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President Clinton's proposals for public investment and deficit reduction.

On March 17, 1993, Tax Executives Institute filed the following statement withthe House Committee on Ways and Means concerning the Clinton Administration's proposals for public investment and deficit reduction. The Institute's oral testimony was presented by TEI Executive Micheal J. Murphy.


Tax Executives Institute is the principal organization of corporate tax professionals in North America. Our approximately 4,800 members represent more than 2,400 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. TEI is firmly committed to maintaining a tax system that works -- one that is consistent with sound tax policy, one that taxpayers can comply with, and one in which the IRS can effectively perform its audit function.

Mr. Chairman, TEI applauds the Committee's decision to hold these hearings in order to obtain preliminary comments on the President's tax proposals. TEI is also pleased with the emerging consensus in both the Administration and the Congress to forge a strong and coherent economic package to reduce the deficit, to cut unnecessary government spending, to create jobs, and to otherwise stimulate the economy. The question, of course, is how best to achieve these laudable goals.

A principal challenge in analyzing the President's proposals -- especially for tax executives whose mission is to divine how they may affect their companies -- is that the specifics of the proposals are in many respects "moving targets." Legislative language has not yet been released, and indeed, some provisions remain undefined or seem to change on a day-to-day basis. The lack of specificity is unfortunate because operational problems with tax proposals frequently are not discovered until the statutory language can be parsed and appraised by those who will have to live with it. In other words, since the details of many of the President's proposals have not yet been released, our comments will of necessity be somewhat tentative. Please be assured that we shall supplement our comments as the legislative process moves forward.

General Comments on the President's Proposals

As a broad-based organization, TEI frequently finds itself unable to take positions on major policy issues that come before the Committee. Our diversity thus limits our ability to opine on certain major policy initiatives. For example, the Institute has historically declined to take a position on proposed changes in the tax rate and to balance such proposals with possible changes in the tax base. Similarly, because of its disparate effect on various segments of our membership, TEI has to date chosen not to take a formal position on the proposal to reinstate the investment tax credit.

We do wish to note, however, that the President's proposals ask a fundamental question about the state of the "compact" that was reached between the government and taxpayers seven years ago when the Tax Reform Act of 1986 became law. At that time, the tax base was broadened and several tax incentives were eliminated in exchange for a lowering of the rates and a generally simpler tax system (especially for individuals). One of the promised consequences was stability -- something that is absolutely essential to business. To plan, one has to know what the rules are and what they will be. Of course, there was a price that the business community had to pay for the promised stability: although the 1986 Act was revenue neutral overall, it exacted $120 billion in additional taxes over five years from the corporate community and imposed compliance burdens out of all proportion to the tax policies supposedly served by the underlying statutory provisions.

Regrettably, the stability that was promised to taxpayers was extraordinarily short-lived. First, in 1988, again in 1989, and most recently in 1990, Congress and the Administration chipped away at the bargain that was struck in 1986. Tax rates were not directly increased in those earlier bills, but business taxpayers were saddled with a large number of complicated tax increases, which required the expenditure of both time and money to understand and implement. Now, the President proposes to increase both corporate and individual tax rates, to reinstate incentives such as the investment tax credit, and to enact a number of provisions that would further complicate the law, require the expenditure of large amounts of money on nonproductive activity, impair America's ability to compete effectively abroad, and arguably spur a resurgence of tax shelters and other uneconomic activities.

TEI does not deny the right -- even obligation -- of the Administration and Congress to fine-tune the Internal Revenue Code and to adapt to changing conditions. We do believe, however, that more than lip service must be paid to the goals of stability and simplification. In proposing to make certain provisions permanent -- including the targeted jobs credit, the research tax credit, and the exclusion for employer-provided educational assistance -- we believe the Administration has moved in the right direction. Specifically, it has sought to remedy the on-again, off-again nature of these provisions and to inject some modicum of certainty into the tax system.

In stark contrast, other provisions of the President's plan would violate all notions of stability, simplicity, and good tax policy. First, we believe the President's proposals to disallow or curtail deductions for legitimate business expenses deviate from what should be a fundamental precept of the tax system: that people are taxed not on gross receipts but on income. Stated differently, the Sixteenth Amendment authorizes a net income tax system in which deductions are generally allowed for the expenses of generating income. The President's proposals would stray from that concept, for example, by disallowing a deduction for lobbying expenses and arbitrarily capping the deduction on executive compensation. TEI questions whether these changes would significantly change how business is conducted: businesses will continue to communicate their views on proposed legislation when it is in their or their shareholders' best interests and will -- if the market demands it -- pay their executives in excess of $1 million. A cynic might say, if behavior will not change, is this not a good way to raise revenue? Leaving aside the question of principle, what that argument ignores is that we operate in a global economy. Whenever the cost of doing business in the United States increases (because a deduction is denied or an additional compliance cost is imposed), the competitive position of the country as a whole cannot be helped.

Second, the international proposals in the President's package would add unnecessary complexity to the Internal Revenue Code and thereby diminish the ability of U.S. business to effectively compete abroad. Consider, for example, the proposal to tax in advance of repatriation to the United States certain accumulations of foreign earnings deemed to be "excessive." The proposal states that a change is needed to prevent the "excessive accumulation" of foreign earnings. There are, however, already two overlapping sets of anti-deferral rules -- one that was enacted in 1962 called Subpart F and the second, relating to "passive foreign investment companies" (PFICs), which was enacted in 1986 to do the very thing the President's proposal is intended to do: end the deferral of tax on passive assets. In other words, in terms of tax policy, the proposal is redundant. In terms of tax administration, it is tremendously complicated. Rather than end the redundancy and streamline the law, the President's proposal would add another layer of rules and another layer of costs and, we submit, garner very little revenue for the government.

Finally, one of the proposals seeks to transfer responsibility for -- and the expense of -- ensuring compliance with certain tax laws from the IRS to already complaint taxpayers. We refer to the proposal to require the filing of information returns -- Forms 1099 -- on all payments for services in excess of $600, including payments to corporations. (Currently, Forms 1099 need not be filed in respect of payments to corporations, in part because the filing of such returns would flood the IRS with information that it could not use.) This proposed "mandate" to file information returns on payments to corporate service providers, however, is not something that can be accomplished cost free.

Indeed, given the Joint Committee on Taxation's revenue estimate for the proposal -- $326 million (as opposed to the Administration's $6.35 billion estimate) -- TEI believes there is a good chance that the cost to the payer community would exceed the revenues flowing to the Treasury. More than one company has already estimated its costs would exceed $1 million to implement the proposed changes and nearly that much to maintain the new system on an ongoing basis. Equally important, there continues to be no convincing evidence that the IRS would be able to process the millions of additional pieces of paper that would be generated under the proposal. In this regard, it is interesting to note that one aspect of the proposal -- an IRS initiative to assist payers in verifying the taxpayer identification number of payees -- has been abandoned, apparently because the IRS cannot implement the program on schedule. There is no similar sympathy demonstrated, however, for the payers that would have to modify their computer systems, institute manual processes, and otherwise gear up for the information reporting program.

In the ensuing sections of this statement, TEI sets forth its views on specific proposals contained in the President's economic package.

Limitations on the Deductibility of Ordinary and Necessary Business Expenses

A. Limitations on the Deductibility of Corporate Salaries

1. President's Proposal. The President's proposal would preclude a corporation from taking a deduction for compensation paid to an executive in excess of $1 million per year. The $1 million limitation would not apply to compensation payments that are linked to productivity, though no details of the productivity exception have yet been released.

