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Statement of the
Investment Company Institute
On Revenue Raising Provisions in
the Administration’s Fiscal Year 1999
Submitted to the Committee on Ways and Means,
U.S. House of Representatives
March 11, 1998
The Investment Company Institute (the "Institute")1 submits for the Committee's consideration the following comments regarding proposals to (1) exempt from withholding tax all distributions made to foreign investors in certain qualified bond funds, (2) enhance retirement security, (3) modify Section 1374 of the Internal Revenue Code2 to require current gain recognition on the conversion of a large C corporation to an S corporation, and (4) increase the penalties under Section 6721 for failure to file correct information returns.
I. Withholding Tax Exemption for Certain Bond Fund Distributions
Individuals around the world increasingly are turning to mutual funds to meet their diverse investment needs. Worldwide mutual fund assets have increased from $2.4 trillion at the end of 1990 to $7.2 trillion on September 30, 1997. This growth in mutual fund assets is expected to continue as the middle class continues to expand around the world and baby boomers enter their peak savings years.
U.S. mutual funds offer numerous advantages that could be attractive to foreign investors. The expertise of the industry’s portfolio managers and analysts, for example, could provide superior fund performance, particularly with respect to U.S. capital markets. Moreover, the U.S. securities laws provide strong shareholder safeguards that foster investor confidence in our funds.
While the U.S. fund industry is the world’s largest, with over half of the world’s mutual fund assets, foreign investment in U.S. funds is low. Today, less than one percent of all U.S. fund assets are held by non-U.S. investors.
One significant disincentive to foreign investment in U.S. funds is the manner in which the Code’s withholding tax rules apply to distributions to non-U.S. shareholders from U.S. funds (treated for federal tax purposes as "regulated investment companies" or "RICs"). Under U.S. law, foreign investors in U.S. funds receive less favorable U.S. withholding tax treatment than they would receive if they made comparable investments directly or through foreign funds. This withholding tax disparity arises because a U.S. fund’s income, without regard to its source, generally is distributed as a "dividend" subject to withholding tax.3 Consequently, foreign investors in U.S. funds are subject to U.S. withholding tax on distributions attributable to two types of income—interest income (on "portfolio interest" obligations and certain other debt instruments) and short-term capital gains—that would be exempt from U.S. withholding tax if received directly or through a foreign fund.
A U.S. fund may "flow through" the character of the income it receives only pursuant to special "designation" rules in the Code. One such character preservation rule permits a U.S. fund to designate distributions of long-term gains to its shareholders (both U.S. and foreign) as "capital gain dividends." As capital gains are exempt from U.S. withholding tax, foreign investors in U.S. funds are not placed at a U.S. tax disadvantage with respect to distributions of funds’ long-term gains.
Legislation introduced in every Congress since 1991 would permit all U.S. funds also to preserve, for withholding tax purposes, the character of interest income and short-term gains that would be exempt from U.S. withholding tax if received by foreign investors directly or through a foreign fund. The Institute strongly supports these "investment competitiveness" bills.
Under the President's Fiscal Year 1999 budget proposal, distributions to foreign investors by a U.S. fund that invests substantially all of its assets in U.S. debt securities or cash generally would be treated as interest exempt from U.S. withholding tax. A fund’s distributions would remain eligible for this withholding tax exemption if the fund invests some of its assets in foreign debt instruments that are free from foreign tax pursuant to the domestic laws of the relevant foreign countries. The taxation of U.S. investors in U.S. funds would not be affected by the proposal.
The Institute urges enactment of this proposal as an important first step toward eliminating all U.S. tax incentives for foreign investors to prefer foreign funds over U.S. funds. The imposition of U.S. withholding tax on distributions by U.S. funds, where the same income would be exempt from U.S. tax if the foreigners invested directly or through foreign funds, serves as a very powerful disincentive to foreign investment in U.S. funds. By providing comparable withholding tax treatment for our bond funds, the proposal would enhance the competitive position of U.S. fund managers and their U.S.-based work force.
As noted above, the Administration’s proposal would exempt from U.S. withholding tax distributions by a U.S. fund that also holds some foreign bonds that are free from foreign tax under the laws of the relevant foreign countries. This is in recognition of the fact that U.S.-managed bond funds may hold some foreign bonds. These can include "Yankee Bonds," which are U.S. dollar-denominated bonds issued by foreign companies that are registered under the U.S. securities laws for sale to U.S. investors, and other U.S. dollar-denominated bonds that may be held by U.S. investors (e.g., "Eurobonds"). The Institute urges appropriate standards ensuring that U.S. funds seeking foreign investors may continue to hold them.
