FROM THE OFFICE OF PUBLIC AFFAIRS

I am pleased to appear before you today to discuss certain of the revenue offsets to the tax-cut package contained in the President’s Fiscal Year 1998 budget. The President’s plan provides tax relief, promotes a fairer tax system and encourages activities that contribute to economic growth, while achieving a balanced budget by Fiscal Year 2002. We look forward to working with this Committee to accomplish these goals.

Yesterday, Deputy Secretary Summers testified before this Committee regarding the several tax proposals in the President’s FY 1998 budget plan to encourage higher education and job training. In addition to encouraging investment in education, the President’s tax plan would provide much-needed tax reductions for working families, capital gains tax relief and simplification for home ownership, and tax incentives to promote savings and to foster the hiring of the economically disadvantaged. Under the President’s plan and Treasury scoring, the gross tax cuts would total $98.4 billion from FY 1998 through FY 2002.

The President’s tax plan is fiscally responsible. The cost of these tax cuts is offset by cutting spending, reducing unwarranted and unintended corporate tax benefits, and extending several excise taxes, some of which have recently expired. In particular, the Administration is concerned that corporations and other sophisticated taxpayers engineer transactions in ways never anticipated by Congress. These transactions exploit gray areas and inconsistencies in the tax law or take advantage of tax rules that are easy to manipulate with little or no change in the economic substance of the transactions.

These measures will improve tax policy, simplify the tax system and help ensure that the burden of deficit reduction is borne fairly by all sectors. They produce budget savings of $34.3 billion through FY 2002. Continuance of trust-fund excise taxes, including some that have expired, will provide additional revenues of $36.2 billion through FY 2002. Attached to this

testimony is a table showing all the revenue provisions in the President’s tax package and their

estimated revenue effects. Effective dates of the revenue offsets have generally (with only one minor exception) been made entirely prospective. For instance, all those proposals that were announced by the Administration in December 1995 (and in the FY 1997 budget released in March 1996) with immediate effective dates are now proposed to be made effective as of the date of first committee action.

In the letter of invitation, you have asked that my testimony focus on the policy objectives underlying four groups of revenue-raising proposals: (1) the proposals relating to financial transactions; (2) the corporate tax proposals; (3) the proposals affecting tax accounting rules; and (4) the international tax proposals. To help illustrate the policy objectives, the discussion below highlights certain of the more notable proposals within each group.

1. PROVISIONS RELATING TO FINANCIAL TRANSACTIONS

In general: The provisions relating to financial transactions focus on the dramatic evolution over the last few years of financial transactions that taxpayers engineer to exploit the gray areas of the tax law. The tax law has not dealt well with the incredible pace of financial innovation, which allows a sophisticated taxpayer to obtain different tax characterizations by making small changes in a transaction’s terms, but without significantly changing its economics. Effectively, the taxpayer can elect the tax treatment desired. As tax engineering of financial transactions has become more aggressive, the tax base has been eroded in a way never foreseen or intended by Congress.

Developers of financial products have focused their efforts on four areas of the tax system that are particularly vulnerable: distinctions between debt and equity; opportunities for arbitrage; opportunities for avoiding gain recognition on transactions that are economically equivalent to sales; and problems with measurement of gain or income. The President’s budget contains proposals to address problems in each of these four areas.

· Maintaining The Distinction Between Debt And Equity

Discussion: The Administration has become increasingly concerned by the blurring of the traditional lines between debt and equity that has occurred in some recently developed financial instruments. Corporations often find it desirable from a non-tax perspective to issue equity, even though it means giving up a tax deduction. Historically, accounting, regulatory, and credit-rating rules and lending practices restrained the amount of debt corporations could issue. In recent years, however, the tension between non-tax rules and tax rules has been significantly eroded. Hybrid instruments have been developed that allow issuers to achieve their business objectives while still maintaining the desirable tax characterization of the instrument as debt. For example, the Federal Reserve recently made it possible for banks to issue instruments that are treated for bank regulatory purposes as equity capital, but can qualify as debt for tax purposes.

