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Tax Executives Institute, Inc. - Joint Committee on Taxation; liaison meeting agenda; January 25, 1990.

Tax Executives Institute, Inc. -- Joint Committee on Taxation

Liaison Meeting


January 25, 1990


A. Overview: Does a Constituency Exist for

That the tax system has become increasingly complex in the last decade is hardly open to dispute. Even apart from teh complex nature of specific statutory schemes (such as those fragmenting the foreign tax credit into countless baskets and the alternative minimum tax scheme), the magnitude and rapidity of change have been staggering. By one count, there have been more than 139 public laws enacted since 1976 that, one way or the other, have changed the Internal Revenue Code--including the Omnibus Budget Reconciliation Act of 1989. 1990 will no doubt bring Law No. 140.

TEI recognizes that tax rules relating to corporations will never be "simple) and that tax reform's promise of simplicity was directed not so much at the business comumunity but at individual taxpayers. A year ago at our liaison meeting, we stated:

[T]he tax system is very much like the weather in at least one respect: easy to complain about, more difficult to remedy. We are also well aware of the budget and political exigencies that lead to the development of particular provisions, and acknowledge the charge that "no one complains about complexity that benefits him." We submit, however, that not all rainmakers--those with proposals to address the complexity conundrum and to confront it systematically--are charlatans. We further submit the proper response to a Chicken Little defense ("the sky is falling, the sky is falling") is not its ornithological opposite -- putting one's head in the sand.

We are pleased that a growing consensus exists that tax simplification must be assigned a higher priority by Congress, the Department of the Treasury and Internal Revenue Service, and the tax community as a whole. Thus, we believe that a "constituency for simplification" is emerging. In this regard, the 1989 Act not only simplified the alternative minimum tax provisions of the Code and repealed the mind-numbingly complex anti-discrimination rules of section 89, but also reformed and simplified the Code's penalty provisions.

On a going-forward basis, Congressman Rostenkowski has scheduled hearings on "the impact, effectiveness and fairness of the Tax Reform Act of 1986" for early February. (1) (*1) In addition, Assistant Treasury Secretary Gideon, IRS Commissioner Goldberg, and Joint Committee Chief of Staff Pearlman have all voice support for efforts to earmark discrete portions of the Internal Revenue Code (for example, the international provisions) for simplification. These efforts may not produce instantaneous results, but they do mark a salutary start.

(1) (*1) Numbered notes are printed at the end of the agenda (page 38).

TEI appreciates that simplification of the tax laws must be an incremental process and that other goals--be they policy or revenue driven -- sometimes take precedence over the goal of simplicity. We do not believe, however, that a "take it or leave it" approach to simplification efforts is appropriate. The solution is continuing dialogue and a willingness to compromise. We recognize, moreover, that the compromises will not be all one way: sometimes simplicity is going to cost money, and sometimes it is going to raise money. That TEI, other professional groups, and other taxpayer representatives decline to support a full slate of revenue-raising proposals--to engage in a "robbing Peter to pay Paul" exercise without any assurance that Paul will ever see a cent of the money -- does not mean that our support for simplification is insincere or hollow.

TEI strongly encourages Congress and committee staffs to redouble their simplification efforts, and we pledge our cooperation and support.

B. Identifying and Adhearing to Governing Principles

A major contributor to the complexity of the tax law is the willy-nilly manner in which changes have been made in recent years. In a very real sense, there seems to be no overriding principles that mold and shape tax policy. To restore order to the tax system (which by itself would bring some certainty), tax policymakers should identify and adhere to, with some degree of constancy, clear principles, rather than championing targeted provisions to address some real, perceived, or perhaps chimerical abuse.

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."

Similarly, if a national consensus emerges concerning the tax law's proper role in encouraging capital formation and savings (for example, through a preferential capital gain rate or an enhanced Individual Retirement Account) or the integration of the corporate and individual income tax system, future legislative amendments should not be considered until those proposals are reconciled with the governing principles. Such an approach would, by itself, contribute to the simplification of the tax system.

C. The Proper Target of Enhanced Compliance Measures

Congressman Pickle, as Chairman of the House Ways and Means Oversight Subcommittee, recently announced the results of the Subcommittee's study of the effects of a budget shortfall at the Internal Revenue Service. The Subcommittee's press release states that the IRS's "financial crisis" has affected the quality of the IRS's taxpayer assistance program, the implementation timetable for a computer system modernization program (and new programs such as a delinquent returns initiative), and the IRS's ability to hire and retain qualified personnel.

Receiving more attention in the press, however, were two items that could well become the basis for future remedial legislation or stepped-up compliance efforts by the IRS:

* The Subcommittee reported that "[a]lmost $60 billion in taxes owed to the government remains uncollected because the IRS does not have the necessary resources to pursue delinquent taxpayers. In many instances, billions of dollars have been lost forever because the statute of limitations for IRS action has expired."

* The Subcommittee reported that "[f]or the first time in history, less than 1 percent of all income tax returns will be audited posing a serious threat to the country's voluntary tax system. Approximately 83 percent of the tax owed in income from legitimate economic activities is voluntarily reported and paid. However, the 'tax gap'--an estimate of the difference between the amount of taxes voluntarily paid in a taxable year and the amount of taxes that would have been paid if all taxpayers had filed complete and accurate returns -- is approaching $100 billion a year and continues to grow. Despite growing noncompliance, the IRS continues to experience budgetary problems and, as a result, critical compliance initiatives have been cancelled or delayed."

