The final point I want to emphasize is the problem created by current law in regard to gifts to colleges and university foundations. Apache, like many other energy companies, is committed to the support of our educational system. There are five officers of our company who are serving on college and university boards, boards of education and as trustees. There is a great interest in their continuing operations and financing. We are concerned about the fact that our company's oil and gas working interests cannot be contributed as gifts to the colleges and universities we represent. We hope to continue our involvement, work, and associations with the college and university foundations for this purpose.

I understand that H.R. 4167 will produce no revenue loss, and from that standpoint, additional tax deductions such as the deductions for depletion and intangible drilling costs, will not only be foregone by exempt institutions but will not be utilized by other investors.

In regard to pension funds, you will find that these investors will be paying taxes on this money eventually as they move into their retirement period.

So I would like to encourage this committee to move with all haste and report this bill favorably.

Thank you.

[The prepared statement and additional comments follow:]

STATEMENT OF EDWIN E. CAIN, VICE PRESIDENT FOR Government RelaTIONS,

APACHE CORP.

Mr. Chairman, my name is Edwin E. Cain. I am representing Apache Corporation as Vice President for Government Relations. Apache Corporation is a domestic oil and gas exploration, development and production company with major agriculture operations in Wyoming and California. Apache has since 1956 offered to the public limited partnership interests in registered drilling partnerships, one of the first companies to offer this type of investment program. Its corporate headquarters are located in Minneapolis, Minnesota, and it has operations in more than 30 states. Apache's twenty-six history in oil and gas public programs and its experience in working with tens of thousands of investors during this period has enabled the corporation to develop a reputation for sound, careful management. Based on our experience and our knowledge of the industry, Apache fully supports HR. 4167, introduced by Congressman Jenkins and co-sponsored by twenty-two of his colleagues.

H.R. 4167 would permit qualified trusts and certain educational institutions to receive income from limited partnership that own working interests in domestic oil and gas properties without becoming subject to tax under the unrelated business taxable income provisions of the Internal Revenue Code.

In the brief time allotted me today, I would like to emphasize three major points which demonstrate the need for amending this provision of the Internal Revenue Code, one which has existed for more than 30 years.

1. EQUAL ACCESS TO CAPITAL

Petroleum exploration and development is a capital intensive business, requiring continuous infusions of new capital. The lack of new capital has contributed to the recent sharp reduction in the exploration and development activities of the 7,000 independent producers who are responsible for developing most of the nation's new oil and gas production. The domestic oil and gas industry's need for capital from the investing public to explore for and develop reserves is exactly the same as that of dividend and interest paying commercial corporations. Yet although interest and dividend income from normal commercial operations is not unrelated taxable income, income from oil and gas operations (other than royalties) is so taxed. The current unrelated business taxable income provisions penalize, through taxation, those college endowments and pension funds that choose to invest in oil and gas working interests. Yet these investments, if made as limited partners, are equally as passive as their other investments.

Thus, the unrelated business income tax effectively precludes access to an investment pool of more than $500 billion for the oil and gas industry while depriving pensions and endowment funds of the potentially higher rates of return that such investments afford.

2. DIVERSIFICATION OF INVESTMENTS

Broad diversification of investments is the basis of sound money management. Energy industry investments frequently are structured in a format other than the traditional stocks and bonds. While large pension trusts have developed programs and procedures for investing in gas and oil activities to take advantage of this phenomenon, the smaller endowments and pension funds have been deprived of this opportunity, because investment opportunities cannot be tailored to their needs without creating unrelated business income.

In his testimony before the Senate Finance Committee on August 1, 1983, concerning the Senate version of H.R. 4167, Paul Overgaard, manager of small pension funds for Independent Service Company, stated "This legislation will make prudent diversification possible and will be of particular interest to the kind of plans we serve. There are millions of small employers in this country, and a great many of them will welcome this change as an opportunity to diversify their investments and hopefully achieve a better rate of return and, thus, a better retirement for their employees."

