that the taxpayer file a request for clearance with the 



1 Also Included as "outbou'Hl" transfers are transfers of assets from one domestic 
corporation to another in a "C" reorganization where the acquirlnfr corporation is con- 
trolled hv foreigners who were not In control of the acquired corporation before the 
reorganization. 



261 

Internal Revenue Service within 183 days after the beginning of the 
transfer. Even this post-transaction clearance from the Internal Rev- 
enue Service may not be required in certain clearcut situations involv- 
ing outbound transfers where significant tax avoidance possibilities do 
not exist or where the amount of any section 367 toll charge can be 
ascertained without a ruling request. The Act provides that the Secre- 
tary is to designate by regulations those transactions which for these 
reasons do not require the filing of a ruling request. For transactions 
designated by the regulations, taxpayers may go ahead with the trans- 
action without a ruling but are subject to any section 367 toll charge 
prescribed by the regulations. For example, if a section 351 transfer to 
a foreign corporation involves only the transfer of cash and inventory 
property, the Secretary may by regulations designate the transaction 
as one which does not require the filing of a request, although the 
regulations would require the inventory to be taken into income. 

The Act provides a special rule dealing with the situation where 
there are a number of transfers which are treated iby the 
Secretary as part of the same exchange. In general, if there is an or- 
ganization, reorganization, or liquidation involving a transfer or 
transfers of property by a U.S. person to a foreign corporation, non- 
recognition of gain will be permitted if a request for a nding that a 
tax avoidance purpose is not present is filed within 183 days after 
the beginning of the transfer. Under this rule, the taxpayer may re- 
quest a nding not later than the 183rd day after the beginning of any 
transfer which is part of the exchange, whether or not a ruling has 
been requested with respect to prior transfers which are part of the 
exchange. If the Secretary detemtiines that the entire exchange does 
not involve a tax avoidance purpose, nonrecognition of gain will be 
permitted for that transfer and any subsequent transfers. Nonrecogni- 
tion will be provided with respect to any transfer which is part of 
the exchange but which begins more than 183 days before the ruling 
request is made if the Secretary determines that tax avoidance will 
not result if the earlier transfer is provided nonrecognition treat- 
ment and if a ruling was obtained for the earlier transfer. If no ruling 
was obtained for the earlier transfer, nonrecognition treatment will 
not be accorded the earlier transfer if a ruling is required for that 
transfer for there to be nonrecognition. However, failure of the tax- 
payer to apply for a ruling with respect to an earlier transfer will 
not automatically result in taxable treatment of the earlier transfer 
because the Secretary may require nonrecognition treatment of the 
earlier transfer in those situations he deems appropriate even in the 
absence of a ruling. 

Tax Court review. — In the case of an actual controversy involving 
a determination or a failure to make a determination by the Secretary 
as to whether a plan has as one of its principal purposes the avoidance 
of Federal income taxes, the Act provides that a taxpayer may liti- 
•gate the determination in the Tax Court. The Act ffenerallv follows the 
declaratorv judgment procedures which were added to the tax law in 
the recently enacted pension reform act. In addition, the Tax Court is 
to review any terms and conditions which the Secretary seeks to im- 
pose upon a taxpayer in makin.qr the determination that the exchange 
is not in pursuance of a plan having as one of its principal purposes the 
avoidance of income taxes. 



234-120 O - 77 - 18 



262 

The Tax Court is to review whether the Secretary's determination 
as to tax avoidance is reasonable and whether the conditions imposed 
in making the determinations are reasonable conditions in order to 
prevent the avoidance of income tax. If the Tax Court finds that the 
Secretary's terms and conditions are not reasonable, then the Tax 
Court is to make a declaration as to the terms and conditions which 
it finds to be reasonable in order to prevent the avoidance of income 
taxes. 

A request for a declaratory judgment under these proceedings can 
only be filed by a petitioner who is a transferor or transferee of stock, 
securities or property in an exchange where money or other property 
is being transferred from the United States (sec. 367(a)(1)). In 
addition, no proceeding may begin unless the exchange with respect 
to which the declaration is being sought has begun. It is not necessary 
for this purpose that the full exchange has been completed. In addi- 
tion, this requirement will be satisfied although the taxpayer has 
transferred assets conditioned upon a stipulation that, if there is a 
failure to obtain fi'om the Internal Revenue Service a determination 
that the transaction does not have as one of its principal purposes the 
avoidance of Federal income taxes, the transaction will not be com- 
pletely consummated and, to the extent possible, the assets transferred 
will be returned. 

Any such declaration is to have the force and effect of a final judg- 
ment or decree and is to be reviewable as such. The court is to base 
its determination upon the reasons provided by the Internal Revenue 
Service in its notice to the party making the request for a determina- 
tion, or upon any new matter which the Service may wish to intro- 
duce at the time of the trial. The Tax Court judgment, however, is 
to be based upon a redetermination of the Internal Revenue Service's 
determination. The burden of proof rules are to be developed by the 
Tax Court under its rule-making powers. Under the existing Tax 
Court rules the taxpayer has the burden of proof as to matters in the 
notice of deficiency. As to matters raised by the Service at the time 
of the Tax Court hearing, the Service has the burden. It is expected 
that rules similar to these will be adopted by the Tax Court. 

The judgment of the Tax Court, in a declaratory judgment proceed- 
ing is to be binding upon the parties to the case based upon the facts 
as presented to the court, in the case for the year or years involved. 
This, of course, does not foreclose action (within the limits of the legal 
d'>ctrines of estoppel and stare decisis) if an examination of the facts 
of the exchange indicates that they differ from those stated in the 
ruling. It is anticipated that the normal rules of the Federal courts 
as they relate to declaratory judgment procedure will apply. 
^ For a petitioner to receive a declaratoi-y judgment from the Tax 
Court under this provision, he must demonstrate to the court that he 
has exhausted all administrative remedies which are available to him 
within the Internal Revenue Service. Thus, he must demonstrate that 
he has made a request to the Internal Revenue Service for a deter- 
mmation and that the Internal Revenue Service has either failed to 
act, or has acted adversely to him, and that he has appealed any 
adverse determination. To exhaust his administrative remedies a party 



263 

must satisfy all procedural requirements of the Service. For example, 
the Service may decline to make a determination if a petitioner fails 
to supply the Service with the necessary information on which to make 
a determination. 

A petitioner is not to be deemed to have exhausted his administra- 
tive remedies in cases where there is a failure by the Internal Revenue 
Service to make a determination before the expiration of 270 days 
after the request for such a determination is made. Once, this 270- 
day period has elapsed, a petitioner who has exhausted his remedies 
may bring an action even though there has been no notice of determina- 
tion from the Internal Revenue Service. 

No petition to the Tax Court may be filed after 90 days from the 
date on which the Internal Revenue Service sends by certified or reg- 
istered mail notice to a person of its determination (including refusals 
to make determinations) as to whether tliere is a tax avoidance purpose 
in an exchange. Such notice is to be treated by the taxpayer as exhaus- 
tion of administrative remedies. This 90-day period does not begin to 
run until the Secretaiy sends the taxpayer the required notice. 

Tax Court Cwmnissioners. — In order to provide the court with 
flexibility in carrying out this provision, the Act authorizes the Chief 
Judge of the Tax Court to assign the Commissioners of the Tax Court 
to hear and make determinations with respect to petitions for a declar- 
atory judgment, subject to such conditions and review as the court 
may provide. Congress does not intend that this be constiiied as indi- 
cating that all of these proceedings should be heard by commissionei-s 
and decisions entered by them rather than by the judges of the court. 
Instead, it is intended to provide more flexibility to the Tax Court in 
the use of commissioners in these types of cases. It is anticipated, for 
example, that if the volume of these cases should be large, the Tax 
Court will expedite the resolution of these cases by authorizing com- 
missioners to hear and enter decisions in cases where similar issues 
have already been heard and decided by the judges of the court or in 
other cases where, in the discretion of the court, it is appropriate for 
the commissioners to hear and decide cases. 

These procedures apply with respect to proceedings filed with the 
Tax Court after the date of the enactment of the Act, but only with 
respect to transfers beginning after October 9. 1975. 

Other transfers. — The Act establishes separate treatment under sec- 
tion 367(b) for a second group of transfers which consists of exchanges 
described in sections 332, 351, 354, 355. 356, and 361 that are not treated 
as transfers out of the ITnited States (under section 367(a) ) under the 
rules described above. With respect to these other transactions, a rul- 
ing is not required. Instead, a foreign corporation will not be treated 
as a corporation to the extent that the Secretary of the TreasuiT pro- 
vides in regulations that are necessar}-^ or approj^riate to prevent the 
avoidance of Federal income taxes. These regulations are to be subject 
to nonnal court review as to whether the regulations are necessar\^ or 
appropriate for the prevention of avoidance of Federal income taxes. 
Thus, a taxpayer may challenge a projwsed deficiency with respect to 
an exchange dealt with in the regulations by arguing in the courts that 
the regulations, as applied in the taxpayers case, are not necessary or 



264 

appropriate to prevent the avoidance of Federal income taxes. If the 
court should agree with the taxpayer, it is to apply the balance of the 
regulations to the extent appropriate. 

Transfers covered in these regulations are to include transfers con- 
stituting a repatriation of foreign earnings. Also included are trans- 
fers that involve solely foreign corporations and shareholders (and 
involve a U.S. tax liability of U.S. shareholders only to the extent 
of determining the amount of any deemed distribution under the sub- 
part F rules). It is anticipated that in this latter group of exchanges, 
the regulations will not provide for any immediate U.S. tax liability 
but will mai' tain the potential tax liability of the U.S. shareliolder. 

It is intended that the regulations promulgated wdth respect to this 
group of transactions will enable taxpayers to determine the extent 
(if any) to which there will be any immediate U.S. tax liability re- 
sulting from any transaction. The Act provides (sec. 367(b) (2^ ) that 
the regulations promulgated with respect to this group will include 
(but shall not be limited to) regulations dealing with the sale or ex- 
cliange of stock or securities in a foreign corporation by a U.S. person, 
including regulations providing the circumstances under which (i) 
gain is recognized currently or is included in income as a dividend, or 
both, or (ii) gain or other amounts may be deferred for inclusion in 
the gross income of a shareholder (or his successor in interest) at a 
later date. The regulations may also provide the extent to which ad- 
justments are to be made to the earnings and profits of any corporation, 
the basis of any stock or securities, and the basis of any assets. 

Examples of transfers into the United States which are to be treated 
within this group (sec. 367(b)(1)) include: (i) the liquidation of 
a foreign corporation into a domestic parent ; (ii) the acquisition of 
assets of a foreign corporation by a domestic corporation in a type 
"C" or "D" reorganization; and (iii) the acquisition of stock in a 
foreign corporation by a domestic corporation in a type "B" reorgani- 
zation. With respect to transfers which exclusively involve foreign 
parties (i.e., where no U.S. persons are parties to the exchange) , exam- 
ples of situations coming within section 367(b)(1) include: (i) the 
acquisition of stock of a controlled foreign corporation by another 
foreign corporation; (ii) the acquisition of stock of a controlled for- 
eign corporation by another foreign corporation which is controlled by 
the same U.S. shareholders as the acquired corporation; (iii) the ac- 
quisition of the assets of a controlled foreign corporation by another 
foreign corporation; (iv) the mere recapitalization of a foreign 
corporation (type "E" reorganization) ; and (v) a transfer of property 
by one controlled foreign corporation to its foreign subsidiary. For 
these exclusively foreign transactions, it is anticipated that regulations 
will provide for no immediate U.S. tax liability. 

The Secretary's authority to prescril)e regulations relating to the 
sale or exchange of stock in a foreign corporation includes authority 
to establish rules pursuant to which an exchange of stock in a second 
tier foreign con^oration for other stock in a similar foreign corpora- 
tion will result in a deferral of the toll charge w^hich otherwise would 
be imposed based on accumulated earnings and profits. This deferral 
could be accomplished by designating the stock received as stock with 



265 

a deferred tax potential in a mpnner similar to section 1248 without 
reference to the December 31, 1962, date; the amount includable as 
foreign source dividend income upon the subsequent disposition of the 
stock in question results in dividend income only to the extent of the 
gain realized on the subsequent sale or exchange. In addition, if a 
second tier foreign subsidiary is liquidated into a first tier foreign 
subsidiary, the regulations may provide that the tax which would 
otherwise be due in the absence of a ruling " is deferred until the 
disposition of the stock in the fii-st tier foreign subsidiary. 