TEI does not underestimate the seriousness of the IRS's accounts receivable inventory or the "tax gap." We submit, however, that attention to these issues must be properly focused. Thus, the class (or classes) of taxpayers that are targeted for action must be specific. In this regard, we note that the IRS's audit coverage of large corporations is not 1 percent, but nearly 100 percent as a result of the Coordinated Examination Program (a program which TEI supports). At a time when most large corporations are subject to continual audit, we suggest the IRS's "critical compliance initiatives" coud more properly be directed to those taxpayers who, unlike CEP taxpayers, are not subject to substantial internal or external controls. (With respect to proposals to implement a document matching program for corporate taxpayers, see Item IV.B.)

As to be size and nature of the "tax gap," caution must also be exercised not to misconstrue the the available statistical analyses. For example, in connection with the Institute's April 1989 liaison meeting with the Joint Commmittee staff, we noted the flaws in the IRS's 1988 report on the tax gap -- "Gross Tax Gap Trends According to New IRS Estimates, Income Years 1973-1992," Statistics of Income Bulletin, Vol. 8, No. 1, at 23-28 (Summer 1988). Cocluding that the net effect of the IRS's report was to cast corporations as tax scofflaws, we made the following specific observations:

* The "gross" voluntary compliance rate among corporations in 1988 was 82.4 percent. Thus, the study confirms that the vast majority of corporate taxpayers comply with the tax laws.

* The size of the tax gap is based on audit adjustments proposed by IRS examiners -- even though a large number of such adjustments are reversed by the IRS itself as cases work their way through the administrative process. (2)

* The estimated increase in the tax gap (tax dollars not voluntarily paid) is attributable in large measure to the growth of income tax liabilities through real expansion of the economy and through inflation, not to growing noncompliance.

* The estimated increase in the tax gap assumes that there will be no change in compliance rates. Thus, an incease in income tax liabilities will, by virtue of simple arithmetic, lead to an increase in the tax gap.

* Perhaps most fundamentally, the IRS has insufficient data to identify the various components of the corporate tax gap.

As Congress considers proposals to augment the IRS's compliance arsenal, we recommend that care be taken to identify the proper target of new compliance proposals.

D. Conclusion

In the succeeding sections of this agenda, TEI discusses several areas that it believes merit attention as efforts continue to simplify or improve the Internal Revenue Code. Taxpayers and government representatives may not always agree (with each other or among themselves) on how particular provisions should be simplified or where concerns of "equity" or "fairness" or revenue should override the simplification objective. TEI remains convinced, however, that progress can be made.


A. Foreign Tax Credit: Carryback and Carryforward Rules

1. Description of the Problem. Section 904(c) of the Code currently provides that any foreign tax credits (FTCs) not used against U.S. tax in the current year may be carried back two years and forward five. The rules for the general business tax credit (section 39) and net operating losses (section 172(b)) provide, however, for a three-year carryback and a fifteen-year carryforward. The effect of the shortened time periods has been to cause FTCs to expire unused, thereby frustrating the purpose of the credit -- the prevention of double taxation.

There is no readily apparent policy reason for the harsher rules in the foreign tax credit area. In fact, when originally enacted as part of the 1954 Code, the carryback/carryforward provisions in respect of the net operating loss (NOL) and the FTC were identical -- two years back and five years forward. Although the rules have been liberalized several times for net operating losses since 1954 (most recently in 1981 as part of the Economic Recovery Tax Act), the FTC provisions have been ignored.

In addition, the ordering rules contained in section 904(c) for FTCs require that the current year's credits be utilized before any carryovers are taken into account. By contrast, in respect of the general business tax credit, a carryover is to be used first, before the current year's credits, to afford the taxpayer the maximum opportunity for using the credit. See I.R.C. [section] 38(a).

The inconsistency in carryback/carryforward perids is not only inquitable, but also complicates the tax laws. The current rules create administrative burdens for the government and taxpayers alike. More fundamentally, the rules effectively penalize taxpayers that experience operating losses, thereby creating a windfall for the federal government that may "collect" a substantial portion (if not all) of the FTCs previously earned and claimed because of the unduly short carryback/carryforward period. Current law effects an especially harsh result in respect of taxpayers in cyclical industries whose ability to utilize FTCs is limited because of income fluctuations.

2. Recommendation. Amend section 904 to conform the FTC carryback/carryfoward periods ot those allowed for net operating losses and general business tax credits (i.e., three years back and fifteen years forward). We also recommend that the FTC ordering rules be made parallel to the general business credit rules: any carryover credit should be taken into account before the current year's credit. These proposals would not only further the goal of simplifying the Code, but would also limit those situations where the purpose of the FTC -- the elimination of double taxation -- is frustrated by unrealistically short carryback and carryforward periods.

