would get them the same economic income-if they are tax free, the tax exemptions are not as important to them. I just wonder why legislation and why they just could not work out a kind of hybrid kind of conditional royalty contract or something else that would end up being the same thing as a working interest. Mr. SCOGGINS. A considerable amount of time and effort has been devoted to that, as you might imagine. Thus far they have not been able to satisfy the IRS. I don't think there would be any revenue impact whatsoever to this provision. It simply would give these organizations more flexibility in how they manage their endowments and their pension trusts and these type of funds and create greater opportunity for them. It also would provide additional sources of much needed capital for investment in exploration and drilling operations which we presently don't have. That will conclude my testimony on that bill, unless there are other questions. [The prepared statement follows:] STATEMENT OF H. B. SCOGGINS, JR., GENERAL COUNSEL, INDEPENDENT PETROLEUM ASSOCIATION OF AMERICA The Independent Petroleum Association of America is a national organization of some 7,000 independent oil and natural gas producers in every producing area of the United States. IPAA, together with the twenty-nine unaffiliated associations listed on the cover page, represents virtually all independent producers and thousands of royalty owners in the United States. We are grateful for this opportunity to present our views in support of H.R. 4167 to update the definition of unrelated business taxable income in connection with the hearings held by this subcommittee on October 3, 1984. We respectfully request that this statement be made a part of the permanent record of that hearing. In general, the statute now provides that a tax exempt organization is subject to tax at the regular corporate rates on income derived from the active conduct of a trade or business which is not substantially related to the function or purpose upon which the tax exemption is based. These provisions were adopted principally to eliminate a competitive advantage a tax exempt organization would have compared to a taxable entity engaged in the same business. The statutes distinguish income derived from a "trade or business," which is taxable and income derived from investments, which is not taxable. Therefore, income received from interest, dividends, rents or royalties does not affect the tax of the organization except in special situations. In order for the unrelated business tax to be imposed, the exempt organization must be regularly engaged in unrelated activities which constitute a trade or business such as the offering of goods for sale or the performance of services. Where an exempt organization is a member of a partnership, the law currently provides that the partner will receive unrelated business income equal to its share of the income derived from any unrelated business activity conducted by the partnership. Interests in oil and gas properties may be held by an exempt organization in two general forms. The entity may acquire a "nonoperating interest," that is, a right to the reserves in place which is not required to bear a proportionate share of the costs of exploration, development or production. These nonoperating interests commonly take the form of royalties, net profit interests or, in limited circumstances, a production payment. The income derived from these interests is not "trade or business" income and is therefore not subject to the unrelated business tax. Oil and gas reserves may also be acquired through an "operating interest," or an interest which shares in the costs of exploration, development and production. These interests are commonly referred to as working interests and unlike a royalty or similar interest, the participation in costs of development and production place the owner in a "trade or business." This determination is not affected by the nature of the activity actually performed by the interest owner. The working interest owner is engaged in a "trade or business" even where the day to day operation of the property is delegated to a third party operator. Thus it is the nature of the interest in the property and not the activities with respect to the property which determines the existence of a "trade or business." The bill currently before the subcommittee, H.R. 4167, would amend the definition of unrelated business taxable income to exclude working interests held through certain limited partnerships for pension trusts and educational organizations. These provisions would provide needed flexibility to the investment managers of pension funds, individual retirement accounts (IRA) and endowments by enabling them to diversify their portfolios. The bill would also make available a new source of funds to the oil and gas industry which is chronically short of investment capital. Provisions which achieve such desirable policy goals in a manner which is essentially revenue neutral, should not be rejected unless the negative potential is both clear and persuasive. The arguments presented against the provisions appear to be neither. H.R. 4167 acknowledges the economic fact that a net profits interest is substantially equivalent to a limited partnership interest in a limited partnership owning an undivided working interest. In either case, the investor's capital investment is limited to the amount initially contributed to the investment. Income from the net profits interest, however, is not considered unrelated business income while income from the limited partnership interest is considered to be unrelated business income. The essential economic similarity of these types of investments does not support disparate income tax treatment. Limited partnerships owning working interest in oil and gas properties have become the standard vehicle to raise equity capital in the market place. This structure has become widespread primarily because it is simpler to negotiate exploration and development activities with industry partners when all parties, including a limited partnership co-owner, have a full working interest in the properties subject to the joint venture agreement. The principal argument against H.R. 4167 is that it is inconsistent with the theory of the unrelated