In some circumstances, however, corporations favor issuing preferred stock over issuing debt. For example, when the dividends-received deduction (DRD) is worth more to the corporate holder than an interest deduction would be to the issuer (e.g., the issuer has net operating losses and so cannot use an interest deduction), the parties will structure an investment as stock instead of debt. Certain kinds of preferred stock are virtually indistinguishable from debt. Often, debt-like preferred stock is marketed specifically to other corporations, so that the yield on this preferred stock takes into account the DRD available to the holder. In this case the gray area between debt and equity is exploited to obtain a benefit that was intended only to apply when one corporation makes an equity investment in another corporation. This can allow taxpayers to avoid most, if not all, of the corporate-level tax.

The ability of taxpayers to manipulate the terms of financial instruments that fall within the gray area between debt and equity means that the problem of hybrid instruments cannot be solved simply by drawing a sharper line between debt and equity. For example, a rule that required instruments with certain terms to be characterized in all cases as equity for tax purposes would only make it easier for issuers that desired equity treatment of a hybrid instrument to get that result. Thus, the most appropriate way to address the treatment of instruments that cannot clearly be characterized as either debt or equity is to reduce the tax implications of the characterization.

Proposals: The President’s tax plan contains several proposals that are designed to reduce inconsistent tax treatment of hybrid financial instruments without generally trying to change the characterization of those instruments. The proposals include:

-- A rule that disallows an interest deduction if payments on a debt instrument will be made in the stock of the issuer. If the holder of a debt instrument can be forced to take stock, the holder and the issuer do not have a clear creditor-debtor relationship.

-- A rule that disallows an interest deduction if the weighted average maturity of a debt instrument exceeds 40 years. An instrument’s term has always been a significant debt/equity factor, but it has never been clear when a term was too long. The proposal provides a clear standard.

-- A rule that prevents corporations from treating an instrument as equity for accounting purposes and debt for tax purposes. This rule prevents "regulatory arbitrage" (i.e., getting different treatment from various regulators for the same product).

-- A rule that defers an interest deduction until the interest is paid in cash if payments on the debt instrument can, at the holder’s option, be made in stock of the issuer.

-- A rule that eliminates the 70% and 80% DRD for preferred stock that has an enhanced likelihood of recovery of principal or of maintaining a dividend, or both, or that otherwise has certain non-stock characteristics. The proposal would not apply to preferred stock that participates in corporate growth. Thus, it generally would not apply to preferred stock that can be converted into common stock.

· Curtailing Arbitrage Opportunities: Reduce Minimum Dividends-Received Deduction to 50 Percent

Discussion: Another gray area that corporations have exploited by using sophisticated financial transactions is the limits on the dividends received deduction. A number of rules are intended to prevent corporate taxpayers from creating tax arbitrage using the DRD or from obtaining the benefit of the deduction without bearing the economic burdens of stock ownership. For example, a corporation is required to establish a 46-day (or, in certain cases, 91-day) holding period for the dividend-paying stock before the deduction is available. These holding periods run only while the stockholder is fully subject to the risks of equity ownership. Another set of rules reduces the 70- and 80-percent dividends received deductions to the extent a holder uses debt to finance its investment in the stock.

A classic example of a DRD tax arbitrage is when a corporation buys stock for $100 one day before the ex-dividend date. The corporation receives a dividend of $2.00 and claims a $1.40 DRD. The day after the ex-dividend date, it sells the stock for $98, claiming a $2.00 loss. The net result is the corporation has no economic gain or loss but can claim a $1.40 net loss for tax purposes. Although the holding period rules described above largely prevent taxpayers from using this specific transaction, there are many ways for a corporation to obtain similar results by entering into more complex transactions. These transactions are relatively easy to structure using portfolio stock (i.e., less than 20-percent owned stock). Not only do these transaction have the potential to eliminate tax on corporate income, they encourage corporations to waste resources on developing tax arbitrage schemes.

