- Fund Regulation
- Retirement Security
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- ICI Comment Letters
Revenue Provisions in the President’s Fiscal Year 2000 Budget Proposals
the Committee on Ways and Means
U.S. House of Representatives
Statement of the
Investment Company Institute
March 10, 1999
1. Retirement Security Initiatives
Retirement Account Portability. In junction with the Administration’s proposal to enhance retirement asset portability, consideration should be given to a broader approach to enable individuals in any type of individual account program (including 401(k), 403(b), 457, and IRAs) to move assets among these programs as they move from employer to employer over the course of their career.
Small Employer Retirement Plan Coverage. As Administration proposals recognize, the low rate of small employer retirement plan coverage is a matter of serious public concern. The following initiatives should be considered:
- Improve the Savings Incentive Match Plan for Employees (SIMPLE ) program for small employers by permitting employees to defer annually up to the $10,000 limit applied to 401(k) plans.
- Reduce the cost of maintaining retirement plans by eliminating or modifying the top-heavy rule, which inhibits small employer plan formation and, as the Administration proposes, consider a tax incentive to induce small employers to establish plans.
- Assure that any new programs for small employers provide effective incentives for employers and do not undermine currently successful programs, such as the SIMPLE program.
Raising Contribution Limits. Consideration should be given to raising plan contribution limits that inhibit adequate retirement savings, including the $2,000 IRA limit, which has not increased since 1981.
2. Withholding Tax Exemption for Certain Bond Fund Distributions
The proposal to eliminate U.S. withholding tax incentives for foreign investors to prefer foreign funds over U.S. bond funds should be enacted in an expanded form. Specifically, distributions to foreign investors in all U.S. funds—equity, balanced, and income—of interest income and short-term gains should be exempt from U.S. withholding tax to the extent the income and gain would be exempt from tax if received directly or through a foreign fund.
3. Mandatory Accrual of Market Discount
The proposal to require accrual basis taxpayers, including RICs, to currently include market discount in income should be rejected. The proposal’s effects—accelerated inclusion of market discount in the RIC’s taxable income and potential over-inclusions of taxable ordinary income—are inappropriate for a RIC’s individual investors.
4. Increased Penalties for Failure to File Correct Information Returns
The Institute opposes the proposal to increase the penalty for failure to file correct information returns. The current penalty structure provides the RIC industry, which maintains a high level of information reporting compliance, with powerful incentives to correct promptly any errors made.
5. Partial Liquidations of Partnership Interests
The proposal to tax partial liquidations of partnership interests in order to prevent deferral of gain should not apply to RIC feeder fund investments in master fund partnerships. The rationale for the proposal—to prevent deferral—simply does not apply to partial liquidations by RIC feeder funds that need cash to meet shareholder redemptions.
6. Conversions of Large C Corporations to S Corporations
Should the proposal to require current gain recognition on the conversion of a large C corporation to an S corporation be adopted, the Institute recommends that the legislative history make clear that the proposal does not impact Notice 88-96, which provides a safe harbor from the recognition of built-in gains when a RIC temporarily fails to qualify under Subchapter M.
The Investment Company Institute (the "Institute")1 submits for the Committee’s consideration the following comments regarding proposals to (1) enhance retirement security, (2) exempt from withholding tax all distributions made to foreign investors in certain qualified bond funds, (3) require mandatory accrual of market discount, (4) increase the penalties under Section 6721 of the Internal Revenue Code2 for failure to file correct information returns, (5) tax partial liquidations of partnership interests, and (6) modify Section 1374 to require current gain recognition on the conversion of a large C corporation to an S corporation.