Transfers treated as exchanges. — A distribution of stock or securities 
(under section 355) is treatecl as an exchange whether or not it other- 
wise would be an exchange. Also, a transfer of property to a foreign 
corporation in the form of a contribution of capital by one or more 
persons having (after application of the ownership attribution rules 
of section 318) at least 80 percent of the total combined voting power 
of all classes of stock entitled to vote is treated as an exchange of the 
property contributed to the corporation in return for the equivalent 
value of stock of the corporation. 

Traiisitional rules. — The changes made to section 367 generally 
apply to transfers within the meaning of section 367, beginning after 
October 9, 1975. However, in order to permit the Internal Revenue 
Service sufficient time to develop the regulations required for transfers 
into the United States and between foreign corporations, the Act 
establishes a transition rule requiring that these regulations need not 
be effective until January 1, 1978. In the intervening period transac- 
tions which would otherwise be covered by those regulations are 
covered by the rules applicable generally to transfers out of the United 
States, and thus a ruling will be required. Moreover, in the case of any 
exchange (as described in section 367 as in effect on December 31, 
1974), in any taxable year beginning after 1962 and before 1976, Avhich 
does not involve the transfer of property to or from a IT.S. person, a 
taxpayer has for purjwses of section 367 until 183 days after the date 
of the enactment of this Act to make a request to the Secretary for 
a finding that such exchange was not in pursuance of a plan having 
as one of its principal purposes the avoidance of Federal inconie taxes 
so that for purposes of that section a foreign corporation is to be 
treated as a foreign corporation. 

Sales or exchanges givii^g rise to dividends. — In addition to the 
above changes in section 367, the Act amends the provision which 
requires that recognized gain on the sale or exchange of stock in a 
foreign corporation l)e taxed as a dividend to the extent of earnings 
and profits of the foreign corporation. The Act applies this provision 
to situations where gain is not recognized under the provisions of sec- 
tions 311, 336, and 337. The Act provides (in a new sec. 1248(f)) 
that if a domestic corporation which meets the stock ownership re- 
quirements of section 1248(a) (2) with respect to a foreign corporation 
distributes, sells, or exclianges the stock of the foreign corporation 
in a transaction to which section 311, 336, or 337 applies, then, not- 
withstanding any other j^rovision, the domestic cornoration is to in- 
clude in gross income as a dividend an amount equal to the excess of 
the fair market value of the stock of the foreign corporation over its 



« See Rev. Rul. 64-157, 1964—1 (Part 1) Cum. Bull. 139. 



266 

basis to the extent of the eurninos and profits of the foreign corpora- 
tion which were accunuihited after 1962 and during the period the 
stock was held by the domestic corporation while the foreign corpora- 
tion was a controlled foreign corporation. For this purpose earnings 
and profits excluded from the dividend treatment (of sec. 1248 (a)) 
are not taken into account. Thus, earnings and prohts of a less devel- 
ojjed couiiti-y corporation (to the extent provided in sec. 1248 (d) (3) ) 
are not taken into account. 

If, however, the domestic corporation distributes the stock of a for- 
eign corporation to a shareholder which is a domestic corporation the 
rule stated above generally does not apply since the basis of the prop- 
erty received is the lesser of fair market value or adjusted basis to the 
distributing corporation. In this type of situation, the corporate dis- 
tributee does not receive a stepped up basis as a result of the distribu- 
tion. Since the potential for the future application of section 1248 
still exists, it is not necessary to overiide the nonrecognition provi- 
sions which otherwise apply to corporate distributions. Consequently, 
the Act provides that the distributing corporation need not include 
nny amounts in income if the distribution is to a domestic coi'poration 
(i) which is treated as holding the stock for the period the stock was 
held by distributing corporation (sec. 1228) : and (ii) which, 
immediate!}^ after the distribution, satisfies the stock ownership re- 
quirements of section 1248(a)(2) with respect to the foreign cor- 
poration. 

The above rules also do not apply to certain section 837 liquida- 
tions of domestic corj^orations where, under prior law, gain Avas sub- 
ject to tax as ordinary income to the shareholders of that corporation 
under the provisions of section 1248(e) dealing with domestic corpo- 
rations formed or availed of to hold stock of a foi-eigii corporation. 
This exception applies if (1) all the stock of a domestic corporation is 
owned by United States persons who have been 10 percent sharehold- 
ers of the domestic corpoi-ation throughout the entire period that the 
stock of the foreign corporation was held by the domestic corporation, 
and (2) the jirovisions of section 124S(a) treating an amount equal to 
the earnings of the foreign corporation as a dividend apply by reason 
of section 1248(e) (1) to any liquidation or distribution from the do- 
mestic corporation and applied to all other transactions relating to the 
stock of the domestic corporation during the period that the domestic 
corporation held the stock of the foreign corporation. 

Also the rules for taxing the sale of a partnership Intercast (under 
sec. 751) are modified so that to the extent any gain from the sale is 
attributable to stock in a controlled foreign corporation, that gain is 
to be treated as ordinai-y income (in the same manner as gain attribut- 
able to section 1245 property and section 1250 property is taxed as 
ordinary income) . 

Effective date 
The modifications to section 867 and to section 1248 and related pro- 
visions apply to transfers beginning after October 9, 1975, and to sales, 
exchanges, and distributions taking place after that date. 

Revenue ejfect 
It is not expected that these })rovisions will have any significant 
impact on the revenues. 



267 

8. Contiguous Country Branches of Domestic Insurance Com- 
panies (sec. 1043 of the bill and sec. 819A of the Code) 

Prior lm.0 
Under prior law, a domestic life insurance company was subject 
to tax on its worldwide taxable income. If the company paid foreign 
income taxes on its income from, foreign sources it was allowed a 
foreign tax credit against its otherwise payable U.S. tax on foreign 
source income. 

Reasons for change 

Since the beginning of this century, U.S. mutual life insurance 
companies have been engaged in the life insurance business in Canada. 
Under prior law, the tax imposed by the United States on the opera- 
tions of Canadian branches of U.S. mutual life insurance companies 
generally exceeded the tax imposed by the Dominion of Canada and 
its pro\ inces. 

The income of the companies from their Canadian operations is 
derived generally by the issuance of policies insuring Canadian risks 
and the investment income from the policyholder reserves on the 
Canadian risks and any surplus. Quite often the investments of the 
Canadian branch is in Canadian securities. A separate branch account 
is maintained by the life insurance companies under which the various 
income, expense, asset, reserve and other items that relate to Canadian 
policyholders are segregated on the books of the company. The sepa- 
rate branch accounting system is used for purposes of establishing 
premiums and policyholder dividend rates based upon the separate 
mortality and earnings experience of the Canadian branch. 

The income earned by the Canadian branch inures solely to the 
benefit of these Canadian policyholders and is reflected either by divi- 
dends paid to them or increases in the size of the reserves and surplus 
with respect to Canadian policyholders. Thus, the additional cost 
resulting because U.S. tax liability exceeded Canadian income tax 
liability on the Canadian branch profits fell primarily upon the 
Canadian policyholders, since it reduced the reser\^es and surplus 
available to the Canadian policyholders. This additional cost made it 
more difficult to issue mutual life insurance policies in Canada. 

Further, under prior law the sale of pension contracts in Canada 
had been almost precluded by uncertainty as to whether reserves for 
Canadian pension contracts qualified for the exclusion from gross 
income which reserves for qualified plans in the XTnited States may 
obtain. 

In contrast, Canada, which generally also taxes Canadian com- 
panies on their worldwide taxable income, does not tax Canadian life 
insurance companies on their foreign source income except when the 
profits are repatriated. 

As a general rule, profits of a U.S. company although earned from 
sources outside the United States should be subiect to U.S. tax when 
earned since those profits are available for distribution to tlie share- 
holders of the compauA^ or are nvailable to the company to be used 
within or without the United States for new investments. However, 
the profits derived by a Canadian branch of a I'^^.S. mutual life insur- 
ance company are not generally available for use other than as re- 



268 

serves and surplus for the Canadian policyholders and may not be 
used to provide insurance for the U.S. policyholders. This unique fea- 
ture of mutuality, in which the earnings are restricted to benefit the 
Canadian policyholders, distinguishes the branch operations of a mu- 
tual life insurance company from the branch operations of other busi- 
nesses. For this reason Congress believes it is appropriate to view 
the Canadian operation as a separate entity in eifect owned by the 
Canadian policyholders. Accordingly, Congress concluded that it was 
desirable to provide that the profits of the Canadian branch of a U.S. 
mutual life insurance company are not to be subject to U.S. taxation 
except in the rare situation where profits are somehow repatriated 
to the United States for the benefit of the non-Canadian operations 
or are derived from sources within the United States. 

Congress concluded tliat it would also ba desirable to provide a 
special rule in the case of stock life insurance companies operating 
in Canada or Mexico. While it is easier for a stock life insurance com- 
pany to operate through a subsidiary organized under foreign law 
than it is for a mutual company, ])roblems would be encountered in 
transferring an existing business to a foreign subsidiary since such 
a transfer would require the satisfaction of the Secretary that one 
of its purposes was not the avoidance of Federal income taxes. Since 
the Act contains special rules for deemed transfers in the case of 
mutual life insurance companies, (^ongress felt it was appropriate to 
provide similar rules in the case of actual transfers by stock com- 
panies to a contiguous country subsidiary. 

Explanation of proi'isions 

Mutual companies. — The Act establishes a special system of taxation 
for branches of U.S. mutual life insurance companies which are oper- 
ated in a contiguous country (i.e., Canada or Mexico) . To be eligible for 
this S|)ecial treatment a mutual life insurance company must make an 
election with respect to a contiguous country life insui'ance branch. 

If a proper election is made, there is excluded from each item in- 
volved in the determination of life insurance company taxable income 
the items separately accounted for in a separate contiguous country 
branch account which the mutual life insurance company is required 
to establish and maintain under the Act. The branch account must be 
esfablished by the end of the first taxable year to which the election 
applies and is to include the various items of income, exclusion, de- 
duction, asset reserve, liability, and surplus properly attributable to 
life insurance contracts issued by the contiguous country branch. The 
separate accounting is to be made in accordance with the method regu- 
larly employed by the company, if the method clearly reflects income 
derived from, and other items attributable to, the life insurance con- 
tracts issued by the contiguous country branch, and in all other cases in 
accordance with regulations issued by the Secretary. Once a method 
of branch accoimting is established, it must be applied consistently and 
may not be changed. HoAvever, the taxpayer may initially choose in his 
return for the first taxable year to which it applies the system of 
branch accounting which properly reflects the results of operations of 
the branch. It is expected that the regulations will provide that a sys- 
tem properly reflects income if it provides for an allocation or designa- 



269 

tion of assets to the contiguous country branch at the time that they 
are acquired. This requirement is satisfied if the allocation or designa- 
tion is made on a periodic basis (either monthly or weekly). Once an 
asset is designated or allocated as a branch asset it must retain that 
character so long as it is held. All income, expense, gain or loss con- 
nected with a branch asset must be accounted for in the branch ac- 
count. Also, new assets acquired by the company must be credited to 
the branch account to the extent attributable to reserves and surplus in 
the branch account. 

For purposes of this provision, a branch is a contiguous country 
life insurance branch if it satisfies three conditions. First, it must issue 
insurance contracts insuring risks in connection with the lives or health 
of residents of a country which is contiguous to the United States (i.e., 
Canada or Mexico) . For this purpose an insurance contract means any 
life, health, accident, or annuity contract or reinsurance contract with 
respect to these contracts or any other type of contract relating to 
these contracts. Second, the branch must have its principal place of 
business in the contiguous country for which it insures risks. Third, 
the branch, if it were a separate domestic corporation, must be able to 
qualify as a separate mutual life insurance company. 

The Act provides that an election to establish a separate contiguous 
country branch is to be treated as a taxable disposition for purposes 
of recognizing any gain by the domestic company. If the aggregate 
fair market value of all the invested assets and tangible property 
which is separately accounted for by the company in the branch 
account exceeds the aggregate adjusted basis of those assets (for pur- 
poses of determining gain), then the company is to be treated as hav- 
ing sold those assets on the first day of the first taxable year for which 
the election is in effect at the fair market value on that day. The net 
gain on the deemed sale of these assets is to be recognized notwith- 
standing any other provision of the Code. The assets taken into ac- 
count for this determination include all of the invested assets (such 
as stock and secur'ties) ar»d all tangible property (such as land, build- 
ijigs, and equipment) which are separately accounted for in the branch 
account. However, goodwill, since it is an intangible asset, is not taken 
into account. 