2. TEI Position. TEI opposes the proposal to arbitrarily limit the deduction for corporate salaries for a number of reasons. First, the proposal to limit the deductibility of corporate salaries violates the basic tenet of America's net income tax system that taxpayers are allowed to deduct their ordinary and necessary business expenses.[1] Enacting a proposal to limit the compensation deduction would give rise to the double taxation of salaries -- once at the individual level (as is currently the case), and once at the corporate level (as a result of the denial of a deduction). This alone should be sufficient reason to defeat such a proposal.

In addition, a corporate compensation limitation would discriminate against similarly situated individuals -- for example, corporate executives and non-corporate executives whose duties are virtually identical -- without any public policy basis. Hence, limitations would not apply to employees of a partnership who perform services substantially identical to those performed by corporate executives at a competing firm, nor would they apply to non-executive employees or to employee-owners of personal service corporations. An enterprise or group of individuals choosing to conduct business as a corporation would find itself subject to the limitation, whereas the same business would escape the limitation's reach by organizing itself as a partnership; investment banking is but one example where firms performing substantially identical services are organized as either partnerships or corporations. In addition, the proposal would not reach certain industries (e.g., law and accounting firms) that generally operate in non-corporate form.[2] Contrary to the avowed purpose of the Tax Reform Act of 1986 (and other recent legislation), therefore, a corporate salary deduction limitation would violate the principle of neutrality and interfere with basic business decisions.

Although the details of the President's proposal remain unclear (especially with respect to any exception for payments linked to productivity), significant issues of retroactivity exist in respet of stock options and forms of deferred compensation "granted" before, but not taxable to the employee (or deductible to the employer) until after, the effective date. Thus, the putative rationale of policing "excessive" corporate compensation is undercut because a limitation on deductibility could obviously not discourage already-granted compensation. Equally important, a limitation proposal would penalize taxpayers who granted stock options as a form of compensation over the same period of time they may have paid their employees lower cash wages. At a minimum, the limitation should not apply to compensation paid pursuant to agreements entered into before the date the Committee adopts the proposal, without regard to whether such amounts are vested or funded at the date of committee action.

Moreover, through its application to compensation in the form of stock options, the President's proposal runs counter to national policies of encouraging entrepreneurship. As SEC Chairman Breeden testified last summer, converting employees into owners (through the grant of stock options) is highly desirable and should be facilitated, not impeded. The President's proposal would discourage businesses from developing compensation arrangements pursuant to which employees would accept lower current wages in exchange for the opportunity to share in the future profits of the corporation as a shareholder. Although the announced (but inchoate) productivity exception might ameliorate the effect on stock option grants, query whether a productivity-based exception would in practice become nothing more than a mirror image of the limitation that exists under current law, viz, compensation is deductible only to the extent it is ordinary and necessary. The productivity standard would necessarily involve either the application of brightline tests to determine the "productivity" of the employee or an examination of all the facts and circumstances in a particular case. The application of any objective standard established by legislative flat would prove extremely rigid with arbitrary and inconsistent results among different classes of employees within the same company.[3] Should a facts-and-circumstances test be mandated, the President's proposal would add nothing but gloss to the existing standard. That "gloss," however, could lead to unproductive disputes between taxpayers and the IRS. In any event, the IRS would likely be flooded with ruling requests on whether particular arrangements satisfied the productivity exception.

Finally, a corporate salary deduction limitation represents a crude attempt to deal with an issue of corporate governance through the tax code. Such a limitation would subject all corporations -- no matter how large or small, no matter how successful, no matter how important the executive is to the company's success -- to the same arbitrary rule.[4] It would thus ignore the specific facts and circumstances that could make compensation in excess of an enacted limitation clearly proper -- in the words of the Internal Revenue Code, "ordinary and necessary." To the extent so-called excessive corporate compensation is a matter of national concern, TEI believes the issue should be dealt with as a matter of corporate governance -- for example, through further revision of certain SEC rules relating to shareholder oversight of executive salaries[5] -- not the tax law.

For the foregoing reasons, TEI recommends that the proposed limitation on the deduction of executive compensation be rejected.

B. Lobbying Expenses

1. President's Proposal. Under current law, businesses may deduct the cost of certain lobbying expenses as ordinary and necessary business expenses. Under section 162(e) of the Code, deductible expenses include amounts paid or incurred for direct communications with Congress or another legislative body; the cost of communicating with a trade organization of which the taxpayer is a member in regard to relevant legislation; and a part of the dues for membership in an organization that engages in lobbying. Under the President's proposal, businesses would no longer be able to deduct lobbying expenses. Lobbying expenses would be defined similarly to the definition of expenditures to influence legislation in section 4911(d) and would include attempts to influence legislation through communications with the executive and legislative branches. In addition, no part of membership dues that are used for such lobbying would be allowed as a deduction and the membership organization would be required to report to members the portion of the dues used for lobbying.

2. TEI Position. Section 162(e) was enacted in 1962 to permit deductions for direct lobbying expenses. The legislative history to that provision shows that Congress overturned previous judical precedent and administrative practice (i) to remedy the inconsistent treatment of expenses incurred in petitioning for judicial and legislative redress of grievances; (ii) to eliminate the disincentive of seeking legislative contact, providing factual knowledge to the legislature, or lending the taxpayers expertise to legislative deliberations; (iii) to provide a better reflection of the taxpayer's true net income; and (iv) to eliminate the compliance and enforcement problems associated with identifying and segregating proscribed expenditures.

"Lobbying" is not a four-letter word. Efforts to punish taxpayers for asserting their First Amendment right to petition for redress of grievances should not be allowed to masquerade as political reforms or attacks on "special interests." The pervasive influence of federal laws and regulations on the conduct of business in America ensures that companies, industries, and the general populace will continue to have an interest in communicating their views to Congress and the Administration. In other words, lobbying will continue. Indeed, Congress and the federal regulatory agencies can hardly expect to develop legislation and to promulgate rules and regulations without accumulating a certain degree of information about the subject matter and practices they seek to regulate. Without the active participation of trade or professional groups and individual businesses in the legislative and regulatory process, rules are likely to be fashioned in a void, spawning economic inefficiencies and imposing compliance burdens that are wholly avoidable. The tax law itself is replete with examples of Congress enacting requirements with too little -- not too much -- information. (Witness the ill-fated section 89 or -- more recently -- the luxury excise tax.) Indeed, Congress recognized its need for information from affected constituencies when it enacted section 162(e):

It also is desirable that taxpayers who have information bearing on the impact of present laws, or proposed legislation, on their trades or businesses not be discouraged in making this information available to the Members of Congress or legislators at other levels of government. The presentation of such information to the legislators is necessary to a proper evaluation on their part of the impact of present or proposed legislation. The deduction of such expenditures on the part of business is also necessary to arrive at a true reflection of their real income for tax purposes. In many cases making sure that legislators are aware of the effect of proposed legislation may be essential to the very existence of the business. (Emphasis added.)[6]

Not only is it important that information be made available to Congress and other legislative bodies, the administrative burden associated with identifying and segregating "lobbying expenses" from other expenditures could prove exceedingly difficult for taxpayers to comply with and the IRS to audit. Controversy would inevitably arise over the types of expenditures included within the definition of lobbying In enacting section 162(e), Congress wisely sought to quell such controversies. The legislative history confirms the wisdom of permitting a deduction for lobbying expenses as ordinary and necessary business expenses as a matter of administrative convenience:

The regulations issued by the Treasury Department in 1959 brought to a head many administrative and enforcement problems and uncertainties which have plagued both the Government and taxpayers. The difficulty in allowing trade or business expenses generally, but isolating expenses relating to legislative matters and denying deductions for them, stems in part from the difficulty in segregating and classifying such expenses. . . . Moreover, in the case of many expenses which may primarily be incurred to inform the business itself as to the application of certain proposed legislation, when such information is also made available to legislators it is difficult to determine how an allocation of the expense should be made between legislation and mere planning of the company.(7)

Depending on the complexity of the prescribed allocation scheme, industry associations, trade groups, or research organizations whose legislative activities are minor (perhaps even de minimis) compared with their educational, research, or other activities might choose to curtail or terminate their lobbying rather than incur the expenses associated with segregating lobbying from their other activities and then notifying their members of the portion of their dues ensnared in the disallowance. (Small and medium-sized businesses might also refrain from lobbying, not because of the "cost" of nondeductibility but because of the attendant recordkeeping burdens.) The "losers" in the process could well be Congress, the Administration, or the country as a whole -- they would be deprived of the knowledge those "lobbyists" would otherwise bring to the legislative process. And, we submit, the fisc would not be at all enriched.