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. Mutual funds also serve as an important 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 traditional and Roth IRAs. As of December 31, 1997, mutual funds held over $1.59 trillion in retirement assets, including $774 billion held in qualified retirement plans.3
The Institute has long supported legislative efforts to enhance retirement savings opportunities for Americans; including legislation that would expand retirement savings opportunities, simplify retirement plan administration, and enable individuals to more easily manage their retirement accounts. Therefore, with respect to the items in the Administration’s FY 2000 budget proposal, we support those provisions that would make retirement savings more portable, thus enabling Americans to more easily manage their retirement savings, and those that would increase small employer retirement plan coverage. Nevertheless, we believe that the Administration’s proposals should be modified and broadened in several respects. In particular, as discussed further below, we recommend that (1) the portability proposal be broadened to include 457 plans, (2) the portability proposal be revised to eliminate unnecessary burdens on IRA custodians and trustees, (3) the SIMPLE plan deferral limit be raised, (4) Congress repeal or modify costly regulations that discourage plan formation, such as the "top-heavy" rule, (5) Congress ensure that any new programs do not undermine successful programs already in existence, such as SIMPLE plans, and (6) Congress raise contribution limits for IRAs and employer-sponsored plans and allow older Americans to make "catch-up" contributions.
Retirement Account Portability
Because average job tenure at any one job is under 5 years,4 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.
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.
The Institute supports the Administration’s legislative proposal to permit portability among different types of retirement plans. Such legislation would enable individuals to bring retirement savings with them when they change jobs, consolidate accounts, and more readily manage retirement assets. However, the Administration’s portability proposal should be expanded to permit rollovers of 457 plan amounts to 401(k) plans and 403(b) arrangements and vice versa.
In addition, the Institute believes that portability legislation should be administratively feasible. Therefore, the Institute does not support the Administration’s proposal to require IRA trustees and custodians to track and report the basis related to after-tax rollovers. Currently, IRA trustees and custodians do not verify or track the tax nature of an IRA contribution; this proposal would impose new and burdensome administrative requirements on IRA trustees and custodians with respect to IRA contributions. A specific methodology and tax form already is being used to track basis in IRA accounts, and could be easily adopted for this purpose. Thus, there is no need to create a wholly new reporting and accounting regime.
With respect to its proposal regarding rollovers of IRAs to qualified plans and 403(b) arrangements, the Administration would limit eligibility to those individuals who have a traditional IRA and whose IRA contributions have all been deductible. The Institute recommends expansion of this eligibility provision to permit taxpayers who have made non-deductible IRA contributions to roll over IRA amounts to qualified plans or 403(b) arrangements. Specifically, Congress should permit the rollover of all pre-tax IRA amounts, including deductible contributions and earnings, to plans regardless of whether a taxpayer has ever made a non-deductible contribution to an IRA. The Institute supports similar IRA rollover proposals contained in H.R. 739, the "Retirement Account Portability Act of 1999," which was introduced by Representative Pomeroy (D-ND), and H.R. 1102, the "Comprehensive Retirement Security and Pension Reform Act of 1999," which was introduced by Representative Portman (R-OH) and Representative Cardin (D-MD).
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 sponsor retirement plans. The percentage is even lower in the case of employers with fewer than 25 employees. The enactment5 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) lower the cost of the plan establishment and administration, especially for small employers, by eliminating or modifying regulations, such as the "top-heavy" rule, and providing a tax credit for small employers establishing plans for the first time, and (3) assure that new small employer plan initiatives provide effective incentives for plan establishment and do not undermine currently successful programs.
Raise the SIMPLE Plan Deferral Limitation.
In 1996, Congress created the successful SIMPLE program. The SIMPLE is a simplified defined contribution plan available to employers with fewer than 100 employees. An informal Institute survey of its largest members found that as of March 31, 1998, approximately 63,000 SIMPLE IRA plans had been established by these firms, representing an increase of 47% during the first three months of 1998. Further, the Institute found that approximately 343,000 SIMPLE IRA accounts had been established as of March 31, 1998, representing an increase of approximately 61% from year-end 1997 figures. Most significantly, the informal survey demonstrated that virtually all (98%) of SIMPLE plan formation is among the smallest of employers—those with fewer than 25 employees. Indeed, employers with 10 or fewer employees represented about 90% of these plans. Thus, for the first time, significant numbers of small employers are able to offer and maintain retirement plans for their employees. We believe the SIMPLE plan works because it is, as its name states, simple. It is easy to implement and easy to understand and places little administrative burden on small employers.
