Anti-Tax-Shelter and Other Revenue-Raising Tax Proposals Considered in the 108th Congress

CRS Report for Congress
Anti-Tax-Shelter and Other Revenue-Raising
Tax Proposals Considered in the 108 Congress
Updated February 7, 2005
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division

Congressional Research Service ˜ The Library of Congress

Anti-Tax-Shelter and Other Revenue-Raising Tax
Proposals in the 108th Congress
Several bills introduced in the 108th Congress included revenue-raising
provisions, particularly those aimed at tax shelters that are generally used by
corporations. In 2003 anti-sheltering provisions were included in bills introduced by
Representative Lloyd Doggett ( H.R. 1555), in the Senate version of the 2003 tax cut
(H.R. 2), in the Senate version of the Care Act (S. 476), and in both the House (H.R.

2896) and Senate (S. 1637) reported versions and final enacted version (H.R. 4520)

of bills which eliminate the extraterritorial income provision (ETI) — which has been
found to contravene World Trade Organization (WTO) restrictions on export
subsidies — and provide tax cuts. The number and size of the revenue-raising
provisions were much greater in S. 1637 ($56 billion over a 10-year period) than in
H.R. 2896 ($26 billion). The Senate bill was revenue neutral overall, while the
House bill lost revenue over the period FY2004-FY2013. The President also
proposed several tax shelter provisions in his FY2005 budget proposals. In 2004, a
somewhat different House bill (H.R. 4520) passed the House (June 17, 2004). The
final legislation was enacted as H.R. 4520 (P.L. 108-357), although not all of the tax
shelter provisions were included. This bill contained $82 billion in revenue raisers
over FY2005-2014, and was also revenue neutral.
Several types of revenue increases in the bills were (1) generic anti-shelter
provisions (including increased penalties and, in the Senate bill, changes in the
economic substance doctrine), (2) provisions related to corporate inversions and
expatriations, and the associated earnings stripping, (3) other provisions targeted at
specific tax abuses, (4) provisions that involve explicit changes in tax policy, and (5)
fees. Fees (basically customs fees), were the single largest revenue producers in the
initial bills; the leasing provision gained the most revenue in the final bill.
The Senate bill’s largest revenue raiser outside of customs fees is a codification
and strengthening of the economic substance doctrine which is used to determine
when an activity’s tax benefits are denied because they are aimed solely at tax
sheltering. This provision is one that has been controversial, with proponents arguing
that is a crucial tool in the battle against corporate tax shelters and opponents
suggesting it will not be effective and will adversely affect ordinary transactions. It
was not enacted but may be reconsidered in the future.
Inversions occur when U.S. firms move the parent corporation abroad to reduce
taxes, often accomplished by earnings stripping methods where domestic income is
shifted abroad. The Senate bill had more stringent provisions directed to U.S.
inverted firms; H.R. 2896 had generic earnings stripping provisions that apply to all
U.S. subsidiaries of foreign parents, not included in H.R. 4520.
A number of specific anti-shelter provisions was included in the bills, some
arising from the investigation of the Enron failure or from other issues raised by
failed firms. There were also some explicit tax policy changes which related
primarily to deferred compensation in the House bill, but touched on a variety of
other areas in the Senate bill. This report will not be updated.

General Anti-Shelter Provisions......................................6
Penalties for Non-Disclosure and Other Purposes.....................8
Economic Substance Doctrine....................................9
Corporate Inversions, Earnings Stripping, and Expatriation................12
Specific Provisions Aimed at Shelters.................................14
Built in Losses...............................................15
Property and Casualty Insurance Companies........................15
Disallowance of Interest on Convertible debt.......................15
Lease term to Include Service Contracts...........................15
Disallowance of Partnership Loss Transfers........................16
Lessors to Tax Exempt Entities..................................16
Mismatching of Items with Related Corporations....................16
Basis Reduction for Partnerships.................................16
Straddle Rules...............................................17
Installment Sales.............................................17
Non-Recognition of Gain in Liquidation...........................17
Like Kind Exchanges for Residences.............................18
Clarification of Banking Business................................18
Estimated Tax on Deemed Asset Sales............................18
Expanded Authority to Disallow Benefits Under Section 269..........18
Modification of the CFC-PFIC Rules.............................18
Limit on Transfer of Losses in REMICs...........................19
Reduction of Fuel Tax Evasion..................................19
Charitable Contributions for Vehicles.............................19
Limit Entertainment Expense Deductions..........................19
Freeze of Provisions Suspending Interest Payments..................19
Application of Basis Rules to Nonresident Aliens...................20
Tax on Gasoline Blendstocks....................................20
Increase Withholding on Supplemental Wages......................20
Increase Continuous Levy for Certain Federal Payments..............20
Tax Policy Changes...............................................20
House Bill..................................................20
Deferred Compensation....................................21
Overpayments and Underpayments of Tax.....................21
Senate Bill..................................................22
Charitable Contributions of Patents...........................22
Intangibles ..............................................22
Increase in Age Limit for Section 1(g ) (“Kiddie Tax”)...........22
Repeal Rehabilitation Credit................................22
Private Debt Collection....................................22
Utility Grading Costs......................................23
Corporate Governance Provisions: Denial of Deductions..........23
Only in Final Legislation as Enacted..............................23
Tax on Influenza Vaccine..................................23
Treatment of Creditors in a Divisive Reorganization.............23

Extensions of Fees................................................23
List of Tables
Table 1. Revenue Raisers in H.R. 2896 as Passed by the House
Raising $100 Million or More, FY2004-FY2013.....................3
Table 2. Revenue Raisers in S. 1637 as Reported Raising $100 Million
or More, FY2004-FY2013.......................................4
Table 3. Revenue Raisers in H.R. 4520 (As Enacted) Raising $100 Million
or More, FY2005-FY2015.......................................5

Anti-Tax-Shelter and Other Revenue-
Raising Tax Proposals in the 108 Congress
Several bills introduced in the 108th Congress included revenue-raising
provisions, particularly those aimed at tax shelters that are generally used by
corporations. Anti-sheltering provisions were included in bills introduced by
Representative Lloyd Doggett (H.R. 1555), in the Senate version of the 2003 tax cut
(H.R. 2), and in the Senate version of the Care Act (S. 476). In 2003, the House
reported H.R. 2896 and the Senate S. 1637, both of which proposed to eliminate the
extraterritorial income provision (ETI) — which has been found to contravene World
Trade Organization (WTO) restrictions on export subsidies — and provide other tax
cuts and were reported from their respective committees. The number and size of the
revenue-raising provisions were much greater in S. 1637 ($56 billion over a 10-year
period) than in the H.R. 2896 ($26 billion). The Senate bill was revenue neutral
overall, while the House bill would have lost revenue over the period FY2004-
FY2013. The Senate passed its bill with amendments in 2004 and the House passed
subsequently passed a new measure as H.R. 4520 (P.L. 108-357), the bill that after
revision in conference was ultimately enacted. This bill contained $82 billion in
revenue raisers and was also revenue neutral.
This report is an overview of the revenue raising provisions in the original
reported versions of H.R. 2896 and S. 1637 and the final bill as enacted. It therefore
addresses both those changes that have been enacted, and those that were proposed,
but not enacted, and thus may be considered in the future. A particularly significant
proposal that was advanced but not adopted, but may be considered in the future, is
a codification of the economic substance doctrine. General earnings stripping
provisions in H.R. 2896 also were not enacted.
Note that there were other interim legislative changes that are not detailed here,
other than a brief mention of major revisions. The Senate bill was amended on the
floor. In addition, a later version of the House bill that was significantly different
from H.R. 2896 was adopted in 2004 (H.R. 4520), and this bill was the basis for the
decisions in conference. The reader is directed to the Committee reports (H.Rept.
108-393 for H.R. 2896, S. Rept. 108-192 for S. 1637, H.Rept. 108-548 for the
House-passed version of H.R. 4520, and H.Rept.108-755 for the conference report
on H.R. 4520) for more detailed descriptions.
The bills had numerous (and complex) provisions, many of which had minor
consequences. To provide an overview, only provisions raising $100 million or more
of revenue over 10 years will be discussed. Tables 1, 2, and 3 list these provisions
in order of descending revenue gain. Table 1, containing the original House
provisions, lists 17 measures. Table 2, containing the original Senate provisions,
lists over twice as many measures, and the final version, H.R. 4520 in Table 3,
shows a similar number. The enacted version also included some additional
provisions from proposed energy legislation, including some revenue raisers.