While Congress does not believe that any of the profits of the con- 
tiguous countrv branch can be accumulated for the benefit of the U.S. 
policyholders (since the branch is treated as operating as a mutual 
life insurance company and insures risk for policyholders only in a 
contiguous country and thus any profits would be accumulated for 
the benefit of the contiguous country policyholders), the Act never- 
theless, in order to provide assurance on this point, provides rules for 
the taxation of the contiguous country branch income if it is ever re- 
patriated. First, payments, transfers, reimbursements, credits, or al- 
lowances which are made from a separate contigiious country branch 
account to one or more accounts of the domestic company as reim- 
bursements for costs (e.g., home office services) incurred for or with 
respect to the insurance (including reinsurance) of risks accounted 
for in the separate branch account are to be taken into account by the 
domestic company in the same manner as if the payment, transfer, 
reimbursement, credit, or allowance were received from a separate 
per-son. For this purpose the rules in the Internal Revenue Code (sec. 



270 

48'2) dealing with reiinbureeinent of costs between related pai-ties are 
to apply and the domestic company is to establish procedures for bill- 
ing the branch at cost. Reimbursements under this provision are not 
treated as repatriation of income. 

If amounts are directly or indirectly transferred or credited from a 
contiguous country branch account to one or more other 'accounts of 
the domestic company they are to be added to the life insurance com- 
pany taxable income of the domestic company except to the extent the 
transfers are I'eimbursements for home office services. The amount 
which is to be added to life insiii-ance company taxable income is not 
to exceed the amount by which the aggregate decrease in life insur- 
ance company taxable income for the taxable year and for all prior 
taxable years resulting solely from the application of these exclusion 
provisions with respect to the contiguous counti\v branch exceeds the 
amount of additions to life insurance company taxable income with 
respect to that branch wdiich were treated as a repatriation of income 
for all prior taxable yeai'S. 

The Act provides that no foreign tax credit (under sees. 901 or 
902) is to be allowed with i-espect to income excluded from life insur- 
ance coinpany taxable income by reason of it being accounted for in a 
contiguous country life insurance branch. In addition, no deduction is 
to be allowed for these amounts. If amounts are treated as repatriated 
from a contiguous country life insurance branch, they are to be treated 
for purposes of the foreign tax credit provisions (sees. 78 and 902) 
as if they were paid as a dividend from a foreign subsidiary. Thus, the 
gross-up provisions of section 78 are to apply. For purposes of taxa- 
tion of any income from U.S. sources which is earned by the contig- 
uous country life insurance branch, the branch is treated as a for- 
eign corporation and is subject to tax under the provisions of sections 
881, 882 and 1442. Thus, if it derives fixed or deteruiinable annual or 
periodic income from the United States it is subject to the ^^■ithhold- 
ing taxes which apply to foreign corporations. For this purpose a 
Canadian branch is to be entitled to any treaty benefits which it would 
be entitled to if it were a Canadian subsidiary of a U.S. corporation. 

The election provided by this provision may be made for any tax- 
able year beginning after December 31, 1975, Once an election is made, 
it is to remain in effect for all subsequent years except that it may be 
revoked with the consent of the Secretary. An election, however, may 
not be made later than the time jirescribecl by law for filing the return 
(including extensions thereof) for the taxable year with respect to 
which the election ig made. Elections and any revocations are to be 
made in a manner prescribed by the Secretary. 

Transfer hy stock companies. — Under the Act, a domestic stock life 
insurance company which has a contiguous counti-y life insurance 
branch may elect to transfer the assets of that branch to a foreign 
corporation organized under the laws of that contiguous country with- 
out the application of section 367 or 1491. Thus, the excise tax under 
section 1491 is not to be imposed on tlie transfer, nor is the Commis- 
sioner's approval of tlie transfei- required under section 367. 

The insurance contracts which may be transferred to the subsidiary 
include only those of the types issued by a mutual life insurance com- 
pany. For this purpose an insurance contract means a life, health, acci- 



271 

dent or annuity contract or reinsurance contract with respect to these 
contracts and other types of contracts relating to such contracts. Con- 
tracts are to be considered as similar to those issued by a mutual life 
insurance company if they provide to the policyholder a reduction in 
premiums similar to the mutual life insurance company's dividend 
or retrospective rate credit. 

The Act provides for the taxation of the net gain on the transfer. 
To the extent that the aggregate fair market value of all the invested 
assets in tangible property which are separately accounted for in the 
contiguous country life insurance branch exceeds the aggregate ad- 
justed basis of all of these assets for purposes of determining gain, the 
domestic life insurance company is to be treated as having sold all of 
the assets on the first day of the first taxable year for which the elec- 
tion is in effect. The sale will be deemed to have been at the fair market 
value on that first day, and notwithstanding any other provision of 
Chapter 1 (e.g., sec. 351) , the net gain is to be recognized to the domes- 
tic life insurance company on the deemed sale. If less than all of the 
invested assets and tangible property of the contiguous country life 
insurance branch of the domestic company are transferred, the domes- 
tic company will recognize only that part of the net gain which is 
proportional to the total net gain as the value of the transferred assets 
is to the value of all such assets. 

This provision also provides that the stock of the subsidiary for 
purposes of determining the income tax of the domestic stock life 
insurance company is to be given the same treatment as is accorded the 
assets of a contiguous country branch of a mutual company under the 
mutual company provision. Similarly, any dividends paid by the sub- 
sidiary to the domestic life insurance company will be added to its life 
insurance company taxable income. 

Effective date 
The provisions of this section apply to taxable years beginning after 
December 31, 1975. 

Revenue effect 
It is estimated that the mutual and stock companj^ provisions will 
result in a decrease in budget receipts of $12 million in fiscal year 1977 
and of $8 million thereafter. 

9. Transitional Rule for Bond, Etc., Losses of Foreign Banks (sec. 
1044 of the Act and sec. 582(c) of the Code) 

Prior law 

The Tax Reform Act of 1969 (Public Law 91-172) eliminated the 
preferential treatment accorded to certain financial institutions for 
transactions involving corporate and government bonds and other 
evidences of indebtedness. Previous to that these financial institutions 
were allowed to treat net gains from these transactions as capital gains 
and to deduct the losses as ordinary losses. The 1969 Act (sec. 433, 
amending sec. 582 of the Code) provided parallel treatment to gains 
and losses pertaining to these transactions by treating net gains as 
ordinary income and by continuing the treatment of net losses as ordi- 
nary losses. The ordinary income and loss treatment provided under the 
1969 Act was also applied to corporations which would be considered 
banks except for the fact that they are foreign corporations. Previous 



272 

to the 1969 Act, these corporations had treated the above-described 
transactions as resulting in either capital gains or capital losses. 

Reasom for change 
Some of the corporations which would be considered banks except 
for the fact that they are foreign corporations had capital loss carrj'- 
overs predating the 1969 Act. However, any post-1969 gains realized 
by these corporations resulting from the sale or exchange of a bond, 
debenture, note, or other evidence of indebtedness were accorded ordi- 
nary income treatment. Thus, these corporations were left with cap- 
ital loss carryforwards which, under prior law, could not be applied 
against any gains resulting from the same type of transactions which 
had previously generated such losses. 

Explanation of provision 
The Act provides a special transitional rule for corporations which 
would bp banks except for the fact that they are foreign corporations. 
Under the Act, net gains (if any) for a taxable year on sales or ex- 
changes of bonds, debentures, notes, or other evidences of indebtedness 
are considered as gains from the sale or exchange of capital assets to 
the extent that such gains do not exceed the portion of any capital loss 
carryover to the taxable year where such capital loss is attributable to 
the same tvpes of sales or exchanges for taxable years beginning before 
July 12, 1969. In addition, the Act provides that the refund or credit of 
any overpayment as a result of its application is not precluded by the 
operation of any law or rule of law (other than section 7122, relating 
to compromises) so long as the claim for credit or refund is filed 
within one year after the date of the enactment of the Act. 

Effective date 
The provision applies to taxable years beginning after July 11, 1969. 

Revermie effect 
The revenue loss for fiscal 1977 is estimated to be less than $5 million. 

10. Tax Treatment of Corporations Conducting Trade or Busi- 
ness in Possessions of the United States (sec. 1051 of the Act 
and sees. 33, 931, and 936 of the Code) 

Prior law 

ITnder prior law, corporations operating a trade or business in a 
possession of the United States were entitled to exclude from gross 
income all income from sources without the ITnited States, including 
foreign source income earned outside of the possession in which they 
conducted business operations, if they met two conditions. First, 80 
percent or more of the gross income of the coi-poration for the -i-year 
period immediately preceding the close of the taxable vear had to be 
derived from sources within a possession of the Ignited States. Second, 
50 percent of the gross income of the corporation for the same .'Vyear 
period had to be derived from the active conduct of a trade or business 
within a possession of the ITnited States. 

Any dividends from a corporation which satisfied these require- 
ments were not eligible for the intercorporate dividends received de- 
duction (sec. 216(a) (2) (B)). In addition, since corporations meeting 
the requirements of section 931 were domestic corporations, no gain or 
loss was recognized by a parent corporation if it liquidated a posses- 
sions corporation (under sec. 332). Corporations satisfying the re- 



273 

quirements of a posspssions corporation and receiving some benefit 
from the exclusion of income were not entitled to l>e included in the 
consolidated return of an affiliated group of corporations (sec. 1504 (b) 

(4)). 

The exclusion of possession income applied to corporations conduct- 
ing business operations in the Commonwealth of Puerto Rico and all 
possessions of the United States except the Virgin Islands. The exclu- 
sion also applied to business operations of U.S. citizens in possessions 
other than Puerto Rico, the Virgin Islands, and Guam. 

Reasons for change 

The special exemption provided (under sec. 931) in conjunction with 
investment incentive programs established by possessions of the United 
States, especially the Commonwealth of Puerto Rico, have been used 
as an inducement to U.S. corporate investment in active trades and 
businesses in Puerto Rico and the possessions. Under these invest- 
ment programs little or no tax is paid to the possession for a period as 
long as 10 to 15 years. Under prior law no tax was paid to the United 
States as long as no dividends were paid to the parent corporation. 

Because no current U.S. tax was imposed on the earnings if they 
were not repatriated, the amount of income which accumulated over 
the years from these business activities could be substantial. The 
amounts allowed to accumulate were often beyond what could be prof- 
itably invested within the possession where the business was con- 
ducted. As a result, corporations generally invested this income in other 
possessions or in foreign countries either directly or through posses- 
sions banks or other financial institutions. In this way possessions cor- 
porations not only avoided U.S. tax on their earnings from businesses 
conducted in a possession, but also avoided U.S. tax on the income 
obtained from reinvesting their business earnings abroad. 

After studving the problem, Congress concluded that it is inappro- 
priate to disturb the existing relationship between the possessions in- 
vestment incentives and the U.S. tax laws because of the important role 
it is l-)elieved they play in keeping investment in the possessions com- 
petitive with investment in neighboring countries. The U.S. Govern- 
ment imposes upon the possessions various requirements, such as mini- 
mum wage requirements ^ and requirements to use U.S. flag ships in 
transporting goods between the United States and various posses- 
sions,2 which substantially incroase the labor, transportation and 
other costs of establishing business operations in Puerto Rico. Thus, 
without significant local tax incentives that are not nullified by U.S. 
taxes, the possessions would find it quite difficult to attract investments 
by TT.S. corporations. 

However, investing the business earnings of these possessions cor- 
porations outside of the possession where the business is being con- 
ducted does not contribute significantly to the economv of that posses- 
sion either by creating new iobs or by providing canital to others to 
acquire new plant and equipment. Accordingly, while Congress be- 
lieves it is appropriate to continue to exempt trade or business income 
derived in a posses^sion and investment income earned in that posses- 
sion, it does not believe it is appropriate to provide a tax exemption for 
income from investments outside of the possession. 

i2fl TT.S.C. 206-208. 
3 46 U.S.C. 883. 



274 

In addition, Congress recognized that the provision of prior law 
denying a dividends received deduction to tnc U.S. ]iarent corporation 
forced a possessions corporation to invest its income abroad until it 
was liquidated (usually upon the termination of the local tax exemp- 
tion) when it could be returned to the United States tax free. These 
accumulated business profits were thus not available for investment 
within the United States, and the income produced was (under prior 
law) not subject to U.S. tax. Congress believed that while it is appro- 
priate to tax the foreign source investment income from possession 
business earnings, possessions corporations should at the same time be 
given the alternative of returning the business income to the United 
States prior to liquidation without paying U.S. tax. Permitting tax- 
free repatriation of the accumulated earnings only upon the liquidation 
of the possessions corporation, while taxing the foreign source invest- 
ment income derived from the accumulated earnings, would lessen to 
a significant extent the tax incentive of making the initial investment. 

