A. TAX REVISION

While no one contends that our income tax system does not need improving, it is still widely acknowledged to be the best in the world. The difficulty faced in improving the system is that the American people want different things from their tax system. On the one hand, they want every individual and corporation to pay a fair share of the overall income tax burden. In a system that depends heavily on voluntary compliance with the tax laws, as ours does, tax equity is especially important. However, at the same time, Americans do not want the income tax system to interfere with economic efficiency and growth. This implies that tax changes to promote equity should not retard either the current recovery from what has been the worst recession since the 1930's or impede the long-run growth of the economy. The tax revisions in the Act represent a careful balance between these sometimes conflicting objectives.

The Act contains many tax revisions, described in more detail below, designed to eliminate tax abuses and make the tax system more equitable.

Tax shelter provisions

Congress believed that changes were needed to end the excessive tax deferrals provided by tax shelters, as well as the opportunity they provide to, in effect, convert ordinary income into capital gains. Too many investments have been motivated by excessive concern with the tax benefits associated with them, not their economic merits. In some cases, the manner in which the tax shelters were contrived was questionable even under prior law. In others, individuals were combining provisions of the law, or leveraging them through nonrecourse borrowings, in a way which multiplied severalfold any possible advantages intended by Congress. Such activities reduce citizens' respect for the income tax and represent an inefficient allocation of resources. The Act contains a number of provisions designed to curb these abuses without interfering with economically worthwhile investments.

The Act expands the use of the so-called "recapture" rules to prevent conversion of ordinary income into capital gains in the case of real estate, oil and gas drilling and sports franchises. For oil and gas drilling, farm operations, equipment leasing, and film purchases and production, losses from accelerated deductions are limited to the amount for which the individual is “at risk." This is designed to prevent leveraging of tax shelter benefits through the use of nonrecourse loans. There is also an "at risk" rule for limited partnerships in areas not specifically dealt with by the Act, which should discourage development of new leveraged tax shelters. In addition, in the case of farm syndicates (or passive farm partnerships) and motion picture production companies (and companies producing books, records, etc.), certain costs are required to be capitalized and written off over the

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productive period of the related assets, or the writeoff is delayed until the items involved are used. For real estate, the Act also requires capitalization of interest and taxes during the construction period.

The provisions relating to various deductions and exclusions in the case of partnerships are tightened so that the deductions or exclusions cannot be allocated among the various partners according to whomever can maximize the tax benefits unless such allocation has substantial economic effect. Also, limits are placed on the amount of "bonus" first-year depreciation deductions of the partners. The Act requires prepaid interest to be deducted over the period to which it relates and requires use of accrual accounting by many farm corporations. Also, it tightens the existing limit on deductions of excess investment interest.

Minimum and maximum taxes

Congress believed that high-income people and corporations should not be able completely to escape liability for income tax. Preventing this is a major feature of the Act. It greatly reduces the incidence of tax avoidance by high-income people through two related provisions—a stiffer minimum tax on tax-preferred income and a revision in the maximum tax designed to discourage use of tax preferences.

Minimum tax

The prior minimum tax for individuals was inadequate. In 1974 it raised only $130 million, down from $182 million in 1973, which is only a small fraction of total tax-preferred income. Also, the minimum tax for individuals was largely a tax on one preference-the excluded half of capital gains. The Act amends the minimum tax both to increase its revenue yield and to broaden the tax preferences covered by it.

The Act raises the minimum tax rate from 10 percent to 15 percent. In place of the existing $30,000 exemption and the deduction for regular income taxes, the Act has an exemption for individuals equal to one-half of regular income taxes or $10,000, whichever is greater. These changes reflect Congress' view that the effective tax rate on tax preferences should be higher.

Two new minimum tax preferences are added. To reduce the tax benefit of shelters in oil and gas drilling and to ensure that oil drillers pay some minimum income tax, the Act adds a preference for intangible drilling costs. To impose some tax in cases where there is excessive use of itemized personal deductions, there is a new preference for itemized deductions (other than medical expenses and casualty losses) in excess of 60 percent of adjusted gross income.