B. Foreign Tax Credit: "Quickie" Refunds Attributable to FTC Carrybacks

1. Description of the Problem. Under normal administrative procedures, tax refunds resulting from a carryback of net operating losses (NOLs), business and research crfedits, capital losses, or foreign tax credits (FTCs) cannot usually be made until a considerable period of time has elapsed after the close of the taxable year in which the carryback arose. Under section 6411(a) of the Code, however, a taxpayer may file an application for a tentative carryback adjustment of the tax (a "quickie" refund) for a prior taxable year affected by an NOL carryback, a business credit carryback, a research credit carryback, or a capital loss carryback. The goal of the procedure is the expeditious refund of monies to a taxpayer that -- as a result of subsequent economic events -- has overpaid its taxes.

The Code's special "quickie" refund procedure is not currently available with respect to FTC carrybacks. TEI suggests that Congress's failure to extend the procedure to such carrybacks may be inadvertent.

2. Recommendation. Amend section 6411 to treat FTC carrybacks in the same manner as other loss and credit carrybacks. TEI submits that no valid policy reason exists for treating FTC carrybacks less favorably than NOL, capital loss, research credit, and general business credit carrybacks for quickie refund purposes. The Institute suggests that the reasons for extending the section 6411 procedure to FTC carrybacks are similar to the reasons that Congress found persuasive in 1966 when it extended the provisions to investment tax credit carrybacks.

C. Foreign Tax Credit: Dividends from Noncontroller 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 must be separately calculated and placed in 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 (non-CFCs). 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 multinational groups, the number of potential adjustments is mind-boggling.

2. Recommendation. Permit all dividends from non-CFCs to be aggregated and placed in a single basket. At a minimum, an exception should be provided that allows all non-CFC dividends to be aggregated and placed in one basket if the underlying earnings of each such non-CFC are subject to a local country statutory rate equal to or greater than 90 percent of the U.S. rate on ordinary income; a separate basket could be used for all other non-CFC dividends. Alternatively, all such dividends could be placed in the general limitation basket subject to a look-through rule similar to that in section 904(d)(3) (in respect of controlled foreign corporations).

D. Foreign Tax Credit: Creditability Against Alternative Minimum Tax

1. Description of the Problem. Under section 59(a)(2) of the Code, a taxpayer's foreign tax credit (FTC) may offset no more than 90 percent of the taxpayer's alternative minimum tax (AMT) liability. (3) In contrast, a taxpayer that is subject to a regular income tax liability is not subject to the 90-percent restriction. The 90-percent limitation is presumably the result of Congress's efforts to reconcile the arguably conflicting policies underlying the FTC and AMT.

Because the United States taxes the worldwide income of its citizens and residents, the FTC was introduced to limit the incidence of double taxation -- the taxation of the same income by two jurisdictions. The policy underlying the FTC has not changed over the years, though certain limitations have been imposed to prevent what has been deemed to be the improper averaging of high-and low-tax foreign source income. Thus, under the regular income tax provision, a U.S. taxpayer may offset fully 100 percent of its U.S. tax liability on foeign-source income with its FTC. This does not mean that the taxpayer is not paying any tax, but rather simply acknowledges that the taxpayer has already paid a tax (to the jurisdiction where the income was derived) at the rate equal to or greater than the amount the United States would assess on that income. The general policy against double taxation has also been pursued through a network of bilateral treaties between the United States and its trading partners.

When the AMT was enacted as part of the Tax Reform Act of 1986, Congress had "one overriding objective: to ensure that no taxpayer with substantial economic income can avoid significant tax liability by using exclusions, deductions, and credits." S. Rep. No. 99-313, 99th Cong., 2d Sess. 518-19 (1986). Thus, the AMT was deemed necessary to address public perceptions about the fairness of the tax system. As part of the AMT regime, Congress imposed the 90-percent FTC limitation.

TEI submits that affording a taxpayer the ability to utilize FTCs to substantially reduce or even eliminate its AMT liability would not frustrate the legitimate policy underlying the AMT. Unlike the other items that may serve the reduce a taxpayer's regular tax liability (which taxpayers are not permitted to take fully into account for AMT purposes), the foreign tax credit represents precisely what its name suggests: a tax. A taxpayer with an AMT liability and sufficient FTC to offset that liability has already paid a hefty tax. Clearly, that the tax has not been paid to the United States has no bearing on the economic cost it represents to the taxpayer. Moreover, to the extent the FTC and AMT regimes do conflict, TEI submits that the policy supporting the FTC (and complementary provisions in U.S. tax treaties)--which is based upon sound economic reasoning and comports with longstanding international norms -- should prevail.

The imposition of an AMT in these circumstances exacerbates the tax burden upon income already subject to tax at a rate equal to (or higher than) the U.S. rate. Consider, for example, a taxpayer, T, with a regular tax liability of $101, an AMT liability of $100, and an available FTC of $100. Because T can credit its entire FTC against its regular tax, T's regular tax is $1. Because of the 90-percent limitation, however, T's AMT is $10 -- notwithstanding that T's regular income tax liability before credits was higher than its AMT liability and a foreign jurisdiction taxed the income at the practical equivalent of T's regular U.S. tax rate. (4)

2. Recommendation. Repeal section 59(a)(2), thereby making the FTC fully creditable against the AMT. The policy reasons that led to the enactment of the FTC and permit that credit to offset 100 percent of a taxpayer's regular tax liability on foreign-source income -- relief from double taxation of the same income -- remain just as viable today for purposes of the AMT. Current law discriminates against the "alternative tax" taxpayer vis-a-vis the "regular tax" taxpayer that realized the same amount of income. The 90-percent limitation should be repealed and the FTC made fully creditable against that part of the AMT attributable to foreign-source income.

