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House
Bill
No provision.
Senate
Amendment
Under the provision, the special recapture rule for
overall foreign losses that currently applies to
dispositions of foreign trade or business assets
applies to the disposition of stock in a controlled
foreign corporation controlled by the taxpayer.
Thus, a disposition of controlled foreign
corporation stock by a controlling shareholder
results in the recognition of foreign-source income
in an amount equal to the lesser of the fair market
value of the stock over its adjusted basis, or the
amount of prior unrecaptured overall foreign losses.
Such income is resourced as U.S.-source income for
foreign tax credit limitation purposes without
regard to the 50-percent limit.
Although the provision generally extends to all
dispositions of such stock, regardless of whether
gain or loss is recognized on the transfer,
exceptions are made for certain internal
restructurings. Contributions to corporations or
partnerships under sections 351 and 721,
respectively, and certain stock and asset
reorganizations do not trigger recapture of overall
foreign losses, provided that the transferor's
underlying indirect interest in the disposed
controlled foreign corporation does not change.
However, any gain recognized in connection with a
transaction meeting any of these exceptions, such as
boot, triggers recapture of overall foreign losses
to the extent of such gain.
Effective date. --The provision applies to
dispositions after the date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment with modifications. Under the provision as
modified, a disposition of controlled foreign
corporation stock in a transaction in which the
taxpayer or a member of its consolidated group
acquires the assets of the controlled foreign
corporation in a liquidation under section 332 or a
reorganization does not trigger the recapture of
overall foreign losses. Any gain recognized in
connection with a transaction meeting this exception
triggers recapture of overall foreign losses to the
extent of such gain.
15. Application of earnings-stripping rules to
partnerships and S corporations (sec. 462 of the
Senate amendment and sec. 163 of the Code)
Present
Law
Present law provides rules to limit the ability of
U.S.
corporations to reduce the
U.S.
tax on their U.S.-source income through earnings
stripping transactions. Section 163(j) specifically
addresses earnings stripping involving interest
payments, by limiting the deductibility of interest
paid to certain related parties ("disqualified
interest"),894
if the payor's debt-equity ratio exceeds 1.5 to 1
and the payor's net interest expense exceeds 50
percent of its "adjusted taxable income"
(generally taxable income computed without regard to
deductions for net interest expense, net operating
losses, and depreciation, amortization, and
depletion). Disallowed interest amounts can be
carried forward indefinitely. In addition, excess
limitation (i.e., any excess of the 50-percent limit
over a company's net interest expense for a given
year) can be carried forward three years.
The present-law earnings stripping provision does
not apply to partnerships. Proposed Treasury
regulations provide that a corporate partner's
proportionate share of the liabilities of a
partnership is treated as debt of the corporate
partner for purposes of applying the earnings
stripping limitation to its own interest payments.895
In addition, interest paid or accrued by a
partnership is treated as interest expense of a
corporate partner, with the result that a deduction
for the interest expense may be disallowed if that
expense would be disallowed under the earnings
stripping rules if paid by the corporate partner
itself.896
The proposed regulations also provide that the
earnings stripping rules do not apply to subchapter
S corporations.897
Thus, under present law and the proposed
regulations, a partnership or S corporation
generally is allowed a deduction for interest paid
or accrued on indebtedness that it issues that
otherwise would be disallowed under the earnings
stripping rules in the case of a subchapter C
corporation.
House
Bill
No provision.
Senate
Amendment
The Senate amendment incorporates a rule attributing
partnership debt to a corporate partner for purposes
of applying the earnings stripping rules to the
corporation.898
Effective date. --The Senate amendment
provision generally is effective for taxable years
beginning on or after the date of enactment.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
16. Recognition of cancellation of indebtedness
income realized on satisfaction of debt with
partnership interest (sec. 463 of the Senate
amendment and sec. 108 of the Code)
Present
Law
Under present law, a corporation that transfers
shares of its stock in satisfaction of its debt must
recognize cancellation of indebtedness income in the
amount that would be realized if the debt were
satisfied with money equal to the fair market value
of the stock.899
Prior to enactment of this present-law provision in
1993, case law provided that a corporation did not
recognize cancellation of indebtedness income when
it transferred stock to a creditor in satisfaction
of debt (referred to as the "stock-for-debt
exception").900
When cancellation of indebtedness income is realized
by a partnership, it generally is allocated among
the partners in accordance with the partnership
agreement, provided the allocations under the
agreement have substantial economic effect. A
partner who is allocated cancellation of
indebtedness income is entitled to exclude it if the
partner qualifies for one of the various exceptions
to recognition of such income, including the
exception for insolvent taxpayers or that for
qualified real property indebtedness of taxpayers
other than subchapter C corporations.901
The availability of each of these exceptions is
determined at the partner, rather than the
partnership, level.
In the case of a partnership that transfers to a
creditor a capital or profits interest in the
partnership in satisfaction of its debt, no Code
provision expressly requires the partnership to
realize cancellation of indebtedness income. Thus,
it is unclear whether the partnership is required to
recognize cancellation of indebtedness income under
either the case law that established the
stock-for-debt exception or the present-law
statutory repeal of the stock-for-debt exception. It
also is unclear whether any requirement to recognize
cancellation of indebtedness income is affected if
the cancelled debt is nonrecourse indebtedness.902
House
Bill
No provision.
Senate
Amendment
The Senate amendment provides that when a
partnership transfers a capital or profits interest
in the partnership to a creditor in satisfaction of
partnership debt, the partnership generally
recognizes cancellation of indebtedness income in
the amount that would be recognized if the debt were
satisfied with money equal to the fair market value
of the partnership interest. The Senate amendment
applies without regard to whether the cancelled debt
is recourse or nonrecourse indebtedness. Any
cancellation of indebtedness income recognized under
the Senate amendment is allocated solely among the
partners who held interests in the partnership
immediately prior to the satisfaction of the debt.
Under the Senate amendment, no inference is intended
as to the treatment under present law of the
transfer of a partnership interest in satisfaction
of partnership debt.
Effective date. --The Senate amendment is
effective for cancellations of indebtedness
occurring on or after the date of enactment.
Conference
Agreement
The conference agreement includes the Senate
amendment.
17. Denial of installment sale treatment for all
readily tradable debt (Sec. 465 of the Senate
amendment and sec. 453 of the Code)
Present
Law
Under present law, taxpayers are permitted to
recognize as gain on a disposition of property only
that proportion of payments received in a taxable
year which is the same as the proportion that the
gross profit bears to the total contract price (the
"installment method").903
However, the installment method is not available if
the taxpayer sells property in exchange for a
readily tradable evidence of indebtedness that is
issued by a corporation or a government or political
subdivision.904
No similar provision under present law prohibits the
use of the installment method where the taxpayer
sells property in exchange for readily tradable
indebtedness issued by a partnership or an
individual.
House
Bill
No provision.
Senate
Amendment
The Senate amendment denies installment sale
treatment with respect to all sales in which the
taxpayer receives indebtedness that is readily
tradable under present-law rules, regardless of the
nature of the issuer. For example, if the taxpayer
receives readily tradable debt of a partnership in a
sale, the partnership debt is treated as payment on
the installment note, and the installment method is
unavailable to the taxpayer.
Effective date. --The Senate amendment
provision is effective for sales occurring on or
after date of enactment.
Conference
Agreement
The conference agreement includes the Senate
amendment.
18. Modify treatment of transfers to creditors in
divisive reorganizations (sec. 466 of the Senate
amendment and secs. 357 and 361 of the Code)
Present
Law
Section 355 of the Code permits a corporation
("distributing") to separate its
businesses by distributing a controlled subsidiary
("controlled") tax-free, if certain
conditions are met. In cases where the distributing
corporation contributes property to the controlled
corporation that is to be distributed, no gain or
loss is recognized if the property is contributed
solely in exchange for stock or securities of the
controlled corporation (which are subsequently
distributed to distributing's shareholders). The
contribution of property to a controlled corporation
that is followed by a distribution of its stock and
securities may qualify as a reorganization described
in section 368(a)(1)(D). That section also applies
to certain transactions that do not involve a
distribution under section 355 and that are
considered 'acquisitive" rather than
"divisive" reorganizations.
The contribution in the course of a divisive section
368(a)(1)(D) reorganization is also subject to the
rules of section 357(c). That section provides that
the transferor corporation will recognize gain if
the amount of liabilities assumed by controlled
exceeds the basis of the property transferred to it.
Because the contribution transaction in connection
with a section 355 distribution is a reorganization
under section 368(a)(1)(D), it is also subject to
certain rules applicable to both divisive and
acquisitive reorganizations. One such rule, in
section 361(b), states that a transferor corporation
will not recognize gain if it receives money or
other property and distributes that money or other
property to its shareholders or creditors. The
amount of property that may be distributed to
creditors without gain recognition is unlimited
under this provision.
House
Bill
No provision.
Senate
Amendment
The bill limits the amount of money plus the fair
market value of other property that a distributing
corporation can distribute to its creditors without
gain recognition under section 361(b) to the amount
of the basis of the assets contributed to a
controlled corporation in a divisive reorganization.
In addition, the bill provides that acquisitive
reorganizations under section 368(a)(1)(D) are no
longer subject to the liabilities assumption rules
of section 357(c).
Effective date. --The bill is effective for
transactions on or after the date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment.
19. Clarify definition of nonqualified preferred
stock (sec. 467 of the Senate amendment and sec.
351(g) of the Code)
Present
Law
The Taxpayer Relief Act of 1997 amended sections
351, 354, 355, 356, and 1036 to treat
"nonqualified preferred stock" as boot in
corporate transactions, subject to certain
exceptions. For this purpose, preferred stock is
defined as stock that is "limited and preferred
as to dividends and does not participate in
corporate growth to any significant extent."
