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Reasons for Change

Congress believed that continuation of this credit helps to encourage efficient use of this form of motor transportation.

Explanation of Provision

The 4-cents-per-gallon partial exemption from motor fuels excise taxes for qualified taxicabs is extended through September 30, 1988.

Effective Date

This provision is effective as of October 1, 1985.

Revenue Effect of Items 1-3

The changes in energy tax credits and related energy incentives (items 1, 2 and 3) are estimated to decrease fiscal year budget receipts by $227 million in 1987 and $58 million in 1988, and to increase fiscal year budget receipts by $1 million in 1989, $13 million in 1990, and $9 million in 1991.

4. Duty on imported alcohol fuels (sec. 423 of the Act and general headnote 3(a) and item 901.50 of the Appendix of the Tariff Schedules of the United States) 29

Prior Law

A 60-cents-per-gallon duty is imposed through 1992 on alcohol imported into the United States for use as a fuel.

Ethyl alcohol may enter the United States duty-free, if it is imported from a Caribbean Basin Initiative (CBI) country, under the terms of the Caribbean Basin Economic Recovery Act (CBERA).

Reasons for Change

Congress is concerned that the simple distillation process for dehydrating ethyl alcohol does not represent the type of economic activity that will increase employment and productivity in the Caribbean area in the way that was intended in the CBI program. Use of the process, instead, has become a tactic to circumvent the 60cents-per-gallon duty and to thwart the intent of the U.S. customs


Explanation of Provision

Under the Act, ethyl alcohol (or an ethyl alcohol mixture) may be admitted into the United States duty-free, if it is an indigenous product of a U.S. insular possession or CBI beneficiary country.

Ethyl alcohol (or ethyl alcohol mixture) may be treated as being an indigenous product of an insular possession or beneficiary country only if the ethyl alcohol (or a mixture) has been both dehydrated and produced by a process of full-scale fermentation within that insular possession or beneficiary country. Alternatively, ethyl alcohol (or a mixture) must have been dehydrated within that insular

29 See footnote 25 (above), under Business Energy Tax Credits, for legislative background.

possession or beneficiary country from hydrous ethyl alcohol that includes hydrous ethyl alcohol which is wholly the product or manufacture of any insular possession or beneficiary country and which has a value not less than (1) 30 percent of the value of the ethyl alcohol or mixture, if entered during calendar year 1987, (2) 60 percent of the value of the ethyl alcohol or mixture, if entered during calendar year 1988, and (3) 75 percent of the value of the ethyl alcohol or mixture, if entered after December 31, 1988.

Transitional exemptions are provided during 1987 and 1988 for up to 20 million gallons per year each produced by certain azeotropic distillation facilities: (1) located in a CBI country or insular possession and in operation on January 1, 1986; or (2) the equipment for which was, on January 1, 1986, ready for shipment to and installation in a CBI country. An additional transitional exemption is provided during 1987 to a facility in the Virgin Islands that received authorization prior to May 1, 1986, to operate a full-scale fermentation facility.

In enacting this provision, Congress expresses its disapproval of rulings by the Customs Service that have found the mere dehydration of industrial-grade ethanol into fuel-grade ethanol to constitute a substantial transformation sufficient to qualify the dehydrated ethanol as a product of a CBI country or insular possession and therefore entitled to duty-free treatment. By discouraging such pass-through operations, the conferees seek to encourage meaningful economic investment in CBI countries and insular possessions.

Effective Date

The limitation on duty-free entry of ethyl alcohol that is not an indigenous product of an insular possession or a beneficiary country is effective beginning on January 1, 1987. The two subsequent increases in the indigenous product's minimum value requirement are effective, respectively, on January 1, 1988, and January 1, 1989.

Revenue Effect

The limitation on duty-free entry of ethyl alcohol is estimated to increase fiscal year budget receipts by less than $5 million each fiscal year.


A. Limitations on Losses and Credits from Passive Activities (secs. 501 and 502 of the Act and new sec. 469 of the Code)1

Prior Law

In general, no limitations were placed on the ability of a taxpayer to use deductions from a particular activity to offset income from other activities. Similarly, most tax credits could be used to offset tax attributable to income from any of the taxpayer's activities.

There were some exceptions to this general rule. For example, deductions for capital losses were limited to the extent that there were not offsetting capital gains.2 For purposes of the alternative minimum tax applying to individuals, expensed intangible drilling costs could be used to reduce net oil and gas income to zero, but could not offset other income of the taxpayer. Foreign tax credits could be used to reduce tax on foreign source income, but not U.S. source income. Research and development credits could be used by individuals to reduce tax liability attributable to research and development activities, but not taxes attributable to other income of the taxpayer.

In the absence of more broadly applicable limitations on the use of deductions and credits from one activity to reduce tax liability attributable to other activities, taxpayers with substantial sources of positive income could eliminate or sharply reduce tax liability by using deductions and credits from other activities, frequently by investing in tax shelters. Tax shelters commonly offered the opportunity to reduce or avoid tax liability with respect to salary or other positive income, by making available deductions and credits, possibly exceeding real economic costs or losses currently borne by the taxpayer, in excess or in advance of income from the shelters.

Reasons for Change

Congress concluded that it had become increasingly clear that taxpayers were losing faith in the Federal income tax system. This loss of confidence resulted in large part from the interaction of two of the system's principal features: its high marginal rates (in 1986, 50 percent for a single individual with taxable income in excess of $88,270), and the opportunities it provided for taxpayers to offset

1 For legislative background of the provision, see: H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 1401; S.Rep. 99-313, pp. 713-746; Senate floor amendment, 132 Cong. Rec. S8146-8158 (June 23, 1986); and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 137-150 (Conference Report).

