The Tax Fairness Act of 1997 offers major opportunities to improve the tax system: July 11, 1997.

On July 11, 1997, Tax Executives Institute submitted the following comments to the House-Senate conferees on H.R. 2014, The Tax Fairness Act of 1997, as well as key officials of the Clinton Administration. Please note: H.R. 2014 was restyled "The Taxpayer Relief Act of 1997" prior to final passage by Congress. TEI's submission, which was prepared with assistance from TEI's Federal, International, and IRS Administrative Affairs Committees, was signed by the Institute's 1996-1997 President, James R. Murray of PacifiCorp.

Tax Executives Institute is the principal association of corporate tax executives in North America. The Institute's 5,000 professionals manage the tax affairs of the leading 2,800 companies in the United States and Canada, and must contend daily with both the planning and compliance aspects of our Nation's business tax laws. TEI is firmly committed to maintaining and improving a tax system that works -- one that effectively implements sound tax policy, that is administrable by the Internal Revenue Service, and that does not impose undue compliance or recordkeeping burdens on taxpayers.

TEI applauds the efforts of Congress and the Clinton Administration to craft meaningful tax reduction and to do so in a manner that enhances, rather than impedes, the U.S. economy. We believe H.R. 2014, the Tax Fairness Act of 1997, holds much promise, though we are concerned that many of the bill's provisions will introduce additional complexity into the Internal Revenue Code and subject both business and individual taxpayers to heavier compliance and recordkeeping burdens.

Because of differences in the House and Senate versions of the bill -- and Treasury Secretary Rubin's recent letter concerning the Clinton Administration's position on the legislation -- the Institute offers the following comments on the legislation. We note at the outset that, because of TEI's diversity and its business tax orientation, the Institute does not take positions on several contentious, and undeniably important, provisions, such as those relating to capital gains, the HOPE scholarship tax credit, and estate and gift taxation; instead, we focus on the policy and administrative aspects of provisions affecting business. We are confident that the adoption of the Institute's recommendations will materially improve the Tax Fairness Act of 1997.

Summary of TEI Recommendations

TEI recommends that the conferees:

* Mandate the netting of interest where the taxpayer is simultaneously in both a tax overpayment and underpayment situation.

* Follow the House bill and repeal the corporate AMT depreciation adjustment.

* Reject the provision in the House bill relating to so-called Morris Trust transactions and further narrow the Senate bill to exempt non-abusive transactions.

* Follow the Senate bill and provide for a permanent extension of the exclusion for employer-provided educational assistance.

* Follow the Senate bill and extend the research tax credit until May 31, 1999.

* Reject the proposal to decrease the carryback period for net operating losses.

* Follow the Senate's Brownfields provision on the treatment of environmental remediation expenses.

* Acknowledge the need to clarify the rules relating to independent contractors.

* Reject the proposed modification of the definition of corporate tax shelter.

* Reject the provision in the House bill to restrict the de minimis rule in respect of the disallowance of an interest deduction on indebtedness allocable to tax-exempt obligations.

* Follow the proposal in the Senate bill to clarify that employers may deduct the full cost of meals provided for the convenience of the employer.

* Reject the Senate proposal to decrease the carryback period for foreign tax credits.

* Adopt the provision in both bills to eliminate the overlap between the passive foreign investment company rules and the controlled foreign corporation rules.

* Follow the House bill calling for the aggregation of dividends received from 10/50 companies for purposes of the foreign tax credit limitation.

* Reject the proposals on limiting treaty benefits for payments to hybrid entities.

Interest Netting

Although neither the House nor the Senate bill contains a provision related to the netting of interest where a taxpayer is simultaneously in both a tax overpayment and underpayment situation, Tax Executives Institute urges the conferees to address this important subject. During the last ten years, Congress has several times manifested its desire that the Internal Revenue Service implement the most comprehensive interest netting possible in order to ameliorate the punitive effect of the Code's imposing a higher interest rate on tax underpayments than the government pays on tax overpayments. The IRS and Treasury Department have failed, however, to effectuate that congressional intent. Indeed, Treasury's recent report on interest netting disavowed the statutory authority to implement netting.

It is long past the time for Congress to mandate the adoption of a global interest netting regime. Consequently, TEI supports the amendment of section 6621 of the Code to provide that where a taxpayer reasonably identifies and establishes an appropriate situation for netting, interest would be equalized (i.e., the net interest rate would be zero) to the extent and for the time the overpayment and underpayment overlap. Under the proposal, netting would be permitted where there have been previously determined deficiencies or refunds on the taxpayer's accounts existing during the same time period whether or not a liability is outstanding at the time of the transaction. Should the final bill not include an interest netting provision, TEI nevertheless recommends that the conference report reiterate Congress's intention that the IRS administratively implement global interest netting without further delay.

