Taxpayer Relief Act of 1997 p4

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Taxpayer Relief Act of 1997 page4

Changes to certain rules applicable to both empowerment zone facility bonds and qualified enterprise community facility bonds

Qualified enterprise zone businesses located in newly designated empowerment zones, as well as those located in previously designated empowerment zones and enterprise communities, would be eligible for special tax-exempt bond financing under present-law rules, subject to the modifications described below (and the exception to the volume cap described above for newly designated empowerment zones).

The conference agreement waives until the end of a "startupperiod" the requirement that 95 percent or more of the proceeds of bond issue be used by a qualified enterprise zone business. With respect to each property, the startup period ends at the beginning of the first taxable year beginning more than two years after the later of (1) the date of the bond issue financing such property, or (2) the date the property was placed in service (but in no event more than three years after the date of bond issuance). This waiver is only available if, at the beginning of the startup period, there is a reasonable expectation that the use by a qualified enterprise zone business would be satisfied at the end of the startup period and the business makes bona fide efforts to satisfy the enterprise zone business definition.

The conference agreement also waives the requirements of an enterprise zone business (other than the requirement that at least 35 percent of the business' employees be residents of the zone or community) for all years after a prescribed testing period equal to first three taxable years after the startup period.

Finally, the conference agreement relaxes the rehabilitation requirement for financing existing property with qualified enterprise zone facility bonds. In the case of property which is substantially renovated by the taxpayer, the property need not be acquired by the taxpayer after zone or community designation or originally used by the taxpayer within the zone if, during any 24-month period after zone or community designation, the additions to the taxpayer's basis in the property exceeded 15 percent of the taxpayer's basis at the beginning of the period, or $5,000 (whichever is greater).

Effective date

The two additional urban empowerment zones (within which generally are available the same tax incentives as are available in the empowerment zones designated pursuant to OBRA 1993) must be designated within 180 days after enactment, but the designation will not take effect before January 1, 2000 . The 20 additional empowerment zones (within which the wage credit is not available) are to be designated after enactment but prior to January 1, 1999 . For purposes of the additional section 179 expensing available within empowerment zones, the modifications to the definition of "enterprisezone business" are effective for taxable years beginning on or after the dateof enactment.

The changes to the tax-exempt financing rules are effective for qualified enterprise zone facility bonds and the new empowerment zone facility bonds issued after the date of enactment.

28. Conducting of certain games of chance not treated as unrelated trade or business (sec. 783 of the Senate amendment)

Present Law

Although generally exempt from Federal income tax, tax-exempt organizations are subject to the unrelated business income tax (UBIT) on income derived from a trade or business regularly carried on that is not substantially related to the performance of the organization's tax-exempt functions (secs. 511-514).⁵⁹ Certain income, however, is exempted from the UBIT (such as interest, dividends, royalties, and certain rents), unless derived from debt-financed property (sec. 512(b)). Other exemptions from the UBIT are provided for activities in which substantially all the work is performed by volunteers and for income from the sale of donated goods (sec. 513(a)).

A specific exemption from the UBIT is provided for certain bingo games ⁶⁰ conducted by tax-exempt organizations, provided that the conducting of the bingo games is not an activity ordinarily carried out on a commercial basis and the conducting of which does not violate any State or local law (sec. 513(f)).⁶¹ In addition, a specific exemption from the UBIT isprovided for qualified public entertainment activities (meaning entertainment or recreation activities of a kind traditionally conducted at fairs or expositions promoting agricultural and educational purposes) conducted by an organization described in section 501(c)(3), (c)(4), or (c)(5) which regularly conducts an agricultural and educational fair or exposition as one of its substantial exempt purposes (sec. 513(d)).⁶²

In South End Italian Independent Club, Inc. v. Commissioner, 87 T.C. 168 (1986), acq. 1987-2 C.B. 1, the Tax Court held that gambling profits of a social club described in section 501(c)(7) that were required by State law to be used for charitable purposes were fully deductible under section 162 in computing the UBIT liability of the social club. The effect of this decision was to exempt gambling income of that social club from UBIT. The IRS has indicated that, until further guidance is available with respect to this issue, the issue of the deductibility of amounts required under State law to be used for charitable or other so-called "lawful" purposesshould be resolved consistent with the South End case, regardless of whether the gaming proceeds are donated to other charitable organizations or spent internally on the organization's own charitable activities.⁶³

House Bill

No provision.

