tured home" (mobile home) financing, generally having maturities of up to 12 years and in revolving credit, also known as open-end credit, which has no stated maturity. It is to accommodate these changes in loan maturities which now exist and will increase in the future that S. 644 seeks to amend existing law. This is not a new exception and will create no revenue loss. The provision merely updates present law and allows all companies in the industry to compete on an equal basis. An identical bill (S. 2396) was introduced in the last Congress and was supported by the Treasury Department in testimony before this Subcommittee. That bill passed the Senate in the last Congress as a part of H.R. 7117. Regretably, due to procedural problems, Congress adjourned before action could be taken in the House. Identical legislation, H.R. 2397, has been introduced in the House by Congressman Holland. Present law Present law imposes a tax of seventy percent on the undistributed income of a personal holding company (Sec. 541-547). A personal holding company is defined as a corporation, sixty percent (60 percent) of the adjusted ordinary gross income of which is personal holding company income (generally passive investment income), and fifty percent (50 percent) of the stock of which is owned by five or fewer persons. Certain types of companies whose active business involves the investment of funds and the earning of interest and dividends (i.e., normally passive income is income not from the active conduct of a business), are excluded from the personal holding company provisions. Among the businesses excluded from the definition of a personal holding company are certain consumer finance companies (Sec. 542(c)(6)). Among the types of consumer finance companies intended to be excluded are licensed personal finance companies operating under the small loan (Russell Sage) laws of the various states, lending companies (not of the Russell Sage type) engaged in the consumer finance business, Morris plan banks, and finance companies engaged in the business of factoring inventories, accounts receivable, and otherwise financing the short-term and intermediate-term needs of business. In order to meet the requirements for the finance and lending company exemption, a finance company, inter alia, must earn 60 percent or more of its income from loans which have an average maturity of less than 60 months. It is this 60-month maturity requirement which has failed to reflect the dynamic changes in the finance industry in recent years. Historical background While the tests to be met in order to enjoy the exclusion are the same, regardless of the type of finance company involved, this has not always been the case; and, it was as the result of Congressional attempts to simplify the various earlier exclusions that the present 60-month limitation inappropriately became a rule of general application. The exeption from the application of personal holding company rules to licensed personal finance companies was added to the Internal Revenue laws by the Revenue Act of 1938. The exception was added to grant exemption for companies operating in the various states under statutes similar to the Uniform Small Loan Act drafted by the Russell Sage Foundation. These statutes have typically been referred to as Russell Sage laws. Under these state laws, interest could not be payable in advance or compounded and could be computed only on unpaid balances. Furthermore, the laws limited the principal amount of the loan (usually to less than $500), the term (usually less than 3 years) and the amount of interest (usually less than 3 percent a month). The provision contained in the tax law attempted to mirror these general state requirements, rather than being more strict, as a means of insuring that the exception generally reflected the active business practices which it was designed to except. As the result, when the circumstances of the consumer lending business have rendered the tax requirements more strict than state regulatory provisions, the tax provisions have been altered as well. The primary example of this reflective action is the change effected in the provision in 1962.1 Prior to 1962, the personal finance company exception mirrored the earlier restrictive provisions of Russell Sage laws. The conditions for exceptions under the law at that time required that a finance company must: 1. Be authorized to engage in the small loan business under one or more state statutes providing for the direct regulation of such business; 1 It should be noted that in 1950, an exception was added to permit interest on business loans to be computed by the "dollar add on" method to reflect changes in the law of almost one-half of the states permitting such loans. 83-405 0-81--5 2. Derive 80 percent or more of their gross income from lawful interest, discount, or other authorized charges; 3. Derive the 80 percent of their income, referred to above, from loans maturing in not more than 36 months made to individuals in accordance with the provisions of applicable state law; 4. Derive this 80 percent of their income from loans where the interest and all other authorized charges do not exceed the amount equal to simple interest computed at the rate of 3 percent per month not payable in advance and only on unpaid balances; 5. Derive 60 percent of their gross income from lawful interest, discount, other lawful authorized charges received from individuals whose indebtedness to the company does not exceed the limit prescribed by the applicable state law, or, if there is no such limit, $500; 6. Have trade or business expenses deductions (other than compensation for personal services rendered by shareholders or members of their family) equal to 15 percent or more of their gross