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IRS Restructuring and Reform Act of 1998

Conference Report page5

TITLE IV. CONGRESSIONAL ACCOUNTABILITY FOR THE IRS

A. Century Date Change (sec. 4001 of the bill)

Present Law

No specific provision.

Reasons for Change

Operations of the IRS computer systems are critical to the viability of the Federal tax system.

Explanation of Provision

The bill provides that it is the sense of the Congress that the IRS should place resolving the century date change computing problems as a high priority. The bill also provides that the Commissioner shall expeditiously submit a report to the Congress on the overall impact of the bill on the ability of the IRS to resolve the century date change computing problems and the provisions of the bill that will require significant amounts of computer programming changes prior to December 31, 1999, in order to carry out the provisions. It is expected that this report will be submitted within 14 days of the date of Committee action on the bill.

Effective Date

The provision is effective on the date of enactment.

B. Tax Law Complexity Analysis (sec. 4002 of the bill)

Present Law

Present law does not require a formal complexity analysis with respect to changes to the tax laws.

Reasons for Change

The National Commission on Restructuring the IRS found a clear connection between the complexity of the Internal Revenue Code and the difficulty of tax law administration and taxpayer frustration. The Committee shares the concern that complexity is a serious problem with the Federal tax system. Complexity and frequent changes in the tax laws create burdens for both the IRS and taxpayers. Failure to address complexity may ultimately reduce voluntary compliance.

The Committee is aware that it may not be possible or desirable to eliminate all complexity in the tax system. There are many objectives of a tax system and particular tax provisions, and simplicity is only one. In some cases other policies, such as fairness, may outweigh concerns about complexity. Nevertheless, the Committee believes complexity of the tax system should be reduced whenever possible. Accordingly, the Committee believes it appropriate to introduce new procedural rules that will focus attention on complexity. The Committee also believes that the tax-writing committees should receive periodic input from the IRS regarding areas of the law that cause problems for taxpayers. This input will be valuable in developing future legislation.

Explanation of Provision

IRS report on complexity

The IRS is to report to the House Ways and Means Committee and the Senate Finance Committee annually regarding sources of complexity in the administration of the Federal tax laws. Factors the IRS may take into account include: (1) frequently asked questions by taxpayers; (2) common errors made by taxpayers in filling out returns; (3) areas of the law that frequently result in disagreements between taxpayers and the IRS; (4) major areas in which there is no or incomplete published guidance or in which the law is uncertain; (5) areas in which revenue agents make frequent errors in interpreting or applying the law; (6) impact of recent legislation on complexity; (7) information regarding forms, including a listing of IRS forms, the time it takes for taxpayers to complete and review forms, the number of taxpayers who use each form, and how the time required changed as a result of recently enacted legislation; and (8) recommendations for reducing complexity in the administration of the Federal tax system.

Complexity analysis with respect to current legislation

The bill requires the Joint Committee on Taxation (in consultation with the IRS and Treasury) to provide an analysis of complexity or administrability concerns raised by tax provisions of widespread applicability to individuals or small businesses. The analysis is to be included in any Committee Report of the House Ways and Means Committee or Senate Finance Committee or Conference Report containing tax provisions, or provided to the Members of the relevant Committee or Committees as soon as practicable after the report is filed. The analysis is to include: (1) an estimate of the number and type of taxpayers affected; and (2) if applicable, the income level of affected individual taxpayers. In addition, such analysis should include, if determinable, the following: (1) the extent to which existing tax forms would require revision and whether a new form or forms would be required; (2) whether and to what extent taxpayers would be required to keep additional records; (3) the estimated cost to taxpayers to comply with the provision; (4) the extent to which enactment of the provision would require the IRS to develop or modify regulatory guidance; (5) whether and to what extent the provision can be expected to lead to disputes between taxpayers and the IRS; and (6) how the IRS can be expected to respond to the provision (including the impact on internal training, whether the Internal Revenue Manual would require revision, whether the change would require reprogramming of computers, and the extent to which the IRS would be required to divert or redirect resources in response to the provision).

Effective Date

The provision requiring the Joint Committee on Taxation to provide a complexity analysis is effective with respect to legislation considered on or after January 1, 1999. The provision requiring the IRS to report on sources of complexity is effective on the date of enactment.