Senate Amendment

The Senate amendment provides that the UBIT will not apply to income from a "qualified game of chance," meaning any game of chance (other thana bingo game exempt under present-law sec. 513(f)) conducted by a tax-exempt organization if (1) such organization is licensed pursuant to State law to conduct such game, (2) only organizations which are organized as nonprofit corporations or are exempt from Federal income tax under section 501(a) may be so licensed to conduct such game within the State, and (3) the conduct of such game does not violate State or local law.

No inference is intended regarding the treatment for purposes of the UBIT of games of chance conducted by tax-exempt organizations prior to the date of enactment.

Effective date. --The provision is effective on the date ofenactment.

Conference Agreement

The conference agreement does not include the Senate amendment.

29. Exclusion from income of certain severance payments (sec. 788(a) of the Senate amendment)

Present Law

Severance payments are includible in income.

House Bill

No provision.

Senate Amendment

Under the Senate amendment, certain severance payments are excludable from income. The provision applies to payments of up to $2,000 received by an individual who was separated from service in connection with a reduction in the work force of the employer and who does not attain employment within 6 months of the separation from service at a compensation level that is at least 95 percent of the compensation the individual was receiving before the separation from service. The exclusion does not apply if the total separation payments received by the individual exceed $125,000.

Effective date. --The provision applies to taxable years beginningafter December 31, 1997 , and before July 1, 2002 .

Conference Agreement

The conference agreement does not include the Senate amendment.

30. Special rule for thrift institutions that became large banks (sec. 790 of the Senate amendment)

Present Law

A provision of the Small Business Job Protection Act of 1996 repealed the percentage-of-taxable-income method of determining bad debt deductions of thrift institutions for taxable years beginning after 1995. A large bank (i.e., one with assets in excess of $500 million as of the end of its 1995 taxable year) that was required to change its method of accounting by reason of the provision generally is required to recapture its post-1987 bad debt reserve over a 6-year period. The amount of recapture for a small bank generally is reduced to the extent the bank's reserve for bad debts determined under the experience method applicable to such institutions exceeded its pre-1988 reserve.

House Bill

No provision.

Senate Amendment

The Senate amendment allows a thrift institution that first became a large bank in its first taxable year beginning after 1994 to be treated as a small bank for purposes of the Small Business Job Protection Act provision. In addition, such institutions may apply the required change in accounting method on a cut-off basis.

Effective date --The provision is effective as if included in theSmall Business Job Protection Act of 1996.

Conference Agreement

The conference agreement does not include the Senate amendment.

31. Income averaging for farmers (sec. 792 of the Senate amendment)

Present Law

The ability for an individual taxpayer to reduce his or her tax liability by averaging his or her income over a number of years was repealed by the Tax Reform Act of 1986.

House Bill

No provision.

Senate Amendment

An individual taxpayer is allowed to elect to compute his or her current year tax liability by averaging, over the prior three-year period, all or a portion of his or her taxable income from the trade of business of farming.

Effective date. --The provision is effective for taxable yearsbeginning after the date of enactment and before January 1, 2001 .

Conference Agreement

The conference agreement includes the Senate amendment with modifications. The conference agreement clarifies that the provision operates such that an electing eligible taxpayer (1) designates all or a portion of his or her taxable income from the trade or business of farming from the current year as "elected farm income;" (2) allocates one-third of such"elected farm income" to each of the prior three taxable years; and (3) determines his or her current year section 1 tax liability by determining the sum of (a) his or her current year section 1 liability without the elected farm income allocated to the three prior taxable years plus (b) the increases in the section 1 tax for each of the three prior taxable years by taking into account the allocable share of the elected farm income for such years. If a taxpayer elects the operation the provision for a taxable year, the allocation of elected farm income among taxable years pursuant to the election shall apply for purposes of any election in a subsequent taxable year.

