Description of Proposal The proposal extends to property and casualty insurers the pro-rata interest disallowance rule that applies to financial institutions under present law section 265(b). As under the presentlaw rules for insurers, however, the proposal applies not only with respect to tax-exempt interest, but also with respect to the untaxed portion of dividends received and insurance inside buildup. Thus, in lieu of the current 15-percent proration rule, a property and casualty insurer would be allowed no deduction for the portion of its interest expense that is allocable to: (1) the insurer's tax-exempt interest, (2) the deductible portion of dividends received (with special rules for dividends from affiliates), and (3) the increase for the taxable year in the cash value of life insurance, endowment or annuity contracts the company owns. The portion of the deduction for interest expense that is subject to the proposal is determined by the ratio of the adjusted basis of the taxpayer's tax-exempt obligations, dividend-paying stock and unborrowed policy cash values to the adjusted basis of all its assets. The proposal does not change the tax treatment of life insurers. Effective Date The proposal is effective for investments acquired on or after the date of enactment. Discussion The premise of the proposal is that interest deduction limitation rules based on fungibility of money should be applied to all corporate taxpayers in a similar manner, to the extent practical. In particular, the arbitrary 15-percent rule currently applicable to property and casualty insurers should be replaced by the more accurate allocation rule of section 265(b) that uses the taxpayer's asset bases to determine the portion of interest costs that finance untaxed income. Because life insurers already are subject to an interest limitation rule (based on investment income) that is specific to life insurance products that pay policyholder dividends and interest (which property and casualty insurance products generally do not), extending the 265(b) rule to life insurers may not be necessary. The proposal arguably imposes a greater administrative and recordkeeping burden on property and casualty insurers by substituting a percentage based on the ratio of adjusted bases of assets for the present-law flat 15-percent rate. However, business taxpayers usually know the adjusted bases of their assets. Further, the proposal simplifies tax administration by applying the same rules to all (or most) taxpayers, and provides a more accurate measurement of taxable income by the use of relative asset basis for determining what portion of interest costs are financing untaxed income in lieu of a flat percentage. A narrower proposal could be limited to interest on tax-exempt obligations as under section 265(b), both for conformity with other taxpayers subject to 265(b), and to facilitate the application of the interest deduction limitation in the case of related parties (some of which might not be property and casualty insurers). However, there may be little difference among types of untaxed income for purposes of applying an interest deduction limitation based on fungibility, particularly when no such distinction among types of untaxed income is made for property and casualty insurers under their present-law interest limitation rule. 469 Because it would be less attractive under the proposal than under current law for property and casualty insurance companies to hold tax-exempt debt, the borrowing costs to State and local governments may rise. As described previously in this report, unrestricted arbitrage opportunities should make the subsidy of tax-exempt bond financing more efficient. That subsidy, however, may never be fully efficient, and arbitrage opportunities may remain. This arbitrage may harm voluntary compliance and creates revenue loss to the Federal government. 469 See Part VII.A. of this Report, "Disallow Deduction for Interest on Indebtedness Allocable to Tax-Exempt Obligations." F. Eliminate Double Deduction of Mining Exploration and Development (sec. 57) Present Law Under present law, mining development costs are expensed in computing taxable income, unless either the deferred expense method is elected under section 616(b) or 10-year amortization is elected under section 59(e). In addition, a taxpayer may elect to expense mining exploration costs under section 617 or amortize the costs over a 10-year period under section 59(e). Also, a deduction for depletion is allowed with respect to mines. One method of computing the allowance for depletion is the percentage method that is based on the income of the mining property and is not limited by the adjusted basis of the property. In determining alternative minimum taxable income (“AMTI”) mining exploration and development costs with respect to a mine are required to be capitalized and amortized over a 10year period, unless the deferred expense method is elected under section 616(b).470 In addition, the deduction for percentage depletion is limited to the adjusted basis of the property at the end of the taxable year (without regard to the depletion deduction for the year)." 