11 The bill, H.R. 4210, is titled the "Tax Fairness and
Economic Growth Act of 1992."
22 The IRA withdrawal and pension simplification provisions are
discussed separately in Institute Memorandum to Pension Members
No. 3-92, dated February 27, 1992.
March 2, 1992
TO: TAX MEMBERS NO. 12-92
CLOSED-END FUND MEMBERS NO. 10-92
UNIT INVESTMENT TRUST MEMBERS NO. 14-92
ACCOUNTING/TREASURERS MEMBERS NO. 8-92
OPERATIONS MEMBERS NO. 8-92
INTERNATIONAL COMMITTEE NO. 4-92
TRANSFER AGENT ADVISORY COMMITTEE NO. 11-92
RE: HOUSE APPROVES TAX FAIRNESS AND ECONOMIC GROWTH ACT OF 1992
__________________________________________________________
The House of Representatives has approved, by a vote of
221-209, major tax legislation11 that would have a significant
impact on investment companies. Among the provisions of interest
to investment companies are those relating to tax simplification
for investment companies (e.g., repeal of the Code section
851(b)(3) "30 percent test" and the requirement on mutual funds
to report shareholder basis), modified taxation of capital gains
(e.g., indexing the basis of capital assets for inflation),
foreign tax simplification (e.g., passive foreign corporation
"anti-deferral" rules and simplification of the foreign tax
credit limitation), amortization of intangibles, penalty-free
withdrawals from individual retirement accounts ("IRAs"), pension
simplification22 and the amended "Taxpayer Bill of Rights".
The following is a summary of the provisions of the bill
which affect regulated investment companies ("RICs") and their
shareholders. The relevant portions of the bill and the
Technical Explanation are attached.
I. The Mutual Fund Tax Simplification Bill
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The House-passed bill contains two provisions (repeal of
the 30 percent test and the requirement that mutual funds report
average cost basis information to certain shareholders) that were
part of the mutual fund tax simplification bill introduced in
June 1991 by House Ways and Means Committee Chairman
Rostenkowski, Congressman Archer, the ranking minority member on
the Committee, and others. (See Institute Memorandum to Tax
Committee No. 20-91, Operations Committee No. 21-91,
Accounting/Treasurers Committee No. 14-91 and Transfer Agent
Advisory Committee No. 31-91, dated June 25, 1991). The section
of the mutual fund tax simplification bill which provided that
expense reimbursements would be disregarded for purposes of the
qualifying income test of Code section 851(b)(2) is not included
in the 1992 tax bill. However, the House-passed bill does
contain a provision which would permit tax-free conversions of
bank common trust funds into RICs that was not part of the mutual
fund tax simplification bill, but was included in a financial
services reform bill that likewise was not enacted last year.
A. Repeal of the 30 Percent Test (Attachment A)
The House-passed bill would repeal the 30 percent test of
Code section 851(b)(3) for taxable years ending after the bill's
date of enactment.
B. Shareholder Basis Reporting (Attachment B)
The bill would amend the reporting requirements of Code
section 6045 to impose upon mutual funds and brokers, which are
presently required to report gross proceeds on sales or exchanges
of mutual fund shares, the obligation to provide to shareholders
and the Internal Revenue Service ("IRS") average cost basis
information for shares redeemed. Consistent with the current
reporting requirements of Code section 6045, basis information
would be provided to shareholders by January 31, and to the IRS
by February 28, of the year following the year of redemption.
This reporting requirement would apply, however, only to accounts
opened on or after January 1, 1994.
The average cost information would be provided using the
"single-category" method, which computes the average cost for all
of the taxpayer's shares and then determines the holding period
of shares sold on a first-in, first-out basis. Regulatory
authority is provided to determine the manner in which basis and
holding periods would be reported. Such authority would include
the authority to require funds and brokers to take into account
wash sales, return of capital distributions and other events that
might affect a basis calculation.
All basis calculations would be done on an account-by-
account basis. Funds and brokers would not be required to
provide average cost information for any account that contains
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shares acquired other than by purchase (such as by gift or
inheritance). Any broker that holds fund shares as a nominee for
another person and transfers the shares to another broker would,
however, be required to provide cost basis information to the
second broker.
