Report of the Treasury Department pursuant to Section 308(g)(2)(F) of the Small Business Investment Act, as amended

Estimates of tax revenue losses and gains from the tax treatment of small business investment companies, 1966

A. SUMMARY

The full extent of tax revenue gains and losses attributable directly and indirectly to the special tax provisions applicable to Small Business Investment Companies (SBICS) and to Small Business Investment Company financing of business taxpayers is almost impossible to measure because of lack of necessary information. The readily quantifiable portions of the aggregate tax benefits accorded SBICS and their shareholders are estimated to be in the range of $0.3 million and $1 million in 1966. The effects of SBICS on Federal tax revenues are traceable to two sources. First, and directly, to those provisions of the Internal Revenue Code which specifically differentiate the tax status of SBICs from other corporations and which also accord special tax benefits to those individuals who trade in SBIC stocks. Second, and indirectly, to the impact of SBIC financing of small businesses and thereby on the business income tax base generally. These two sources of tax effects are interrelated: the special tax provisions provided by Congress may channel more private capital to small businesses than would normally be available to them in established capital markets; and, owing to these tax incentives, the lost tax revenues due to these special tax provisions would nevertheless be compensated eventually by the expanded tax base and increased revenue flow among the SBIC financed small businesses.

At this time, the state of knowledge of the direct and indirect effects of SBIC taxation does not permit a measurement of these effects on revenue flows to the Treasury. Information available to the Treasury is limited to that provided by taxpayers in their tax returns. Unfortunately, of all taxpayers affected by SBIC-related tax policy, only SBICs are specifically identifiable as such in tax returns. From the required entries in tax returns there is no way of distinguishing those individuals who may own, or have exchanged, stock in SBICS from the owners of other securities; nor are SBIC-financed businesses distinguishable from businesses not receiving such assistance. There is thus little prospect of extracting from tax returns the kind of information which might shed

1 Report as submitted by the Department of the Treasury.

light on tax payments directly affected by any specific SBIC tax provisions of the code.

As for the indirect effects of these provisions, any meaningful evaluation would require a detailed and comprehensive analysis of the changes in performance of the entire economy attributable to SBIC operations, including analysis of what SBIC-assisted firms would have done in the absence of this assistance and analysis of whether less expansion of SBIC-assisted firms would have resulted in more expansion of other firms. Such an evaluation and economic analysis transcends the information limits of tax returns. Thus, a reliable assessment of both the direct and indirect effects of tax policy pertaining to SBICS could be accomplished only after completion of a fullfledged study of the economics of SBIC financing of small businesses.

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B. SOME LIMITED ESTIMATES

The Technical Amendments Act of 1958 provided a number of tax advantages to SBICs and their stockholders. The amended Section 243 (a) of the Internal Revenue Code allowed SBICs to deduct all dividends received from domestic corporations in arriving at taxable income rather than the 85-percent deduction allowed other corporations. Section 1243 of the code also permits SBICs to treat losses on convertible debentures, or on the stock into which the debentures are converted, as ordinary rather than capital losses. Also, Section 1242 permits any individual taxpayer who incurs a loss in the sale or exchange of SBIC stock to treat such loss as ordinary rather than as a deduction from capital gains. On the other hand, any profit realized from the sale or exchange of SBIC stock would receive capital gains treatment.

Section 542 (c) (8) of the code also exempts SBICS from taxation as personal holding companies under certain circumstances. It is believed that this provision has negligible revenue significance.

As for the revenue effects of Section 1242, since the present format of personal tax returns does not require identification of the special benefit from this section, it is impossible to estimate the resultant loss of tax revenues. For a somewhat different reason, no estimate can be made of the revenue consequences of Section 1243. In this instance, the losses on debentures which SBICS have taken as deductions against ordinary income are not tabulated separately in published data. Information extracted from business tax returns for tabulation and publication in the Statistics of Income is limited in detail to that generally applicable to all businesses. Although bad debt

2 Neither the Treasury nor the Small Business Administration has been authorized to undertake such a study at present.

expense is tabulated for all businesses, this does not include Section 1243 losses."

The revenue differential attributable to the full dividend deduction provision of Section 243 (a) probably amounted to about $32,200 for 1966.*

In addition to these code provisions, Revenue Ruling 64– 48 administratively allowed SBICS to maintain bad debt reserve ceilings equal to 10 percent of outstanding loans over a 10-year period ending December 31, 1968, and hence, to charge as bad debt expense 10 percent of any increment to loans outstanding during a tax year. The effect of this ruling is to exampt, for the stipulated period, SBICS from the application of regulation 1.166-4 which requires taxpayers who utilize the bad debt reserve method to support their choice of a reserve ratio with evidence of its reasonableness. The extent of this preference in terms of

reductions in SBIC tax liabilities cannot be measured directly. However inferences which may be drawn from evidence of SBIC bad debt experience indicate that the revenue effect of the ruling may have amounted to between $0.3 and $1 million. The magnitude of this estimated revenue loss to the Treasury is substantiated by an imputation from the experience of comparable financial institutions.