TITLE V. REVENUE OFFSETS

A. Employer Deduction for Vacation and Severance Pay (sec. 5001 of the bill and sec. 404 of the Code)

Present Law

For deduction purposes, any method or arrangement that has the effect of a plan deferring the receipt of compensation or other benefits for employees is treated as a deferred compensation plan (sec. 404(b)). In general, contributions under a deferred compensation plan (other than certain pension, profit-sharing and similar plans) are deductible in the taxable year in which an amount attributable to the contribution is includible in income of the employee. However, vacation pay which is treated as deferred compensation is deductible for the taxable year of the employer in which the vacation pay is paid to the employee (sec. 404(a)(5)).

Temporary Treasury regulations provide that a plan, method, or arrangement defers the receipt of compensation or benefits to the extent it is one under which an employee receives compensation or benefits more than a brief period of time after the end of the employer's taxable year in which the services creating the right to such compensation or benefits are performed. A plan, method or arrangement is presumed to defer the receipt of compensation for more than a brief period of time after the end of an employer's taxable year to the extent that compensation is received after the 15th day of the 3rd calendar month after the end of the employer's taxable year in which the related services are rendered (the "2-1/2 month" period). A plan, method or arrangement is not considered to defer the receipt of compensation or benefits for more than a brief period of time after the end of the employer's taxable year to the extent that compensation or benefits are received by the employee on or before the end of the applicable 2-1/2 month period. (Temp. Treas. Reg. sec. 1.404(b)-1T A-2).

The Tax Court recently addressed the issue of when vacation pay and severance pay are considered deferred compensation in Schmidt Baking Co., Inc., 107 T.C. 271 (1996). In Schmidt Baking, the taxpayer was an accrual basis taxpayer with a fiscal year that ended December 28, 1991. The taxpayer funded its accrued vacation and severance pay liabilities for 1991 by purchasing an irrevocable letter of credit on March 13, 1992. The parties stipulated that the letter of credit represented a transfer of substantially vested interest in property to employees for purposes of section 83, and that the fair market value of such interest was includible in the employees' gross incomes for 1992 as a result of the transfer.⁵⁰ The Tax Court held that the purchase of the letter of credit, and the resulting income inclusion, constituted payment of the vacation and severance pay within the 2-1/2 month period. Thus, the vacation and severance pay were treated as received by the employees within the 2-1/2 month period and were not treated as deferred compensation. The vacation pay and severance pay were deductible by the taxpayer for its 1991 fiscal year pursuant to its normal accrual method of accounting.

Reasons for Change

The Committee believes that the decision in Schmidt Baking reaches an inappropriate and unintended result. To permit methods such as that used in Schmidt Baking to be considered payment or receipt would allow taxpayers to avoid the 2-1/2 month rule and inappropriately accelerate deductions. The Committee believes that the intent of the 2-1/2 rule was clearly to provide that a deduction for deferred compensation is not available for the current taxable year unless the compensation is actually paid to employees within 2-1/2 months after the end of the year. Moreover, previous legislative histories reflect Congressional intent and understanding that compensation actually paid beyond the 2-1/2 month period is deferred compensation.⁵¹

Further, the Committee is concerned that taxpayers may inappropriately extend the rationale of Schmidt Baking to other situations in which a deduction or other tax consequences are contingent upon an item being paid. The Committee does not believe that, as a general rule, letters of credit and similar mechanisms should be considered payment for any purposes of the Code.

Explanation of Provision

Under the bill, for purposes of determining whether an item of compensation is deferred compensation (under Code sec. 404), the compensation is not considered to be paid or received until actually received by the employee. In addition, an item of deferred compensation is not considered paid to an employee until actually received by the employee. The provision is intended to overrule the result inSchmidt Baking. For example, with respect to the determination of whether vacation pay is deferred compensation, the fact that the value of the vacation pay is includible in the income of employees within the applicable 2-1/2 month period would not be relevant. Rather, the vacation pay must have been actually received by employees within the 2-1/2 month period in order for the compensation not to be treated as deferred compensation.

It is intended that similar arrangements, in addition to the letter of credit approach used in Schmidt Baking, do not constitute actual receipt by the employee, even if there is an income inclusion. Thus, for example, actual receipt does not include the furnishing of a note or letter or other evidence of indebtedness of the taxpayer, whether or not the evidence is guaranteed by any other instrument or by any third party. As a further example, actual receipt does not include a promise of the taxpayer to provide service or property in the future (whether or not the promise is evidenced by a contract or other written agreement). In addition, actual receipt does not include an amount transferred as a loan, refundable deposit, or contingent payment. Amounts set aside in a trust for employees are not considered to be actually received by the employee.