The Institute supports drawing a distinction between a foreign bond (such as a Yankee Bond or a Eurobond) that is exempt from foreign withholding tax under the domestic law of the relevant foreign country and one that is exempt only pursuant to an income tax treaty with the U.S. By treating investments in foreign bonds that are exempt from withholding tax pursuant to treaty as "nonqualifying" for purposes of the "substantially all" test, the proposal prevents foreign investors from improperly taking advantage of the U.S. treaty network.
II. Retirement Security Initiatives
The U.S. mutual fund industry serves the needs of American households saving for their retirement and other long-term financial goals. By permitting millions of individuals to pool their savings in a diversified fund that is professionally managed, mutual funds provide an important financial management role for middle-income Americans.4 Mutual funds also serve as the investment medium for employer-sponsored retirement programs, including small employer savings vehicles like the new Savings Incentive Match Plan for Employees ("SIMPLE") and Section 401(k) plans, and for individual savings programs such as the traditional and Roth IRAs. As of December 31, 1996, mutual funds held over $1.24 trillion in retirement assets.5
The Institute has long supported legislative efforts to enhance retirement savings opportunities for Americans. It strongly advocates legislation to increase small employer retirement plan coverage and make retirement savings more portable, thus enabling Americans to more easily manage their retirement savings. Our prescriptions for attaining these goals, however, differ in some respects from the Administration’s.
A. Small Employer Retirement Plan Coverage
Retirement plan coverage is a matter of serious public concern. Coverage rates remain especially low among small employers. Less than one-half of employers with 25 to 100 employees sponsored retirement plans. More starkly, under 20 percent of employers with fewer than 25 employees offer their employees a retirement plan.6 The enactment of legislation creating SIMPLE plans was a major first step toward improving coverage, but more remains to be done.
Congress should (1) improve the SIMPLE plan program for small employers by raising the salary deferral limitation, (2) eliminate or modify regulations, such as the "top-heavy" rule, that continue to retard small employer plan formation, and (3) assure that new small employer plan initiatives provide effective incentives for plan establishment and do not undermine currently successful programs.
1. Raise the SIMPLE Plan Deferral Limitation
In 1996, Congress created the successful SIMPLE program. The SIMPLE is a simplified defined contribution plan available to small employers with fewer than 100 employees. In just the first seven months of its availability, an Institute survey of its largest members found that no less than 18,250 SIMPLE plans had been established, covering over 95,000 employees. Virtually all (97 percent) SIMPLE plan formation is among the smallest of employers—those with fewer than 25 employees. Indeed, employers with 10 or fewer employees established about 87 percent of these plans. For the first time, significant numbers of small employers are able to offer and maintain a retirement plan for their employees.
Presently, however, an employee working for an employer offering the SIMPLE may save only up to $6,000 annually in his or her SIMPLE account. Yet, an employee in a 401(k) plan, typically sponsored by a mid-size or larger employer, is permitted to contribute up to $10,000. Congress can readily address this inequity by amending the SIMPLE program to permit participating employees to defer up to $10,000 of their salary into the plan, that is, up to the limit set forth at Section 402(g) of the Internal Revenue Code. This change would enhance the ability of many individuals to save for retirement and, yet, would impose no additional costs on small employers sponsoring SIMPLEs.
2. Reduce Unnecessary, Costly Regulations, Such as The Top-Heavy Rule, That Retard Small Employer Plan Formation
Congress could raise the level of small employer retirement plan formation if it reduced the cost of plan formation and maintenance. One way to reduce these costs is for the federal government to subsidize them. The Administration has proposed a "start-up tax credit" for small employers that establish a retirement plan in 1999. Such a tax incentive may induce certain small employers to establish retirement plans.
Another approach would be to seek the actual reduction of on-going plan costs attributed to regulation. For example, repeal or modification of the "top-heavy" rule7 may lead to more long-term plan formation than a one-time tax credit program. A 1996 U. S. Chamber of Commerce survey showed that the top-heavy rule is the most significant regulatory impediment to small businesses establishing a retirement plan.8
Finally, Congress certainly should avoid discouraging plan formation by adding to the cost of retirement plans. Thus, the Institute strongly urges that Congress not enact the Administration’s recommendation that a new mandatory employer contribution be required of employers permitted to use design-based safe harbor formulas in their 401(k) plans beginning in 1999.
3. New Programs For Small Employers Should Provide Effective Incentives For Plan Establishment and Not Undermine Currently Successful Programs
The Administration has also proposed enhancing the "payroll deduction IRA" program and creating a new simplified defined benefit plan program for small employers. In considering these proposals, it is important to assure that incentives are appropriately designed to induce program participation and that the programs do not undermine current retirement plan options.
