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TEI recommendations on simplifying the Internal Revenue Code.

TEI Recommendations on Simplifying the Internal Revenue Code

On April 20, 1990, Tax Executives submitted the following Recommendations on Simplifying the Internal Revenue Code to the House Committee on Ways and Means. The submission was made in response to the simplification study announced by Committee Chairman Rostenkowski at February 7, 1990, hearing on the effect of the Tax Reform Act of 1986. TEI's testimony (at the hearing) was reprinted in the March-April 1990 issue of The Tax Executive.

I. Introduction

Tax Executives Institute (TEI) is the principal association of corporate tax executives in North America. Our approximately 4,300 members represent more than 2,000 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. As a professional association, 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 Internal Revenue Service can effectively perform its audit function. TEI is pleased to submit the following comments in response to the Committee on Ways and Means study of tax law simplification, which Chairman Rostenkowski announced on February 7, 1990.

That the tax system became increasingly complex during the 1980s is incontrovertible. Although more and more attention has been paid to the complexity of the tax law in recent years, previous efforts to simplify the tax code - especially for business taxpayers - have not proven wholly effective.*

Apart from the complex nature of specific statutory schemes (such as the fragmentation of the foreign tax credit into myriad separate baskets and the superimposition of the alternative minimum tax scheme on an already complex "regular tax" system), the magnitude and rapidity of change have contributed mightily to the complexity of the tax law. By one count, more than 140 public laws have been enacted since 1976 that, one way or the other, changed the Internal Revenue Code. In many cases, the ink may not have dried - or regulations been issued - on the old law, before a new law was enacted. Change has been piled upon change, and a vast array of provisions have been enacted, revised, repealed, and (in some cases) reinstated within a few short years.

The churning of the tax laws adds to their complexity. Tax laws may always be complicated, because the transactions to which they apply are complicated, but the 1980s' juggernaut of tax legislation has raised complexity to a new, almost insurmountable peak. This ever-changing playing field affects not only corporate taxpayers, which must contend with the changes on a day-to-day basis, but also the Internal Revenue Service, which must issue the necessary guidance and, ultimately, ensure compliance through its examination process. Moreover, the continuing enactment of new legislation has a "rippling" effect on the state and local tax structures tied to the federal system.

The maelstrom of legislation also breeds another, perhaps more insidious form of complexity - transitional complexity - which encompasses the burdens and problems associated with the instability of the tax laws. Although the effects of transitional complexity might be thought to dissipate quickly, that is not the case. Not only do some provisions have long phase-in periods (e.g., the adjusted current earnings provisions of the AMT), but broad delegations of rulemaking authority to the Department of the Treasury and the IRS postpone the day when taxpayers are provided with meaningful guidance on what a new provision means. In addition, such broad delegations of authority may actually work to deny taxpayers the very relief Congress sought to give. Consider, for example, the recently promulgated consolidated return investment adjustment regulations which - in effectuating Congress's repeal of the General Utilities doctrine - disallow all losses on the disposition of a subsidiary's stock. TEI submits that such a result is contrary to congressional intent to allow the deduction of losses under section 165 of the Code. We believe that such derogation of a congressional mandate could be avoided by more carefully crafted guidance during the legislative process.

Retroactive (or essentially retroactive) legislation produces yet another form of complexity, even where the substantive provision benefits the taxpayer. For example, since its enactment in 1978, section 127 (which excludes from taxation certain employer-provided educational assistance) has expired and been extended four times - three times retroactively. Employers have been required to design and implement programs to tax and withhold upon the value of employer-provided assistance only to modify (or undo completely) those programs on an after-the-fact basis. We submit that imposing such confusion and hardship on employers (and their employees) is simply unnecessary. The timely passage of extension legislation or, better yet, the enactment of "permanent" legislation would further the goal of tax simplification.

II. Adherence to Governing

Principles

Fast, furious, and complex legislation might be understandable if significant policy goals were achieved. TEI submits, however, that a major contributor to the complexity of the tax law is the manner in which the changes have been made. There often seems to be no overriding principles that mold and shape tax policy. The goal seems simply to raise revenue; while this goal is unassailable, it should not be pursued to the exclusion of sound policy and proper administration. To restore a fuller measure of order and certainty to the tax system, tax policymakers should identify and adhere to, with some degree of constancy, clear principles, rather than championing targeted provisions to address real, perceived, or merely chimerical abuses.