Repeal of AMT Depreciation

Under the corporate alternative minimum tax regime that was enacted in 1986, depreciation on property placed in service after 1986 must be computed by using the class lives prescribed by the alternative depreciation system of section 168(g) and either (1) the straight-line method in the case of property subject to the straight-line method under the regular tax, or (2) the 150-percent declining balance method in the case of other property. Under the regular tax, depreciation on such property is generally determined using shorter recovery periods and more accelerated recovery methods. Section 403 of the House bill would modify the corporate AMT by repealing the depreciation adjustment for property placed in service after December 31, 1998. There is no similar provision in the Senate bill.

TEI strongly endorses the repeal of the AMT depreciation set forth in the House bill. The current AMT depreciation rules present a disincentive to investment and punish taxpayers for engaging in activities otherwise sanctioned -- indeed, encouraged -- by the Internal Revenue Code. Moreover, the interplay of the regular tax and AMT systems-creates tremendous compliance burdens by forcing companies to comply simultaneously with multiple tax systems. For example, for an ordinary piece of office equipment, depreciation must be calculated for regular tax purposes (200-percent declining balance method over 7 years), AMT purposes (150-percent declining balance method over 10 years), and adjusted current earnings (straight-line method over 10 years). In the absence of repealing the entire AMT regime (which TEI would support), eliminating the AMT depreciation method represents a major and much needed simplification. Consequently, we are disheartened that, even though the Clinton Administration has recognized the need to exempt small corporations from the AMT, it has abandoned its simplification goal in respect of large businesses. Notwithstanding the Clinton Administration's opposition, the House provision should be adopted.

Morris Trust Transactions: Recognition of Gain on Certain Stock Distributions

Under specified conditions, section 355 of the Code currently permits companies to distribute, or "spin-off," the stock of controlled subsidiaries on a tax-free basis. As a result of publicity about certain acquisitions where an acquired entity incurring new debt is subsequently separated from the company receiving the funds derived from the debt -- i.e., transactions combining so-called Morris Trust spin-offs with a monetization of the value of the business assets acquired -- both the House and Senate bills contain provisions that would substantially restrict the number and scope of tax-free spin-off transactions.

TEI recognizes that Congress has a legitimate interest in circumscribing the inappropriate use of the Morris Trust doctrine to prevent de facto sales from escaping taxation. Section 1012 of the House bill, however, extends far beyond its putative purpose of curbing abusive spin-off transactions. Hence, it effectively would repeal section 355 with respect to any distribution of stock within an affiliated group of corporations (and, hence, taxing purely internal or intragroup restructurings) and, further, would repeal section 355 for most distributions outside of an affiliated group of corporations. While narrower in scope, section 812 of the Senate bill would also tax certain intragroup, and many external, distributions of stock of controlled companies.

The Institute firmly believes that section 355 serves a critical role in permitting companies to restructure on a tax-free basis in order to remain competitive within the global economy. We thus urge the conferees to reject the provision in the House bill and, indeed, to narrow the Senate bill even further to exempt non-abusive transactions. Consequently, TEI is pleased that Chairman Archer himself has acknowledged the need to revise the House's Morris Rust repeal provision, and that the Clinton Administration has also voiced concern about the broad scope of the House bill. We urge the conferees to give full weight to proposals that would carefully target the transactions giving rise to congressional concerns.

Extension of Exclusion for Employer-Provided Educational Assistance

Once again, the exclusion for employer-provided educational assistance provided by section 127 of the Code has been permitted to expire during 1997. Section 221 of the Senate bill would make the educational assistance exclusion permanent and apply to graduate as well as undergraduate courses. Section 221 of the House bill would extend the educational assistance exclusion for undergraduate courses through December 31, 1997.

The educational assistance exclusion represents an important investment in America's future, and, for years, section 127 has enjoyed widespread support in Congress, the Clinton Administration, and the employer community. The transitory nature of the exclusion, however, has significantly limited its incentive effect. The on-again, off-again, sometimes retroactive nature of the extension also imposes substantial administrative burdens on taxpayers, sometimes requiring the filing of corrected Forms W-2 by employers and amended tax returns by employees. In light of the high priority assigned education and education tax incentives by the Clinton Administration and senior leaders of Congress, now is the time to make section 127 permanent. Accordingly, because of its broader scope, permanent nature, and the support expressed by the Administration for a permanent extension, TEI supports the Senate bill.