The provision does not change the rule under which deferred compensation (other than vacation pay and deferred compensation under qualified plans) is deductible in the year includible in the gross income of employees participating in the plan if separate accounts are maintained for each employee.

While Schmidt Baking involved only vacation pay and severance pay, there is concern that this type of arrangement may be tried to circumvent other provisions of the Code where payment is required in order for a deduction to occur. Thus, it is intended that the Secretary will prevent the use of similar arrangements. No inference is intended that the result in Schmidt Baking is present law beyond its immediate facts or that the use of similar arrangements is permitted under present law.

The provision does not affect the determination of whether an item is includible in income. Thus, for example, using the mechanism in Schmidt Baking for vacation pay could still result in income inclusion to the employees, but the employer would not be entitled to a deduction for the vacation pay until actually paid to and received by the employees.

Effective Date

The provision is effective for taxable years ending after the date of enactment. Any change in method of accounting required by the bill is treated as initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment required by section 481 as a result of the change will be taken into account in the year of the change.

B. Modify Foreign Tax Credit Carryover Rules (sec. 5002 of the bill and sec. 904 of the Code)

Present Law

U.S. persons may credit foreign taxes against U.S. tax on foreign source income. The amount of foreign tax credits that can be claimed in a year is subject to a limitation that prevents taxpayers from using foreign tax credits to offset U.S. tax on U.S. source income. Separate foreign tax credit limitations are applied to specific categories of income.

The amount of creditable taxes paid or accrued (or deemed paid) in any taxable year which exceeds the foreign tax credit limitation is permitted to be carried back two years and forward five years. The amount carried over may be used as a credit in a carryover year to the extent the taxpayer otherwise has excess foreign tax credit limitation for such year. The separate foreign tax credit limitations apply for purposes of the carryover rules.

Reasons for Change

The Committee believes that reducing the carryback period for foreign tax credits to one year and increasing the carryforward period to seven years will reduce some of the complexity associated with carrybacks while continuing to address the timing differences between U.S. and foreign tax rules.

Explanation of Provision

The bill reduces the carryback period for excess foreign tax credits from two years to one year. The bill also extends the excess foreign tax credit carryforward period from five years to seven years.

Effective Date

The provision applies to foreign tax credits arising in taxable years ending after the date of enactment.

C. Clarify and Expand Mathematical Error Procedures (sec. 5003 of the bill and sec. 6213(g)(2) of the Code)

Present Law

Taxpayer identification numbers ("TINs")

The IRS may deny a personal exemption for a taxpayer, the taxpayer's spouse or the taxpayer's dependents if the taxpayer fails to provide a correct TIN for each person for whom the taxpayer claims an exemption. This TIN requirement also indirectly effects other tax benefits currently conditioned on a taxpayer being able to claim a personal exemption for a dependent (e.g., head-of-household filing status and the dependent care credit). Other tax benefits, including the adoption credit, the child tax credit, the Hope Scholarship credit and Lifetime Learning credit, and the earned income credit also have TIN requirements. For most individuals, their TIN is their Social Security Number ("SSN"). The mathematical and clerical error procedure currently applies to the omission of a correct TIN for purposes of personal exemptions and all of the credits listed above except for the adoption credit.

Mathematical or clerical errors

The IRS may summarily assess additional tax due as a result of a mathematical or clerical error without sending the taxpayer a notice of deficiency and giving the taxpayer an opportunity to petition the Tax Court. Where the IRS uses the summary assessment procedure for mathematical or clerical errors, the taxpayer must be given an explanation of the asserted error and a period of 60 days to request that the IRS abate its assessment. The IRS may not proceed to collect the amount of the assessment until the taxpayer has agreed to it or has allowed the 60-day period for objecting to expire. If the taxpayer files a request for abatement of the assessment specified in the notice, the IRS must abate the assessment. Any reassessment of the abated amount is subject to the ordinary deficiency procedures. The request for abatement of the assessment is the only procedure a taxpayer may use prior to paying the assessed amount in order to contest an assessment arising out of a mathematical or clerical error. Once the assessment is satisfied, however, the taxpayer may file a claim for refund if he or she believes the assessment was made in error.