It is also arguable that a holder of portfolio stock is a passive investor, regardless of whether the holder is an individual or a corporation. Thus, a corporation which owns a small minority interest in another corporation should not qualify for a special tax benefit when individual investors do not.

Proposal: The proposal responds to the arbitrage problems not by creating more complex rules to prevent taxpayers from engaging in dividend arbitrage transactions, but rather by reducing the benefits taxpayers would obtain from engaging in those transactions. The proposal would reduce from 70% to 50% the DRD for stock holdings of corporations that own less than 20% of the dividend-paying corporation. A separate proposal would modify the holding period rules to require corporations to bear the risk of equity ownership near the time a dividend is received in order to obtain the DRD.

· Preventing Avoidance of Gain Recognition on Functional Sales: Require Recognition of Gain on Certain Appreciated Positions in Personal Property

Discussion: A person who sells or exchanges property is generally taxed on any gain from the sale or exchange, and, with certain limitations, can deduct any loss from the sale or exchange. Whether a particular transaction or set of transactions results in a sale or exchange for tax purposes is determined under principles developed in case law, but generally turns on whether the taxpayer has disposed of all the benefits and burdens of ownership. In the case of financial instruments, however, this standard is fairly easy to manipulate. It is clear under current law that taxpayers are able to engineer financial transactions to dispose of all of the economic risk and rewards associated with owning particular property without being treated as selling or exchanging the property, and without being taxed on any gain on the property.

A common example of a gain deferral technique is a so-called "short sale against the box." In that transaction a taxpayer who owns a share of stock borrows an identical share and sells it. At that point the taxpayer has cash from the sale, a share of stock, and an obligation to deliver the share or an identical share to the lender. Because the value of the share of stock is completely offset by the obligation to deliver the share, the taxpayer has disposed of economic ownership of the share. Under current tax law, however, gain or loss on the transaction is not recognized until the taxpayer delivers the share (or an identical share) to the lender. This recognition event can be postponed until long after the sale of the stock has occurred.

An equity swap is another example of a transaction that can be engineered to result in the economic equivalent of a sale without any corresponding gain recognition. In an equity swap a taxpayer agrees to pay to a counterparty dividends and appreciation on a certain number of shares of stock, and the counterparty agrees to pay the taxpayer interest (or some other return), based on a "notional" amount equal to the value of the shares, and any depreciation on the shares.

We believe that economically similar transactions should be taxed similarly, and that taxpayers should not be able to elect dramatically different tax treatments for the same transaction based on the transaction’s form. Thus, a person who enters into a transaction that has the same economic effect as a sale of an interest in stock or a bond should be subject to tax in the same way as a person who actually sells the stock or bond. Because that is not how current law works, however, taxpayers have an incentive to undertake complex financial transactions, such as equity swaps, to avoid tax on the sale of stock, bonds and other securities.

Proposal: A taxpayer who enters into a transaction that has the same economic effect as a sale of an interest in stock, a debt instrument or certain other securities would be taxed on any gain as if there had been a sale of the interest. The proposal would treat as constructive sales the types of transactions described above, but only if risk of loss and opportunity for gain is substantially eliminated. Thus, for example, if a taxpayer agrees to sell a particular share of stock he owns to another person in two years for a fixed price, that agreement would cause the taxpayer to recognize any gain on the stock as if he had sold it on the date he entered into the agreement.

· Proper Measurement of Gain/Income: Require Average Cost Basis for Securities

Discussion: Treasury has long been concerned about the ability of sophisticated taxpayers to manipulate the amount of income and gain they recognize in financial transactions. A person who sells property is generally taxed on any gain from the sale, and, with certain limitations, can deduct any loss from the sale. The gain or loss is measured by the difference between the basis of the property, which is often equal to the property’s cost, and the amount received from the sale. If a taxpayer holds more than one share of the same stock or more than one of the same bond, and the taxpayer sells less than all of the shares or bonds that he or she holds, the taxpayer can use one of several ways to determine the cost of the shares or bonds sold. The taxpayer may be able to specifically identify the securities sold by their cost, for example by simply instructing a broker to sell shares that were acquired at the highest price. Or the taxpayer can determine the cost of securities sold by treating the transaction as a sale of the securities the taxpayer has held the longest (the "first-in first-out" method). Any holder of shares in a mutual fund is also permitted to determine the cost of each share by averaging the cost of all the shares.

