[17628]
June 4, 2004
TO: TAX MEMBERS No. 29-04
ADVISER DISTRIBUTOR TAX ISSUES TASK FORCE No. 6-04
RE: SENATE PASSES ETI LEGISLATION WITH EXTENSIVE TAX PROVISIONS
The Senate has passed S.1637, the “Jumpstart Our Business Strength (“JOBS”) Act.”1
This legislation is intended to comply with the ruling of the World Trade Organization
(“WTO”) that the extraterritorial income (“ETI”) regime is inconsistent with our obligations
under the General Agreement on Tariffs and Trade.
In addition to the provisions making changes to certain aspects of the US international
tax rules, S.1637 includes a number of other tax provisions that may be of interest to Institute
members.2 Legislation to comply with the WTO ruling (H.R. 4520, “the American Jobs Creation
Act”) was introduced in the House of Representatives today and may be considered by the
House Ways and Means Committee and the full House this month.
1. Election to Use Spot Exchange Rate for Foreign Taxes Paid
Section 224 of the bill would amend section 986(a) of the Internal Revenue Code (the
“Code”) to permit taxpayers to elect not to use the average exchange rate for the year in
translating foreign taxes paid into dollars to determine the foreign tax credit available. Under
the provision, regulated investment companies (“RICs”) could use the spot exchange rate at the
time the tax was paid for purposes of calculating foreign tax credits. The election to use spot
rates would apply for all taxable years, and could not be revoked except with permission of the
Treasury.
The effective date of this provision would be tax years beginning on or after January 1,
2005.
1 The full text of S.1637 as passed by the Senate can be found through the Library of Congress’ online legislative
service at http://thomas.loc.gov.
2 Several of these provisions were passed by the Senate earlier this year in unrelated legislation. See Institute
Memorandum to Tax Members No. 17-04, and to Adviser Distributor Tax Issues Task Force No. 4-04 [17184], dated
March 23, 2004.
2
2. Denial of Deduction for Certain Penalties
Section 423 of the bill would amend section 162(f) of the Code regarding the
deductibility of fines, penalties and other amounts. Currently section 162(f) denies a tax
deduction only for a “fine or similar penalty paid to a government.” Section 423 would expand
this provision to deny a deduction for “any amount paid . . . to, or at the direction of, a
government or [certain self-regulatory organizations] in relation to the violation of any law or
the investigation or inquiry . . . into the potential violation of any law.”
However, the provision expressly provides for the deductibility of any payment “which
the taxpayer establishes constitutes restitution . . . for damage or harm caused by or which may
be caused by the violation of any law or the potential violation of any law” (but not including
any amounts paid as reimbursement for the costs of investigation or litigation). The provision
also does not deny deductibility for payments made pursuant to a court order where no
government or relevant SRO is a party to the action.
The provision would be effective for payments made after April 27, 2003, except it
would not apply to any payments made pursuant to a binding order or agreement entered into
before April 27, 2003.3
3. Distributions From Publicly-Traded Partnerships
Section 899 of the bill would amend section 851(b)(2) of the Code to provide that
distributions or other income derived from a “qualified publicly-traded partnership” (“QPTP”)
constitute “good income” for Subchapter M RIC qualification test purposes without looking-
through the partnership to determine the income’s source. The provision also would amend the
asset test of Section 851(b)(3) to include equities issued by a QPTP within the term “outstanding
voting securities,” and to limit a RIC to investing no more than 25 percent of its total assets in
the securities of one or more QPTPs.
A QPTP would be defined as a publicly-traded partnership under section 7704(b), but
would not include a partnership if 90 percent or more of its gross income would be “good
income” within the meaning of current section 851(b)(2).
The provision also would make RICs subject to the passive activity loss rules of section
469 separately with respect to losses attributable to each investment in a publicly-traded
partnership. The provision would take effect for taxable years beginning after the date of
enactment.
4. Straddles
Section 464 of the bill would make several changes to the rules governing straddles.
First, this provision would enact new rules for identified straddles. Under the bill, a taxpayer
who identifies a straddle at the time the straddle is created, and realizes a loss on one leg of the
straddle, would increase its basis in the remaining leg of the identified straddle by the amount
of the loss, rather than deferring the loss to the extent of unrealized gain.
3 An agreement subject to court approval is not considered binding for these purposes unless court approval was
obtained on or before April 27, 2003.
3
Example. A taxpayer owns 100 shares of C Corp. with a basis of $75 per share
and a fair market value of $100 per share, and purchases a put with a strike price
of $90 on 100 shares for $500. The put expires unexercised. If the taxpayer had
identified the straddle at the time the put was purchased, then the taxpayer
would increase its basis in the shares to $80 a share ($500 loss spread over 100
shares).
Second, the bill would repeal the stock exception (section 1092(d)(3)) to the straddle
rules, and would also repeal Treasury’s authority to apply the qualified covered call exception
(section 1092(c)(4)) to over-the-counter options. In addition, the bill would amend Section
246(c) to suspend holding periods for stock when a taxpayer writes an “in the money” qualified
covered call (i.e., with a strike price below the stock price) on substantially identical stock or
securities.