For example, if sound U.S. tax and economic policy supports minimizing double taxation on income earned abroad and deferring U.S. tax on unrepatriated earnings - and we submit it does - then proponents of proposals to dilute the foreign tax credit or chip away at the concept of deferral should be required to openly defend the proposed deviation from those principles. The incremental nature of such proposals should not relieve their defenders of the obligation to justify their proposals on policy grounds. Otherwise, taxpayers will find themselves at the bottom of the proverbial "slippery slope." We submit that the professed desire to close "tax pinholes" does not of itself justify the substantive, transactional, and transitional complexity it spawns.

The development of tax legislation requires a careful balancing of myriad, competing interests: national goals with respect to international trade, competitiveness, and economic growth (and the interaction of the tax rules with other legislative programs); prevailing economic theories; and a healthy respect for what is "doable" - by both the government and taxpayers. Regrettably, the current system contains too many examples where the fulcrum was misplaced and an improper balance was struck. Too frequently theoretical purity has been exalted above practical realities, and the burdens generated have been markedly disproportionate to the relative policy and revenue goals served by the statutory provisions.

In many cases, the changes in the tax laws marked a deviation from financial accounting rules (i.e., generally accepted accounting principles), requiring the establishment of new accounting systems. Provisions such as the uniform capitalization rules generate significant revenues only in the early years. Taxpayers, however, will be forced to contend with the "unicap" rules for many years to come when the provisions raise little, if any, additional revenue. We submit a tax regime that imposes such a long-term administrative cost on taxpayers in return for a short-term "quick fix" to the public treasury is ill-advised and irrational.

Another area that continues to merit reform is the corporate alternative minimum tax. Even after last year's revision of the adjusted current earnings (ACE) provisions, the administration of the AMT remains inordinately complex. The AMT is, in effect, a separate and independent tax system that not only operates parallel to, but also (to a certain extent) undermines tax and economic policy decisions reflected in, the regular tax system. Each year (indeed, each quarter) taxpayers must compute both their regular tax liability and their AMT liability in order to determine under which system they will pay tax for the year (or quarter). Although as a policy matter TEI questions whether the United States truly benefits from the maintenance of two separate tax schemes (which require, among other things, numerous separate depreciation systems), we believe that the AMT provisions could be further simplified without unduly affecting revenue. In short, if we must keep the AMT, keep it simple.

The choice between policy and complexity is not an absolute one. It is one that should be informed and open. In the past, the "constituency for simplification" has had no mechanism for effectively voicing its concerns. There has been no adequate means of gauging the administrability of particular proposals within the time constraints of the legislative process. There has been no "administrability estimates" to counteract, or complement, the revenue estimates. There has been little or no accountability. We hope the Committee's initiative signals its commitment to elevate administrability and compliance concerns to their rightful position in the tax legislative process.

III. Toward a More Administrable

Tax System

We believe a growing consensus exists that tax simplification must be assigned a higher priority by Congress, the Department of the Treasury and the Internal Revenue Service, and the tax community as a whole. We submit that Congress can - and must - take steps to ease the heavy compliance burden imposed on corporate taxpayers during the last decade. The Committee's simplification study is a salutary step in this war on complexity.

TEI is pleased to have this opportunity to offer its recommendations for a simpler tax system. Initially, we note that one way to ensure more administrable tax laws in the future would be to place greater emphasis on the administrability of particular provisions during the legislative process. In our February 1990 testimony before the full Committee on the effect of the Tax Reform Act of 1986, we stated that the most effective safeguard would be the allotment of time in which to analyze the administrability of specific proposals. We also made the following specific recommendations:

* Ask the Internal Revenue

Service to testify before Congress

specifically to address

the administrative aspects of

proposed tax legislation.

* Make a greater effort to prepare

draft legislative language

in advance of hearings and

mark-up sessions to allow the

discovery and correction of administrative

flaws before the

legislation becomes law.

* In appropriate cases, ask the

IRS to develop necessary tax

forms and schedules before a

proposal is enacted so that administrative

problems can be

identified and resolved beforehand.

TEI's goal in making these recommendations is simple: to make the tax legislative process more sensitive to "real world" limitations and constraints. This can be done by bringing into the process (both at the staff level and in hearings), on a systematic basis, individuals who are responsible for the preparation of corporate tax returns (and all they entail); those who can attest from experience that compliance cannot be achieved instantaneously by a flick of the computer switch. TEI fervently hopes that by subjecting future proposals to scrutiny on grounds of administrability, compliance problems can be minimized.