Nonqualified preferred stock is defined as any
preferred stock if (1) the holder has the right to
require the issuer or a related person to redeem or
purchase the stock, (2) the issuer or a related
person is required to redeem or purchase, (3) the
issuer or a related person has the right to redeem
or repurchase, and, as of the issue date, it is more
likely than not that such right will be exercised,
or (4) the dividend rate varies in whole or in part
(directly or indirectly) with reference to interest
rates, commodity prices, or similar indices,
regardless of whether such varying rate is provided
as an express term of the stock (as in the case of
an adjustable rate stock) or as a practical result
of other aspects of the stock (as in the case of
auction stock). For this purpose, clauses (1), (2),
and (3) apply if the right or obligation may be
exercised within 20 years of the issue date and is
not subject to a contingency which, as of the issue
date, makes remote the likelihood of the redemption
or purchase.
House
Bill
No provision.
Senate
Amendment
The provision clarifies the definition of
nonqualified preferred stock to ensure that stock
for which there is not a real and meaningful
likelihood of actually participating in the earnings
and profits of the corporation is not considered to
be outside the definition of stock that is limited
and preferred as to dividends and does not
participate in corporate growth to any significant
extent.
As one example, instruments that are preferred on
liquidation and that are entitled to the same
dividends as may be declared on common stock do not
escape being nonqualified preferred stock by reason
of that right if the corporation does not in fact
pay dividends either to its common or preferred
stockholders. As another example, stock that
entitles the holder to a dividend that is the
greater of seven percent or the dividends common
shareholders receive does not avoid being preferred
stock if the common shareholders are not expected to
receive dividends greater than seven percent.
No inference is intended as to the characterization
of stock under present law that has terms providing
for unlimited dividends or participation rights but,
based on all the facts and circumstances, is limited
and preferred as to dividends and does not
participate in corporate growth to any significant
extent.
Effective date. --The provision is effective
for transactions after
May 14, 2003
.
Conference
Agreement
The conference agreement follows the Senate
amendment.
20. Modify definition of controlled group of
corporations (sec. 468 of the Senate amendment and
sec. 1563 of the Code)
Present
Law
Under present law, a tax is imposed on the taxable
income of corporations. The rates are as follows:
Marginal
Federal Corporate Income Tax Rates
If taxable Then the income tax
income is : rate is :
_______________ _____________________
$0 - $50,000 ...................15 percent of taxable income
$50,001 - $75,000 ..............25 percent of taxable income
$75,001 - $10,000,000 ..........34 percent of taxable income
Over $10,000,000................35 percent of taxable income
The first two graduated rates described above are
phased out by a five-percent surcharge for
corporations with taxable income between $100,000
and $335,000. Also, the application of the
34-percent rate is phased out by a three-percent
surcharge for corporations with taxable income
between $15 million and $18,333,333.
The component members of a controlled group of
corporations are limited to one amount in each of
the taxable income brackets shown above.905
For this purpose, a controlled group of corporations
means a parent-subsidiary controlled group and a
brother-sister controlled group.
A brother-sister controlled group means two or more
corporations if five or fewer persons who are
individuals, estates or trusts own (or
constructively own) stock possessing (1) at least 80
percent of the total combined voting power of all
classes of stock entitled to vote and at least 80
percent of the total value of all stock, and (2)
more than 50 percent of percent of the total
combined voting power of all classes of stock
entitled to vote or more than 50 percent of the
total value of all stock, taking into account the
stock ownership of each person only to the extent
the stock ownership is identical with respect to
each corporation.906
House
Bill
No provision.
Senate
Amendment
Under the provision, a brother-sister controlled
group means two or more corporations if five or
fewer persons who are individuals, estates or trusts
own (or constructively own) stock possessing more
than 50 percent of the total combined voting power
of all classes of stock entitled to vote, or more
than 50 percent of the total value of all stock,
taking into account the stock ownership of each
person only to the extent the stock ownership is
identical with respect to each corporation.
The provision applies only for purposes of section
1561, currently relating to corporate tax brackets,
the accumulated earnings credit, and the minimum
tax. The provision does not affect other Code
sections or other provisions that utilize or refer
to the section 1563 brothersister corporation
controlled group test for other purposes.907
Effective date. --The provision applies to
taxable years beginning after the date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment.
21. Establish specific class lives for utility
grading costs (sec. 472 of the Senate amendment and
sec. 168 of the Code)
Present
Law
A taxpayer is allowed a depreciation deduction for
the exhaustion, wear and tear, and obsolescence of
property that is used in a trade or business or held
for the production of income. For most tangible
property placed in service after 1986, the amount of
the depreciation deduction is determined under the
modified accelerated cost recovery system ("MACRS")
using a statutorily prescribed depreciation method,
recovery period, and placed in service convention.
For some assets, the recovery period for the asset
is provided in section 168. In other cases, the
recovery period of an asset is determined by
reference to its class life. The class lives of
assets placed in service after 1986 are generally
set forth in Revenue Procedure 87-56.908
If no class life is provided, the asset is allowed a
7-year recovery period under MACRS.
Assets that are used in the transmission and
distribution of electricity for sale are included in
asset class 49.14, with a class life of 30 years and
a MACRS recovery period of 20 years. The cost of
initially clearing and grading land improvements are
specifically excluded from asset class 49.14. Prior
to adoption of the accelerated cost recovery system,
the
IRS
ruled that an average useful life of 84 years for
the initial clearing and grading relating to
electric transmission lines and 46 years for the
initial clearing and grading relating to electric
distribution lines, would be accepted. However, the
result in this ruling was not incorporated in the
asset classes included in Rev. Proc. 87-56 or its
predecessors. Accordingly such costs are depreciated
over a 7-year recovery period under MACRS as assets
for which no class life is provided.
A similar situation exists with regard to gas
utility trunk pipelines and related storage
facilities. Such assets are included in asset class
49.24, with a class life of 22 years and a MACRS
recovery period of 15 years. Initial clearing and
grade improvements are specifically excluded from
the asset class, and no separate asset class is
provided for such costs.
Accordingly, such costs are depreciated over a
7-year recovery period under MACRS as assets for
which no class life is provided.
House
Bill
No provision.
Senate
Amendment
The Senate amendment assigns a class life to
depreciable electric and gas utility clearing and
grading costs incurred to locate transmission and
distribution lines and pipelines. The provision
includes these assets in the asset classes of the
property to which the clearing and grading costs
relate (generally, asset class 49.14 for electric
utilities and asset class 49.24 for gas utilities,
giving these assets a recovery period of 20 years
and 15 years, respectively).
Effective date. --The Senate amendment is
effective for property placed in service after the
date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment.
22. Expansion of limitation on expensing of
certain passenger automobiles (sec. 473 of the
Senate amendment and sec. 179 of the Code)
Present
Law
A taxpayer is allowed to recover, through annual
depreciation deductions, the cost of certain
property used in a trade or business or for the
production of income. The amount of the depreciation
deduction allowed with respect to tangible property
for a taxable year is determined under the modified
accelerated cost recovery system ("MACRS").
Under MACRS, passenger automobiles generally are
recovered over five years. However, section 280F
limits the annual depreciation deduction with
respect to certain passenger automobiles.909
For purposes of the depreciation limitation,
passenger automobiles are defined broadly to include
any 4-wheeled vehicles that are manufactured
primarily for use on public streets, roads, and
highways and which are rated at 6,000 pounds
unloaded gross vehicle weight or less.910
In the case of a truck or a van, the depreciation
limitation applies to vehicles that are rated at
6,000 pounds gross vehicle weight or less. Sports
utility vehicles are treated as a truck for the
purpose of applying the section 280F limitation.
In lieu of depreciation, a taxpayer with a
sufficiently small amount of annual investment may
elect to expense such investment (sec. 179). The
Jobs and Growth Tax Relief Reconciliation Act (JGTRRA)
of 2003911
increased the amount a taxpayer may deduct, for
taxable years beginning in 2003 through 2005, to
$100,000 of the cost of qualifying property placed
in service for the taxable year.912
In general, qualifying property is defined as
depreciable tangible personal property that is
purchased for use in the active conduct of a trade
or business. The $100,000 amount is reduced (but not
below zero) by the amount by which the cost of
qualifying property placed in service during the
taxable year exceeds $400,000. Prior to the
enactment of JGTRRA (and for taxable years beginning
in 2006 and thereafter) a taxpayer with a
sufficiently small amount of annual investment may
elect to deduct up to $25,000 of the cost of
qualifying property placed in service for the
taxable year. The $25,000 amount is reduced (but not
below zero) by the amount by which the cost of
qualifying property placed in service during the
taxable year exceeds $200,000. Passenger automobiles
subject to section 280F are eligible for section 179
expensing only to the extent of the applicable
limits contained in section 280F.
House
Bill
No provision.
Senate
Amendment
The Senate amendment limits the ability of taxpayers
to claim deductions under section 179 for certain
vehicles not subject to section 280F to $25,000. The
provision applies to sport utility vehicles rated at
14,000 pounds gross vehicle weight or less (in place
of the present law 6,000 pound rating). For this
purpose, a sport utility vehicle is defined to
exclude any vehicle that: (1) is designed for more
than nine individuals in seating rearward of the
driver's seat; (2) is equipped with an open cargo
area, or a covered box not readily accessible from
the passenger compartment, of at least six feet in
interior length; or (3) has an integral enclosure,
fully enclosing the driver compartment and load
carrying device, does not have seating rearward of
the driver's seat, and has no body section
protruding more than 30 inches ahead of the leading
edge of the windshield.
The following example illustrates the operation of
the provision.