business tax and that creating an exemption for certain oil and gas limited partnerships will lead to similar treatment for all business activity conducted by limited partnerships. These arguments are clearly strained. The "theory" of the unrelated business tax is to prevent exempt entities from using their exempt status to gain a competitive advantage. An exempt organization which holds a limited partnership interest in a partnership holding working interests has no greater or lesser competitive advantage than if it held the same interest in the form of a royalty or net profits interest. In both situations, the essential source of income is the sale of the production and this function is not affected by the nature of the economic interest held by the exempt entity. The provisions of H.R. 4167 simply allow exempt entities to acquire ownership of oil and gas reserves in a direct, straightforward manner without placing unwarranted emphasis on the legal nature of the economic interest acquired. Concerns that the treatment of oil and gas limited partnerships proposed in this legislation will ultimately extend to other limited partnerships do not appear valid. Although Congress has chosen to treat all limited partnership income as "passive" for individuals (the limited business interest provisions of section 55 IRC for purposes of the alternative minimum tax) concerns over the future direction of policy are not appropriate reasons to object to these provisions. It is also argued that the unique risks of oil and gas investments make this investment inappropriate for institutions such as pension trusts and educational endowments. It is without question that the exploration and development of oil and gas reserves involve great risk. As a result, they are not appropriate investments for those without knowledge and experience in evaluating these investments. The provisions of H.R. 4167, however, do not create new opportunity for exempt entities to expose themselves to risk; the provisions of the bill simply add flexibility to those investments. Exempt organizations, guided by prudent investment advice, can and do now make investments in oil and gas either through royalty interests or through the ownership of stock in producing companies. Depending upon the stage of development, the risk in these investments is just as great as in acquiring a working interest. We would not, however, seek to preclude these investments because of risk, but only require that they be guided by the standards of prudent judgment. It has also been stated in opposition to the bill that there are not sufficient limitations on partnership allocations to prevent the transfer of tax benefits from tax exempt partners to taxable partners. When viewed in context of the existing statutory and regulatory framework, we believe these concerns are overstated. The provisions of the bill when combined with the provisions of section 704, regarding substantial economic effect in partnership allocations, and section 613A, determining basis for depletion, provide a solid basis for denying tax benefits in cases of perceived abuse. To determine the potential for abuse, the entire structure of the Internal Revenue Code must be considered, not just this isolated amendment. In summary, we believe that H.R. 4167 would provide flexibility to institutions and much needed capital to the oil and gas industry with little or no cost to the Treasury. The benefits to be derived from these provisions by both the institutions and the oil and gas industry are obvious, while opposition to the provisions is strained and highly subjective. The provisions of H.R. 4167 represents a well balanced approach to allow institutions to directly acquire interests which they can now acquire only indirectly. The provisions of the bill are a straightforward attempt to update the definition of unrelated business taxable income to reflect current business realities and should be enacted. Chairman STARK. OK. Mr. Duncan, do you have any questions on that? Mr. DUNCAN. I have no questions other than to thank Mr. Scoggins. I have said a number of times that your association always does, I think, make one of the best presentations to this committee. You are always prepared. Mr. Chairman, I have a letter that Mr. Campbell would like to be made a part of the record. It is from the president of the University of South Carolina. Chairman STARK. Without objection, the letter will be included. [The letter appears in the appendix.] Chairman STARK. Do you have testimony on a second bill? Chairman STARK. Proceed. Mr. SCOGGINS. You heard earlier this morning from Mr. Thomas, the principal sponsor of that bill. It concerns the exemption from the windfall profit tax for an amount of crude oil exchanged for fuel oil to be used to fire boilers to create steam for enhancement recovery projects, primarily within the State of California. The Treasury is in support of the bill and indicated that it was simply an oversight in the drafting of the windfall profit tax legislation originally that created this problem. I don't believe there is any need to elaborate on that any further except to indicate that most of the larger producers have been able to make arrangements to burn crude oil and avoid the windfall tax, because they have been able to finance the installation of scrubbers to meet the environmental restraints. Many of the smaller producers just cannot afford the initial capital outlay. These installations cost up to $2 million for installation and can cost as much as $600,000 per year just for operation of the scrubbers on one of these steam generator plants. Consequently, many of the properties owned by the smaller independents are having to be plugged and abandoned prematurely because of the uneconomic situation. I do have some additional data which we received just this morning and were not able to include in our statement for the record. I would like permission to submit it. Chairman STARK. Without objection, we would be glad to have it for the record. Mr. SCOGGINS. I would be glad to answer any questions about that. Chairman STARK. Mr. Duncan. Mr. DUNCAN. I have no questions. Chairman STARK. I have none either. Do we have any other witnesses in the room? I will be glad to take them out of order now. Nobody here to testify on anything