Reasons for Change

The Committee believes that it is appropriate to provide additional guidance to the Internal Revenue Service with respect to the application of the TIN requirement. It will also improve compliance to allow the IRS to use date of birth data, from the Social Security Administration, to determine ineligibility for the dependent care credit, the child tax credit and the earned income credit. Once this determination is made, the Committee believes that the IRS should use the mathematical and clerical error procedure to correctly assess the tax due with respect to affected tax returns.

Explanation of Provision

The bill provides in the application of the mathematical and clerical error procedure that a correct TIN is a TIN that was assigned by the Social Security Administration (or in certain limited cases, the IRS) to the individual identified on the return. For this purpose the IRS is authorized to determine that the individual identified on the tax return corresponds in every aspect (including, name, age, date of birth, and SSN) to the individual to whom the TIN is issued. The IRS also is authorized to use the mathematical and clerical error procedure to deny eligibility for the dependent care tax credit, the child tax credit, and the earned income credit even though a correct TIN has been supplied if the IRS determines that the statutory age restrictions for eligibility for any of the respective credits is not satisfied (e.g., the TIN issued for the child claimed as the basis of the child tax credit identifies the child as over the age of 17 at the end of the taxable year).

Effective Date

The provision is effective for taxable years ending after the date of enactment.

D. Freeze Grandfather Status of Stapled REITs (sec. 5004 of the bill)

Present Law

In general

A real estate investment trust ("REIT") is an entity that receives most of its income from passive real estate related investments and that essentially receives pass-through treatment for income that is distributed to shareholders. If an electing entity meets the qualifications for REIT status, the portion of its income that is distributed to the investors each year generally is taxed to the investors without being subjected to a tax at the REIT level. In general, a REIT must derive its income from passive sources and not engage in any active trade or business.

Requirements for REIT status

A REIT must satisfy a number of tests on a year-by-year basis that relate to the entity's (1) organizational structure, (2) source of income, (3) nature of assets, and (4) distribution of income. These tests are intended to allow pass-through treatment only if there is a pooling of investment arrangement, if the entity's investments are basically in real estate assets, and its income is passive income from real estate investment, as contrasted with income from the operation of a business involving real estate. In addition, substantially all of the entity's income must be passed through to its shareholders on a current basis.

Under the organizational structure tests, except for the first taxable year for which an entity elects to be a REIT, the beneficial ownership of the entity must be held by 100 or more persons. Generally, no more than 50 percent of the value of the REIT's stock can be owned by five or fewer individuals during the last half of the taxable year.

Under the source-of-income tests, at least 95 percent of its gross income generally must be derived from rents, dividends, interest and certain other passive sources (the "95-percent test"). In addition, at least 75 percent of its income generally must be from real estate sources, including rents from real property and interest on mortgages secured by real property (the "75-percent test").

For purposes of these tests, rents from real property generally include charges for services customarily rendered in connection with the rental of real property, whether or not such charges are separately stated. Where a REIT furnishes non-customary services to tenants, amounts received generally are not treated as qualifying rents unless the services are furnished through an independent contractor from whom the REIT does not derive any income. In general, an independent contractor is a person who does not own more than a 35-percent interest in the REIT, and in which no more than a 35-percent interest is held by persons with a 35-percent or greater interest in the REIT.

To satisfy the REIT asset requirements, at the close of each quarter of its taxable year, an entity must have at least 75 percent of the value of its assets invested in real estate assets, cash and cash items, and government securities. Not more than 25 percent of the value of the REIT's assets can be invested in securities (other than government securities and other securities described in the preceding sentence). The securities of any one issuer may not comprise more than five percent of the value of a REIT's assets. Moreover, the REIT may not own more than 10 percent of the outstanding securities of any one issuer, determined by voting power.

A REIT is permitted to have a wholly-owned subsidiary subject to certain restrictions. A REIT's subsidiary is treated as one with the REIT.

The income distribution requirement provides generally that at least 95 percent of a REIT's income (with certain minor exceptions) must be distributed to shareholders as dividends.

Stapled REITs

In a stapled REIT structure, both the shares of a REIT and a C corporation may be traded, but are subject to a provision that they may not be sold separately. Thus, the REIT and the C corporation have identical ownership at all times.

