Second, the exception contained in H.R. 2686 for business development companies that are personal holding companies or that would be personal holding companies but for the application of section 542(c)(8) should be deleted. By making such companies ineligible to become RICS, H.R. 2686 is consistent with section 851(a) as it existed prior to this year. The Tax Reform Act of 1984, however, amended section 851(a) by deleting the prohibition against the election of RIC status by a personal holding company (although a RIC that is a personal holding company is subject to tax at the maximum corporate rate on its undistributed income). Since a personal holding company that is registered under the Investment Company Act as a management company may now elect to be treated as a RIC if its meets all other requirements, we see no reason why a personal holding company (or a company that would be a personal holding company but for section 542(c)(8)) that elects to be regulated as a business development company should forgo the opportunity to be taxed as a RIC, as long as its undistributed income is subject to tax at the highest corporate rate. Finally, if enacted H.R. 2686 should be prospective only in its application. Since this legislation is designed to remove a tax disincentive to registration as a business development company, there is no reason to extend its benefits to companies that have previously decided to forgo RIC status by registering as business development companies. Accordingly, we would recommend that this legislation apply only to taxable years ending after the date of enactment.

H.R. 3388

APPLICATION OF SECTION 252 OF ERTA TO CERTAIN TRANSFERS IN 1973

Current law

Prior to the ERTA any taxpayer who received stock subject to section 16(b) of The Securities Exchange Act of 1934, (under which an "insider's" profit may be recovered by a corporation if the stock is sold within 6 months of receipt), was required to treat the value of the stock (less any amount paid) as compensation when received. Section 252 of ERTA revised this rule, on the theory that restrictions on transferability which are mandated by Federal securities laws or accounting principles should be taken into account in determining the time at which the value of the stock should be included in income. After ERTA, any taxpayer who receives stock subject either to section 16(b) or to the "pooling-of-interest" accounting rules will be treated as being subject to a substantial risk of forfeiture within the meaning of Code section 83 for the 6-month period during which the mandated restrictions apply. Thus, the employee will include in income, and the employer may deduct at the time the restriction lapses, the difference between the value of the stock at that time and the amount paid for the stock (if any). This provision applies to transfers after December 31, 1981.

Description of H.R. 3388

H.R. 3388 addresses the effective date of this section and would apply the abovedescribed change in the restricted stock transfer rule prior to its effective date in the following narrowly defined set of circumstances:

The stock was acquired in November or December of 1973 under stock options granted in November or December of 1971;

The corporation granting the options was acquired in a tax-free reorganization occurring in December 1973;

The fair market value of the stock dropped by 50 percent during the holding period before sale;

Substantially all the stock was sold in 1975 or 1976.

If these conditions are met, the taxpayer may elect to apply the provisions of section 252(a) and (b) of ERTA to the extent that the credits or refunds produced thereby do not exceed $100,000 per taxpayer (disregarding interest).

H.R. 3388 is in substance identical to H.R. 4577, introduced in 1982. The narrowly defined set of circumstances described in these bills is meant to describe particular beneficiaries.

Discussion

Treasury opposes H.R. 3388 for a number of reasons. First, because the bill is intended to grant special tax relief to a few individuals, it is inequitable and is the antithesis of sound tax policy. The tax laws cannot be administered fairly if special exceptions are made for favored individuals.

Second, Treasury has consistently opposed any retroactive application of the ERTA change in the restricted property rules. This opposition is consistent with our

general opposition to retroactivity even where, as here, the substantive change in the law is sound.

Third, retroactivity is particularly inappropriate in this case because the bill would permit taxpayers to elect to open years closed by the statute of limitations. The purpose of a statute of limitations is to prevent both the Internal Revenue Service and taxpayers from reopening issues after a certain period of time regardless of how meritorious the position may be. This legislation would clearly violate that rule.

H.R. 3528

DEDUCTION FOR LOSS IN VALUE OF FREIGHT FORWARDER OPERATING AUTHORITIES

H.R. 3284

Current law

DEDUCTION FOR LOSS IN VALUE OF BUS OPERATING AUTHORITIES

On July 1, 1980, the Motor Carrier Act of 1980 was enacted to reduce regulation of the interstate motor carrier industry. The Act made it easier for motor carriers to obtain operating authorities from the Interstate Commerce Commission. Although the legislative deregulation of the motor carrier industry applied only to motor contract carriers and motor common carriers, and not to freight forwarders, the ICC, on its own initiative, and concurrently with the enactment of the Motor Carrier Act, substantially reduced entry restrictions for freight forwarders as well. As a result of this legislative and administrative easing of regulation, the value of previously granted operating authorities held by motor carriers and freight forwarders has declined.

