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Senator ARMSTRONG. I also want to refer to one other question that was raised by the Department. Again, I quote, a business that is owned by a tax exempt entity often has a competitive advantage over a similar business owned by taxable persons. Would that apply in the case of El Pomar and the ownership of the Broadmoor?
Mr. HYBL. No; it certainly would not apply, Mr. Chairman, in that the Broadmoor Hotel does pay full taxes like any other taxable entity. The trustees of the El Pomar Foundation have viewed investment in the Broadmoor Hotel similar to the way that they would look at IBM, Zerox or any other profit making entity, expecting a full and fair return.
Senator ARMSTRONG. Thank you, Mr. Hybl.
Mr. Morris, don't feel obligated to comment on those questions because I think they are new to you at least, but if you would care to we would welcome your response.
Mr. MORRIS. I believe that I can respond just as Mr. Hybl has, that certainly since 1969 there has been no hint that the Altman Foundation has been involved in any transaction that would involve any of the issues raised by the Treasury Department. And similar to Mr. Hybl's response with respect to unfair competitive advantage, the foundation which owns B. Altman and Co. owns a company which is subject to all State, local and Federal taxes just as any other taxable entity, and does not enjoy any particular tax favored status.
Senator ARMSTRONG. I appreciate that. And I would invite each of you if you would like to review at your leisure the statements submitted by the Treasury Department, and if you have any written thoughts that you would like to add. Our hope is that the Senate will adopt this legislation, whether the Treasury Department has a different thought later or not. But it will be helpful if we can answer these questions point by point. And I noted-I think neither of you were in the room this morning-but I noted that in recent years on only two occasions has the Treasury Department testified in favor of legislation. It is their norm to come in and testify against anything that is proposed, and rightfully so in a sense. It is their job to, in effect, defend the status quo at least in part, and they have done that. But whatever answers you have on the issues they have raised we would be glad to have.
Unless Senator Long has something else, I think that takes care of what we need to do on S. 1464.
Mr. HYBL. Thank you, Mr. Chairman.
Senator ARMSTRONG. Thank you, gentlemen.
We now come to S. 1549, which would permit individual retirement accounts, qualified retirement trusts, and certain educational organizations to invest in working interests in oil and gas properties without incurring unrelated business taxable income.
STATEMENTS ON INTRODUCED BILLS AND JOINT RESOLUTIONS UPDATING THE
By Mr. Armstrong, Long, Durenberger, Wallop, Grassley, Symms, Bentsen, Baucus, Boren, Pryor.
S. 1549. A bill to amend the Internal Revenue Code of 1954 to permit individual retirement accounts, qualified retirement trusts and certain educational organizations to invest in working interests in oil and gas properties without incurring unrelated business taxable income.
UPDATING THE UNRELATED BUSINESS INCOME TAX
Mr. ARMSTRONG. Mr. President, legislation I have introduced with Senators Durenberger, Long, Wallop, Grassley, Symms, Bentsen, Baucus, Boren and Pryor could, once enacted, increase profits earned by pension plans and college endowments, at the same time, infuse new and badly needed capital in domestic oil production.
This legislation is nearly identical to H.R. 7217, a House bill introduced by Representatives Jenkins, Matsui, Gephardt, and Frenzel, and is simple in concept. It permits pension plans and college endowments to treat, for tax purposes, income from oil and gas production exactly like income earned from stocks, bonds, and royalties. Once enacted, an additional investment pool of more than $500 billion would be available for investment in oil and gas production, and at the same time give pensions and endowments possibly higher rates of return on their holdings.