Having multiple methods for determining basis and holding periods for securities is complex and difficult to administer. Record keeping for multiple methods is confusing, and mistakes are easy to make. Less sophisticated taxpayers, unaware of their ability to specifically identify securities sold, can be disadvantaged by the default first-in first-out rule. In addition, any third-party record keeping and reporting of basis, such as that increasingly performed by mutual funds for their shareholders, is not as useful as it could be because taxpayers often use a method for calculating their basis that is different from the one used for reporting basis to them.

Further, the current rules give inappropriate results and can lead to abuse. In most cases, and especially when a taxpayer holds stock or securities in "street name," the taxpayer has no way to determine the cost of the actual shares sold. The "specific identification" technique, available under current law, allows taxpayers to avoid tax on true economic gains. This technique invites manipulation by allowing taxpayers to distinguish among fungible securities exclusively by their tax characteristics, even though those tax characteristics have no independent economic significance.

Proposal: The Administration’s proposal would simplify and rationalize current law by providing taxpayers with a single method of accounting for their basis in securities and determining holding period. In general, the proposal provides that the basis for fungible securities is the average cost of the securities. In addition, a first-in first-out method would be used for other purposes such as determining the holding period of fungible securities. The proposal would eliminate the specific identification method. Averaging the cost of all the identical shares or securities the taxpayer owns allows a more accurate measurement of the taxpayer’s true income from a sale.

· Proper Measurement of Gain/Income: Require Reasonable Payment Assumptions for Interest Income on Certain Debt

Discussion: A person who owns a debt instrument or who lends money must include in income any interest on the debt or loan. In general, a corporation is subject to tax on this interest income as it accrues, rather than when it is actually paid. If a debt can be paid off by the borrower by a specified date without interest (as is the case with certain credit card balances), interest generally does not accrue (and no tax is imposed) under tax rules until the specified date has passed. This is true even though the taxpayer can accurately predict that a certain percentage of borrowers will not pay off the debt by the specified date. Tax rules that apply to pools of mortgages require investors in the pools to use statistical predictions of payment patterns to determine how much interest income to accrue from the mortgages each year.

In many cases receivables have a low interest rate, or a zero interest rate, if they are paid within a certain period. Many credit cards, for example, do not charge a card holder interest if the holder pays the outstanding balance on the card within a grace period. Even though most credit card balances are not paid within this grace period, current tax rules can allow the credit card company to assume the cardholder's balance will be paid off in the period. Since the company assumes that no interest will be incurred by the holder, it accrues no interest income on outstanding balance during the grace period. The treatment allows a permanent deferral of interest income.

Proposal: Rules similar to the rules that apply to pools of mortgages would be applied to pools of credit card receivables and other loans that can be paid by a specified date without interest. This measure would require an investor in such a pool to take into account that many of the borrowers in the pool will owe interest.

2. CORPORATE PROVISIONS

Like the proposals that relate to financial instruments, these provisions prevent taxpayers from exploiting gray areas and inconsistencies in the tax law to manipulate income. The proposals also eliminate unwarranted corporate subsidies. Highlights include:

· Require Gain Recognition for Certain Extraordinary Dividends

Discussion: A redemption of stock by a corporation is sometimes treated like a sale of the stock, and the income is generally treated as capital gain. A corporate shareholder, however, prefers to receive dividends rather than capital gains in order to take advantage of the dividends received deduction. Some corporate taxpayers take the position that certain redemptions of stock that are effectively sales of the stock are treated as dividends. This allows most of the proceeds of the sale to escape taxation because the corporate taxpayer will claim a dividends received deduction.