Currently, however, an employee working for an employer offering the SIMPLE may save only up to $6,000 annually in his or her SIMPLE account while 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.6
We also believe that the SIMPLE program would be more effective for employers of 25-100 employees if there were a salary-reduction-only formula option. Such an option has been proposed in H.R. 1102 and should be considered as part of any retirement program reform bill seeking to address small employer coverage rates.
Repeal or Modify Unnecessary, Costly Regulations, Such as the Top-Heavy Rule, that Inhibit 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 2000. Such a tax incentive may induce certain small employers to establish retirement plans.
Another approach would be to seek the actual reduction of ongoing plan costs attributed to regulation. For instance, a 1996 U.S. Chamber of Commerce survey showed that the "top-heavy" rule7 is the most significant regulatory impediment to small businesses establishing a retirement plan.8 Repeal or modification of the "top-heavy" rule would likely lead to additional small employer plan formation.
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 using design-based safe harbor formulas in their 401(k) plans.
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 alone may not provide a 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 this already existing, successful small employer program. 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.
Permit Individuals to Save Adequate Amounts for Retirement by Raising Contribution Limits, Including The IRA Limit
Many individuals cannot save as much as they need to under current retirement plan caps. An item notably absent from the FY 2000 budget proposal is a proposal to raise the contribution limits applicable to qualified plans and IRAs. Most significantly, the IRA limit remains at $2,000—a limit set in 1981. If adjusted for inflation, this limit would be at about $5,000. IRAs are especially important for individuals with no available employer-sponsored plan, who are significantly disadvantaged.
Similarly, we believe other retirement plan limits, such as the Section 402(g) limit on salary deferrals and the Section 415 limit on defined contribution plan contributions should be raised. These limits should also be adjusted to reflect the typical work and saving patterns of most Americans. Many Americans find it difficult to save for retirement when they have more pressing financial obligations, including purchasing a home, raising a family, and providing college education for their children. All of these circumstances reflect the need to create a "catch-up" rule for employer-sponsored plans and IRAs whereby individuals age 50 and older can increase their annual contributions. All of these proposals, which are strongly supported by the Institute, are contained in H.R. 1102.
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 $7.6 trillion as of September 30, 1998. 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. Foreign investors may buy U.S. funds for professional portfolio management, diversification, and liquidity. Investor confidence in our funds is strong because of the significant shareholder safeguards provided by the U.S. securities laws. Investors also value the convenient shareholder services provided by U.S. funds.
Nevertheless, while the U.S. fund industry is the global leader, 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.9 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 a U.S. fund are not placed at a U.S. tax disadvantage with respect to distributions of the fund’s long-term gains.
Legislation introduced in both the House and the Senate in every Congress since 1991, and most recently in 1997,10 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.
The President’s Fiscal Year 2000 budget proposal, like the 1999 budget proposal, includes a provision that generally would exempt from U.S. withholding tax all distributions to foreign investors by a U.S. fund that invests substantially all of its assets in U.S. debt securities or cash.11 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. Importantly, the taxation of U.S. investors in U.S. funds would not be affected by the proposal.
The Institute urges the Committee to support enactment of legislation broader than that proposed by the Administration. Specifically, such legislation would exempt from U.S. withholding tax all distributions by U.S. funds—including equity, balanced and bond funds—of interest and short-term capital gains to foreign investors that would be exempt if received by a foreign investor either directly or through a foreign fund.12 Such legislation would eliminate U.S. tax incentives for foreign investors to prefer foreign funds over U.S. funds. Providing comparable withholding tax treatment for all U.S. funds would enhance the competitive position of U.S. fund managers and their U.S.-based work force.
