purpose well in the case of individuals using preferences in combination to excess, but their application to corporations requires further careful consideration." "

Thus, two different sets of Treasury Department officials, each of whom carefully considered the application of the recommended provisions to corporations, expressly declined to recommend that application. Each group noted quite clearly that the core problem was one of individuals abusing the so-called tax preference items or incentive items, usually by combining several of these preference items in such a fashion that they were able to impair the progressivity of the individual income tax system and avoid contributing their fair share to the Federal Government. Each group expressly recognized that the question whether their recommended provisions should be applied to corporations was fundamentally different from the question of their application to individuals, since ordinary business corporations were not in a position to structure their income and combine preference items in the way that individuals could. The few corporations that would be significantly affected by the minimum tax were generally engaged in businesses which called for the intensive use of a particular preference item which Congress had deliberately legislated as an incentive measure for the development of that business because it was in the national interest to promote development of the business. Both groups agreed that the question whether the tax structures of these particular industries should be changed depended upon a careful analysis of the industries and the effects such changes would have on them. Therefore, the question of application of the tax on tax preferences to corporations was one which required further careful consideration.

The distinction which these Treasury Department officials made was based on the fact that ordinary business corporations obtain tax preferences primarily because they make active investments for good business reasons in areas where a particular preference applies, whereas individuals primarily make passive investments, often in several areas where preferences apply, and usually for tax reasons rather than for good business reasons. Thus, Mr. Cohen made it very clear during questioning by the Chairman of the Ways and Means Committee that the focus of the attack was not upon the various preference items, but rather upon the abuse of those items by individuals:

"The Chairman. What implication is there to be drawn from your proposal to include in your tax base half of the amount of the excess of percentage depletion over cost depletion and intangible drilling costs? Does that mean you have concluded that the amounts themselves are 50 percent too high?

"Mr. Cohen. No, Mr. Chairman, the theory of this is that we are not prepared to make judgment at this juncture about the operation of the provisions and the incentives in any particular industry, be it real estate or oil. But we are saying that the difficulties that have occurred under existing law stem from the excessive use of these special provisions and incentives by any individual.

"Our proposal does not attempt to pass judgment that the preferences afe 50 percent good and 50 percent bad. It attempts to curb the extent to which they can be used by any individual to eliminate his contribution to the Federal Government. It would not, therefore, change at the moment any rules regarding depreciation on real estate, but it would limit the ability of a person to invest and invest and invest in real estate and use accelerated depreciation to the point that he makes no contribution to the Government."" The version of the Tax Reform Act of 1969 passed by the House contained essentially the LTP and the allocation of deductions provisions which had been recommended by the Nixon Administration, applying them only to individuals. The list of preference items was changed, however, by dropping intangible drilling expenses and the amount of percentage depletion in excess of cost, and adding exempt interest on state and local bonds and the excluded portion of net long-term capital gains.

In presenting the recommendations of the Nixon Administration to the Finance Committee, the Treasury Department recommended several changes in the list

• Id., at 27.

Hearings on H.R. 13270 Before the House Committee on Ways and Means, 91st Cong., 1st Sess., Pt. 14, at 5525 (1969).

of preference items, but it did not recommend application of the LTP and allocation of deductions provisions to corporations.*

On October 24, 1969, the Finance Committee announced in a press release that it had decided in executive session to substitute a 5 percent minimum tax (which was really an additional tax) on preference income in excess of $30,000 in place of the LTP and allocation of deductions provisions. In spite of the repeated failure of the Treasury Department over an extended period of time to recommend application of the previous minimum tax and the LTP to corporations, the Finance Committee decided to apply its new minimum tax to corporations as well as to individuals. The decision to extend application of the minimum tax to corporations apparently was based upon a desire to increase revenue. Thus, the Chairman of the Finance Committee stated in support of the new tax that it was far simpler than the House provisions, and that it also produced more revenue, largely because of its extension to corporations. Regardless of the validity of the claim that the minimum tax was simpler than the LTP and allocation of deductions, the minimum tax did in fact introduce enormous new complexities into an already sufficiently complex Internal Revenue Code.

10

The Report of the Finance Committee which accompanied its version of the Tax Reform Act purported to explain why the minimum tax could apply to corporations whereas the LTP and allocation of deductions provisions could not:

"Moreover, the House provisions for a limit on tax preferences and allocation of deductions would apply only to individuals and not to corporations. In large measure, this is because these provisions do not lend themselves to the taxation of preferences enjoyed by corporations. For example, a corporation with sufficient tax preferences to be affected by these provisions could arrange to escape from their impact by merging with other corporations with relatively small amounts of tax preference income.