For instance, the Administration would create an additional incentive to use the payroll deduction IRA program by excluding payroll deduction contributions from an employee’s income. Accordingly, they would not be reported on the employee’s Form W-2. As the success of the 401(k) and SIMPLE programs demonstrate, payroll deduction provides an effective, disciplined way for individuals to save, and its encouragement is a laudable policy goal. However, simplifying tax reporting may not add sufficient incentive for employers to establish a payroll deduction IRA program. More importantly, the interaction of an expanded payroll deduction IRA program with the new and successful SIMPLE program should be carefully considered. As noted above, the SIMPLE plan program has been extremely attractive to the smallest employers, exactly those for whom a payroll deduction IRA program is designed. Any new program expansion should not undermine already existing, successful small employer programs. Because the maximum IRA contribution amount is $2,000 (an amount not increased since 1981), it may not be appropriate to induce small employers to use that program rather than the popular SIMPLE program, which would permit employees a larger plan contribution. Similar considerations should be made with regard to any simplified defined benefit program.
B. Retirement Account Portability
Because average job tenure at any one job is under 5 years,9 individuals are likely to have at least several employers over the course of their careers. As a result, the portability of retirement plan assets is an important policy goal. The Administration advocates an accelerated vesting schedule for 401(k) plan matching contributions to address this issue. Consideration should be given to a broader approach to portability that would enhance the ability of all individuals to move their account balances from employer to employer when they change jobs.
Under current law, an individual moving from one private employer to another, where both employers provide Section 401(k) plan coverage, generally may roll over his or her vested account balance to the new employer. Where an individual moves from a private employer to a university or hospital or to the government sector, however, such account portability is not permitted. The problem arises because each type of employer has its own separate type of tax-qualified individual account program. Neither the university’s Section 403(b) program nor the governmental employer’s "457 plan" program may accept 401(k) plan money, and vice versa. Moreover, with the exception of "conduit IRAs," moving IRA assets into an employer-sponsored plan is prohibited.
Legislation to permit portability amongst these retirement plans would enable individuals to bring retirement savings with them when they change jobs, consolidate accounts and more readily manage retirement assets. Congress should amend the tax laws pertaining to all individual account-type retirement plans to permit individuals to roll over retirement account balances as they move from employer to employer, regardless of the nature of the employer.
C. Variable Annuities
The Administration has proposed imposing new taxes on the owners of variable annuity contracts. Proposals include taxing owners upon the exchange of one contract for another and in the event of a reallocation of contract savings from one investment option to another under the variable annuity contract.
The Institute opposes these proposals, because they would tax many individuals who save for retirement through variable annuities.
III. Conversions of Large C Corporations to S Corporations
Section 1374 generally provides that when a C corporation converts to an S corporation, the S corporation will be subject to corporate level taxation on the net built-in gain on any asset that is held at the time of the conversion and sold within 10 years. In Notice 88-19, 1988-1 C.B. 486, the IRS announced that regulations implementing repeal of the so-called General Utilities doctrine would be promulgated under Section 337(d) to provide that Section 1374 principles, including Section 1374’s "10-year rule" for the recognition of built-in gains, would be applied to C corporations that convert to regulated investment company ("RIC") or real estate investment trust ("REIT") status.
Notice 88-19 was supplemented by Notice 88-96, 1988-2 C.B. 420, which states that the regulations to be promulgated under Section 337(d) will provide a safe harbor from the recognition of built-in gain in situations in which a RIC fails to qualify under Subchapter M for one taxable year and subsequently requalifies as a RIC. Specifically, Notice 88-96 provides a safe harbor for a corporation that (1) immediately prior to qualifying as a RIC was taxed as a C corporation for not more than one taxable year, and (2) immediately prior to being taxed as a C corporation was taxed as a RIC for at least one taxable year. The safe harbor does not apply to assets acquired by a corporation during the C corporation year in a transaction that results in its basis in the assets being determined by reference to a corporate transferor's basis.
The President's Fiscal Year 1999 budget proposes to repeal Section 1374 for large corporations. For this purpose, a corporation is a large corporation if its stock is valued at more than five million dollars at the time of the conversion to an S corporation. Thus, a conversion of a large C corporation to an S corporation would result in gain recognition both to the converting corporation and its shareholders. The proposal further provides that Notice 88-19 would be revised to provide that the conversion of a large C corporation to a RIC or REIT would result in the immediate recognition of the corporation's net built-in gain. Thus, the Notice, if revised as proposed, would no longer permit a large corporation that converts to a RIC or REIT to elect to apply rules similar to the 10-year built-in gain recognition rules of Section 1374.