Example. --Assume that during 2005, a
calendar year taxpayer acquires and places in
service a sport utility vehicle subject to the
provision that costs $70,000. In addition, assume
that the property otherwise qualifies for the
expensing election under section 179. Under the
provision, the taxpayer is first allowed a $25,000
deduction under section 179. The taxpayer is also
allowed an additional first-year depreciation
deduction (sec. 168(k)) of $22,500 based on $45,000
($70,000 original cost less the section 179
deduction of $25,000) of adjusted basis. Finally,
the remaining adjusted basis of $22,500 ($45,000
adjusted basis less $22,500 additional first-year
depreciation) is eligible for an additional
depreciation deduction of $4,500 under the general
depreciation rules (automobiles are five-year
recovery property). The remaining $18,000 of cost
($70,000 original cost less $52,000 deductible
currently) would be recovered in 2006 and subsequent
years pursuant to the general depreciation rules.
Effective date. --The Senate amendment is
effective for property placed in service after the
date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment.
23. Provide consistent amortization period for
intangibles (sec. 474 of the Senate amendment and
secs. 195, 248, and 709 of the Code)
Present
Law
At the election of the taxpayer, start-up
expenditures913
and organizational expenditures914
may be amortized over a period of not less than 60
months, beginning with the month in which the trade
or business begins. Start-up expenditures are
amounts that would have been deductible as trade or
business expenses, had they not been paid or
incurred before business began. Organizational
expenditures are expenditures that are incident to
the creation of a corporation (sec. 248) or the
organization of a partnership (sec. 709), are
chargeable to capital, and that would be eligible
for amortization had they been paid or incurred in
connection with the organization of a corporation or
partnership with a limited or ascertainable life.
Treasury regulations915
require that a taxpayer file an election to amortize
start-up expenditures no later than the due date for
the taxable year in which the trade or business
begins. The election must describe the trade or
business, indicate the period of amortization (not
less than 60 months), describe each start-up
expenditure incurred, and indicate the month in
which the trade or business began. Similar
requirements apply to the election to amortize
organizational expenditures. A revised statement may
be filed to include start-up and organizational
expenditures that were not included on the original
statement, but a taxpayer may not include as a
start-up expenditure any amount that was previously
claimed as a deduction.
Section 197 requires most acquired intangible assets
(such as goodwill, trademarks, franchises, and
patents) that are held in connection with the
conduct of a trade or business or an activity for
the production of income to be amortized over 15
years beginning with the month in which the
intangible was acquired.
House
Bill
No provision.
Senate
Amendment
The Senate amendment modifies the treatment of
start-up and organizational expenditures. A taxpayer
would be allowed to elect to deduct up to $5,000 of
start-up and $5,000 of organizational expenditures
in the taxable year in which the trade or business
begins. However, each $5,000 amount is reduced (but
not below zero) by the amount by which the
cumulative cost of start-up or organizational
expenditures exceeds $50,000, respectively. Start-up
and organizational expenditures that are not
deductible in the year in which the trade or
business begins would be amortized over a 15-year
period consistent with the amortization period for
section 197 intangibles.
Effective date. --The Senate amendment is
effective for start-up and organizational
expenditures incurred after the date of enactment.
Start-up and organizational expenditures that are
incurred on or before the date of enactment would
continue to be eligible to be amortized over a
period not to exceed 60 months. However, all
start-up and organizational expenditures related to
a particular trade or business, whether incurred
before or after the date of enactment, would be
considered in determining whether the cumulative
cost of start-up or organizational expenditures
exceeds $50,000.
Conference
Agreement
The conference agreement follows the Senate
amendment.
24. Doubling of certain penalties, fines, and
interest on underpayments related to certain
offshore financial arrangements (sec. 483 of the
Senate amendment)
Present
Law
The Code contains numerous civil penalties, such as
the delinquency, accuracy-related and fraud
penalties. These civil penalties are in addition to
any interest that may be due.
In January 2003, Treasury announced the Offshore
Voluntary Compliance Initiative ("OVCI")
running through
April 15, 2003
, to encourage the voluntary disclosure of
previously unreported income placed by taxpayers in
offshore accounts and accessed through credit card
or other financial arrangements. The taxpayer will
pay back taxes, interest and certain accuracyrelated
and delinquency penalties.
A taxpayer's timely, voluntary disclosure of a
substantial unreported tax liability has long been
an important factor in deciding whether the
taxpayer's case should ultimately be referred for
criminal prosecution. The voluntary disclosure must
be truthful, timely, and complete. A voluntary
disclosure does not guarantee immunity from
prosecution.
House
Bill
No provision.
Senate
Amendment
Increases by a factor of two the total amount of
civil penalties, interest and fines applicable for
taxpayers who would have been eligible to
participate in either the OVCI or the Treasury
Department's voluntary disclosure initiative but did
not participate in either program.
Effective date. --Taxpayers' open tax years
on or after date of enactment.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
25. Whistleblower reforms (sec. 488 of the Senate
amendment)
Present
Law
Under section 7623, the
IRS
is authorized to pay such sums as deemed necessary
for: "(1) detecting underpayments of tax; and
(2) detecting and bringing to trial and punishment
persons guilty of violating the internal revenue
laws or conniving at the same." Amounts are
paid based on a percentage of tax, fines, and
penalties (but not interest) actually collected
based on the information provided. For specific
information that caused the investigation and
resulted in recovery, the
IRS
administratively has set the reward in an amount not
to exceed 15 percent of the amounts recovered. For
information, although not specific, that nonetheless
caused the investigation and was of value in the
determination of tax liabilities, the reward is not
to exceed 10 percent of the amount recovered. For
information that caused the investigation, but had
no direct relationship to the determination of tax
liabilities, the reward is not to exceed one percent
of the amount recovered. The reward ceiling is $10
million (for payments made after
November 7, 2002
), and the reward floor is $100. No reward will be
paid if the recovery was so small as to call for
payment of less than $100 under the above formulas.
Both the ceiling and percentages can be increased
with a Special Agreement. The Code permits the
IRS
to disclose return information pursuant to a
contract for tax administration services (sec.
6103(n)).
House
Bill
No provision.
Senate
Amendment
The Senate amendment creates a reward program for
actions in which the tax, penalties, interest,
additions to tax, and additional amounts in dispute
exceed $20,000, and, if the taxpayer is an
individual, the individual's gross income exceeds
$200,000 for any taxable year.
Generally, the Senate amendment establishes a reward
floor of 15 percent of the collected proceeds
(including penalties, interest, additions to tax and
additional amounts) if the
IRS
proceeds with an administrative or judicial action
based on information brought to the
IRS
's attention by an individual. The Senate amendment
permits awards of lesser amounts (but no less than
10 percent) if the action was based principally on
allegations (other than information provided by the
individual) resulting from a judicial or
administrative hearing, government report, hearing,
audit, investigation, or from the news media. The
Senate amendment caps the available reward at 30
percent of the collected proceeds. Any determination
regarding a reward may be appealed to the U.S. Tax
Court.
The Senate amendment creates a Whistleblower Office
within the
IRS
to administer this reward program. The Whistleblower
Office is funded with amounts equal to rewards made.
The Whistleblower Office may seek the assistance
from the individual providing information or from
his legal representative, and may reimburse the
costs incurred by any legal representative out of
the funds of the Whistleblower Office. To the extent
the disclosure of returns or return information is
required to render such assistance, the disclosure
must be pursuant to an
IRS
tax administration contract.
Effective date. --Information provided on or
after the date of enactment.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
26. Increase in age of minor children whose
unearned income is taxed as if parent's income (sec.
495 of the Senate amendment and sec. 1 of the Code)
Present
Law
Filing
requirements for children
A single unmarried individual eligible to be claimed
as a dependent on another taxpayer's return
generally must file an individual income tax return
if he or she has: (1) earned income only over $4,850
(for 2004); (2) unearned income only over the
minimum standard deduction amount for dependents
($800 in 2004); or (3) both earned income and
unearned income totaling more than the smaller of
(a) $4,850 (for 2004) or (b) the larger of (i) $800
(for 2004), or (ii) earned income plus $250.916
Thus, if a dependent child has less than $800 in
gross income, the child does not have to file an
individual income tax return for 2004.917
A child who cannot be claimed as a dependent on
another person's tax return (e.g., because the
support test is not satisfied by any other person)
is subject to the generally applicable filing
requirements. That is, such an individual generally
must file a return if the individual's gross income
exceeds the sum of the standard deduction and the
personal exemption amounts applicable to the
individual.
Taxation of unearned income under section 1(g)
Special rules (generally referred to as the "kiddie
tax") apply to the unearned income of a child
who is under age 14.918
The kiddie tax applies if: (1) the child has not
reached the age of 14 by the close of the taxable
year; (2) the child's unearned income was more than
$1,600 (for 2004); and (3) the child is required to
file a return for the year. The kiddie tax applies
regardless of whether the child may be claimed as a
dependent on the parent's return.
For these purposes, unearned income is income other
than wages, salaries, professional fees, or other
amounts received as compensation for personal
services actually rendered.919
For children under age 14, net unearned income (for
2004, generally unearned income over $1,600) is
taxed at the parent's rate if the parent's rate is
higher than the child's rate. The remainder of a
child's taxable income (i.e., earned income, plus
unearned income up to $1,600 (for 2004), less the
child's standard deduction) is taxed at the child's
rates, regardless of whether the kiddie tax applies
to the child. In general, a child is eligible to use
the preferential tax rates for qualified dividends
and capital gains.920
The kiddie tax is calculated by computing the
"allocable parental tax." This involves
adding the net unearned income of the child to the
parent's income and then applying the parent's tax
rate. A child's "net unearned income" is
the child's unearned income less the sum of (1) the
minimum standard deduction allowed to dependents
($800 for 2004), and (2) the greater of (a) such
minimum standard deduction amount or (b) the amount
of allowable itemized deductions that are directly
connected with the production of the unearned
income.921
A child's net unearned income cannot exceed the
child's taxable income.