E. 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.

Section 986(a)(1) 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. For example, Japanese companies pay three separate creditable 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 codify 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.

F. Foreign Tax Credit: Foreign Loss Recapture Rules

1. Description of the Problem. The foreign tax credit (FTC) recapture rules under section 904(f) of the Code are deficient in several respects. Perhaps most significant, they lack symmetry in situations where foreign source income is offset by a domestic source loss. This could result in an unintended (or, in any event, inequitable) permanent loss of FTCs with respect to foreign taxes paid on the foreign source income, unless in subsequent years an equal amount of domestic source income is reclassified as foreign source income.

Section 904(f) provides for recapture of overall foreign losses, but does not provide for similar recapture treatment when there is an overall domestic loss that is offset against foreign income in year one and in a subsequent year(s) there is sufficient domestic income to otherwise absorb such overall domestic loss. Consequently, the credit can be lost where a taxpayer has an overall domestic loss and positive foreign income. The shorter FTC carryforward period (see Part II.A. above) serves to exacerbate this problem.

2. Recommendation. Amend section 904(f) to provide that U.S.-source losses will be recaptured in the same manner as foreign-source losses. Thus, the Code should permit an adjustment for the recapture of domestic-source losses that would increase foreign-source taxable income when the taxpayer subsequently earns domestic income. The ability to recapture U.S.-source losses would not only provide parallel treatment, but would also foster U.S. competitiveness.

G. 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 porportionate 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.

b. 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.

H. Interest Allocation Rules

1. Description of the Problem. Section 864(e) of the Code provides that the taxable income of each member of an affiliated group from sources outside the United States must be determined by allocating and apportioning interest expense for each member as if all members of such group were a single corporation. This "fungibility" rule was adopted because of a congressional perception that taxpayers could arrange to have interest expense reduce U.S. income, although the interest expense funded foreign activities (or freed up other cash to fund foreign activities), the income from which was sheltered from U.S. tax by the foreign tax credit (FTC) or deferral. S. Rep. No. 99-313, 99th Cong., 2d Sess. 347 (1986).

The interest allocation provision fails to take into account, however, the interest expense incurred by a taxpayer's foreign affiliates. Thus, although domestic interest expense may be allocated to foreign source income, the debt of the foreign affiliates earning that income is ignored for purposes of the interest allocation rules.

Section 864(e) incorrectly assumes that the debt of U.S. members of the consolidated group finances overseas operations and all third-party interest expenses of such members must be geographically sourced between U.S. and foreign income. This is a fiction, however, since many foreign affiliates borrow funds to finance their own asset acquisitions or finance their assets with cash from retained earnings. As the Senate Finance Committee recognized when considering a similar proposal in respect of the Tax Reform Act of 1986, to the extent section 864(e) employs a fungibility concept, it is appropriate to consider interest expense incurred and assets owned by foreign affiliates -- acknowledging that borrowings of foreign affiliates "may bear o the allocation of the interest expense that the U.S. group does incur." S. Rep. No. 99-313 at 349.

2. Recommendation. Amend section 864(e) to provide that the interest expense to be allocated among members of the consolidated group includes the interest expense of foreign corporations. Adoption of this suggestion would eliminate the need for the controversial CFC "netting" rule now contained in the temporary regulations under section 864(e). See Temp. Reg. [Section] 1.861-10T(e). (5) Adopting TEI's recommendation would not only be consistent with the fungibility concept, but would also materially reduce the administrative complexity engendered by the interest allocation rules.

I. Sourcing of U.S. Research and Experimental Expenditures

1. Description of the Problem. In 1977, the Treasury Department issued regulations under section 861 relating to the allocation of U.S. research and experimental (R&E) expenses against foreign income. To encourage U.S.-based R&E, in 1981 Congress enacted a temporary moratorium on the application of the Treasury regulations. That moratorium has been extended and modified several times, with the current statutory provision setting forth a so-called 64-percent solution. Under the current provision (which was enacted by the Omnibus Budget Reconciliation Act of 1989), 64 percent of research expenses (other than expenses incurred solely to meet legal requirements imposed by a government) that are attributable to activities conducted in the United States are allocated to U.S.-source income, and 64 percent of research expenses that are attributable to activities conducted outside the United States are allocated to foreign-source income.

The current rule is effective only for the taxpayer's first taxable year beginning after August 1, 1989, and before August 2, 1990, and applies only to that portion of research expenses treated (on a pro rata basis) as having been paid or incurred during the first nine months of that year. Because the rule is not applicable for the entire taxable year, taxpayers face the complicated task of applying two different rules in respect of the same year.

The House version of the 1989 Act would have made permanent the research and experimental expense allocation rules. TEI strongly supports the enactment of a permanent solution to the allocation and apportionment of research and experimental expenditures. We believe there is a need for certainty and stability in this area.