"The minimum tax provided by the committee avoids these problems since it merely involves applying the 5 percent rate to tax preference income in excess of the specified exemption. It also differs from the House provisions in that it does not treat differently two individuals with the same amounts of tax preference income merely because they have different amounts of taxable income. In addition, the minimum tax is readily applicable to corporation tax preferences since, unlike the House provisions, it is not feasible for corporations to avoid this tax through mergers." "

The only reason which the Finance Committee specified for the proposition that its minimum tax was readily applicable to corporations while the House's LTP and allocation of deductions were not, i.e., elimination of the possibility of avoidance through merger, was itself eliminated by an amendment to the minimum tax provision on the floor of the Senate. The amendment essentially increased the rate of the minimum tax from 5 to 10 percent, and provided that in addition to the $30,000 exclusion, the amount of ordinary income tax paid should be deducted from the base of the tax. This amendment thereby eliminated the validity of the claim that the minimum tax does not treat differently two taxpayers with the same amounts of tax preference income solely because they have different amounts of taxable income and thus reopened the avenue of avoidance through merger.

13

The version of the minimum tax which was finally enacted 12 imposes a 10 percent tax on the amount of tax preference items which exceed $30,000 plus the ordinary income tax liability of the taxpayer reduced by certain credits. Nine items were originally treated as tax preference items: excess investment interest, accelerated depreciation on real property, accelerated depreciation on personal property subject to a net lease, amortization of railroad rolling stock, stock options, reserves for losses on bad debts of financial institutions, percentage depletion in excess of cost, and capital gains. A tenth preference item, amortization of on-the-job training and child care facilities, was added in 1971." The

8 Senate Committee on Finance, 91st Cong., 1st Sess., Tax Reform Act of 1969, H.R. 13270, Technical Memorandum of Treasury Position 38-50 (Comm. Print 1969).

Senate Committee on Finance, 91st Cong., 1st Sess., Tax Reform Act of 1969, Compilation of Decisions Reached in Executive Sess 43-45 (Comm. Print 1969).

10 Id.. at 43.

11 S. Rep. No. 91-552. 91st Cong., 1st Sess. 113 (1969).

12 Section 301 of the Tax Reform Act of 1969.

13 Excess investment interest is an item of tax preference only for taxable years beginning before January 1, 1972. Proposed Reg. § 1.57-2(a).

14 Section 303 of the Revenue Act of 1971.

statute provides for deferral of minimum tax liability in a year in which the taxpayer incurs a net operating loss any portion of which can be carried over to a succeeding taxable year. A 1970 amendment permits the carry forward of the amount of any ordinary tax liability not used in the current year to offset tax preference items for a period of 7 years.

15

Recently, several bills have been introduced which would amend the "minimum tax so as to increase the tax burden on preference items." 10 Although these various bills are not identical, they are designed to accomplish similar goals. In general they would:

(1) Eliminate entirely the present deduction from the minimum tax base for the amount of income tax paid (thereby eliminating any vestige of justification for calling the tax a "minimum" tax);

(2) Reduce the $30,000 minimum tax exemption to $12,000;1 and

(3) Change the rate of the minimum tax from 10 percent to 20 percent.18

APPLICATION OF THE MINIMUM TAX TO CORPORATIONS

Examination of the ten items which are treated as tax preferences for purposes of the minimum tax points up that many of them do not apply to ordinary business corporations and that most of those which do apply are not as significant for corporate taxpayers as they are for individual taxpayers, that is, the tax benefits they produce are much greater in the case of individuals than in the case of corporations.

Thus, three of the preference items which are of substantial benefit to individuals are inapplicable to ordinary business corporations. These are excess investment interest, accelerated depreciation on personal property subject to a net lease, and stock options. Another preference item, reserves for losses on bad debts of financial institutions applies only to financial institutions such as banks, mutual savings banks, and building and loan associations.

Four other preference items, accelerated depreciation on real property, amortization of certified pollution control facilities, amortization of railroad rolling stock, and amortization of on-the-job training and child care facilities, are only preferential in that they permit deductions which normally would be taken in later years to be taken in earlier years. Since for all practical purposes the corporate tax rate is a flat rate once the $25,000 surtax exemption is exceeded, the timing of deductions is not nearly as important for corporate taxpayers as it is for individual taxpayers whose rates are truly progressive. Individual taxpayers, by manipulating the timing of deductions and creating large deductions in high income years can actually reduce their ultimate income tax liability. This ability to impair the progressivity of the individual income tax rate structure, which was one of the chief reasons for the development of the tax on preference items, simply does not apply in the case of corporations, the tax rate of which is almost completely nonprogressive. For the vast majority of corporations, the timing of deductions does not produce ultimate tax savings. For corporations, the real benefit of accelerating deductions is a cash flow benefit, not a benefit which reduces the amount of taxes paid to the Federal Government. Furthermore, corporations which make the expenditures producing these deductions are merely responding to a Congressional policy of encouraging them to do so.