To accomplish these two major changes, the Act revises prior law to 
provide for a more efficient system for exemption of possessions cor- 
porations. Under the Act, these corporations aj-e generally to be taxed 
on worldwide income in a manner similar to that applicable to any 
other U.S. corporation, but a full credit is to be given for the U.S. tax 
on the business and qualified investment income from possessions re- 
gardless of whether or not any tax is paid to the government of the 
possession. The effect of this revised treatment is to exempt from tax 
the income from business activities and qualified investments in the 
possessions, to allow a dividends received deduction for dividends from 
a possessions corporation to its U.S. parent corjioration, and to tax 
currentlv all other foreign source income of possessions corporations 
(with allowance for the usual foreign tax credit for foreign taxes paid 
with respect to that other income). Congress believes that this revised 
treatment will assist the U.S. possessions in obtaining employment- 
producing investments by U.S. corporations, while at the same time 
encouraging those corporations to bring back to the United States the 
earnings from these investments to the extent they cannot be reinvested 
productively in the possession. 

A second set of difficulties under prior law resulted from the rela- 
tionship of the possessions corporation provisions to the provisions 
relating to the filinsr of consolidated tax returns. Domestic corpoi-a- 
tions which are affiliated (i.e., generally where there is a common 
ownership of 80 percent or more of their stock) usually file a consoli- 
dated tax return. Among the l>enefits of a consolidated return is the 
opportunity to offset the losses of one cor))oration against the income 
of other corporations. A corpoi-ation which was entitled to the Ijenefits 
of the special possessions corporation exclusion could not participate 
in the filing of a consolidated return. Plowever, the courts detemiined 
that possessions corporations could join in filing consolidated retui-ns 
in years in which they incur losses.'' As a result, these corporations 

3 The Internal Revenue Service had taken the po.sition that a corporation whicli meets 
both of the gross income tests of the possession corporation exclusion provision may not 
file a consolidnted return in years In which that corporation incurred a loss. However, the 
Tax Court In Burke Concrete Accesftorien, Inc., 56 T.C. 5RS (1971), held that the posses- 
sion corporation was properly includable in the consolidated return in these years since it 
could not be entitled to any benefit from the exclusion jtrovision where it had a loss year. 
The Internal Revenue Service reversed its position in ligbt of this decision (Rev. Kul. 
73-498. 1973-2 C.B. 316). 



275 

could in effect gain a double benefit. Not only was the possessions and 
other foreign source income of these corporations excluded from U.S. 
taxable income, but losses of possessions corporations could, by filing 
a consolidated return, reduce U.S. tax on the U.S. income of related 
corporations in the consolidated group. Congress believes that it is 
appropriate to allow the losses of a possession corporation to reduce 
U.S. tax on other income by filing a consolidated return only in the 
case of initial or start-up losses of possessions corporation just be- 
ginning its possession operations. Moi ?over, even in the case of start- 
up losses which offset U.S. source income Congress believes that these 
losses should be recaptured if in a later year foreign source income is 
derived. 

Explanation of provisions 

Accordingly, the Act provides that a possessions corporation must 
make an election to obtain the benefits of possessions corporation status 
and that after this election the corporation is ineligible to join in 
filing a consolidated return for a period of 10 years.* Once the election 
is made the losses of the possessions corporation cannot offset the in- 
come of other related corporations. 

The Act achieves the results described above by adding a new provi- 
sion (sec. 936 of the Code) for the tax treatment of U.S. corporations 
operating in Puerto Rico and pos.sessions of the United States, other 
than the Virgin Islands. The provision of prior law (sec. 931 of the 
(.We) is retained for citizens with business operations in possessions 
of the United States, other than the Virgin Islands, Guam, and Puerto 
Rico. The new provision establishes a new tax credit for certain in- 
come of possessions corporations. This tax credit (called the section 
936 credit) is given in lieu of the ordinary foreign tax credit (pro- 
vided in sec. 901 of the Code) . 

The Act provides that any domestic corporation which elects to be 
a section 936 corporation can receive the section 936 tax credit if it 
satisfies two conditions. First, 80 percrnt or more of its gross income 
for the 3-year period immediately pr-^ceding the close of the taxable 
year must be from sources within a possession (or possessions). Sec- 
ond, 50 percent or more of its gross income must be derived from the 
active conduct of a trade or business within a possession (or 
possessions). 

The amount of the credit allowed under this provision is to equal 
the portion of the U.S. tax on the domestic corporation attributable 
to taxable income from sources without the United States from the 
active conduct of a trade or business within a possession of the United 
States and from qualified possession source investment income. In 
determining the amount of tax attributable to the income fiom the 
active conduct of a possession trade or business or from qualified pos- 
session investment income, losses from other sources are to be taken 
into account. For example, if a corporation has an overall loss from 
foreign sources (not taking into account income qualifying for the 
section 936 tax credit) , these losses reduce income from U.S. sources 

* Unlike the act of incorporating a branch in a foreign jurisdiction, the malting of a 
section 936 election does by itself cause a recapture of an earlier loss. 



276 

and income qualifying for the section 936 credit proportionately for 
purposes of determining the tax on the taxable income from which the 
section 936 credit is allowed. 

Qualified possession source investment income includes only income 
from sources within a possession in which the possessions corporation 
actively conducts a trade or business (whether or not sucli business 
produces taxable income in that taxable year). It is intended that 
interest paid by one possessions corporation to a secoiid unrelated 
possessions corporation operating in the same possession is to be 
treated as qualified possessions source investment income. Further, 
the taxpayer must establish to the satisfaction of the Secretary that 
the funds invested were derived from the active conduct of a trade 
or business within that same possession and were actually invested 
in assets in that possession. It is intended that income from sources 
within the possession attributable to reinvestments of qualified pos- 
session source investment income is also to be treated as qualified pos- 
sessions source investment income. Funds placed with an intermediary 
(such as a bank located in the possession) are to be treated as invested 
in that possession only if it can be shown that the intermediary did not 
reinvest the funds outside the possession. The special treatment for 
qualified i:>ossessions source investment income is provided so that the 
possessions do not lose a significant source of capital which they 
pi'esently have available to them for the financing of government de- 
velopment programs and private investment. 

To avoid a double credit against U.S. taxes if a coi-poration is eligi- 
ble for the section 936 credit, any actual taxes paid to a foreign country 
(because it has different source rules) or a possession with respect to 
the gross income taken into account for the credit are not treated as a 
creditable tax (under sec. 901 of the Code), and no deduction is to be 
allowed with respect to that tax. Thus, the section 936 credit replaces 
entirely any section 901 foreign tax credit and any deduction for taxes 
paid which otherwise would be allowed with respect to the income 
taken into account. 

Since the new section 936 tax credit is separate from the tax credit 
permitted under section 901, the limitation under section 904 of the 
Code is not to apply to income subject to a section 936 credit, and such 
income is not to be taken into account in computing the limitation on 
the amount of allowable tax credits (under sec. 904 of the Code).^ 

The credit provided for under section 936 is generally to be allowed 
against taxes imposed by chapter 1 of the Internal Revenue Code. 
However, the credit is not to be taken against any minimum tax for 
tax preferences (sec. 56 of the Code), any tax on accumulated earn- 
ings (sec. 531 of the Code), taxes relating to recoveries of foreign 
expropriation losses (sec. 1351 of the Code), or the personal holding 
company tax (sec. 541 of the Code). In computing the amount of U.S. 
tax paid by the corporation which is attributable to possessions active 
trade or business and qualified investment income, taxes paid relating 
to the items described above are not taken into account. 



"Thus, the numerator and denominator of the limitinp; fraction fprorided in see. 904) 
are to he calculated without regard to the taxable income for which a credit is permitted 
under section 936. 



277 

In order to receive the benefits of the section 936 tax credit, a corpo- 
ration must make an election at the time and in the manner as the 
Secretary prescribes by regulations. Once the election is made, the 
domestic corporation cannot join in a consolidated return with other 
related taxpayers. The election is to remain in effect for nine taxable 
years after the first year for which the election was effective and for 
which the domestic corporation satisfied the 80 percent possession 
source income and 50 percent active trade or business income require- 
ments. However, the election may be revoked before the expiration of 
the 10-year period with the consent of the Secretaiy. It is contem- 
plated that consent will be given only in cases of substantial hardship 
where no tax avoidance can result from the revocation of the election. 
In determining whether there would be substantial hardship, the Sec- 
retary is to take into account changes in business conditions. The elec- 
tion shall remain in effect after the 10-year period unless such domestic 
corporation revokes such election. After a revocation the domestic 
corporation may again make the election for a 10-year period in any 
taxable year in which it satisfies the 80 percent possession source income 
and 50 percent active trade or business tests. 

The Act retains existing law by providing that any gross income 
actually received by a possessions corporation within the United 
States, whether or not that income is derived from sources within or 
without the United States, is not taken into account as income for 
which a section 936 tax credit may be allowed. However, this income 
may be eligible for a section 901 tax credit if any foreign taxes were 
paid on that income. 

Finally, the Act provides for a dividends-received deduction (sec. 
246(a)(1) of the Code) for dividends received from corporations 
eligible for the section 936 tax credit. Thus, corporations which other- 
wise would qualify for the 100-percent dividends-received deduction 
if an election (under sec. 936) were not in effect are to receive that 
deduction for dividends from a possessions corporation. Also, corpora- 
tions eligible for the 85-percent dividends-received deduction are to 
receive that deduction with respect to dividends fronl possessions cor- 
porations. The amount of any income received as a dividend from a 
possessions corporation is to be domestic or foreign source income 
as determined under existing rules of the Code (sec. 861), and is to 
be included in the computation of the limitation on the section 901 
foreign tax credit (sec. 904 of the Code) . 

" Since the 100-percent dividends-received deduction totally elimi- 
nates any U.S. tax on dividends paid by a possessions corporation, 
and the 85 percent dividends-received deduction (after the allocation 
of expenses) will in many cases eliminate any U.S. tax on the diiadend, 
the Act adds a provision disallowing a'credit or a deduction for any 
income taxes paid to a possession or foreign country with respect to the 
repatriation of earnings. Further, the disallowance provision applies 
in the case of a tax-free liquidation of a possessions corporation. 

It is the understanding of Congress that the Department of the 
Treasury is to review the operations of section 936 corporations in 
order to apprise Congress of the effects of the changes made by the Act. 
The Treasury is to submit an annual report to the Congress setting 
forth an analysis of the operation and effect of the possessions corpo- 



234-120 O - 77 



278 

ration system of taxation. Among other things, the report is to in- 
clude an analysis of the revenue effects to the provision as well as the 
effects on inevstment and employment in the j)ossessions. These reports, 
which are to begin with a report for calendar year 1976, are to be sub- 
mitted to the Congress within 18 months following the close of each 
calendar year. 

Effective dates 

The provisions of the Act establishing a new section 936 tax credit 
for certain possessions income apply to taxable years of possessions 
corporations beginning after December 31, 1975. The new rules on the 
dividends-received deduction apply to dividends paid in taxable years 
of possessions corporations beginning after that date regardless of 
when the earnings out of which the dividends were paid were 
accumulated. 

Although these provisions generally apply to taxable years of pos- 
sessions corporations beginning after December 31, 1975, the Act 
continues to exempt foreign source income derived from sources out- 
side the possession by treating the investment income as qualified 
possession source investment income if the taxpayer can establish to 
the satisfaction of the Secretary that the income was earned before 
October 1, 1976, whether or not the invested funds were initally derived 
from the possessions business. Similarly, funds which are properly 
reinvested in the possession will produce qualified possession source 
investment income provided those funds had been derived initially 
from a trade or business conducted by the corporation in that posses- 
sion. In addition, the foreign tax credit is allowed for taxes paid with 
respect to liquidations occurring before January 1, 1979, to the extent 
the taxes are attributable to amounts earned before January 1, 1976. 

Revenue effect 
It is estimated that these provisions will result in an increase budget 
receipts of $6 million in fiscal year 1977 and of $10 million thereafter. 

11. Western Hemisphere Trade Corporations (sec. 1052 of the Act 
and sees. 921 and 922 of the Code) 

Prior law 

Under prior law, certain domestic corporations called "Western 
Hemisphere Trade Corporations" ( WHTCs) were entitled to a deduc- 
tion which could reduce their applicable corporate income tax rate by 
as much as 14 percentage points below the applicable rate for other 
domestic corporations.^ 

A domestic corporation had to meet three basic requirements to 
qualify as a WHTC. First, all of its business (other than incidental 
purchases) had to be conducted in countries in North, Central or South 
America or in the West Indies. Second, the corporation had to derive 
at least 95 percent of its gross income for the 3-year period immedi- 
ately preceding the close of the taxable year from sources outside the 
United States. Third, at least 90 percent of the corporation's income 
for the above period had to be derived from the active conduct of a 



^The deduction (sec. 922 of the Code) was equal to taxable income multiplied by 14 over 
the normal tax and surtax rates. 