income; 7. Have outstanding loans with respect to any person who is a shareholder having a 10-percent interest in the stock of the company (including stock owned by members of the family) of not in excess of $5,000. Recognizing that the requirements no longer reflected the then-existing state statutory limits, but were more strict, Congress, in the 1962 legislation, deleted the three percent interest requirement entirely, deleted entirely the 36-month loan limit, and increased the limit on maximum amounts for loans from $500 to $1500. The legislative history of these changes as contained in the Report of the Senate Committee on Finance is instructive (in pertinent part): "This bill omits this 3-percent-simple-interest requirement entirely, on the grounds that the personal holding company tax is not intended as a means of regulating the lending companies, but rather as a tax applicable in certain cases, to passive investments. In any event, this is an ineffectual regulatory device since this restriction applies only to about 10 percent of the outstanding small loans that are made by widely held finance companies, and therefore not treated as personal holding companies since they do not have five or fewer stockholders owning more than 50 percent of their stock. Moreover, even the companies presently subject to this restriction need to meet it only with respect to 80 percent of their gross income. "The bill also deletes the requirement that these lending companies derive_most of their income from loans maturing in not more than 36 months. Several States already have gone beyond this as a permissive period for loans and it appears likely that in the near future a number of additional States may extend maturities to more than 36 months. Your committee agrees with the House committee that it should not impose a requirement substantially more restrictive in nature than the State laws regulating this type of lending company. "A third change made by the House bill modifies the maximum size of a loan which may qualify under the 80-percent-income requirement where there is no State law governing the maximum size of a loan. Under present law where there is not such limit under State law, a limitation of $500 is provided. Under the bill this limitation is increased to $1,500. It is understood that the only State which does not have a ceiling of its own is the State of California. When the $500 limit provided by present law was considered, this represented the usual ceiling among the States. The States have changed these ceilings materially, however, with the result that today relatively few States have a ceiling of $500 or less and in these cases there usually is provision for supplementary loans which exceeds this ceiling in certain situations. The $1,500,000 provided by this bill, where there is no applicable State limitation, today is substantially in conformance with the ceilings applicable in those States providing their own maximums. * "A fifth change relates to the use of the term 'small loan business,' which represents the type of business in which a lending company must be engaged in order to be removed from application of the personal holding company tax under this exception. The bill adds after the term 'small loan businesses' the term '(consumer finance business)'. This is intended to make it clear that this exception is not limited to small loans in the narrow sense, but rather is intended to encompass consumer finance loans generally. Moreover, the reference to consumer finance business will bring this exception more directly in accord with the terminology now used by a number of State legislatures which have retitled the applicable provisions governing these institutions as 'consumer finance laws' as a means of providing a more descriptive title for the type of business involved. S. Rep. No. 2047, 87th Cong., 2d Sess. (1962), reprinted in [1962] U.S. Code Cong. & Ad. News 2825, 2827-2828.' An equally compelling policy reason for eliminating tax requirements which are more restrictive than requirements of the various state laws was expressed by thenAssistant Secretary of the Treasury, Stanley Surrey, in his comments to the Senate Committee on the proposed revisions: "It has been the Department's consistent position that taxpayers in like situations should be subject to the same rules and rates of taxation. The effectiveness of our self-assessing system to a large extent depends upon each taxpayer's willing compliance with laws which are regarded as rational and fair. Since [the small loan provisions] selects only a portion of the small loan industry for regulation, and since that portion is similar to other businesses not subject to these rules, the Department has no objection to the removal of the 3-percent-a-month and 36-month regulatory limits. S. Rep. No. 2047, 87th Cong., 2d Sess. (1962), reprinted in [1962] U.S. Code Cong. & Ad. News 2825, 2830-31." While the 1962 legislation vastly improved the equity of the tax treatment accorded closely-held finance companies, the provision, as amended, remained extremely complex. As the result, in the Revenue Act of 1964, Congress simplified the exception by imposing one set of standards upon all types of finance companies. In so doing, a limitation on the term of loans for consumer finance companies found its way back into the law. Subsequent to the revisions made by the 1962 Act, there remained four different types of personal finance companies which were excluded from the personal holding company category: "1. Licensed personal finance companies, 80 percent of whose gross income is interest from loans if at least 60 percent of their gross income is received from loans classified as "small loans" by State law (or $500 if there is not State law limit) and