Of the four reasons cited by Congress in 1962, the erosion of the principle that the income tax is derived after measuring the net income of the taxpayer is the most important for opposing enactment of the provision. We believe that the compromise struck by Congress in enacting section 162(e) strikes an appropriate balance between direct lobbying and "grass roots" lobbying activities. Should Congress determine that some action is necessary to address the "power" of the "special interests," then TEI submits that nontax laws -- such as those governing campaign finances and the disclosure of lobbying activities and expenditures -- should be the vehicle for reform.

TEI urges that the proposed disallowance of deductions for lobbying expenses be rejected.

C. Deductible Portion of Business Meals

1. President's Proposal. Under section 274(n) of the Code, a taxpayer is permitted to deduct only 80 percent of the expense for meals and entertainment that meet certain legal and substantiation requirements to establish the business purpose of the expense. The President's proposal would reduce the deductible portion of the otherwise allowable business meals and entertainment expenses from 80 percent to 50 percent.

2. TEI Position. The justification proffered by the Administration for the proposed reduction in the percentage of the allowable deduction is that a portion of the expense relates to an entirely personal and, hence, non-deductible expenditure. Allowing a full (or even 80-percent) deduction for consumption of the business meal, the summary of the President's proposal states, amounts to an improper tax subsidy for a personal expense of the employee.

Apart from a possible search for revenues, we are unable to discern how the Administration arrived at the proposed 50 percent disallowance figure. How was the personal element of the business meal expenditure determined to be one half of the expenditure? We respectfully suggest the determination was arbitrary and devoid of any legitimate tax policy rationale. Indeed, the President's proposal ignores the underpinnings of current law in disallowing deductions for ordinary and necessary business expenses incurred primarily to produce taxable income. The proposal is based on the notion that any incidental personal benefit that accrues from an expenditure may be measured and should be eliminated from the tax base. The quest for such a theoritically perfect measure of the tax base, however, is not only flawed but wasteful of taxpayer and government resources because it violates the economic law of diminishing returns.(8) In 1986, TEI opposed the proposed 20-percent disallowance on the ground that it represented bad tax policy and would impose administrative burdens likely to exceed the incremental revenues raised by the provision. We believe those arguments apply with equal force to the proposed racheting up of the disallowance to 50 percent.

Accordingly, TEI urges that the provision to disallow a deduction for 50 percent of the cost of meals and entertainment be rejected. Indeed, for the foregoing policy reasons, TEI believes the current 20-percent disallowance should be repealed.

D. Club Dues

1. President's Proposal. Under section 274(a) of the Code, a deduction is permitted for club dues if the taxpayer establishes that the use of the club is primarily for furtherance of the taxpayer's trade or business. Even after this test is met, the taxpayer is permitted to deduct only that portion of the dues that qualify as "directly related" to the active conduct of the trade or business. The President's proposal would disallow entirely deductions for expenditures for all manner of club dues including business, social, athletic, luncheon, and sporting clubs.

2. TEI Position. As with the deduction for business meals, the putative reason for the proposed change is that taxpayers obtain a deduction for dues for a club (such as a country club) with respect to which a significant element of personal pleasure, enjoyment, and social benefit is present. This facile explanation should be rejected in light of the formidable gauntlet of tests already imposed by the Code to establish that an expenditure for club dues is directly related to the active conduct of a taxpayer's trade or business. If a taxpayer is able to surmount the obstacles in present law and establish that the expenditure is directly related to the conduct of its business, a net income tax system demands that ordinary and necessary expenses related to the production of the income be deductible.(9)

TEI urges that the elimination of the deduction for club dues be rejected.

Corporate Estimated Taxes

1. President's Proposal. Under section 6655 of the Code, a corporation is subject to an addition to tax (or penalty) for any underpayment of estimated tax. For taxable years beginning after June 30, 1992, and before 1997, a corporation does not have an underpayment of estimated tax if it makes four equal timely estimated tax payments that total at least 97 percent of the tax liability shown on its return for the current taxable year. For taxable years beginning after 1996, current law provides that the 97-percent requirement will be reduced to 91 percent. The President's proposal would make the 97-percent requirement permanent.

2. TEI Position. Current law effectively requires large corporations to overpay their estimated taxes, without the benefit of interest, or in order to avoid an underpayment penalty under section 6655 of the Code. This Hobson's choice -- between a penalty and what is essentially a non-penalty penalty -- does not confront other taxpayers because they may generally avoid the section 6655 penalty by availing themselves of the statutory safe harbor. Specifically, smaller corporations -- those whose taxable income is less than $1 million for all of the preceding three years -- may avail themselves of a statutory safe harbor to avoid the underpayment penalty by making quarterly deposits equal to 100 percent of their prior year's tax liability. Because the safe harbor is based on the company's prior year's liability (which obviously is known), smaller companies can approach the estimated tax rules with confidence. Large corporations currently may not use this prior year's safe harbor.

Because they are not permitted to use the prior year's tax rule, large corporations must base their quarterly deposits on estimates of their current year's tax liability. The existing task is literally impossible in light of the complexity of the tax laws, the rapidity with which they have changed in recent years, and the fact that numerous adjustments to financial income can accurately be done only annually. Consequently, the large corporate taxpayer faces a choice of either (i) paying a penalty (under section 6655) for underestimating its liability or (ii) overpaying its taxes (in order to avoid the penalty).

The second option (which large corporations are generally compelled to choose not only by internal business conduct policies but by business exigencies -- the the desire to avoid penalties) does not come without a cost. The cost is the effective denial of interest on the mandatory overpayment by operation of section 6611(e), which provides that interest on an overpayment does not begin to run until the filing of a claim for refund. The President's proposal would exacerbate a serious administrative difficulty that exists under current law.

TEI recommends that the estimated tax proposal in the President's package be rejected and the corporate estimated tax provisions of the Code be truly reformed.

Although we question whether a valid tax policy reason exists for denying "large corporations" the availability of the prior year's tax rule under section 6655, we suggest that either of the following alternatives would temper the unfairness and unrealistic nature of the current rules:

* Alternative One: No penalty would be imposed if the taxpayer makes estimated tax payments based on a specified percentage (say, 120 percent(10)) of the average of its tax liabilities for the preceding three (or more) years (after taking into account credits).

* Alternative Two: In the event the taxpayer overpays its estimated taxes, interest (at the rate prescribed by section 6621(a)(1) of the Code) would be paid to the taxpayer on the amount of the overpayment from (i) the later of the due date of the estimated taxes or the date payment is made, to (ii) the date such overpayment is refunded (or applied to a subsequent liability).