The allocable parental tax equals the hypothetical
increase in tax to the parent that results from
adding the child's net unearned income to the
parent's taxable income. If a parent has more than
one child subject to the kiddie tax, the net
unearned income of all children is combined, and a
single kiddie tax is calculated. Each child is then
allocated a proportionate share of the hypothetical
increase, based upon the child's net unearned income
relative to the aggregate net unearned income of all
of the parent's children subject to the tax.
Special rules apply to determine which parent's tax
return and rate is used to calculate the kiddie tax.
If the parents file a joint return, the allocable
parental tax is calculated using the income reported
on the joint return. In the case of parents who are
married but file separate returns, the allocable
parental tax is calculated using the income of the
parent with the greater amount of taxable income. In
the case of unmarried parents, the child's custodial
parent is the parent whose taxable income is taken
into account in determining the child's liability.
If the custodial parent has remarried, the
stepparent is treated as the child's other parent.
Thus, if the custodial parent and stepparent file a
joint return, the kiddie tax is calculated using
that joint return. If the custodial parent and
stepparent file separate returns, the return of the
one with the greater taxable income is used. If the
parents are unmarried but lived together all year,
the return of the parent with the greater taxable
income is used.922
Unless the parent elects to include the child's
income on the parent's return (as described below)
the child files a separate return to report the
child's income.923
In this case, items on the parent's return are not
affected by the child's income. The total tax due
from a child is the greater of:
(1) the sum of (a) the tax payable by the child on
the child's earned income plus (b) the allocable
parental tax on the child's unearned income, or
(2) the tax on the child's income without regard to
the kiddie tax provisions..
Parental election to include child's dividends
and interest on parent's return
Under certain circumstances, a parent may elect to
report a child's dividends and interest on the
parent's return. If the election is made, the child
is treated as having no income for the year and the
child does not have to file a return. The parent
makes the election on Form 8814, Parents' Election
To Report Child's Interest and Dividends. The
requirements for the parent's election are that:
(1) the child has gross income only from interest
and dividends (including capital gains distributions
and Alaska Permanent Fund Dividends);924
(2) such income is more than the minimum standard
deduction amount for dependents ($800 in 2004) and
less than 10 times that amount ($8000 in 2004);
(3) no estimated tax payments for the year were made
in the child's name and taxpayer identification
number;
(4) no backup withholding occurred; and
(5) the child is required to file a return if the
parent does not make the election.
Only the parent whose return must be used when
calculating the kiddie tax may make the election.
The parent includes in income the child's gross
income in excess of twice the minimum standard
deduction amount for dependents (i.e., the child's
gross income in excess of $1,600 for 2004). This
amount is taxed at the parent's rate. The parent
also must report an additional tax liability equal
to the lesser of: (1) $80 (in 2004), or (2) 10
percent of the child's gross income exceeding the
child's standard deduction ($800 in 2004).
Including the child's income on the parent's return
can affect the parent's deductions and credits that
are based on adjusted gross income, as well as
income-based phaseouts, limitations, and floors.925
In addition, certain deductions that the child would
have been entitled to take on his or her own return
are lost.926
Further, if the child received tax-exempt interest
from a private activity bond, that item is
considered a tax preference of the parent for
alternative minimum tax purposes.927
Taxation of compensation for services under
section 1(g)
Compensation for a child's services is considered
the gross income of the child, not the parent, even
if the compensation is not received or retained by
the child (e.g., is the parent's income under local
law).928
If the child's income tax is not paid, however, an
assessment against the child will be considered as
also made against the parent to the extent the
assessment is attributable to amounts received for
the child's services.929
House
Bill
No provision.
Senate
Amendment
The Senate amendment increases the age of minors to
which the kiddie tax provisions apply from under 14
to under 18.
Effective date. --The provision is effective
for taxable years beginning after
December 31, 2003
.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
27. Modify holding period requirement for
qualification for reduced tax rate on dividends on
preferred stock (sec. 496 of the Senate amendment
and sec. 1 of the Code)
Present
Law
Section 1(h)(11) provides that if a taxpayer
receives "qualified dividend income," the
dividend income is taxed as net capital gain. The
maximum rate of tax on qualified dividend income
therefore generally is 15 percent.930
Dividends are treated as qualified dividend income
only if certain conditions, including holding period
requirements, are satisfied. The holding period
requirements under section 1(h)(11) are defined by
reference, with modifications, to the holding period
requirements under section 246(c) for qualification
for the dividends received deduction. A dividend
paid on a share of common stock is qualified
dividend income only if, among other requirements,
the recipient holds the share for more than 60 days
during the 121-day period beginning on the date that
is 60 days before the date on which the share
becomes exdividend with respect to the dividend.931
A dividend paid on a share of preferred stock is
qualified dividend income only if the recipient
holds the share for more than 90 days during the
181-day period beginning 90 days before the
ex-dividend date.932
House
Bill
No provision.
Senate
Amendment933
The Senate amendment changes the holding period
requirement for treatment as qualified dividend
income for dividends paid on preferred stock. Under
the Senate amendment, stock must be held for more
than 120 days during the 240-day period beginning
120 days before the ex-dividend date.
Effective date. --The Senate amendment
provision applies to taxable years beginning after
the date of enactment.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
28. Grant Treasury regulatory authority to
address foreign tax credit transactions involving
inappropriate separation of foreign taxes from
related foreign income (sec. 661A of Senate
amendment and sec. 901 of the Code)
Present
Law
The United States provides a credit for foreign
income taxes paid or accrued. For purposes of the
foreign tax credit, the taxpayer "is the person
on whom foreign law imposes legal liability for such
tax." Treas. Reg. sec. 1.901-2(f)(1). Thus, if
a U.S. corporation owns a foreign partnership, the
U.S. corporation can claim foreign tax credits for
the tax that is imposed on it as a partner in the
foreign entity. This is true even if the U.S.
corporation elects to treat the foreign entity as a
corporation for U.S. tax purposes. If the foreign
entity does not meet the definition of a controlled
foreign corporation or does not generate income that
is subject to current inclusion under the rules of
an anti-deferral regime, the income generated by the
foreign entity may never be reported on a U.S.
return, despite the fact that the U.S. corporation
can claim credits for taxes imposed on that income.
The Treasury Department and the
IRS
have expressed concern about transactions that
involve inappropriate foreign tax credit results,
including the second class of transactions described
in Notice 98-5.934
The tax benefits claimed in these transactions are
inconsistent with the purposes of the foreign tax
credit provisions.935
House
Bill
No provision.
Senate
Amendment
The provision expands existing regulatory authority
to provide Treasury and the
IRS
additional mechanisms to address the second class of
transactions described in Notice 98-5 as well as
other abusive foreign tax credit schemes that
involve the inappropriate separation of foreign
taxes from the related foreign income in cases where
foreign taxes are imposed on any person with respect
to income of an entity.
The regulations may provide for: (1) the
disallowance of a credit for all or a portion of the
foreign taxes; or (2) for the allocation of the
foreign taxes among the participants in the
transaction in a manner that is more consistent with
the underlying economics of the transaction.
Effective date. --The provision is effective
for transactions entered into after the date of
enactment.
Conference
Agreement
No provision.
29. Freeze of provision regarding suspension of
interest where Secretary fails to contact taxpayer
(sec. 662B of the Senate amendment and sec. 6404(g)
of the Code)
Present
Law
In general, interest and penalties accrue during
periods for which taxes were unpaid without regard
to whether the taxpayer was aware that there was tax
due. The Code suspends the accrual of certain
penalties and interest after 1 year after the filing
of the tax return936
if the
IRS
has not sent the taxpayer a notice specifically
stating the taxpayer's liability and the basis for
the liability within the specified period.937
With respect to taxable years beginning before
January 1, 2004
, the one-year period is increased to 18 months.
Interest and penalties resume 21 days after the
IRS
sends the required notice to the taxpayer. The
provision is applied separately with respect to each
item or adjustment. The provision does not apply
where a taxpayer has self-assessed the tax. The
suspension only applies to taxpayers who file a
timely tax return. The provision applies only to
individuals and does not apply to the failure to pay
penalty, in the case of fraud, or with respect to
criminal penalties.
House
Bill
No provision.
Senate
Amendment
The Senate amendment makes the 18-month rule the
permanent rule. The Senate amendment also adds gross
misstatements938
and listed and reportable transactions to the list
of provisions to which the suspension of interest
rules do not apply.
Effective date. --The Senate amendment is
effective for taxable years beginning after
December 31, 2003
,939
except that the addition of listed and reportable
transactions applies to interest accruing after
May 5, 2004
.
Conference
Agreement
The conference agreement follows the Senate
amendment, except: (1) the provision relating to
reportable transactions is made applicable only to
reportable avoidance transactions;940
and (2) that the addition of listed and reportable
avoidance transactions applies to interest accruing
after
October 3, 2004
.
30. Increase in withholding from supplemental
wage payments in excess of $1 million (sec. 673 of
the Senate amendment and sec. 13273 of the Revenue
Reconciliation Act of 1993)
Present
Law
An employer must withhold income taxes from wages
paid to employees; there are several possible
methods for determining the amount of income tax to
be withheld. The
IRS
publishes tables (Publication 15, "Circular
E") to be used in determining the amount of
income tax to be withheld. The tables generally
reflect the income tax rates under the Code so that
withholding approximates the ultimate tax liability
with respect to the wage payments. In some cases,
"supplemental" wage payments (e.g.,
bonuses or commissions) may be subject to
withholding at a flat rate,941
based on the third lowest income tax rate under the
Code (25 percent for 2005).942
House
Bill
No provision.
Senate
Amendment
Under the Senate amendment, once annual supplemental
wage payments to an employee exceed $1 million, any
additional supplemental wage payments to the
employee in that year are subject to withholding at
the highest income tax rate (35 percent for 2004 and
2005), regardless of any other withholding rules and
regardless of the employee's Form W-4.