279 

trade or business. The above requirements were intended to insure that 
the corporation was engaged in an active trade or business outside the 
United States, but within the Western Hemisphere. 

Reasons for change 

The WHTC provisions were originally enacted in 1942 during a 
period of high U.S. wartime taxes and generally low taxes in other 
Western Hemisphere countries. The provision was aimed at insuring 
that domestic corporations did not operate at a disadvantage in com- 
peting with foreign corporations within the Western Hemisphere. 
While not explicitly stated, it appears that the goal was to retain U.S. 
ownership of foreign investments, which if placed in a foreign cor- 
poration, might end up being owned by foreign interests. 

Congress believes general tax equity requires that income derived 
from all foreign sources be taxed at the same rate. To the extent that 
incentives are needed for the export of U.S. manufactured goods 
Congress believes that the Domestic International Sale Corporation 
(DISC) provisions are a more appropriate incentive. Further, because 
the taxes imposed by other Western Hemisphere countries have been 
substantially increased since the original enactment of the provision, 
many companies which qualified as WHTCs received little or no bene- 
fit from the deduction. Thus, in many instances i\\B WHTC deduction 
merely added to the complexity of preparing an income tax return 
without providing significant tax benefits. 

The preferential rate granted to WHTCs also encouraged U.S. 
manufacturers to set the price on sales of goods to related WHTCs 
so as to maximize the income derived by the WHTCs since this in- 
come was taxed at the lower WHTC rate. These pricing practices have 
been the source of many controversies between taxpayers and the In- 
ternal Revenue Service. Finally, the broad interpretation given to 
the WHTC provisions by the Internal Revenue Service enabled cor- 
porations to obtain the benefits of the WHTC provisions for goods 
manufactured outside the Western Hemisphere by causing the title to 
the goods sold to the WHTC to be passed within the Western Hemis- 
phere. In such a situation Congress believes it is inappropriate to give 
special tax relief. 

Explan/aMon of provision 
The Act repeals the WHTC provisions for taxable years beginning 
after December 31, 1979. However, corporations which qualifj' for 
WHTC treatment are provided a transitional period in which they 
can adjust their operations to the repeal of the provisions. During 
this transitional period the 14-percent tax reduction {i.e., the numera- 
tor in the 14/48ths fraction) is gradually phased out beginning in 
1976. I^^nder the phaseout rules the percentage rate reduction is re- 
duced to 11 percent in 1976, 8 percent in 1977, 5 percent in 1978 and 2 
percent in 1979. Corporations which presently do not qualify for 
WHTC treatment are able to qualify and receive the remaining benefits 
of the treatment during the transitional period. Thus, during the 
phaseout period no distinction is to be made between corporations 
qualifvin."" for WHTC treatment in 1975 and other corporations which 
first qualify during the phaseout period. It is anticipated by the Con- 
gress that in appropriate situations the modifications made by the Act 
to section 367 will make it easier for certain WHTCs to adjust to the 



280 

repeal of the WHTC provisions by reincorporating in a foreign coun- 
try where they are doing business in order to retain tax advantages 
provided by the tax laws of foreign governments. 

Effective date 
The provision phasing out WHTC treatment applies to taxable years 
begimiing after December 31, 1975. 

Revenue effect 
This provision will increase budget receipts by $19 million in fiscal 
year 1977, $25 million in fiscal year 1978, and $50 million in fiscal year 
1981. 

12. China Trade Act Corporations (sec. 1053 of the Act and sees. 
941 to 943 of the Code) 

Prior law 

Under prior law, China Trade Act Corporations ("CTA corpora- 
tions") and their shareholders were entitled to special tax benefits. 
Under those provisions, a CTA corporation was subject to the same tax 
rates as any other domestic corporation, but, upon meeting certain re- 
quirements, was allowed a special deduction which could completely 
eliminate any income subject to tax (sec. 941) } 

The special deduction was allowed against taxable income derived 
from sources within Formosa and Hong Kong in the proportion which 
the par value of stock held by residents of Formosa, Hong Kong, the 
United States, or by individual citizens of the United States, wherever 
resident, bore to the i3ar value of all outstanding stock. Thus, where 
all the shareholders of the CTA corporation were either U.S. citizens 
or residents of Hong Kong, Formosa, or the United States, and all of 
the corporation's income was derived from sources within Hong Kong 
and Formosa, the special deduction equaled and thereby eliminated 
the taxable income of the corporation. 

The special deduction was limited by a requirement that a dividend 
be paid in an amount at least equal to the amount of Federal tax that 
would have been due were it not for the special deduction. The "special 
dividend" had to be paid to stockholders who, on the last day of the 
taxable j^ear, were resident in Formosa, Hong Kong, or were either 
residents or citizens of the United States.^ The special dividend de- 
duction enabled the CTA corporation to operate free of tax. 

In addition to the favorable tax treatment at the corporate level, 
special benefits were accorded to the shareholders of a CTA corpora- 
tion. Dividends paid by a CTA corporation to shareholders who re- 
sided in Hong Kong or Formosa were not includable in the gross 
income of the shareholrler (sec. 943) . This applied to all dividends paid 
to Hong Kong or Formosa resident shareholders, regardless of 
whether they were regular or special dividends. 



'The CTA corporation was not entitled to the forelcrn tax crerllt (sec. 942), but was en- 
titled to the deduction of all foreign taxes paid with respect to taxable income derived 
from sources within Hong Kong or Formosa ^sec. 164). 

2 For example, if the taxable Income before the special deduction was $100,000, the 
special dividend would have to equal at least $41,500 (22 percent of the first $25,000 olus 
4S percent of the remaining $75,000). In this example, upon payment of the special dividend 
of $41,500, the CTA corporation deriving all of its taxable income from sources within 
Hong Kong and Formosa ($100,000) would be entitled to a special deduction in an amount 
equal to its taxable income, i.e., $100,000. 



281 

Reasons for change 

The combination of benefits granted to CTA corporations and their 
shareholders was unprecedented.^ Both the corporation and its share- 
holders could operate free of any U.S. tax liability. 

As originally enacted, the Chma Trade Act was intended to apply 
to mainland China, including Manchuria, Tibet, Mongolia, and any 
territory leased by China to any foreign government, the Crown 
Colony of Hong Kong, and the Province of Macao. However, since 
the earlj^ 1950's the provisions have only applied to business trans- 
actions by CTA corporations in Hong Kong and Formosa. 

Since the enactment of the China Trade Act of 1922, Sino-U.S. 
trade has changed dramatically. In 1922, China was considered an 
unequal trade partner — a market which Western companies competed 
for under rules that were laid down by their own governments, not 
by the Chinese Government. Prior to the Communist occupation of 
the China mainland in 1949, approximately 250 companies were con- 
ducting business there under the China Trade Act. At the time the 
Act w^as enacted, this situation no longer existed, trade being restricted 
to Hong Kong and Formosa ; nor was it likely to exist in the foresee- 
able future. At that time there were only three active CTA corpora- 
tions, which reportedly accounted for a rather negligible amount of 
trade. 

Thus, the original purpose of the China Trade Act, that of expand- 
ing trade with China, was no longer being served by the very favorable 
tax advantages it provided. Moreover, there were innumerable U.S. 
companies currently trading in Hong Kong and Formosa without the 
extensive tax benefits provided by the China Trade Act. 

The tax advantages enjoyed by a CTA corporation, and particu- 
larly its shareholders, were almost without parallel. While there are 
cases where U.S. tax is not owing with respect to corporate income 
derived by a foreign subsidiary involved in an active trade or business 
abroad, dividend payments received from such corporations by U.S. 
shareholders are subject to U.S. taxation. There was no longer any 
justification for exempting CTA corporation dividends paid to its 
Hong Kong and Formosa resident shareholders who were U.S. citizens. 

Explanation of provision 
The Act provides for a phaseout over a 3-year period of the provi- 
sions permitting special tax treatment for CTA corporations and 
their shareholders. Thus, the special deduction allowable under section 
941 (a) and the dividend exclusion under section 943 will be reduced by 
one- third for taxable years beginning in 1976, by two-thirds for tax- 
able years beginning in 1977, and repealed for taxable years begin- 
ning *in 1978.* 



3 For example, If in a plven year, a CTA corporation, whose shareholders were U.S. 
citizens residing In Hong Kong or Formosa, had $500,000 of taxable income and paid a 
special dividend of at least $233,500 to Its shareholders, neither the corporation nor Its 
shareholders would incur any U.S. tax liability, whereas a domestic corporation and Its 
shareholders in this situation (assuming marginal tax brackets of 50 percent for the share- 
holders) would incur respective U.S. tax liabilities of $233,500 and $116,750. The tax 
savings to the CTA corporation and its shareholders in the above example would be 
$350,250. If the balance of the earnings of the CTA corporation were paid out, the tax 
savings would be even greater. 

* For example. If the taxable Inrome before the special deduction of a CTA corporation 
was $100,000 and the special dividend was $41,500. the special deduction for the corpo- 
ration and the amount of dividend excludlble from income for taxable years beginning 
in 1976 would be S66.667 and $13,S33. respectively. For taxable years beginning in 1977. 
the amounts would be $33,333 and $27,667. For taxable years beginning in 1978 and 
subsequent years, the CTA provisions are repealed and no special deduction nor dividend 
exclusion would be available. 



282 

Effective date 
The provision phasing out China Trade Act corporations applies to 
taxable years beginning after December 31, 1975. 

Revenue effect 
This provision is expected to increase receipts by less than $5 mil- 
lion per year. 

13. Denial of Certain Tax Benefits for Cooperation With or Par- 
ticipation in an International Boycott (sees. 1061-1064, 1066 
and 1067 of the Act and sees. 908, 952, 995 and 999 of the Code) 

Prior law 

U.S. taxpayers operating abroad receive a number of bene- 
fits or incentives which enable them to compete with foreign- 
owned businesses or to increase the export of U.S.-made goods. The 
three major tax provisions which are significant in connection with 
overseas operations are (1) the foreign tax credit for foreign taxes 
paid, (2) the deferral of earnings of foreign subsidiaries, and (3) the 
deferral of earnings of Domestic International Sales Corporations. 

Prior law contained no tax provisions dealing with international 
boycotts and thus taxpayers were entitled to receive these tax benefits 
with respect to operations in connection with which they agreed to 
participate in an international boycott. 

Reasons foi' change 

Congress is concerned that U.S. businesses have been prevented 
from freely operating in international markets by the threat of eco- 
nomic sanctions by certain foreign countries or their nationals or com- 
panies. Unless the U.S. businesses agree to participate in or cooperate 
witli certain foreign countries in an international boycott, they are 
denied the opportunity to conduct business with a country. Congress 
believes that it is particularly unfair to tliose taxpayers who refuse to 
participate in the boycott, when the taxpayer who does participate in 
the boycott is a recipient of tax benefits by reason of the participation. 
Congress believes that many taxpayers would not participate in an 
international boycott if the taxpayer and the foreign countries were 
made aware that tax benefits were not available to a taxpayer who 
participates in a boycott. 

Congress believes that these three tax benefits referred to above in 
connection Avith overseas operations should not be made available with 
respect to operations in connection with which there has been an 
agreement to participate in or cooperate with an international boycott. 

Explanation of provision 

The Act denies to any person who agrees to participate in or coop- 
erate with any international boycott the benefits of the foreign tax 
credit, deferral of earnings of foreign subsidiaries, and DISC to the 
extent these tax benefits are attributable to operations of that person 
(or its affiliates) in connection with which there was an agreement to 
participate in or cooperate with an international boycott. 

The benefits of deferral and DISC are denied to the taxpayer by 
requiring a deemed distribution of earnings to the shareholders of the 
DISC or controlled foreign corporation. The benefits of the foreign 



283 

tax credit are denied to the taxpayer Tdj reducing the otherwise allow- 
able foreign tax credit to which the taxpayer would be entitled under 
section 901, 902, and 960 of the Code, after applying the limitation, if 
applicable, of section 907. AVliere a foreign corporation has agreed to 
participate in or cooperate with the boycott, the otherwise allowable 
indirect foreign tax credits to which the United States shareholders 
would be entitled (under sec. 902 or 960) are reduced under the Act re- 
gardless of whether the foreign corporation is a controlled foreign 
corporation (i.e., more than 50 percent of its stock owned by U.S. 
shareholders). Taxes which are denied the foreign tax credit under 
this provision are not entitled to be carried back or forward as foreign 
tax credits but may be eligible to be deducted in computing taxable 
income. Of course, if so deducted, the rules of sections 861 and 862 will 
apply with respect to the deduction. 