Some background on current tax law will explain the need for this legislation. Most college endowments and private pension plans are granted tax exempt status. Even if they are tax exempt, some sources of income received by pensions and endowments can, under current law be taxable. For Federal tax purposes, there are two sources of income-passive and unrelated business-for pensions and endowments. Passive income-not taxed-usually is interest and dividends earned on stocks, bonds, and royalties. Unrelated business is income taxed at corporate rates because, in theory, the income is derived from a business or investment not related to the purpose of the pension or endowment for which it received its tax exempt
This tax theory is 30 years old, and it makes sense. It seeks to eliminate unfair competition to taxpaying businesses by taxing their competitors controlled by tax organizations on the same basis. For example, an endowment owning controlling interest in a manufacturing plant should be taxed on the same basis as the manufacturer's competitor.
Generally, endowment and pension income that is exempted from the unrelated business income-or UBTI-will not be taxed. The problem is that in the past 30 years there has been precious little updating of UBTI. The result is not surprising. Changing economic conditions and new investment opportunities have somewhat outdated the unrelated business income tax. For example, it used to be that stocks and bonds enjoyed high rates of return and tax exempt organizations invested in them heavily. But the past 10 years have found the traditional equities-stocks and bonds-have been hard pressed to maintain an economic rate of return.
Simultaneously, however, direct investments in oil and gas producing properties have proved to be low risk, consistently performing assets that have brought yields outpacing inflation rates. Solomon Bros. reports that annual rates of return for oil assets have outpaced return rates on real estate, stocks, gold, and silver.
But the problem is that the current UBTI taxes earnings from most oil and gas production holdings of pension plans and private investments. The inevitable result is that pension and endowment trustees do not invest in oil and gas production and are foreclosed from higher investment returns than are available from stocks and bonds. Concurrently, oil and gas producers lose access from a large investment pool, estimated to be about $500 billion.
The bill I am introducing today is the solution to this problem. This bill permits pension and college endowments to invest through limited partnerships in working interests in oil and gas properties without being subject to the unrelated business income tax. This legislation is consistent with the underlying theory of the UBTI because it permits these funds to only passively invest in oil and gas production meaning that the pension and endowment trustees cannot take part in the control of the business of producing oil and gas.
The bill has important safeguards that should make this bill noncontroversial: First. Pension plans and endowments can only invest as a passive owner in a limited partnership, meaning they cannot exercise control in business decisions. In fact, limited partners exercise even less control over business decisions than stockholders do.
Second. Only qualified pension funds and educational organizations, as already defined in current tax laws, are covered under this legislation.
Third. These funds can only invest in working interests in oil and gas properties, meaning they must pay a share of the development and operating costs to receive a
share of income. The definition of working interest is the same now used in current law.
Fourth. Pension plans and endowments will receive no benefit from income tax credits and deductions available to taxable limited partners. The bill also precludes allocations of these deductions and credits to taxable partners.
Fifth. Pensions and endowments will not receive exempt income from working interests held by a limited partnership if either organization is related to the general partner.
There are a number of reasons why this bill should pass, and soon. First, the bill has no revenue loss since investments in oil and gas production will only augment investments otherwise made in currently tax-exempt investments.
Second, the bill encourages portfolio diversification by pension plans and endowments that control nearly $500 billion.
Third, this bill offers the promise of higher rates of return than these pensions and endowments now presently receive.
Fourth, it will infuse new and badly needed capital in oil and gas production without raising energy prices. In fact, capital expenditures this year in oil and gas activity has decreased 35 percent this year.
Fifth, the legislation is consistent with the underlying theory governing unrelated business taxable income.
Sixth, this legislation corrects an anomaly in the current UBTI law. Currently, pensions and endowments can receive tax free income from oil royalties-simply investments in oil and gas activities where the investor pays none of the development costs-but cannot receive tax free income from working interests in oil producing properties. In both types of oil investments-royalty and working interest programs-investors are passive * exercising no control over business decisions. Thus, partnerships owning working interests should be subject to the same tax rules as are applied to oil royalties.
This legislation is nearly identical to legislation I introduced in 1982. A number of important provisions have been added to address issues raised since the bill was first introduced. These provisions, about four in number address concerns raised about partnership allocation, abusive sale-leaseback arrangements, and the use of debt in buying shares in a limited partnership.