3. GIFTS TO EDUCATIONAL INSTITUTIONS

A major concern among Apache management has been the inability of college and university endowments to accept gifts of oil and gas limited partnership interests. Currently, five Apache officers and managers are serving on the boards of educational institutions. I am sure this is not unusual among energy companies throughout the United States. A recent experience by an Apache officer resulted in a significant donation to a university being rejected on the basis that it would produce unrelated business income tax. This is neither a unique nor an unusual situation. Under current law, when a tax-exempt organization accepts gifts of oil and gas properties owned in limited partnership form, such investments are usually sold at a considerable loss in order for the organization to avoid becoming subject to the unrelated business income tax.

Many investors in oil and gas limited partnerships are active alumni and supporters of their educational institutions. H.R. 4167 will provide opportunities for gifts and investments that our colleges and universities sorely need.

Higher education has been confronted with severe economic problems during the past few years. Traditional sources of revenue have been greatly reduced at the very time that greater demands are being made on these institutions. H.R. 4167 permits college and university endowments to receive gifts of oil and gas limited partnership interests, thus providing a much needed, new source of income.

Mr. Chairman, it is my understanding that this legislation will result in no revenue loss because exempt institutions that are not now investing in oil and gas properties will do so in the future by transferring to this industry investment funds already producing income that is not taxed. In addition, the tax deductions, such as the deductions for depletion and intangible drilling costs, will not only be foregone by the exempt investing institutions themselves but will not be utilized by any other investor. H.R. 4167 is clearly beneficial to the domestic oil and gas industry. It is clearly beneficial to educational endowment funds and pension trusts across the country. It will cost the Treasury nothing. All of this being so, I can't think of more sensible legislation. I hope that H.R. 4167 will be favorably reported by this Subcommittee.

ADDITIONAL COMMENTS OF EDWIN E. CAIN

At the hearing held before the Subcommittee on Select Revenue Measures of the House Committee on Ways and Means on H.R. 4167 on October 3, 1984, Mr. Mikel M. Rollyson, Acting Tax Legislative Counsel of the Department of the Treasury, appeared in opposition to H.R. 4167. He advanced a number of reasons for Treasury's opposition to H.R. 4167. These comments are submitted in response to Mr. Rollyson's testimony.

HR 4167 will not lead to repeal of the unrelated business income tax

Mr. Rollyson's first objection is that enactment of this legislation can be expected to lead to repeal of the unrelated business income tax whereever exempt organiza

tions invest through limited partnerships. This conclusion represents a misunderstanding of the forms of oil and gas investments and of the competitive effects of the bill, coupled with an overly restrictive interpretation of the intent of Congress in enacting Section 512 of the Internal Revenue Code in 1950 (which excluded, among other items, royalties and net profit interests from unrelated business taxable income).

Treasury appears to fear that H.R. 4167 will constitute precedent that would erode the long-standing rule that an exempt organization's share of income from a partnership is unrelated business taxable income regardless of whether the exempt organization is holding its interest in general or limited partnership form. This, most assuredly, will not be the case. In permitting certain exempt investors to hold oil and gas working interests as limited partners without incurring unrelated business income tax, H.R. 4167 is effectuating a limited legislative change that would do no more than equate one type of passive investment in oil and gas properties (i.e., investments as limited partners in working interests) with a type of passive investment in oil and gas interests that has long been exempt from unrelated business income tax under IRC § 512 (i.e., investments in royalties, net profit interests and production payments). The limited partnership format is used as a ready administrative device to assure that the owner of the working interest holds the investment passively, thereby equating it in all respects to a royalty or net profit interest. There would be no policy or other reason to extend the principle of H.R. 4167 to free exempt limited partners from tax on income from active types of business operations such as automobile manufacturing or spaghetti making.

Operating interests (i.e., working interests) and nonoperating interests (i.,e., royalty and net profit interests) are treated differently for purposes of the unrelated business income tax even though the exempt organization may engage in no greater activities with respect to the operating interest than the nonoperating interest. It is the nature of the interest in the properties and not the activities with respect to them which determines the existence of a "trade or business." This lack of differentiation between type of interest and nature of activities for tax purposes is not a rational one and, as discussed below, no policy consideration requires that it be maintained.