To begin the discussion, it is helpful to organize the provisions into basic
categories. The five categories (in the order in which they will be discussed) are (1)
generic anti-shelter provisions, (2) provisions related to corporate inversions and
expatriations, and the associated earnings stripping, (3) other provisions targeted at
specific tax abuses, (4) provisions that involve explicit changes in tax policy, and (5)
fees. Fees (basically customs fees) were actually the single largest revenue producers
in the original bills and accounted for about 30% of the gain in the initial Senate bill
and 60% of the gain in the initial House bill.
On the Senate floor several amendments relating to tax shelters were adopted
when S. 1637 was passed on May 11, 2004, which are not reflected in Table 2. They
included tougher penalties on tax shelter promoters, taxation of stock options in
corporate inversions, and modifications in charitable donations and deferred
compensation. There has been a significant increase in the projected revenue gain
from restrictions on leasing to tax exempt entities, so that the original revenue
estimates may have been understated. The House-passed version of H.R. 4520
contained a $19.6 billion (2004-2014) leasing provision over an 11 year period, while
dropping the earnings stripping provision in H.R. 2896. H.R. 4520, as enacted, also
contained a significant leasing revenue raiser and omitted earnings stripping.1 The
leasing provision is the single largest revenue producer in H.R. 4520.
The provisions that were not ultimately enacted in H.R. 4520 may be
reconsidered in the 109th Congress if legislation needing offsetting revenue raisers
is considered. Legislation providing additional tax incentives for charitable
contributions was considered but not enacted in the 108th Congress. There may also
be potential legislation making tax cuts permanent and addressing the growing
problem of the alternative minimum tax. Finally, President Bush has indicated an
interest in fundamental tax reform. And, while codifying the economic substance
doctrine is controversial, some observers consider future legislation in this area to be
Note also that the President proposed some anti-shelter provisions in his
FY2005 budget plan, amounting to $44 billion over 10 years. The largest provision
was one addressing leasing transactions, accounting for $33 billion. Other major
provisions included limiting interest deductions for related party transactions,
preventing excess valuations for charitable contributions of property, addressing the
small property and casualty insurance firm issue, and providing increased regulatory
authority for monitoring abusive tax shelters. See the Treasury Department’s
February 2004 General Explanation of the Administration’s Fiscal Year 2005
Revenue Proposals for further explanation, online at [
/tax-policy/], page 111.

1 An extensive discussion of leasing provisions is contained in CRS Report RL32479, Tax
Implications of SILOs, QTEs, and Other Leasing Transactions with Tax-Exempt Entities,
by Maxim Shvedov.

Table 1. Revenue Raisers in H.R. 2896 as Passed by the House
Raising $100 Million or More, FY2004-FY2013
(in millions of dollars)
ProvisionRevenue Gain
1. Extension of customs fees16,916
2. Earnings Stripping2,726
3. Tax Shelters: Penalties for Non-Reporting 1,559
4. Small property and casualty companies1,179
5. Non-qualified deferred compensation800
6. Corporate inversions 450
7. Mismatching of items with related corporations 444
8. Basis reduction for partnerships364
9. Extension of IRS user fees 345
10. Individual expatriations327
11. Extension of provision allowing DB plan transfers298
12. Like-kind exchange for residences171
13. Clarification of banking business154
14. Estimated taxes on deemed asset sales123
15. Exclusion of interest on overpayments115
16. Prepayment of interest on underpayments101
17. Limit on transfer of losses on REMIC residuals100
Source: Joint Committee on Taxation, JCX-95-03, October 24, 2003.
Note: See text for revisions in H.R. 4520; earnings stripping provisions were dropped and a significant
leasing provision added.

Table 2. Revenue Raisers in S. 1637 as Reported Raising $100
Million or More, FY2004-FY2013
(in millions of dollars)
ProvisionRevenue Gain
1. Extension of customs fees17,139
2. Economic substance doctrine13,322
3. Charitable contributions of patents3,851
4. Intangibles, broader application of rules 3,291
5. Corporate inversions2,747
6. Built in losses1,800
7. Tax shelters: penalties for non-reporting1,559
8. Qualification rules (tax exempt and casualty insurance)1,273
9. Increase age limit for section 1(g)1,180
10. Repeal rehabilitation credit, non-historic buildings1,013
11. Private debt collection973
12. Disallowance of interest on convertible debt891
13. Lease term to include service contracts864
14. Disallowance of partnership loss transfers705
15. Establish specific class lives for utility grading costs701
16. Individual expatriation (mark to market)700
17. Lessors to tax exempt entities519
18. Mismatching of items with related corporations 444
19. Extend IRS user fees 386
20. Basis reduction for partnership368
21. Denial of deduction for punitive damages333
22. Earnings stripping applied to Subchapter S and individuals244
23. Straddle rules230
24. Installment sale treatment 215
25. Denial of deduction for fines191
25. Non-recognition of gain in liquidation 189
27. Like-kind sales of residences171
28. Clarification of banking business166
29. Estimated tax on deemed assets sales123
30. Expanded authority to disallow benefits under Section 269108
31. Modification of CFC/PFIC rules106
32. Deposits to stop interest running on underpayments101
Source: Senate Finance Committee Report 108-292. See text for revisions on floor.

Table 3. Revenue Raisers in H.R. 4520 (As Enacted) Raising
$100 Million or More, FY2005-FY2015
(in millions of dollars)
ProvisionRevenue Gain
1. Leasing provisions 26,560
2. Extension of customs fees18,614
3. Reduction of fuel tax evasion9,138
4. Charitable contributions of patents3,653
5. Intangibles, broader application of rules 3,467
6. Charitable contributions for vehicles2,379
7. Limit entertainment expense deductions2,292
8. Built-in losses1,851
9. Tax shelters: penalties for non-reporting1,620
10. Freeze of provisions suspending interest payments1,545
11. Private debt collection1,017
12. Disallowance of interest on convertible debt1,004
13. Corporate inversions932
14. Establish specific class lives for utility grading costs806
15. Disallowance of partnership loss transfers581
16. Mismatching of items with related corporations475
17. Clarification of banking business404
18. Extend IRS user fees396
19. Individual expatriation377
20. Straddle rules331
21. Tax on influenza vaccine314
22. Basis reduction for partnership249
23. Application of basis rules for nonresident aliens241
24. Installment sale treatment221
25. Repeal reduced excise rate for gasoline used in blends220
26. Like-kind sales of residences200
27. Increase withholding from supplemental wages186
28. Increase continuous levy for certain federal payments185
29. Estimated tax on deemed assets sales117
30. Modify treatment of creditors in certain reorganizations105
Source: Joint Committee on Taxation, JCX-69-04, October 7, 2004.