Proposal: The proposal would eliminate this loophole by eliminating the ability of corporate shareholders to use certain rights to acquire stock as actual stock ownership. This provision has received bipartisan, bicameral support as the appropriate course to halt a current corporate tax loophole. It was included in the Balanced Budget Act of 1995.

· Treat Certain Preferred Stock Like Debt in Reorganizations

Discussion: In mergers and acquisitions, a person receiving stock of the acquiring corporation in exchange for stock of the target corporation generally recognizes no gain. By contrast, if a person receives property (including debt securities) in exchange for stock, gain generally will be recognized. A holder of common stock in the target corporation can receive preferred stock in the acquiring corporation without recognizing gain, even though the preferred stock may be substantially equivalent to a debt security. Similar rules apply to the exchange of assets for stock when a corporation is formed.

Preferred stock can be structured to be economically equivalent to a debt security that does not represent a meaningful equity interest in the issuing corporation. A shareholder receiving this debt-like instrument has effectively sold its interest in the corporation. The tax treatment of this type of transaction should not depend on an arbitrary distinction between debt and equity.

Proposal: The proposal would prevent taxpayers from exploiting the gray area between debt and equity and eliminate the inconsistency that exists under current law. The proposal would require shareholders who receive preferred stock that is like a debt security to recognize gain in a merger, acquisition, or corporate formation. In general, the proposal applies to preferred stock that has an enhanced likelihood of recovery of principal or of maintaining a dividend, or both, or that otherwise has certain non-stock characteristics.

· Repeal Section 1374 for Large Corporations

Discussion: Corporate income is generally subject to two levels of tax. The corporation is taxed directly on its income and the shareholders are taxed on any distributions they receive from the corporation. A corporation can avoid this two-tier tax by electing to be an "S corporation" or by converting to a partnership. In both cases, any future income and gain are taxed directly to the shareholders or the partners, and distributions of cash are tax-free. The effects of converting to an S corporation or a partnership, however, are quite different. Under section 1374, a conversion to an S corporation is generally tax-free, except that any built-in gain in the corporation’s assets at the time of conversion is triggered if the assets are sold within 10 years of the conversion. By contrast, a conversion to a partnership is a fully taxable transaction in which the corporation is taxed on all of the built-in gain in its assets and the shareholders are taxed on the built-in gain in their stock.

The tax treatment of the conversion of a C corporation to an S corporation generally should be consistent with the treatment of its conversion to a partnership. In particular, any appreciation in corporate assets that occurred during the time the corporation is a C corporation should be subject to the corporate-level tax.

Proposal: An election by a large corporation to be treated as an S corporation will be treated in the same manner as a conversion to a partnership. As a result, a large corporation that elected to be an S corporation would recognize any built-in gain in its assets and the shareholders would recognize any built-in gain in their stock. For this purpose, a large corporation is any corporation with a value of more than $5 million at the time of conversion. The value of the corporation is the fair market value of the stock on the date of the conversion.

· Require Gain Recognition on Certain Distributions of Controlled Corporation Stock

Discussion: Since 1986, most corporate distributions of property (including stock of a subsidiary) cause the corporation to be taxed on the appreciation in the asset distributed, and result in a taxable event to the shareholder receiving the property. Section 355 provides a limited exception to this treatment. If certain statutory requirements are met, a corporation may distribute stock of a controlled subsidiary to its shareholders on a tax-free basis. This treatment is designed to permit corporate structures to be rearranged without tax effect, provided the shareholders continue their investment in the modified enterprise.

Under section 355 of current law, economically identical transactions can be treated as tax-free or taxable depending on the order of the various steps. Transactions that in end result are effectively complete dispositions of a business to new investors presently can qualify for the favorable tax treatment under section 355. These transactions combine a tax-free distribution of the stock of a corporation under section 355 with a tax-free reorganization (such as a merger). These transactions are often referred to as Morris Trust transactions.