The loss of deferral benefits is accomplished under the Act by treat- 
ing as subpart F income the earnings attributable to boycott partici- 
pation. Thus, deferral benefits are only lost with respect to earnings 
of controlled foreign corporations. Each U.S. shareholder of the con- 
trolled foreign corporation (that is, each U.S. person owning, or 
treated under the applicable attribution rules as owning, at least 10 
percent of its stock) is currently to include in income under the sub- 
part F provisions its pro rata portion of the earnings of the controlled 
foreign corporation attributable to boycott participation, whether or 
not the shareholder and the controUecl foreign corporation are mem- 
bers of the same controlled group. 

The denial of DISC benefits is accomplished by treating as a deemed 
distribution by a DISC to its shareholders the earnings of the DISC 
attributable to the boycott participation. The deemed distribution 
is similar to the other deemed distributions from a DISC to its share- 
holders. Thus, the amount deemed distributed is, for purposes of com- 
puting the DISC earnings and profits, treated as being part of the 
previously taxed income account. 

A person participates in or cooperates with an international boycott 
if the person agrees, as a condition of doing business directly or in- 
directly within a country or with the government, a company, or a 
national of a countiy (1) to refrain from doing business with or in a 
country which is the object of an international boycott or with the gov- 
ernment, companies, or nationals of that country; (2) to refrain from 
doing business with any U.S. person engaged in trade within another 
country which is the object of an international boycott or with the 
government, companies, or nationals of that country; (3) to refrain 
from doing business with any company whose ownership or manage- 
ment is made up, all or in part, of indiv'iduals of a particular national- 
ity, race, or religion, oi- to remove (or refrain from selecting) corpo- 
rate directors who are individuals of a particular nationality, race, or 
religion : (4) to refrain from emplorinn- individuals of a particular na- 
tionality, race, or religion; or (5) to rrfraiii from shipping or insuring 
products on a carrier owned, leased, or operated by a person who does 
not participate in or cooperate with an international bovcott. While it 
is anticipated that in most cases a third country will be the object of an 
international boycott, it is possible that the United States may be the 
object of an international boycott. The agreement maj^ be with respect 



284 

to any type of business (including manufacturing, banking, and service 
businesses). 

llie Act permits a person to agree to comply with certain laws with- 
out being treated as agreeing to participate in or cooperate with an in- 
ternational boycott. A person may agree to meet requirements imposed 
by a foreign country with respect to an international boycott if a U.S. 
law, executive order, or regulation sanctions that participation or co- 
operation. Secondly, the person may agree to comply with a prohibition 
on the importation of goods produced in whole or in part in any boy- 
cotted country or to comply with a prohibition imposed by a country 
on the exportation of products obtained in that country to any boy- 
cotted country, 'i'he person however, may not agree to refrain from 
importing or exporting to or from a particular country products which 
are, or wnich contain components wnich are, made by a company on a 
boycott list. 

A pei-son is not considered as having participated in or cooperated 
^yith an international boycott unless he has agreed to such participa- 
tion or cooperation. The agreement need not be in writing ; there may 
be an implied agreement. However, an agreement will not be inferred 
from the mere fact that any country is exercising its sovereign rights. 
Thus, a person is not considered to have agreed to participate in or 
cooperate with an international boycott merely by reason of the in- 
ability of the person to obtain an export or import license from a 
sovereign country for specific goods. Similarly, a person's inability, 
under the laws or administrative practices of a country, to bring 
certain personnel into that country, to bring certain ships into the 
waters of that country, to provide certain services in that country, or 
to import or export certain products to or from a country, is not to be 
considered to constitute an agreement to participate in or cooperate 
with an international boycott. Further, the signing (at the time of 
import) of a certification as to content, which is required to obtain an 
import license, does not by itself constitute an agreement by the per- 
son. However, this will not permit the making of an agreement not to 
import certain goods into the country. In addition, a course of conduct 
of complying with sovereign law may, along with other factors, be 
evidence of an agreement. 

If a person or a member of the controlled group (within the mean- 
ing of section 993(a) (3) ) which includes that person has participated 
in or cooperated with an international boycott in a country, that person 
or group is presumed to have participated in or cooperated with that 
boycott with respect to all operations in all countries which require of 
the person (or of other persons, whether or not related to that pereon) 
participation in or cooperation with that international boycott. How- 
ever, the taxpayer may establish that he has, or related persons have, 
conducted clearly separate and identifiable operations in that country 
or another country with respect to which there is no cooperation with 
or participation in that boycott. Where the person involved is a for- 
eign corporation, its United States shareholders (within the meaning 
of section 951(b) of the Code) may establish that it has conducted 
clearly separate and identifiable operations with respect to which there 
has been no participation in or cooperation with the boycott. 



285 

Where there are not continuous business activities within a country, 
separate and identifiable operations may include separate export or 
import transactions. Where there are continuous business activities 
within a country, each separate business activity (taking into account 
basic differences in the types of any products sold or services offered, 
clear separation of the management of the activities, and so forth) 
may represent a separate and identifiable operation. If the taxpayer is 
able to establish separate and identifiable operations, he may then 
establish that with respect to certain operations there was no partici- 
pation in or cooperation with that international boycott. The burden 
of proof will be upon the taxpayer to establish that an operation is 
separate and identifiable and that there was no participation in or 
cooperation with an international boycott in connection with that 
operation. 

In addition, the Act contains a special rule extending the presump- 
tion of participation to related persons in certain limited situations 
where the related persons are not members of the same controlled 
group (under sec. 993), The rule provides that if a person (e.g.. an 
individual or a corporation) controls a corporation, (i) participation 
in or cooperation with an international boycott by the corporation is 
presumed to be participation in or cooperation with the boycott by that 
person (and thus by all members of the controlled group including 
that person), and (2) participation or cooperation by the person is 
presumed to be participation or cooperation by the controlled cor]:)ora- 
tion (and thus by all members of the controlled group including that 
corporation). Control for this purpose has the same meaning as it does 
in Code section 304(c) ; that is, a person is considered to control a cor- 
poration if, after application of the appropriate attribution of stock 
ownership rules, the person owns at least 50 percent of stock of the cor- 
poration. Thus, the presumption applies in the case of noncorporate 
shareholders owning at least 50 percent of a corporation's stock, or 
corporate shareholders owning only 50 percent of a corporation's stock, 
even though in both cases the shareholders are not members of the same 
controlled group as the corporations in which they own the stock in- 
terest. As above, however, the taxpayer may rebut the presumption 
by establishing clearly separate and identifiable operations with re- 
spect to which there was no boycott participation. 

In addition, the Act provides a proration formula for computing the 
amount of tax benefits which are related to an international boycott, 
and thus are denied to the taxpayer. This formula, it is anticipated, 
will be used by taxpayers who are unable to separate their tax benefits 
between boycott and nonboycott operations. Under this formula, the 
reduction of the tax benefits allowed to the taxpaj-er are determined 
by multiplying the otherwise allowable tax benefits by a fraction. 
Generally, the numerator of the fraction reflects the worldwide opera- 
tions of the taxpayer (or. in the case of a controlled group within the 
meaning of sec. 993(a) (3) which includes that taxpayer, of the group) 
in countries associated in carrying out the international boycott (exclu- 
sive of those operations for which the presumption of participation 
or cooperation has been rebutted). The denominator reflects the world- 
wide foreign operations of the taxpayer (or the group). The factors 
to be taken into account in computing the fraction are to be determined 



286 

in accordance with the regulations prescribed by the Secretary. It is 
anticipated that the regulations will reflect the nature of the boycott 
activity carried on by the taxpayer (or group) and will take into 
account such factors as purchases, sales, payroll or other items which 
may be relevant. Unless the taxpayer establishes to the contrary, all 
operations of the taxpayer (or group) in connection with countries 
which require participation in or cooperation with the boycott are to 
be reflected in the numerator of the fraction. 

A U.S. taxpayer is to take into account the operations of all mem- 
bers of the same controlled group to which it belongs in computing its 
international boycott factor. However, if the taxpayer is a share- 
holder of a person who is not a member of a controlled group with the 
U.S. taxpayer, and that person has agreed to cooperate with or par- 
ticipate in an international boycott, the U.S. taxpayer is to compute 
separately the international boycott factor with respect to that person 
(and any corporation controlled by that person) for purposes of 
determining the DISC benefits, deferral of earnings of a foreign 
subsidiary or deemed paid foreign tax credit, the benefits of which are 
denied to that U.S. taxpayer. 

The proration formula is not to apply if instead the taxpayer, with 
respect to the operations which are related to participation in or co- 
operation with an international boycott, clearly demonstrates the 
amount of the foreign taxes and earnings which are allocable to the 
boycott operations. Those taxpayers who are not able clearly to ac- 
count separately for the foreign taxes and earnings which are allocable 
to boycott operations must apply the proration formula in computing 
the amount of tax benefits which are denied to them. Of course, all 
operations of the person in countries which require participation in 
or cooperation with that boycott are presumed to be boycott operations 
unless the taxpayer establishes to the contrary. 

It is expected that the provisions of the Act will be administered 
in the normal course of a tax audit. However, if a person, or a member 
of a controlled group (within the meaning of section 993(a)(3)) 
which includes that person, has operations in or related to a country 
(or with the government, a company, or a national of a country) 
which is on a list (maintained by the Secretary of the Treasury) of 
countries requiring participation in or cooperation with an inter- 
national boycott, or in any other country which the person (or if the 
person is a foreign corporation, any United States shareholder of the 
corporation) knows or has reason to know requires boycott participa- 
tion or cooperation, that person or shareholder must report those oper- 
ations to the Secretary of the Treasury. In the case of these operations 
of a foreign subsidiary, however, the report is to be made by its United 
States shareholders. 

The taxpayer is to include in the report the identity of any country 
in connection with which the taxpayer has participated in or cooper- 
ated with (or has been requested to participate in) an international 
boycott as a condition of doing business in that country (or with such 
government, company or national). The report should also indicate 
the nature of any operations in connection with such countries. A tax- 
payer will also be expected to disclose in the report any country where 
the taxpayer has been requested to participate in such a manner which 



287 

could be interpreted as an official request of that country. This is not 
to say that the request must be made directly by a government official 
or representative. 

The Secretary of the Treasury is to publish the list, which is to be 
updated periodically, of those countries which may require participa- 
tion in or cooperation with an international boycott. The initial list 
must be published Avithin 30 days after date of enactment. However, 
the absence of a countiy from the list does not mean that the country 
is not a country which requires participation in or cooperation with 
an international boycott. 

The willful failure to make a report will subject the taxpayer to a 
fine of not more than $25,000 or imprisonment for not more than one 
year, or both. A failure to make a report will not be a willful failure 
if the taxpayer had no knowledge of a boycott operation unless the 
taxpayer's failure to have knowledge is so negligent as to constitute a 
reckless disregard of the requirements of the law. 

The initial determination of participation in or cooperation with 
any international boycott is to be made by the taxpayer, who will be 
expected on his return to reduce the amount of the foreign tax credit, 
deferral benefits, or DISC benefits to the extent necessary to reflect the 
participation in or cooperation with an international boycott. The tax- 
payer is to show how any reduction is made. However, it is expected 
that the returns and the determinations by the taxpayer will be audited 
and the accuracy of the taxpayer's determinations will be verified 
in the usual course of such an audit. While this verification will be 
done in the usual course of a tax audit, it is anticipated that the IRS 
will develop a group of experts who are knowledgeable in audit 
aspects of determining whether a taxpayer is involved in an inter- 
national boycott. 

The Act also establishes a determination procedure so that tax- 
payers conducting business with foreign countries will be able to 
obtain a determination from the Secretary of the Treasury as to 
whether their operations constitute an international boycott agree- 
ment. While the determination procedure may rely upon the audit 
expertise of the IRS, it is anticipated that this procedure will be dele- 
gated to Treasury officials. The determination request may be filed 
by the taxpayer before he has computed and filed his tax return, or 
at any time during the course of an audit of a tax return in which 
the question is raised as to whether the taxpayer has agreed to par- 
ticipate in or cooperate with an international boycott. To obtain a 
determination from the Secretary, the taxpayer will be required to 
make available all factual materials which may be relevant to the 
Secretary's determination. If the request for a determination is made 
before the particular operation is commenced or before the close of 
the taxable year, the Secretary may defer making the determination 
until the close of the taxable year. 