2. Recommendation. Make the research and experimental allocation rules set forth in the Omnibus Budget Reconciliation Act of 1989 permanent.

J. 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]."

Notice 88-99 (issued by the IRS on August 16, 1988) provides rules for the application of section 263A(f). Section VIII(B) of the Notice 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 actually borrowed by (and secured by the assets of) a second (albeit related) company, even though the operations of the two companies -- located in different countries, continents, or even hemispheres -- are completely unrelated.

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 263(i) to specifically exempt CFCs from the reach of the related-party rules.


A. Environmental Tax

1. Description of the Problem. Section 59A of the Code imposes an environmental tax equal to 0.12 percent of the excess modified alternative minimum taxable income over $2,000,000. The tax applies whether or not the corporation is subject to the alternative minimum tax (AMT) and is computed without regard to net operating losses (NOLs) or foreign tax credits (FTCs).

Not permitting a deduction for NOLs in computing the environmental tax can produce inequitable results. For example, a taxpayer with stable income may have a smaller environmental tax liability over time than another taxpayer whose income fluctuates, even though the total income of both taxpayers is identical. In addition, taxpayers that claim the FTC for income tax purposes are not permitted to deduct foreign taxes from the environmental tax base. Since a taxpayer choosing to deduct its foreign taxes for federal income tax purposes is permitted a correlative deduction for environmental tax purposes, the tax inequitably affects similarly situated taxpayers. Moreover, section 59A causes U.S. corporations claiming the FTC to pay a U.S. tax not only on its worldwide income but also on funds expended to pay the foreign taxes on that income -- "phantom income" that can never be repatriated to the United States. Such a policy is contrary to international principles eschewing double taxation and impedes the international competitiveness of multinational corporations. (6)

2. Recommendation. Amend section 59A to provide a deduction for the AMT net operating loss. Section 59A should also be amended to permit the deduciton of foreign taxes in determining the environmental tax base for all taxpayers, thereby eliminating the section 78 gross-up.

B. Corporate Capital Loss Carryforward Period

1. Description of the Problem. Under section 1212(a)(1) of the Code, a corporation may generally carry a capital loss back for three years and forward for five years. In contrast, net operating losses may be carried forward for fifteen years. In addition, taxpayers with large NOLs may elect to relinquish the carryback period for any loss year.

The disparate treatment of capital losses and net operating losses makes no sense from a policy standpoint. On several occasions, Congress has evidenced a clear intent to avoid situations where taxpayers are unable to generate sufficient income during their carryover periods to use their operating loss carryovers. Congress was also concerned that a mandatory carryback of NOLs may actually result in an increased tax liability because of the interaction of the loss provisions with other provisions of the Code. See, e.g., Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1976, at 189 (1976). Congress therefore expanded the NOL carryforward period and provided an election in respect of NOL carrybacks.

When Congress enacted the carryback period for capital losses in 1969, it saw no reason "why capital losses should be treated any differently ... in the case of corporations than net operating losses." S. Rep. No. 91-552, 91st Cong., 1st Sess. (1969), reprinted at 1969-3 C.B. 548. TEI submits that this statement is jus as valid today.

2. Recommendation. Amend section 1212(a) to extend the capital loss carryforward period to fifteen years in conformity with the net operating loss carryforward provision in section 172(b). In addition, taxpayers should be permitted to elect not to have a mandatory carry back of a capital loss.

C. Credit for Increasing Research Activities

1. Description of the Problem. Taxpayers may generally claim a credit equal to 20 percent (25 percent for expenditures incurred before 1986) of certain qualified research expenditures incurred in connection with their trade or business. Since its enactment in 1981, the research and experimental (R&E) tax credit has been extended three times; it is now due to expire (once again) in 1990.

Planning for R&E expenditures is, almost without exception, a multi-year effort by taxpayers. The temporary nature of the R&E credit makes it extremely difficult to include the credit in planning intermediate and long-range projects. Thus, the structure of current law spawns extreme administrative difficulties for companies.

In addition, the temporary credit materially detracts from the incentive effect of the provision. The credit was enacted specifically to reverse the decline in research spending and overcome the reluctance of many companies to incur the substantial costs associated with R&E activities. Staff of the Joint Committee on Taxation, General Explanation of the Economic Recovery Tax Act of 1981, at 119-20 (1981). Because companies cannot depend upon continued extensions of the credit, its transitory nature frustrates congressional intent.

2. Recommendation. Amend section 41 to make the R&E credit permanent.

D. Alternative Minimum Tax -- Net Operating Loss Offset

1. Description of the Problem. Under the alternative minimum tax (AMT) rules, a net operating loss (NOL) deduction is limited to 90 percent of a taxpayer's alternative minimum taxable income, computed without regard to the NOL deduction. TEI believes that the 90-percent limitation is misguided and recommends that it be repealed.

The rationale for allowing a deduction for NOLs is to "ameliorate the unduly drastic consequences of taxing income strictly on an annual basis." The NOL carryover provisions were specifically "designed to permit a taxpayer to set off its lean years against its lush years, and to strike something like an average taxable income over a period longer than one year." Libson Shops v. Koehler, 353 U.S. 382, 386 (1957). In addition, the NOL carryover provisions reduce the disparity between the taxation of businesses that have stable incomes and those that experience fluctuations.