Proposal: The proposal would eliminate the loophole under current law by limiting the ability of a corporation to avoid recognizing gain when it disposes of a business. A parent corporation would be taxed on the distribution of appreciated stock of its controlled subsidiary, unless the same shareholders own at least 50 percent of both the parent and the subsidiary throughout the period beginning two years before the distribution and ending two years after it. This modification is intended to limit the favorable tax treatment under section 355 to situations where the shareholders maintain their investment in the existing corporate enterprise, albeit it in modified form. This proposal would not change the treatment of shareholders; they would continue to have neither gain nor dividend income under section 355.

· Reform the Treatment of Certain Corporate Stock Transfers

Discussion: In certain circumstances, a transfer of subsidiary stock between related corporations is treated as a dividend distribution instead of a sale. Inconsistencies in the tax law allow U.S. corporate groups to use this treatment to produce tax losses when no economic loss has occurred. A similar transaction may be available to U.S. subsidiaries owned by a foreign parent corporation. A U.S. corporation receiving a dividend from a foreign subsidiary that it owns is generally allowed a credit for the foreign taxes paid by the subsidiary because the U.S. corporation has indirectly paid that tax (in other words, the U.S. corporation bears the burden of that tax because it could have received a larger dividend if the tax had not been paid to the foreign government). The special rules for transfers of stock between related parties, however, may treat a U.S. subsidiary as receiving a dividend from a corporation that it does not actually own. In this case, the foreign tax credit is inappropriate because the U.S. corporation did not bear the burden of the foreign taxes.

Proposal: The proposal would prevent the creation of artificial losses and inappropriate tax credits by reforming the treatment of "dividends" deemed to arise from stock transfers between related parties. Specifically, if the purchaser is a domestic corporation, the proposal would treat the transactions with more consistency by clarifying that the deemed dividend from the purchaser would generally be treated as an extraordinary dividend requiring a basis reduction. The proposal would further require gain recognition to the extent the nontaxed portion of the extraordinary dividend exceeds the basis of the shares transferred.

If the purchaser is a foreign corporation, the proposal would limit the amount treated as a dividend (and the associated foreign tax credits) from the purchaser to the amount of the purchaser's earnings and profits attributable to stock owned by U.S. persons related to the seller.

3. ACCOUNTING PROVISIONS

These measures are designed to improve measurement of income by eliminating loopholes and inconsistent treatments.

· Phase out Preferential Tax Deferral for Certain Large Farm Corporations Required to Use Accrual Accounting

Discussion: Corporate taxpayers engaged in a farming business are required to use the accrual method of accounting (i.e., by recognizing revenues when earned and deducting expenses when incurred) rather than the cash method when their annual gross receipts exceed a specified threshold ($25 million in the case of closely held corporations). However, when the method is changed from cash to accrual, income would ordinarily escape taxation if it had been earned in a year in which the cash method is used and received in a year in which the accrual method is used. In the case of any taxpayer other than a farming corporation, a one-time adjustment must be made in order to ensure that income and deductions are not duplicated or omitted. Farming corporations are permitted to place the amount of this adjustment in "suspense," although the adjustment is required to be included in income in whole or in part upon the occurrence of certain subsequent events, such as contraction of the business or a change in its status as a closely held corporation. The suspended adjustment thus represents a potentially indefinite deferral of the recognition of income.

The current-law treatment of the accounting change for large farming corporations, which permits a potentially indefinite deferral of income, is a substantial and inappropriate departure from the policies underlying the rules for accounting method changes generally, in which the cumulative effect of an accounting method change is taken into account generally over a period not exceeding six years. These large farming corporations should be subject to the same rules that apply to all other taxpayers upon a change in their method of accounting.

Proposal: The proposal would eliminate the ability of large farming corporations to defer indefinitely this special adjustment upon a change to the accrual method of accounting. In addition, the proposal would require that any existing "suspense" account created by a farming corporation that has previously changed to the accrual method would be added to taxable income over a 10-year period.