Should the Committee determine to support the Administration’s narrower proposal, which is limited to U.S. bond funds, the Institute recommends that such legislation distinguish between "tax-exempt" and "taxable" foreign securities. Specifically, no limit should be placed on the ability of a U.S. fund to hold a foreign bond, such as a Eurobond,13 that is exempt from foreign tax in the hands of a U.S. investor pursuant to the domestic law of the relevant foreign country (a "tax-exempt" foreign bond). In contrast, strict limits should be placed on the ability of a U.S. fund to hold a foreign bond that would be subject to foreign tax in the hands of a U.S. investor but for an income tax treaty with the United States (a "taxable" foreign bond). Such an approach was followed in legislation introduced last year that was drafted to reflect the Administration’s Fiscal Year 1999 budget proposal.14
Mandatory Accrual of Market Discount
Market discount generally is defined as the excess of the principal amount of a debt instrument (or the adjusted issue price in the case of a debt instrument issued with original issue discount15) over a holder’s basis in the debt instrument immediately after acquisition. A bond typically will trade in the secondary market at a price below its principal amount (and hence with market discount) because an increase in interest rates after the date the bond was issued has reduced its value.16 Assuming no further changes in interest rates or in the creditworthiness of the issuer, the market value of a bond purchased with market discount would increase on a consistent yield basis until its maturity date.
Current law generally does not require any taxpayer—whether the taxpayer determines income on a cash or an accrual basis—to take market discount accruals into taxable income until the date the bond matures or is sold.17 Upon disposition, the amount of gain on a market discount bond, up to the amount of the accrued market discount, is taxed as ordinary income; any excess amount is treated as capital gain. Among the reasons for not taking market discount accruals into income on a current basis are that market discount (1) arises from market changes that affect the yield of a bond rather than from the terms of the bond itself, (2) may not be realized in part or in whole by any holder disposing of a bond prior to maturity,18 and (3) can be difficult to compute.
Under the President’s Fiscal Year 2000 budget proposal, accrual basis taxpayers would be required to include market discount in income currently, i.e., as it accrues.19 The holder’s yield for market discount purposes would be limited to the greater of (1) the original yield-to-maturity of the debt instrument plus five percentage points or (2) the applicable Federal rate (at the time the holder acquired the debt instrument) plus five percentage points. Importantly, the proposal would not apply to cash basis taxpayers, such as individuals.
The Institute urges the Committee to reject the proposed requirement that accrual basis taxpayers, such as RICs, currently include in taxable income their market discount accruals. First, the proposal would accelerate the inclusion of market discount in the RIC’s taxable income without the receipt of any cash that could be used by the RIC to meet its distribution obligations to its shareholders.20 Second, the proposal would result in over-inclusions of taxable ordinary income to the extent that a bond purchased with market discount is sold for an amount that is less than the purchase price plus accrued market discount. These results are particularly inappropriate for a RIC’s individual shareholders, who would experience neither income acceleration nor over-inclusion of market discount if they were to make comparable investments directly.
To illustrate these effects, assume a bond with a principal amount of $10,000 and a five percent coupon payment that has five years to maturity. Further assume that a RIC acquires this bond for $9,000 and holds it for three years. Finally, assume that interest rate fluctuations between the date the bond was acquired by the RIC and the date the bond was sold were such that the value of the bond, at disposition, was only $9,500.
Under current law, the RIC accrues $200 of market discount each year, but need not include the accruals in income until the year of sale.21 Upon disposition, the RIC would treat the $500 gain ($9,500 proceeds less $9,000 basis) as ordinary income.
As the proposal would not apply to cash basis taxpayers, an individual that held the market discount bond directly would continue to receive the same tax treatment that the RIC receives under current law; prior to disposition, no amounts would be includible in taxable income.
In contrast, the proposal would require the RIC to treat the $200 accrual in each of the three years as ordinary income, which must be distributed currently by the RIC to its shareholders. Upon disposition, at which time the RIC’s cost basis has been increased to $9,600 (to reflect the $600 of market discount included in income), the RIC would have a $100 capital loss. This loss could be used by the RIC to offset capital gain at the RIC level, but could not be "flowed through" to the RIC’s shareholders.22
The proposal also should be rejected because of the potential negative impact on the liquidity of bonds (tax-exempt bonds, in particular) in any interest rate environment in which existing bonds would trade at a significant discount to principal amount. Because of the potential negative tax consequences of purchasing market discount bonds (e.g., accelerated inclusion of ordinary income and capital losses in the event of subsequent interest rate increases), RICs and other accrual basis taxpayers might have strong incentives to buy only newly issued bonds.