General Anti-Shelter Provisions
The term “tax shelter” is not easily defined and the usage of the term varies.
Sometimes it refers to any method of shielding income from tax including provisions
that were explicitly adopted by Congress as incentives. Sometimes it refers to
practices that meet the letter of the law (often by combining provisions in different
parts of the tax code) but are unintended by the law. In some cases, they are activities
that do not clearly meet the letter of the law. The provisions in the tax bills are
largely aimed at what might be called “abusive” tax shelters — activities set up to
take advantage of the strict letter of the law but whose purpose is to avoid taxes
rather than engage in any meaningful economic activity, and whose benefits were not
intended by Congress.
Tax shelters today are different from those that attracted attention in the 1970s,
and the legislation enacted to address those shelters does not address today’s2
shelters. Most of the earlier tax shelters were in real estate or some other type of
physical investment (oil and gas, farming) and involved limited partnership interests
in highly leveraged assets which benefitted from both interest deductions and
deductions for accelerated depreciation (or other deductions for costs). Before
generic anti-shelter provisions directed at this type of shelter were enacted, a high
income taxpayer could take deductions many times his actual investment as his claim
to deductions (or his basis) included not only the amount financed by his cash
investment but also any associated debt (for which he would not be personally at
risk). These shelters were largely sold to high tax rate individuals. A series of law
changes (slowing depreciation, lowering tax rates, and enacting limits on deductions
through at-risk rules and passive loss restrictions) and economic changes (a decline
in inflation and in interest rates) have made those shelters obsolete.
Today’s tax shelters do not follow a consistent pattern and they are highly3
varied. They are largely corporate shelters. Often, they do not involve investments
in real assets but rather in financial instruments that are highly liquid, held for a short
period of time, and structured to avoid risk. One paper discussing a court case
referred to the underlying stock asset held by the company “which, under a charitable4
view of the facts, it owned for an hour.” This case was a dividend stripping case
where a tax exempt entity owned stock in a foreign firm and could not use foreign
tax credits; the entity arranged to sell a block of stock to a taxable firm just before
the dividend was paid; the taxable firm then sold the stock at a loss (because it was
worth the original price less the dividend) which wiped out the taxable income but
left the firm with a foreign tax credit attached to the dividend.

2 For a discussion of old and new style tax shelters and their interaction with “at risk” rules,
see James Whitmire and Bruce Lemons, “Putting Tax Shelters at Risk — Discussion and
Proposal for Change,” Tax Notes, Jan. 27, 2003, pp. 585-596.
3 See Gerald R. Miller, “Corporate Tax Shelters and Economic Substance: An Analysis of
the Problem and Its Common Law Solution,” Texas Tech Law Review, vol. 34, 2003, pp.

1015-1069 for a discussion of some of the common features of tax shelters.

4 Daniel Shaviro, “Economic Substance, Corporate Tax Shelters, and the COMPAQ Case,”
Tax Notes, July 10, 2000, p. 222.

The general objective of most tax shelters is to generate tax deductions, often
by contriving to increase the basis of the taxpayer in assets, or to shift losses or
deductions from tax indifferent parties (those not subject to U.S. tax such as foreign
corporations or tax exempt organizations) to taxable parties. Tax shelters may take
advantage of the flexibility allowed to partnerships in allocating income and assets,
may take advantage of related parties that are incorporated abroad and not subject to
current U.S. tax, may involve leasing arrangements to tax exempt organizations, and
have even involved firms’ buying life insurance on their rank and file employees (so-
called “janitors” insurance).5 Some of the shelters are put together by promoters who
then sell them to firms; these promoters include prestigious accounting firms and
financial institutions. (Some accounting firms have indicated that they have closed
these operations.)6
Measuring the amount of revenue lost from tax shelters is difficult, although
some data suggest that the loss is substantial. The role of tax shelters is especially
difficult to monitor since these shelters may lead to mismeasurement of pre-tax
profits and make their magnitude difficult to detect. Several studies comparing book
and tax income have noted the widening gap between the two that cannot be
explained by the traditional measures of depreciation, stock options, and foreign
source income retained abroad. A study by Desai found $155 billion of unexplained
discrepancies in 1998,7 implying lost taxes that could be up to $54 billion (at a 35%
tax rate). This amount could be lower because some firms are operating at a tax loss,
some firms do not pay the top marginal tax rate, and some firms have unused credits.
But the amount is significant.
Some of this gap between book and taxable income was due to intended tax
benefits, and examining tax expenditures — which measure the revenue cost of
explicit special tax deductions, exclusions, and credits not considered to be part of
a normal income tax — may help to adjust for that effect. Our calculations suggest
that about $23 billion of such a gap would be attributable to tax expenditures.8 While

5 See CRS Report RS21498, Corporate-Owned Life Insurance: Tax Issues, by Don
Richards, for a discussion.
6 See Sheryl Stratton, “KPMG Skewered at Senate Shelter Hearing,” Tax Notes, Nov. 24,

2003, pp. 942-946.

7 Mehir Desai, “The Corporate Profit Base, Tax Sheltering Activity and the Changing
Nature of Employee Compensation,” National Bureau of Economic Research, Working
Paper 8866, April 2002.
8 In the same year for which Desai estimated the $155 billion gap, the projected tax
expenditures for corporations were about $72 billion according to the Joint Committee on
Taxation. Almost half ($33.5 billion) was due to accelerated depreciation, largely for
equipment (and including expensing of research and development, or R&D, costs), which
Desai accounted for. Another $1.2 billion was retained earnings of controlled foreign
corporations, which he also accounted for. (These earnings are profits of subsidiaries of
U.S. firms incorporated under the laws of foreign countries and not paid as dividends to the
U.S. parent company). If one also eliminates $2.5 billion for tax deductions for charitable
contributions which were probably deducted as a book expense, $4.2 billion lost because
of graduated tax rates, and $7.6 billion of credits, the remaining tax expenditures account

there are many possible errors in calculating these effects, there nevertheless appears
to be significant potential for a relatively large size of unintended corporate tax base
reductions given the potential size of the book tax difference discovered by Desai.
Of course, not all of these differences represent illegal, or even abusive, tax shelters.
For example, there are certain types of preferred securities that are treated as debt for
tax purposes but as equity for book purposes, whose treatment for tax purposes has
been tested in court.
The general scope of this potential loss (i.e., a discrepancy of up to $54 billion
reduced by $23 billion leaving a potential of $31 billion unaccounted for)
accommodates estimates made by a Internal Revenue Service (IRS) contractor and
reported in a GAO study that suggested a loss from abusive tax shelters of $13.6 to
$17.3 billion for that same year.9 This study also reports an IRS database covering
the period 1989-2003 with a cumulative estimate of $85 billion. Additionally, the
study explains the efforts that IRS has been making to address these abusive tax
shelters, including listing specific transactions it found to be illegal and requiring
Setting aside the explicit provisions adopted by Congress, tax sheltering
activities raise two types of challenges for tax administration — and anti-shelter
legislation addresses one or both of these issues. First, in order for the IRS to collect
taxes avoided illegally, it is necessary to detect the tax shelters. Because of the
complexity of these operations, the elements of the tax shelter may be buried in other
deductions. IRS has engaged in an aggressive enforcement program against tax
shelter operations, including requiring disclosure of shelters. The penalties for non-
disclosure, included in both bills, were designed to provide more incentives to
comply with disclosure rules. Secondly, when a tax activity technically meets the
requirements of the statute, it may nevertheless be disallowed in the courts under
certain doctrines of common law. These doctrines include examining the activity to
determine if it is a sham transaction, if it has no economic substance, and/or if it has
no business purpose. A provision clarifying and codifying the economic substance
doctrine was included in the Senate bill and was the largest revenue raiser after
customs fees in that bill (although there is some uncertainty about the amount of
revenue that might be raised).
Penalties for Non-Disclosure and Other Purposes
New initiatives and Treasury regulations require taxpayers to report information
about certain categories of “reportable transactions” which include those that are
similar to tax transactions already disallowed, those offered under conditions of
confidentiality, those contingent on tax treatment, those generating losses of a certain
size, those where tax treatment differs from book treatment, and those resulting in a
significant tax credit while being held a short period of time. There are no specific

