1 See Institute Memorandum to Tax Members No. 6-98 and International Members No. 4-98, dated February 9,
1998.
2 Note, however, that legislation introduced in July 1998, which was drafted with the intention of implementing
generally the Treasury proposal, included an Institute suggestion that income derived from foreign bonds
generally be exempt from U.S. withholding tax, so long as foreign tax (if any) with respect to the bonds is not
reduced or eliminated by a treaty with the United States. Thus, under the July 1998 bill, no limit would have been
placed on the ability of U.S. funds to invest in foreign securities, such as Euro bonds, that are free from foreign
tax pursuant to foreign law. See Institute Memorandum to International Members No. 15-98 and Tax Members
No. 21-98, dated July 14, 1998.
[10695]
February 3, 1999
TO: ACCOUNTING/TREASURERS MEMBERS No. 7-99
INTERNATIONAL MEMBERS No. 5-99
TAX MEMBERS No. 8-99
TRANSFER AGENT ADVISORY COMMITTEE No. 13-99
RE: TAX PROVISIONS IN CLINTON ADMINISTRATION'S FY 2000 BUDGET
PROPOSAL
______________________________________________________________________________
The Clinton Administration’s budget proposal for the fiscal year beginning October 1, 1999
includes several provisions of interest to regulated investment companies (“RICs”) and their
shareholders. Many of the provisions discussed below previously have been proposed by the
Administration. All of the attached proposal descriptions are from the Treasury Department’s “General
Explanations of the Administration’s Revenue Proposals.”
A. Withholding Tax Exemption for Certain Bond Fund Distributions
(Attachment A)
The Administration again1 has proposed to exempt from U.S. withholding tax all distributions
made to foreign investors in certain bond funds. The proposal would apply to mutual fund taxable years
beginning after the date of enactment.
Specifically, the Treasury explanation provides that all income received by a U.S. mutual fund
“that invests substantially all of its assets in U.S. debt securities or cash” would be treated as interest
exempt from U.S. withholding tax when distributed to the fund’s foreign investors. A fund would be
treated as meeting this “substantially all” test “if it also invests some of its assets in foreign debt
instruments that are free from foreign tax pursuant to the domestic laws of the relevant foreign
countries.” The Treasury explanation does not indicate what portion of a fund’s assets could be
invested in foreign bonds without violating the “some” standard.2
3 See Institute Memorandum to Tax Committee No. 9-98, International Committee No. 12-98 and Transfer Agent
Advisory Committee No. 17-98 (among others), dated March 13, 1998.
4 This proposal first was advanced by the Administration late in 1995. See Institute Memorandum to Tax
Committee No. 4-96 and Transfer Agent Advisory Committee No. 5-96 (among others), dated January 25, 1996.
5 See e.g., Institute Memorandum to Tax Committee No. 15-96, dated May 21, 1996, and the Institute
Memorandum cited in footnote 3, supra.
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The Institute previously has supported this Administration proposal as an important first step
toward eliminating all U.S. tax incentives for foreign investors to prefer foreign funds over U.S. funds.3
The Institute’s position on the Administration proposal remains unchanged.
B. Mandatory Accrual of Market Discount (Attachment B)
The Administration would modify significantly the taxation of market discount by eliminating
the option taxpayers now have to defer the inclusion of any market discount into income until the debt
instrument acquired with market discount is sold. Under the Administration’s proposal, accrual basis
taxpayers would be required to include market discount in income currently, i.e., as it accrues. The
holder’s yield for market discount accrual purposes would be limited to the greater of (1) the original
yield-to-maturity of the debt instrument plus five percentage points or (2) the applicable Federal rate (at
the time the holder acquired the debt instrument) plus five percentage points. The proposal would apply
to debt instruments acquired on or after the date of enactment.
C. Increased Penalties for Failure to File Correct Information Returns (Attachment C)
The Administration again4 has proposed to increase the maximum penalty for failure to file
correct information returns -- currently set at $50 per return -- to the greater of $50 per return or five
percent of the aggregate amount required to be reported correctly (subject, in general, to a $250,000
cap). An exception to the increased penalty would apply, however, if the aggregate amount actually
reported by the taxpayer on all returns filed for that calendar year was at least 97 percent of the amount
required to be reported. The proposal would be effective for returns the due date for which (without
regard to extensions) is more than 90 days after the date of enactment.
The Institute previously has opposed this proposal because the current penalty structure
provides powerful incentives for RICs to correct promptly any error made.5
D. 15-Year Amortization of Start-Up Expenses (Attachment D)
The Administration also proposes to extend from 5 years to 15 years the amortization period
provided by sections 195 and 248, respectively, for start-up and organizational expenses; this proposal
would apply to expenditures incurred after the date of enactment. While small taxpayers could deduct
up to $5,000 each of start-up and organizational expenditures in the year a trade or business begins, the
6 This proposal first was included in an Administration budget proposal in 1996. See Institute Memorandum to
Tax Members No. 13-97 and Transfer Agent Advisory Committee No. 15-96 (among others), dated March 26,
1996. See also the Institute Memorandum cited in footnote 4, supra.
7 See, e.g., the Institute Memoranda cited at note 5, supra.
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$5,000 amount would be reduced (but not below zero) by the amount by which the cumulative cost of
start-up or organizational expenditures, respectively, exceeds $50,000.
E. Partial Liquidation of Partnership Interests (Attachment E)
The rules for partial liquidations of partnership interests would be modified under the
Administration’s budget proposal to treat (1) the partial liquidation of the entire partnership interest as
(2) a complete liquidation of a portion of the partnership interest. Thus, a partial liquidation no longer
would be treated as a nonrecognition event (unless the amount of money distributed exceeded the
partner’s basis in the partnership interest). Instead, the partial liquidation would be treated as a taxable
disposition of that portion of the partnership interest.