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 $250,000.23 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 2000 budget contains a proposal that 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.24 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 urges the Committee to reject 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 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.25 The current penalty structure provides adequate, indeed very powerful, incentives for RICs to promptly correct any errors made.
Partial Liquidations of Partnership Interests
Under current law, a partial liquidation of a partnership interest is taxable only to the extent that any cash distributed exceeds the partner’s adjusted basis in its partnership interest immediately before the distribution. Thus, in the case of a "master/feeder fund structure,"26 a RIC feeder fund partner typically may liquidate a portion of its interest in the master fund partnership in the ordinary course of its business without incurring capital gain on its underlying investment in the partnership. A RIC feeder fund will partially liquidate its interest in the master fund partnership on any day in which it needs to generate cash to meet shareholder redemptions.27
Under the President’s Fiscal Year 2000 budget proposal, a partial liquidation of a partner’s interest in a partnership would be taxed as a complete liquidation of that portion of the partner’s interest.28 Gain or loss on the partial liquidation would be determined by allocating the distributee partner’s basis ratably over the portions of the partnership interest that are liquidated and retained. The rationale for the proposed change, according to the Treasury Department’s "General Explanations of the Administration’s Revenue Proposals," is that the current law rules "provide for an inappropriate deferral of gain."
Should the Committee decide to expand the circumstances in which partial liquidations of partnership interests are taxed, the Institute urges the Committee not to apply the change to RIC feeder fund investments in master funds. This exception should be made because the rationale for the proposal—to prevent deferral—simply does not apply.
Under current law, the shareholder in a RIC feeder fund whose redemption request triggers the RIC’s need for cash, and hence the partial liquidation of the RIC’s interest in the master fund partnership, already is required to take into account currently any gain—attributable to appreciation in the value of the shareholder’s investment, through the RIC, in the master fund partnership—on the shares redeemed. The existing basis calculation rules of Section 1012 and share redemption rules of Section 302 apply to prevent deferral.
The only impact of applying this proposal to master/feeder funds would be to require a taxable distribution by a RIC feeder fund of gains to its non- redeeming shareholders, who did not trigger the partial liquidation.29 This result would be unfair and presumably is unintended. Consequently, should the Committee determine to pursue the Administration’s proposal, an exception for the master/feeder fund structure should be adopted.
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 2000 budget proposes to repeal Section 1374 for large corporations.30 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, no longer would 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 typically are middle-income 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 this proposal be adopted, 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.
1The Investment Company Institute is the national association of the American investment company industry. Its membership includes 7,446 open-end investment companies ("mutual funds"), 456 closed-end investment companies, and 8 sponsors of unit investment trusts. Its mutual fund members have assets of about $5.662 trillion, accounting for approximately 95% of total industry assets, and have over 73 million individual shareholders.
2All references to "sections" are to sections of the Internal Revenue Code of 1986, as amended (the "Code").
3"Mutual Funds and the Retirement Market," Fundamentals, Vol. 7, No. 2 (Investment Company Institute, July 1998).
4"Debunking the Retirement Myth: Lifetime Jobs Never Existed for Most Workers," Employee Benefit Research Institute, Issue Brief No. 197 (May 1998).
5In 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.
6As noted below, we also believe that the limits under Section 402(g) should be raised.
7Section 416 of the Internal Revenue Code. The "top-heavy" rule requires employers, in situations where over 60 percent of total plan assets represent benefits for "key" employees, to (1) increase the benefits paid to non-key employees, and (2) accelerate the plan’s vesting schedule. Small businesses are more likely to have individuals with ownership interests working at the company and in supervisory or officer positions, each of which are considered "key" employees, thereby exacerbating 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.