The provision does not apply for employment tax purposes, or to an estate or a trust. Further, the provision does not apply for purposes of the alternative minimum tax under section 55. Finally, the provision does not require the recalculation of the tax liability of any other taxpayer, including a minor child required to use the tax rates of his or her parents under section 1(g).

The election shall be made in the manner prescribed by the Secretary of the Treasury and, except as provided by the Secretary, shall be irrevocable. In addition, the Secretary of the Treasury shall prescribe such regulations as are necessary to carry out the purposes of the provision, including regulations regarding the order and manner in which items of income, gain, deduction, loss, and credits (and any limitations thereon) are to be taken into account for purposes of the provision and the application of the provision to any short taxable year. It is expected that such regulations will deny the multiple application of items that carryover from one taxable year to the next (e.g., net operating loss or tax credit carryovers).

The provision applies to taxable years beginning after December 31, 1997, and before January 1, 2001.

32. Intercity Passenger Rail Fund; Elective carryback of existing net

operating losses of the National Railroad Passenger Corporation (Amtrak) (sec. 702 of the Senate amendment)

Present Law

In addition to current transportation-related trust fund fuels excise taxes, there is a permanent 4.3-cents-per-gallon General Fund excise tax on transportation fuels.

Generally, net operating losses may be carried back to the three taxable years preceding the year of loss (10 taxable years preceding the year of loss in certain circumstances).

House Bill

No provision.

Senate Amendment

The Senate amendment dedicates net revenues from 0.5 cent per gallon of the 4.3-cents-per gallon transportation motor fuels excise tax to a new Intercity Passenger Rail Fund ("Rail Fund") to finance capital improvementsof National Railroad Passenger Corporation (Amtrak) and certain transportation activities in States not receiving Amtrak service. Dedicated revenues are those from fuels taxes imposed from October 1, 1997 through April 15, 2001 .

The Senate amendment also expands the purposes for which non-Amtrak States may use Rail Fund monies to include: (1) local transit needs such as transportation for the elderly and handicapped; (2) rail/highway crossing safety projects (generally financed through the Highway Trust Fund); (3) certain capital expenditures of smaller freight railroads; and (4) certain rural airport capital expenditures.

Amounts received from the Rail Fund are not included in income. No tax deduction or addition to basis is allowed by the recipient with respect to expenditure of the amount.

Rail Fund spending is subject to appropriation, and is provided for under provisions of the Fiscal Year 1998 Budget Resolution.

Effective date. --The provision is effective on the date ofenactment.

Conference Agreement

The conference agreement follows the approach of the Senate amendment with modifications. The conference agreement provides elective procedures that allows Amtrak to consider the tax attributes of its predecessors, those railroads that were relieved of their responsibility to provide intercity rail passenger service as a result of the Rail Passenger Service Act of 1970, in the use of its net operating losses. The benefit allowable under these procedures is limited to the least of: (1) 35 percent of Amtrak's existing qualified carryovers, (2) the net tax liability for the carryback period, or (3) $2,323,000,000. One half of the amount so calculated will be treated as a payment of the tax imposed by chapter 1 of the Internal Revenue Code of 1986 for each of the first two taxable years ending after the date of enactment.

The existing qualified carryovers are the net operating loss carryovers that are available under section 172(b) in Amtrak's first taxable year ending after September 30, 1997. The net tax liability for the carryback period is the aggregate of the net tax liability of Amtrak's railroad predecessors for all taxable years beginning before January 1, 1971, for which there is a net Federal tax liability. Amtrak's railroad predecessors are those railroads that were relieved of their responsibility to provide intercity rail passenger service as a result of the Rail Passenger Service Act of 1970, and their predecessors. In the case of a railroad predecessor who joined in the filing of a consolidated tax return, the net tax liability of the predecessor will be the net tax liability of the consolidated group.