Modification of the AMT Depreciation Schedule

1. President's Proposal. Under current law, taxpayers are subject to an alternative minimum tax (AMT) and must make adjustments to their regular taxable income to arrive at their AMT income. One of these adjustments relates to depreciation. Under the AMT, depreciation for personal property placed in service after 1986 is generally computed under the modified accelerated cost recovery system (MACRS) using the 150-percent declining balance method (switching to straight line at a point maximizing the deduction). The class lives for AMT depreciation purposes are generally longer than those permitted for regular tax purposes. For taxable years beginning after 1989, corporate AMT income is increased by an amount equal to 75 percent of the amount by which the adjusted current earnings (ACE) of the corporation exceed AMT income. In general, ACE requires additional adjustments to AMT income. For purposes of ACE, depreciation is computed using the straight-line method over the class life of the property.

For property placed in service after December 31, 1993, the President's proposal would eliminate the depreciation component of the adjustment used in computing ACE; depreciation for purposes of the AMT would be computed using the 120-percent declining balance method over the recovery periods applicable for regular tax purposes. The amendment would not apply to property eligible only for the straightline method for regular tax purposes (i.e., residential and nonresidential property).

2. TEI Position. In our view, the AMT provisions of the Code stand as an admission of the tax law's failure. The AMT takes away with one hand the tax treatment given by the other hand, and in the process, it unduly burdens taxpayers. For example, the AMT regime requires taxpayers to make three separate computations to determine regular taxable income and AMT income. Our preference -- from both a tax administration and tax policy perspective -- would be to repeal the AMT. Recognizing that such a change is unlikely to occur, however, we welcome the Administration's modest step toward simplification of the system.

The AMT treatment of depreciation is clearly a source of considerable complexity in the Code. Rather than recognizing that the mere existence of two separate and distinct federal taxing schemes breeds inordinate complexity, however, the President's proposal sets forth a partial solution that would apply only in calculating the AMT/ACE rules for newly acquired property. It regretfully ignores the requirement that taxpayers comply with the ACE requirements beginning in 1990 and the fact that, even under the proposal, they would continue to "track" the various depreciation regimes for assets acquired before the effective date of the simpler method (with some assets having depreciable lives of 40 years or longer). Indeed, for some taxpayers the provision may actually increase their burden by forcing them to maintain one more depreciation system for property placed in service before 1994. We urge the Committee to address this problem.

TEI applauds the concept of computing AMT depreciation only once and recommends that taxpayers be accorded an election to apply the simplified method retroactively for all years to which ACE applies.

Permanent Extension of Employer-Provided Educational Assistance, Targeted Jobs Tax Credit, and the Research Tax Credit

1. President's Proposal. Section 127 of the Code excludes from taxation the value of certain employer-provided educational assistance. Since its enactment in 1978, section 127's exclusion has expired and been extended six times (five times retroactively). The provision expired on June 30, 1992. The President's proposal would make the exclusion permanent, retroactive to July 1, 1992.

The President's proposal would also permanently extend the targeted jobs credit under section 51 of the Code. This statute has been extended four times since its enactment in 1976 and expired on June 30, 1992. The President's proposal would retroactively reinstate the credit for individuals who begin work for the employer after that date.

Finally, the Administration proposes to permanently extend the research tax credit under section 41 of the Code. This provision was originally enacted in 1981 and has been extended five times; it expired on June 30, 1992. Under the proposal, the credit would apply to expenditures incurred on or after June 30, 1992.

2. TEI Position. TEI believes the President's proposal to make these three incentives permanent represents a very positive step. Permanence would enhance the incentive effect of the educational assistance, targeted jobs, and research tax credit provisions of the Code and, taken together, would further the goal of tax system stability. Indeed, we believe that the uncertainty and confusion caused by the repeated "sunsetting" of the provisions since their original enactment greatly diminished their incentive effect. The on-again, off-again nature of the provisions also imposed substantial administrative burdens on taxpayers. For example, with respect to employer-provided educational assistance, employers have been required to design and implement programs to tax and withhold the value of such assistance, only to modify (or undo completely) those programs on an after-the-fact basis.

Employees, too, have been subject to confusion and hardship from the see-sawing effect of extensions and retroactive legislation. Employer educational assistance and the targeted jobs credit provide job opportunities and advancement for lower-paid and unskilled workers. By making sections 127 and 51 permanent, the administrative confusion for employers and the financial burden for employees could be ameliorated.

With respect to the research tax credit, corporations generally plan for research and development projects years in advance. The repeated, short-term reenactment of the tax credit cannot help but engender uncertainty and impede the incentive effect of the R&D provision. A permanent extension would reduce complexity and permit taxpayers to effectively plan their research activities, thereby furthering the legislative intent underlying the credit.

TEI therefore supports the permanent extension of the educational-assistance exclusion, the targeted jobs credit, and the research tax credit.

Allocation of Research and Experimentation Expenses

1. President's Proposal. Treas. Reg. Section 1.861-8(e)(3) generally provides that research and experimentation (R&E) expenses may be allocated to domestic and foreign source income based on either the taxpayer's relative amounts of domestic and foreign source gross income or the taxpayer's relative gross sales receipts from domestic or foreign sources. If the sales method is used, the taxpayer must first allocate 30 percent of its R&E expense to gross income from the location where most of its R&E activity is conducted. Since 1981, the regulation has been modified eight times by temporary legislation. The most recent statutory rule permits the taxpayer to allocate 64-percent of U.S.-based R&E expense to domestic source income and 64-percent of foreign-based R&E expense to foreign source income. The statutory rule expired on June 30, 1992, but a Treasury announcement permits the taxpayer to continue using the 64-percent allocation rule until the end of 1993.

The President's proposal would allocate 100 percent of the R&E expense to the place of performance of the R&E. The proposal would apply to taxable years beginning after December 31, 1993.

2. TEI Position. TEI agrees that a permanent solution to the allocation of R&E expense is warranted. The on-again, off-again effect of the frequent statutory modifications has been counterproductive to fostering U.S.-based research. As the summary of the President's proposal states, "A direct allocation of United States-based R&E expenses to domestic source income encourages taxpayers to conduct R&E in the United States." The allocation rules under the Treasury regulations represent a clear disincentive to the performance of R&E activities in the United States. It is time for Congress to simplify the R&E allocation rules and make them permanent. Simplicity and permanence would reduce the compliance costs associated with the complex, changing rules. We believe that the President's proposal would accomplish these goals.

TEI therefore recommends adoption of the rule to allocate R&E expenses to the place of performance.

Treatment of Royalties as Passive Income for Foreign Tax Credit Purposes

1. President's Proposal. To ensure that the foreign tax credit offsets only the U.S. tax on the taxpayer's foreign source income, section 904 of the Code prescribes a statutory limitation formula. This foreign tax credit (FTC) limitation is calculated separately for certain categories -- or "baskets" -- of income, including passive income. Passive income generally includes rents, royalties, interest, and other types of income defined in section 954(c) of the Code (generally referred to as "foreign personal holding company income"). There are two exceptions for royalty income: (i) certain royalties received from foreign affiliates are categorized on a "look-through" basis that often results in the royalties being treated as general limitation income; and (ii) royalties received from an unrelated party in the active conduct of a trade or business are excluded from the passive basket.

The President's proposal would provide for the treatment of all foreign source royalty income as income in the separate basket for passive income. The summary of the President's proposal states that the provision is necessary to remove the preference for foreign licensing of intangibles. The summary also states that "[p]lacement of royalties in the passive category would generally eliminate existing opportunities for cross-crediting of high foreign taxes paid on other business income against low-taxed royalty income." The provision would apply to taxable years beginning after December 31, 1993.