This rule applies only for purposes of wage
withholding; other types of withholding (such as
pension withholding and backup withholding) are not
affected.
Effective date. --The provision is effective
with respect to payments made after
December 31, 2003
.
Conference
Agreement
The conference agreement follows the Senate
amendment except that the conference agreement is
effective for payments made after
December 31, 2004
.
31. Capital gain treatment on sale of stock
acquired from exercise of statutory stock options to
comply with conflict of interest requirements (sec.
674 of the Senate amendment and sec. 421 of the
Code)
Present
Law
Statutory stock options
Generally, when an employee exercises a compensatory
option on employer stock, the difference between the
option price and the fair market value of the stock
(i.e., the "spread") is includible in
income as compensation. Upon such exercise, an
employer is allowed a corresponding compensation
deduction. In the case of an incentive stock option
or an option to purchase stock under an employee
stock purchase plan (collectively referred to as
"statutory stock options"), the spread is
not included in income at the time of exercise.943
If an employee disposes of stock acquired upon the
exercise of a statutory option, the employee
generally is taxed at capital gains rates with
respect to the excess of the fair market value of
the stock on the date of disposition over the option
price, and no compensation expense deduction is
allowable to the employer, unless the employee fails
to meet a holding period requirement. The employee
fails to meet this holding period requirement if the
disposition occurs within two years after the date
the option is granted or one year after the date the
option is exercised. The gain upon a disposition
that occurs prior to the expiration of the
applicable holding period(s) (a "disqualifying
disposition") does not qualify for capital
gains treatment. In the event of a disqualifying
disposition, the income attributable to the
disposition is treated by the employee as income
received in the taxable year in which the
disposition occurs, and a corresponding deduction is
allowable to the employer for the taxable year in
which the disposition occurs.
Sale of property to comply with conflict of
interest requirements
The Code provides special rules for recognizing gain
on sales of property which are required in order to
comply with certain conflict of interest
requirements imposed by the Federal Government.944
Certain executive branch Federal employees (and
their spouses and minor or dependent children) who
are required to divest property in order to comply
with conflict of interest requirements may elect to
postpone the recognition of resulting gains by
investing in certain replacement property within a
60-day period. The basis of the replacement property
is reduced by the amount of the gain not recognized.
Permitted replacement property is limited to any
obligation of the United States or any diversified
investment fund approved by regulations issued by
the Office of Government Ethics. The rule applies
only to sales under certificates of divestiture
issued by the President or the Director of the
Office of Government Ethics.
House
Bill
No provision.
Senate
Amendment
Under the Senate amendment, an eligible person who,
in order to comply with Federal conflict of interest
requirements, is required to sell shares of stock
acquired pursuant to the exercise of a statutory
stock option is treated as satisfying the statutory
holding period requirements, regardless of how long
the stock was actually held. An eligible person
generally includes an officer or employee of the
executive branch of the Federal Government (and any
spouse or minor or dependent children whose
ownership in property is attributable to the officer
or employee). Because the sale is not treated as a
disqualifying disposition, the individual is
afforded capital gain treatment on any resulting
gains. Such gains are eligible for deferral
treatment under section 1043.
The employer granting the option is not allowed a
deduction upon the sale of the stock by the
individual.
Effective date. --The Senate amendment is
effective for sales after the date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment.
32. Application of basis rules to nonresident
aliens (sec. 675 of the Senate amendment and new
sec. 72(w) and sec. 83 of the Code)
Present
Law
Distributions from retirement plans
Distributions from retirement plans are includible
in gross income under the rules relating to
annuities945
and, thus, are generally includible in income,
except to the extent the amount received represents
investment in the contract (i.e., the participant's
basis). The participant's basis includes amounts
contributed by the participant on an after-tax
basis, together with certain amounts contributed by
the employer, minus the aggregate amount (if any)
previously distributed to the extent that such
amount was excludable from gross income. Amounts
contributed by the employer are included in the
calculation of the participant's basis only to the
extent that such amounts were includible in the
gross income of the participant, or to the extent
that such amounts would have been excludable from
the participant's gross income if they had been paid
directly to the participant at the time they were
contributed.946
Employer contributions to retirement plans and other
payments for labor or personal services performed
outside the United States by a nonresident alien
generally are not treated as U.S. source income.
Such contributions, therefore, generally would not
be includible in the nonresident alien's gross
income if they had been paid directly to the
nonresident alien at the time they were contributed.
Consequently, the amounts of such contributions
generally are includible in the employee's basis and
are not taxed by the United States if a distribution
is made when the employee is a U.S. citizen or
resident.947
Earnings on contributions are not included in basis
unless previously includible in income. In general,
in the case of a nonexempt trust, earnings are
includible in income when distributed or made
available.948
In the case of highly compensated employees, the
amount of the vested accrued benefit under the trust
(other than the employee's investment in the
contract) is generally required to be included in
income annually (to the extent not previously
includible). That is, earnings, as well as
contributions, that are part of the vested accrued
benefit are currently includible in income.949
Property transferred in connection with the
performance of services
The Code contains rules governing the amount and
timing of income and deductions attributable to
transfers of property in connection with the
performance of services. If, in connection with the
performance of services, property is transferred to
any person other than the person for whom such
services are performed, in general, an amount is
includible in the gross income of the person
performing the services (the "service
provider") for the taxable year in which the
property is first vested (i.e., transferable or not
subject to a substantial risk of forfeiture).950
The amount includible in the service provider's
income is the excess of the fair market value of the
property over the amount (if any) paid for the
property. Basis in such property includes any amount
that is included in income as a result of the
transfer.951
U.S. income tax treaties
Under the 1996 U.S. Model Income Tax Treaty
("U.S. Model") and some U.S. income tax
treaties in force, retirement plan distributions
beneficially owned by a resident of a treaty country
in consideration for past employment generally are
taxable only by the individual recipient's country
of residence. Under the U.S. Model treaty and some
U.S. income tax treaties, this exclusive
residence-based taxation rule is limited to the
taxation of amounts that were not previously
included in taxable income in the other country. For
example, if a treaty country had imposed tax on a
resident individual with respect to some portion of
a retirement plan's earnings, subsequent
distributions to that person while a resident of the
United States would not be taxable in the United
States to the extent the distributions were
attributable to such previously taxed amounts.
Compensation of employees of foreign
governments or international organizations
Under section 893, wages, fees, and salaries of any
employee of a foreign government or international
organization (including a consular or other officer
or a nondiplomatic representative) received as
compensation for official services to the foreign
government or international organization generally
are excluded from gross income when (1) the employee
is not a citizen of the United States, or is a
citizen of the Republic of the Philippines (whether
or not a citizen of the United States); (2) in the
case of an employee of a foreign government, the
services are of a character similar to those
performed by employees of the United States in
foreign countries; and (3) in the case of an
employee of a foreign government, the foreign
government grants an equivalent exemption to
employees of the United States performing similar
services in such foreign country. The Secretary of
State certifies the names of the foreign countries
which grant an equivalent exclusion to employees of
the United States performing services in those
countries, and the character of those services.
The exclusion does not apply to employees of
controlled commercial entities or employees of
foreign governments whose services are primarily in
connection with commercial activity (whether within
or outside the United States) of the foreign
government.
House
Bill
No provision.
Senate
Amendment
The Senate amendment modifies the present-law rules
under which certain contributions and earnings that
have not been previously taxed are treated as basis
(under sec. 72). Under the Senate amendment,
employee or employer contributions are not included
in basis if: (1) the employee was a nonresident
alien at the time the services were performed with
respect to which the contribution was made; (2) the
contribution is with respect to compensation for
labor or personal services from sources without the
United States; and (3) the contribution was not
subject to income tax under the laws of the United
States or any foreign country.
The Senate amendment authorizes the Secretary of the
Treasury to issue regulations to carry out the
purposes of the Senate amendment, including
regulations treating contributions as not subject to
income tax under the laws of any foreign country
under appropriate circumstances.
Effective date. --The Senate amendment is
effective for distributions occurring on or after
the date of enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment with modifications.
Under the conference agreement, employee or employer
contributions are not included in basis (under sec.
72) if: (1) the employee was a nonresident alien at
the time the services were performed with respect to
which the contribution was made; (2) the
contribution is with respect to compensation for
labor or personal services from sources without the
United States; and (3) the contribution was not
subject to income tax (and would have been subject
to income tax if paid as cash compensation when the
services were rendered) under the laws of the United
States or any foreign country.
Additionally, earnings on employer or employee
contributions are not included in basis if: (1) the
earnings are paid or accrued with respect to any
employer or employee contributions which were made
with respect to compensation for labor or personal
services; (2) the employee was a nonresident alien
at the time the earnings were paid or accrued; and
(3) the earnings were not subject to income tax
under the laws of the United States or any foreign
country.
The conference agreement does not change the rules
applicable to calculation of basis with respect to
contributions or earnings while an employee is a
U.S. resident.
There is no inference that this conference agreement
applies in any case to create tax jurisdiction with
respect to wages, fees, and salaries otherwise
exempt under section 893. Similarly, there is no
inference that the conference agreement applies
where contrary to an agreement of the United States
that has been validly authorized by Congress (or in
the case of a treaty, ratified by the Senate), and
which provides an exemption for income.
Most U.S. tax treaties specifically address the
taxation of pension distributions. The U.S. Model
treaty provides for exclusive residence-based
taxation of pension distributions to the extent such
distributions were not previously included in
taxable income in the other country. For purposes of
the U.S. Model treaty, the United States treats any
amount that has increased the recipient's basis (as
defined in section 72) as having been previously
included in taxable income. The following example
illustrates how the conference agreement could
affect the amount of a distribution that may be
taxed by the United States pursuant to a tax treaty.