Congress also believed that the minimum tax on corporations should be strengthened in order to raise the effective tax rate on corporate tax preferences. However, because corporate income is subject to both the individual and corporate income taxes, Congress felt it was appropriate to retain in full the deduction for regular taxes for corporations.

Maximum tax

In 1969, Congress enacted a 50-percent maximum marginal tax rate on income from personal services. To reduce the incentive to invest in tax shelters, the law provided that income eligible for this maximum

rate be reduced by tax preferences (as defined under the minimum tax) in excess of $30,000. The Act extends this 50-percent maximum rate to deferred compensation (including pensions and annuities).

The "preference offset" in the maximum tax has not been as effective in discouraging investment in tax shelters as originally planned. The expanded list of minimum tax preferences will make the preference offset more effective. Also, the Act repeals the existing $30,000 floor on preferences that reduce personal service income eligible for the maximum tax.

Business expenses under the individual income tax law

Many individuals are now claiming deductions for the business use of their home, for expenses related to the rental of their vacation homes for a brief part of the year, or for expenses of attending foreign conventions. While in theory there is nothing wrong with appropriate deductions for business or investment expenses, in practice it is often extremely difficult to allocate between deductible business expenses and nondeductible personal expenses. The result is that many people have been deducting amounts as business expenses which in part actually represent personal expenses. To deal with this problem, the Act places strict limitations on these deductions.

The Act also repeals the special tax treatment for qualified stock options. With personal service income subject to a maximum rate of 50 percent, Congress decided that there is no reason for not taxing this form of compensation as ordinary income.

Tax treatment of foreign income

The Act makes several important changes in the tax treatment of foreign income. Congress believed that it is necessary to strike a delicate balance between encouraging the free flow of capital across national borders and making sure that the tax laws do not provide excessive incentives for foreign investment instead of investment in the United States. Congress decided to retain the basic structure of the taxation of foreign income-namely, a foreign tax credit for income earned abroad and deferral of tax on income of foreign subsidiaries (except in the case of "tax haven" income) until returned to this country. However, the Act eliminates virtually all other tax-related incentives for investment abroad.

An important change made by the Act is the repeal of the percountry limitation on the foreign tax credit. The per-country limit enables a firm with a loss in one country and a profit in another to deduct the loss against U.S. income and still avoid U.S. tax on the profit through the foreign tax credit. Its repeal will eliminate this possibility and will also greatly simplify this part of the tax law. The Act also provides for recapture of foreign losses deducted from U.S. income when foreign profits are earned in subsequent years.

The Act repeals numerous tax incentives which favor investment in some foreign areas over others those which favor investment in less-developed country corporations, China Trade Act corporations and Western Hemisphere trade corporations. It also substantially revises and improves the tax provisions relating to U.S. possessions. Except in the case of U.S. possessions, Congress felt that there was no longer any good reason for favoring investment in one of these foreign areas over another.

The Act, while retaining an exclusion for income earned abroad by individuals, eliminates special features of this provision enabling those with income above the basic exemption levels to obtain additional tax benefits from the exclusion and reduces the maximum amounts eligible for the exclusion. Congress did not feel that the tax preference for income earned abroad should be as large as it was under prior law.

Another area of concern is the DISC provision that permits deferral of tax for one-half of export income. To make this incentive more efficient, the Act limits DISC treatment to the excess of a firm's exports above a moving base period level.

Congress did not believe that multinational corporations should benefit from tax incentives when they engage in misconduct. Thus, the Act denies the foreign tax credit, tax deferral, and DISC treatment for income earned in connection with participation in international boycotts, such as the Arab boycott of Israel. Similarly, it provides that amounts paid as bribes by foreign subsidiaries will be taxed to the U.S. parent corporation.