2 In the case of an individual, a net capital loss of up to $3,000 was deductible. Net capital losses of corporations generally were not deductible.

income from one source with tax shelter deductions and credits from another.

The increasing prevalence of tax shelters-even after the highest marginal rate for individuals was reduced in 1981 from 70 percent to 50 percent-was well documented. For example, a Treasury study revealed that in 1983, out of 260,000 tax returns reporting "total positive income"4 in excess of $250,000, 11 percent paid taxes equaling 5 percent or less of total positive income, and 21 percent paid taxes equaling 10 percent or less of total positive income. Similarly, in the case of tax returns reporting total positive income in excess of $1 million, 11 percent paid tax equaling less than 5 percent of total positive income, and 19 percent paid tax equaling less than 10 percent of total positive income. 5

Congress determined that such patterns gave rise to a number of undesirable consequences, even aside from their effect in reducing Federal tax revenues. Extensive shelter activity contributed to public concerns that the tax system was unfair, and to the belief that tax is paid only by the naive and the unsophisticated. This, in turn, not only undermined compliance, but encouraged further expansion of the tax shelter market, in many cases diverting investment capital from productive activities to those principally or exclusively serving tax avoidance goals.

Congress concluded that the most important sources of support for the Federal income tax system were the average citizens who simply reported their income (typically consisting predominantly of items such as salaries, wages, pensions, interest, and dividends) and paid tax under the general rules. To the extent that these citizens felt that they were bearing a disproportionate burden with regard to the costs of government because of their unwillingness or inability to engage in tax-oriented investment activity, the tax system itself was threatened.

Under these circumstances, Congress determined that decisive action was needed to curb the expansion of tax sheltering and to restore to the tax system the degree of equity that was a necessary precondition to a beneficial and widely desired reduction in rates. So long as tax shelters were permitted to erode the Federal tax base, a low-rate system could provide neither sufficient revenues, nor sufficient progressivity, to satisfy the general public that tax liability bore a fair relationship to the ability to pay. In particular, a provision significantly limiting the use of tax shelter losses was viewed as unavoidable if substantial rate reductions were to be provided to high-income taxpayers without disproportionately reducing the share of total liability under the individual income tax borne by high-income taxpayers as a group.

Congress viewed the question of how to prevent harmful and excessive tax sheltering as not a simple one. One way to address the

3 Treasury Department, "Taxes Paid by High-Income Taxpayers and the Growth of Partnerships," reprinted in IRS Statistics of Income Bulletin (Fall 1985), beginning at page 55.

Total positive income was defined as the sum of salary, interest, dividends, and income from profitable businesses and investments, as reported on tax returns.

5 Other studies similarly reached the conclusion that tax shelters, by flowing through tax benefits to individuals with positive sources of income, permitted some taxpayers with sizeable economic incomes substantially to reduce their tax liabilities. See Joint Committee on Taxation, Tax Reform Proposals: Tax Shelters and Minimum Tax (JCS-34-85), August 7, 1985.

problem would have been to eliminate substantially all tax preferences in the Internal Revenue Code. For two reasons, however, this course was determined by Congress to be inappropriate.

First, while the Act reduces or eliminates some tax preference items that Congress decided did not provide social or economic benefits commensurate with their cost, there were many preferences that Congress concluded were socially or economically beneficial. It was determined that certain preferences were particularly beneficial when used primarily to advance the purposes upon which Congress relied in enacting them, rather than to avoid taxation of income from sources unrelated to the preferred activity.

Second, Congress viewed as prohibitively difficult, and perhaps impossible, the task of designing a tax system that measured income perfectly. For example, the statutory allowance for depreciation, even under the normative system used under the Act for alternative minimum tax purposes, reflects broad industry averages, as opposed to providing precise item-by-item measurements. Accordingly, taxpayers with assets that depreciate less rapidly than the average, or that appreciate over time (as may be the case with certain real estate), could engage in tax sheltering even under the minimum tax, in the absence of direct action regarding the tax shelter problem.

Even to the extent that rules for the accurate measurement of income could theoretically be devised, Congress concluded that such rules would involve undue complexity from the perspective of many taxpayers. For example, a system that required all taxpayers to use a theoretically pure accrual method of accounting (e.g., inIcluding unrealized appreciation, and allowing only the amount of depreciation actually incurred for each specific asset in each taxable year) would create serious difficulties in both compliance and administration.

However, Congress concluded that when the tax system permits simpler rules to be applied (e.g., generally not taxing unrealized gain, and allowing depreciation based on broad industry averages), opportunities for manipulation are created. Taxpayers may structure transactions specifically to take advantage of the situations in which the simpler rules lead to undermeasurement or deferral of income.

The question of what constituted a tax shelter that should be subject to limitations was viewed as closely related to the question of who Congress intends to benefit when it enacts tax preferences. For example, in providing preferential depreciation for real estate or favorable accounting rules for farming, it was not Congress's primary intent to permit outside investors to avoid tax liability with respect to their salaries by investing in limited partnership syndications. Rather, Congress intended to benefit and provide incentives to taxpayers active in the businesses to which the preferences were directed.

In some cases, the availability of tax preferences to nonparticipating investors was viewed as harmful to the industries that the preferences were intended to benefit. For example, in the case of farming, credits and favorable deductions often encouraged investments by wealthy individuals whose principal or only interest in farming was to receive an investment return, largely in the form of

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