2. TEI Position. In 1986, Congress greatly expanded the categories of income that must be segregated into FTC "baskets." To prevent taxpayers from avoiding these limitations, it also expanded the types of income subject to section 904(d)(3), which prescribes "look-through" rules to preserve the character of income when it is earned through related parties.(11) In enacting the 1986 amendments, Congress concluded that the overall limitation was consistent with the integrated nature of U.S. multinational operations and that the averaging of foreign tax rates generally should be allowed. It recognized, however, that cross-crediting should not be allowed when it would distort the purpose of the FTC limitation.(12) It provided a separate FTC basket for passive income because of its concern that passive investments can often be quickly shifted or easily made in low or no tax jurisdictions.(13)

TEI submits that allocating royalties from a related party to the passive basket would undermine the policy decisions made when the 1986 Act was enacted. Moreover, the proposal would actually serve as a disincentive to companies to repatriate their earnings and would exacerbate double taxation by creating excess FTCs that may never be offset against U.S. income.

The look-through rules embodied in section 904(d)(3) recognize that royalties received from a related party should retain the character of income out of which the royalty was paid. Interest, rents, and royalties received from a related party are all payments of the earnings of a foreign affiliate. Realization that the "form" of the repatriation should not lead to a different characterization under the FTC rules led the American Law Institute to conclude in 1986 that royalties passing from one member of an affiliated group to another have the same character and should be treated as non-passive income, unless the underlying income of the related party is passive. In such circumstances, the royalty is just one part of an integrated enterprise.(14)

In enacting the expanded look-through rules in 1986, Congress also recognized that interest, rents, and royalties often serve as alternatives to dividends as a means of removing earnings from a foreign affiliate. Congress determined that such income should be treated at least as favorably as dividends eligible for the deemed paid credit so that payment of the former would not be discouraged, stating that because interest, rents, and royalty payments are generally deductible in foreign countries (while dividends are not), they "reduce foreign taxes of U.S.-owned foreign corporations more than dividend payments do."(15)

The Administration argues that treating all foreign source royalty income as passive would eliminate the tax preference for licensing intangibles to a foreign person for use in production activities abroad. This argument, however, ignores the manner in which companies conduct business. For economic, non-tax business reasons, many businesses must produce their products close to the place of sale. A manufacturer of processed foods, for example, will license his patent on the products to an overseas subsidiary to preserve freshness, to adapt to local market conditions, or to avoid the high cost of shipping those products for sale into that region. Forcing such a company to make an uneconomic -- and uncompetitive -- decision to avoid the receipt of passive basket income would be counterproductive. Moreover, treating all royalty income as passive might cause companies to locate their R&D activities abroad, thereby frustrating the policy underlying the President's proposal concerning the allocation of R&D expenditures.

The Administration also argues that the provision is necessary to prevent the cross-crediting of high-taxed income with low-taxed royalties. Again, this argument ignores the fact that multinational corporations generally conduct their business on a worldwide basis. In 1977, a task force chaired by Congressman Rostenkowski concluded that the averaging of foreign taxes was frequently appropriate, explaining --

Many businesses do not have separate operations in each foreign country but have an integrated structure that covers an entire region (such as Western Europe). In these instances a good case can be made for allowing the taxes paid to the various countries within the region to be added together for purposes of the taxes credit limitation.(16)

Although Congress has rejected the enactment of one overall FTC limitation, it has generally restricted the separate FTC limitations to classes of income that were "movable."(17) Because the source of royalty income depends upon the country in which the use of (or right to use) the intangible arises, the source is not "movable" in the same sense that other income may be.(18)

In the 1986 Act, Congress actively sought to encourage the payment of royalties because it believed that such payments acted to preserve the U.S. tax base. As the House Ways and Means Committee determined --

Under the foreign tax credit system, the payment of interest and royalties by controlled foreign corporations and other related foreign corporations whose dividends carry a deemed-paid credit may, therefore, reserve for the United States more of the precredit U.S. tax on these U.S.-owned corporations' foreign earnings than the payment of dividends.(19)

Congress should not now unravel that determination by treating all royalties as passive income.(20)

TEI therefore recommends that royalties should not be treated as passive income for purposes of the foreign tax credit limitation.

Current Taxation of Certain Earnings of Controlled Foreign Corporations

1. President's Proposal. The United States generally does not tax the foreign income of foreign subsidiaries of U.S. corporations when earned. Rather, the tax on foreign income is "deferred" until the income is repatriated through the payment of dividends to the parent corporation. There are, however, several exceptions to the deferral rule. Under Subpart F of the Code, certain types of income received by controlled foreign corporations (CFCs) are currently taxed as a constructive dividend to U.S. shareholders. Subpart F income is generally income that is considered "movable" from one taxing jurisdiction to another and that is subject to low rates of tax.

The passive foreign investment company (PFIC) rules overlap with the Subpart F rules to tax active overseas business operations. The PFIC rules were enacted in 1986 to remove the economic benefit of tax deferral and the ability to convert ordinary income into capital gain which was available to U.S. investors in foreign investment funds. Unfortunately, the definition of a PFIC is so broad it has resulted in the classification of many corporations with active businesses (and substantial passive income or assets) as PFICs -- even in situations where the foreign corporation is subject to high rates of tax.

The President's proposal would require 10-percent U.S. shareholders of certain CFCs to include in income currently their pro rata shares of a specified portion of the CFC's current and accumulated earnings. The proposal would apply to a CFC -- including a CFC that is a PFIC -- holding passive assets that represent 25 percent or more of the value of the CFC's total assets. The portion of current and accumulated earnings subject to inclusion ("includible earnings") would be the lesser of (i) total current and accumulated earnings and profits, or (ii) the amount by which the value of the CFC's passive assets exceed 25 percent of the value of its total assets. The proposal would generally be effective for taxable years beginning after December 31, 1993. The proposal would provide for a phase-in of the amount subject to current inclusion over a five-year period.

2. TEI Position. TEI strongly objects to the proposal to tax in advance of repatriation to the United States certain accumulations of foreign earnings deemed to be "excessive." As a policy matter, the Institute disputes the need to overlay another type of regime on top of Subpart F. The PFIC provisions -- which themselves are a prime example of legislative overkill -- were enacted to prevent the very situation that the Administration now seeks to address: to eliminate deferral on passive assets. We submit that the last thing the tax system needs is another regime that, in terms of tax policy, is wholly redundant. In terms of administration, the President's proposal is tremendously complicated. It would add needless complexity to an already complex area and reduce the ability of U.S. multinationals to compete abroad. Moreover, we question whether the proposal would encourage companies to invest in facilities in the United States since corporations investing overseas generally tend to "plow back" the resulting profits in the business of that foreign affiliate. In reality, the provision could perversely act as an inducement to invest in active manufacturing facilities abroad to reduce a company's passive assets.

Finally, TEI objects to the provision to the extent that it would tax retained earnings and assets of foreign subsidiaries from prior years. Such retroactive application of the tax laws would be unwarranted and -- quite frankly -- inequitable. The retroactive effective date would also be unprecedented; when similar provisions (such as section 956's investment-in-U.S.-property regime) were enacted, the statute applied prospectively to future investments.

TEI therefore opposes the repeal of deferral for "excessive" earnings of controlled foreign corporations.

Transfer Pricing Initiative

1. President's Proposal. Section 6662 of the Code imposes a penalty of 20 percent of the amount of any understatement of tax attributable to "substantial valuation misstatements." Under section 6662(e), the penalty is imposed either (i) when the transfer price adjustments in any one taxable year exceed $10 million, or (ii) when the transfer price or adjusted basis for property or services exceeds 200 percent or more (or is 50 percent or less) of the amount ultimately determined to be the "correct" transfer price. This so-called section 482 penalty is increased to 40 percent of the understatement if there is a "gross valuation misstatement," which is defined as adjustments exceeding $20 million, or 400 percent or more (or 25 percent or less) of the "correct" transfer price. Under section 6664(c), the penalty does not apply to any portion of the understatement if the taxpayer has reasonable cause for the position taken and acted in good faith with respect to that position.

