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c. Tax Treatment of Payments and Loan Forgiveness Received by Certain Graduate Science Students

Present Law

In general

Subject to several limitations, gross income does not include amounts received as a scholarship at an educational institution or as a fellowship grant (Code sec. 117). In general, a degree candidate may exclude the entire amount of the scholarship or fellowship grant, except for any portion which is regarded as payment for services in the nature of part-time employment. An individual who is not a candidate for a degree is limited to an exclusion of $300 per month for a period of 36 months.

Future services as compensation

In general, scholarships or fellowship grants are not excludable from gross income if they constitute compensation for past, present, or future employment services or for services subject to the direction or supervision of the grantor, or if the funded studies or research are primarily for the benefit of the grantor (Treas. Regs. sec. 1.117-4(c)). However, amounts received under Federal programs that are used for qualified tuition and related expenses are not disqualified from the exclusion merely because the recipient agrees to perform future services as a Federal employee or in a health manpower shortage area (sec. 117(c)).

In 1977, the Internal Revenue Service ruled that awards made under the provisions of the National Research Service Awards Act to individuals who, in return for receiving the awards, must subsequently engage in health research or teaching or some equivalent service (and must allow the government to make royalty-free use of any copyrighted materials produced as a result of the research) are not excludable as scholarships or fellowship grants (Rev. Rul. 77319, 1977-2 C.B. 48). However, this ruling was overturned by the Revenue Act of 1978 for awards made during calendar years 19741979, and by subsequent legislation for awards made through 1983. Income from debt cancellation

As a general rule, income is realized when indebtedness is forgiven or cancelled (sec. 61(a)(12)). In the case of discharge when the taxpayer is in bankruptcy or is insolvent or the discharge of qualified business indebtedness, the discharge amount instead may be applied to reduce tax attributes of the debtor (secs. 108, 1017).

The Tax Reform Act of 1976 provided a special income exclusion rule for cancellation of certain student loans. The exclusion under that rule applied to debt discharges (prior to 1979) pursuant to a loan agreement under which the indebtedness would be discharged

if the individual worked for a period of time in specified professions in certain geographical areas or for certain classes of employers. This rule applied to student loans made to an individual to assist in attending an educational institution only if the loan was made by a government unit or agency. The rule was extended by the Revenue Act of 1978 to such discharges occurring through 1982.

Explanation of Section 4, S. 1194 and Section 4, S. 1195

In general

The bills would provide a new Code section under which gross income would not include amounts received by certain graduate science students as a scholarship, fellowship grant, or qualified student loan forgiveness. The exclusion generally also would extend to amounts received to cover expenses for travel, research, clerical help, or equipment incidental to the scholarship or fellowship grant, so long as such amounts are expended by the recipient, and to the value of contributed services and accommodations.

Qualified recipients

Under the bills, the new provision would apply to students having a bachelor's degree or its equivalent who are engaged in postgraduate study as a degree candidate in mathematics, engineering, the physical or biological sciences, or certain computer fields 35 at qualified educational organizations. The latter term would mean an educational institution that is described in section 170(b)(1)(A)(ii), 36 admits as regular students only individuals having a certificate of graduation from a high school (or the recognized equivalent of such certificate), is legally authorized to provide an educational program beyond high school, and provides an educational program for which it awards a bachelor's or higher degree. Qualified student loan forgiveness would be defined as forgiveness of a loan received by such science students for the purpose of financing their postgraduate study in certain specified fields (but only to the extent that the loan was actually expended for such postgraduate study), where the student is required to perform teaching services for a qualified educational organization on completion of the postgraduate course of study, under the terms of a written loan agreement and as a condition of receiving loan forgiveness.

Limitations on exclusion

The exclusion from gross income under the bills would not extend to amounts received as payment for teaching, research, or other services as part-time employment required as a condition to receiving the scholarship, fellowship grant, or qualified student loan. However, teaching, research, or other services would not be regarded as part-time employment if such activities are required of all candidates (whether or not recipients of funds) for a particular degree as a condition to receiving the degree.

35 In S. 1194, computer science; in S. 1195, computer science and applications. 36 See note 4, supra.

The bills provide that amounts otherwise qualifying for exclusion from gross income as a scholarship, fellowship grant, or qualified student loan forgiveness under the new Code section would not be includible in gross income merely because of a requirement for postgraduate performance of teaching services for a qualified educational organization. For this rule to apply, the recipient also must establish that the amount of the award or grant was used for qualified tuition and related expenses, under the terms of the scholarship, fellowship, or qualified student loan. Qualified tuition and related expenses would be defined as tuition and fees required for attendance and fees, books, supplies, and equipment required for courses at the educational institution.

Effective date

The Scholarship and loan forgiveness provisions of S. 1194 and of S. 1195 would apply to taxable years beginning after the date of enactment.

Senator DANFORTH. The hearing will come to order. Is Congressman Shannon here?

Congressman SHANNON. Yes.

Senator DANFORTH. Good morning. Thank you for being here.

STATEMENT OF HON. JAMES M. SHANNON, U.S.
REPRESENTATIVE, STATE OF MASSACHUSETTS

Congressman SHANNON. Thank you very much for having me. My statement will be brief. I very much appreciate the opportunity to appear before you and discuss the legislation which you are considering today. All of these bills are good ones and I hope that the committee will give them favorable consideration. S. 1194 and S. 1195 are similar to legislation which I have introduced in the House. This legislation will further the progress we have started to make in getting educational institutions and private businesses together to upgrade the scientific and technical training offered to the students who will comprise our future work force.

S. 654 is another important bill. It would overturn the current Treasury regulation on 861 which requires that R&D expenses of corporations with foreign operations are allocated between domestic source income and foreign source income, regardless of where the expenses are actually incurred.

