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respect to those participants who received prohibited allocations. Thus, failure to comply results in income inclusion for those participants of the value of their prohibited allocations on the date of such allocations.

Second, if there is a prohibited allocation or accrual, then a 50 percent excise tax is imposed on the amount involved in the prohibited allocation. This excise tax is to be paid by the employer who maintains the ESOP or by the eligible worker-owned cooperative. The deduction provided by section 2057 does not apply unless the employer files with the Secretary a written statement acknowledging its potential liability for the 50 percent excise tax.

Deduction for dividends paid on employer securities

Under the Act, the deduction for dividends paid on employer securities is expanded to apply to dividends that are used to make payments on ESOP loans (including payments of interest as well as principal). Such repayments are not treated differently from repayments attributable to nondeductible dividends for purposes of applying the limit on employer deductions (sec. 404(j)) or for purposes of applying the limitations on benefits and contributions (sec. 415). With respect to allocated employer securities, the deduction for dividends paid on employer securities is available only to the extent that the dividends are paid out currently to plan participants or beneficiaries. With respect to unallocated employer securities, the deduction is available to the extent that the dividends are used to repay acquisition indebtedness incurred to acquire the employer securities on which the dividends are paid or are paid out currently to participants or beneficiaries in proportion to the stock allocated to their accounts.

Partial exclusion of interest earned on ESOP loans

Definition of securities acquisition loan

In general.-The Act makes several changes to the definition of "securities acquisition loan." The Act (1) clarifies the definition of securities acquisition loan in the case of a loan to a sponsoring corporation with a corresponding loan from the sponsoring corporation to the ESOP ("back-to-back" loans); (2) includes in the definition of securities acquisition loan a loan to a corporation if, within 30 days of the date of the loan, employer securities are transferred to the plan in an amount equal to the proceeds of such loan and such securities are allocable to participant accounts within 1 year of the date of such loan ("immediate allocation loans"); (3) clarifies that the refinancing of a loan to an ESOP after May 23, 1984, will qualify as a securities acquisition loan; and (4) clarifies the definition of securities acquisition loan with respect to loans within a controlled group of corporations.21

Back-to-back loans.-The Act clarifies the definition of a securities acquisition loan in the case of a loan to a corporation. The Act provides that a loan to a sponsoring corporation will qualify as a securities acquisition loan if the terms of such loan are substantially similar to the terms of the corresponding exempt loan from the

21 Items (1) and (4) are in the technical corrections portion of the 1986 Act.

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corporation to the ESOP (i.e., a back-to-back loan). In addition, the Act provides that, if the terms of the 2 loans are not substantially similar, the loan to the sponsoring corporation will still qualify as a securities acquisition loan if (1) the corresponding loan to the ESOP provides for more rapid payment of principal or interest than the loan to the sponsoring corporation; (2) the allocations of stock within the ESOP attributable to the difference in payment schedules do not result in discrimination in favor of highly compensated employees; and (3) the total commitment period of the loan to the sponsoring corporation is not more than 7 years.22

The 7-year limitation applies to the total commitment period. Thus, provided the final maturity of the credit arrangement is not greater than 7 years, the funds may be provided by one or more lenders in a series of shorter maturity loans, each of which (other than the first) is used to repay the preceding loan. If the total commitment period of the loan is extended beyond 7 years, then the partial exclusion will apply for the first 7 years of the loan only.23 The 7-year limitation on the term of the loan does not apply to loans directly from a commercial lender to an ESOP or to back-toback loans if the terms of the loans are substantially similar. For example, assume a bank makes a loan to employer X with a term of 10 years and employer X in turn makes a loan to its ESOP. If the terms of the two loans are substantially similar, then the partial interest exclusion is available for the entire 10-year commitment period of the loan. Similarly, the partial interest exclusion applies for the entire commitment period of the loan if the loan is made directly from the bank to the ESOP.

Immediate allocation loans.—The Act extends the definition of "securities acquisition loan" to include certain loans to a corporation which are used by the corporation to purchase employer securities that are immediately allocated to employees' accounts. Thus, the partial exclusion is available with respect to interest paid on a loan to a corporation to the extent that (1) within 30 days of the date of the loan, employer securities are transferred to the ESOP in an amount equal to the proceeds of the loan, (2) such contributions are allocable to accounts of plan participants within 1 year of the date of the loan, and (3) the total commitment period of the loan does not exceed 7 years. In general, the date of a loan is the date interest begins to accrue on the loan.

As in the case of other loans to which the 7-year limitation applies, the limitation applies to the total commitment period. Thus, provided the final maturity of the credit arrangement is not greater than 7 years, the funds may be provided by 1 or more lenders in a series of shorter maturity loans, each of which (other than the first) is used to repay the preceding loan. If the total commitment period of the loan is extended beyond 7 years, then the partial exclusion will continue to apply for the first 7 years of the loan.24 Refinancings.-The Act clarifies that the refinancing of a loan to an ESOP (other than an immediate allocation loan or a back-toback loan that has terms that are not substantially similar) after

22 This provision is contained in the technical corrections provisions of the Act (sec. 1854(c)). 23 A technical correction may be needed so that the statute reflects this intent. 24 A technical correction may be needed so that the statute reflects this intent.