The legislative history of the Revenue Act of 1950 discloses no policy reason why income from working interests, if held passively, should be treated differently from income from rents, royalties, dividends and interest, which, as Mr. Rollyson observed, are the traditional types of income long recognized as proper for educational and charitable organizations. The purpose of the unrelated business income tax was to prevent tax exempt organizations engaged in business from gaining a competitive advantage over taxable businesses. However, the legislative history makes it clear that Congress intended to exclude “overriding" royalties from unrelated business taxable income, thereby benefitting the landowner. H. Rep. No. 2319, 81st Cong., 2d Sess. 38 (1950). The regulations extended the definition of royalty to include net profit interests and certain production payments. Treas. Reg. § 1.512–1(b). Excluding such income from unrelated income has obviously not resulted in serious competition for taxable businesses having similar income. However, Mr. Rollyson implies that exending the definition of royalties to include passively-held working interests would be likely to result in serious new competition for taxable businesses having similar income. The contrary is, in fact, the case: this action will stimulate competition in the oil and gas industry.

H.R. 4167 will stimulate competition in the oil and gas industry

A fair reading of the bill discloses that it is neither intended to, nor will its consequences be, to provide exempt organizations with an anti-competitive advantage over taxable oil and gas businesses. Rather, the purpose of the legislation is to facilitate-without any material loss of revenue-increased portfolio investment by exempt organizations in the oil and gas industry through established investment channels, thereby benefitting the entire industry. This is done by requiring such investment to be made through programs managed and operated by taxable, non-controlled general partners. In this way, all taxable oil and gas operators will have access on equal terms to a new source of capital. At present, investment by exempt organizations in oil and gas properties can be made only through liquidating vehicles such as royalty trusts or through highly sophisticated institutional programs especially designed for major exempt funds.

Further, the proposed ligislation is no more anti-competitive than existing law as it applies to oil and gas investment. Under present law, tax-exempt investors can pool tax-exempt income by investing in royalty interests or net profit interests. As I have noted above, income from these types of investments is excluded from unrelat

ed business income tax. Such income can therefore be accumulated without tax by the exempt organization to acquire further investments.

Limited partners are passive investors

Mr. Rollyson argues that limited partners are not "necessarily" passive investors and that they enjoy opportunities for "substantial active involvement" in the business of the venture. This appears to be a clear misreading by him of the law of limited partnerships. The rights granted to limited partners under the 1976 Revised Uniform Limited Partnership Act (RULPA), as under its predecessor, the Uniform Limited Partnership Act (ULPA), are in fact extremely restricted.

Basically, these rights are to inspect and copy certain of the partnership records (§ 305(1)); to obtain from the general partner information about the state of the business and financial condition of the partnership (§ 305(2)(i)), copies of the partnership's tax returns (§ 305(2)(ii)), and other information regarding the partnership's affairs as is just and reasonable; and to apply for judicial dissolution and winding up of the partnership (§§ 802, 803). In addition, but only to the extent that the partnership agreement does not have specific governing provisions, a limited partner is entitled to allocations of profits and losses (§ 503) and distributions (§ 504) on the basis of his relative contribution; to withdraw upon six months' notice (§ 603); upon withdrawal to receive the fair value of his interest (§ 604); to assign his interest (§ 702); to wind up the partnership (§ 803); and to receive distributions upon winding up of the partnership (§ 804). Whether rights in the foregoing respects are granted in the partnership agreement or, because the agreement is silent, by RULPA, they cannot be said to cause the limited partner, his relation to the partnership's investment or the partnership's investments themselves to be active rather than "passive."

Contrary to the suggestion in the Treasury Statement, RULPA does not give a limited partner the right to consult with and advise a general partner or to vote on removal of a general partner. Those are simply some of the activities that a limited partner may engage in without being considered to have participated in control of the business of the partnership so as to endanger his limited liability (§ 303). For a limited partner to have rights in those respects, they must be granted in the partnership agreement. Even where rights in those respects are granted in the partnership agreement-for instance, the right of limited partners having a specified minimum percentage of the total partnership interests to vote to remove a general partner or to dissolve the partnership-they do not cause the limited partners to be other than "passive" investors in the partnership. Corporate investors also have voting rights, but exempt organizations holding stock in corporations are not deemed to be active investors merely by virtue of possessing such rights. Both the investing limited partner and the investment that results in distribution to him of a share of partnership income are no less "passive" than the nonmanager stockholder of a corporation and the investment that results in dividends to him out of corporate income.