Implementation of this regulation has so far been halted by a congressional moratorium which will expire this year. We must not allow this regulation to go into effect. I believe that it would be a serious deterrent to domestic research and development expenses by companies with foreign operations.

As an original sponsor of the tax credit for incremental R&D expenditures, however, I would like to focus on S. 738, the Research Incentives Continuation Act of 1983, which would eliminate the 1985 sunset on this tax credit and make it permanent. In order to understand why the R&D tax credit is so important, it is helpful to take a look at the situation that existed before it was enacted. There was a growing realization that the continued health and competitiveness of the U.S. economy depended upon constant inno

vation and increases in productivity, and that for the past decade that had just not been occurring. Between 1968 and 1979, expenditures for R&D remained at a stable level in constant dollars, fluctuating between $19 billion and $23 billion. R&D expenditures as a percentage of the GNP, after increasing steadily up until the late 1960's, stagnated through the 1970's. Combined military and civilian R&D reached a high of almost 3 percent of GNP in 1968, then declined to less than 2.3 percent by 1977, and stayed at around that level. Civilian R&D steadily increased to 1.5 percent of GNP in 1968 and has remained at around that level ever since. Meanwhile, civilian R&D had grown to about 1.9 percent of GNP for Japan and 2.3 percent for West Germany. The consequence of this was a steady decline in U.S. productivity between 1969 and 1980.

Adding to this problem was the fact that we were in a period of high interest rates, discouraging all types of investment. This was especially true of R&D where the payoff from investment, if any, is not immediate and concrete but long-term and uncertain. And the ACRS provisions that were proposed and enacted in the same year did very little for the innovative high technology companies whose growth would be most important to the future of our economy because the actual depreciation lives of their principal assets were already as short as the shortest ACRS lives. This is the situation that the R&D tax credit was intended to address, and the situation that, to a great extent, continues to exist. One of the best features of the credit is that it is specifically designed to address this situation. The credit is only for increases in R&D spending; companies that simply maintain their current level of spending and don't try for real innovation will not be able to use it. Thus, if the incentive works as intended, we should see those R&D figures start to move off their plateau and start going up again.

It is a little early yet to be able to tell for sure whether the tax credit is having its intended effect. Tax returns for the years in which it has been in effect have only just begun to be analyzed. Regulations for this provision were only issued last January and are not yet final, creating an uncertainty which may be deterring some companies from using the credit. However, the indications so far are encouraging.

Every year, the McGraw Hill Co. takes a survey of business plans for current and future research and development expenditures. This year's survey has just come out, and while it is not quite as optimistic as last year's projections, it still contains good news on the R&D front. During 1981, R&D expenditures by more than 300 firms surveyed by McGraw Hill increased by 16.5 percent. Last year R&D spending increased by 8.4 percent. This year it is projected to increase by 8.2 percent.

It is important to look at these figures in the light of the recent economic events. First of all, the boom in R&D spending that was getting underway in 1981 collided squarely with the recession. Also, the inflation rate has significantly declined, and spending projections have been adjusted downward to account for this. What is significant, however, is that these companies have still, even during a severe recession, continued to substantially increase their R&D spending. This runs directly counter to the usual trend during and shortly after a recession. Usually at such times, spend

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ing for both capital goods and R&D is cut back, with firms tending to eliminate expenditures that aren't tied to current operations. During this recession, however, firms were making increases in R&D at the same time that they were cutting capital spending. This trend was expected to continue during 1983. The report also found that the ratio of R&D to capital outlays was projected to keep rising through 1986.

The report also noted the possibility that R&D spending could actually rise faster than envisioned by current plans. This is because plans for upcoming years were made during the depths of the recession and might well change as the recovery proceeds, and also because it would be consistent with patterns in recent history.

The R&D tax credit cannot take all of the credit for this new trend, of course. The jump in R&D spending was getting underway even before it was passed. But I am convinced that it constituted an important additional stimulus.

I can see the results in the high technology firms in my own district, companies like Wang, Digital, and Data General. These companies are reporting significant increases in R&D spending, increases far beyond the dollar amount of the credit. These increases can be seen both in absolute dollars and as an increasing percentage of sales, at a time when sales themselves are also growing.

I have received testimony from one of these companies, M/A COM, Inc., a leading firm in the communications area, which I understand will be part of the written record of these hearings. I would urge the committee members to study this testimony carefully. It states specifically that the R&D credit has encouraged M/A COM and companies like it to undertake research and development efforts which they would not otherwise undertake. For this company, the credit during the 2 years it has been in existence "has become imbedded in the thinking" of the company's senior management and it "has had the effect of heightening the corporate priority for research."

I think that we should make sure that this trend continues. A short spurt of increased R&D spending, followed by another drop or plateau, is not going to keep the economy healthy in the long run. We need a permanent incentive. And the fact that a sunset was written into the R&D tax credit provisions does not mean that they were not supposed to be a permanent incentive. The purpose for the sunset was to give Congress a chance to see whether the credit actually worked and whether any of its provisions needed to be adjusted to make it work better. There may well be room to improve the credit by expanding the list of qualifying expenses, for example, and this is something we should look at a little further down the road. But for now, our first priority must be to recognize the fact that the credit is working and that we should make it permanent.

Why eliminate the sunset now? Why not wait until closer to 1985 when we can be more sure of exactly how the tax credit is working? For one very important reason: We must create a climate of certainty for the businesses that will be using the credit. Companies have already been grappling with a great deal of economic uncertainty as they try to plan their future expenditures. It is hard for them to plan their R&D expenditures when they can't even be

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