Assume the following facts. A, a nonresident alien
individual, performs services outside the United
States, in A's country of residence, country Z. A's
employer makes contributions on behalf of A to a
pension plan established in country Z. For U.S. tax
purposes, no portion of the contributions or
earnings are included in A's income (and would not
be included in income if the amounts were paid as
cash compensation when the services were performed)
because such amounts relate to services performed
without the United States.952
Later in time, A retires and becomes a permanent
resident of the United States.
Under the conference agreement, the employer
contributions to the pension plan would not be taken
into account in determining A's basis if A was not
subject to income tax on the contributions by a
foreign country and the contributions would have
been subject to tax by a foreign country if the
contributions had been paid to A as cash
compensation when the services were performed. Thus,
in those circumstances, A would be subject to U.S.
tax on the distribution of all of the contributions,
as such distributions are made. However, if the
contributions would not have been subject to tax in
the foreign country if they had been paid to A as
cash compensation when the services were performed,
under the conference agreement, the contributions
would be included in A's basis. Earnings that
accrued while A was a nonresident alien would not
result in basis if not taxed under U.S. or foreign
law. Earnings that accrued while A was a permanent
resident of the United States would be subject to
present-law rules. This result generally is
consistent with the treatment of pension
distributions under the U.S. Model treaty.
The conference agreement authorizes the Secretary of
the Treasury to issue regulations to carry out the
purposes of the conference agreement, including
regulations treating contributions as not subject to
income tax under the laws of any foreign country
under appropriate circumstances. For example,
Treasury could provide that foreign income tax that
was merely nominal would not satisfy the
"subject to income tax" requirement.
The conference agreement also changes the rules for
determining basis in property received in connection
for the performance of services in the case of an
individual who was a nonresident alien at the time
of the performance of services, if the property is
treated as income from sources outside the United
States. In that case, the individual's basis in the
property does not include any amount that was not
subject to income tax (and would have been subject
to income tax if paid as cash compensation when the
services were performed) under the laws of the
United States or any foreign country.
Effective date. --The conference agreement is
effective for distributions occurring on or after
the date of enactment. No inference is intended that
the earnings subject to the conference agreement are
included in basis under present law.
33. Residence and source rules related to a
United States possession (sec. 497 of the Senate
amendment and new sec. 937 of the Code)
Present
Law
In general
Generally, U.S. citizens are subject to U.S. income
taxation on their worldwide income. Thus, all income
earned by U.S. citizens is subject to U.S. income
tax, regardless of its source.
The U.S. income taxation of alien individuals varies
depending on whether they are resident or
non-resident aliens. A resident alien is generally
taxed in the same manner as a U.S. citizen.953
In contrast, a nonresident alien is generally
subject to U.S. tax only on certain gross U.S.
source income at a flat 30 percent rate (unless such
rate is eliminated or reduced by treaty) and on net
income that has a sufficient nexus to the United
States at the graduated rates applicable to U.S.
citizens and residents under section 1.
An alien is considered a resident of the United
States if the individual: (1) has entered the United
States as a lawful permanent resident and is such a
resident at any time during the calendar year, (2)
is present in the United States for a substantial
period of time (the so-called "substantial
presence test"), or (3) makes an election to be
treated as a resident of the United States (sec.
7701(b)). An alien who does not meet the definition
of a "resident alien" is considered to be
a non-resident alien for U.S. income tax purposes.
Under the substantial presence test, an alien
individual is generally treated as a resident alien
if he or she is present in the United States for 31
days during the taxable year and the sum of the
number of days on which such individual was present
in the United States (when multiplied by the
applicable multiplier) during the current year and
the preceding two calendar years equals or exceeds
183 days. The applicable multiplier for: the current
year is one; the first preceding year is one-third;
and the second preceding year is one-sixth.
An alien individual who meets the above test may
nevertheless be a nonresident if he or she (1) is
present in the United States for fewer than 183 days
during the current year; (2) has a tax home in a
foreign country during the year; and (3) has a
closer connection to that country than to the United
States.
For purposes of the substantial presence test, the
United States includes the states and the District
of Columbia, but does not include U.S. possessions.
An individual is present in the United States for a
particular day if he or she is physically present in
the United States during any time during such day.
However, in certain circumstances an individual's
presence in the United States is ignored, including
presence in the United States as a result of certain
medical emergencies.
U.S. income taxation of residents of U.S.
possessions
Generally, special U.S. income tax rules apply with
respect to U.S. persons who are bona fide residents
of certain U.S. possessions (i.e., Puerto Rico,
Virgins Islands, Guam, Northern Mariana Islands and
American Samoa) and who have possession source
income or income effectively connected to the
conduct of a trade or business within a possession.
Generally, a bona fide resident of a U.S. possession
(regardless of whether the individual is a U.S.
citizen or alien) is determined using the principles
of a subjective, facts-and-circumstances test set
forth in the regulations under section 871. Prior to
the adoption of present-law section 7701(b), this
subjective test was used to determine whether an
alien individual was a resident of the United
States. Under these rules, an individual is
generally a resident of the United States if an
individual (1) is actually present in the United
States, and (2) is not a mere transient or
sojourner.954
Whether individuals are transients is determined by
their intentions with regard to the length and
nature of their stay. However, the regulations
provide that section 7701(b) (discussed above)
provides the basis for determining whether an alien
individual is a resident of a U.S. possession with a
mirror income tax code.955
Pursuant to regulations, the principles that
generally apply for determining income from sources
within and without the United States also generally
apply in determining income from sources within and
without a U.S. possession. 956
The Code and regulations do not indicate how to
determine whether income is effectively connected
with the conduct of a trade or business within a
U.S. possession. However, section 864(c) provides
rules for determining whether income is effectively
connected to a trade or business conducted within
the United States.
Information reporting
Section 7654(e) provides that Treasury may require
information reporting with respect to individuals
that may take advantage of certain special U.S.
income tax rules with respect to U.S. possessions.
Section 6688 provides that an individual may be
subject to a $100 penalty if the individual fails to
furnish the information required by regulations
issued pursuant to section 7654(e).
House
Bill
No provision.
Senate
Amendment
The provision provides the term "bona fide
resident" means a person who satisfies a test,
determined by the Secretary, similar to the
substantial presence test of section 7701(b)(3) with
respect to Guam, American Samoa, the Northern
Mariana Islands, Puerto Rico, or the Virgin Islands.
The provision also requires bona fide residents of
the Virgin Islands to file an informational income
tax return with the United States and imposes a
penalty for the failure to file such a return.
Effective date. --The provision is effective
for taxable years ending after the date of
enactment.
Conference
Agreement
The conference agreement follows the Senate
amendment with modifications.
The conferees understand that certain U.S. citizens
and residents are claiming that they are exempt from
U.S. income tax on their worldwide income based on a
position that they are bona fide residents of the
Virgin Islands or another possession. However, these
individuals often do not spend a significant amount
of time in the particular possession during a
taxable year and, in some cases, continue to live
and work in the United States. Under the Virgin
Island's Economic Development Program, many of these
same individuals secure a reduction of up to 90
percent of their Virgin Islands income tax liability
on income they take the position is Virgin Islands
source or effectively connected with the conduct of
a Virgin Islands trade or business. The conferees
are also aware that taxpayers are taking the
position that income earned for services performed
in the United States is Virgin Islands source or
that their U.S. activities generate income
effectively connected with the conduct of a Virgin
Islands trade or business.
The conferees believe that the various exemptions
from U.S. tax provided to residents of possessions
should not be available to individuals who continue
to live and work in the United States. The conferees
also believe that the special U.S. income tax rules
applicable to residents in a possession need to be
rationalized. The conferees are further concerned
that the general rules for determining whether
income is effectively connected with the conduct of
a trade or business in a possession present numerous
opportunities for erosion of the U.S. tax base.
Generally, the provision provides that the term
"bona fide resident" means a person who
meets a two-part test with respect to Guam, American
Samoa, the Northern Mariana Islands, Puerto Rico, or
the Virgin Islands, as the case may be, for the
taxable year. First, an individual must be present
in the possession for at least 183 days in the
taxable year. Second, an individual must (i) not
have a tax home outside such possession during the
taxable year and (ii) not have a closer connection
to the United States or a foreign country during
such year.
The provision also grants authority to Treasury to
create exceptions to these general rules as
appropriate. The conferees intend for such
exceptions to cover, in particular, persons whose
presence outside a possession for extended periods
of time lacks a tax avoidance purpose, such as
military personnel, workers in the fisheries trade,
and retirees who travel outside the possession for
certain personal reasons.
An individual is present in a possession for a
particular day if he is physically present in such
possession during any time during such day. In
certain circumstances an individual's presence
outside a possession is ignored (e.g., certain
medical emergencies) as provided under the
principles of section 7701(b).
The provision provides that a taxpayer must file a
notice in the first taxable year they claim bona
fide residence in a possession. The provision
imposes a penalty of $1000 for the failure to file
such notice or to comply with any filing required by
regulation under section 7654(e).
The provision generally codifies the existing rules
for determining when income is considered to be from
sources within a possession by providing that, as a
general rule, for all purposes of the Code, the
principles for determining whether income is U.S.
source are applicable for purposes of determining
whether income is possession source. In addition,
the provision provides that the principles for
determining whether income is effectively connected
with the conduct of a U.S. trade or business are
applicable for purposes of determining whether
income is effectively connected to the conduct of a
possession trade or business. However, the provision
further provides that except as provided in
regulations any income treated as U.S. source income
or as effectively connected with the conduct of a
U.S. trade or business is not treated as income from
within any possession or as effectively connected
with a trade or business within any such possession.
The provision also grants authority to the Secretary
of the Treasury to create exceptions to these
general rules regarding possession source income and
income effectively connected with a possession trade
or business as appropriate. The conferees anticipate
that this authority will be used to continue the
existing treatment of income from the sale of goods
manufactured in a possession. The conferees also
intend for this authority to be used to prevent
abuse, for example, to prevent U.S. persons from
avoiding U.S. tax on appreciated property by
acquiring residence in a possession prior to its
disposition.
