DIFFERING VERSIONS OF TAX/BUDGET BILL APPROVED BY HOUSE AND SENATE

1 See Institute Memorandum to Tax Members No. 19-97, Accounting/Treasurers Members No. 20-97, International Committee No. 20-97, Operations Committee No. 16-97, Transfer Agent Advisory Committee No. 25-97, Closed-End Investment Company Committee No. 23-97 and Unit Investment Trust Committee No. 41-97, dated June 13, 1997. For a discussion of the pension-related provisions in the House Ways and Means Committee’s bill, see Institute Memorandum to Pension Members No. 23-97, Tax Members No. 20-97, Operations Committee No. 17-97, Transfer Agent Advisory Committee No. 26-97 and Pension Operations Advisory Committee No. 17-97, dated June 13, 1997. 2 See Institute Memorandum to Tax Members No. 23-97, Accounting/Treasurers Members No. 22-97, International Committee No. 23-97, Operations Committee No. 19-97, Transfer Agent Advisory Committee No. 29-97, Closed- End Investment Company Committee No. 24-97 and Unit Investment Trust Committee No. 42-97, dated June 20, 1997. For a discussion of the pension-related provisions in the Senate Finance Committee’s bill, see Institute Memorandum to Pension Members No. 24-97, Tax Members No. 22-97, Operations Committee No. 18-97, Pension Operations Advisory Committee No. 18-97 and Transfer Agent Advisory Committee No. 28-97, dated June 20, 1997. June 27, 1997 TO: TAX MEMBERS No. 24-97 ACCOUNTING/TREASURERS MEMBERS No. 23-97 INTERNATIONAL COMMITTEE No. 24-97 OPERATIONS COMMITTEE No. 20-97 TRANSFER AGENT ADVISORY COMMITTEE No. 30-97 CLOSED-END INVESTMENT COMPANY COMMITTEE No. 25-97 UNIT INVESTMENT TRUST COMMITTEE No. 45-97 RE: DIFFERING VERSIONS OF TAX/BUDGET BILL APPROVED BY HOUSE AND SENATE ______________________________________________________________________________ The US House of Representatives on June 26 approved, by a vote of 253-179, a bill including the tax portions of the recent budget agreement. For all purposes relevant to regulated investment companies ("RICs") and their shareholders, the House-passed bill is identical to the bill approved two weeks ago by the House Ways and Means Committee.1 Today, the US Senate approved, by a vote of 80-18, its version of the tax bill. None of the amendments adopted by the Senate during its floor debate modified the "tax" (as opposed to "pension") provisions approved last week by the Senate Finance Committee. 2 Differences between these two bills will be resolved during the House-Senate Conference scheduled to begin following Congress’ return from the July 4 recess. This memorandum describes the similarities and differences between the House and Senate bills. Copies of statutory provisions and/or committee report language for either bill may be obtained by calling the Institute’s Information Resource Center and asking for attachments to memo number 9018. I. Repeal of the 30 Percent Test -- (in both bills, with different effective dates) Both bills include the Institute’s number 1 tax legislative priority by proposing to repeal the 30 percent test of Internal Revenue Code ("Code") section 851(b)(3). The effective dates for repeal are different, however, in the two bills. The repeal provision would apply under the House bill to taxable years ending after date of enactment, rather than, as under the Senate bill, to taxable years beginning after December 31, 1997. II. Capital Gains Provisions 3 A RIC would be treated as owning its proportionate share of the assets of any partnership in which it invests. A separate "at risk" rule would provide that an asset (such as a RIC’s portfolio asset) would not be treated as an indexed asset for any period during which a taxpayer’s risk of loss on the asset had been substantially reduced. 4 Mark-to-market losses, however, could never be used to reduce a taxpayer’s tax liability. - 2 - A. Maximum Rate of Tax on Net Capital Gains of Individuals -- (in both bills) Under both bills, the maximum rate of tax on net capital gains realized by individuals would be reduced from 28 percent to 20 percent. Gains taxed under current law at a 15-percent rate would be taxed under the bills at a 10 percent rate. The 20-percent and 10-percent rates also would apply under the bills for alternative minimum tax purposes. These reduced maximum capital gains tax rates would apply to taxable years ending after May 6, 1997. For any taxable year that includes May 6, 1997, only the net capital gains attributable to gains or losses properly taken into account for the part of the year on or after May 7 would be entitled to the benefits of these new maximum rates. In applying the effective date rules to distributions from RICs and certain other pass-through entities, the determination of when gains and losses are properly taken into account would be made at the entity level. B. Alternative Tax on Net Capital Gains of Corporations -- (in House bill only) Under the House bill only, net capital gains on assets held by corporations for more than 8 years would be taxed under the bill at the following rates: 32 percent (for assets sold in 1998), 31 percent (for assets sold in 1999) and 30 percent (for assets sold after 1999). Special transition rules would apply to fiscal-year taxpayers for taxable years beginning