The cost basis provisions of Code section 1012 would be
amended to require fund shareholders to use the cost basis
information provided in calculating gain or loss on the sale of
fund shares, unless the shareholder elected in the year of the
first redemption from the account to use another cost basis
method (either first-in, first-out or specific identification).
Under the bill, shareholders could elect different cost basis
methods for different accounts in the same fund.
Special rules are also provided regarding the information
reporting penalty provisions of Code sections 6721 through 6724.
First, the bill provides that the amount "required to be
reported" for purposes of determining the penalty for intentional
disregard of reporting requirements would be computed without
regard to basis amounts reported. Second, the explanation of
provisions contemplates that amended basis reports may be
necessary in certain cases, such as certain wash sales.
C. Tax-Free Conversions of Bank Common Trust Funds
(Attachment C)
The 1992 tax bill would generally permit a bank common
trust fund with diversified assets to transfer its assets to a
RIC in a tax-free conversion. The transfer must be solely in
exchange for RIC shares which must then be distributed to the
fund's participants (also tax-free) in exchange for the
participants' interests in the fund. The basis of the RIC's
assets will be the same as the common trust fund's basis in its
assets. The RIC shareholders' basis in their RIC shares will be
the same as the basis in their common trust fund interests.
II. Modified Taxation of Capital Gains
A. Indexing (Attachment D)
The bill would permit taxpayers other than corporations to
index the basis of certain assets acquired on or after February
1, 1992. In the case of RIC investments, indexing adjustments
could be made at both the RIC level and the shareholder level.
In most respects, the indexing provisions in the 1992 House-
passed bill are comparable to the indexing provisions contained
in the bill that passed the House in 1989. (See Institute
Memorandum to Tax Members No. 32-89, Closed-End Fund Members No.
43-89, Unit Investment Trust Members No. 49-89,
Accounting/Treasurers Committee No. 38-89, Operations Committee
No. 17-89 and Transfer Agent Advisory Committee No. 24-89, dated
September 27, 1989.)
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1. Indexing in General
The bill would provide that for purposes of determining
gain (but not loss) on the sale or disposition by a taxpayer
other than a corporation of an "indexed asset" which was held for
more than one year, the indexed basis of the asset would be
substituted for its adjusted basis.
The term "indexed asset" would be defined generally as any
stock in a corporation and any tangible property which was a
capital asset or used in a trade or business and was acquired on
or after February 1, 1992. The term "indexed asset" would not
include, among other things, debt, collectibles, options, and
stock in a foreign corporation (unless, in general, that stock
was regularly traded on a U.S. national or regional exchange).
Any taxpayer holding a readily tradable security acquired
prior to February 1, 1992 who desired to index the security for
future inflation could elect to mark the asset to market as of
February 1, 1992. Gain on any security for which the mark-to-
market election had been made would be taxable, while loss on any
security for which the election had been made would be
disallowed.
The indexed basis for any asset would be the asset's
adjusted basis multiplied by the "applicable inflation ratio."
To compute the applicable inflation ratio, the consumer price
index ("CPI") for the calendar year preceding the calendar year
in which the disposition took place would be divided by the CPI
for the calendar year preceding the calendar year in which the
taxpayer's holding period for such asset began. The applicable
inflation ratio would be disregarded if it were less than 1.
A "convention" would be provided in the bill whereby all
assets disposed of during a calendar year would be treated as
disposed of on the last day of that year. Under this convention,
to the extent that the date of disposition was moved forward, the
date of acquisition would correspondingly be moved forward. For
example, if an asset were acquired on October 1, 1992 and sold 33
months later on June 30, 1995, under the convention the asset
would be treated as sold on December 31, 1995 and acquired on
April 1, 1993 (i.e., 33 months prior to the deemed disposition
date). Consequently, indexing would be permitted to the extent
that the CPI increased from 1992 (the calendar year preceding the
year of the deemed acquisition) to 1994 (the calendar year
preceding the year of the deemed disposition).
The bill also would provide two special short sale rules.
First, if an indexed asset were sold short and the sale was not
closed for more than one year, the amount realized would be
increased by the applicable inflation ratio. Second, if a
taxpayer sold short property substantially identical to an asset
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held by the taxpayer, neither the asset held by the taxpayer nor
the substantially identical property would be treated as an
indexed asset during the short sale period.