Similarly, the bus Regulatory Reform Act of 1982 (enacted on November 19, 1982), in deregulating the intercity bus industry, substantially eased entry into the intercity bus business. As a result of deregulation, the value of previously granted bus operating authorities has declined.

Under section 165(a) of the Code, a deduction is allowed for any loss incurred in a trade or business which is evidenced during the taxable year by a closed and completed transaction and fixed by an identifiable event. The amount of any deduction allowed may not exceed the adjusted basis of the property involved. No deduction is allowed, however, for a mere decline in value of property. These rules have been applied by the courts to deny deductions for the diminution in value of an operating permit or license in circumstances closely comparable to those presented by the reduced regulation of interstate freight forwarders and intercity bus operators.

After the interstate motor carrier industry was legislatively deregulated, Congress enacted section 266 of the Economic Recovery Tax Act of 1981, as a special relief provision for taxpayers who held motor carrier operating rights at that time. Under section 266, a deduction is allowed ratably over a 60-month period for taxpayers who held one or more motor carrier operating authorities on July 1, 1980. The term "motor carrier operating authority" means a "certificate or permit held by a motor common or contract carrier of property and issued pursuant to subchapter II of chapter 109 of title 49 of the United States Code." Section 266 provides no relief for taxpayers which held operating authorities as freight forwarders. Description of H.R. 3528

H.R. 3528 would amend section 266 of the Economic Recovery Tax Act of 1981 to define the term “motor carrier operating authority" to include a “certificate or permit held by a motor common or contract carrier of property or a freight forwarder." Under this amendment, taxpayers holding operating authorities as freight forwarders on July 1, 1980 would be entitled to deduct ratably over a 60-month period (commencing with the month of July 1980, or, at the election of the taxpayer, with the first month of the taxpayer's first taxable year beginning after July 1, 1980) the aggregate adjusted basis of all all motor carrier operating authorities held by the taxpayer on such date, including those held as a freight forwarder. Description of H.R. 3284

Under H.R. 3284, a deduction would be allowed ratably over a 60-month period (generally beginning with the later of the month of November 1982 or, if later, at the election of the taxpayer, the first month of the taxpayer's first taxable year beginning after November 19, 1982) for taxpayers holding one or more bus operating authorities on November 19, 1982. The amount of the deduction would be the aggregate adjusted basis of all bus operating authorities held by the taxpayer on that

date or acquired thereafter under a contract that was binding on that date, subject to a per-taxpayer limitation of $5 million. The bill also provides authority for the Treasury Department to prescribe regulations under which, for purposes of this deduction, if a controlling stock interest in a corporation holding eligible bus operating authorities was purchased by a person or group of noncorporate persons within a 12month period, the corporation would be able to elect to allocate to the operating authorities a ratable portion of the purchaser's basis in the corporation's stock. This election would be available only if the stock was acquired on or before November 19, 1982, or pursuant to a binding contract in effect on that date.

For purposes of the $5 million limitation, a corporation which is a member of an affiliated group would be treated as a separate taxpayer.

Discussion

H.R. 3528 would expand the scope of section 266 of the Economic Recovery Tax Act of 1981, which allowed taxpayers who held operating authorities as motor carriers of property to amortize the adjusted basis of those operating authorities over a 60-month period. H.R. 3284 would enact substantially similar rules for taxpayers who held bus operating authorities prior to deregulation of the intercity bus industry.

Treasury opposed the enactment of section 266 on the ground that even though the deregulation of the trucking industry caused a decline in the value of the operating rights of motor carriers, those rights continue to have value, since the ICC continues to require a staxpayer to secure such rights in order to conduct a trucking business. We also pointed out that if it was decided that special tax relief should be given to affected motor carrier operators, the proper amount of the loss deduction should be the excess of the taxpayer's basis in the operating rights over the postderegulation value of those rights, not the full amount of the taxpayer's basis in the operating rights.

I would like to emphasize that the deregulation of motor carriers (including freight forwarders) and intercity bus operators is not different from any other deregulation that causes a diminution in value of a license or operating right. Other industries, most notably the airline industry, have been deregulated without the grant of any special tax relief for this reduction in value.