To eliminate the possibility that oil companies which operate abroad gain undue advantage from the characterization of their payments to foreign governments as creditable taxes, the Act further limits the extent to which foreign tax credits from oil extraction can be used while continuing the requirement that these taxes may not reduce the tax on other foreign oil income.

The Act also makes several technical corrections that were considered necessary resulting from the changes in the taxation of foreign income made by the Tax Reduction Act of 1975.

Capital gains and losses

The Act makes three important changes in the tax treatment of capital gains and losses. The holding period defining long-term capital gains, which receive preferential tax treatment, is raised (over a period of two years) from six months to one year. This should encourage longer term investments as contrasted to short-term speculative investments. Also, the Act (over a period of two years) increases the amount of ordinary income against which capital losses can be deducted from $1,000 to $3,000. This change is designed to provide relief to those who have capital losses in excess of capital gains, which is not only fair but also should encourage individuals to make equity investments. Finally, the Act increases the exemption level for capital gains on the sale of a principal residence by a taxpayer age 65 or over.

Other tax revisions

The Act makes a large number of other relatively minor revisions in the tax law. These deal with inequities or technical problems that have come to the attention of the Congress.

There are several provisions relating to tax-exempt organizations. Among these is one which sets the payout requirement (if larger than actual earnings) for foundations at 5 percent of asset value (instead of a minimum of 6 percent) and provides that this limit is not to be varied as interest rates generally change. A second provision sets up a court review procedure where the IRS holds that an organization does not qualify for exempt status. A third change makes more specific the rules for lobbying by charitable and educational organizations.

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The Act includes a number of provisions relating to pensions. Probably the most important of these is one which expands the existing provision for individual retirement accounts (IRAs) to permit a working spouse to set up an IRA for a nonworking spouse. This change recognizes the contributions to the family made by non working spouses. If an IRA is set up for both spouses, a $1,750 contribution limit applies. Contributions can be made, subject to that limit, to a single IRA with separate subaccounts or two separate IRAs. Another pension provision permits an amount of up to $750 to be set aside each year in an H.R. 10-type plan where income is $15,000 or under without the amount set aside being limited to 25 percent of an individual's earnings.

There also are a number of changes relating to the taxation of insurance companies. Among these is one which, after a period of five years, will permit casualty insurance companies to file consolidated returns with life insurance companies but in a manner which does not permit the losses of the casualty companies to remove more than a limited amount of the life insurance income from taxation.

There are technical changes in the tax treatment of real estate investment trusts, housing cooperatives and condominiums, certain franchise transfers, authors and publishers, creditors of political parties, subchapter S corporations, the work incentive (WIN) tax credit, personal holding companies, oil and gas producers, losses from disasters, simultaneous liquidation of parent and subsidiary corporations, gain from sales or exchanges between related parties, and deductions for removing architectural and transportation barriers for handicapped and elderly people.

The Act makes revisions in depreciation rules designed to encourage rehabilitation of historic structures.

Several tax provisions that have recently expired are extended in the Act. These include rapid amortization provisions for pollution control facilities and rehabilitated low-income housing. Pollution control facilities are also given half of the normal investment credit, which differs from the prior provision under which 5-year amortization was an alternative to the investment credit. Congress believed that since Federal regulations require installation of pollution control equipment, it is equitable to reduce the cost of capital for such equipment. Also, the exclusion from income for certain forgiven student loans is extended through 1978. Further, the Act extends for a limited period the exclusion for certain health-related scholarships for members of the uniformed services for those participating in 1976.

Tax exemption is provided for contributions by employers to qualified group legal services plans, designed to encourage use of this fringe

benefit.

To broaden the market for State and local government bonds, mutual funds are allowed to pass through tax-exempt interest on such bonds to shareholders.

Also, the Act redefines income or loss from writing options as shortterm capital gain or loss in order to limit the tax shelters that have developed in recent years in stock option hedges.

In addition, the Act makes certain small changes in the excise tax treatment of truck modifications and truck parts and accessories, and simplifies and revises the excise tax treatment of cigars.