No inference is intended as to the present-law rules
for determining (1) bona fide residence in a
possession, (2) whether income is possession source,
and (3) whether income is effectively connected with
the conduct of a trade or business within a
possession.
Effective date. --Generally, the provision is
effective for taxable years ending after the date of
enactment. The first prong of the two-part residency
test (i.e., the 183-day test) is effective for
taxable years beginning after date of enactment. The
general effective date applies with respect to the
second prong of such test. The rule providing that
income treated as U.S. source income or as
effectively connected with the conduct of a U.S.
trade or business is not treated as income from
within any possession or as effectively connected
with the conduct of a trade or business within any
such possession is effective for income earned after
date of enactment.
34. Include employer provided housing under
foreign earned income exclusion cap (sec. 632 of the
Senate amendment and sec. 911 of the Code)
Present
Law
U.S. citizens generally are subject to U.S. income
tax on all their income, whether derived in the
United States or elsewhere. A U.S. citizen who earns
income in a foreign country also may be taxed on
such income by that foreign country. However, the
United States generally cedes the primary right to
tax income derived by a U.S. citizen from sources
outside the United States to the foreign country
where such income is derived. Accordingly, a credit
against the U.S. income tax imposed on foreign
source income is generally available for foreign
taxes paid on that income, to the extent of the U.S.
tax otherwise owed on such income. If the foreign
income tax rate is lower than the U.S. income tax
rate, then the United States generally provides a
credit up to the amount of the foreign tax and
imposes a residual tax to the extent of the
difference.
U.S. citizens living abroad may be eligible to
exclude from their income for U.S. tax purposes
certain foreign earned income and foreign housing
costs, in which case no residual U.S. tax is imposed
to the extent of such exclusion, regardless of the
foreign tax rate. In order to qualify for these
exclusions, an individual must be either: (1) a U.S.
citizen who is a bona fide resident of a foreign
country for an uninterrupted period that includes an
entire taxable year;957
or (2) a U.S. citizen or resident present overseas
for 330 days out of any 12-consecutive-month period.
In addition, the taxpayer must have his or her tax
home in a foreign country.
The foreign earned income exclusion generally
applies to income earned from sources outside the
United States as compensation for personal services
rendered by the taxpayer. The maximum exclusion
amount for foreign earned income is $80,000 per
taxable year for 2002 and thereafter. For taxable
years beginning after 2007, the maximum exclusion
amount is indexed for inflation.
The exclusion for housing costs applies to
reasonable expenses, other than deductible interest
and taxes, paid or incurred by or on behalf of the
taxpayer for housing in a foreign country but only
to the extent the housing costs exceed a base
housing amount. The base housing amount is equal to
16 percent of the annual salary earned by a GS-14,
Step 1 U.S. government employee. In the case of
housing costs that are not paid or reimbursed by the
taxpayer's employer, the amount that would be
excludible is treated instead as a deduction.
The combined foreign earned income exclusion and
housing cost exclusion may not exceed the taxpayer's
total foreign earned income for the taxable year.
The taxpayer's foreign tax credit is reduced by the
amount of such credit that is attributable to
excluded income.
House
Bill
No provision.
Senate
Amendment
The provision applies the annual foreign earned
income exclusion cap to the combined value of
foreign earned income and employer-provided housing
amounts.
The present-law provision providing indexation for
inflation for tax years beginning after 2007 remains
unchanged. The present law provision imposing an
additional foreign earned income cap on exclusions
and deductions also remains unchanged.
Effective date. --The provision is effective
for taxable years beginning after
December 31, 2003
.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
35. Deduction for personal use of company
aircraft and other entertainment expenses (sec.
103(b) of the Senate amendment and sec. 274(e) of
the Code)
Present
Law
Under present law, no deduction is allowed with
respect to (1) an activity generally considered to
be entertainment, amusement or recreation, unless
the taxpayer establishes that the item was directly
related to (or, in certain cases, associated with)
the active conduct of the taxpayer's trade or
business, or (2) a facility (e.g., an airplane) used
in connection with such activity.958
The Code includes a number of exceptions to the
general rule disallowing deductions of entertainment
expenses. Under one exception, the deduction
disallowance rule does not apply to expenses for
goods, services, and facilities to the extent that
the expenses are reported by the taxpayer as
compensation and wages to an employee.959
The deduction disallowance rule also does not apply
to expenses paid or incurred by the taxpayer for
goods, services, and facilities to the extent that
the expenses are includible in the gross income of a
recipient who is not an employee (e.g., a
nonemployee director) as compensation for services
rendered or as a prize or award.960
The exceptions apply only to the extent that amounts
are properly reported by the company as compensation
and wages or otherwise includible in income. In no
event can the amount of the deduction exceed the
amount of the actual cost, even if a greater amount
is includible in income.
Except as otherwise provided, gross income includes
compensation for services, including fees,
commissions, fringe benefits, and similar items. In
general, an employee or other service provider must
include in gross income the amount by which the fair
value of a fringe benefit exceeds the amount paid by
the individual. Treasury regulations provide rules
regarding the valuation of fringe benefits,
including flights on an employer-provided aircraft.961
In general, the value of a non-commercial flight is
determined under the base aircraft valuation
formula, also known as the Standard Industry Fare
Level formula or "SIFL".962
If the SIFL valuation rules do not apply, the value
of a flight on a company-provided aircraft is
generally equal to the amount that an individual
would have to pay in an arm's-length transaction to
charter the same or a comparable aircraft for that
period for the same or a comparable flight.963
In the context of an employer providing an aircraft
to employees for nonbusiness (e.g., vacation)
flights, the exception for expenses treated as
compensation has been interpreted as not limiting
the company's deduction for operation of the
aircraft to the amount of compensation reportable to
its employees,964
which can result in a deduction multiple times
larger than the amount required to be included in
income. In many cases, the individual including
amounts attributable to personal travel in income
directly benefits from the enhanced deduction,
resulting in a net deduction for the personal use of
the company aircraft.
House
Bill
No provision.
Senate
Amendment
Under the Senate amendment, in the case of covered
employees, the exceptions to the general
entertainment expense disallowance rule for expenses
treated as compensation or includible in income
apply only to the extent of the amount of expenses
treated as compensation or includible in income.
Covered employees are defined as under section
162(m)(3) and include the chief executive officer
(or individual acting in such capacity) and the four
highest-compensated officers of publicly-traded
corporations. No deduction is allowed with respect
to expenses for (1) a nonbusiness activity generally
considered to be entertainment, amusement or
recreation, or (2) a facility (e.g., an airplane)
used in connection with such activity to the extent
that such expenses exceed the amount treated as
compensation or includible in income to the covered
employee. For example, a company's deduction
attributable to aircraft operating costs for a
covered employee's vacation use of a company
aircraft is limited to the amount reported as
compensation to the employee. As under present law,
the amount of the deduction cannot exceed the actual
cost.
The provision is intended to overturn Sutherland
Lumber-Southwest, Inc. v. Commissioner with
respect to covered employees. As under present law,
the exceptions apply only if amounts are properly
reported by the company as compensation and wages or
otherwise includible in income.
Effective date. --The Senate amendment is
effective for expenses incurred after the date of
enactment and before
January 1, 2006
.
Conference
Agreement
The conference agreement follows the Senate
amendment except that the provision applies with
respect to individuals who, with respect to an
employer or other service recipient, are subject to
the requirements of section 16(a) of the Securities
and Exchange Act of 1934, or would be subject to
such requirements if the employer or service
recipient were an issuer of equity securities
referred to in section 16(a). Such individuals
generally include officers (as defined by section
16(a)),965
directors, and 10-percent-or-greater owners of
private and publicly-held companies.
Effective date. --The conference agreement is
effective for amounts deferred after the date of
enactment.
36. Treatment of contingent payment convertible
debt instruments (sec. 733 of the Senate Amendment
and sec. 1275 of the Code)
Present
Law
Under present law, a taxpayer generally deducts the
amount of interest paid or accrued within the
taxable year on indebtedness issued by the taxpayer.
In the case of original issue discount ("OID"),
the issuer of a debt instrument generally accrues
and deducts, as interest, the OID over the life of
the obligation, even though the amount of the OID
may not be paid until the maturity of the
instrument.
The amount of OID with respect to a debt instrument
is equal to the excess of the stated redemption
price at maturity over the issue price of the debt
instrument. The stated redemption price at maturity
includes all amounts that are payable on the debt
instrument by maturity. The amount of OID with
respect to a debt instrument is allocated over the
life of the instrument through a series of
adjustments to the issue price for each accrual
period. The adjustment to the issue price is
determined by multiplying the adjusted issue price
(i.e., the issue price increased or decreased by
adjustments prior to the accrual period) by the
instrument's yield to maturity, and then subtracting
any payments on the debt instrument (other than non-OID
stated interest) during the accrual period. Thus, in
order to compute the amount of OID and the portion
of OID allocable to a particular period, the stated
redemption price at maturity and the time of
maturity must be known. Issuers of debt instruments
with OID accrue and deduct the amount of OID as
interest expense in the same manner as the holders
of such instruments accrue and include in gross
income the amount of OID as interest income.