The net operating losses of Amtrak are required to be reduced by an amount equal to the amount obtained by Amtrak under this provision, divided by 0.35. The Secretary of the Treasury is to adjust, as he deems appropriate, the tax account of each predecessor railroad for the carryback period to reflect the utilization of the net operating losses. The amount of the adjustment is equal to the amount of the benefit and is to be taken into consideration on the tax accounts of the predecessor railroads on a first-in, first-out basis, starting with balances for the earliest year for which any predecessor railroad has a net tax liability. No additional refund to any taxpayer other than Amtrak is to be allowed as a result of these adjustments.

The availability of the elective procedures is conditioned on Amtrak (1) agreeing to make payments of one percent (1%) of the amount it receives to each of the non-Amtrak States to offset certain transportation related expenditures and (2) using the balance for certain qualified expenses. Non-Amtrak States are those States that are not receiving Amtrak service at any time during the period beginning on the date of enactment and ending on the date of payment.

No deduction is allowed with respect to any qualified expense whose payment is attributable to the proceeds made available as a result of this provision. The basis of any property must be reduced by the portion of its cost that is attributable to such proceeds. An item of cost or expense is attributable to such proceeds if it is (1) paid from the proceeds of the refund or (2) to the extent the principal and interest of any borrowings are paid from the proceeds of the refund, from the proceeds of such borrowings.

Amtrak's earnings and profits will be increased by the amount of the refund. However, the conferees expect that this amount will not be included in adjusted current earnings for alternative minimum tax purposes, consistent with Treas. Reg. sec. 1.56(g)-1(c)(4) (ii).

Effective date. --The provision is effective on the date ofenactment. However, no refund shall be made as a result of this provision earlier than the date of enactment of Federal legislation which authorizes reforms of Amtrak. No interest shall accrue with respect to the payment of any refund until 45 days after the later of (1) the enactment of such reform legislation, or (2) the filing by Amtrak of a Federal income tax return which includes the election to use the procedures described in this provision.

X. REVENUE-INCREASE PROVISIONS

A. Financial Products

1. Require recognition of gain on certain appreciated financial positions in personal property (sec. 1001(a) of the House bill and sec. 801(a) of the Senate amendment)

Present Law

In general, gain or loss is taken into account for tax purposes when realized. Gain or loss generally is realized with respect to a capital asset at the time the asset is sold, exchanged, or otherwise disposed of. Special rules under the Code can defer or accelerate recognition in certain circumstances. Transactions designed to reduce or eliminate risk of loss, such as a"short sale against the box," or an "equity swap," generally do notcause realization.

House Bill

The House bill requires recognition of gain (but not loss) upon a constructive sale of any "appreciated financial position" in stock, apartnership interest or debt other than certain "straight" debt instruments (as definedin sec. 1361(c)(5)(B)). A constructive sale occurs when the taxpayer enters into one of the following transactions with respect to the same or substantially identical property: (1) a short sale, (2) an offsetting notional principal contract, or (3) a futures or forward contact. For a taxpayer who has one of these transactions, a constructive sale occurs when it acquires the related long position. Other transactions will be treated as constructive sales to the extent provided in Treasury regulations.

The House bill provides an exception for transactions that are closed before the end of the 30th day after the close of the taxable year. This exception does not apply to transactions closed during the 90-day period ending on such day unless, for the 60 days after closing, (1) the taxpayer holds the appreciated financial position and (2) at no time is the taxpayer's risk of loss reduced by holding certain other positions.

Effective date. --The constructive sale provision is effective for constructive sales entered into after June 8, 1997 . In the case of a decedent dying after June 8, 1997 , if (1) a constructive sale occurred before such date, (2) the transaction remains open for not less than two years, and (3) the transaction is not closed in a taxable transaction within 30 days after the date of enactment, all positions comprising the constructive sale will be treated as property constituting rights to receive income in respect of a decedent under section 691. A special rule is also provided for transactions entered into before June 8, 1997 , that in some circumstances prevents such transactions from resulting in constructive sales after the effective date.