IV. Legislative Simplification

Proposals

TEI firmly believes that simplification must be an incremental process. The process of simplifying the entire Internal Revenue Code is seemingly overwhelming - so much so that many would not undertake the task. Although we recognize that provisions such as the consolidated return, Subchapter C, and foreign tax credit rules will never be truly simple, we believe that compliance burdens can be eased considerably through the enactment of safe harbors, de minimis rules, and provisions that alleviate the volume of paperwork and technical computations. On a project-by-project basis, strides can be made. Discrete issues can be attacked and victories achieved.

TEI's recommendations for legislative simplification follow. We submit the adoption of these proposals would lessen the compliance burdens not only for taxpayers but also the government without sacrificing sound tax policy goals.

A. Foreign Tax Credit:

Dividends from Noncontrolled

Foreign Subsidiaries

1. Description of the Problem. Under section 904(d)(1)(E) of the Code, dividends from each 10-percent to 50-percent owned foreign subsidiary ("noncontrolled section 902" companies) must be separately calculated and placed in a separate foreign tax credit (FTC) limitation "basket." Consequently, taxpayers face hundreds (or, in some instances, even thousands) of separate FTC calculations for both corporate and minimum tax purposes in respect of their noncontrolled foreign corporations. What's more, because of the relationship between all the baskets, the adjustment of a single item (e.g., a nominal adjustment in the earnings and profits (E&P) of one company) will have a rippling, flow-through effect on all the others - not only for the current year, but for carryback and carryforward purposes as well. With respect to large U.S. multinational groups, the number of potential adjustments is mind-boggling.

2. Recommendation. Permit all dividends from noncontrolled section 902 corporations to be aggregated and placed in a single basket. Alternatively, only two baskets should be required in respect of such dividends: one for dividends from noncontrolled section 902 corporations whose underlying earnings are subject to a local country statutory rate equal to or greater than 90 percent of the U.S. rate on ordinary income and another for all other noncontrolled section 902 corporation dividends.

B. Passive Foreign Investment

Companies

1. Description of the Problem. The passive foreign investment companies (PFIC) provisions of the Code, contained in sections 1291 through 1296, were intended to remove the economic benefit of tax deferral and the ability to convert ordinary income to capital gain which was available to U.S. investors in foreign investment funds. In addition, in enacting the PFIC rules Congress was also concerned that the tax rules not provide incentives to make investments outside the United States (current taxation is the order of the day for passive investments in the United States).

Unfortunately, when the PFIC provisions were enacted, the definition of a PFIC was so broad it 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 foreign tax). Thus, not just traditional investment companies were ensnared in the PFIC trap.

Pursuant to section 1296 of the Code, a foreign corporation is a PFIC if, for any taxable year, either (i) 75 percent of its gross income consists of passive income, or (ii) at least 50 percent of the average value of its assets produce, or are held to produce, passive income. In addition, section 1296(c)(1) contains a look-through rule providing that if a foreign corporation owns 25 percent of the value of the stock of another corporation, such foreign corporation is treated as if it held its proportionate share of the assets of such other corporation and received directly its proportionate share of the income of such other corporation.

Combined with the look-through rule, the gross-income and assets test creates a tremendous compliance burden for corporate taxpayers. First, corporate taxpayers must analyze both the income and assets of their active foreign subsidiaries. In addition, because of the look-through rule, the income and assets of lower-tier subsidiaries must be attributed to higher-tier subsidiaries, thereby compounding and complicating the analysis process.

There are also definitional problems with respect to both tests. For example, the income test is based upon gross income. An operating company could realize a loss from operations but, because it has passive income, be classified as a PFIC. The asset test is cumbersome because corporate taxpayers must periodically analyze the assets of their foreign subsidiaries to see if such subsidiaries meet the definitional test. Since the test is one of "average percentage," this analysis cannot be done on a year-end basis.

Even a corporation with a modest number of active subsidiaries is required to devote substantial time to analyzing the applicability of the PFIC rules. For example, one TEI member, with only 30 active subsidiaries, devotes between 300 and 400 hours per year to such analysis. Such a compliance burden is not warranted, particularly in connection with controlled foreign corporations (CFCs) whose shareholders must currently include the CFCs' Subpart F income in their income.