The President's proposal would amend section 6662(e) to provide that the reasonable cause and good faith exception will be satisfied only if the taxpayer provides contemporaneous documentation demonstrating the application of one or more reasonable transfer pricing methodologies to the taxpayer's controlled transactions. In order for the application of the transfer pricing methodologies to be reasonable, any procedural or other requirements imposed by regulation must be observed and documented. In addition, methods other than those specifically prescribed in the regulations may be reasonable if the taxpayer establishes that, at the time of the transaction, the prescribed methods will not be likely to lead to an arm's-length result and that the so-called fourth method actually applied was likely to lead to such a result. The provision would be effective for taxable years beginning after December 31, 1993.

2. TEI Position. The President's proposal essentially codifies the reasonable cause and good faith exception set forth in the recently proposed section 6662 regulations (which require contemporaneous documentation to escape the section 482 penalty). Although the Institute generally supports the codification of a specific reasonable cause exception, we believe significant questions remain about the proposed standard, especially to the extent it becomes the exclusive means of escaping the section 482 penalty.

Penalties are generally intended to encourage compliant behavior and to punish taxpayer misconduct. (Their purpose should never be to raise revenue.) To be effective in deterring culpable behavior, the penalty must warn taxpayers in advance that they will be held to a certain standard of conduct. We submit that in areas where reasonable parties may differ, the mechanical assertion of penalties is simply wrong. The determination of the "correct" transfer price between related parties is an inherently factual, complex undertaking. Recent court cases demonstrate that highly trained economic experts may substantially disagree on the proper pricing method in a particular factual setting. The recently proposed section 482 regulations themselves acknowledge that there is rarely any single, unassailable "right" answer.(21) In these circumstances, the section 482 penalty should not be routinely applied; rather, it should be limited to instances of truly culpable behavior.

TEI submits that the reasonable cause exception should encompass safe harbors or presumptions of good-faith conduct. We recommend that the contemporaneous documentation requirement in the President's proposal be recast as a safe harbor from assertion of the penalty. In other words, a taxpayer should be entitled to a presumption of reasonable cause and good faith where it can show that it has adopted a business policy designed to establish arm's-length prices between related parties, produces contemporaneous documentation showing how the transfer price was set, and verifies that the business policy was in fact followed. Such a provision would serve two purposes: (i) it would mitigate the severe underpayment penalty that may result from second-guessing a taxpayer's analysis and interpretation of complex factual data; and (ii) it would clarify the definition of "contemporaneous documentation" (which is undefined in both the President's proposals and the section 482 penalty regulations).(22)

Having contemporaneous documentation of transfer prices, however, cannot and should not be the sole means of satisfying the reasonable cause exception. Other safe harbors should be available. For example, if a taxpayer's pricing methodology has been continuously reviewed by the IRS for a certain number of years and found acceptable, reasonable cause and good faith should be deemed to exist. The reasonable cause and good faith standard should also be deemed satisfied for the amount of any timely, voluntary, self-assessed adjustment. Thus, where a taxpayer voluntarily self-assesses a net section 482 adjustment by filing an amended return, brings the adjustment to the attention of an IRS agent during an audit, or otherwise corrects an error through its normal accounting procedures, no penalty should be assessed. TEI believes that self-assessment upon the discovery of an error is evidence of good faith compliance that should negate any otherwise applicable section 482 penalty.(23)

TEI also believes that taxpayers who wish to use the so-called fourth method for establishing transfer prices should not be required to prove the inapplicability of the other prescribed methods in order to avoid the section 482 penalty. Establishing the inapplicability of a pricing method effectively requires the taxpayer to prove a negative -- that no other pricing methodology produces an arm's-length price -- and creates the presumption that the use of an "other" method is inherently wrong. This is a difficult -- if not impossible -- burden to meet.

In sum, TEI recommends that the President's proposal be revised to codify a "contemporaneous documentation" standard as a safe harbor -- i.e., as one means of satisfying the reasonable cause and good faith exception of section 6662(e). In addition, the proposal should be revised to eliminate the requirement that a taxpayer disprove the applicability of the other prescribed methods to establish reasonable cause.

Earnings Stripping Rules

1. President's Proposal. Section 163(j) was added to the Code in 1989 to prevent the possible erosion of the U.S. tax base by the use of excessive deductions for interest paid by a taxable corporation to a tax-exempt related party. In enacting the earnings stripping provision, Congress was primarily concerned with the thin capitalization of corporations. The current provision limits the U.S. interest deduction when (i) a corporation's debt-to-equity ratio exceeds 1.5 to 1; (ii) the interest is paid to a related party who is exempt from U.S. taxation; and (iii) the corporation has "excess interest expense," i.e., its net interest expense exceeds 50 percent of its adjusted taxable income plus the excess limitation carryforward.

The President's proposal would provide that any loan from an unrelated lender that is guranteed by a related party would be treated as related party debt for purposes of the earnings stripping rule. Except as provided by regulations, a guarantee would be defined to include any arrangement under which a person directly or indirectly assures the payment of another's obligation. The proposal would apply to any interest paid or accrued in taxable years commencing after December 31, 1993, without regard to when the underlying loan agreement was executed.

2. TEI Position. TEI submits that the interest disallowance rule should apply only where the transaction presents a possibility of earnings being "stripped." Hence, section 163(j) only applies to interest that is not subject to U.S. income tax on the payee/recipient. If, for example, a domestic corporation pays interest to its foreign parent that is subject to the 30-percent withholding tax, section 163(j) is inapplicable. In such a case, no earnings have been "stripped" from the United States without taxation and the domestic subsidiary's interest expense is properly deductible.

Similarly, where a U.S. subsidiary of a foreign parent corporation borrows from a U.S. bank (or other taxable third-party lender) and pays interest on the loan to the U.S. lender, there is no earnings stripping, regardless of whether such loans are guaranteed (or otherwise supported) by the borrower's foreign parent. All of the interest paid to the U.S. lender is fully subject to U.S. income tax. TEI submits that section 163(j) should not be expanded to deny an interest deduction to the U.S. subsidiary in such circumstances.

In addition, the President's proposal would discriminate against U.S. companies that are foreign owned vis-a-vis their U.S. competitors that are domestically owned. In either situation, indebtedness owed to U.S. lenders may be guaranteed by the corporate parent. Denying an interest deduction to a foreign-owned company might not only violate the anti-discrimination clauses of treaties with many countries, but would also represent bad tax policy. When the earnings stripping provision was enacted in 1989, Congress expressed concern that the use of loan guarantees not be used to circumvent the application of the rule. It recognized, however, that loan guarantees were often given in the ordinary course of business:

Some have argued that the House report's discussion of parent-guaranteed debt would potentially have made ordinary third-party financing transactions subject to the disallowance rule, in view of the common practice of having parents guarantee the debt of their subsidiaries in order to reduce the cost of third-party borrowings. The conferees intend to clarify that the provision is not to be interpreted generally to subject third-party interest to disallowance under the rule whenever such a guarantee is given in the ordinary course.(24)

This rationale remains valid today. Loan guarantees that are given in the ordinary course of business should not be viewed as a tax-avoidance device.

Finally, TEI objects to the retroactive nature of the provision. The proposed expansion of the earnings stripping provision would apparently apply to transactions that were entered into before December 31, 1993. Such retroactive application of the proposal is inequitable and unwarranted. The proposed effective date is especially improper in light of the generally prospective effective date of section 163(j) when it was enacted.

TEI therefore opposes the enhancement of the earnings stripping provision.