9The U.S. statutory withholding tax rate imposed on non-exempt income paid to foreign investors is 30 percent. U.S. income tax treaties typically reduce the withholding tax rate to 15 percent.
10The "Investment Competitiveness Act of 1997" was introduced by Representatives Crane, Dunn and McDermott (as H.R. 707) and by Senators Baucus, Gorton and Murray (as S. 815).
11The proposal would be effective for taxable years beginning after the date of enactment.
12This legislation should contain appropriate safeguards to ensure that the exemption (1) applies only to interest that would be exempt from U.S. withholding tax if received by a foreign investor directly or through a foreign fund and (2) does not permit foreign investors in U.S. funds to avoid otherwise-applicable foreign tax by investing in U.S. funds that qualify for treaty benefits under the U.S. treaty network.
13"Eurobonds" are corporate or government bonds denominated in a currency other than the national currency of the issuer, including U.S. dollars. Eurobonds are an important capital source for multinational companies.
14The "International Tax Simplification for American Competitiveness Act of 1998" was introduced in the House by Representatives Houghton, Levin, and Crane (as H.R. 4173) and in the Senate by Senators Hatch and Baucus (as S. 2331).
15Original issue discount ("OID") is defined generally as the excess of a debt instrument’s stated redemption price at maturity over its issue price. The total amount of OID on a debt instrument generally does not change over the period the debt instrument is outstanding.
16A decline in the creditworthiness of an issuer also may cause a bond to trade in the secondary market at a discount.
17Partial principal payments on a market discount bond are included as ordinary income to the extent of accrued market discount. Holders also may elect to take market discount accruals into income currently.
18The amount that ultimately will be received upon the sale of a bond depends, among other things, upon future changes in interest rates. If interest rates increase, bonds purchased with market discount may be sold at a loss; in this case, none of the accrued market discount ever is realized.
19The proposal would apply to debt instruments acquired on or after the date of enactment.
20Under Section 852(a), a RIC must distribute at least 90 percent of its ordinary income with respect to its fiscal year to qualify for treatment under Subchapter M of the Code. In addition, under Section 4982, a RIC will incur an excise tax unless it distributes by December 31 essentially all of its calendar year ordinary income (and capital gain through October 31).
21Alternatively, a RIC could elect to accrue the market discount on a "constant yield" basis under Section 1276(b)(2).
22RICs may not flow through capital losses to their investors, pursuant to Subchapter M of the Code. Capital losses may be carried forward for eight years, pursuant to Section 1212(a)(1)(C)(i). In recent years, some RICs investing in bonds have been unable to generate sufficient capital gains to offset losses carried forward before they expired.
23Failures attributable to intentional disregard of the filing requirement generally are subject to a $100 per failure penalty that is not eligible for the $250,000 maximum.
24The proposal would be effective for returns the due date for which (without regard to extensions) is more than 90 days after the date of enactment.
25In 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).
26The master/feeder structure has developed as a vehicle pursuant to which RICs (known as "feeder funds") generally invest substantially all of their assets in one partnership (known as the "master fund"). On occasion, institutional investors or other entities also may be feeder funds.
27RIC feeder funds typically are structured as open-end investment companies, the shares of which are redeemable upon shareholder demand pursuant to the Investment Company Act of 1940. On occasion, RIC feeder funds also may be structured as "interval funds," which issue shares that are redeemable on a periodic, rather than daily, basis.
28The proposal would apply to certain partial liquidations made after date of enactment. From a discussion with a Treasury Department official, we understand that the proposal is not intended to be applied on a daily basis.
29The distribution requirements applicable to RICs require that dividends be declared ratably to all RIC shares outstanding on the date the dividend distribution is declared. Unlike the rules applicable to partnerships, no ability exists to specially allocate the gain to the redeeming RIC shareholder.
30The proposal to repeal Section 1374 for large corporations would apply to Subchapter S elections first effective for a taxable year beginning after January 1, 2000 and to acquisitions (e.g., mergers) after December 31, 1999.