Senate Amendment

The Senate amendment is the same as the House bill with two modifications. Under the Senate amendment, the types of debt instruments excluded from the definition of "appreciated financial position" are instrumentsthat are not convertible and the interest on which is either fixed, payable at certain variable rates or based on certain interest payments on a pool of mortgages. In addition, the Senate amendment provides an exception for transactions closed during the 90-day period ending on the 30th day after the close of the taxable year that are reestablished during such period, so long as the normal requirements for positions closed within such 90-day period are met by the reestablished position.

Conference Agreement

The conference agreement follows the Senate amendment with the following modifications.

A trust instrument that is actively traded is generally treated as stock for purposes of determining whether the instrument is an appreciated financial position. The conference agreement provides that a trust instrument will not be treated as stock if substantially all (by value) of the property held by the trust is debt that qualifies for the exception to the definition of appreciated financial position for certain debt instruments. In addition, the conference agreement clarifies that only debt instruments that entitle the holder to receive an unconditional principal amount qualify for the exception.

The conference agreement modifies the exception to constructive sale treatment for transactions that are closed in the 90-day period ending with the 30th day after the close of the taxable year by applying similar requirements to all transactions closed prior to such day. Under the conference agreement, the exception is available only if, for the 60 days after closing a transaction, (1) the taxpayer holds the appreciated financial position and (2) at no time is the taxpayer's risk of loss reduced by holding certain other positions. If a transaction that is closed is reestablished in a substantially similar position, the exception applies provided that the reestablished position is closed prior to the end of the 30th day after the close of the taxable year and the above two requirements are met after such closing.

The conferees also wish to clarify some aspects of the application of the provision. The conferees do not intend that an agreement that is not a contract for purposes of applicable contract law will be treated as a forward contract. Thus, contingencies to which the contract is subject will generally be taken into account.

The conferees intend that the constructive sale provision generally will apply to transactions that are identified hedging or straddle transactions under other Code provisions (secs. 1092(a)(2), (b)(2) and (e), 1221 and 1256(e)). Where either position in such an identified transaction is an appreciated financial position and a constructive sale of such position results from the other position, the conferees intend that the constructive sale will be treated as having occurred immediately before the identified transaction. The constructive sale will not, however, prevent qualification of the transaction as an identified hedging or straddle transaction. Where, after the establishment of such an identified transaction, there is a constructive sale of either position in the transaction, gain will generally be recognized and accounted for under the relevant hedging or straddle provision. However, the conferees intend that future Treasury regulations may except certain transactions from the constructive sale provision where the gain recognized would be deferred under an identified hedging or straddle provision (e.g. Treas. reg. sec. 1.446-4(b)).

The conferees wish to clarify certain other aspects of the Treasury's regulatory authority under the provision. The conferees urge that the Treasury issue prompt guidance, including safe harbors, with respect to common transactions entered into by taxpayers.

The legislative history to both the House bill and the Senate amendment describe "collar" transactions and recommend that Treasuryregulations provide standards for determining which collar transactions result in constructive sales. The conferees expect that these Treasury regulations with respect to collars will be applied prospectively, except in cases to prevent abuse.

The legislative history states that, under the regulations to be issued by the Treasury, either a taxpayer's appreciated financial position or an offsetting transaction may in certain circumstances be considered on a disaggregated basis for purposes of the constructive sale determination. The conferees wish to clarify that this authority is intended to be used only where such disaggregated treatment reflects the economic reality of the transaction and is administratively feasible. For example, one transaction for which disaggregated treatment might be appropriate is an equity swap that references a small group of stocks, where the transaction is entered into by a taxpayer owning only one of the stocks.¹

Effective date. --The conference agreement modifies the special rulefor decedents dying after June 8, 1997, to require that a position be open at some time during the three-year period ending on the decedent's death. Thus, no amount will be treated as income in respect of a decedent under the rule unless this requirement is met, as well as the requirements that the transaction remains open for not less than two years and that the transaction is not closed within 30 days after the date of enactment. Finally, the conference agreement modifies the special rule to provide that gain with respect to a position that accrues after the transaction is closed will not be included in income in respect of a decedent.