Finally, the bill would enact a new rule for certain physically-settled positions. If a
taxpayer would incur a loss by terminating a position in a straddle, and instead settles the
position by delivering property, the taxpayer would be treated as having engaged in two
transactions: 1) terminating the straddle position at fair market value, and 2) selling at fair
market value the property used to settle the position.
These amendments would take effect for positions established on or after the date of
enactment of the legislation.
5. Holding Period for QDI on Preferred Stock
Section 496 of the bill would extend the holding period requirement for shareholders to
treat dividend income on preferred stock as qualified dividend income (“QDI”) from 90 days
out of the 180-day period surrounding the ex-dividend date to 120 days out the 240-day period
surrounding the ex-dividend date.4
This provision would be effective for taxable years beginning after enactment of the
legislation.
6. Minimum Holding Period for Foreign Tax Credits on Income Other Than
Dividends
Section 456 of the bill would amend section 901 of the Code to establish a new holding
period requirement to be eligible for foreign tax credits attributable to withholding tax on
income other than dividends. Under the provision, in order to be entitled to a tax credit for a
foreign withholding tax, a taxpayer would be required to hold the relevant property for more
than 15 days during the 30 day period that begins 15 days before the date on which the right to
receive the payment arises.
4 The provision does not reflect the provision of the pending technical correction legislation that would change the
interval over which holding periods are tested to 121 days for common stock and 181 (or 241) days for preferred
stock.
4
In addition, a taxpayer would not be entitled to a foreign tax credit to the extent that it is
obligated to make related payments with respect to positions in substantially similar or related
property, and certain rules similar to the existing rules under section 901(k) would apply.
The provision would be effective for amounts paid or accrued more than 30 days after
enactment of the legislation.
7. CEO Declaration Regarding Corporate Tax Return Accuracy
Section 422 of the bill would require every tax return filed by a corporation to include a
declaration by the chief executive officer (CEO) under penalties of perjury that the corporation
has policies and procedures to ensure the accuracy of the return, and the CEO has received
reasonable assurances as to the accuracy of all material aspects of the return. This provision
would not apply to RICs.
This provision would be effective for returns filed with respect to income for tax years
ending after the date of enactment of the legislation.
8. Tax Shelters
There are several provisions in the bill relating to abusive tax shelters. Section 402 of the
bill would impose a penalty of $50,000 for failing to disclose a reportable transaction and
$100,000 for failure to disclose a listed transaction.5 These penalties would be doubled for large
entities and high net worth individuals.6 The Commissioner would have the authority to
rescind these penalties under certain circumstances, and must keep a record of any rescissions
granted. A taxpayer that is required to file periodic reports under section 13 or 15(d) of the
Securities Exchange Act of 1934 would report under these rules any penalty imposed for (1)
failing to disclose a reportable transaction, (2) a substantial understatement of tax attributable to
a reportable transaction or (3) a substantial understatement of tax attributable to a transaction
that lacks economic substance. A failure to report the imposition of any of these penalties to the
SEC could subject the taxpayer to additional penalties for failing to disclose a reportable
transaction.
If a taxpayer has a reportable transaction understatement for any taxable year, section
403 of the bill would impose an additional tax equal to 20 percent of the amount of the
understatement. This additional tax generally applies to any listed transaction and any
reportable transaction if a significant purpose of the transaction is the avoidance or evasion of
Federal income tax. A higher additional tax of 30 percent of the understatement is imposed if
the taxpayer fails to disclose the listed or reportable transaction. The bill also addresses special
5 As suggested by the Institute, RICs are excluded from every reportable transaction category except for listed
transactions. See Institute Memorandum to 529 Plan Advisory Committee No. 14-03, Accounting/Treasurers
Members No. 13-03, Advisor Distributor Tax Issues Task Force No. 5-03, Tax Members No. 15-03 and Unit
Investment Trust Members No. 9-03 (No. 15707), dated March 7, 2003.
6 A “large entity” means, with respect to any taxable year, a person (other than a natural person), with gross receipts
in excess of $10,000,000 for the taxable year in which the reportable transaction occurs or the preceding taxable year.
“High net worth individual” means, with respect to a reportable transaction, a natural person whose net worth
exceeds $2,000,000 immediately before the transaction.”
5
rules for (1) coordination of this substantial understatement penalty with other penalties,
including penalties on other understatements, (2) amended returns and (3) administrative
review. This substantial understatement penalty would not be imposed if the taxpayer shows
that there was reasonable cause (as described in the bill and subject to certain qualifications) for
the understatement and the taxpayer acted in good faith.
Under section 404 of the bill, if a taxpayer has a non-economic substance transaction
understatement (as defined in the bill) for any taxable year, the taxpayer would be subject to a
penalty equal to 40 percent of the amount of the understatement.7 This penalty would be
reduced to 20% in situations where the taxpayer has adequately disclosed relevant facts
affecting the tax treatment of the item on a tax return.