at all. You want to introduce any new bills while you are here? The committee will recess until 2 o'cock or 30 minutes after the vote on the issue being debated now. If there is a vote on the floor, we will reconvene 30 minutes after that. Otherwise, at 2 o'clock. [Whereupon, at 1:15 p.m., the subcommittee was recessed, to reconvene at 2 p.m] AFTERNOON SESSION Chairman STARK. The committee will resume. We will call Father Paschal Phillips, Brother Wollman, Brother or Mr. Stevenson, John Huffaker and Leonard Jensen, counsel for the organizations represented by the witnesses to testify on the bill H.R. 4507. And I wanted to bring the regards of Congressman Foley to his friends from the State of Washington. He has been quite busy on the floor of the House debating a rather contentious amendment and was unable to be here and he asked me to send his regards. He is the author of this bill and I was proud to cosponsor it, as a matter of fact, at the request of former Governor Jerry Brown of the State of California. You may proceed in whatever manner. I think we have prepared statements-not only prepared statements, we have prepared sweets and goodies for which I thank you. If you would like to summarize your statement as best you can, you may start in any order that you are comfortable. STATEMENT OF JOHN B. HUFFAKER, COUNSEL, ORDER OF THE CISTERCIANS OF THE STRICT OBSERVANCE, COMMUNITIES OF HUTTERIAN BRETHREN IN WASHINGTON STATE, AND COMMUNITIES OF THE SOCIETY OF BROTHERS Mr. HUFFAKER. Thank you, Mr. Chairman. We appreciate being here. I am John Huffaker, acting as counsel. With me is cocounsel, Leonard Jensen. This bill is sponsored by three groups of religious communities. We have the Hutterian Brethren of the State of Washington who are represented by Jake Wollman; the Order of the Cistercians of the Strict Observance, better known as Trappist, represented by Father Phillips. Father Phillips is from Oregon. Mr. Wollman is from Washington. Then the Society of Brothers represented by Alan Stevenson, of Connecticut. We are very pleased that we have as a sponsor or cosponsor each of the States in which we have a community, and as you know, Mr. Chairman, one of the largest of the Trappist monasteries is in the State of California. We felt the Treasury did a very fair job of summarizing the purpose of the bill. These religious communities do not pay tax on their business income, but the business income is all taxed to the members of the community. In that way it is very much like a partnership or a subchapter S corporation. For years many people thought that because they were required to file partnership tax returns, the provision for partnerships passing the investment credit through to the partners applied to them also. However, the ninth circuit in the Kleinsasser decision, a little over 1 year ago, held that "Reluctantly we affirm. While we see no legislative purpose being served, nevertheless only Congress can provide for the pass through." So, therefore, we have designed a bill working closely with the staff that is constructed to permit the pass through. It is so constructed to produce minimum administrative problems, and we do have one staff amendment that-or one amendment to offer that we have discussed with the staff that would restrict the bill to those religious communities in which all persons enjoy substantially the same standard of living. Now, Mr. Chairman, I want each of the community representatives to explain briefly to you what his community does and as you listen think of the Treasury's objection, the Treasury had two objections. In the first place, they said this might lead to grant of other credits. I want to assure this committee that we do not see any other credits that are either important or really relevant. Second, they said it would give a competitive advantage. We think we presently suffer from a disadvantage because all other taxpayers who make these investments get the investment credit. I would like Mr. Wollman, in not more than 4 minutes, to summarize the situation in the Warden community of the Hutterian Brethren. [The prepared statement follows:] STATEMENT OF JOHN B. HUFFAKER, COUNSEL, COMMUNITIES OF HUTTERIAN BRETHREN IN WASHINGTON STATE, ORDER OF THE CISTERCIANS OF THE STRICT OBSERVANCE, AND THE COMMUNITIES OF THE SOCIETY OF BROTHERS This statement is submitted by John B. Huffaker and Scott B. Lukins as counsel for the following groups: Communities of Hutterian Brethren in Washington State, the Communities of The Order of the Cistercians of the Strict Observance that are described in Section 501(d), and the Communities of the Society of Brothers. Members of each of these groups will appear with the panel at the hearing in order to explain how their communities are conducted and to answer any other questions. Religious communities that elect pursuant to Section 501(d) are not taxed on the income, but the members must report each one's pro rata share of the income as a dividend. Each community is required to maintain a community treasury and as a practical matter the members living in the community actually handle very little cash. Although it is not a requirement of the statute, the members of the communities for whom this statement is submitted are all subject to a vow of poverty. All the corporations are membership corporations, so that the member does not own a fractional interest of the community property. The predecessor of Section 501(d) was enacted about 50 years ago to provide for a special rule for the taxation of those religious communities that were not entitled to income tax exemption under the existing law, because the community conducts a business that supports the community and, if possible, produces an excess that can be used to further the charitable and religious purposes of the community. Section 501(d) is remarkable for the long time that it has been in the Code and the lack of litigation that has surrounded its application. We are informed by the Internal Revenue Service that there are currently about 75 organizations in the United States that have elected under Section 501(d). In many ways Section 501(d) was a very simple form of Subchapter S for membership corporations. It was passed before the investment credit, and it was entirely proper to merely provide for the pass through |