2. Election of mark-to-market for securities traders and for traders and dealers in commodities

(sec. 1001(b) of the House bill and sec. 801(b) of the Senate amendment)

Present Law

A dealer in securities must compute its income pursuant to the mark-to-market method of accounting. Mark-to-market treatment does not apply to traders in securities or dealers in other property.

House Bill

The House bill allows securities traders and commodities traders and dealers to elect mark-to-market accounting similar to that currently required for securities dealers. All securities held by an electing taxpayer in connection with a trade or business as a securities trader, and all commodities held by an electing taxpayer in connection with a trade or business as a commodities dealer or trader, are subject to mark-to-market treatment. Property not held in connection with its trade or business is not subject to the election provided that it is identified by the taxpayer under rules similar to the present law rules for securities dealers. Gain or loss recognized by an electing taxpayer under the provision is ordinary gain or loss.

Under the House bill, commodities for purposes of the provision would include only commodities of a kind customarily dealt in on an organized commodities exchange.

Effective date. --The election applies to taxable years ending afterthe date of enactment.

Senate Amendment

The Senate amendment is the same as the House bill.

Conference Agreement

The conference agreement follows the House bill and Senate amendment with the following modifications.

The conference agreement clarifies that if a securities trader elects application of the provision, all securities held in connection with its trade or business will generally be subject to mark-to-market accounting. An exception is provided for securities that have no connection with activities as a trader and that are identified on the day acquired (or at such other times as provided in Treasury regulations). The conferees do not intend that an electing taxpayer can mark-to-market loans made to customers or receivables or debt instruments acquired from customers that are not received or acquired in connection with a trade or business as a securities trader. Because the conferees are concerned about issues of taxpayer selectivity, the conferees intend that an electing taxpayer must be able to demonstrate by clear and convincing evidence that a security bears no relation to activities as a trader in order to be identified as not subject to the mark-to-market regime. Any security that hedges another security that is held in connection with the taxpayer's trade or business as a trader will be treated as so held. Any position that is properly subject to the mark-to-market regime will not be taken into account for purposes of the constructive sale rules of section 1259. Similar rules apply to commodities traders.

The conference agreement expands the definition of a commodity for purposes of the provision to include any commodity that is actively traded (within the meaning of section 1092(d)(1)), any option, forward contract, futures contract, short position, notional principal contract or derivative instrument that references such a commodity, and any other evidence of an interest in such a commodity. Also included are positions that hedge the listed items and that are identified by the taxpayer under rules similar to the rules for securities.

The conferees anticipate that Treasury regulations applying section 475(b)(4), which prevents a dealer from treating certain notional principal contracts and other derivative financial instruments as held for investment, will in the case of a commodities trader or dealer apply only to contracts and instruments referenced to commodities.

Effective date. --The conferees wish to clarify that the specialrule with respect to the section 481 adjustment applies only to taxpayers making the election for the taxable year which includes the date of enactment. Any elections made thereafter will be governed by rules and procedures established by the Secretary of the Treasury.