2. Recommendation. Exempt CFCs from the reach of the PFIC provisions. The PFIC rules stand as an excellent example of overkill - taxing not only passive income but also the operating income of foreign corporations. Adoption of the Institute's recommendation will ameliorate substantial compliance burdens without doing violence to the congressional intent underlying the PFIC provisions.

C. Foreign Tax Credit:

Translation of Deemed-Paid

Foreign Taxes

1. Description of the Problem. Section 986(a)(1) of the Code provides that, for purposes of determining the foreign tax credit (FTC), foreign taxes are translated into dollars using the exchange rate in effect when the foreign taxes are paid. This rule applies generally to both direct and indirect credits.

Prior to the enactment of section 986 as part of the Tax Reform Act of 1986, deemed-paid foreign taxes arising with respect to dividends from "10-percent owned" foreign corporations were translated at the exchange rate in effect on the date of distribution, in accordance with the decision in Bon Ami Co., 39 B.T.A. 825 (1939). Accumulated profits were translated using the spot rate on the dividend date. By using the same rate to translate foreign taxes and accumulated profits, the Bon Ami approach preserved the historical ratio between those two items.

Section 986(a)(1) was added to the Code to eliminate a perceived inconsistency between the rules applicable to taxpayers operating through branches and those operating through foreign subsidiaries. In addition, Congress believed that "the purpose of the FTC would be served more properly by fixing the dollar cost of foreign taxes when those taxes are paid." Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, at 1091 (1987). Although foreign taxes are translated into dollars as of the date the taxes are paid, accumulated profits are still translated using the spot rate on the dividend date.

Under prior law, taxpayers were required to convert tax payments only when the foreign affiliate paid a dividend (which may not be on an annual basis). Section 986(a)(1), however, places considerable administrative burdens on taxpayers to collect and analyze the information on foreign tax payments necessary to compute the dollar values for each tax payment and refund using multiple exchange rates. Conversion rates for such payments now must be performed on an annual basis. For example, companies operating in Japan pay separate creditable income taxes (to say nothing of numerous local income taxes), and Japanese corporate income tax payments and adjustments generally occur throughout the year. In addition, foreign tax returns and receipts, required as documentation under Treas. Reg. [section] 1.905-2, often do not evidence a time of payment. We believe that the administrative burden engendered by section 986(a)(1) is totally disproportionate to any practical purpose that may be served. The Bon Ami rule would not only preserve the historical ratio between foreign taxes and accumulated profits, but would also substantially reduce the administrative burden associated with categorizing the foreign tax credit by separate baskets.

2. Recommendation. Amend section 986 to reinstate the Bon Ami rule. In contrast to current section 986(a)(1), which creates unnecessary complexity and imposes unjustified administrative burdens, the Bon Ami rule is simple, well understood, and easy to administer.

D. Definition of Compensation

for Employee Benefit

Purposes

1. Description of the Problem. Currently, sections 401(a)(17), 414(q), 414(s), and 415 of the Code contain different definitions of the term "compensation." The myriad provisions generate complexity, as well as confusion, among plan sponsors, administrators, and participants.

2. Recommendation. Enact a uniform definition of compensation in order to simplify the administrative and communication tasks of plan sponsors and administrators. The uniform definition should be tied to taxable compensation (reportable on Form W-2) with elective contributions (e.g., section 125) added back at the employer's election on a uniform and nondiscriminatory basis. The uniform definition could be based on section 414(s), which ensures that limitations placed on highly compensated employees do not harm lower paid employees.

E. Capitalization of Interest in

the Foreign Context

1. Description of the Problem. Section 263A(f) of the Code provides that interest paid or incurred during the production period of certain property which is allocable to the production of such property must be capitalized as part of the cost of such property. Property subject to this rule generally includes real property, property with a depreciation class life of 20 years or more, and property with an estimated production period of more than two years (one year if the cost of the property exceeds $1 million). Section 263A(i)(1) provides for "regulations to prevent the use of related parties . . . to avoid the application of [section 263A]."

Pursuant to section 263A(i)'s grant of regulatory authority, the IRS issued Notice 88-99 which requires the application of section 263A(f) to the interest expense of all parties related to the taxpayer, including foreign subsidiaries outside the consolidated group.