In the Deficit Reduction Act of 1984 (the "1984 Act"), Congress required that, in applying the tests for REIT status, all stapled entities are treated as one entity (sec. 269B(a)(3)). The 1984 Act included grandfather rules, one of which provided that certain then-existing stapled REITs were not subject to the new provision (sec. 136(c)(3) of the 1984 Act). That grandfather rule provided that the new provision did not apply to a REIT that was a part of a group of stapled entities if the group of entities was stapled on June 30, 1983, and included a REIT on that date.

Reasons for Change

In the 1984 Act, Congress eliminated the tax benefits of the stapled REIT structure out of concern that it could effectively result in one level of tax on active corporate business income that would otherwise be subject to two levels of tax. Congress also believed that allowing a corporate business to be stapled to a REIT was inconsistent with the policy that led Congress to create REITs.

As part of the 1984 Act provision, Congress provided grandfather relief to the small number of stapled REITs that were already in existence. Since 1984, however, many of the grandfathered stapled REITs have been acquired by new owners. Some have entered into new lines of businesses, and most of the grandfathered REITs have used the stapled structure to engage in large-scale acquisitions of assets. The Committee believes that such unlimited relief from a general tax provision by a handful of taxpayers raises new questions not only of fairness, but of unfair competition, because the stapled REITs are in direct competition with other companies that cannot use the benefits of the stapled structure.

The Committee believes that it would be unfair to remove the benefit of the stapled REIT structure with respect to real estate interests that have already been acquired. On the other hand, the Committee believes that future acquisitions of interests in real property by these grandfathered entities, or improvements of property that are tantamount to new acquisitions, should not be accorded the benefits of the stapled REIT structure. Accordingly, the rules of the Committee bill generally apply with respect to real property interests acquired by the REIT or a stapled entity after March 26, 1998, pursuant to transactions not in progress on that date. Further, the Committee is concerned that the some of the benefit of the stapled REIT structure can be derived through mortgages and interests in subsidiaries and partnerships. Accordingly, the Committee bill provides rules for mortgages acquired after March 26, 1998, and indirect acquisitions of real property interests through entities after such date (with transition relief similar to that for direct acquisitions).

Explanation of Provision

Overview

Under the provision, rules similar to the rules of present law treating a REIT and all stapled entities as a single entity for purposes of determining REIT status (sec. 269B) apply to real property interests acquired after March 26, 1998, by an existing stapled REIT, a stapled entity, or a subsidiary or partnership in which a 10-percent or greater interest is owned by an existing stapled REIT or stapled entity (together referred to as the "stapled REIT group"), unless the real property interest is grandfathered as described below. Special rules apply to certain mortgages acquired by the stapled REIT group after March 26, 1998, where a member of the stapled REIT group performs services with respect to the property secured by the mortgage.

Rules for real property interests

In general

The provision generally applies to real property interests acquired by a member of the stapled REIT group after March 26, 1998. Real property interests that are acquired by a member of the REIT group after such date, and which are not grandfathered under the rules described below, are referred to as "nonqualified real property interests".

The provision treats activities and gross income of a stapled REIT group with respect to nonqualified real property interests held by any member of the stapled REIT group as activities and income of the REIT for certain purposes in the same manner as if the stapled REIT group were a single entity. This treatment applies for purposes of the following provisions that depend on a REIT's gross income: (1) the 95-percent test (sec. 856(c)(2)); (2) the 75-percent test (sec. 856(c)(3)); (3) the "reasonable cause" exception for failure to meet either test (sec. 856(c)(6)); and (4) the special tax on excess gross income for REITs with net income from prohibited transactions (sec. 857(b)(5)).

Thus, for example, where a stapled entity leases nonqualified real property from the REIT and earns gross income from operating the property, such gross income will be subject to the provision. The REIT and the stapled entity will be treated as a single entity, with the result that the lease payments from the stapled entity to the REIT would be ignored. The gross income earned by the stapled entity from operating the property will be treated as gross income of the REIT, with the result that either the 75-percent or 95-percent test might not be met and REIT status might be lost. Similarly, where a stapled entity leases property from a third party after March 26, 1998, and uses that property in a business, the gross income it derives will be treated as income of the REIT because the lease would be a nonqualified real property interest.

Grandfathered real property interests

Under the provision, all real property interests acquired by a member of the stapled REIT group after March 26, 1998, are treated as nonqualified real property interests subject to the general rules described above, unless they qualify under one of the grandfather rules. An option to acquire real property is generally treated as a real property interest for purposes of the provision. However, a real property interest acquired by exercise of an option after March 26, 1998, is treated as a nonqualified real property interest, even though the option was acquired before such date.