Section 406 of the bill would provide for a tax shelter exception to confidentiality
privileges relating to taxpayer communications. The privilege would not apply to
communications involving a federally authorized tax practitioner in connection with the
promotion of direct or indirect participation in a tax shelter.
The bill includes a number of provisions that would be applicable to material advisors,8
which would not affect RICs, but might affect management companies in some circumstances.
Section 407 would require material advisors to file a return setting forth (1) information
identifying and describing the reportable transaction, (2) information describing any potential
tax benefits expected to result from the transaction and (3) any other information required by
the Secretary. Material advisors also would keep lists of their advisees and furnish these lists to
the Secretary upon request.
Section 408 of the bill would modify the penalty provisions applicable to tax shelters. If
a material advisor fails to file a return or files a false return with respect to a reportable
transaction, a penalty of $50,000 for any failure is imposed. The penalty imposed on material
advisors for failure to file a return or for filing a false return with respect to any listed
transaction would be the greater of $200,000 or 50 percent (75 percent in the case of an
intentional failure or act) of the gross income derived by such person with respect to aid,
assistance, or advice provided with respect to the listed transaction before the date the return
including the transaction is filed. The Commissioner would have the authority to rescind this
penalty under rules similar to the penalty rescission rules applicable to failures to disclose
reportable transactions.
7 As defined in sec. 401 of the bill, a transaction has economic substance if “(I) the transaction changes in a
meaningful way (apart from Federal tax effects) the taxpayer’s economic position, and (II) the taxpayer has a
substantial non-tax purpose for entering into such transaction and the transaction is a reasonable means of
accomplishing such purpose.” The bill’s definition includes special rules for situations where the taxpayer relies on
economic substance by reason of having profit potential and transactions involving tax-indifferent parties, i.e.,
entities not subject to Federal income tax.
8 A material advisor means any person who provides any material aid, assistance, or advice with respect to
organizing, managing, promoting, selling, implementing, or carrying out any reportable transaction and who directly
or indirectly derives gross income in excess of the threshold amount for such aid, assistance, or advice. The threshold
amount is equal to $50,000 in the case of a reportable transaction where substantially all of the tax benefits are
provided to a natural person, and $250,000 in all other cases.
6
Section 409 of the bill would provide that, if a material advisor fails to provide the
Secretary with a list of advisees within 20 business days after the date of the Secretary’s written
request, such person will be subject to a penalty of $10,000 for each day of such failure. No
penalty would be imposed if there is a reasonable cause for the failure to provide the list.
The bill’s tax shelter provisions generally would be applicable to transactions in taxable
years beginning after the date of enactment.
9. Miscellaneous Provisions
In addition to the provisions highlighted above, there are a number of other provisions
that may be of interest to members. These provisions include:
Section 221 would repeal Sections 551 through 558, relating to foreign personal holding
companies, and Sections 1246 and 1247, relating to foreign investment companies, and make
certain related and conforming amendments;
Section 225 would amend section 904(d)(2) of the Code to allow taxpayers to elect to
treat tax imposed on amounts that do not constitute income for US tax purposes as tax imposed
on income;
Section 308 would amend section 541 of the Code to suspend the personal holding
company tax for any year in which current section 1(h)(11) is in effect;
Section 433 would repeal sections 860H through 860L of the Code, relating to financial
asset securitization trusts (“FASITs”), and make certain additional conforming amendments;
Section 441 would establish new rules (section 7874 of the Code) for treating certain
foreign corporations as inverted domestic corporations; as requested by the Institute, a special
transition rule for RICs would apply to acquisitions completed between March 20, 2002 and
January 1, 2004;
Section 461 would grant Treasury authority to promulgate regulations to apply the rules
of Code sections 1286 and 305(e) (relating to stripped bonds and preferred stock) to accounts or
entities substantially all of the assets of which are bonds, preferred stock, or both;
Section 474 would amend section 195(b), section 248(a), and section 709(b) (which relate
to start-up expenditures of an active trade or business, organizational expenditures of a
corporation, and organizational expenditures of a partnership, respectively), to provide that no
more than $5,000 of start-up or organizational expenditures can be deducted in the first year of
a new business,9 with the remaining organizational expenditures deducted ratably over fifteen
years, rather than five years;
Section 661 would amend section 1(h)(5) of the Code to tax bullion at regular capital
gain rates, rather than as collectibles; and
9 The amount that can be deducted in the first year is the lesser of actual expenses or $5,000, reduced (but not below
zero) by expenditures in excess of $50,000.
7
Section 733 would amend Section 1275(d) of the Code to require the regulations dealing
with contingent payment debt instruments to provide that the comparable yield on a contingent
convertible debt instrument is determined by reference to a noncontingent convertible debt
instrument, rather than a noncontingent debt instrument that is not convertible.
David Orlin Lisa Robinson
Assistant Counsel Assistant Counsel