The question of special allocations

Mr. Rollyson further indicated concern that partnership allocations may be used to transfer tax benefits from tax-exempt partners to taxable partners. The bill already contains a number of provisions carefully designed to deal with this problem, and I am sure the sponsors of the legislation would have no objection to amending the legislation to include further restrictions designed to remedy any technical difficulties identified by Mr. Rollyson.

I would also like to point out that after the introduction of H.R. 4167, Congress developed special rules for dealing with the problem of allocations of income and loss between taxable and tax-exempt partners as part of the tax-exempt leasing provisions of the Tax Reform Act of 1984. These provisions are contained in Section 168(j)(9) of the Internal Revenue Code, and I am sure the sponsors of the legislation would not object to substituting a cross-reference to the requirements of Section 168(j)(9) for the allocation rules presently contained in the bill. Indeed, the provision exempting real estate investments of certain exempt organizations from the acquisition indebtedness rules (IRC § 514(c)(9) was amended in the 1984 Act to include a cross-reference to that subsection.

Other concerns

Mr. Rollyson also expressed concern that investments by exempt entities in limited partnerships might be used to benefit taxable partners in ways other than by the transfer of tax benefits. For example, a limited partnership with exempt partners might conduct exploratory drilling on a tract of land that could benefit the owners of adjacent land. This is a problem that exists with respect to any investment by tax-exempt entities regardless of the form of investment. Moreover, the problem

may be less pronounced in the area of investment in oil and gas limited partneships because state laws and the guidelines of the North American Securities Administrators Association impose fiduciary obligations on general partners that run to limited partners, taxable and exempt alike.

Mr. Rollyson's final point is that H.R. 4167's allowance of debt financing would lead to the abusive use of exceptions. He objects in particular to the fact that restrictions on sale-leasebacks in the bill do not apply to sale-leasebacks between the limited partnership and a person related to the general partner. The answer to this concern is that it is frequently necessary in the oil and gas industry to permit financing arrangements or property transfers between affiliated entities and the bill not only contains the same anti-abuse provisions included by Congress in IRC § 514(c)(9) (relating to real estate debt financing by pension funds) but also a further safeguard against sale-leaseback abuses, namely, that the terms of any sale or lease must be consistent with the terms of similar transfers in the geographic area. Since such similar transfers would involve taxable persons on both sides of the transaction, it is just not likely, as an economic matter, that oil and gas programs operated by taxable general partners but having exempt limited partners would be able to trade on the exempt status of the latter. if so, the Treasury is provided with adequate tools in its arsenal to attack the transaction.

Chairman STARK. Mr. Graham.

STATEMENT OF C. ANDREW GRAHAM, PRESIDENT, OIL INVESTMENT INSTITUTE, AND PRESIDENT, CHAIRMAN OF THE BOARD, AND CHIEF EXECUTIVE OFFICER, OF EMCOR PETROLEUM, INC., DENVER, CO

Mr. GRAHAM. Thank you, Mr. Chairman.

My name is Andy Graham. I am the president of the Oil Investment Institute. I also serve as chairman of EMCOR Petroleum out of Denver, CO. We sponsor SEC registered public oil and gas income programs for the public.

We appreciate the opportunity to appear before the subcommittee to express our support for this bill and I respectfully request that this statement be made a part of the permanent record of this hearing.

Chairman STARK. Without objection.

Mr. GRAHAM. The Oil Investment Institute is a national trade association comprised of 26 independent oil and gas producers who sponsor federally-registered limited partnerships for oil and gas. These companies account for approximately 80 percent of all the public funds invested and our members cumulatively manage currently in excess of $6 billion of public funds.

In our role as a manager of these funds, the performance record of public oil income programs in preserving capital and providing attractive returns has drawn the attention and the interest of retirement trusts and college endowments.

These entities are seeking to enlarge their investment opportunities by accessing the domestic oil and gas industry. Investments which provide increased rates of return, long-term growth possibilities, and portfolio diversification are being sought by these portfolio managers.

Because the Tax Code currently permits an investment by tax exempt entities in such things as royalties and net operating profits, oil company debt and stocks without the imposition of the unrelated business taxable income, certain sponsors have structured oil investments for the tax-exempt investors. Most sponsors, however, are deterred by the cost of creating these so-called hybrid type in