in 1997, 1998 and 1999 to determine the appropriate 8-year gain for each period. For example, for taxable years ending in 1998, 8-year gain would not exceed the 8-year gain determined by taking into account only gains and losses properly taken into account for the portion of the taxable year after December 31, 1997. In applying the effective date rules to distributions from RICs and certain other pass-thru entities to corporate shareholders, the determination of when gains and losses are properly taken into account would be made at the entity level. C. Indexing Cost Basis For Inflation -- (in House bill only) Under the House bill only, individuals would be permitted, for purposes of calculating gain (but not loss), to increase or "index" for inflation the cost basis of certain assets acquired after December 31, 2000 and held for more than three years. For example, if an eligible asset were purchased on January 1, 2001 for $100 and held for 10 years, during which time inflation totaled 40 percent, the indexed basis of the asset would be $140. If the asset were sold at the end of 10 years for $200, the indexed gain would be $60 ($200 - $140), rather than $100 ($200-$100), as under present law. Similarly, under the "indexing cannot create a loss" rule, if the asset were sold for between $100 and $140, the taxpayer would report neither gain nor loss. Under the House bill, RICs would be permitted to index the cost basis of their indexing-eligible assets (e.g., common stock, generally, but not debt). Eligible RIC shareholders would index the cost basis of their RIC shares to the extent that the underlying RIC portfolio consisted of indexing-eligible assets.3 Specifically, RIC shares would be treated as an "indexed asset" eligible for indexing for any calendar quarter in the same ratio as the average value of the RIC’s indexed assets at the close of each month in the quarter bears to the average value of all of the RIC’s assets at the close of such months (the "indexed asset calculation"). Pursuant to a "safe harbor" suggested by the Institute, RIC shares would be treated as eligible for (i) 100 percent of any indexing adjustment for a particular quarter if at least 80 percent of the RIC’s assets (on average) were invested in indexed assets on the last day of each month in the quarter and (ii) no inflation adjustment for that quarter if 20 percent or less of the RIC’s assets (on average) were invested in indexed assets on the last day of each month in the quarter. A special mark-to-market transition rule would permit individuals who acquired assets such as RIC shares before 2001 to index them for inflation occurring after 2000 if they (i) marked them to market using January 1, 2001 values, (ii) included in income during 2001 any resulting mark-to-market gain4 and (iii) held the assets for at least three more years. This election would be made on an asset-by-asset basis. One significant effect of the House bill’s limitation of indexing benefits to individual shareholders would be to cause RICs with both corporate and individual shareholders to report different amounts of taxable income to each group, even though they would receive the same distributions. Under the House bill, RICs would be required to distribute to shareholders only the amount of gain that would be taxable to individual shareholders after application of the indexing adjustment. For example, if a RIC realized a $100 gain, $40 of which was attributable to inflation, the RIC would be required to distribute only $60 to shareholders. However, because corporate shareholders would not be entitled to the benefits of indexing, RICs would have to report as dividends to these shareholders their allocable share of both the amount distributed ($60) and the amount retained ($40), all of which would be taxable to these corporate shareholders. 5 The bills also would allow securities traders, commodities traders and commodities dealers to elect application of the mark-to-market rules of Code section 475 that apply presently only to securities dealers. - 3 - D. Qualified Small Business Stock -- (in Senate bill only) Under the Senate bill only, the 50 percent exclusion provided by Code section 1202 for gains realized by individuals upon the disposition of "qualified small business stock" held for more than 5 years would be modified in several respects. First, corporations as well as individuals would be eligible to claim the 50 percent exclusion. Second, the maximum size of a corporation eligible for qualified small business stock status would be doubled, from gross assets of $50 million to gross assets of $100 million. These two changes would be effective for stock issued after date of enactment. In two other proposed changes, both of which would be effective for stock issued after August 10, 1993 (the original effective date of the provision), (1) the present law limit on the amount of qualified small business stock gain realized by an individual that is eligible for the exclusion (the greater of ten times the taxpayer’s basis in the stock or $10 million) would be repealed and (2) a taxpayer would have 60 days following the sale or exchange of qualified small business stock to roll over the gain in a