As discussed in Item II.D., the AMT was designed to ensure that taxpayers with substantial economic incomes paid some tax. This purpose notwithstanding, TEI submits that it is difficult to reconcile the 90-percent limitation with the objective of either the NOL or the AMT. By its very nature, the NOL provision seeks to prevent taxation of those taxpayers that do not have economic income.

2. Recommendation. Amend the AMT rules to repeal the 90-percent limitation on the utilization of net operating losses to offset the AMT.

E. Alternative Minimum Tax -- ACE Preference: Depreciation

1. Description of the Problem. Beginning with 1990, the book income preference (which is set forth in section 56(f)) has been replaced by the adjusted current earnings (ACE) preference, which is based primarily on tax earnings and profits concepts. (The ACE adjustment is set forth in section 56(g).) Although the Omnibus Budget Reconciliation Act of 1989 modified and simplified the ACE preference, the transition to ACE will still cause major problems, especially in respect of the depreciation provision.

Under ACE, a taxpayer's depreciation is based on its remaining regular tax basis for assets placed in service between 1981 and 1986, or its remaining AMT basis for assets placed in service between 1987 and 1989. That basis is then depreciated over the remaining useful life under the alternative depreciation system (for earnings and profits purposes).

By starting with the regular tax (or tentative alternative minimum taxable income before ACE adjustment) basis, the system creates a major transitional problem. For 1990 and subsequent years, taxpayers will have relatively small depreciation deductions for assets placed in service in 1989 and earlier years, because the remaining basis is assumed to be that under the regular tax (or AMT), not that remaining for earnings and profits purposes. This differs from the book income preference depreciation system, which used book depreciation for all periods. The result is a substantial decrease in depreciation deductions.

In effect, ACE uses inconsistent depreciation methods during the transitional period until all pre-1990 assets are retired. In fact, the depreciation deductions permitted under ACE during this period will be susbstantially less than any fair measure of economic reality. Hence, the current system goes far beyond the goal of the AMT to tax "economic income."

2. Recommendation. Amend the ACE provisions to apply whatever the depreciation system used for AMT purposes to all assets of the taxpayer as the date of acquisition. This rule, which should govern regardless of whether such assets were acquired before or after the effective date of the current AMT system, would more accurately reflect economic depreciation in computing the ACE preference.

F. alternative Minimum Tax -- ACE Preference: Foreign Source Income

1. Description of the Problem. Section 59(a)(1)(C) of the Code provides that, for purposes of the alternative minimum foreign tax credit, the book income preference must --

still have the same proportionate source (and character as alternative minimum taxable income determined without regard to [the book income preference].

A similar rule, however, does not apply to the adjusted current earnings (ACE) preference. Consequently, under ACE a taxpayer will be required to source all items of income and allocate and apportion all items of expense under the principles of sections 861 and 862. Such complexity is unwarranted and unduly burdensome, particularly in years when the net negative adjustment rules of section 56(g)(2) apply.

2. recommendation. amend the AMT rules to provide a simplyfying rule with regard to the ACE preference similar to that provided in respect of the book income preference in section 59(a)(1)(C).

G. Education Assistance Payments

1. Description of the Problem. Section 127 of the Code excludes from taxation employer-provided educational assistance for non-graduate level courses. Since its enactment in 1978, section 127's exclusion has expired and been extended four times (three times retroactively). Once again, the provision is set to expire in 1990.

The uncertainly and confusion created by the "sunsetting" of the exclusion greatly diminishes its incentive effect and spawns substantial administrative burdens. For example, 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. Employees, too, have been subject to confusion and hardship.

2. Recommendation. Amend section 127 to made permanent the exclusion for employee assistance payments. Employer assistance provides job advancement opportunities for lower-paid and unskilled workers. By making section 127 permanent, the administrative confusion for employers and the financial burden for employees resulting from numerous expiration and retroactive extensions of section 127 would be eliminated.

H. Definition of compensation for Employee Benefit Purposes

1. Description of the Problem. Currently, sections 414(s), 414(q), 415 and 401(a)(17) 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 constributions (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.


A. Corporate Estimated Taxes

1. Description of the Problem. Current law effectively requires large corporations to overpay their estimated taxes, without the benefit of interest, in order to avoid an underpayment penalty under section 6655 of the Code. This Hobson's choice does not confront other taxpayers because they may generally avoid the section 6655 penalty by availing themselves of a statutory safe harbor. Regrettably, the Omnibus Budget Reconciliation Act of 1989, which substantially reformed the Code's penalty provisions, did not address the corporate estimated tax rules -- which operate as a "non-penalty penalty."

Specifically, under section 6655, corporate taxpayers are generally subject to a penalty if they fail to estimate their tax liability and make quarterly deposits equal to either (i) at least 90 percent of their (subsequently determined) actual tax liability, or (ii) 100 percent of their prior year's tax liability. Regrettably, the "prior year's tax" option is not available to so-called large corporations -- roughly corporations whose taxable income is $1 million or more in any of the preceding three years. (Section 6655(d)(2) provides that the prior year's tax rule is not available to large corporations; section 6655(g)(2) defines "large corporation".)