The expansion of section 263A(f) to treat foreign subsidiaries as related parties creates tremendous administrative and compliance burdens for U.S. companies, principally in the computation of indirect foreign tax credits (FTCs) under section 902 of the Code. Because all post-1986 earnings are pooled for purposes of this section, and capitalization only postpones the deduction, the section 263A(f) amount becomes increasingly insignificant over time. The existence of excess FTCs has a further averaging effect. Thus, the application of the rules in the foreign context produces relatively insignificant revenue - certainly not enough to justify the increased cost of compliance on taxpayers.

More fundamentally, the rules set forth in Notice 88-99 are fictive: they presume, for example, that a company has borrowed money when in fact the funds are borrowed by (and secured by the assets of) a second, related company - even though the operations of the two companies (located in different countries, continents, or even hemispheres) are completely unrelated.

The Notice also requires the allocation of interest incurred by foreign subsidiaries against production property of related foreign affiliates, frequently with little or no effect on the U.S. parent's tax liability in the United States. For example, assume that a U.S. parent owns foreign subsidiaries in Italy and Germany. The German company has substantial production property with no debt, while the Italian company incurs substantial interest expense. Under Notice 88-99, the interest expense of the Italian company must be allocated to, and capitalized over the life of, the German assets. Such calculations - especially for multinational corporations that may have dozens (or even hundreds) of construction projects and debt instruments in myriad countries - cannot be accomplished with a mere flick of a computer switch. The compliance burden imposed on these companies under Notice 88-99 is tremendous.

Finally, the movement of cash between CFCs and between a CFC and its U.S. parent is subject to significant U.S. and foreign tax consequences that serve to prevent abuse. Thus, the extension of section 263A(f) to foreign subsidiaries is unwarranted.

2. Recommendation. Amend section 263A(f) and section 263A(i) to specifically exempt controlled foreign corporations from the reach of the related-party rules (and the IRS's rulemaking authority).

F. Uniform Capitalization:

Election to Use Specific

Capitalization Rate

1. Description of the Problem. The complexity of the uniform capitalization rules has created enormous compliance problems for corporate taxpayers. Because of the roll-over effect of the adjustment, following a transition period, the cost of compliance could easily exceed the revenue generated by the provision. This administrative burden strains not only the taxpayer's resources, but also the IRS's since it must audit the taxpayer's continuing compliance with the statute.

2. Recommendation. Permit taxpayers that have complied with the uniform capitalization rules to elect to use a specific capitalization rate for future years. This one-time determination could be based, for example, on an average capitalization rate determined from a three-year base period. This could be accomplished by directing the IRS to issue regulations permitting the use of such historically (or otherwise mandated) capitalization rules.

G. Filing of Forms 3115

1. Description of the Problem. Statutory changes such as the uniform capitalization rules require taxpayers to file a separate Form 3115 (Application for Change in Accounting Method) for each corporate affiliate. For large multinationals (which may have hundreds of subsidiaries), such a requirement is burdensome and unnecessary.

2. Recommendation. Relieve taxpayers that are required to change their method of accounting under a statutory mandate from the burden of filing separate Forms 3115 for each subsidiary. At a minimum, taxpayers should be permitted to file one Form 3115 for all subsidiaries. Although the IRS may possess the regulatory authority to effect this recommendation, the inclusion of a congressional mandate to do so would demonstrate Congress's seriousness about simplification.

V. Conclusion

Tax Executives Institute appreciates this opportunity to present its simplification recommendations to the Committee and would be pleased to answer any questions you may have about its positions. In this regard, please do not hesitate to call either William M. Burk, TEI's President, at (201) 894-2641 or the Institute's professional staff (Timothy J. McCormally or Mary L. Fahey) at (202) 638-5601.

* There can be no doubt that the law is simpler for those individuals whose return filing obligation was eliminated by the Tax Reform Act of 1986 or who are eligible to claim the standard deduction. For other individuals and practically all business taxpayers, however, the opposite is true.

PHOTO : IRS Audits & Appeals Seminar: Gerald Williams of Brigham Young University describes tax negotiation techniques to seminar participants.

PHOTO : IRS Audits and Appeals Seminar: Wilson Stockey, Assistant Chief, Examination Division, IRS Chicago District, discusses proposed changes in the Coordinated Examination Program (CEP).
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Title Annotation:Tax Executives Institute
Publication:Tax Executive
Date:May 1, 1990
Words:4318
Previous Article:Interest on federal tax deficiencies and overpayments revisited.
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