8 (...continued)
for about $23 billion.
9 Internal Revenue Service: Challenges Remain in Combating Abusive Tax Shelters,
Statement of Michael Brostek, Government Accountability Office, before the Senate
Finance Committee, Tuesday, Oct. 21, 2003.

penalties for not reporting these transactions, and both H.R. 2896 and S. 1637
imposed a penalty on failure to provide required information on reportable
transactions (items 3 in Table 1, 7 in Table 2, and 9 in Table 3 respectively); this
provision accounts for the bulk of the $1.6 billion in revenue gain from penalties,
although there are some changes in other penalties. Some critics objected to certain
aspects of the penalty provisions, including the flat rate shelter disclosure penalty that
applies regardless of whether the taxpayer’s position is upheld and a new higher
penalty on understatement that applies to transactions lacking economic substance
in the Senate bill (because of uncertainty regarding the definition of economic
substance). 10
Economic Substance Doctrine
The provision in the Senate bill codifying the economic substance doctrine was
the largest revenue raiser in the Senate bill after customs fees, accounting for $13.3
billion over 10 years.
As noted above, even when transactions meet the letter of the tax law, tax
benefits may be disallowed by the courts if the activity is found to be a type of sham
transaction; in the particular case of tax shelters the related issues of economic
substance or business purpose are often used. 11 That is, if an activity does not have
economic substance or there is no business purpose, the tax benefits are disallowed.
The Senate bill would have recognized these doctrines in the tax law itself and
provided a number of specific guidelines. For example, if the court found the
economic substance doctrine to be relevant, the bill provided that the taxpayer must
meet both the objective test of economic substance and the subjective test of having
a non-tax business purpose to keep the tax benefit. Requiring both is referred to as
a conjunctive rule, while requiring either is referred to as a disjunctive rule. The
objective is to strengthen the rule and to bring more uniformity to court decisions.
Some court cases have required both aspects to be met and others only one. The bill
also set out specific rules for determining when the taxpayer meets the economic
substance test through demonstrating profit potential, by requiring that the return
outside the tax benefits exceed the riskless rate of return; it also provided that the
transactions must be a reasonable means of achieving the business purpose.
The purpose of the provision regarding economic substance (according to the
Committee report) was:12

10 See letter written to Chairman William F. Thomas by Andrew Berg, Tax Section, New
York State Bar Association, Sept. 24, 2003, reprinted in Tax Notes, Oct. 20, 2003, pp. 401-
403. See Berg’s letter to Chairman Thomas and Senator Grassley on the economic
substance doctrine dated Aug. 5, 2003.
11 For a general background on the economic substance doctrine see Joseph Bankman, “The
Economic Substance Doctrine,” Southern California Law Review, vol. 74, Nov. 2000, pp.

5-30; Miller, “Corporate Tax Shelters and Economic Substance,” op. cit, and Martin J.

McMahon, Jr. “Economic Substance, Purposive Activity, and Corporate Tax Shelters,” Tax
Notes, Feb. 25, 2002, pp. 1017-1026.
12 S.Rept. 108-192, to accompany S. 1637, p. 85.

The Committee is concerned that many taxpayers are engaging in tax avoidance
transactions that rely on the interaction of highly technical tax law provisions.
And the report goes on to add in a footnote:
These transactions usually produce surprising results that were not contemplated
by Congress. Whether these transactions are respected usually hinges on whether
the transaction had sufficient economic substance. The Committee is concerned
that in addressing these transactions the courts, in some cases, are reaching
conclusions inconsistent with Congressional intent. In addition, the Committee
is concerned that in determining whether a transaction has economic substance,
taxpayers are subject to different legal standards based on the circuit in which the
taxpayer is located. Thus, the Committee believes it is appropriate to clarify for
the courts the appropriate standards to use in determining whether a transaction
has economic substance.
There has been a great deal of controversy about the economic substance
doctrine legislation. While the proposal was in the Senate bill, it was not in the
House bill. It was opposed by Treasury officials in the current Bush Administration.
Many firms, practicing tax attorneys, and tax executives in businesses objected to the
provision, both individually and formally through organizations such as the Tax
Executives Institute, the Tax Section of the American Bar Association and the Tax
Section of the New York State Bar Association.13
At the same time, there was much support for the codification of the economic
substance doctrine, in addition to the position taken by the Finance Committee. The
Clinton Administration supported the bill, and Chairman Thomas’s 2002 bill in theth
107 Congress (H.R. 5095) included an economic substance provision. There are a
number of attorneys and law professors who have taken the view that codification of
the economic substance doctrine, as was in the Senate provision or with some
modification is advisable and even necessary to stem the tide of tax shelters.14

13 Pamela Olson (at her nomination hearings for Assistant Secretary of Treasury for Tax
Policy) commented on economic substance in answer to a question; these comments are
reported in Samuel C. Thompson Jr. and Robert Allen Clary 11, “Coming in from the Cold:
The Case for ESD Codification” Tax Notes, May 26, 2003, pp. 1270-1274. See also, as
noted above, the letter from Andrew Berg to Chairman Thomas and Senator Grassley on the
economic substance doctrine and the Apr. 24 letter to Chairman Grassley and Ranking
Member Baucus from Herbert Beller of the American Bar Association (reprinted in the
Bureau of National Affairs, Daily Tax Report, Apr. 28, 2003). See also New York State Bar
Association Tax Section, “Economic Substance Codification,” Tax Notes, June 23, 2003;
Peter L. Faber, letter to the Chairman Thomas, reprinted as “Practitioner to Congress: Don’t
Try to Codify Economic Substance,” Tax Notes, Oct. 21, 2002, pp. 423-424; James M.
Peaslee, letter to the Finance Committee, reprinted as “More Thoughts on Proposed
Economic Substance Clarification,” Tax Notes, May 5, 2003, pp. 747-750, May 5, 2003.
14 Lawrence M. Stone, Letter to Chairman Thomas, reprinted as “Congress Should Codify
Economic Substance,” in Tax Notes, Nov. 18, 2002; Samuel C. Thompson Jr. and Robert
Allen Clary II, “Coming in from the Cold: The Case for ESD Codification” Tax Notes, May
26, 2003, pp. 1270-1274; Terrill A. Hyde and Glen Arlen Kohl, “The Shelter Problem is