Because they are not permitted to utilize 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 a literally impossible one in light of the complexity of the tax laws, the rapidity with which they have been changed in recent years, and the fact that the numerous adjustments to financial income can accurately be done only annually. Consequently, the large corporate taxpayer faces the following choice:

* paying a penalty (under section 6655) for understanding its liability, or

* overpaying its taxes (in order to avoid the penalty).

The second option (which, quite candidly, large corporations are generally required to choose not only by internal business conduct policies but by basic business exigencies -- the desire to avoid penalties) does not come without cost. The cost is the effective denial of interest on the amount of the compelled overpayment by operation of section 6611(e), which provides that interest on an overpayment will not begin to run until the filing of a claim for refund.

2. Recommendation. Reform the corporate estimated tax provisions of the Code. 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) of the average of its tax liabilities in the preceding three (or more) years (after taking into account credits). (8)

* 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 the payment is made, to

ii. the date such overpayment is refunded (or applied to a subsequent liability). (9)

B. Business Document Matching: Corporate Information Returns

1. Description of the Problem. Under section 6041 of the Code, income payors engaged in a trade or business must file information returns (Forms 1099) with respect to payments of $600 or more made in the normal course of business. Treas. Reg. [section] 1.6041-3 provides that information returns are not required to be filed in respect of payments made to corporations (except for corporations providing certain services in the health care field).

In October 1988, the House Government Operations Committee issued a report entitled "Implementation, by IRS, of a Document Matching Program for Income Paid to Business Taxpayers Should Produce Billions of Additional Dollars of Tax Revenue." The 1988 report recommends that the IRS develop information-matching programs for business taxpayers comparable to the program already in place for individual taxpayers. The report was based on a March 1987 hearing before the Subcommittee on Consumer and Monetary Affairs and a General Accounting Office study issued in July 1988. (10)

TEI believes that a document-matching program for corporations is ill-conceived and unwarranted. To our knowledge, there is no evidence that large, publicly held corporations fail to report any income. Such companies are subject to stringent reporting requirements by government agencies and their financial statements must be reviewed and certified by independent auditors. This safeguard is complemented by the companies' lack of incentive (for financial reporting purposes) to underreport income: they generally wish to report as much earnings as possible. What's more, financial controls represent a clear "audit trail" for IRS examiners to follow to confirm that income is correctly reported. As the IRS itself admits, "internal financial controls established by larger corporations to protect the interests of their stockholders make it difficult to hide corporate income from tax agencies." "Gross Tax Gap Trends According to New IRS Estimates, Income Years 1973-1992," Statistics of Income Bulletin, Vol. 8, No. 1, at 24 (Summer 1988).

Moreover, a corporate document matching program presents myriad practical problems. Unlike most individual taxpayers, the majority of corporations operate on an accrual, rather than cash, basis and may have different fiscal year-ends. In addition, the business names on information returns are not always identical to the names on corresponding tax returns and, indeed, numerous information returns would be generated in respect of income paid to subsidiaries that do not file separate tax returns (but, rather, whose income is included in a consolidated return). Thus, the amount of usable information obtained from a matching program would be marginal and, in any event, would have to be reconciled with the corporation's own reporting procedures. The costs associated with such a reconciliation would be substantial for the IRS and taxpayers alike.

In light of the costs, administrative problems, and lack of firm data on the amount of income not reported, the IRS has generally opposed a corporate document matching program. See "The Next Step in Information Matching: Business Returns," Tax Notes 1236, 1238 (Sept. 19, 1988) (Statement of then-Commissioner Lawrence Gibbs). (11)

2. Recommendation. Reject proposals to implement a corporate document matching program as unnecessary. The current information-reporting systems are sufficient to ensure that corporations correctly report the receipt of income. Consequently, the Institute opposes any efforts to require the IRS to implement a document matching program for corporate taxpayers.

C. Joint Committee Cases

1. Increase in Dollar Threshold for Joint Committee Review

a. Description of the Problem. Under section 6405 of the Code, no refund or credit of any income, estate, gift, or other specified taxes in excess of $200,000 may be made until 30 days after the IRS submits a report in respect of the refund or credit to the Joint Committee on Taxation. Although the House version of the Omnibus Budget Reconciliation Act of 1989 would have increased the Joint Committee review threshold to $1 million, the conference agreement on the bill did not include the provision.

TEI has long supported increasing the section 6405 jurisdictional amount to $1 million. The current $200,000 threshold was set by Congress in the Tax Reform Act of 1976. (The threshold had previously been $100,000.) We submit that an increase in the threshold is necessary to reflect the effects of inflation during the intervening 13 years and that the increase would not impair the ability of the Joint Committee to monitor problems in the administration of the tax laws. Such an increase would accelerate the issuance of refunds to many taxpayers and would also permit both taxpayers and the IRS to close out prior years on a more expeditious basis. In addition, increasing the jurisdictional amount will prevent the Joint Committee staff from being overburdened with refund cases.

b. Recommendation. Amend section 6405 to increase the jurisdictional amount in respect of Joint Committee cases to $1 million.