3. Limitation on exception for investment companies under section 351 (sec. 1002 of the House bill and sec. 802 of the Senate amendment)

Present Law

Gain or loss is recognized upon a contribution by a shareholder to a corporation that is an investment company. Gain, but not loss, is recognized upon a contribution by a partner to a partnership that would be treated as an investment company. Under Treasury regulations, a contribution of property is treated as made to an investment company only if (1) the contribution results, directly or indirectly, in a diversification of the transferor's interest and (2) the transferee is (a) a regulated investment company (" RIC "),(b) a real estate investment trust ("REIT") or (c) a corporation more than 80percent of the assets of which by value (excluding cash and non-convertible debt instruments) are readily marketable stocks or securities or interests in RICs or REITs that are held for investment

House Bill

The House bill modifies the definition of an investment company by requiring that the following assets also be taken into account for purposes of the 80-percent test: money, financial instruments, foreign currency, and interests in RICs, REITs, common trust funds, publicly-traded partnerships and precious metals. The House bill provides an exception for precious metals that are produced, used or held in an active trade or business by a partnership. The House bill also provides "look through" rules for certain entitiesthat hold the above-listed items.

Effective date. The provision is effective for transfers after June 8, 1997 , in taxable years ending after such date, with an exception for transfers pursuant to certain binding written contracts in effect on that date.

Senate Amendment

The Senate amendment follows the House bill, but clarifies that equity interests in non-corporate entities will be taken into account for purposes of the investment company determination only if (1) the entity is a REIT, publicly-traded partnership or common trust fund, (2) the interest is convertible into or exchangeable for one of the other listed assets or (3) the entity holds listed assets and is subject to the "look-through"rules. The Senate amendment also clarifies that the exception for precious metals used or held in an active trade or business applies to both corporations and partnerships. The Senate amendment deletes the exception for precious metals that are produced by a partnership. The Senate amendment also provides the Treasury with regulatory authority to remove items from the list in appropriate circumstances.

Conference Agreement

The conference agreement is the same as the Senate amendment.

4. Disallowance of interest on indebtedness allocable to tax-exempt obligations (sec. 1003 of the House bill)

Present Law

In general

Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is not subject to tax (tax-exempt obligations) (sec. 265). This rule applies to tax-exempt obligations held by individual and corporate taxpayers. The rule also applies to certain cases in which a taxpayer incurs or continues indebtedness and a related person acquires or holds tax-exempt obligations.²

Application to non-financial corporations

General guidelines. --In Rev. Proc. 72-18, 1972-1 C.B. 740, the IRS provided guidelines for application of the disallowance provision to individuals, dealers in tax-exempt obligations, other business enterprises, and banks in certain situations. Under Rev. Proc. 72-18, a deduction is disallowed only when indebtedness is incurred or continued for the purpose of purchasing or carrying tax-exempt obligations.

This purpose may be established either by direct or circumstantial evidence. Direct evidence of a purpose to purchase tax-exempt obligations exists when the proceeds of indebtedness are directly traceable to the purchase of tax-exempt obligations or when such obligations are used as collateral for indebtedness. In the absence of direct evidence, a deduction is disallowed only if the totality of facts and circumstances establishes a sufficiently direct relationship between the borrowing and the investment in tax-exempt obligations.

Two-percent de minimis exception. --In the case of an individual, interest on indebtedness generally is not disallowed if during the taxable year the average adjusted basis of the tax-exempt obligations does not exceed 2 percent of the average adjusted basis of the individual's portfolio investments and trade or business assets. In the case of a corporation other than a financial institution or a dealer in tax-exempt obligations, interest on indebtedness generally is not disallowed if during the taxable year the average adjusted basis of the tax-exempt obligations does not exceed 2 percent of the average adjusted basis of all assets held in the active conduct of the trade or business. These safe harbors are inapplicable to financial institutions and dealers in tax-exempt obligations.