Under the provision, grandfathered real property interests include properties acquired by a member of the stapled REIT group after March 26, 1998, pursuant to a written agreement which was binding on March 26, 1998, and all times thereafter. Grandfathered properties also include certain properties, the acquisition of which were described in a public announcement or in a filing with the Securities and Exchange Commission on or before March 26, 1998.

A real property interest does not generally lose its status as a grandfathered interest by reason of a repair to, an improvement of, or a lease of, the real property. Thus, if a REIT leases a grandfathered real property to a stapled entity, a renewal of the lease does not cause the property to lose its grandfathered status, whether the renewal is pursuant to the terms of the lease or otherwise. Similarly, if a REIT owns a grandfathered real property interest that is leased to a third party and, at the expiration of that lease, the REIT leases the property to a stapled entity, the interest would remain a grandfathered interest. Finally, if a stapled entity leases a grandfathered property interest from a third party and the property is repaired or improved, the interest would remain a grandfathered interest except as described below.

An improvement of a grandfathered real property interest will cause loss of grandfathered status and become a nonqualified real property interest in certain circumstances. Any expansion beyond the boundaries of the land of the otherwise grandfathered interest occurring after March 26, 1998, will be treated as a non-qualified real property interest to the extent of such expansion. Moreover, any improvement of an otherwise grandfathered real property interest (within its land boundaries) that is placed in service after December 31, 1999, is treated as a separate nonqualified real property interest in certain circumstances. Such treatment applies where (1) the improvement changes the use of the property and (2) its cost is greater than (a) 200 percent of the undepreciated cost of the property (prior to the improvement) or (b) in the case of property acquired where there is a substituted basis, the fair market value of the property on the date that the property was acquired by the stapled entity or the REIT. There is an exception for improvements placed in service before January 1, 2004, pursuant to a binding contract in effect on December 31, 1999, and at all times thereafter. The rule treating improvements as nonqualified real property interests could apply, for example, if a member of the stapled REIT group constructs a building after December 31, 1999, on previously undeveloped raw land that had been acquired on or before March 26, 1998.

Ownership through entities

If a REIT or stapled entity owns, directly or indirectly, a 10-percent-or-greater interest in a corporate subsidiary or partnership (or other entity described below) that owns a real property interest, the above rules apply with respect to a proportionate part of the entity's real property interest, activities and gross income. Thus, any real property interest acquired by such a subsidiary or partnership that is not grandfathered under the rules described above is treated as a nonqualified real property interest held by the REIT or stapled entity in the same proportion as its ownership interest in the entity. The same proportion of the subsidiary's or partnership's gross income from any nonqualified real property interest owned by it or another member of the stapled REIT group will be treated as income of the REIT under the rules described above. However, an interest in real property acquired by a grandfathered 10-percent-or-greater partnership or subsidiary is treated as grandfathered if such interest would be a grandfathered interest if held directly by the REIT or stapled entity. Thus, for example, if a REIT contributes a grandfathered real property interest to a partnership 10 percent or more of which is owned on March 26, 1998, the interest will not cease to be a grandfathered interest.⁵²

Similar rules attributing the proportionate part of the subsidiary's or partnership's real property interests and gross income will apply when a REIT or stapled entity acquires a 10-percent-or-greater interest (or in the case of a previously-owned entity, acquires an additional interest) after March 26, 1998, with exceptions for interests acquired pursuant to binding written agreements or public announcements described above. Transition relief can apply to both an entity's assets and the interest in the entity under the above rules. Thus, if on March 26, 1998, and at all times thereafter, a stapled entity has a binding written contract to buy 10-percent or more of the stock of a corporation and the corporation also has a binding written contract to buy real property, no portion of the property will be treated as a nonqualified real property interest as a result of the transaction.

Under the above rules, gross income of a REIT or stapled entity with respect to a nonqualified real property interest held by a 10-percent-or-greater partnership or subsidiary is subject to the rules for nonqualified real property interests only in proportion to the interest held in the partnership or subsidiary. For example, assume that a stapled entity has a contract to manage a nonqualified real property interest held by a partnership in which the stapled entity owns an 85-percent interest. Under the above rules, for purposes of applying the gross income tests, 85 percent of the partnership's activities and gross income from the property are attributed to the REIT. As a result, 85 percent of the stapled entity's income from the management contract is ignored under the single-entity analysis described above. The remaining 15 percent of the management fee is not treated as gross income of the REIT because it is not income from a nonqualified real property interest held or deemed held by the REIT or a stapled entity.

