Statement of Richard M. Lipton on the Subject of Tax Simplification
April 26, 2001

3.  Business Tax Provisions

16. Simplify the Consolidated Return Rules

    Affiliated groups of corporations can elect to file a single consolidated income tax return. The dominant theory governing the development of the consolidated return regulations is that the consolidated group should be treated as a single entity. As evidenced by the hundreds of pages of regulations and excruciating detail, this seemingly simple concept has evolved into one of the most complex and burdensome areas of the tax law. The consolidated return rules, are laced with numerous traps for the unwary and are virtually incomprehensible to experienced tax practitioners unless they spend an entire career practicing in the consolidated return area. With the advent of single-member limited liability companies ("LLCs") and the check-the-box regulations, many taxpayers may be able to avoid or ameliorate the complexity of the consolidated return rules. For taxpayers that desire or are required to use a C corporation, however, the consolidated return rules still present a major source of complexity. Accordingly, simplification of the consolidated return rules would be a major step towards the ultimate goal of simplifying the tax laws. For example, in the small business context, all wholly owned subsidiaries could be treated as flow-through entities.

17. Simplify the PFIC Rules

    In 1997, the passive foreign investment company ("PFIC") rules were greatly simplified by the elimination of the controlled foreign corporation-PFIC overlap and by allowing for a mark-to-market election for marketable stock. A great deal of complication remains, however, and further simplification is necessary. We recommend, for example, that Congress eliminate the application of the PFIC rules to smaller investments in foreign companies whose stock is not marketable.

18. Simplify the Foreign Tax Credit Rules

    The core purpose of the foreign tax credit ("FTC"), which has been part of the Code for more than eighty years, is to prevent double taxation of income by both the United States and a foreign country. The FTC rules are complex in large measure, but not exclusively, because the global economy is complex. The section 904(d)(1) basket regime, which includes nine separate baskets for allocating income and credits and is intended to prevent inappropriate averaging of high-and-low-tax earnings, is especially complicated to apply.

    The FTC rules may never be truly simple, but actions can be taken to temper the extraordinary complexity of the current regime. At a minimum, Congress should (i) consolidate the separate baskets for businesses that are either starting up abroad or that have only small investments abroad; and (ii) eliminate the alternative minimum tax credit limitations on the use of the FTC.

    In addition, Congress should consider accelerating the effective date of the "look-through" rules for dividends from so-called 10/50 companies. The Tax Reform Act of 1986 created a separate FTC limitation for foreign affiliates that are owned between ten and fifty percent by a U.S. shareholder. The requirement for separate baskets for dividends from each 10/50 company was among the most complicated provisions of the 1986 Act, and in 1998, Congress acted to afford taxpayers an election to use a "look-through" rule for dividends (similar to the one provided for controlled foreign corporations under section 904(d)(3)). The implementation of the rule was delayed, however, until 2002. In addition taxpayers must maintain a separate "super" FTC basket for dividends received after 2002 that are attributable to pre-2003 earnings and profits. The current application of both a single basket approach for pre-2003 earnings and a look-through approach for post-2002 earnings results in unnecessary complexity. Congress should eliminate the "super" basket and accelerate the effective date of the look-through rule.

19. Simplify Application of Subpart F

    In general, ten percent or greater U.S. shareholders of a controlled foreign corporation ("CFC") are required to include in current income certain income of the CFC (referred to as "Subpart F" income). The Subpart F rules are an exception to the Code’s general rule of deferral and were initially enacted in 1962 to tax passive income or income that is readily moveable from one taxing jurisdiction to another to, for example, take advantage of low rates of tax. Congress subsequently expanded the Subpart F rules to capture more and more categories of active operating income. Nevertheless, taxation of CFC income may be deferred under various "same-country" exceptions to the Subpart F provisions. U.S.-based companies incur substantial administrative and transaction costs in navigating the maze of the Subpart F rules to minimize their tax liability.

    The Subpart F rules sorely need to be updated to deal with today's global environment in which companies are centralizing their services, distribution, and invoicing (and often manufacturing operations). We recognize that the Treasury Department is preparing a study on the policy goals and administration of the Subpart F regime, which we eagerly await. Whatever effect this study may eventually have, substantial simplification could be achieved now through the following basic measures:

    1. Except smaller taxpayers or smaller foreign investments from the Subpart F rules;
        
    2. Exclude foreign base company sales and services income from current taxation; and
        
    3. Treat countries of the European Union as a single country for purposes of the same-country exception.
        
20. Repeal Section 514(c)(9)(E)

    In general, income of a tax exempt organization from debt financed property is treated as unrelated business taxable income. Debt financed property is defined in section 514 as income producing property subject to "acquisition indebtedness," which generally does not include debt incurred to acquire or improve real property. Section 514(c)(9)(E) (the "fractions rule") provides, in general, that debt of a partnership will not be treated as acquisition indebtedness if the allocation of income and loss items to a tax exempt partner cannot result in the share of the overall taxable income of that organization for any year exceeding the smallest share of loss that will ever be allocated to that organization. This provision was enacted to prevent disproportionate allocations of income to tax exempt partners and disproportionate allocations of loss items to taxable partners. The provision has become a trap for the unwary as well as a tremendous source of planning complexity even for those familiar with it. Anecdotal evidence suggests that few practitioners understand the provision completely, and almost no IRS agents or auditors raise it as an issue on audits. Instead, because of its daunting complexity, it has become a barrier to legitimate investment in real estate by exempt organizations. At the same time, other provisions in the tax law (such as the requirement of substantial economic effect under section 704(b)) substantially limit the ability to shift tax benefits among partners. Therefore, section 514(c)(9)(E) could be repealed without substantial risk of abuse.