Moreover, our tax system taxes gains and permits a deduction for losses only when those gains or losses are recognized by an identifiable event; in the case of gains or losses attributable to property, this typically occurs upon the sale or exchange of the property. Permitting a current deduction for a decline in the value of assets prior to disposition while not taxing unrealized gains is contrary to our present system of taxation and sets an unfortunate precedent. While we acknowledge that no distinctions can be made between the deregulation of motor carriers, freight forwardes, and bus operators, if H.R. 3528 and H.R. 3284 are enacted the door will be open for all other deregulated industries to seek similar relief. Therefore, we must oppose H.R. 3528 and H.R. 3284 on the same ground as that on which we opposed section 266 of the Economic Recovery Tax Act of 1981.

Additionally, in the case of H.R. 3284, we are concerned that treating members of an affiliated group of corporations as separate taxpayers for purposes of the $5 million per-taxpayer limitation would create an unwarranted distinction between a parent corporation that purchased (before November 19, 1982) a controlling interest in a single subsidiary holding multiple bus operating authorities and a parent corporation that purchased (before November 19, 1982) multiple subsidiaries each of which held a single bus operating authority. Similarly, an unwarranted distinction would exist between a corporation which expended funds to acquire bus operating authorities directly, and one which acquired operating authorities indirectly by purchasing the stock of corporations already holding operating authorities. In both cases, more favorable treatment would be given to the affiliated group more members of which held operating authorities. Accordingly, we oppose the provision of H.R. 3284 that provides that members of an affiliated group would be treated as separate taxpayer for purposes of the $5 million per-taxpayer limitation.

H.R. 4167

EXEMPTION FROM TAX ON UNRELATED BUSINESS INCOME FROM OIL AND GAS INVESTMENTS BY SCHOOLS, PENSION TRUSTS, AND INDIVIDUAL RETIREMENT ACCOUNTS Current law

As discussed earlier, Congress long ago determined that a tax should be imposed on income earned by exempt organizations from business activities that are unrelat

ed to their exempt purposes. The primary purpose of the tax is to prevent exempt organizations engaged in commercial activities from having a competitive advantage over taxable entities. Exemptions from the tax on unrelated business income are provided for rents, royalties, dividends, and interest. The legislative history shows that these particular types of income were exempted because they are "passive" in character, are unlikely to result in serious competition for taxable businesses having similar income, and had long been recognized as a proper source of revenue for educational and charitable organizations.

The passive income exceptions generally do not apply, however, if the income is derived from property that is acquired or improved with borrowed funds. In general, the rules relating to debt-financed property provide that a share of any income from debt-financed property, proportional to the ratio of debt on the property to the adjusted basis of the property, is treated as income from an unrelated trade or business. An exception to the debt-financed property rules provides that income from debt-financed real estate investments of qualified pension trusts and certain educational institutions are not subject to tax, provided certain conditions are satisfied. The original rules relating to debt-financed property were developed in response to abusive sale-leaseback transactions between tax-exempt organizations and taxable owners of active businesses. These transactions typically involved a tax-exempt organization's purchase of an active business, financed primarily by a contingent, nonrecourse note, followed by a lease of the assets of the business to the seller. The effect of these transactions was to convert the ordinary income of the business into capital gains for the seller while allowing the tax-exempt organization eventually to acquire property with little or no investment of its own funds. The primary objection to sale-leaseback arrangements involving borrowed funds was that they permitted an organization's tax exemption to benefit the taxable seller, either by conversion of ordinary income to capital gain or by payment of a higher price for the the property than a taxable purchaser would pay.

Enactment in 1950 of a tax on income from certain leases was insufficient to prevent abuse because new forms of transactions involving leveraged investments quickly developed. In response to these new transactions, the provision was strengthened in 1969 by subjecting to the unrelated business income tax the income received from all kinds of debt-financed property. This broad revision reflected concern not only with existing sale-leaseback transactions, but with the possibility of other abusive uses of leveraged investments by tax-exempt organizations. Description of H.R. 4167

H.R. 4167 would provide an exemption from the tax on unrelated business income for income received by qualified pension trusts, individual retirement accounts, and educational organizations from investments as limited partners in partnerships holding working interests in domestic oil and gas wells. This exemption would not apply if the general partner of the limited partnership were related to one or more of the tax-exempt limited partners. In addition, the exemption would not apply to income allocated to a limited partner during a partnership year in which allocations of deductions, losses, credits, and cash distributions were not consistent with allocations of income or gain. Use of multi-tier partnership or other arrangements for the principal purpose of avoiding these limitations on allocations would be prohibited. The limitations would not apply to allocations of depreciation, depletion, or gain or loss with respect to property contributed to a partnership which are made, in accordance with section 704(c)(2), on a nondiscriminatory basis between exempt and nonexempt limited partners.