471 Under the rules, notwithstanding the adjusted basis limitation on percentage depletion, a taxpayer may deduct more than 100 percent of its exploration and development costs in computing AMTI. For example, assume a taxpayer incurs $1 million in development costs in 2005 with respect to a mine that has a zero basis and that the deferred expense method is not elected. Also, assume that the deduction for percentage depletion (without regard to the basis limitation) for 2005 is $900,000. Under present law, in computing AMTI, the taxpayer is allowed to deduct $100,000 per year in development costs for each of the 10 taxable years beginning in 2005, and, in addition, is allowed to deduct percentage depletion of $900,000 in 2005, for a total of $1.9 million in deductions. Reasons for Change The double deduction of the same expenses in computing alternative minimum taxable income should not be permitted. Description of Proposal The deduction for depletion under the alternative minimum tax is amended by excluding from the adjusted basis of any mining property, the amount of mining exploration and development costs that may be allowed as a deduction to the taxpayer in computing AMTI in a future taxable year. In the example described above, the $1 million development costs will be amortized over a 10-year period and no amount will be allowed as a deduction for depletion in computing AMTI. 472 Effective Date The proposal applies to taxable years beginning after the date of enactment. Discussion The 10-year amortization requirement was enacted in 1986 to better measure the economic income from mineral properties. However, because percentage depletion (not in excess of adjusted basis) is also allowed in computing AMTI, the failure to coordinate the two provisions improperly allows a deduction in excess of costs incurred. 472 If the taxpayer elects the deferred expense method under section 616(b) or 10-year amortization under section 59(e), the deduction for depletion will remain zero. VIII. EXEMPT ORGANIZATIONS A. Require Five-Year Review of Exempt Status of Public Charities Not Required to File Information Returns (sec. 508) Present Law Application for tax exemption Section 501(c)(3) organizations (with certain exceptions) are required to seek formal recognition of tax-exempt status by filing an application with the IRS (Form 1023). In response to the application, the IRS issues a determination letter or ruling either recognizing the applicant as tax-exempt or not. Certain organizations are not required to apply for recognition of taxexempt status in order to qualify as tax-exempt under section 501(c)(3) but may do so. These organizations include churches, certain church-related organizations, organizations (other than private foundations) the gross receipts of which in each taxable year are normally not more than $5,000, and organizations (other than private foundations) subordinate to another tax-exempt organization that are covered by a group exemption letter. 473 A favorable determination by the IRS on an application for recognition of tax-exempt status will be retroactive to the date that the section 501(c)(3) organization was created if it files a completed Form 1023 within 15 months from the end of the month it was formed. If the organization does not file Form 1023 or files a late application, it will not be treated as taxexempt under section 501(c)(3) for any period prior to the filing of an application for recognition of tax exemption. Contributions to section 501(c)(3) organizations that are subject to the requirement that the organization apply for recognition of tax-exempt status generally are not deductible from income, gift, or estate tax until the organization receives a determination letter from the IRS.475 474 Information required on Form 1023 includes, but is not limited to: (1) a detailed statement of actual and proposed activities; (2) compensation and financial information 473 Pursuant to Treas. Reg. sec. 301.9100-2(a)(2)(iv), organizations are allowed an automatic 12-month extension as long as the application for recognition of tax exemption is filed within the extended, i.e., 27-month, period. The IRS also may grant an extension beyond the 27month period if the organization is able to establish that it acted reasonably and in good faith and that granting relief will not prejudice the interests of the government. Treas. Reg. secs. 301.9100-1 and 301.9100-3. 474 475 Treas. Reg. sec. 1.508-1(a)(1). Sec. 508(d)(2)(B). Contributions made prior to receipt of a favorable determination letter may be deductible prior to the organization's receipt of such favorable determination letter if the organization has timely filed its application to be recognized as tax-exempt. Treas. Reg. secs. 1.508-1(a) and 1.508-2(b)(1)(i)(b). |