Enhancement of Accuracy-Related and Preparer Penalties

1. President's Proposal. Under section 6662, a taxpayer may generally avoid the accuracy-related penalty (for either substantial understatement of tax liability or negligence) for an underpayment of tax attributable to a position taken on a tax return if the position is not frivolous and is adequately disclosed. If the position is supported by substantial authority, disclosure is not required to avoid the penalty.(25) Similarly, the income tax return preparer penalty under section 6694 will not be imposed for an understatement of tax attributable to a position taken on a return if the position is not frivolous and is adequately disclosed. In the absence of disclosure, the penalty may be imposed if the position did not have a realistic possibility of being sustained on the merits and the preparer knew or reasonably should have known of the position. With respect to both penalties, a "frivolous" position is defined as one that is patently improper.

The President's proposal would substitute a "reasonable basis" standard for the "not frivolous" standard in both the accuracy-related penalty and the preparer penalty. "Reasonable basis" would be defined as a standard that is significantly higher than "not patently improper," thereby requiring that a return position be stronger than merely arguable or colorable in order to avoid the penalty. As a result of the change in standard, a taxpayer could avoid a substantial understatement penalty by adequately disclosing a return position only if the position had at least a reasonable basis; similarly, the penalty for disregarding rules or regulations would not be excused by disclosure unless the taxpayer's position had at least a reasonable basis. Finally, the requirement that a taxpayer disclose a position in order to avoid the negligence penalty would not be necessary because a taxpayer having a reasonable basis for its position would, by definition, be treated as not having been negligent. With respect to preparers, a penalty could be avoided by disclosure only where the position disclosed had at least a reasonable basis.

2. TEI Position. TEI has been concerned about the scope and proper application of the accuracy-related penalty since its enactment in 1982. We were thus pleased to participate in, and generally satisfied with the results of, Congress's 1989 reform of the Code's penalty provisions, which confirmed that the goal of penalties should not be to generate revenue but rather to encourage compliance by punishing culpable behavior. We believe Congressman Pickle should be applauded for his leadership role in crafting the Improved Penalty Administration Compliance Tax Act. We also believe the Internal Revenue Service should be commended for adopting a more customer-oriented approach to penalty administration.

Based on our long involvement with the accuracy-related penalty and with penalty administration generally, we are concerned about the inclusion of the accuracy-related proposal as a revenue raiser in the President's economic package. Nevertheless, as the professional association of in-house tax professionals who subscribe to rigorous Standards of Conducts, TEI supports the President's proposal to replace the "not frivolous" standard with the "reasonable basis" standard. Taxpayers and the IRS have experience with the proposed standard (which previously governed the application of the negligence penalty without regard to whether a position was adequately disclosed), and we believe the adoption of the standard would reduce the amount of "hair-splitting" that may occur with beneficial aspect of the proposal is its application of the same standard to both preparers and taxpayers.

Notwithstanding TEI's support for the President's proposal, we believe Congess musts underscore the need for the IRS to fairly apply the reasonable cause exception of section 6664. Specifically, in the proper exercise of its oversight responsibilities, the Committee should instruct the IRS ro confirm that the reasonable cause exception can be met without requiring the taxpayer to be omniscient -- to recognize that not every error requires the assertion of a penalty. In other words, they should distinguish, as Oliver Wendell Holmes said even dogs do, between someone who kicks them and someone who simply stumbles over them. A taxpayer should not be penalized for stumbling, especially given the complex state of today's tax law.(26)

For the foregoing reasons, TEI supports the President's proposal to amend the accuracy-related and preparer penalty provisions and recommends that the IRS be instructed to revise its regulations to properly implement the reasonable cause exception of the 1989 penalty reform act.

Service Industry Non-Compliance Initiative

1. President's Proposal. Under current law, payers must generally file information returns with respect to persons to whom they have made annual payments of $600 or more in the course of the payer's trade or business. Treasury regulations generally exempt payments to corporations from this requirement. The President's proposal would eliminate the exemption in respect of payments to corporations.

2. TEI's Position. TEI shares the Administration's and Congress's concerns about the level of noncompliance and pledges its best efforts in assisting the IRS and Congress to design initiatives to attack noncompliance without imposing undue costs on either compliant taxpayers or the IRS. In this regard, we have over the last year held several meetings with IRS officials as well as with appropriate congressional aides on the general issue of corporate information reporting.

Based on our analysis, we must express significant reservations about the President's proposal, especially since it would be effective with respect to all payments made after 1993. We submit that the proposal to require the filing of Forms 1099 in respect of service payments to corporations would impose substantial costs and yield little benefit to the tax administration system. Our concerns -- which could be either abated or heightened as more details are released -- go not only (or primarily) to the potential effect of the proposal on our members as payees (recipients of the information returns), but rather to the tremendous burdens the proposal would impose on our members as payers. Let there be no mistake: the target of the Administration's proposal to require the filing of information returns on payments to corporate service providers is not the large and medium-sized corporations whose members belong to TEI. Nearly all the companies represented by our membership are subject to continual, or at least regular, audit by the Internal Revenue Service; are subject to rigorous internal controls to forestall the nonreporting of income;(27) and have their financial statements certified by independent auditors. The IRS and the General Accounting Office both acknowledge that larger corporations are extraordinarily compliant with respect to service payments and, indeed, other categories of income.

Notwithstanding the high compliance level of the large corporations, the proposal would "deputize" payers to collect, prepare, and file information returns on payments to corporate service providers. The imposition of such a mandate -- which would extend to payments made by nonprofit organizations, state and local governments, and even the smallest company -- would spawn significant administrative costs. Payers would have to change their accounts payable systems (which could involve both hardware and software changes), designate and train staff to perform the data entry tasks, and absorb the cost of preparing the necessary reports and sending them both to payees and the IRS. For example, accounting systems in many (if not most) companies do not distinguish between payments for services and other payments; all that is recorded is the account payable. Under the Administration's proposals, payers would be required to change their systems to differentiate between the two types of payments. Regrettably, such a task is not as simple as "flipping a switch."

Given the Joint Committee on Taxation's revenue estimate for the proposal -- $326 million (as opposed to the Administration's $6.35 billion estimate) -- TEI believes there is a strong possibility that the cost to the payer community would exceed the revenues flowing to the Treasury. Obviously, it is difficult to predict either the cost of the programs or how much revenue it would generate because so few details have been released. Based on the sketchy information that has been released, more than one company has already estimated that its costs would exceed $1 million to implement the proposed changes and that it would cost nearly that much to maintain the new system on an ongoing basis. Whether any exception -- for example, for corporate payees whose gross receipts exceed a certain threshold or that are subject to continual audit -- could significantly reduce the burden on payers remains unclear.(28)

The burdens that the proposal would impose on corporate payees should also not be underestimated. Corporations that receive the Forms 1099 would have to store them, and the proposal raises the specter that payees might be compelled to formally match, or reconcile, the amounts so reported to their books of account or their tax returns -- a process that the IRS acknowledges could lead to countless mismatches, especially where the payee is an accrual basis or fiscal-year taxpayer (receiving information returns prepared on a cash, calendar-year basis). The situation is further complicated where the payments are received by a subsidiary but reported on the consolidated return filed by the corporate parent. These considerations have led the IRS in the past to oppose a broad-scale information reporting system; we suggest they apply with equal force to the "limited" program proposed by the Administration.

Equally important, there continues to be no convincing evidence that the IRS would be able to process the millions of additional pieces of paper that would be generated under the proposal.(29) In this regard, it is interesting to note that one aspect of the proposal -- an IRS initiative to assist payers in verifying the taxpayer identification number of payees -- has apparently been abandoned because the IRS cannot establish the program on schedule. There is no similar sympathy demonstrated, however, for the payers that would have to modify their computer systems and otherwise get geared up for the information reporting program.