May 23, 1984, will qualify as a securities acquisition loan provided that (1) the original loan met the requirements of section 133(b)(1); (2) the original loan was used to acquire employer securities after May 23, 1984; and (3) the total commitment period of the loan does not exceed the greater of the original commitment period of the original loan or 7 years.25 The limitation on the commitment period of refinancings of immediate allocation loans and back-toback loans which have terms that are not substantially similar is described above.

If a securities acquisition loan (other than an immediate allocation loan or a back-to-back loan that has terms that are not substantially similar) is refinanced and as a result the total commitment period exceeds the greater of the original commitment period or 7 years, then the partial exclusion will continue to apply, but only for interest paid during the first 7 years of the commitment period or the original commitment period, whichever is greater. For example, if an otherwise qualified securities acquisition loan to an ESOP with an original commitment period of 5 years is refinanced and the commitment period is extended for 2 years (for a total commitment period of 7 years), the partial exclusion will apply for interest paid during the entire 7 years of the loan.

However, under the Act, if the terms of the back-to-back loans are no longer substantially similar as a result of the refinancing, the partial exclusion is available only for interest paid during the first 7 years of the loan.

All refinancings, including refinancings of back-to-back loans which are not substantially similar, are required to comply with section 4975.

Controlled group loans.-The Act clarifies that, although a securities acquisition loan may not originate with any member of the controlled group, it may be held by any member of the controlled group. However, during any such time that a securities acquisition loan is held by a member of the controlled group, any interest received with respect to such loan during such period will not qualify for the exclusion provided under section 133.

Eligible lenders.-Under the Act, a lender eligible for the interest exclusion is amended to include a regulated investment company (as defined in sec. 851). Congress intended that the tax treatment accorded such income be permitted to "flow through" to shareholders of the regulated investment company under rules analogous to the treatment of interest paid on certain governmental obligations as described in section 103(a).

In determining whether a regulated investment company qualifies to pay exempt-interest dividends, 1⁄2 of the outstanding balance of such securities acquisition loans held by a regulated investment company is treated as obligations described in section 103(a)(1). One-half of the interest on such securities acquisition loans are treated as interest excludable under section 103(a) for purposes of determining the amount of exempt-interest dividends that the regulated investment company may pay.

25 A technical correction may be needed so that the statute reflects this intent. Such a technical correction was included in the versions of H.Con.Res. 395 that passed the House and Senate in the 99th Congress.

The written notice of designation requirements applicable to exempt-interest dividends applies to dividends attributable to securities acquisition loans. Congress intended, however, that the regulated investment company include in such notice an explanation to shareholders that this income is partially excludable from tax because the interest thereon is utilized to repay a loan structured to acquire employer stock for employees through an employee stock ownership plan.

It is intended that a regulated investment company that is otherwise fully invested in ESOP obligations will be permitted to pay out exempt-interest obligations despite having certain amounts of cash or other assets on hand at the end of a taxable quarter, and expects that the Secretary will promulgate appropriate regulations in this regard.

Because only 50 percent of the interest income from ESOP loans is exempt from tax, Congress believed that, for this purpose, it may be appropriate for a mutual fund to have 2 classes of stock, 1 of which pays exempt-interest dividends and the other of which pays taxable dividends.26 Such allocation is to be reflected in the notice of designation. Any such 2-class arrangement is not subject to the rules of section 654 (relating to series funds) because there will not be segregated portfolios of assets.

Effective Dates

Estate tax deduction for sales to an ESOP

The provision relating to the deduction of 50 percent of the proceeds of a qualified sale from the gross estate (including IRS Notice 87-13) is effective for sales after October 22, 1986, and before January 1, 1992, by the executor of an estate required to file a return (including extensions of time) after October 22, 1986.

Deduction for dividends paid on employer securities

The provision relating to the deductibility of dividends is effective for taxable years beginning after October 22, 1986.

Partial exclusion of interest earned on ESOP loans

The provision relating to the availability of the section 133 interest exclusion in the case of back-to-back loans the terms of which are not substantially similar and controlled group loans are effective as if included in DEFRA, i.e., they are effective with respect to loans made after July 18, 1984, and used to acquire employer securities after such date.

The modification made by the Act with respect to immediate allocation loans is effective for loans incurred after October 22, 1986. The provision that makes a regulated investment company a lender eligible for the interest exclusion under section 133 is effective with respect to loans used to acquire employer securities after October 22, 1986, including loans that are refinancings of loans used to acquire employer securities before such date if such loans were used to acquire employer securities after May 23, 1984.

26 Rev. Rul. 74-177, 1974-1 C.B. 165.

The refinancing provision is effective with respect to loans used to refinance a loan which met the requirements of section 133 and which was used to acquire employer securities after May 23, 1984.27

Revenue Effect of ESOP Provisions

The provisions of the Act relating to ESOPs are estimated to increase fiscal year budget receipts by $1,013 million in 1987, $879 million in 1988, $221 million in 1989, and $51 million in 1990, and to decrease fiscal year budget receipts by $40 million in 1991.

27 A technical correction may be needed so that the statute reflects this intent.

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