2. Special Indexing Rules for RICs and Their
Shareholders
For RIC investments, indexing would generally apply at both
the RIC level and at the RIC shareholder level. A RIC would be
permitted to index its basis in all indexed assets. Indexing
would apply in the computation of both the RIC's taxable income
and its earnings and profits. Thus, a RIC would be required
generally to distribute to its shareholders only its gains after
indexing. Indexing would not apply, however, in computing income
for purposes of the RIC qualification test (e.g., sections
851(b)(2) and (b)(3)). In addition, to the extent that a RIC
retained capital gains that were not designated pursuant to
section 852(b)(3)(D), the corporate level tax imposed under
section 852(b)(3)(A) would be increased to eliminate the benefit
of the indexing adjustment.
Because a RIC's corporate shareholders would not be
eligible for indexing, the bill would effectively treat these
shareholders as having received distributions equal to what they
would have received had indexing adjustments not been made at the
RIC level.
A RIC's non-corporate shareholders would be permitted in
general to index their RIC stock for any calendar month in the
same ratio as the fair market value of the indexed assets held by
the RIC at the close of such month bore to the fair market value
of all of the RIC's assets at the close of such month. Under
safe harbors in the bill, the ratio for any month would be deemed
to be 100 percent if the actual ratio for the calendar month were
90 percent or more. Conversely, if the ratio for any calendar
month were 10 percent or less, the ratio for such month would be
zero.
B. Capital Gains Exclusion on Certain Small Business
Stock (Attachment E)
The bill provides a 50 percent exclusion from tax for
capital gains realized upon the disposition of qualified small
business stock acquired by the taxpayer at its original issuance,
on or after February 1, 1992, and held for more than five years.
A qualified small business would be defined as a domestic
corporation with an aggregate capitalization of not more than
$100 million that is engaged in an active trade or business and
that employs substantially all of its assets in the active
conduct of a trade or business. Neither RICs nor corporations
with more than 10 percent of their assets in portfolio stock
investments could be treated as qualified small businesses.
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RIC shareholders would be eligible to claim the 50 percent
exclusion for gains on the sale of qualified small business stock
originally issued to the RIC if the RIC held the stock for more
than five years and the shareholder held the RIC stock on which
the capital gain dividend was paid from the date the RIC acquired
the qualified small business stock through the date the qualified
small business stock was sold.
III. Foreign Investment Provisions
The bill contains provisions relating to foreign investment
that are substantially similar to provisions of the "Tax
Simplification Act of 1991" and of interest to RICs and their
shareholders. (See Institute Memorandum to Tax Members No. 23-
91, Closed-End Fund Members No. 27-91, International Committee
No. 11-91 and Accounting/Treasurers Committee No. 16-91, dated
July 1, 1991.)
A. Passive Foreign Corporations (Attachment F)
The bill creates a new definition, the passive foreign
corporation or "PFC", which replaces, among other definitions,
the definition of a PFIC. A PFC is any foreign corporation if
(1) 60 percent or more of its gross income is passive income
(compared to a 75 percent requirement under the current PFIC
definition), (2) 50 percent or more of its assets by value
(measured on average over the year) produce or are held for the
production of passive income, or (3) it is registered under the
Investment Company Act of 1940 as either a management company or
a unit investment trust. Under a new election, PFCs which meet
certain requirements can elect to be treated as foreign
corporations.
The bill adds a mark-to-market system of taxation of PFICs
to the two existing tax regimes for PFICs, current inclusion
under the qualified electing fund or "QEF" rules and the deferred
interest charge method. As proposed, QEF rules will be available
to any U.S. person owning less than 25 percent of the stock of a
PFC that is not U.S. controlled (U.S. control is generally
defined as five or fewer U.S. persons owning more than 50 percent
of the PFC stock).
Shareholders not electing QEF treatment are subject to one
of two methods for taxing the economic equivalent of the PFC's
current income. Under the bill, the mark-to-market system will
be mandatory for all taxpayers holding marketable PFC stock. For
these purposes, all PFCs held by open-end registered investment
companies will be considered marketable, as will such stock held
by a closed-end fund, unless the Internal Revenue Service
promulgates regulations which disallow such treatment for closed-
end funds.