Treasury regulations provide special rules for
determining the amount of OID allocated to a period
with respect to certain debt instruments that
provide for one or more contingent payments of
principal or interest.966
The regulations provide that a debt instrument does
not provide for contingent payments merely because
it provides for an option to convert the debt
instrument into the stock of the issuer, into the
stock or debt of a related party, or into cash or
other property in an amount equal to the approximate
value of such stock or debt.967
The regulations also provide that a payment is not a
contingent payment merely because of a contingency
that, as of the issue date of the debt instrument,
is either remote or incidental.968
In the case of contingent payment debt instruments
that are issued for money or publicly traded
property,969
the regulations provide that interest on a debt
instrument must be taken into account (as OID)
whether or not the amount of any payment is fixed or
determinable in the taxable year. The amount of OID
that is taken into account for each accrual period
is determined by constructing a comparable yield and
a projected payment schedule for the debt
instrument, and then accruing the OID on the basis
of the comparable yield and projected payment
schedule by applying rules similar to those for
accruing OID on a noncontingent debt instrument (the
"noncontingent bond method"). If the
actual amount of a contingent payment is not equal
to the projected amount, appropriate adjustments are
made to reflect the difference. The comparable yield
for a debt instrument is the yield at which the
issuer would be able to issue a fixed-rate
noncontingent debt instrument with terms and
conditions similar to those of the contingent
payment debt instrument (i.e., the comparable
fixed-rate debt instrument), including the level of
subordination, term, timing of payments, and general
market conditions.970
With respect to certain debt instruments that are
convertible into the common stock of the issuer and
that also provide for contingent payments (other
than the conversion feature) --often referred to as
"contingent convertible" debt instruments
--the
IRS
has stated that the noncontingent bond method
applies in computing the accrual of OID on the debt
instrument.971
In applying the noncontingent bond method, the
IRS
has stated that the comparable yield for a
contingent convertible debt instrument is determined
by reference to a comparable fixed-rate
nonconvertible debt instrument, and the projected
payment schedule is determined by treating the
issuer stock received upon a conversion of the debt
instrument as a contingent payment.
House
Bill
No provision.
Senate
Amendment
The Senate amendment provides that, in the case of a
contingent convertible debt instrument,972
any Treasury regulations which require OID to be
determined by reference to the comparable yield of a
noncontingent fixed-rate debt instrument shall be
applied as requiring that such comparable yield be
determined by reference to a noncontingent
fixed-rate debt instrument which is convertible into
stock. For purposes of applying the Senate
amendment, the comparable yield shall be determined
without taking into account the yield resulting from
the conversion of a debt instrument into stock.
Thus, the noncontingent bond method in the Treasury
regulations shall be applied in a manner such that
the comparable yield for contingent convertible debt
instruments shall be determined by reference to
comparable noncontingent fixed-rate convertible
(rather than nonconvertible) debt instruments.
Effective date. --The Senate amendment
provision is effective for debt instruments issued
on or after date of enactment.
Conference
Agreement
The conference agreement does not include the Senate
amendment provision.
TITLE
XI --TRADE PROVISIONS
A.
Suspension of Duties on Ceiling Fans (sec. 801 of
the House bill and Chapter 99, II of the Harmonized
Tariff Schedule of the United States)
Present
Law
A 4.7-percent ad valorem customs duty is
collected on imported ceiling fans from all sources.
House
Bill
The House bill suspends the present customs duty
applicable to ceiling fans through
December 31, 2006
.
Effective date. --The provision is effective
on the fifteenth day after the date of enactment.
Senate
Amendment
No provision.
Conference
Agreement
The conference agreement includes the House bill
provision.
B.
Temporary Suspension of Certain Customs Duties
1. Suspension of duties on nuclear steam
generators (sec. 802(a) of the House bill and
Chapter 99, II of the Harmonized Tariff Schedule of
the United States)
Present
Law
Nuclear steam generators, as classified under
heading 9902.84.02 of the Harmonized Tariff Schedule
of the United States, enter the United States duty
free until
December 31, 2006
. After
December 31, 2006
, the duty on nuclear steam generators returns to
the column 1 rate of 5.2 percent under subheading
8402.11.00 of the Harmonized Tariff Schedule of the
United States.
House
Bill
The House bill extends the present-law suspension of
customs duty applicable to nuclear steam generators
through
December 31, 2008
.
Effective date. --The provision is effective
on the date of enactment.
Senate
Amendment
No provision.
Conference
Agreement
The conference agreement includes the House bill
provision.
2. Suspension of Duties on Nuclear Reactor Vessel
Heads (sec. 802(b) of the House bill and Chapter 99,
II of the Harmonized Tariff Schedule of the United
States)
Present
Law
According to section 5202 of the Trade Act of 2002,
nuclear reactor vessel heads are classified under
subheading 8401.40.00 of the Harmonized Tariff
Schedule of the United States and enter the United
States with a column 1 duty rate of 3.3 percent.
House
Bill
The House bill temporarily suspends the present
customs duty applicable to nuclear reactor vessel
heads for column 1 countries through
December 31, 2008
.
Effective date. --The provision is effective
on the fifteenth day after the date of enactment.
Senate
Amendment
No provision.
Conference
Agreement
The conference agreement includes the House bill
provision with a modification. The conference
agreement also temporarily suspends the customs duty
applicable to nuclear reactor pressurizers.
II.
TAX COMPLEXITY ANALYSIS
The following tax complexity analysis is provided
pursuant to section 4022(b) of the Internal Revenue
Service Reform and Restructuring Act of 1998, which
requires the staff of the Joint Committee on
Taxation (in consultation with the Internal Revenue
Service ("
IRS
") and the Treasury Department) to provide a
complexity analysis of tax legislation reported by
the House Committee on Ways and Means, the Senate
Committee on Finance, or a Conference Report
containing tax provisions. The complexity analysis
is required to report on the complexity and
administrative issues raised by provisions that
directly or indirectly amend the Internal Revenue
Code and that have widespread applicability to
individuals or small businesses. For each such
provision identified by the staff of the Joint
Committee on Taxation, a summary description of the
provision is provided along with an estimate of the
number and type of affected taxpayers, and a
discussion regarding the relevant complexity and
administrative issues.
Following the analysis of the staff of the Joint
Committee on Taxation are the comments of the
IRS
and the Treasury Department regarding each of the
provisions included in the complexity analysis,
including a discussion of the likely effect on
IRS
forms and any expected impact on the
IRS
.
1. Deduction relating to income attributable to
United States production activities (sec. 102 of the
House bill, secs. 102 and 103 of the Senate
amendment, and sec. 11 of the Code)
Summary description of provision
The conference agreement provides a deduction
attributable to certain qualified production
activities in the United States of a C corporation,
S corporation, partnership, or sole proprietorship.
Such activities generally include: (1)
manufacturing, production, growth or extraction of
certain tangible personal property, computer
software, property described in section 168(f)(3) or
(4) of the Code, and electricity, natural gas, or
potable water produced by the taxpayer; (2)
construction; and (3) engineering or architectural
services.
The amount of the deduction in taxable years
beginning in 2005, 2006, 2007, 2008, 2009, and 2010
and thereafter generally is three, three, six, six,
six, and nine percent, respectively. The deduction
is limited for a taxable year to 50 percent of the
wages paid by the taxpayer during such taxable year.
In addition, the deduction cannot exceed the lesser
of the taxpayer's taxable income (computed without
regard to the deduction) or the taxpayer's qualified
production activities income.
The bill is effective for taxable years beginning
after 2004.
Number of affected taxpayers
It is estimated that the provision will affect more
than 10 percent of small businesses.
Discussion
It is anticipated that small businesses engaged in
qualified production activities will need to keep
additional records due to this provision, and that
extensive additional regulatory guidance will be
necessary to effectively implement the provision. It
is anticipated that the provision will result in an
increase in disputes between small businesses and
the
IRS
. Reasons for such disputes include the complexity
of the provision and the inherent incentive for
small businesses and other taxpayers to characterize
their activities as qualified production activities
to claim the deduction under the provision.
The provision likely will increase the tax
preparation costs for most small businesses that
are, or may be, engaged in qualified production
activities. Small businesses will have to perform
additional analysis and make subjective
determinations concerning whether their activities
constitute qualified production activities and,
thus, whether income attributable to such activities
qualifies for the deduction allowed under the
provision. In this regard, the provision does not
provide detailed definitions of the activities that
produce income eligible for the deduction, and it
will be difficult for the Treasury Secretary to
define qualified production activities
administratively. It should be noted that a similar
provision in the Canadian tax laws was found to be
highly complex and difficult to administer, which
led to numerous disputes and litigation between
affected taxpayers and the Canadian tax authorities.
Canada
recently repealed the provision and provided a
general reduction in corporate tax rates.
For income that is determined to be eligible for the
deduction under the provision, small businesses will
be required to perform additional and complex
calculations to determine the amount of the
deduction under the provision. Because the deduction
is based upon modified taxable income rather than
gross income, small businesses will be required to
undertake complicated calculations to determine the
amount of costs that are allocable to gross income
from qualified production activities. In many cases,
small businesses would not have been required
otherwise to perform these calculations but for the
provision.
The wage limitation on the deduction is likely to
impact small businesses disproportionately. After
undertaking the calculations and analyses to
determine the amount of their potential deduction,
many small business will find that such amount is
significantly reduced, or eliminated altogether, by
the wage limitation.
Under the provision, it may be necessary for small
businesses to make certain allocations of income
that are not required under present law,
particularly with respect to businesses that have
both income that is directly attributable to
qualified production activities and income that is
attributable to processes associated with qualified
production activities (e.g., vertically integrated
manufacturers that also engage in the selling,
storage, and installation of manufactured goods). To
the extent the deduction under the provision is not
based upon income from processes associated with
qualified production activities, taxpayers that
engage in such processes will be required to
allocate their aggregate income between qualified
production activities and processes associated with
qualified production activities. In general, it is
expected that the multiple calculations and analyses
required by this provision will lead to intentional
or inadvertent noncompliance among small businesses,
as well as other taxpayers.
Due to the detailed calculations required by the
provision, it is anticipated that the Secretary of
the Treasury will have to make appropriate revisions
to several types of income tax forms, schedules,
spreadsheets and instructions.
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