2. Joint Committee Case Procedures: Extensions of the Statute of Limitations Where Refund Is Attributable to Carryback

a. Description of the Problem. Under the general mitigation provisions of section 6501 of the Code, the time for assessing a deficiency for a carryback year is extended to include the period of assessment for the loss or unused credit year. Stated simply, the loss year controls the carryback year(s) with respect to the assessment period. If the carryback results in a net refund in excess of the current requirement of $200,000, it must be submitted for Joint Committee review under section 6405(b).

Section 42(11)(10).4 of the Internal Revenue Manual, dealing with the procedures to be followed in Joint Committee cases involving tentative carryback adjustments ("quickie refunds"), requires that "at least 15 months should remain in the statutory period of all returns (loss year and years tentatively closed)." In practice, Joint Committee case procedures require that the taxpayer sign Forms 872 for both the loss year and the carryback period, thereby extending the assessment for the carryback period separately from the loss year.

Clearly, the signing of a separate Form 872 for the carryback years is not required since section 6501 of the Code specifically protects the government's interest by automatically extending the assessment period for the carryback year with the assessment period for the loss year. (12) Current Joint Committee case procedures raise the collateral issue of the validity of a Form 870 or Form 870-AD for the carryback year if subsequently a Form 872 is required for the same year.

b. Recommendation. Revise the Joint Committee case procedures dealing with carrybacks to require the Joint Committee to accept cases for review with an executed Form 872 for the loss year only.

Footnotes -- TEI-JCT Liaison Meeting Agenda

(1) TEI has requested an opportunity to testify at the hearing and intends to focus on the administrative burdens and complexity spawned by the 1986 Act. During last year's liaison meeting, we discussed the Institute's survey on this subject. The survey focused on how the return preparation burden was affected by tax reform. Respondents were asked, among other things, to compare the amount of staff time devoted to preparing their 1987 return to the corresponding figure for 1986. Not one company reported a reduced reporting burden as a result of tax reform; the reported increases ranged from 10 to 91 percent. Similarly, the companies reported increases in staff time devoted to substantive research from 30 to 1,025 percent, and increases in the amount of fees paid to outside tax advisers from 0 to 3,750 percent.

(2) Indeed, if the figures are adjusted to reflect assessed amounts, the voluntary compliance rate for corporations in 1988 increases to 86.9 percent--higher than the compliance rate for individuals. The compliance rate would be even higher if adjusted to reflect the results of litigation (i.e., the judicial rejection of IRS positions).

(3) This limitation is imposed in addition to the foreign source income limitations of section 904 as it applies to both AMT and regular taxpayers.

(4) This effect is not mitigated by section 59(a)(2)(B) which provides for crediting the AMT against future tax liabilities. When it is paid, the AMT is a tax -- an additional economic sanction upon income -- and it remains a tax until it can be credited against a regular income tax liability. In the above example, T has a minimum tax credit of $9 ($10 AMT - $1 regular tax), which it may use if and when its regular tax exceeds its AMT liability (subject, of course, to the section 904 limitations). Where that does not occur and T is never able to use its minimum tax credit, the AMT represents double taxation.

(5) Under the netting rule, the debt-to-assets ratio of the U.S. affiliated group is compared to that of controlled foreign corporations; if the CFC's debt-to-assets ratio is substantially less (measured by a phased-in scale, then third-party indebtedness of the U.S. affiliated group will be directly allocated against foreign source income.

(6) Although U.S. income taxes paid cannot be deducted in computing the environmental tax income base, the environmental tax is deductible for U.S. income tax purposes, thereby reducing the overall tax burden and any "tax on tax." Taxpayers with foreign income should be accorded similar relief.

(7) The filing of a tax return could constitute a claim for refund, but for most calendar-year large corporations, their tax returns will not be filed until close to September 15 (the extended due date of their return), though an outstanding tax would have to be paid no later than March 15. Thus, there could be, at a minimum, a six-month period during which no interest would be paid on the amount of the overpayment.

(8) Such a rule would be comparable to the temporary safe harbor established by the Treasury Department in light of the momentous changes worked by the Tax Reform Act of 1986. See T.D. 8132, 52 Fed. Reg. 10049 (March 30, 1987).

(9) In this regard, TEI also recommends that section 6621 be amended to eliminate the so-called interest-rate differential, whereby interest paid by a taxpayer on an underpayment is one percentage point higher than interest paid by the government on a tax refund.

(10) The General Accounting Office's report on business document matching was entitled Tax Administration: IRS' Efforts to Establish a Business Information Returns Program (GAO/GGD-88-102). The GAO report makes reference to a December 1981 study, The Business Master File Information Returns Program Study Report, prepared by the IRS on the subject.

(11) In analyzing the need for, and the administrative difficulties attendant to, the implementation of a business information returns program, the IRS has acknowledged the differences between corporate and other business taxpayers (sole proprietorships and partnerships).

(12) Section 6501(k) deals specifically with limitations on assessment and collection in respect of the tentative carryback adjustment period. Under that provision, the statute of limitations for the carryback year shall be extended so that the government can raise issues in respect of the carryback year to offset the amount of any quickie refund. The amount of any assessment made pursuant to the mitigation provisions of section 6501(k), however, may not exceed the amount of the quickie refund.
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Publication:Tax Executive
Date:Jan 1, 1990
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