If the Secretary does determine that a person has agreed to partici- 
pate in or cooperate with an international boycott, there will be a 
presumption that the participation or cooperation of the person 
relates to all of the operations of the taxpayer in all of the boycott 
countries involved. However, the taxpayer will be entitled to rebut 
this presumption by demonstrating that certain operations are clearly 



288 

separate and identifiable and are not connected with an international 
boycott agreement. An adverse determination by the Secretary will 
be reflected by the taxpayer either directly in his return or by normal 
deficiency procedures of the Internal Revenue Service. Thus, a 
determination by the Secretary that a person has agreed to participate 
in or cooperate with an international boycott will be reviewable by the 
courts in the same manner as the usual tax controversy. 

In order to assess the effectiveness of this legislation in discouraging 
participation in or cooperation with international boycotts, the Act 
requires the Secretary to report annually to the taxwriting commit- 
tees the number of boycott reports filed with the IRS and the percent- 
age which indicated that there had been participation in an interna- 
tional boycott. Further, the report to the committees should contain 
a detailed description of the results of the audits of these taxpayers in 
connection with boycott operations, the changes made by the IRS on 
unreported boycott activities, and such other information which would 
be useful or helpful in evaluating the administration of these provi- 
sions. The report should also indicate to the extent possible the tax 
benefits which are claimed for operations in each boycott country ; the 
benefits claimed by taxpayers in those countries and the benefits denied 
by application of these provisions ; and the extent that benefits denied 
were attributable to boycott agreements determined by reason of an 
Internal Revenue audit. The report must be in such a form that it can- 
not, directly or indirectly, be associated with or otherwise identify a 
particular taxpayer. 

Effective date 
The international boycott provisions apply to any participation in 
or cooperation with an international boycott made more than 30 days 
after the date of enactment (October 4, 1976) . However, in the case of 
operations which are carried out in accordance with the terms of a 
binding contract entered into before September 2, 1976, the interna- 
tional boycott provisions apply to participation or cooperation after 
December 31, 1977. 

Revenue e-ffect 
It is estimated that the international boycott provisions will increase 
budget receipts by $32 million in fiscal year 1978, and by 5tJ70 million 
in fiscal year 1981. 

14. Denial of Certain Tax Benefits Attributable to Bribe-Pro- 
duced Income (sees. 1065 and 1066 of the Act and sees. 952, 
964(a), and 995(b) (1) of the Code) 

Prior laio 
Under prior law, illegal payments to government officials were not 
deductible, but the denial of tlie deduction for bribes had little impact 
on bribes paid by foreign subsidiaries or DISCs. 

Reasons for change 
Prior law in many cases provided more favorable tax treatment for 
illegal payments made by a foreign subsidiary of a U.S. corporation 
than by its parent. Further, the Congress is concerned over the re- 
cent revelations that disclosed the practice of using foreign bribes 



289 

as a means of doing business overseas. The Congress believes that 
illegal payments made out of funds entitled to tax deferral should 
cause the termination of the tax deferral. 

Explanation of provisions 

The Act subjects to current taxation as a deemed dividend an 
amount equal to the amount of any illegal bribes, kickbacks, or other 
payments (within the meaning of section 162(c)) paid by or on be- 
half of a DISC or a controlled foreign corporation (a foreign corpo- 
ration more than 50 percent of the stock of which is owned by United 
States shareholders) directly or indirectly to an official or employee 
of any government (or of any agency or instrumentality of any gov- 
ernment). Illegal payments include payments which are unlawful un- 
der the laws of the United States or, if made to an official or employee 
of a foreign government, payments which would be unlawful under 
the laws of the United States if such laws were applicable. 

In the case of a controlled foreign corporation, the deemed dividend 
is accomplished by treating an amount equal to the bribe as subpart 
F income includible in the income of the subsidiary's United States 
shareholders in the same manner as other subpart F income. In the 
case of a DISC, the deemed dividend is made under the same rules 
which are applicable to other deemed distributions required during 
qualified years (e.g., deemed distributions of interest on producer's 
loans) . 

In addition, the earnings and profits of any foreign subsidiary 
which has made an illegal payment are not to be reduced by the 
amount paid. 

Effective date 
The provisions dealing with the making of illegal payments by 
foreign corporations apply to payments made after November 3, 1976. 

Revenue effect 
It is estimated that these provisions will increase budget receipts 
by less than $5 million on an annual basis. 



J. DOMESTIC INTERNATIONAL SALES CORPORATIONS 
(Sec. 1101 of the Act and Sees. 991-997 of the Code) 

Prior law 

The tax law provides for a system of tax deferral for corporations 
known as Domestic International Sales Corporations, or "DISCs", 
and tlieir shareholders. Under this tax system, the profits of a DISC are 
not taxed to the DISC but are taxed to the shareholders of the DISC 
when distributed to them. However, each year a DISC is deemed to 
have distributed income representing 50 percent of its profits, thereby 
subjecting that income to current taxation in the shareholders' hands. 
In this way, imder the prior rules, the tax deferral which was available 
under the DISC provisions was limited to 50 percent of the export in- 
come of the DISC. 

To qualify as a DISC, at least 95 percent of the corporation's assets 
must be export-related and at least 95 percent of a corporation's gross 
income must arise from export sale or lease transactions and other 
export-related activities (i.e., qualified export receipts). Qualified ex- 
port receipts include receipts from the sale of export property, which 
generally means property such as inventory manufactured or pro- 
duced in the United States and held for sale for direct use, consump- 
tion or disposition outside the United States (or to an unrelated DISC 
for such a purpose). The President has the authority to exclude from 
export property any property which he determines (by Executive 
order) to be in short supply. However, energy resources, such as oil 
and gas and depletable minerals, are automatically denied DISC bene- 
fits under the Tax Reduction Act of 1975. That Act also eliminated 
DISC benefits for products the export of which is prohibited or 
curtailed under the Export Administration Act of 1969 by reason of 
scarcity. 

If a DISC fails to meet the qualifications for any reason (including 
legislation excluding the corporation's products from export prop- 
erty), the DISC provisions provide for an automatic recapture of the 
DISC benefits received in previous years. LTnder prior law, this re- 
capture was spread out over the number of years for which the corpo- 
ration was qualified as a DISC but could not exceed 10 years. In addi- 
tion, the DISC provisions provide for recapture of the DISC benefits 
if the stock of the DISC is sold or exchanged. 

Reasons for change 
Congress has examined the DISC provisions at great length and 
has concluded that the legislation has had a beneficial impact on 
U.S. exports. Since 1971. when DISC was enacted, exports have in- 
creased from $43 billion to $107 billion for 1975. It is clear that much 
of this increase has resulted from the devaluation of the dollar which 
took place in that period. Nonetheless, Congress has concluded that 
a significant portion of the increase in exports which has taken place 

(290) 



291 

resulted from the DISC legislation. This increase in exports, Congress 
concluded, provides jobs for U.S. workers and helps the U.S. balance 
of payments. 

However, Congress also recognized that questions have been raised 
as to the revenue cost of the DISC program. In 1975, the program 
is estimated to have cost nearly $1.3 billion and it is estimated that in 
1976 the amount would have been $1.4 billion. Furthermore, Congress 
believed that the DISC legislation was made less efficient because the 
benefits applied to all exports of a company, regardless of whether 
or not a company's products would be sold in similar amounts without 
export incentive and regardless of whether or not the company was 
increasing or decreasing its exports. 

Given these considerations, Congress concluded that the DISC pro- 
gram could become more efficient and less costly while still providing 
the same incentive for increased exports and jobs by granting DISC 
benefits only to the extent that a company increases its exports over 
a base period amount and by reducing DISC benefits for certain 
products and commodities. 

Explanation of provisions 

Incremental computation of DISC henefts. — Under the Act, the 
tax deferral benefits provided to a DISC and its shareholders are to 
be computed on an incremental basis. However, the basic structure 
of the DISC provisions of prior law are continued. DISCs continue 
not to be taxable entities themselves, but certain amounts of the taxable 
income of the DISCs are deemed distributed to the shareholders of the 
DISCs and taxed to them. Furthermore, the requirements for qualify- 
ing as a DISC are to remain the same, as are the intercompany pricing 
rules and most of the technical provisions of the DISC provisions. 

Deemed distribution. — The Act provides for the incremental com- 
putation of DISC benefits by adding a new category of deemed 
distribution from a DISC to its shareholders. The amount of this 
new deemed distribution is the adjusted taxable income for the cur- 
rent taxable year which is attributable to adjusted base period export 
gross receipts (i.e., the nonincremental portion of the current year's 
export receipts). 

Adjusted taxable income is the taxable income of the DISC in the 
current year reduced by producer's loan interest and gain on the sale 
of certain property of the DISC. These amounts are deemed distribu- 
tions from a DISC to its shareholders under prior law. The amount 
of the new deemed distribution is that portion of the current year's 
adjusted taxable income which is attributable to the current year's 
export gross receipts not in excess of the adjusted base period export 
gross receipts. For example, if adjusted base period export gross 
receipts were $100 and the current year's export gross receipts were 
$300, one-third of the adjusted taxable income of the DISC in the 
current year would be treated as attributable to adjusted base period 
export gross receipts and thus would be a deemed distribution for 
the current year. 

The deemed distribution is computed by takinsr the ratio of "adjusted 
base period export gross receipts" of the DISC to the export gross 
receipts for the current year and multiplying it by the adjusted tax- 



292 

able income of the DISC for the current year. Adjusted base period 
export gross receipts are defined as 67 percent of the average of the 
disc's export gross receipts during a moving 4-year base period. 
Thus, this nonincremental dividend is computed as follows: 

67 percent of the average base 
DISC income for current s^ period export gross receipts 

y^^^ Export gross receipts 

for current year 

The nonincremental dividend is to be deemed distributed to the 
shareholder prior to the computation of the deemed distribution (pro- 
vided under prior law) equal to one-half of the taxable income of 
the DISC. That is, adjusted taxable income attributable to adjusted 
base period export gross receipts is to be deemed distributed first, and 
then one-half of remaining taxable income of the DISC is to be deemed 
distributed. For example, if a DISC had taxable income of $100 and 
taxable income attributable to the adjusted base period export gross 
receipts of $30, the deemed distributions for the year would be $65 
($30+ 1/2 ($100- $30) ). Thus, a deferral of tax would be permitted on 
$35. 

Export gross receipts. — The term "export gross receipts" includes 
those receipts which are received in the ordinary course of the export 
trade or business of the DISC in which the DISC derives its income 
(see sec. 993(a) ). For this reason, the term includes income from the 
sale, exchange, or rental (and related subsidiary services) of export 
property (as defined in sec. 993(c)) for consumption outside of the 
United States; engineering and architectural services for projects out- 
side the United States; and the performance of managerial services 
for a DISC which relate to the sale, exchange, rental or other dis- 
position of export property. However, the term does not include gross 
receipts from the sale, exchange or other disposition of qualified export 
assets (under sec. 993(b) ) other than export property (i.e., assets such 
as warehouses and packaging machines which generally are used in 
the export business but uhich are not sold in the ordinary course of 
business) ; dividends or deemed distributions (under subpart F) from 
a related foreign export corporation (as defined in sec. 993(e)) ; and 
interest on any obligation (such as Export-Import Bank obligations) 
which is a qualified export asset. 

Base period years. — Under the Act, the base period for taxable years 
beginning in 1976, 1977, 1978. and 1979 is composed of the DISC'S 
taxable years beginning in 1972, 1973, 1974, and 1975. In taxable years 
beginning in 1980 and later years, the base period becomes a 4-year 
moving base period. The base period is to move forward 1 year for 
each year beyond 1979, so that the base period years for any year are 
the taxable years beginning in the 4th, 5th, 6th, and 7th calendar years 
preceding such calendar year. For example, for 1980, the base period 
years are 1973, 1974, 1975, and 1976, and for 1981, the base period years 
are 1974, 1975, 1976, and 1977. 

The average export gross receipts for the base period is the sum of 
the export gross receipts for tlie 4 base period years divided by 4. If 
the taxpayer did not haAe a DISC in any year wliich would be in- 
cluded in the base period for the current year, the taxpayer is to cal- 



293 

culate base period export gross receipts by attributing a zero amount 
of export gross receipts to that base period year. For example, in the 
case of a DISC which was not in existence in 1973 and 1974, but had 
$25 of export gross receipts in 1975, and $35 in 1976, the base period 
export gross receipts of the DISC for taxable year 1980 would 
be ($0 + $04-$25 + $35) divided by 4 or $15. Sixty-seven percent of this 
average, or roughly $10, would be the adjusted base period export gross 
receipts of the DISC. 