tax- free transaction to another investment in qualified small business stock. III. Passive Foreign Investment Companies ("PFICs") -- (in both bills) Under both bills, every taxpayer that holds shares of "marketable" passive foreign investment companies ("PFICs") would have an election to mark that stock to market at the close of the taxpayer’s fiscal year, for income tax purposes, but also at October 31, for purposes of the excise tax minimum distribution requirements of Code section 4982. The provision would be effective for taxable years of US persons beginning after December 31, 1997, and taxable years of foreign corporations ending with or within such taxable years of US persons. All PFIC stock held by open-end RICs (and by closed-end RICs, except as provided by regulation) would be treated as marketable stock. Once a taxpayer made a mark-to-market election with respect to a stock, the election would apply to that stock for all subsequent years, unless the IRS consented to a revocation of the election. Any PFIC mark-to-market gain would be treated as ordinary income. PFIC mark-to-market losses would be allowable as an ordinary loss to the extent of net mark-to-market gains previously included with respect to such stock. The bills also would provide that the nondeductible "interest charge" that otherwise would be imposed on a RIC that held PFIC stock prior to the provision’s effective date would not be imposed if the RIC had elected mark-to-market treatment (presumably under proposed regulations previously issued by IRS) for the prior taxable year. IV. Foreign Tax Credit Provisions A. Simplified Procedures for Claiming Foreign Tax Credits -- (in both bills) Both bills would simplify the procedures by which investors could claim credits for foreign taxes paid, including taxes deemed paid by RIC shareholders pursuant to Code section 853. Specifically, investors who pay (or are deemed to have paid) foreign taxes totaling less than $300 ($600 on a joint return) during a year, all of which are reported on IRS Forms 1099, would be permitted to claim credits against US tax for these amounts by reporting them directly on their IRS Form 1040 income tax returns, rather than first being required to complete a separate, detailed form (IRS Form 1116) used to establish eligibility for the credits. This provision would apply to taxable years beginning after December 31, 1997. B. Holding Period for Claiming Foreign Tax Credits -- (in both bills) Both bills generally would deny a credit for foreign tax paid by an investor with respect to any dividend -- paid or accrued more than 30 days after date of enactment -- unless the taxpayer held the stock (without protection from risk of loss) on the dividend entitlement date and for at least 14 additional days immediately before and/or thereafter. Any taxpayer who failed to satisfy this 15-day holding period requirement would be allowed a deduction equal to the amount of any foreign tax credits disallowed by operation of the holding period requirement. In the case of shareholders in RICs that have made the Code section 853 election to "flow through" to shareholders their payments of foreign taxes -- which then are deemed paid by the RIC shareholders -- this holding period requirement would apply in determining whether (1) the RIC held each of its foreign securities long enough to flow through "creditable" foreign taxes and (2) the RIC shareholder held his or her RIC shares long enough to claim the foreign taxes deemed paid under Code section 853. To meet this first holding period requirement, the bills would require that a RIC include, within its notice to shareholders regarding the amount of foreign taxes deemed paid by a RIC shareholder, notification of any amount of such taxes which would not be creditable because the RIC did not meet the new holding period requirement. V. Appreciated Positions in Personal Property A. Constructive Sale Treatment for Appreciated Financial Positions -- (in both bills) Both bills would require a taxpayer holding an "appreciated financial position," defined generally to include an appreciated position in any stock, debt instrument (other than "straight debt") or partnership interest, to recognize gain upon entering into a "constructive sale." Among other things, the term constructive sale would include (1) entering into a short sale of the same or substantially identical property, (2) entering into an offsetting notional principal contract with respect to the same or substantially identical property, (3) entering into a futures or forward contract to deliver the same or substantially identical property and (4) acquiring the same or substantially identical property where the appreciated financial position is a short sale, an offsetting notional principal contract or an offsetting futures or forward contract. A constructive sale, however, would not include any appreciated financial position that is marked to market, including transactions subject to the securities dealer mark-to-market rules of Code section 4755 and transactions subject to mark-to-market rules of Code section 1256. 