In general, the arguments for codification in these discussions and commentary
include the need to take more aggressive action to stem the tide of tax shelter cases,
since a stricter rule would change the cost-benefit calculus faced in this area and
strengthen the position of the tax authorities. The argument is also made that in the
face of aggressive tax sheltering, even compliant taxpayers will be pressured into
these activities unless Congress (or the Supreme Court) takes action to clarify
economic substance. Moreover, in addition to creating more conformity in court
decisions, putting the doctrine into the code would allow the Treasury to write more
detailed regulations.
The criticisms of the proposal include both criticisms of any codification of the
economic substance doctrine, as well as the particular ones used in the provision.
Pam Olson, answering a question at her nomination hearing as Assistant Secretary
of Treasury for Tax Policy,15 made the case against codification roughly as follows:
such an approach is too wooden and rigid (not flexible enough), it will be both too
broad (presumably covering unintended transactions) and too narrow (presumably
leaving ways for individuals to get around the rules), and that it will increase
complexity for the IRS and slow audits. In general, in the discussion by many of the
critics several themes emerge. One is that the courts are the proper place to
adjudicate complex technical issues. Another is that the legislation as written would
also be applicable to perfectly common transactions that have long been occurring
and whose benefits are intended by the Congress — even ordinary actions like
electing Subchapter S (a small corporation electing to be taxed as a partnership) or
incorporating a foreign branch operation (which allows deferral of U.S. tax on active
income). Critics also argue that the new language would still have significant
ambiguities that would require adjudication and that designers of shelters will simply
devise new ways to get around the rules.
Supporters have written rejoinders, for example suggesting that too much
flexibility is the underlying problem with tax shelters and that more rigid rules are
needed, and that clearer rules would simplify IRS administration and enforcement.
The rejoinders also argue that the claims about interference with ordinary accepted
transactions are greatly exaggerated: the Committee report makes it clear that the
intent is not to deny deliberate benefits bestowed by Congress, and that the legislation
applies only to cases where the court decides economic substance is an issue. They
also contend out that the tax authorities would not press cases of this nature in any
While the economic substance doctrine revisions were not a part of H.R. 4520,
as enacted, there are some indications that the issue may arise again. The Joint
Committee on Taxation’s recent tax study includes a proposal for statutory revisions

14 (...continued)
Too Serious Not to Change the Law,” Tax Notes, July 7, 2003, pp. 119-122; Lawrence
Stone, “Economic Substance Codification: Naysayers Can Help Make it Work,” Tax Notes,
Aug. 4, 2003, pp. 730-731. A paper supporting the general notion is Martin J. McMahon,
“Economic Substance, Purposive Activity, and Corporate Tax Shelters,” op cit.
15 Reported in Thompson and Clary, “Coming in from the Cold,” op. cit.

including requiring both the subjective and objective tests.16 In addition, the IRS
recently lost several tax cases and in one the fact that Congress did not act to codify
the doctrine was cited by the judge in finding for the taxpayer.17 These outcomes
may increase pressure to codify and strengthen the economic substance doctrine.
Corporate Inversions, Earnings Stripping,
and Expatriation
Anti-tax sheltering provisions include provisions that are directly related to an
activity called corporate inversion and also provisions dealing with individual
expatriates (individuals who change residence or renounce citizenship to avoid U.S.
tax). The provisions discussed in this section are items 2, 6 and 10 in Table 1, items18
5, 16 and 22 in Table 2, and items 13 and 20 in Table 3. Actions after the original
bills were reported reduced the impact of the House bill and expanded the impact of
the Senate bill. Earnings stripping provisions (item 2) were dropped from the House
bill, H.R. 4520. A provision taxing stock options in inversions was adopted on the
Senate floor. The final version had smaller effects than either of the two initial bills.
Corporate inversion occurs when a U.S. company sets up a foreign incorporated
firm to become the parent corporation (and the current U.S. firm now becomes the
subsidiary corporation). This inversion confers two related tax advantages: avoiding
tax on foreign earnings and earnings stripping which allows a reduction of tax on
domestic earnings.
First, any income earned abroad would be beyond the ambit of the U.S. tax
system. Foreign subsidiaries of U.S. parent companies are subject to tax on certain
types of passive income even if not paid back to the U.S. parent (this income is called
Subpart F income), and the U.S. is stricter than many other countries in taxing this
income. However, income of foreign subsidiaries of a foreign parent company (and
the parent company’s income) is not subject to this tax (even if the shareholders are
U.S. citizens). Thus an inversion would permit a company to avoid the tax on
passive earnings of foreign operations. (The tax on active earnings does not apply
in any case until the income is repatriated as a dividend. Note also that the tax
avoidance matters in countries that have no taxes or low taxes where foreign tax
credits cannot be used to offset the additional U.S. tax).
The second advantage is that setting up the firm with a foreign parent allows
more scope for reducing tax on U.S. source income by allowing the U.S. subsidiary
to rely heavily on debt held by a foreign related company. Interest is deductible and
while interest paid to a related foreign corporation is subject to a withholding tax, tax

16 Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax
Expenditures, JCS-02-05, January 27, 2005.
17 See Kenneth A. Gary and Sheryl Stratton, “Economic Substance: Will Congress Have to
Intercede?” Tax Notes, Nov. 15, 2004, pp. 907-910.
18 See also CRS Report RL31444, Firms That Incorporate Abroad for Tax Purposes:
Corporate “Inversions” and “Expatriation,” by David Brumbaugh for further discussion.

treaties often eliminate or greatly reduce that withholding tax. Some inversion
operations are set up with three related firms: the U.S. firm, the new foreign parent
firm in a country without a treaty, and another subsidiary in a country with a treaty
to receive and transmit the interest payments. Reducing U.S. tax with debt or other
deductible payments to related firms is referred to as “earnings stripping” and it is an
issue not just with inverted firms, but with U.S. subsidiaries of foreign parent firms
in general. Because of the potential for abuse, the current tax code has a restriction
on deductibility of interest for thinly capitalized U.S. firms (with more than 60% of
assets held in debt and with more than 50% of earnings paid in interest).
The tax benefits of inversions are limited by the possibility that stockholders
will pay individual capital gains tax on the appreciation that occurred from the time
they purchased the stock to the time of the inversion. However, increasingly large
shares of stock are held in tax exempt form (e.g., pensions, IRAs) and the capital
gains tax rate is relatively low (currently only 15%).
Individuals can also act to limit their tax liability by changing their citizenship
to a low tax country.
The responses to these issues vary across bills in the 18th Congress. Under H.R.
2896 the general earnings stripping rules would have been tightened (item 2 in Table
1) by dropping the asset share test (i.e., disallowing interest based only on the
interest as a share of income) and lowering the interest share (to 25% for ordinary
debt and 50% for guaranteed, or 30% overall). This provision, which had a broader
scope than on firms with inversions, would have raised much of the $3.5 billion
revenue gain for 2004-2013 in this area — $2.726 billion. However, this provision
was eliminated from H.R. 4520. H.R. 2896 had some provisions focused directly on
inversions as well (item 6) which would prevent use of foreign tax credits or net
operating losses from offsetting taxes on inversion transactions (this and other items
are grouped in item 5). It would also impose a 15% excise tax on stock options
related to inversions. The limits on credits and loss offsets raise about $340 million
and the stock option tax $78 million. There were also small gains estimated from a
provision to require reporting of mergers and acquisitions and to allocate items for
reinsurance contracts.
The other significant revenue raiser in this group was a $327 million provision
imposing taxes on expatriate individuals (item 10 in Table 1). U.S. citizens or
residents are taxed on worldwide income (but are allowed a foreign tax credit for
taxes paid on foreign source income); nonresidents who are not citizens are subject
to a 30% withholding tax that may be lowered or eliminated through a tax treaty.
Individuals who renounce citizenship or residency for the purpose of avoiding tax
must pay tax on U.S. source income at ordinary tax rates, if they exceed certain
thresholds with respect to tax liability in the past and assets. H.R. 2896 would
replace this subjective determination of intent with an objective test based on prior
taxes paid and assets.
S. 1637 focused on inverted firms and would not have altered the general
earnings stripping rules. The inverted firms provisions (item 5 in Table 2) would
tax inverted firms as if they were domestic firms if 80% of the new foreign parent is
owned by former shareholders of the U.S. firm (for inversions occurring after March