Extension of Research Tax Credit

Like the educational assistance exclusion, the tax credit provided by section 41 in respect of U.S.-based research activities has been permitted to expire even though there is widespread agreement that the country must do more to encourage such activities. Under section 501 of the Senate bill, the research tax credit would be extended until May 31, 1999. The House bill is narrower in scope; section 601 would extend the credit only to December 31, 1998.

The situs of research activities is important not only for its own sake but because it drives the location of manufacturing and related activities. For the research tax credit to be effective, companies must have confidence that it will not be here today, gone tomorrow. That confidence has been shaken, however, by the on-again, off-again nature of the credit. Indeed, in light of the planning horizon (generally, a minimum of five years) for research and development activities, the repeated short-term reenactment of section 41 cannot help but engender uncertainty and impede the credit's intended effect of encouraging companies to engage in research projects in the United States. Accordingly, TEI supports the permanent extension of the credit. As between the House and Senate bills, the Institute supports the Senate version because of its longer duration.

TEI also recommends that the conference report express Congress's concern about the restrictive interpretation of section 41 adopted by many IRS agents and by the agency itself in its research tax regulations, especially in respect to the qualification of costs related to the development of computer software.

Modification of Loss Carryover Rules

Under current law, taxpayers that incur net operating losses may carry those losses back 3 years and forward 15 years. These provisions help ameliorate the sometimes harsh effect of the Code's annual accounting rules. Under section 1062 of the House bill and section 872 of the Senate bill, the net operating loss carryover periods would be revised, decreasing the carryback period to 2 years while increasing the carryforward period to 20 years.

TEI agrees that the carryforward period could be usefully expanded in order to ensure that operating losses do not expire unused. The expansion of the carryforward period, however, should not come at the expense of truncating the carryback period. The loss carryback provision enables companies to obtain tax refunds -- providing a vital infusion of cash to preserve a company and related employee jobs -- at a time when a downturn in the business cycle might otherwise jeopardize the company's continued viability. Accordingly, TEI urges that the proposal to decrease the carryback period to 2 years be dropped from the final bill.

Brownfields: Environmental Cleanup Expenditures in Designated Areas

Section 768 of the Senate bill permits taxpayers to elect to treat certain environmental remediation expenditures that are otherwise chargeable to capital accounts as deductible in the year paid or incurred in respect of sites within "targeted" areas (so-called Brownfields areas). The House Bill does not include a companion provision. TEI believes that this provision would have a salutary incentive effect and encourage companies to promptly clean up hazardous substances at "targeted" areas. Hence, TEI supports the provision and recommends that the conferees include the provision in the final bill.

In addition, TEI recommends that the conference report clarify that environmental remediation expenditures per se are not "chargeable to a capital account." Indeed, the Senate report accurately summarizes the uncertainty surrounding the proper tax treatment of environmental remediation expenditures. We believe the conference report should go further and direct the IRS to promptly issue guidance confirming that expenditures incurred for environmental remediation activities are generally deductible under section 162 as ordinary and necessary repair or maintenance expenses. By eliminating uncertainty under current law, such guidance would have as great an incentive effect in spurring environmental cleanups as permitting an election to deduct amounts otherwise chargeable to capital accounts that are incurred in respect of the targeted areas. At a minimum, we recommend that the conference report include a statement that no inference should be drawn regarding the proper treatment of environmental remediation expenditures incurred either for "targeted" areas prior to the date of enactment or for "non-targeted" areas prior or subsequent to the date of enactment.

Independent Contractor Rules

The House and Senate bills include provisions modifying the tax rules relating to the classification of workers as independent contractors or employees. The House bill is more ambitious, with section 934 of the House bill setting forth extensive safe harbor rules for determining whether individuals are not employees. The Senate bill does not contain a comparable provision, and the Clinton Administration has voiced its strong opposition to the provisions, which it asserts would permit employers to avoid essential worker protections and could lead to widespread shifting of employees to independent contractor status. The Administration argues that an issue as important as the Code's worker classification rules requires "much deeper and fuller study and input from all affected parties."

TEI agrees that the independent contractor issue requires serious attention and that the long-term consequences of the House bill could be far reaching. Indeed, significant changes to the worker classification rules were enacted by Congress in 1996, and the full effect of those changes -- complemented by recent administrative changes adopted by the IRS -- may not yet be fully appreciated. We recommend that Congress in the future devote significant efforts to clarifying this area. Currently, too many companies spend too much time dealing with IRS challenges to the classification of their workers, which can have significant collateral effects on their employee benefit plans. Whether or not a safe harbor approach such as that in the House bill is adopted, one thing should be clear: the tax law's worker classification rules must be updated to reflect changes in business realities (including how and where services are performed) and to minimize after-the-fact disputes.