I welcome further consideration of this bill.
Senator ARMSTRONG. We welcome a panel consisting of Dwight Moorhead, vice president of Petro-Lewis from Denver; I. Jon Brumley, president of the Southland Royalty Co. of Fort Worth, Tex.; Paul F. Overgaard, vice president, Independent Service Company, of Albert Lea, Minn.; and Bert H. Murphy, of the Murphy Energy Corp., Roswell, N. Mex. Gentlemen, would you come forward, and we will be pleased to have your statements.
Mr. Moorhead, why don't you begin. I know that you have a statement and we would be glad to have that. And it is possible that we will also have some questions as we go on.
STATEMENT OF DWIGHT MOORHEAD, VICE CHAIRMAN, PETROLEWIS CORP., DENVER, COLO.
Mr. MOORHEAD. Thank you, Mr. Chairman. I first have to wonder if anyone has taken the opportunity, with the permission of the committee, to wish you Happy Colorado Day.
It is appropriate to note that I have previously submitted written testimony, and I would ask at this time that it be entered into the record of these proceedings. Further, Bert Murphy, as a result of an unexpected family situation, is unable to attend today, but has asked me to request that his written testimony, which he had intended and expected to present today, be included in the record.
Further, Ed Cain, from Apache Corp., is at this table, with the permission of the committee.
[The prepared statements of Dwight Moorhead and Bert Murphy follow:]
TESTIMONY OF DWIGHT C. MOORHEAD
SUBCOMMITTEE ON TAXATION AND DEBT MANAGEMENT
Mr. Chairman, my name is Dwight Moorhead. I am Vice Chairman of the Board of Petro-Lewis Corporation. Petro-Lewis is an independent producer of oil and gas headquartered in Denver, Colorado. Petro-Lewis acts as the principal operating entity for a large number of limited partnerships, which own oil and gas producing properties located throughout the United States. Petro-Lewis serves over 145,000 limited partners and has five regional offices in Houston, Texas; Oklahoma City, Oklahoma; Billings, Montana; Lubbock, Texas; and Bakersfield, California. . About 43% of our 2,127 employees work in these regional offices. At the present time, Petro-Lewis manages daily production of 62,200 barrels of oil and 243.6 million cubic feet of natural gas.
Petro-Lewis is not a traditional exploration and production company. The company acquires and manages oil and gas properties on behalf of investors. The investment concept of the oil income program was pioneered by Petro-Lewis in 1970. Each month, a limited partnership is formed that permits investors to acquire an interest in domestic oil and gas properties which are already producing, and Petro-Lewis manages
the partnerships' activities as general partner. The oil and gas income program functions very much like mutual fund holding stocks or bonds in that it is designed to provide cash flow and competitive market yield and to offer liquidity. Investors have found our oil income program an attractive investment vehicle and thus have invested about $1.9 billion (February 1983 data) of their funds in our program. These funds have financed the acquisition of more than $3.1 billion (Feburary 1983 data) worth of producing properties, which Petro-Lewis presently manages. The average rate of return on our program is 17.2%, assuming that an investor made equal investments in each monthly partnership from October, 1970, through October, 1982, and that all investments were liquidated on December 31, 1982. This compares very favorably with other investments like stocks and bonds and Treasury bills. For example, from 1970 to 1982, the Standard & Poor's 500 Stock Index returned an average 9.5% per year; the Salomon Brothers Bond Index returned 8.1% per year; and T-bills returned an average 7.8% per year. Current oil income program yields are also attractive, compared to municipal bonds (8-9%), and corporate bonds (12-13.5%) 20% on our PLPC I partnership, 9% on our PLPC II partnership, and 12-14% on the more recently formed oil income partnerships (since November 1980).
In addition, investors recognize the considerable potential for improvements in both the value of their oil and gas producing properties and in their income stream. Such potential stems from price increases on oil and gas sales and