20, 2002 and where the company had no existing substantial interest in the foreign
country). For other inversions, a “toll” tax equal to the top corporate (or individual,
in the case of a partnership) rate would be imposed (and could not be offset by
foreign tax credits or carryover of net operating losses). For earnings stripping, S.
1637 had provisions to eliminate the asset test and reduce the interest share test to
25% but the bill applied these stricter rules only to inverted corporations. These
provisions together accounted for $2.6 billion over FY2004-FY2013. In additional
revenue provisions added to the bill, there is a 20% excise tax on stock options linked
to the inversion and an extension of earnings stripping rules to Subchapter S
corporations (corporations taxed as partnerships) and partnerships; their bill
strengthens them for inverted corporations. Individual expatriates would be taxed
immediately under a mark to market rule (i.e., the individual must pay tax as if he or
she had sold the asset).
Overall, the original House bill focused much more heavily on general revenues
from tightening the earnings stripping rules for all corporations, and is less targeted
to inverted companies, while the Senate bill has much stricter tax provisions for
inversions and did not contain a general provision for earnings stripping. The Senate
bill’s provision for individual expatriates required an immediate tax on accumulated
gain from assets through a mark to market provision. H.R. 4520 does not include the
major revenue raiser, the earnings stripping provision.
The enacted legislation (H.R. 4520) generally follows the Senate provisions in
treating inversions with 80% identical ownership; for firms with 60% to 80%
ownership, any firm-level capital gains tax will not be offset by net operating losses
or foreign tax credits. There are no earnings stripping provisions. For individual
expatriates, the provisions are similar to the H.R. 2896.
Specific Provisions Aimed at Shelters
This section discusses specific provisions aimed at practices that many agree
may require a legislative remedy but may still be thought of as tax shelters. They
vary in the fundamentals, but as one can see from the following discussion, many of
them involve transactions, sometimes between related parties, where one party is
exempt from the U.S. tax and the other is not. Arrangements involve ways of
reducing taxable income by increasing debt (since interest is deductible) as in the
case of earnings stripping, increasing basis (the part of an asset’s price that is exempt
when the asset is sold), increasing other deductions, or excluding or reducing income.
The following discussions are brief explanations; the reader is directed to the
committee reports for more detailed information. Provisions are arrayed from
highest to lowest revenue gain.
The Senate bill also singled out certain provisions as relating to Enron — a
report by the Joint Committee on Taxation investigating Enron uncovered some of
the methods used to avoid taxes. When provisions fall into these categories, they will
be noted.

Built in Losses
This largest of the provisions in this section in projected revenue gains ($1.8
billion) arose from the Enron investigation, and was in the Senate bill and the final
bill. It addresses the situation when firms or other parties exchange assets for stock
and control the corporation after the exchange; under current law this is generally a
tax free transaction, that is, no gain or loss is recognized. If one party to the
exchange is an exempt foreign entity and the asset has a loss (i.e., basis, that is, the
amount deducted on sale, is above market value), and the U.S. corporation takes the
foreign party’s basis, the domestic taxable firm can benefit from this transaction
(because when the asset is sold, a loss will be recognized). The provision requires
basis to be fair market value in these cases.
Property and Casualty Insurance Companies
This item was included in both initial bills (item 4 in Table 1 and 8 in Table 2)
and would have raised about $1.2 billion. It basically addresses a provision that has
been in the tax law for a long time that allows tax exemptions for very small property
and casualty companies. These firms are entirely tax exempt if they receive less than
$350,000 in premiums. They are taxable only on investment income if premiums are
less than $1 million. This provision had been used to exempt large amounts of
investment income by setting up a firm with nominal premiums but huge investment
reserves.19 The new provision would require more than 50% of gross receipts from
premiums to be eligible for these tax benefits; the House bill also raises the
exemption level for firms that do qualify. The 50% was increased to 60% in the
Senate bill prior to conference.
The final bill does not include this provision because the issue was addressed
in the Pension Funding Equity Act passed in April of 2004. This provision provided
for the 50% test and increased the ceiling to $600,000.
Disallowance of Interest on Convertible debt
This provision is also an Enron-related one, and is in the Senate bill and the
final legislation; it raises about $1 trillion over the ten year period. Under prior law
interest including original issue discount (the difference between issue cost and face
value of a security on maturity, which is equivalent to interest paid at the end),
cannot be deducted if it is contingent on the value of securities of the issuer or a
related party (involving ownership of 50% or more). This provision applies the
restrictions without regard to the 50% rule.
Lease term to Include Service Contracts
This provision, initially projected to raise almost $800 million and subsequently
$4.3 billion, was originally only in the Senate bill. To prevent tax exempt entities

19 This activity was described in David Cay Johnston, “From Tiny Insurers Big Tax
Breaks,” New York Times, Apr. 1, 2003, Sect. C, p. 1

from transferring accelerated depreciation to taxable entities via leases, the useful life
of property that is leased to tax exempt entities is a life that is the longest of the
specified tax life or 125% of the lease term. Some attempts have been made to
bypass this rule by using service contracts; this provision requires that the length of
service contracts be included in determining lease term. The final legislation
includes combined leasing provisions (including a separate item below) that raise $26
billion. While the revenue cost depends on the actual design, part of the increase is
due to changes in estimated revenue gain.
Disallowance of Partnership Loss Transfers
This $700 million provision is highly technical and contained originally only in
the Senate bill. Many tax shelters are associated with partnerships, which have a lot
of flexibility. This flexibility includes assigning basis to individual partners.
Currently when property is distributed or a partnership interest transferred, the
partnership is not required to make an adjustment to basis, and when property is
distributed to other partners later, the basis adjustments may be made in a way that
permits double recognition of losses or transfers of losses. This provision would
have disallowed that outcome. The final bill contains restrictions but limited to non-
contributing partners.
Lessors to Tax Exempt Entities
This $500 million provision was originally only in the Senate bill, and an
updated estimate yielded $4.7 billion. Combined leasing provisions in the substitute
Senate bill would have raised about $24 billion, and the provision in H.R. 4520 as
passed by the House would have raised $19.6 billion. The final bill includes leasing
provisions of a similar magnitude. Leasing to tax exempt entities by taxable firms
(who receive accelerated depreciation deductions) has figured heavily in a number
of tax shelter arrangements. This provision limits deductions to income received
from the lease, imposing a treatment much like the passive loss restrictions that apply
to passive individual investors.
Mismatching of Items with Related Corporations
This provision, raising about $450 million, is included in both bills (item 7 in
Table 1 and Item 18 in Table 2) and in the final legislation (item 16 in Table 3). It
corrects a circumstance where U.S. companies who are creditors do not include
original issue discount on behalf of their foreign subsidiaries even though the
deductions themselves are reflected in current income.
Basis Reduction for Partnerships
This $400 million provision came out of the Enron investigation and is included
in all bills (item 8 in Table 1, item 20 in Table 2, and item 22 in Table 3). It also
arises from the flexibility allowed partnerships. When partners contribute assets to
a partnership or the partnership distributes assets to a partner, there is no gain or loss
realized. However, it may be necessary to adjust the basis of the asset (which
determines how much of an asset is return on capital and exempt from taxes when