Corporate Tax Shelter Provisions

Section 1021 of the House bill and section 821 of the Senate bill would impose a requirement that certain confidential tax shelters be registered and, further, would amend the definition of tax shelter for penalty purposes to include, among other things, transactions with "a significant" tax avoidance purpose. (Current law imposes "a principal purpose" standard.)

TEI has previously expressed its opposition to the corporate tax shelter registration provision on the grounds that, in certain instances, it would impose a heavy compliance burden, not on the promoters of so-called tax shelters, but on the taxpayers to whom those shelters are marketed even where the taxpayer declines to participate in the shelter. We confine our comments here to urging the conferees to reject the proposed broadening of the definition of a tax shelter to include any entity, plan, arrangement, or transaction a significant purpose of which is the avoidance of tax. The proposed definition is so broad that the IRS might use the provision -- indeed, merely threaten to assert a penalty -- in order to force concessions on issues where the taxpayer's position is wholly legitimate. Such activity would obviously not be in keeping with recent taxpayer rights legislation. Hence, even if the tax shelter registration provision is retained in the final legislation, the governing "a principal purpose" standard should not be changed.

Disallowance of Interest on Indebtedness Allocable to Tax-Exempt Obligations

Section 265 of the Code disallows a deduction for interest on indebtedness incurred to purchase obligations the interest on which is not subject to tax. Rev. Proc. 72-18, 1972-1 C.B. 740, provides that in the case of corporations (other than financial institutions and dealers in such obligations), interest is generally deductible if during the taxable year the average adjusted basis of the tax-exempt obligations does not exceed two percent of the average adjusted basis of all assets held in the active conduct of a trade or business. This 25-year-old de minimis rule obviates taxpayers having to engage in complicated tracing procedures in order to confirm that debt was not incurred to purchase or carry tax-exempt assets. Section 1003 of the House bill would constrict the de minimis exception to exempt the lesser of $1 million or two percent of assets, thereby substantially reducing its salutary effect. There is no similar provision in the Senate bill.

TEI opposes the proposed reduction of the section 265 de minimis exception. The provision would represent a major disincentive to investing in tax-exempt obligations (thereby harming state and local governments) and would impose burdensome tracing requirements on corporations. The Institute therefore urges the conferees to follow the Senate bill.

Employee Meals

In general, only 50 percent of business meal and entertainment expenses are allowed as a deduction. An exception is provided, however, for meals that are provided for the convenience of the employer because these are generally excludable from the employees' income under section 119 of the Code. An issue has arisen, however, concerning the full deductibility of these expenses by the employer. Section 778 of the Senate bill would clarify that meals provided for the convenience of the employer are excludable from the employees' income as a de minimis fringe benefit (pursuant to section 132 of the Code) and therefore are fully deductible by the employer. There is no similar provision in the House bill.

TEI supports the Senate's clarification of the full deductibility of meals provided for the convenience of the employer. The partial disallowance of a deduction for business meals was enacted in 1986 as a proxy for taxing individuals on the personal benefit associated with business meals. Inasmuch as Congress has separately decided in enacting section 119 that employees should not be taxed in respect of the value of meals provided for the convenience of the employer, absolutely no rational policy reason exists to disallow a portion of the employer's expense deduction for such meals.

Modification of Foreign Tax Credit Carryback

Section 904(c) of the Code currently provides that any foreign tax credits (FTCs) not used against U.S. tax in the current year may be carried back two years and forward five. Section 867 of the Senate bill would limit the carryback to one year and extend the carryforward to seven years. There is no similar provision in the House bill.

TEI believes that the Senate provision would undermine the very purpose for which the FTC was enacted almost 80 years ago: the mitigation of the double taxation arising because the United States taxes corporations on their worldwide income. This purpose is frustrated by unrealistically short carryover periods, which cause credits to expire unused. Enactment of this short-sighted tax increase would only serve to exacerbate the double taxation caused by expiring FTCs. We agree with the Senate that the carryforward period should be lengthened (because it would reduce instances of double taxation), but not at the expense of the carryback. TEI therefore opposes the proposed shortening of the FTC carryback period set forth in the Senate bill.