As stated at the outset, TEI is committed to working with the government in attacking noncompliance in respect of service payments. We submit, however, that the burden of the compliance initiative should not be cavalierly imposed on compliant payers or on payees that have already demonstrated an extraordinarily high level of compliance.

For the foregoing reasons, Tax Executives Institute continues to have strong misgivings about the Administration's service industry non-compliance initiative.


Mr. Chairman, Tax Executives Institute appreciates this opportunity to present its views on President Clinton's Proposals for Public Investment and Deficit Reduction, and would be pleased to answer any questions you may have about its positions. In this regard, please do not hesitate to call Robert H. Perlman of Intel Corporation, TEI's President, at (408) 765-1202 or Timothy J. McCormally, the Institute's General Counsel and Director of Tax Affairs, at (202) 638-5601.

(1) The Internal Revenue Service currently has ample authority to challenge the reasonableness and, hence, the deductibility of excessive salaries. Indeed, the case law is replete with examples of situations where the IRS has successfully argued that no deduction should be allowed for an unreasonably large salary on the grounds that the payment constitutes a disguised dividend. In other words, the President's proposal is not necessary to protect against tax law abuses.

(2) Under the proposal, the limitation would apply to the salary paid to a corporate general counsel but not to the fees paid by the corporation to its outside counsel, frequently for substantially similar services.

(3) While there are elements of compensation packages that are common to all or many employers, there is a whole industry of compensation consultants and corporate human resources employees who devote their fulltime energies to devising incentive compensation arrangements that meet the particular, unique needs of individual enterprises. We doubt that an entirely objective, brightline tests of productivity will be flexible enough to accommodate all employees or all types of businesses.

(4) That it is not possible to establish a reasonable, generally applicable cap on deductible compensation is underscored by reference to the sporting and entertainment worlds. Many people might question whether certain professional athletes or entertainers are "worth" the salaries they command, but the fact is, their value is set in the marketplace. In the same fashion, corporate shareholders, acting by and through corporate boards of directors, determine the value of services provided by corporate executives. An arbitrary limitation on deductions for corporate salaries will likely not reduce the salaries paid to executives, because the value of their services will be set by a competitive market. Instead, the cost of increased corporate taxes caused by the disallowed deductions will be borne by either the customers or the shareholders of the corporation.

(5) We recognize that the SEC recently revised its rules relating to the disclosure of executive compensation in proxy materials and submit that such rules -- not the tax code -- are the proper venue for addressing issues of "excessive" executive compensation.

(6) See H.R. Rep. No. 1447 (Report of the Committee on Ways and Means to accompany H.R. 10650), 87th Cong., 2d Sess. 16 (1962), reprinted in Legislative History of H.R. 10650 (The Revenue Act of 1962), Public Law No. 87-834, Part 1, at 1151 (1967).

(7) Id.

(8) At best, the President's proposal is a blunt instrument: the disallowance would apply equally to both the sandwiches consumed during an all-day business meeting and the proverbial "three-martini lunch."

(9) While references to "country clubs" conjure up pictures of abuse, TEI questions why no exception is provided for facilities having absolutely no mixed business and personal uses, e.g., a business lunch club (with no accompanying athletic facility privileges) that is open only during business hours.

(10) This percentage could be adjusted to ensure that the rules are not manipulated to the government's detriment.

(11) From 1984 (when section 904(d)(3) was enacted) to 1986, a limited "look-through" rule applied to dividends, Subpart F income, and interest.

(12) Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 862 (1987) (hereinafter cited as the "1986 General Explanation").

(13) Id. at 863.

(14) American Law Institute, International Aspects of United States Income Taxation 247 (May 14, 1986) (hereinafter cited as the "ALI Report").

(15) H.R. No. 99-426, 99th Cong., 1st Sess. 341 (1985) (hereinafter cited as the "House Report"). See also 1986 General Explanation at 866. Moreover, Congress concluded that the look-through rule for royalties reduces the disparity between the tax treatment of branches and subsidiaries:

Look-through rules reduce disparities that might otherwise occur between the amount of income subject to a particular limitation when a taxpayer earns income abroad directly (as through a foreign branch) and the amount of income subject to a particular limitation when a taxpayer earns income abroad through a controlled foreign corporation.

1986 General Explanation at 866.

(16) House Committee on Ways and Means, Recommendations of the Task Force on Foreign Source Income, 95th Cong., 1st Sess. 35 (March 1977).

(17) See House Report at 333.

(18) ALI Report at 342.

(19) House Report at 341.

(20) With respect to royalties from unrelated parties, the ALI Report concludes that for self-developed intangibles, licensing "can be said to be merely one of the many techniques for realizing a return on the resulting asset and should not be differentiated from the use of the property by, for example, a foreign subsidiary that utilizes the property in carrying on its own business." ALI Report at 342. Again, because the source of the royalty is not "movable," the ALI Report concludes that the royalties should be left in the general limitation basket. Id. We submit that royalties received in the active conduct of a trade or business should not be relegated to the passive limitation basket.

(21) See Prop. Reg. Section 1.482-1T(d)(2) (permitting a range of arm's-length prices to be used under all methodologies).

(22) The lack of a definition for "contemporaneous documentation" causes considerable administrative problems. What, for example, will be considered "contemporaneous"? Must taxpayers have the documents "in hand" in order to rely upon them? Will it be sufficient for the foreign affiliate to certify that the documents exist? What is the effect of documents that come into existence after the return is filed, but support the use of the methodology? Will they be ignored? The term clearly needs to be clarified, especially if it becomes the sole means of avoiding the section 482 penalty.

(23) TEI continues to believe that sound policy requires the enactment of a de minimis rule, based on a percentage of total intercompany sales. Thus, where the total net section 482 adjustments are insubstantial (say, 10 percent) in relation to the value of the taxpayer's total gross intercompany transactions subject to scrutiny under section 482, a penalty should not be asserted. We submit that such a rule is necessary in light of the size and multitude of intercompany transactions that must be monitored by large corporations.

(24) H.R. Rep. No. 101-386, 101st Cong., 1st Sess. 566 (1989).

(25) In addition, section 6664(c) provides that an otherwise applicable penalty will not be imposed if the taxpayer can demonstrate that there was reasonable cause for the understatement of tax and that the taxpayer acted in good faith.

(26) TEI is especially concerned about the application of the reasonable cause exception to large, multi-divisional companies. We believe that the IRS needs to give due weight to the taxpayer's effort to self-assess the proper tax liability, taking into account not only the complexity of the rules with which the taxpayer must grapple, but also the operational constraints under which the taxpayer operates. In other words, the inquiry should focus on whether the taxpayer establishes reasonable business procedures (i.e., acceptable internal controls) to ensure compliance with its obligation and then makes a good faith effort to ensure those procedures are followed. The failure of a non-tax employee to abide by the company's procedures should not give rise to a penalty.

(27) Publicity held companies in particular have no incentive to underreport income for financial reporting purposes. Moreover, financial controls mandated by the Securities and Exchange Commission represent a clear "audit trail" for IRS examiners to confirm that income is correctly and completely reported.

(28) The Administration's proposal states that "some payors have suggested that it would be less burdensome to report all payments [for services], rather than to except payments made to corporate service providers [as allowed by current law]." Based on the corporate representatives whom we have heard from, that "suggestion" represents at best a minority view.

(29) Our understanding is that the IRS believes between 20 and 25 million additional information returns would be required to be filed under the President's proposal. Ancedotal information received from our members strongly suggests that the IRS's estimate is considerably understated.
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Date:Mar 1, 1993
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Deficit delusions.

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