· Repeal Lower of Cost or Market and Subnormal Goods Inventory Accounting Methods

Discussion: Taxpayers are permitted to use a variety of inventory methods in determining their income tax liability. In connection with the first-in, first-out ("FIFO") method or the retail inventory method, taxpayers may reduce the value of their inventories under either the "subnormal goods" method or the "lower of cost or market" method. Under the subnormal goods method, taxpayers may write down, to net realizable value, the value of inventory items that have declined in value due to damage, imperfections, shop wear, changes of style, odd or broken lots, or other similar causes. Under the lower of cost or market method, taxpayers examine individual inventory items and write down the value of those that have a replacement cost lower than their original cost (i.e., those that have declined in value). These methods generate a tax deduction in the year the write-down is taken, although the deduction is recaptured when the inventory item is sold or otherwise disposed of.

These inventory methods distort income by inappropriately reducing the tax basis, or cost, of ending inventories, thus overstating cost of goods sold and understating taxable income. Allowing write-downs when either the value or replacement cost declines prior to the sale of the goods is an exception to the realization principle of the income tax system and results in costs not being properly matched with revenues. These methods allow write-downs for value decreases, but do not require write-ups for either value increases or recoveries of previous write-downs, resulting in a one-way mark-to-market provision benefitting a small number of taxpayers to the detriment of the taxpaying public. In addition, the methods are complex and require substantial taxpayer and IRS resources for compliance and examination.

Proposal: The proposal would eliminate the ability of taxpayers to use these inventory methods, postponing the recognition of the loss through decline in value of inventory to the year in which the property is sold or otherwise disposed of. The proposal includes an exception for small businesses with average annual gross receipts over a three-year period of $5 million or less.

· Repeal Components-of-Cost Inventory Accounting Method

Discussion: Under current law, taxpayers are permitted to use a variety of inventory methods in determining their income tax liability. One is the last-in, first-out ("LIFO") method. By assuming that the goods sold in any taxable year are the goods most recently purchased or produced, the LIFO method permits taxpayers to factor out the effects of inflation in the cost of their inventories, thus matching current costs of purchase or production against current revenues. One method of determining the extent of inflation in the cost of manufactured inventories is the "components of cost" method, under which taxpayers treat their inventories as consisting of units of raw material and labor and overhead content, rather than as finished products.

The components-of-cost inventory method distorts income by inappropriately reducing the tax basis, or cost, of ending inventories, thus overstating cost of goods sold and understating taxable income. This method can cause inventory expenses to be overstated, because in some cases it will not adequately account for the effects of technological changes in manufacturing processes upon changes in the cost of the inventory items or their components. Due to technological developments, where skilled labor is substituted for less-skilled labor, or where increased overhead due to factory automation is substituted for labor costs, price indexes computed under this method may tend to overstate the actual impact of inflation on inventories.

Proposal: The proposal would eliminate the ability of taxpayers to use the components-of-cost method.

4. FOREIGN PROVISIONS

These provisions measure foreign income more accurately, prevent manipulation and inappropriate use of the foreign tax credit rules, and eliminate the use of derivative financial instruments to exploit inconsistencies and gray areas in current law. Highlights include:

· Replace Sales Source Rules with Activity-based Rule

Discussion: Current law generally allows 50 percent of the income from manufacturing products in the United States and selling them abroad to be treated as foreign income, even if most of the economic activity generating the income takes place in the United States. This treatment is relevant to the computation of a U.S. taxpayer’s foreign tax credit limitation, i.e., the limits on the use of foreign tax credits against U.S. tax on foreign income. By having more income treated as foreign, a U.S.-based multinational with excess foreign tax credits is able to use more of its foreign tax credits and reduce its residual income tax liability to the United States.

The treatment of income as foreign or domestic source, and the foreign tax credit limitation, are relevant only to companies that are subject to high foreign taxes on their foreign operations. Export sales income generally is not subject to any foreign tax. Thus, the 50-percent rule benefits only exporters that have multinational operations, not U.S. exporters that keep all their operations within the United States. Different categories of exporters should be treated equally.