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Gains on PFIC stock will be recognized in full as ordinary
gain. Mark-to-market losses will be ordinary to the extent of
prior net gains, referred to in the bill as "unreversed
inclusions". Mark-to-market losses in excess of unreversed
inclusions will be suspended (i.e., no basis adjustment is made
in that year and no loss is recognized). In addition, upon
actual disposition, loss will be treated as ordinary to the
extent of unreversed inclusions. However, losses in excess of
unreversed inclusions will be treated as capital losses upon
disposition.
RICs which hold PFIC stock on the first day of the RIC's
first taxable year beginning after December 31, 1992, will not be
subject to tax on any gain, but will be required to pay a non-
deductible interest charge in an amount equal to the interest
which would be owed if the deferred interest charge method
applied. The mark-to-market rules would then apply from that
point forward.
Under special RIC rules, mark-to-market gain is treated as
a dividend for purposes of the 90 percent test of Code section
851(b)(2) and the 30 percent limitation of section 851(b)(3).
This provision of the bill would be generally effective for
taxable years of U.S. persons beginning after December 31, 1992,
and taxable years of foreign corporations ending with or within
such taxable years of U.S. persons.
B. Foreign Tax Credit Limitation (Attachment G)
Consistent with the Institute's prior requests, the bill
would allow individuals with no more than $200 of foreign taxes
which can be claimed as a credit and with no foreign source
income other than passive income (i.e., dividends, interest,
etc.) to elect a simplified foreign tax credit limitation equal
to the lesser of the actual foreign taxes paid or 25 percent of
the individual's foreign source income. (See Institute
Memorandum to Tax Committee No. 2-91, dated January 30, 1991.)
The explanation to the bill specifically states that a Form 1116,
the individual foreign tax credit reporting form, should not be
required. The simplified limitation will only be available to
persons who receive a payee statement, such as a Form 1099, with
the amount of the foreign taxes reported on the form.
This provision would apply to taxable years beginning after
December 31, 1991.
IV. Amortization of Intangible Assets (Attachment H)
The House-passed bill also contains a provision similar to
that introduced by Chairman Rostenkowski of the House Ways and
Means Committee to require that the purchase price for certain
intangible assets acquired from another party be amortized over a
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uniform 14-year period. (See Institute Memorandum to Members -
One Per Complex No. 32-91, Tax Members No. 32-91 and
Accounting/Treasurers Members No. 20-91, dated July 31, 1991.)
Like the original Rostenkowski bill, the House-passed bill does
not change the tax treatment of costs incurred in the creation of
intangible assets by a taxpayer, such as advertising expenses.
Among the acquired intangible assets subject to the 14-year
amortization period proposed under the bill are goodwill, going
concern value and various customer-based intangibles, such as
investment management contracts. The acquisition costs for some
of these assets are not currently amortizable. Where
amortization is permitted under current law, the amortization
period is based on a factual determination of the asset's useful
life and can, therefore, become a subject of dispute between
taxpayers and the IRS.
The bill would generally apply prospectively, to intangible
assets acquired after the date of the bill's enactment. However,
taxpayers could elect to apply the rules to either (1) all
property acquired after July 25, 1991 or (2) all property
acquired in certain taxable years for which the statute of
limitations has not expired. The amortization period would be 14
years if the first election were made and 17 years (beginning
with the month that the intangible asset was acquired) if the
second election were made. In addition, a taxpayer could elect
to apply present law (rather than the bill) to property acquired
after date of enactment pursuant to a binding written contract in
effect on February 14, 1992.
V. Taxpayer Bill of Rights Amendments (Attachment I)
One provision in the Taxpayer Bill of Rights would require
payors such as funds to include their telephone numbers on
information returns sent to taxpayers. This provision would
apply to statements required to be furnished after December 31,
1992.
VI. Penalties for Failure to Provide Reports Relating to
Pension Payments (Attachment J)
The bill would conform the information reporting penalties
that apply with respect to pension payments to the general
information reporting penalty structure by incorporating into the
general penalty structure the penalties for failure to provide
information reports relating to pension payments to the IRS and
to recipients. This provision would apply to returns and
statements the due date for which is after December 31, 1992.
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* * *
We will keep you informed of developments concerning this
legislation.
Keith D. Lawson
Associate Counsel - Tax
Attachments
KDL:bmb