Grandfathered real property interests that are deemed owned by a REIT or a stapled entity under the rules for 10-percent-or-greater interests will not be treated as acquired after March 26, 1998, if the REIT or a stapled entity subsequently becomes the actual owner. For example, assume a REIT has a 50-percent interest in a partnership that distributes a grandfathered real property interest to the REIT in complete liquidation of its interest. The 50-percent interest that was previously deemed owned by the REIT will continue to be grandfathered; the remaining 50-percent interest will be a nonqualified real property interest because it was acquired by the REIT after March 26, 1998.

Mortgage rules

Under the provision, special rules apply where a member of the stapled REIT group holds a mortgage (that is not an existing obligation under the rules described below) that is secured by an interest in real property, and a member of the stapled REIT group engages in certain activities with respect to that property. The activities that have this effect under the provision are activities that would result in impermissible tenant service income (as defined in sec.856(d)(7)) if performed by the REIT with respect to property it held. In such a case, all interest on the mortgage that is allocable to that property and all gross income received by a member of the stapled REIT group from the activity will be treated as impermissible tenant service income of the REIT, which is not qualifying income under either the 75-percent or 95-percent tests. For example, assume that the REIT makes a mortgage loan on a hotel owned by a third party which is operated by a stapled entity under a management contract. Unless an exception applies, both the management fees earned by the stapled entity and the interest earned by the REIT will be treated as impermissible tenant services income of the REIT.

An exception to the above rules is provided for mortgages the interest on which does not exceed an arm's-length rate and which would be treated as interest for purposes of the REIT rules. An exception also is available for mortgages that are held by a member of the stapled REIT group on March 26, 1998, and at all times thereafter, and which are secured by an interest in real property on that date, and at all times thereafter (the "existing mortgage exception"). The existing mortgage exception ceases to apply if the mortgage is refinanced and the principal amount is increased in such refinancing.

In the case of a partnership or subsidiary in which the REIT or a stapled entity owns a 10-percent-or-greater interest, a proportionate part of the entity's mortgages, interest and gross income from activities would be attributed to the REIT or the stapled entity, subject to rules similar to those for nonqualified real property interests. Thus, if a REIT or a stapled entity acquires a 10-percent-or-greater interest in a partnership or corporation after March 26, 1998, no mortgage held by the partnership or subsidiary at such time would qualify for the existing mortgage exception. Similarly, if a REIT or stapled entity owns a 10-percent-or-greater interest in a partnership or subsidiary on March 26, 1998, and the REIT or the stapled entity subsequently acquires a greater interest, a portion of each of the partnership's or subsidiary's mortgages that is the same as the proportionate increase in the ownership interest would fail to qualify for the existing mortgage exception.

Under the provision's priority rules, the mortgage rules do not apply to any part of a real property interest that is owned or deemed owned by the REIT or a stapled entity under the rules for real property interests described above. Thus, for example, if the REIT makes a mortgage loan on real property owned by a stapled entity, the mortgage rules would not apply. If the property is a nonqualified real property interest, the interest on the mortgage would be ignored under the single-entity analysis described above, and the gross income of the stapled entity from the property would be treated as income of the REIT. Similarly, assume that a stapled entity owns 75 percent of the stock of a subsidiary and has a management contract to operate a hotel owned by the subsidiary. Assume also that the REIT makes a mortgage loan for the hotel. Under the real property interest rules, 75 percent of the hotel is treated as owned by the stapled entity. Thus, if the hotel is a nonqualified real property interest, 75 percent of the subsidiary's gross income from the hotel is treated as income of the REIT and 75 percent of the income on the management contract is ignored under the single-entity analysis. With respect to the remaining 25-percent interest in the subsidiary, the real property interest rules do not apply, but the mortgage rules would treat 25 percent of the mortgage interest and 25 percent of management contract income as impermissible tenant services income of the REIT.