the taxpayer does sell the property). For example, if a partner contributed a building
for which he had paid $100,000 to the partnership, his basis in the partnership is
$100,000, but if the partnership returns the building to him in a distribution and also
pays him $20,000, then he has to reduce his basis to $80,000 so that when he sells the
property, he will pay tax on the $20,000. The partnership may elect to adjust the
basis of its assets in a corresponding manner and is required to group assets of a
similar type in allocating basis. The grouping rules have permitted partnerships in
such situations to reduce the basis of stock and increase the basis of physical assets,
which is advantageous for corporate partners who do not include cash from the sale
of stock in income but do include such gains on real assets.
Straddle Rules
This provision is in the Senate bill and the final legislation. Straddles occur
when individuals hold (generally two) assets that move in opposite directions (such
as an option to buy, or call, along with an option to sell, or put, at a fixed price). If
one of the assets is sold for a loss, current law allows the loss only in excess of the
gain of the other asset, with unused loss carried over. Some stock positions are
exempt from this treatment and there is some confusion regarding circumstances
when the parts of the straddle are not identified.
The provision makes a number of detailed changes in the straddle rule including
repeal of the stock exemptions, providing that taxpayers identify the components of
straddles, and changing the rule from a deferral of loss to a change in basis.
Installment Sales
This provision is in the Senate bill and the final legislation, raising slightly over
$200 million. Under present law, individuals who sell property with payments to be
received as installments only recognize gain when the payments are actually made.
If the taxpayer also receives a readily tradable debt instrument from a corporation or
government, this instrument is considered the payment and gain is taxed
immediately. This provision extends this rule to debt issued by partnerships and
Non-Recognition of Gain in Liquidation
This provision was only in the Senate bill, and would have raised slightly under
$200 million. U.S. subsidiaries of foreign parents pay U.S. corporate tax on their
earnings and when they transfer profits to the foreign parent pay a withholding tax
of 30% unless there is a tax treaty; there is a similar tax on the shifting of branch
earnings abroad. However, if a subsidiary or branch is closing down (a liquidation)
assets may be transferred tax free (if certain restrictions are met). There is a concern
that firms may create U.S. holding companies to obtain the earnings of the domestic
operation and then transfer them tax-free. This provision would have denied tax free
treatment to a U.S. holding company that has been in existence less than five years.

Like Kind Exchanges for Residences
This provision raises around $200 million and is in all bills (item 12 in Table
1, item 27 in Table 2, and item 26 in Table 3). Under current law married couples
can exclude $500,000 of gain ($250,000 for singles) when they sell their residence
as long as they have lived in it for two of the past five years. This provision denies
this exclusion if they acquired the house in a like kind exchange with no recognition
of gain. For example, this provision would tax gain that arose from rental properties
converted into residences.
Clarification of Banking Business
This provision is in all bills (item 13 in Table 1, item 28 in Table 2, and item

17 in Table 3); it raises about $400 million in the final bill. Under current law,

income from foreign incorporated subsidiaries (other than earnings of certain types
of passive assets) is not taxed until paid to the U.S. shareholder. However,
investments of the foreign subsidiary in the United States are subject to tax (as they
can be equivalent to a distribution). There are a series of exceptions to this rule, and
one of them is for bank deposits. In a recent court case, payments to a shareholder
for purposes of carrying on a department store credit card business were found to be
banking by the courts; this provision bases the definition of banking on the taxpayer’s
being subject to banking regulations.
Estimated Tax on Deemed Asset Sales
This $120 million provision is in all bills (item 14 in Table 1, item 29 in Table
2, and item 29 in Table 3). In some circumstances a company acquiring another
company may elect to treat the transactions as a sale of assets by the acquired
company rather than stock. Apparently some taxpayers have interpreted a related
provision about estimated taxes to require no estimated tax payments; this provision
provides that effects of an asset sale must be reflected in estimated tax payments.
Expanded Authority to Disallow Benefits Under Section 269
This $100 million provision relates to the Enron investigation and was only in
the Senate bill. Present law (Section 269) provides that a taxpayer who acquires
control of another corporation cannot use the acquired firm’s tax benefits if the
acquisition was for the purposes of avoiding tax. This provision would have
expanded the scope of present law by not requiring that the acquisition of assets
establishes control.
Modification of the CFC-PFIC Rules
This provision is related to the Enron investigation and raises about $100
million; it was only in the Senate bill. Under current law shareholders in controlled
foreign corporations, or CFCs, are taxed currently on certain tax haven income
(Subpart F income). There are also rules requiring current taxation of income of
passive foreign investment companies (PFICs) that have most of their assets in a
passive form. To prevent overlap, a CFC cannot also be treated as a PFIC and

shareholders are not subject to the rules even if they are expected to pay no tax on
Subpart F income. This provision would have applied the PFIC rules in those cases.
Limit on Transfer of Losses in REMICs
This $100 million provision was only in the House bill and relates to the Enron
investigation. Because of rules recognizing no gain or loss in a transfer of property
for stock, Enron was able to use REMICs (real estate mortgage investment conduits,
which are used to convert mortgages to securities) to duplicate losses. This provision
would have limited the basis of certain interests in REMICs (residual interests, which
are the remainder after subtracting regular interests that involve fixed payments) that
are transferred to corporations to the fair market value in cases where the basis of a
REMIC residual is greater than fair market value.
Reduction of Fuel Tax Evasion
These provisions are included only in the final bill and they are a series of
provisions designed to reduce evasion of fuel taxes that are generally applied for
transportation purposes. They include a variety of measures such as codifying the
definition of off-highway vehicles that are exempt from highway fuel and other taxes,
changing the stage of production/distribution at which taxes are collected, improving
control over dyeing fuel (used to separate non-transport fuel from transport fuel) and
similar measures.
Charitable Contributions for Vehicles
This provision is only in the final bill. Studies had indicated that many
taxpayers were donating used vehicles to charities with an inflated value. These
donations were often made to entities that sold the cars and then provided the cash
to charities. The new bill requires that the deduction equal the actual amount of the
sales price in these cases.
Limit Entertainment Expense Deductions
This provision is only in the final bill. A recent court case found for the
taxpayer who deducted the cost of providing private company airline flights, although
that cost was in excess of the income includible to the companies employees. This
provision limits the deduction to the amount includible in income in the case of
individuals who are officers, directors or owners of a 10% or more share.
Freeze of Provisions Suspending Interest Payments
This provision is only in the final bill. Interest and penalties accrue on unpaid
taxes whether or not the taxpayer is aware that they are due, but cease after a year if
a notice is not sent (except in certain cases, such as fraud). This period has been
temporarily increased to 18 months. This provision makes the 18 months permanent.
It also excludes from the suspension tax deficiencies related to gross misstatements
and officially identified (reportable) transactions.

Application of Basis Rules to Nonresident Aliens
This provision is only in the final bill. When distributions from retirement plans
are made they are taxable to the individuals except to the extent that the individual
made contributions that were not excludible from income. For certain nonresident
aliens, some of this excluded income was not taxed under U.S. law because it was
not from U.S. sources. This provisions includes these untaxed contributions in
income if the income was not taxed by the United States or by any other country.
Tax on Gasoline Blendstocks
This provision is only in the final bill. This provision taxes certain blended
fuels unless it can be established they were not used in making gasoline.
Increase Withholding on Supplemental Wages
This provision is only in the final bill. Currently withholding on supplemental
wages is at the third highest tax rate; this provision withholds supplemental wages
in excess of $1 million at the top tax rate.
Increase Continuous Levy for Certain Federal Payments
This provision is only in the final bill. Currently, the government may attach
(collect prior to individual receipt) up to 15% of payments for tax deficiencies. This
amount in increased to 100% if the payment is made by the federal government.
Tax Policy Changes
Many of the provisions listed thus for were in both the House and Senate bills;
however, in the area of actual tax policy changes — items that change provisions of
the income tax without seeming to be directed at a tax shelter abuse, the focus was
quite different. The larger revenue raisers in the House bill were focused on deferred
compensation, and, to a lesser degree, underpayments and overpayments of tax. The
Senate bill, while including the underpayment provision, had several significant
changes in tax provisions that were different from those in the House bill.
Accordingly, in this section, we discuss first the House bill provisions and then the
Senate bill provisions. In some cases these provisions would have actually provided
benefits, and the revenue gain only reflects timing. We note whether these changes
are in the final legislation as well and conclude with provisions in the final legislation
that were in neither the House nor the Senate original bills.
House Bill
The House bill contained about $1.3 billion of tax increases resulting from tax
policy changes, $800 million of which was due to the deferred compensation
provision discussed immediately below. These provisions were not in the final bill,
but the provision allowing transfer of excess benefits into employee health plans was