Interest on installment sales to State and local governments. --If a taxpayer sells property to a State or local government in exchange for an installment obligation, interest on the obligation may be exempt from tax. Present law has been interpreted to not disallow interest on a taxpayer's indebtedness if the taxpayer acquires nonsalable tax-exempt obligations in the ordinary course of business in payment for services performed for, or goods supplied to, State or local governments.³

Application to financial corporations and dealers in tax-exempt obligations

In the case of a financial institution, the allocation of the interest expense of the financial institution (which is not otherwise allocable to tax-exempt obligations) is based on the ratio of the average adjusted basis of the tax-exempt obligations acquired after August 7, 1987 , to the average adjusted basis of all assets of the taxpayer (sec. 265). In the case of an obligation of an issuer which reasonably anticipates to issue not more than $10 million of tax-exempt obligations (other than certain private activity bonds) within a calendar year (the "small issuer exception"), only 20 percent ofthe interest allocable to such tax-exempt obligations is disallowed (sec. 291(a)(3)). A similar pro rata rule applies to dealers in tax-exempt obligations, but there is no small issuer exception, and the 20-percent disallowance rule does not apply (Rev. Proc. 72-18).

Treatment of insurance companies

Present law provides that a life insurance company's deduction for additions to reserves is reduced by a portion of the company's income that is not subject to tax (generally, tax-exempt interest and deductible intercorporate dividends) (secs. 807 and 812). The portion by which the life insurance company's reserve deduction is reduced is related to its earnings rate. Similarly, in the case of property and casualty insurance companies, the deduction for losses incurred is reduced by a percentage (15 percent) of (1) the insurer's tax-exempt interest and (2) the deductible portion of dividends received (with special rules for dividends from affiliates) (sec. 832(b)(5)(B)). If the amount of this reduction exceeds the amount otherwise deductible as losses incurred, the excess is includible in the property and casualty insurer's income.

House Bill

General rule

The House bill extends to all corporations (other than insurance companies) the rule that applies to financial institutions that disallows interest deductions of a taxpayer (that are not otherwise disallowed as allocable under present law to tax-exempt obligations) in the same proportion as the average basis of its tax-exempt obligations bears to the average basis of all of the taxpayer's assets. However, the House bill does not extend the small-issuer exception to taxpayers which are not financial institutions.

Exceptions

The House bill does not apply to nonsalable tax-exempt debt acquired by a corporation in the ordinary course of business in payment for goods or services sold to a State or local government. In addition, the House bill provides a de minimis exception under which the disallowance rule does not apply to corporations, other than financial institutions and dealers in tax-exempt obligations, if the average adjusted basis of tax-exempt obligations acquired after August 7, 1986 , is less than the lesser of $1 million or 2 percent of the basis of all of the corporation's assets. Under the House bill, insurance companies are not subject to the pro rata rule but would continue to be subject to present law.

Holdings by related persons

The House bill applies the interest disallowance provision to all related persons that are members of the same consolidated group as if all the members of the group were a single taxpayer. The consolidated group rule is to be applied without regard to any member that is an insurance company. In the case of affiliated corporations that are not members of the same consolidated group, tracing rules apply as if all of the related persons are a single entity.

In the case of a corporation (other than a financial institution) that is a partner in a partnership, the corporate partners are treated as holding their allocable shares of all of the assets of the partnership.

The provision is not intended to affect the application of section 265 to related parties under present law.

Effective date. --The provision is effective for taxable yearsbeginning after the date of enactment with respect to obligations acquired after June 8, 1997 .

Senate Amendment

No provision.

Conference Agreement

The conference agreement does not include the provision of the House bill.

5. Gains and losses from certain terminations with respect to property (sec. 1004 of the House bill and sec. 803 of the Senate amendment)

Present Law

Extinguishment treated as sale or exchange. --The definition ofcapital gains and losses in section 1222 requires that there be a "sale orexchange" of a capital asset. Court decisions interpreted this requirement to mean that when a disposition is not a sale or exchange of a capital asset, for example, a lapse, cancellation, or abandonment, the disposition produces ordinary income or loss.⁴ Under a special provision, gains and lossesattributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to certain personal property are treated as gains or losses from the sale of a capital asset (sec. 1234A). Personal property subject to this rule is (1) personal property (other than stock that is not part of straddle or of a corporation that is not formed or availed of to take positions which offset positions in personal property of its shareholders) of a type which is actively traded and which is, or would be on acquisition, a capital asset in the hands of the taxpayer and (2) a "section 1256contract"