Other rules

For purposes of both the real property interest and mortgage rules, if a stapled REIT is not stapled as of March 26, 1998, and at all times thereafter, or if it fails to qualify as a REIT as of such date or any time thereafter, no assets of any member of the stapled REIT group would qualify under the grandfather rules. Thus, all of the real property interests held by the group would be nonqualified real property interests and none of the mortgages held by the group would qualify for the existing mortgage exception.

For a corporate subsidiary owned by a stapled entity, the 10-percent ownership test would be met if a stapled entity owns, directly or indirectly, 10 percent or more of the corporation's stock, by either vote or value.⁵³ For this purpose, any change in proportionate ownership that is attributable solely to fluctuations in the relative fair market values of different classes of stock is not taken into account. For interests in partnerships, the ownership test would be met if either the REIT or a stapled entity owns, directly or indirectly, a 10-percent or greater interest in the partnership's assets or net profits. Interests in other entities, such as trusts, are treated in the same manner as 10-percent-or-greater interests in partnerships or corporations if the REIT or a stapled entity owns, directly or indirectly, 10 percent or more of the beneficial interests in the entity.

Under the provision, terms used that are also used in the stapled stock rules (sec. 269B) or the REIT rules (sec. 856) have the same meanings as under those rules.

The Secretary of the Treasury is given authority to prescribe such guidance as may be necessary or appropriate to carry out the purposes of the provision, including guidance to prevent the double counting of income and to prevent transactions that would avoid the purposes of the provision.

Effective Date

The provision is effective for taxable years ending after March 26, 1998.

E. Make Certain Trade Receivables Ineligible for Mark-to-Market Treatment

(sec. 5005 of the bill and sec. 475 of the Code)

Present Law

In general, dealers in securities are required to use a mark-to-market method of accounting for securities (sec. 475). Exceptions to the mark-to-market rule are provided for securities held for investment, certain debt instruments and obligations to acquire debt instruments and certain securities that hedge securities. A dealer in securities is a taxpayer who regularly purchases securities from or sells securities to customers in the ordinary course of a trade or business, or who regularly offers to enter into, assume, offset, assign, or otherwise terminate positions in certain types of securities with customers in the ordinary course of a trade or business. A security includes (1) a share of stock, (2) an interest in a widely held or publicly traded partnership or trust, (3) an evidence of indebtedness, (4) an interest rate, currency, or equity notional principal contract, (5) an evidence of an interest in, or derivative financial instrument in, any of the foregoing securities, or any currency, including any option, forward contract, short position, or similar financial instrument in such a security or currency, or (6) a position that is an identified hedge with respect to any of the foregoing securities.

Treasury regulations provide that if a taxpayer would be a dealer in securities only because of its purchases and sales of debt instruments that, at the time of purchase or sale, are customer paper with respect to either the taxpayer or a corporation that is a member of the same consolidated group, the taxpayer will not normally be treated as a dealer in securities. However, the regulations allow such a taxpayer to elect out of this exception to dealer status.⁵⁴ For this purpose, a debt instrument is customer paper with respect to a person if: (1) the person's principal activity is selling nonfinancial goods or providing nonfinancial services; (2) the debt instrument was issued by the purchaser of the goods or services at the time of the purchase of those goods and services in order to finance the purchase; and (3) at all times since the debt instrument was issued, it has been held either by the person selling those goods or services or by a corporation that is a member of the same consolidated group as that person.

Reasons for Change

Congress enacted the mark-to-market rules of section 475 to provide a more accurate reflection of the income of securities dealers. The Committee does not believe that these provisions were intended to be used by taxpayers whose principal activity is selling goods and services to obtain a deduction for loss in value of their receivables at a time earlier than otherwise would be permitted.

Explanation of Provision

The provision provides that certain trade receivables are not eligible for mark-to-market treatment. A trade receivable is covered by the provision if it is a note, bond or debenture arising out of the sale of goods by a person the principal activity of which is selling or providing non-financial goods and services and it is held by such person or a related person at all times since it was issued.

Under the provision, a receivable meeting the above definition is not treated as a security for purposes of the mark-to-market rules (sec. 475). Thus, such receivables are not marked-to-market, even if the taxpayer qualifies as a dealer in other securities. Because trade receivables cease to meet the above definition when they are disposed of (other than to a related person), a taxpayer who regularly sells trade receivables is treated as a dealer in securities as under present law, with the result that the taxpayer's other securities would be subject to mark-to-market treatment unless an exception to section 475 applies (such as that for securities identified as held for investment).

Effective Date