6 Under present law, an investment company precluded from the nonrecognition of gain rules of Code sections 351 and 721 is defined, by Treas. Reg. section 1.351-1(c)(1), to include RICs, real estate investment trusts ("REITS") and any other corporation "more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations) are held for investment and are readily marketable stocks or securities, or interests in [RICs] or [REITs]." 7 For example, if one percent of a corporate taxpayer’s assets were tax-exempt bonds (and the bonds had an adjusted basis of, say, $20 million), one percent of the taxpayer’s interest expense would be disallowed. - 4 - A "closed transaction" exception from constructive sale treatment would be provided for any transaction that is closed before the end of the 30th day after the close of the taxable year in which it was entered into. This exception would not apply, however, where a transaction is closed during the last 60 days of the taxable year or within 30 days thereafter unless (1) the taxpayer holds the appreciated financial position to which the transaction relates throughout the 60-day period beginning on the date the transaction is closed and (2) at no time during such 60-day period is the taxpayer’s risk of loss reduced by holding positions with respect to substantially similar or related property. A taxpayer holding property subject to the constructive sale rule would be treated as having sold and immediately repurchased the appreciated property and would receive a new basis and holding period in the property. If a taxpayer entered into a constructive sale with respect to less than all of his or her appreciated positions in the property, the property deemed sold would be determined under the general rules governing actual sales. The bills’ constructive sale provision would be effective for constructive sales entered into after June 8, 1997. In the case of transactions entered into before this date, which otherwise would have been constructive sales under the proposal, the positions would not be taken into account in determining whether a constructive sale after June 8, 1997 has occurred, provided that the taxpayer identifies the offsetting positions of the earlier transaction within 30 days after date of enactment. B. Restrictions on Swap Funds -- (in both bills) Both bills would restrict the ability of investors to contribute appreciated assets on a tax-free basis to diversified investment pools known as "swap funds," effective for transfers after June 8, 1997 (unless the transfer is pursuant to a written binding contract in effect on that date). Under the bills, the definition of investment company -- contributions to which may generate capital gain6 -- would be expanded to include any company if more than 80 percent of the value of its assets are attributable to money, any financial instrument, any foreign currency, any interest in certain investment pools (including RICs and publicly- traded partnerships), certain other assets (whether or not actively traded or marketable) and any other asset specified in Treasury regulations. VI. Offshore Funds "Principal Office/Ten Commandments" Safe Harbor -- (in both bills) Both bills would eliminate the requirement, imposed by Code section 864(b) and the so-called "ten commandment" regulations of Treas. Reg. section 1.864-2(c)(2)(iii), that certain foreign persons (including certain offshore investment funds) trading US securities for their own account establish their "principal office" outside the US to avoid being treated as engaged in a US trade or business. This change would apply to taxable years beginning after December 31, 1997. VII. Extension of Pro Rata Disallowance of Tax-Exempt Interest Expense -- (in House bill only) Under the House bill only, all corporations (other than insurance companies) investing in tax-exempt obligations generally would be disallowed deductions for a portion of their interest expense equal to the portion of their total assets that is comprised of tax-exempt investments.7 Pursuant to a de minimis exception provided by the House bill, however, this disallowance rule would not apply to any corporation, other than a financial institution or dealer in tax-exempt obligations, if the average adjusted basis of tax-exempt obligations acquired by the corporation after August 7, 1986 is less than the lesser of $1 million or 2 percent of the basis of all of the corporation’s assets. The House bill’s disallowance rule would apply to taxable years beginning after the date of enactment with respect to obligations acquired after June 8, 1997. VIII. Dividends Received Deduction Holding Period Requirement -- (in both bills, with different effective dates) Both bills would make the dividends received deduction generally unavailable if the 46-day holding period for the stock (or the 91-day holding period for certain preferred stock) is not satisfied by the taxpayer (without protection from risk of loss) over a period immediately before or immediately after the taxpayer becomes entitled to the dividend. Under the House bill, this change generally would be effective for dividends paid or accrued after the 30th day after date of enactment. While the Senate bill has the same general effective date, a two-year transition rule would be provided for hedged positions entered into before