included in the Pension Funding Equity Act of 2004, with a sunset of 2013 and a
more limited provision dealing with rabbi trusts (discussed below) was included.
Deferred Compensation. The House bill contained two revisions to the
treatment of deferred compensation (compensation that accrues to individuals but is
not paid out to them) — items 5 and 11 in Table 1, respectively raising $800 million
and $300 million. Non-qualified deferred compensation is taxable to an individual
on a facts and circumstances basis designed to determine whether an individual has
really obtained a right to the compensation. Firms had set up “rabbi trusts” (so called
because the first case that came to the attention of the IRS was set up for a rabbi)
where deferred compensation in the trust could be used to satisfy creditors if the firm
became insolvent and this feature was used to justify not taxing the compensation
currently. The bill would have eliminated this use of exposure of trust fund assets
to creditors in the case of insolvency as a justification for not taxing deferred
This provision clearly involves a tax increase; the gain from this provision
represents in part, therefore, a speeding up of tax payments, since at some point in
the future, the taxes which would otherwise occur on deferred compensation will not
The second provision extended a current provision that allows firms to avoid
plan disqualification (if made prior to termination) or penalties (if made on plan
termination) when taking excess assets out of defined benefit pension plans, by
transferring them to a retiree health benefits plan. The excise tax is 20% or 50%,
depending on whether a replacement plan or certain benefit increases occur. The
excise tax applies in addition to regular income tax on the withdrawal. When
transfers are made, no deduction can be taken for the transfers or the expenditures
they fund. If all the funds are not used currently, they revert and are subject to the
20% excise tax. This change involved providing a tax benefit, not a penalty. The
provision was projected to raise revenue, however, presumably because the increased
transfers from the funds would have paid for costs while not permitting a deduction
and because a penalty is applied to unused funds. This provision would have
eventually lost revenue, however, by reducing the size of plans (and the eventual
individual tax on pension recipients) or by reducing the amount of future
contributions that must be made to fund benefits.
Overpayments and Underpayments of Tax. The House bill included two
other policy changes that related to tax administration and which raised revenue
during the budget horizon — items 15 and 16 in Table 1 (raising about $100 million
each). The first was the elimination of taxes on interest accrued on overpayments of
tax. This provision also established a benefit, and presumably resulted in a revenue
gain because it increased the likelihood of overpayments, although it should have led
to a long term loss. The other provision also provided a benefit and a speedup in
collections by allowing more flexibility for taxpayers to prepay amounts to stop
interest payments on tax underpayments; this gain would also be transitory.

Senate Bill
The Senate bill also contained the provision on underpayments (item 32, Table

2), but there are five other provisions that were permanent increases in most cases;

altogether these provisions accounted for $11.6 billion in revenue, almost ten times
the size of the provisions in the House bill. All references are to Table 2 unless
otherwise noted.
Charitable Contributions of Patents. The largest revenue raiser ($3.9
billion) involved limiting deductions for charitable contributions of patents (item 3).
Under certain circumstances, donors of property to charitable organizations are able
to deduct the entire fair market value of an asset even though they have not been
taxed on the gain. For certain other types of contributions, such as contributions to
foundations or contributions of certain created property, they can only deduct the
basis — what they paid for it or spent creating it. The Senate bill’s provision,
reflecting concerns that the fair market value of patents is not easily determined and
may be inflated, limits the contribution to the basis. However, it also allows an
exception to the general rule disallowing benefits for contributions of partial
interests, by permitting the donor to receive a share of the royalties. This provision
was also included in the final enacted legislation.
Intangibles. The second provision involved the treatment of intangibles (item
4), raising $3.3 billion. Under current law acquired intangibles are deducted over a
15 year period — a compromise to prevent disputes and allocational issues across
intangibles including some (such as good will) which were previously not deductible
at all, and others (such as patient lists) that taxpayers had successfully made a case
in court for deducting over shorter periods of time. In the Senate bill, two intangibles
provisions would have added organizational and certain start up costs (currently
deductible over five years) and sports franchises (which had a variety of rules,
including special rules for player contracts) to the 15 year category. The bill also
permitted the first $5,000 for organization and start-up costs to be deducted
immediately. This provision was also in the final bill.
Increase in Age Limit for Section 1(g ) (“Kiddie Tax”). A third
provision (item 9), raising $1.2 billion, expanded coverage of the “kiddie tax” that
requires unearned income to be taxed at the parent’s rate. The bill increased
coverage from those under age 14 to those under age 18. This provision was not in
the final legislation.
Repeal Rehabilitation Credit. A fourth change (item 10) repealed the 10%
credit for rehabilitation expenditures on buildings constructed before 1936, gaining
$1 billion. No change was made in the 20% rehabilitation credit for historic
buildings. This provision was not in the final legislation.
Private Debt Collection. This provision (item 11) projected to raise almost
$1 billion authorized the IRS to use private debt collection services. This provision
was in the final legislation.

Utility Grading Costs. Utility assets (such as transmission or distribution
lines) are placed in classes that allow them to be depreciated over 15 or 20 years.
However, because certain regulations were never adopted, grading and preparing
property for these lines is not assigned a class and by default is depreciated over
seven years. This provision placed the grading and land preparation costs for
transmission and distribution lines into the same class as the assets themselves,
raising about $700 million. This provision was in the final legislation.
Corporate Governance Provisions: Denial of Deductions. The Senate
bill included several provisions on corporate governance that reflected concerns
arising from the collapse of Enron and other firms. Two of the provisions were
projected to raise revenues of about $330 million (item 21) and $190 million (item
25) respectively. The first would have disallowed firms’ deductions for punitive
damages (normally all settlements are considered a cost of doing business and are
deductible). The second related to deductions for fines. Taxpayers are not allowed
to deduct the costs of fines. This provision clarified that payments made to the
government or at the direction of the government pursuant to an investigation,
including those made to avoid further investigation, were not deductible unless they
are determined to provide restitution. These provisions were not in the final
Only in Final Legislation as Enacted
Tax on Influenza Vaccine. Certain vaccines are taxed and used to provide
a fund for compensation for those injured by vaccines. This provision adds the
influenza vaccine to the list (hepatitis A is also added, but its revenue effect is
Treatment of Creditors in a Divisive Reorganization. Under current
law, in certain circumstances, gain in a reorganization will not be recognized if the
proceeds are used to pay creditors. This provision requires that gain will be
recognized in these distributions
Extensions of Fees
In both original bills, the largest revenue raiser was the extension of customs
fees (merchandising, passenger and conveyance processing fees), accounting for
about $17 billion, accounting for about 60% of the revenue gain in the House bill and
about 30% of the gain in the Senate bill. This provision was also in the final bill. A
fee extension with a smaller gain is the IRS user fee (item 9 in Table 1, item 19 in
Table 2, and item 18 in Table 3), which accounts for about $400 million.