The bill also would exempt from the debt-financed property rules a pension trust's, IRA's, or educational institution's share of a limited partnership's income from working interests in domestic oil and gas wells unless

(1) the acquisition price of the working interest is not a fixed amount determined as of the date of acquisition;

(2) the amount of indebtedness incurred in acquiring, developing or operating the working interest or any other amount payable with respect to such indebtedness, or the time for making any payment of any such amount, is dependent, in whole or in part, upon any revenue, income, or profits derived by or from such limited partnership;

(3) the working interest is at any time after its acquisition leased by the limited partnership to the person who sold it to the limited partnership or to certain persons related to the seller;

(4) the working interest is acquired from, or at any time after the acquisition is leased by the limited partnership to, certain persons related to the pension trust or educational organization; or

(5) the seller of the working interest, certain persons related to the seller, or certain persons related to the pension trust, IRA or educational organization provide the limited partnership, the pension trust, or the educational organization with nonrecourse financing in connection with the purchase of the working interest and such financing is subordinate to any other debt on the property or bears interest at a rate which is significantly lower than the rate otherwise available.

However, the last three of these restrictions would not apply to any acquisition, lease, farmout, or other transfer of working interests to a person related to the general partner, provided the terms of such transfer are consistent with the terms of similar transfers in the geographic area.

Discussion

Treasury opposes H.R. 4167. The exemption provided by H.R. 4167 would apply only to income from working interests in oil and gas wells received by pension trusts, IRAs, and schools. However, the rationale given for granting the exemption is that investment through a limited partnership is "passive" in nature and therefore should not be subject to the unrelated business income tax. This rational would apply equally to investments in any active business by any tax-exempt organization as long as the investment was made through a limited partnership. Therefore, adoption of this legislation would lead one to conclude that there should be a repeal of the unrelated business income tax for any investment made through a limited partnership. Such a repeal, however, would be inconsistent with the purpose for which the tax was enacted.

Placing an investment in an active business in a limited partnership does not eliminate the primary problem-unfair competition-to which the unrelated business income tax is directed. The competitive advantages available to a business owned by a tax-exempt entity arise from the fact that the tax-exempt owner does not pay tax on the income received from its equity investment in the business. While the degree to which the tax-exempt organization is involved in the active management of the business may affect whether the attention of the managers of the tax-exempt organization is diverted from exempt activities, it is not relevant to the issue of whether the business obtains a competitive advantage because of its taxexempt ownership.

The exemption from the unrelated business income tax for rents, royalties, dividends, and interest was provided because, in addition to being "passive," investments producing these types of income had long been recognized as proper for educational and charitable organizations and because they did not appear likely to result in serious competition for taxable businesses having similar income. Thus, the "passive" nature of investments made through limited partnerships is not sufficient to justify an exemption from the unrelated business income tax.

Even if the “passive" nature of an investment were sufficient to justify exemption from the unrelated business income tax, limited partners are not necessarily "passive" investors. For example, under the 1976 Uniform Limited Partnership Act, a limited partner is permitted to engage in a number of activities relating to the operation of a business without being considered a general partner. These permitted activities include, among others, consulting with and advising a general partner with respect to the business of the limited partnership and voting on the removal of a general partner. Clearly, limited partners that can consult with and advise a general partner on business matters and can remove the general partner may have substantial active involvement in and control over the business of the limited partnership.

In addition to our objectives to providing a competitive advantage to an active business by allowing tax-exempt ownership through a limited partnership, we are concerned that partnership allocations may be used to transfer tax benefits from tax-exempt partners to taxable partners. We do not believe that the limitations on allocations contained in H.R. 4167 are sufficient to prevent such abuse. Rather, these limitations merely elevate the level of sophistication required to attain the desired results.

The allocation provisions of the bill contain certain technical deficiencies. For example, the bill does not require that allocations of basis be consistent with allocations of income or gain. Since the depletion with respect to an oil or gas property and gain or loss on the disposition of such property are computed at the partner level rather than the partnership level, allocation of basis to taxable partners may have the effect of allocating depletion deductions to taxable partners while allocating gain to tax-exempt partners. Similarly, the allocation rules in the bill do not prohibit the allocation of capital gain to the taxable partners and ordinary income to the tax-exempt partners, nor do they prevent distribution schemes under which