June 9, 1997, so long as the taxpayer identifies and maintains the hedged position. IX. OID Where Pooled Debt Obligations Subject to Acceleration -- (in House bill only) Under the House bill only, the special rules for determining original issue discount ("OID"), applicable to any regular interest in a real estate mortgage investment conduit ("REMIC"), qualified mortgages held by a REMIC or certain other debt instruments, would be extended to any pool of debt instruments the payments on which may be accelerated by reason of prepayments. For example, a taxpayer holding a pool of credit card receivables that require interest to be paid if the borrowers do not pay their accounts by a specified date would be required by the House bill to accrue interest or OID on such pool based upon a reasonable assumption regarding the timing of the payments of the accounts in the pool. The proposal would be effective, in general, for taxable years beginning after date of enactment. - 5 - X. Publicly Traded Partnerships -- (in both bills, with different tax rate) Both bills would modify the treatment of so-called "grandfathered" publicly traded partnerships, which are to become taxable as corporations (rather than treated as partnerships) for taxable years beginning after December 31, 1997. Under the bills, any existing publicly traded partnership (other than one that receives this status under the passive-type income exception of Code section 7704(c)(1)) could elect to maintain its treatment as a partnership (rather than become taxable as a corporation) so long as it paid a tax based upon of its gross income from the active conduct of a trade or business (with no offset for tax credits). The applicable tax rate would be 15 percent under the House bill and 3.5 percent under the Senate bill. This proposal would be effective for taxable years beginning after December 31, 1997. XI. Gains and Losses from Certain Terminations -- (in both bills, with difference in effective dates) Both bills would modify the taxation of gains and losses attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to certain personal property. First, the rule in Code section 1234A -- that treats as capital (rather than ordinary) the gain or loss from the extinguishment of certain rights or obligations -- would be extended by the bills to all types of property, effective for property acquired or positions established more than 30 days after date of enactment. Second, the bills would treat as capital (rather than ordinary) the gain or loss from the retirement of debt obligations issued by natural persons, generally effective for debt issued or purchased after June 8, 1997 (under the Senate bill) or more than 30 days after date of enactment (under the House bill). XII. Delay in Imposition of Penalties for Failure to Make Payments Electronically -- (in both bills, with difference in length of penalty moratorium) Under both bills, employers and payors who, on or after July 1, 1997, become subject to the requirement to remit withholding taxes (including backup withholding) electronically using the Electronic Federal Tax Payment System (or "EFTPS") would not be penalized merely for a failure, during a specified period beginning July 1, 1997, to make them using EFTPS. The penalty moratorium would expire under the Senate bill on June 30, 1998 and on December 31, 1998 under the House bill. 8 See Institute Memoranda to Closed-End Investment Company Committee No. 3-97, Operations Members No. 6-97, Pension Members No. 7-97, Pension Operations Advisory Committee No. 4-97, Tax Members No. 7-97, Transfer Agent Advisory Committee No. 8-97, Unit Investment Trust Committee No. 9-97 and Accounting/ Treasurers Members No. 7-97, dated February 12, 1997; and to Tax Committee No. 12-97, dated April 1, 1997. 9 Id. 10 See, e.g., Institute Memorandum to International Members No. 9-97 and Tax Members No. 18-97, dated June 9, 1997. - 6 - XIII. Provisions NOT in Either House or Senate Bill A. Mandatory Use of the Average Cost Basis Method by All Securities Sellers Neither the Senate nor the House bill includes the Treasury Department proposal, strongly opposed by the Institute, to require that all securities sellers compute cost basis using the average cost method. 8 B. Increased Penalties for Failure to File Correct Information Returns Neither bill includes the Treasury Department proposal, opposed by the Institute, 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 5 percent of the aggregate amount required to be reported correctly (subject, in general, to a $250,000 cap).9 C. Flow Through of Interest and Short-Term Capital Gains to Foreign Investors Neither bill includes the proposal, included in recent "international tax simplification" and "investment competitiveness" bills, to permit the character of US-source interest income and short-term capital gains to flow through a RIC to foreign shareholders. 10 The Institute supports this "flow through" legislation because it would eliminate a US tax barrier that effectively encourages foreign investors to invest in US securities either directly or through foreign, rather than US, funds. * * * We will keep you informed of developments. Keith D. Lawson Associate Counsel - Tax