Elimination of the PFIC/CFC Overlap

Both section 1121 of the House bill and section 751 of the Senate bill would rectify an inequity that has existed for the past decade, as well as reduce unnecessary taxpayer burden. Enacted in 1986, the passive foreign investment company (PFIC) rules were intended to limit the economic benefit of tax deferral available to U.S. investors in foreign investment funds, as well as to restrict the ability of such investors to convert ordinary income into capital gain. Unfortunately, the provisions were flawed, resulting in the classification of many corporations with active businesses as PFICs. The PFIC rules thus not only tax passive income, but also impose a financial toll charge on the operating income of controlled foreign corporations (CFCs), which are already subject to tax on their passive income under Subpart F of the Code. H.R. 2014 would eliminate this overlap.

TEI strongly supports the elimination of the PFIC / CFC overlap. Such a move would ameliorate substantial compliance burdens without undermining the congressional intent underlying the PFIC provisions. Under current law, a corporation with even a modest number of active subsidiaries must devote substantial time to analyzing the applicability Of the PFIC rules and taking action to minimize their punitive intent. These burdens are not warranted, particularly in connection with CFCs whose U.S. shareholders must independently include the CFCs' passive income in their taxable income under the rigorous rules of Subpart F. Thus, we believe that the Clinton Administration's opposition to this provision is baseless and should be rejected. Indeed, TEI believes that the provision represents such a significant simplification of the law that it should become effective immediately (i.e., for taxable years ending after enactment rather than for taxable years beginning after December 31, 1997).

Foreign Tax Credit: Dividends from 10/50 Companies

Under section 904(d)(1)(E) of the Code, dividends (and the related deemed-paid foreign tax credits) from each 10-percent to 50-percent owned foreign subsidiary (so-called 10/50 companies) must be separately calculated and placed in a separate foreign tax credit (FTC) limitation "basket." Section 1107 of the House bill would generally aggregate these dividends received from 10/50 companies into a single basket; the separate FTC limitation would continue to apply, however, to dividends received by taxpayers from each 10/50 company that qualifies as a passive foreign investment company (PFIC). There is no similar provision in the Senate bill.

The House bill represents a major simplification of the FTC limitation rules. Current law limits the taxpayers' ability to utilize the foreign tax credit to minimize double taxation. In addition, taxpayers face hundreds (or, in some instances, perhaps even thousands) of separate FTC calculations for both regular and AMT purposes in respect of their 10/50 companies. TEI recommends that the final conference bill provide for the aggregation of all non-PFIC, 10150 dividends into one basket under the FTC limitation rules.

Limitation on Treaty Benefits for Payments to Hybrid Entities

Section 1175 of the House bill would limit the availability of reduced withholding tax rates under U.S. tax treaties on payments to hybrid tax entities. Specifically, the provision would deny the reduced withholding rate on payments by U.S. companies to certain limited liability companies -- hybrids -- treated as partnerships under U.S. tax law but recognized as corporations under foreign tax law. This provision appears targeted primarily at Canadian corporations financing their U.S. operating affiliates with loans through wholly owned limited liability companies. Nonetheless, the provision would abrogate many pre-existing treaties that do not address specifically the treatment of hybrid entities. Section 742 of the Senate bill would authorize the IRS to issue regulations denying the reduced withholding tax rate for payments to hybrid entities.

TEI opposes the enactment of either provision. Tax treaties between the United States and its trading parties represent solemn compacts negotiated in good faith. To the extent new issues arise as a result of subsequent commercial or legal developments in either treaty country, the issues should be addressed through a protocol revising the original agreement. In our view, the United States should never abrogate its treaty obligations because such actions only serve to breed suspicion in our trading partners and undermine the trust essential to negotiating subsequent treaties. The treaty override here is particularly. offensive since the reduced withholding rate can easily be obtained by Canadian corporations restructuring their loans directly to their U.S.-based operating affiliates. Hence, to the extent there is an erosion of a tax base through the use of a hybrid financing affiliate, it is the Canadian tax base not the U.S. tax base that is diminished. TEI urges the conferees to reject both provisions.

Unfinished Business

In addition to the foregoing comments, TEI wishes to emphasize that the enactment of the Tax Fairness Act of 1997 should be regarded as only a step on the journey of simplifying and reforming the Internal Revenue Code. Thus, although we are pleased that both the House and Senate bills contain many simplification provisions (including, for example, the complicated rules for translation of foreign taxes and the rules related to TEFRA partnerships), there is much that remains to be done, especially in the foreign area. Thus, we strongly encourage Congress to redouble its efforts to make the tax code work in a more equitable fashion.