Apart from the direct revenue effect of particular tax provisions designed to stimulate the SBIC program, a more general revenue effect from the standpoint of the Treasury resulting from the full range of Government incentives provided to SBICS may reach several million dollars if we take the experience of comparable financial institutions to represent the normal tax yield from the investment of private funds in the business financing industry."

3 In order to obtain information on Sec. 1243 losses, all SBIC tax returns would have to be sifted out from the files of the Internal Revenue Service and reviewed, a costly procedure for which the necessary resources are not budgeted.

• According to their tax returns filed for the period July 1966 to June 1967, the SBICs took about $899,000 of deductions for dividends received, $464,000 by the 321 SBICs reporting net income and $435,000 by 333 SBICs without income. For the SBICS with net income, this constituted a deduction $70,000 greater than would have been taken under the normal 85-percent dividend credit allowed all other corporations. Assuming for 1966, 34 percent of the taxable income of these SBICs was taxed at the normal rate of 22 percent while 66 percent of the income was subject to surtax of 26 percent, and the weighted average tax rate is therefore 39.2 percent, these 321 SBICs with net income are thus estimated to have saved $27,440 of taxes. For the SBICS without net income, the dividend credit was $65,250 larger than normal for corporations; it was assumed that onethird of this, if not allowed, would have caused the affected SBICS to become taxable at the normal rate of 22 percent, and this yields an estimated tax saving of $4,740. This amount and $27,440 estimated above for SBICs with net income total $32,180.

The actual bad debt loss experience of SBICS compiled by the Small Business Administration is summarized in table F-1. This table indicates that the actual loss experience of these SBICs, not including an indeterminate number that were licensed and then disappeared, is between 4.53 and 8.56 percent of all loans made. The lower figure represents the ratio of all losses to all loans made by Mar. 31, 1968; the higher figure represents the ratio of the same losses to all loans made before Mar. 31, 1965. Due to the length of the average term of an SBIC loan, the first figure is clearly an understatement of the relevant average loss ratio the actual losses now known are an incomplete record of the losses which will be ultimately generated by the loans tabulated. On the other hand, the higher figure is probably a slight overstatement of the loss experience, for it arbitrarily excludes loans during the latest 3 years from the denominator of the ratio while including at least some of the losses attributable to them in the numerator-a procedure which had to be employed because of the lack of individual loan detail in the original data collection. No data are available on those SBICs which left the program voluntarily and those in receivership. Most of these

are believed to have experienced substantial losses.

According to tax returns for 1966, about 320 SBICs with net income deducted a total of $5 million for bad debts. If the actual bad debt loss rate were as low as 4.53 percent, the ruling in effect allowed a 55 percent extra margin, or $2.7 million in terms of extra allowable deductions. This amounted to an estimated tax saving of about $1 million.

At the loss rate of 8.56 percent the extra margin would be 14 percent, or the value equivalent of about $0.7 million, and the tax benefit of about $0.3 million.

If the bad debt experience of the business credit agencies (BCA's) of comparable size is taken as the lower limit of expected bad debt expense deduction of SBICs, the difference between this base and the deduction actually taken by SBICs for tax purposes should establish an upper bound to the amount of tax preferences given to SBICS by Revenue Ruling 64-48.

Table F-2 shows selected financial data of BCA's reporting $25 million or less of total assets compared with similar data of SBICS. The BCA's deductions for bad debts equalled 0.94 percent of receivables among those firms with net income, and 5.2 percent among those without net income. These percentages were applied to SBIC receivables, and the excess bad debt deduction allowed SBICs for tax purposes is calculated at $3.8 million for those with net income and $1.5 million for those without net income. On the basis of an average tax rate of 40 percent for those with net income and 22 percent on one-third of the increment in taxable income of those without income, the maximum likely tax preference given to SBICS by the ruling is estimated at $1.6 million for 1966.

Table F-2 shows that private citizens had invested $299 million in 654 SBICs which yielded a tax payment of $2 million in 1966. In contrast, private citizens had invested $676 million in 3,652 BCA's and this investment yielded a tax payment of $21 million in that same year. From the Treasury point of view, encouragement to investors to invest in SBICs by provision of low-interest loans and the incorporation of tax preferences for SBICS had reduced the tax yield from such capital from 3.1 percent paid by private investment in BCA's to 0.7 percent paid by private investment in SBICs. Thus,, if the experience of BCA's represents the normal tax yield from investment in the business finance industry, an estimated loss in tax revenues arising from the taxation of SBICs themselves would be about $7 million.

Report of the Treasury Department pursuant to Section 308(g) (2) (G) of the Small Business Investment Act, as amended

Section 308 (g) (2) (G) of the Small Business Investment Act, as amended, directs the Treasury Department to make recommendations of "additional tax incentives

1 Report as submitted by the Department of the Treasury.

to improve and facilitate the operations of Small Business Investment Companies and to encourage the use of their financing facilities by eligible small business concerns." In view of the limited evidence presently available concerning the effectiveness of small business investment companies operating under the current provisions of the Internal Revenue Code, no recommendations for revision of the tax laws affecting these companies are being submitted at this time.