if the interest is not payable in advance computed only on unpaid balances. In addition, loans to a person who is a 10-percent shareholder must not exceed $5,000 in principal amount. These frequently are known as "Russell Sage" type personal finance companies. "2. Other lending companies engaged in the small loan or consumer finance business, 80 percent of whose gross income consists of interest or similar charges on loans to individuals and income from 80-percent-owned subsidiaries which in turn themselves meet this test. In addition, at least 60 percent of the company's income must be from interest or similar charges made in accordance with small loan or consumer finance laws to individuals where the loans do not exceed the State specification for small loans (or if there is no such limit, $1,500) and if the trade or business expenses of the company represent 15 percent or more of the company's gross income. These companies also must not have loans outstanding to shareholders, with a 10-percent interest or more, which exceed $5,000. "3. A loan or investment company (such as a Morris Plan bank), a substantial part of whose business consists of receiving funds not subject to check and evidenced by certificates of indebtedness or investment, and making loans and discounts. Here also loans to a person who is a 10-percent shareholder may not exceed $5,000 in principal amount. "4. A finance company actively engaged in purchasing or discounting accounts or notes receivable, or installment obligations, or in making loans secured by any of these or by tangible personal property, if at least 80 percent of its gross income is derived from such business. In addition, at least 60 percent of such a company's gross income must be derived from certain categories of income. These categories, in general, relate to business or factoring-type loans: such as purchasing or discounting accounts or notes receivable, or installment obligations arising out of the sale of goods or services by the borrower in his business; making loans for not more than 36 months to businesses where the amounts are secured by accounts or notes receivable or installment obligations of the type described above, or secured by warehouse receipts, bills of lading, inventories, chattel mortgages on property used in the borrower's trade or business, etc. In the case of these companies, the trade or business expenses deductions must represent at least 15 percent of the gross income of the company, and loans to those who are 10-percent shareholders in such company must not exceed $5,000 in principal amount.' It should be noted that the only type of finance company upon which a maturity limit was imposed was a finance company engaged in purchasing or discounting accounts or notes receivable, or installment obligations, or in making loans secured by any of these or by tangible property. Such factoring-type companies were required to earn at least 60 percent of their income from, inter alia, loans to businesses for not more than 36 months, where the loans arose out of the borrowers trade or business. Curiously, when the Congress "simplified" the exception in the 1964 Act, the limit was written to have precisely the opposite effect. As the result of the 1964 Act, the 36-month limit was expanded to 60 months, but rather than applying to loans by factoring-type companies, the limit, now cantained in Sec. 542(d)(1)(B)(i) was written to apply to all but such factoring-type loans. It is important to note that if the word "unless" in Sec. 542(d)(1)(B)(i) were changed to the word "if," the new law would have accomplished the simplification result without resurrecting a limit previously deleted as too restrictive. That simplification was the intent of the 1964 changes and that the same policy underlying the deletion of the 36-month limit was to be retained is clearly reflected in the House Committee Report: "In the interest of simplification, your committee concluded that it would be desirable to have one exclusion available for all four of these categories of lending or finance companies. At the same time, it saw no need for purposes of the personal holding company provision to restrict the type of loans which these companies could make. This is properly a matter of regulation by State law governing these lending or finance businesses. Moreover, it was recognized that in any event the personal holding provisions do not apply to widely held corporations. In such cases only State law governs the type of loans which can be made. H. Rep. No. 749, 88th Cong. 2d Sess. (1964), reprinted in [1964] U.S. CODE CONG. & AD NEWS 1313, 1389-1390." In the absence of an explicit explanation in the legislative history of the inclusion of a 60-month limit, one might conclude that Congress merely painted with too broad a brush when it simplified prior law. However, in light of the total reversal of the type of company to which it was to be applied and the reiteration of the policy underlying the original deletion, it is far more plausible to conclude that the 60month limitation of present laws does not reflect legislative policy, but rather inadvertent error. Reasons for change Whether the result of error or generalization, the 60-month limit needlessly restricts closely-held consumer finance companies from competing on an equal basis with more widely-held companies in rapidly expanding areas of consumer finance. As previously stated, the limitation on the term of loans was deleted because the lending and maturity restrictions under most State laws had become far more liberal than the federal tax provision. That is even more the case today. Most consumer finance companies presently operate, not only under Small Loan laws, but also under generally applicable second