The current rule also distorts overseas investment decisions by providing tax encouragement to companies to create operations in high-tax foreign countries and use artificially created foreign income to offset U.S. taxes with these high foreign taxes. This works to the ultimate benefit of high-tax foreign countries.

A recent industry-funded study finds that the present sales source rules have a revenue cost of more than $1 billion each year without affecting the number of people employed in the United States. We agree with these findings. However, we strongly disagree with the study’s projections of the extent to which the present sales source rules promote exports. The study’s findings are out of line with other economic studies of the price responsiveness of exports. Relying on more mainstream estimates, Treasury believes that the industry study overstates the increase in exports attributable to the present rules by more than twenty fold. Consequently, we believe that the existing rules’ effect on wages is dramatically smaller than the estimate in the industry study. However, even accepting the results of the industry study, the reduction in government revenues is nearly equivalent to the projected increase in wages. Regardless of our differences with the industry study, we are agreed on several key economic conclusions: the existing rule does not increase the number of people employed in the United States, and the revenue cost of the existing rule is substantial.

Proposal: The budget would apportion export income between production activities and sales activities, and thus between U.S. and foreign income, on the basis of an objective measure of actual economic activity.

· Reform Treatment of Dual-Capacity Taxpayers and Foreign Oil and Gas Income

Discussion: A foreign levy, to be eligible for the U.S. foreign tax credit, must be the substantial equivalent of an income tax in the U.S. sense, and must not constitute compensation for a specific economic benefit provided by the foreign country. Taxpayers that are subject to a foreign levy and that also receive (directly or indirectly) a specific economic benefit from the levying country are referred to as "dual capacity" taxpayers, and may not claim a credit for that portion of the foreign levy paid as compensation for the specific economic benefit received. Under a regulatory safe-harbor test, the dual-capacity taxpayer may treat as a creditable tax the portion of the foreign levy that does not exceed the amount of a generally imposed income tax in the foreign country. If there is no generally imposed income tax, the regulation treats the payment as a creditable tax up to the amount of the applicable U.S. tax rate applied to net income.

Foreign oil and gas extraction income (FOGEI) and foreign oil related income (FORI) are subject to special foreign tax credit limitation rules. FORI generally is subject to current U.S. tax under subpart F, while FOGEI generally is not.

The purpose of the foreign tax credit is to avoid double taxation of income by both the United States and a foreign jurisdiction. When a payment to a foreign government is made as compensation for a specific economic benefit, that payment should be deducted as an ordinary cost of doing business; there is no double taxation. Current law recognizes the distinction between creditable taxes and non-creditable payments for a specific economic benefit, but fails to achieve the appropriate split between the two in a case where a foreign country imposes a levy on, for example, oil and gas income only, but has no generally imposed income tax.

Proposal: The proposal would treat payments by a dual-capacity taxpayer to a foreign country as taxes only if there is a "generally applicable income tax" in that country. A tax will not qualify as a generally applicable income tax unless it has substantial application both to non-dual-capacity taxpayers and to persons who are citizens or residents of that country. The proposal thus would treat no portion of a foreign levy as a tax if the foreign country has no generally applicable income tax. The proposal generally would retain the rule of present law where the foreign country does generally impose an income tax. In that case, credits would be allowed up to the level of taxation that would be imposed under that general tax, as long as the tax satisfies the statutory definition of a "generally applicable income tax."

The change to the dual-capacity taxpayer rules would permit two additional rationalizing and simplifying changes to related tax rules. The proposal would convert the special foreign tax credit limitation rules of present-law into a new foreign tax credit separate limitation basket for foreign oil and gas income. It also would treat foreign oil and gas income (including both FOGEI and FORI) as subpart F income.

Conclusion

In conclusion, the President’s FY 1998 budget plan proposes to reach balance by 2002 with prudent tax reductions that are pro-family, pro-education, and pro-economic growth, and that are targeted to those who need them the most, with offsets that emphasize stopping abuses and closing loopholes but that do not raise taxes on legitimate business transactions. We look forward to working with the Committee on these proposals. I would be pleased to answer any questions you might have.