Because base period years in which a DISC was not in existence are 
included as zero base period years under these provisions, DISCs be- 
ginning operation in 1976 have no base period export gross receipts for 
4 full years (until 1980), when the base period begins to include a year 
in which the DISC had export gross receipts. In 1980 its base period 
export gross receipts would be its 1976 export gross receipts divided 
by 4, The DISC would thus first have a full 4-year base period in 1983,^ 

Short taxable years. — In the case of a taxpayer having a short tax- 
able year in the base period, the Secretary is to prescribe regulations 
including the annualization, if necessary, of export gross receipts in 
the short base period taxable year or years in determining base period 
export gross receipts. Similar regulations are to be prescribed if the 
current year is a short year in order to compute the deemed distribu- 
tion. It is intended that under these regulations short taxable years in 
the base period will generally be annualized for purposes of deter- 
mining base period export gross receipts so that the amount of the 
increase in current year export gross receipts is based on an equivalent 
full year amount of export gross receipts in each base period year. 
Similarly, in cases where the current year is a short taxable year, 
it is intended that export gross receipts in the current year will gen- 
erally be expanded proportionately by the ratio of the length of the 
short taxable year to a full taxable year. Of course, this adjustment 
is only to affect the computation of export gross receipts to be used 
in determining the amount of the current year's taxable income which 
is attributable to base period export gross receipts. The adjustment 
is not to affect the amount of taxable income of the DISC for the 
current taxable year or the amount of accumulated DISC benefits from 
any base period year. 

Adjustments to hose period. — The Act includes three special rules 
to deal with situations where a corporation has an interest in more than 
one DISC, or where a DISC and the underlying trade or business 

iThe Incremental computation of DISC benefits can be illustrated by the following 
example : 

In 1980 a DISC makes exports of $13,400. and that the taxable income allocable to the 
DISC Is $500. Assume further that the DISC was established in 1974 and that the exports 
through the DISC during the applicable base period are : 

1973 

1974 $2, 000 

1975 6, 000 

1976 8, 000 

Assuming all the exports are of nonmilitary goods, the DISC benefits would be computed 
as follows : 

ia) DISC'S Income on exports $500 

(6) Average base period export eross receipts (SIR 000/4) 4,000 

(c) Adi'nsted base period export gross receipts (67 percent of (b)) 2,680 

(d) Export gross receipts for current year 13, 400 

(e) Nonlncremental portion of the DISC'S Income ((a) times (c)/(d)) 100 

(/) DTSC Income remaining after nonlncremental dividend ((a) — (e)) 400 

ia) Reeular deemed distribution of 50 percent of DISC income 200 

(h) DISC income eligible for deferral 200 



234-120 O - 77 - 20 



294 

giving rise to the DISC income have been separated. The purposes of 
these rules are, first, to insure that in every year the base period export 
gross receipts wliich are attributable to a DISC for purposes of deemed 
distributions in the current year are appropriately matched with the 
current period export receipts of the DISC and, second, to prevent 
taxpayei-s from creating multiple DISCs, or trading DISCs, to re- 
duce deemed distributions attributable to base period export gross 
receipts. 

ControUed grouj). The Act provides tliat if one or more members 
of a controlled group of corporations (as defined in sec. 993(a) (3) to 
include all corporations with 50 percent or more common ownership) 
qualify as a DISC in the current or base period years, the amount 
deemed distributed as taxable income attributable to adjusted base 
period export gross receipts to the common shareholder of the DISCs 
(and the adjusted taxable income for purposes of the small DISC rule) 
is to be determined by aggregating taxable income, current year export 
gross receipts, and base period export gross receipts of the commonly 
owned DISCs. This aggregation is to be accomplished under regula- 
tions prescribed by the Secretary and is to be reflected on a pro rata 
basis (i.e., according to taxable income) in each DISC for purposes of 
determining the deemed distribution from each DISC. The Secre- 
tary's regulations thus are not intended to require aggregation of 
commonly owned DISCs for all purposes (including for purposes of 
meeting the qualifications of a DISC). Rather, this aggregation is to 
be required only to the extent necessary so that a taxpayer which ex- 
ports through more than one related DISC (in the current year or 
the base period) , cannot gain any advantage by increasing its exports 
in one DISC or the other, since the base period of all DISCs are 
taken into account in determining the amount of the deemed distribu- 
tion of taxable income attributable to base period export gross receipts. 
In determining base period export receipts for this purpose, commonly 
owned DISCs are to use the same 4 base years during the base period. 
It is intended that in cases where two DISCs are members of a con- 
trolled group, but (where an unrelated person owns some stock in one 
of the DISC?, the aogres^ation rule does not apply in computing any 
deemed distribution to that shareholder. 

Separation, of DISC and its trade or husin'^''^. — A second special 
rule is provided for situations where the ownership of a DISC and 
the underlying trade or business which gives rise to the export gross 
receipts of the DISC are separated. This could arise through the sale 
of the underlying trade or business or through a tax-free reorganiza- 
tion in which the DISC and the underlying trade or business are sep- 
arated. The special rule requires that a person owning the underlying 
trade or business during the taxable yeai-s after the separation of the 
trade or business from the DISC be treated as having, in any DISC in 
which the owner of the trade or business has an interest, an amount 
of additional export gross receipts for base period vears eqaal to ex- 
port gross receipts in base period years of the DISC attributable to 
that trade or business. 

The effect of this provision is to provide a double attribution of base 
period export gross receipts in cases where a DISC is separated from 
the underlying trade or business through a tax-free reorganization or 



295 

through a sale of the underlying trade or business. In these cases the 
base period export gross receipts of the DISC also remain with the 
DISC and are to be taken into account by the shareholders of the DISC 
(whether or not the DISC has acquired new shareholders in a tax-free 
reorganization) in computing adjusted base period export gi'oss re- 
ceipts of the DISC for years prior to the reorganization or sale.- 

Since, in the case of a sale or disqualification of a DISC, the DISC 
benefits for jDrior years are recaptured, export gross receipts for base 
period years prior to any sale (or disqualification) are to be reduced on 
a pro rata basis to the extent of the recapture. For example, if a DISC 
which was disqualified was entitled to defer $100 of accumulated DISC 
income, $40 of which was recaptured, the export gross receipts for the 
base period years are to be reduced by 40 percent. 

A separation of the DISC and the underlying trade or business does 
not occur if the DISC and the trade or business which gave rise to the 
base period export gross receipts of the DISC are owned throughout 
the current taxable year by members of the same controlled groups, but 
only to the extent that the ownership of the DISC and the trade or 
business is proportionate during all of the current taxable year (i.e., 
the taxpayer owns the same proportionate amount of stock in the 
DISC as it owns in the trade or business during the current year). As 
a result, in cases where a DISC is transferred at the same time that the 
underlying trade or business is transferred (either by sale or tax-free 
reorganization) , the double attribution of the base period export gross 
receipts of the DISC does not apply. The intent of these provisions is 
to prevent taxpayers from separating a DISC from the underlying 
trade or business giving rise to the export gross receipts of the DISC in 
order to reduce base period export gross receipts. 

In order to permit the transfer of a DISC and the transfer of the 
underlying trade or business as part of the same exchange, the Act pro- 
vides special rules modifying the corporate spinoff provisions. The Act 
provides that if (i) a corporation owns the stock of a subsidiary and 
of a DISC, (ii) the subsidiary has been engaged in the active conduct 
of a trade or business for the requisite 5-year period, and (iii) during 
the taxable year of the subsidiary in which its stock is transferred and 
during its preceding taxable year, the trade or business of the sub- 
sidiary gave rise to qualified export receipts, the Secretary is to pre- 
scribe regulations under which the transfer of assets, stock, or both 
will be treated as a reorganization within the meaning of section 368, 
a transaction to which section 855 applies, or an exchange to which 
section 351 applies. This special treatment will apply only to the extent 
that the transfer is for the purpose of preventing the separation of the 
ownership of the stock in the DISC from the ownership of the trade 
or business which produced the base period export gross receipts of the 
DISC. 



* For example. If a r>ISC alone is transferred in a section 355 spin-off transaction, the 
shareholders of the DISC after the transfer will in computing any deemed distributions, 
take into account the adjusted base period export gross receipts for all base years of the 
DISC. IncludlnR years prior to the section 355 transaction. In addition, the owners of 
the trade or business from which the DISC is spun off will also be treated as having base 
period export gross receipts equal to the amount of the base period export gross receipts 
of the DISC which was spun off. These amounts are to be added to any base period export 
gross receipts which may exist in any DISC in which the owners of the trade or business 
have an interest or subsequently obtain an Interest. 



296 

Shareholders of two or more unrelated DISCs. — A final special 
rule is provided to apply to situations where a person owns a partial 
interest in a DISC (i.e., 5 percent or more of the stock of a DISC). 
Under this rule, if a person has had an interest in more than one DISC 
(either simultaneous ownership or ownership of one DISC during the 
base period and ownership of the second DISC during the current 
year), then, to the extent provided in regulations prescribed by the 
Secretary to prevent circumvention of the rules for deemed distribu- 
tions of taxable income attributable to adjusted base period export 
gross receipts, amounts equal to that shareholder's pro rata portion of 
the base period export gross receipts of DISCs owned during the base 
period are to be included in base period export ^ross receipts of DISCs 
currently owned by the shareholder. This provision is intended to give 
the Secretar-y general authority to prevent situations where, by 
having an interest in more than one DISC, a taxpayer could artificially 
reduce the base period export gross receipts that would otherwise be 
attributable to a currently active DISC in order to obtain a smaller 
deemed distribution in the current year. 

Where the provisions of the first two special rules are applied, it is 
contemplated that generally the rules regarding deemed distributions 
will not have been circumvented, and thus no further adjustment of 
base period export gross receipts is to be required. Further, it is in- 
tended that this provision will generally not be applied in cases where 
a taxpayer has sold all the shares he held in any DISC, since the 
amount of benefits received from that DISC will have been recaptured. 
HoM-ever, the Secretary is to have authority to attribute base period 
gross receipts to more than one DISC in cases of separations and 
acquisitions of DISCs from underlying trades or businesses if such 
double attribution is consistent with the purposes of the special rules 
of the Act and is appropriate to eliminate any incentive to separate 
DISC assets from their underlying trades or businesses. 

Small DISCs exception.- — The Act exempts small DISCs from the 
new incremental rules. Under the Act, DISCs with adjusted taxable 
income in the current taxable year of $100,000 or less are not subject 
to the new incremental rules. Instead, these DISCs will continue to 
receive the full DISC benefits provided under prior law. The excep- 
tion is phased-out on a 2-for-l basis so that DISCs with taxable income 
of $150,000 or more receive no benefit. In computing adjusted taxable 
income for purposes of the small DISC exception to the incremental 
rules, if more than one member of a controlled group qualifies as a 
DISC, the small DISC exemption is computed by aggregating the 
adjusted taxable income of each DISC who is a member of that group. 

DISCs with taxable income of over $100,000 for a taxable year are to 
be treated as having made deemed distributions equal to the amount of 
their adjusted base period gross export receipts, but this amount is first 
to be reduced by twice the excess (if any) of the $150,000 over the 
disc's adjusted taxable income. The effect of this provision is to phase 
out the special treatment for small DISCs on a 2-for-l basis, so that 
DISCs with adjusted taxable income of $150,000 or more receive no 



297 

benefit from the rule and DISCs with adjusted taxable income between 
$100,000 and $150,000 will lose $2 out of the $100,000 exemption for 
each $1 of adjusted taxable income beyond $100,000.^ 

Reduction of DISC benefits foi' military goods. — The Act reduces 
the DISC deferral on sales of military goods to half the amount which 
would otherwise be allowed. The reduction in DISC benefits on mili- 
tary sales is accomplished by requiring a deemed distribution of one 
half of the DISCs taxable income from military sales. The DISCs 
taxable income from military sales is its gross income from the sale 
of military property (gross receipts less cost of goods sold) reduced by , 
the deductions properly allocable to that income. The determination/ 
of this amount may require separate accounting for militaiy and non- 
military sales. IMilitary goods are defined as arms, ammunition, or im- 
plements of war designated in the munitions list published pui"suant 
to the Military Security Act of 1954 (22 U.S.C. 1934). The list pub- 
lished pursuant to that statute appears at 22 Code of Federal Regula- 
tions, sec. 121. 

The deemed distribution of the DISC income from military sales 
is made prior to the nonincremental and the regular 50 percent deemed 
distributions. In computing the nonincremental dividend, only half 
of the military sales are included in the ratio of the average gross re- 
ceipts for the base period to the gross receipts for the current year.* 

Exclusion from hose period. — For purposes of establishing base 
period export gross receipts of a DISC some of the products of which 
have been made ineligible for DISC benefits under the Tax Reduction 
Act of 1975, an adjustment is to be made to reduce base period export 
gross receipts of that DISC to reflect the elimination of DISC bene- 
fits for those products or commodities. This adjustment is to be made 
by eliminating from each base period year the amount of actual expor