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 partnerships 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 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 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 The Treasury Department opposes S. 1549. The exemption provided by S. 1549 would apply only to income from working interests in oil and gas wells received by pension trusts 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 rationale 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 can be expected to lead to repeal of the unrelated business income tax for any investment through a limited partnership. Exemption from the unrelated business income tax of investments made through limited partnerships would be inconsistent with the purpose for which the tax was enacted. - Placing investments in active businesses 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 tax-exempt 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 new 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 without being considered to have participated in control of a business. 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 the business of the limited partnership. In addition to our objections 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 S. 1549 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 deduction 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 tax-exempt partners receive property on which there is substantial unrealized gain while taxable partners receive property on which there is little or no unrealized gain. In addition, the bill fails to preclude potential abuse through the use of partnership "flip-flops." Although the bill attempts to insure that in each partnership taxable year the tax-exempt partner will be allocated no less a share of partnership loss, deduction, and credit than its share of partnership income and gain, it does not prevent the tax-exempt partner from having a disproportionately large share of all partnership items during partnership taxable years in which net taxable income is expected, and a disproportionately small share of all partnership items during partnership taxable years in which net losses are expected. We also are concerned that investments by tax-exempt entities in limited partnerships engaged in active businesses may be used to benefit taxable persons in ways other than by the transfer of tax benefits. Participation in an active business provides numerous opportunities for subtle forms of self-dealing. For example, exploratory drilling conducted by a limited partnership on a tract of land can benefit owners of adjacent land. We see no justification for allowing tax-exempt income to be used to benefit taxable persons in this way. In addition, removal of the unrelated business income tax on income from limited partnership interests would give tax-exempt organizations an incentive to solicit and accept gifts of "cross over" tax shelters, which would provide additional tax advantages to the taxable investors who make the gifts. Finally, even if limited partnership interests in working interests in oil and gas wells were to be exempt from the tax on unrelated business income, we see no justification for exempting debt-financed investments in such property from the debt-financed property rules. As I have explained, the debt-financed property rules were intended to prevent use of tax exemptions for the benefit of taxable persons. For several reasons, we do not believe the limitations on purchase price and financing provided in S. 1549 would prevent the abusive use of exemptions if debt-financed investments in working interests in oil and gas wells were not subject to the tax on unrelated business income. One possibility for abuse exists because the restrictions on sale-leasebacks in the bill do not apply to sale-leasebacks between a limited partnership and a person related to the general partner. Thus, a tax-exempt organization could enter into a sale-leaseback with a taxable seller if the seller were a general partner and the terms of the sale and lease were consistent with the terms of similar transfers in the geographic area. Another possibility for benefit to a taxable person is that a tax-exempt organization may be willing to pay a higher price for the property than a taxable investor would, particularly since it could obtain nonrecourse financing from the seller. Finally, we are concerned that debt-financing would provide additional tax benefits that might be allocated unequally between taxable and nontaxable partners. For the reasons described above, we oppose S. 1549. This concludes my prepared testimony. to answer your questions. I would be happy Senator ARMSTRONG. Well, Mr. Secretary, I thought maybe you had gotten up on the wrong side of the bed this morning when I heard you mention that you were here to oppose each of these wonderful bills. Is this the first time that you have appeared before the committee? Mr. PEARLMAN. It is, Mr. Chairman. Senator ARMSTRONG. I am especially glad to welcome you. Senator ARMSTRONG. Just to put your testimony in perspective, I was trying to reflect how often the Department has come up and testified in favor of proposed changes in the Tax Code, and I have been consulting the institutional memory here on the dais and they think that maybe only twice in recent years has the Department actually come forward to testify in support of any legislation. And so they tell me that I need not take your comments personally. Mr. PEARLMAN. Certainly not. Senator ARMSTRONG. And that I might even, in looking through your statement, particularly that portion of it in which you comment favorably upon indexing the personal tax rates, I might even recall that at one point the Department was less enthusiastic about that proposal than it is today. And so we are hopeful, as you have a chance to reflect on these issues, that maybe the Department will have a change of heart. Mr. PEARLMAN. Mr. Chairman, one of your colleagues on this committee, a Senator from Missouri, when I discussed coming to Washington with him, said that one of the basic attributes that I would have to learn if I were to represent the Treasury is the ability to say no and to say it frequently. Senator ARMSTRONG. You know, I think he advised me of the same thing when I joined the Senate Finance Committee. [Laughter.] Mr. Secretary, I have several questions to ask you. However, I believe that you are also scheduled to testify this afternoon on another bill. Mr. PEARLMAN. That's correct. Senator ARMSTRONG. Would you like to submit your testimony on that at this time also in order to save coming back this afternoon? Mr. PEARLMAN. Well, I would be happy to, except that the testimony is not quite prepared. Senator ARMSTRONG. Fine. Mr. PEARLMAN. We will be back this afternoon. Senator ARMSTRONG. Let's deal then with the items which you have discussed this morning. And we are very grateful for your testimony, even though I personally may draw some different conclusions. I compliment you on a fine statement. Mr. PEARLMAN. Thank you. Senator ARMSTRONG. First of all, I want to ask about your observations on the indexing of the basis for capital gains. Is it the position of the Treasury Department that you would support this legislation if it was broader in scope? I notice that you emphasized that it was limited, which, of course, is correct. Mr. PEARLMAN. Yes; we have another concern, which I think is probably shared by everyone, and that is the revenue impact of |