To illustrate, assume a feeder fund that holds a $100 million investment (with a cost basis of $80
million) in a master fund. Further assume that the feeder fund experiences net redemptions of $5
million and receives that amount in cash from the master fund. Under present law, the cash distribution
attributable to the partial redemption reduces the feeder fund’s cost basis in its partnership interest to
$75 million. Under the Administration’s proposal, the feeder fund would be treated as having disposed
of a $5 million interest in the partnership with a gain of $1 million ($5 million proceeds less $4 million
basis in the partnership interest).
F. Conversions of Large C Corporations to S Corporations (Attachment F)
The Administration again6 has proposed to repeal section 1374 for “large corporations” (i.e., any
corporation with a value of more than $5 million). Under section 1374, corporations may convert tax-
free from Subchapter C status to Subchapter S status, although the new “S” corporation remains subject
to tax at the entity level to the extent that it recognizes built-in gain on any assets, held at the time of
conversion, that are sold within 10 years of the conversion. The proposal to repeal section 1374 for
large corporations would apply to Subchapter S elections first effective for a taxable year beginning after
January 1, 2000 and to acquisitions (e.g., mergers) after December 31, 1999.
While section 1374 does not apply to RICs, IRS Notice 88-19 provides that similar rules will
apply to the conversion of a corporation to a RIC (or to a real estate investment trust (“REIT”)).
Consequently, the Administration’s explanation indicates that IRS would revise IRS Notice 88-19 to
conform to the proposed change to section 1374. Effective dates similar to those provided for section
1374 repeal would apply to any change to Notice 88-19.
The Institute previously has urged that, should this proposal be enacted, the legislative history
include a statement making it clear that the proposal would not impact IRS Notice 88-96. This notice
provides a safe harbor from recognition of built-in gain for the situation in which a C corporation that
previously was a RIC requalifies under Subchapter M following a temporary failure so to qualify.7 The
Institute continues to hold this position.
G. Constructive Ownership of Partnership Interests (Attachment G)
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The Administration’s budget proposal also would address an investment strategy whereby,
according to the Treasury explanation, certain taxpayers have entered into derivative transactions
designed to provide the taxpayer with the “economics” of an equity interest in a partnership without
giving the taxpayer an actual ownership interest. These “constructive ownership” transactions, the
Treasury asserts, are designed to provide taxpayers with income deferral and conversion of ordinary
income and short-term capital gain into long-term capital gain.
Specifically, the proposal would limit the amount of long-term capital gain that a taxpayer could
recognize from a “constructive ownership” transaction with respect to a partnership interest by treating
any gain in excess of the “net underlying long-term capital gain” as ordinary income. An interest charge
would apply to the extent gain was recharacterized as ordinary income (by assuming that the ordinary
income was earned ratably over the period of constructive ownership). Alternatively, taxpayers could
elect mark-to-market treatment for constructive ownership transactions in lieu of applying the gain
recharacterization and interest rules. The proposal would be effective for gains recognized on or after
the date of first committee action.
“Constructive ownership transactions” would be defined to include (1) holding a long position
under a notional principal contract with respect to the partnership interest; (2) entering into a forward
contract to acquire the partnership interest; (3) being the holder of a call option and the grantor of a put
option with respect to the partnership interest and (4) entering into one or more transactions having
substantially the same effect. “Net underlying long-term capital gain” with respect to a transaction
would be the aggregate amount of capital gain that the taxpayer would have had from an actual
ownership interest in the partnership during the period of the constructive ownership.
H. Precluding Taxpayers From Taking Tax Positions Inconsistent with the Form of Their
Transactions (Attachment H)
The Administration’s budget proposal also generally would preclude a corporate taxpayer from
taking any position (on a tax return) that the Federal income tax treatment of a transaction is different
from that dictated by its form if a “tax indifferent party” has a direct or indirect interest in such
transaction. A “tax indifferent party” would be defined to include a foreign person, a tax-exempt
organization and any domestic corporation with any loss or credit
carryforward that is more than three years old. The proposal would be effective for transactions entered
into on or after the date of first committee action.
The proposal would not apply (1) if the taxpayer discloses the inconsistent position on its timely-
filed Federal income tax return for the year in which the transaction was entered into; (2) to the extent
provided in regulations, if reporting the substance of the transaction more clearly reflects the taxpayer’s
income; or (3) to certain transactions (such as publicly-available securities lending and repurchase
agreement transactions) identified in regulations. Moreover, nothing in the proposal would prevent IRS
from asserting the substance-over-form doctrine or imposing any applicable penalties.
I. Straddle Rules (Attachment I)
The Administration’s budget proposal also would modify and clarify the straddle rules, effective
for straddles entered into on or after the date of enactment. First, the definition of personal property
(for straddle purposes) would be modified to include actively traded stock. Second, the proposal would
“clarify” that a taxpayer holding an appreciated position in personal property cannot recognize currently
any loss or deduct currently any expenses (including interest expenses) that are attributable to structured
financial transactions that include a leg of the straddle. The Treasury explanation provides the example
of a taxpayer holding an appreciated position in actively traded stock that enters into a prepaid or
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collateralized forward contract to sell the stock. Under the proposal, the taxpayer would be required to
capitalize all expenses associated with the forward contract.
Keith D. Lawson
Senior Counsel
Attachment
Note: Not all recipients of this memo will receive an attachment. If you wish to obtain a copy of the
attachment referred to in this memo, please call the Institute's Library Services Division at (202)326-
8304, and ask for this memo's attachment number: 10695.