mortgage, usury, industrial loan and similar laws. In almost all instances, the general usury law imposes no maximum maturity. This expansion beyond small loan laws has resulted from fundamental changes in the competitive structure of the entire finance industry. Rather than competing for small loans, the bulk of recent market expansion has been in the areas of revolving credit and second mortgage loans. In the case of revolving credit, the loans have no fixed maturity. In the case of second mortgage and manufactured home loans, probably owing to the size of the loan, the maturities typically equal or exceed 60 months. (Generally, up to 12 years (144 months)). The trend in personal loans is definitely toward longer maturities, and, in the case of the rapidly expanding revolving or open-end credit, no fixed maturity at all in the traditional sense. According to statistics developed by the Federal Reserve Board, the percentage of personal loans having a maturity of over 42 months increased from a negligible amount in 1972 to 26.4 percent of loans made in 1977. The 1977 figure almost doubles the percentage of higher maturity loans from the year before. Additional data on consumer finance transactions compiled by the First National Bank of Chicago reflects that the percentage of loans written for longer than 37 months (the only category including over 60-month loans) grew from 11.76 percent in 1972 to 20.35 percent in 1977 to 30 percent in 1978. This data reflects not only the increase in numbers of longer maturity loans but the rapidity with which the numbers of such loans are increasing. It may be expected that, particularly with the tremendous increase in the volume of second mortgage loans (almost all of which have maturities of at least 60 months or longer), the strength of the trend will continue. S. 644 S. 644 will amend section 542 of the Internal Revenue Code in two respects. First, section 542(d)(1)(B)(i) will be amended by replacing the 60-month maturity limitation with a limitation of 144 months. Additionally, the bill will except from the computation of average maturities all open-end or revolving credit transactions (indeterminate credit) as that term is defined in the Truth in Lending Act. The second amendment will tighten the eligibility rules for the consumer finance company exclusion from the definition of "personal holding company." Section (c) of section 542 excepts a number of business enterprises from the definition of a "personal holding company." Paragraph (6) of that subsection provides for the exclusion of certain lending or finance companies if certain conditions are met. Among those conditions is the requirement that the sum of deductions which are directly allocable to the finance business must exceed the sum of 15 percent of the first $500,000 of ordinary gross income from the finance business, plus 5 percent of the second $500,000 of gross income from the finance business. At the request of the Joint Committee on Taxation, S. 644 will extend the amount to which the 5 percent applies from $500,000 to the total amount of all gross income derived from the finance business which exceeds $500,000. The result will be that overall percentage of deductions directly attributable to gross income from the finance business must be greater than under present law in order for a consumer finance company to qualify for exclusion under the personal holding company provisions. Conclusion S. 644, therefore, represents a balance between the need to accommodate a changing business environment and the need to insure that the exception is not employed as a device to avoid the personal holding company rules. We respectfully urge expeditious and favorable consideration of this legislation. Senator PACKWOOD. Thank you very much for coming. The last bill we have is S. 798, introduced by Senator Danforth and I believe there are no witnesses to testify for or against this bill. That will conclude our hearings for the day. Senator MATSUNAGA. Thank you, Mr. Chairman. Senator PACKWOOD. Thank you, Senator Matsunaga, for coming. [Hearing adjourned at 10:35 a.m.] [By direction of the chairman the following communications were made a part of the hearing record:] Hon. BOB PACKWOOD, U.S. DEPARTMENT OF LABOR, Chairman, Subcommittee on Taxation and Debt Management, Committee on Finance, Washington, D.C. DEAR MR. CHAIRMAN: This is in response to your request for information on prepaid legal service plans for your upcoming hearings. As you are aware, section 2134(d) of the Tax Reform Act of 1976 (Public Law 94-55) required the Secretaries of Labor and Treasury to report on continuation of the exclusion from income for certain prepaid legal service plans under section 120 of the Internal Revenue Code of 1954. In order to obtain information for that report the Department of Labor contracted with the National Resource Center for Consumers of Legal Services. The Center has recently submitted a preliminary draft of its findings under that contract, including data on the number and types of plans. While, like most preliminary drafts, this draft requires further work before it is accepted by the Department of Labor, we believe the preliminary data provided in the report may be of use to your Subcommittee in its deliberations. Accordingly, we are enclosing the two chapters of the preliminary draft that provide the data. We hope this data is helpful. We would like to reiterate that this draft represents only the contractor's preliminary submission and has not been fully evaluated by the Department. Further in submitting the draft to you, the Department is not taking any position on the merits of either extending or not extending the section 120 exclusion. We would be happy to provide whatever further assistance you may require. |