Because the safe harbor set forth in Notice 88-96 is not based upon the 10-year built-in gain rules of Section 1374, the repeal of Section 1374 for a large C corporation should have no effect on Notice 88-96. The safe harbor is based on the recognition that the imposition of a significant tax burden on a RIC that requalifies under Subchapter M after failing to qualify for a single year would be inappropriate. Moreover, the imposition of tax in such a case would fall directly on the RIC's shareholders, who are typically middle-class investors.
The Institute understands from discussions with the Treasury Department that the proposed revision to Section 1374 and the related change to Notice 88-19 are not intended to impact the safe harbor provided by Notice 88-96.
Should the Congress adopt this proposal, the Institute recommends that the legislative history include a statement, such as the following, making it clear that the proposed revision to Section 1374 and the related change to Notice 88-19 would not impact the safe harbor set forth in Notice 88-96 for RICs that fail to qualify for one taxable year:
This provision is not intended to affect Notice 88-96, 1988-2 C.B. 420, which provides that regulations to be promulgated under Section 337(d) will provide a safe harbor from the built-in gain recognition rules announced in Notice 88-19, 1988-1 C.B. 486, for situations in which a RIC temporarily fails to qualify under Subchapter M. Thus, it is intended that the regulations to be promulgated under Section 337(d) will contain the safe harbor described in Notice 88-96.
IV. Increased Penalties for Failure to File Correct Information Returns
Current law imposes penalties on payers, including RICs, that fail to file with the Internal Revenue Service ("IRS") correct information returns showing, among other things, payments of dividends and gross proceeds to shareholders. Specifically, Section 6721 imposes on each payer a penalty of $50 for each return with respect to which a failure occurs, with a maximum penalty of $250,000.10 The $50 penalty is reduced to $15 per return for any failure that is corrected within 30 days of the required filing date and to $30 per return for any failure corrected by August 1 of the calendar year in which the required filing date occurs.
The President's Fiscal Year 1999 budget contains a proposal which would increase the $50-per-return penalty for failure to file correct information returns to the greater of $50 per return or five percent of the aggregate amount required to be reported correctly but not so reported. The increased penalty would not apply if the total amount reported for the calendar year was at least 97 percent of the amount required to be reported.
The Institute opposes the proposal to increase the penalty for failure to file correct information returns. Information reporting compliance is a matter of serious concern to RICs. Significant effort is devoted to providing the IRS and RIC shareholders with timely, accurate information returns and statements. As a result, a high level of information reporting compliance is maintained within the industry.
The Internal Revenue Code's information reporting penalty structure was comprehensively revised by Congress in 1989 to encourage voluntary compliance. Information reporting penalties are not designed to raise revenues.11 The current penalty structure provides adequate, indeed very powerful, incentives for RICs to promptly correct any errors made.
1The Investment Company Institute is the national association of the American investment company industry. Its membership includes 6,860 open-end investment companies ("mutual funds"), 441 closed-end investment companies, and 10 sponsors of unit investment trusts. Its mutual fund members have assets of about $4.419 trillion, accounting for approximately 95% of total industry assets, and have over 62 million individual shareholders.
4An estimated 37 million households, representing 37% of all U.S. households, owned mutual funds in 1996. See Brian Reid, "Mutual Fund Developments in 1996," Perspective, Vol. 3, No. 1 (Investment Company Institute, March 1997).
6In 1993, the most recent year for which data is available, only 19 percent of employers with fewer than 25 employees sponsored a retirement plan. EBRI Databook on Employee Benefits. Employee Benefit Research Institute, 1997.
7Section 416 of the Internal Revenue Code. The top-heavy rule looks at the total pool of assets in a plan to determine if too high a percentage (more than 60 percent) of those assets represent benefits for "key" employees. If so, the employer is required to (1) increase the benefits paid to non-key employees, and (2) accelerate the plan’s vesting schedule. Small businesses are particularly effected by this costly rule, because "key" employees include individuals with an ownership interest in the company. Small businesses are more likely to have concentrated ownership and individuals with ownership interests working at the company and in supervisory or officer positions, each of which exacerbates the impact of the rule.
8Federal Regulation and Its Effect on Business—A Survey of Business by the U.S. Chamber of Commerce About Federal Labor, Employee Benefits, Environmental and Natural Resource Regulations, U.S. Chamber of Commerce, June 25, 1996.
11In the Conference Report to the 1989 changes, Congress recommended to IRS that they "develop a policy statement emphasizing that civil tax penalties exist for the purpose of encouraging voluntary compliance." H.R. Conf. Rep. No. 386, 101st Cong., 1st Sess. 661 (1989).