While corporations do have net long-term capital gains, the preferential tax treatment which that type of income is accorded is much more significant in the case of individuals than in the case of corporations. In the first place, the difference between the effective capital gains tax rates and the ordinary income tax rates is more extreme with respect to individuals than with respect to corporations. In addition, most business corporations are engaged solely or primarily in the active conduct of a trade or business which generally produces ordinary income rather than capital gains.

The remaining preference item, percentage depletion, does have a substantial impact on corporate taxpayers, particularly relatively small, nondiversified mining corporations. The percentage depletion deduction, which was already

15 Section 501 of the Excise. Estate, and Gift Tax Adjustment Act of 1970.

10 H.R. 1932, H.R. 3841, and S. 294.

17 S. 294 would reduce the exemption to $10,000.

18 S. 294 would leave the rate at 10 percent.

limited to 50 percent of the taxable income from the mineral property, was given separate, careful reconsideration during the course of the enactment of the Tax Reform Act. In cases where Congres found it appropriate to reduce the rate of depletion, it did so. Yet the present 10 percent minimum tax has the effect in many cases of further reducing the depletion deduction, presumably beyond what Congress intended, and adoption of some of the amendments currently being proposed could effectively cut the present nominal depletion rates by more than 40 percent.

Specifically, in the case of the china clay producers submitting this statement, the minimum tax has had the effect of reducing the benefit of the incentive intended by Congress in granting the percentage depletion allowance to china clay. The principal producing area for this mineral in the United States lies in a belt of rural counties in Georgia and South Carolina. The china clay industry is small when compared to most other mining industries, but it is extremely important to the economy of the rural area of Georgia and South Carolina where it is located. The percentage depletion allowance has contributed significantly to the growth of this industry and of the economy of the area in which it operates, and to the industry's ability to compete with foreign producers of the mineral, thereby reducing imports and increasing exports of china clay and favorably affecting our balance of payments. The reduction in the applicable percentage depletion resulting from the minimum tax (as well as from the reduction in rate from 15 percent to 14 percent also enacted in 1969) adversely affects the continued ability of the industry to grow and to compete with foreign producers.

In addition, the minimum tax can create situations which give rise to questions of fundamental fairness. Consider a corporation with a $1,000,000 net operating loss carryover from 1967, none of which is attributable to any tax preference item. If that corporation has $1,000,000 of taxable income before depletion in 1972, and a current depletion deduction of $500,000, it will have to use the current tax preference item to reduce taxable income (before application of the net operating loss carryover) to $500,000, even though that means that it will lose $500,000 of its net operating loss forever. In addition, it will have to pay a $47,000 minimum tax even though the tax preference item deduction has produced no real tax benefit. It seems manifestly unfair and contrary to the intended purpose of the minimum tax to impose a tax upon a preference item which has produced no tax benefit.

RECOMMENDATIONS

For the following reasons, the minimum tax should be repealed at least insofar as it applies to corporations. The legislative history of the minimum tax indicates clearly that the original versions of the tax on tax preferences, which had been carefully developed by Treasury officials, were not intended to apply to corporations, but only to individuals. Perhaps the most significant distinction between individuals and ordinary business corporations for minimum tax purposes is the difference in their roles as investors. Individuals are in a position to make unintended use of combinations of preferences through passive investments primarily for tax reasons, thereby impairing the progressivity of the individual income tax and avoiding their obligation to contribute to the Federal Government. This ability of individuals to combine preferences and avoid paying any income tax, which was one of the primary reasons for enactment of a tax on tax preferences, is simply not available as a practical matter to ordinary business corporations. The ordinary business corporations which are affected most seriously by the minimum tax generally make intensive use of a particular preference item in an intended manner through active investments for good business reasons. In addition, an analysis of the items which have been classified as tax preference items for minimum tax purposes points up that many of them are not applicable to ordinary business corporations, and that many others do not produce the tax advantages for corporations which they produce for individuals. Also, examination of the impact of the minimum tax on corporations demonstrates it can unfairly cause a tax to be imposed where the corporation realizes no benefit from the tax preference item.

It is understandable that Congress, under extreme time pressure and faced with the need to raise a certain amount of revenue, would make decisions without giving the careful consideration it ideally would like to give to the probably consequences of those decisions, relying on its ability to change those decisions at a later date when the consequences become more apparent. It is submitted that the decision to apply the minimum tax to corporations was such a decision, 19 Section 501 of the Tax Reform Act

-9.

and that the decision now should be changed. In the event that the revenue loss which such repeal would produce is considered to be excessive, then the repeal could be accompanied by other measures which would produce the same overall revenue from corporations but on a more equitable basis.

If complete repeal as to corporations is not considered desirable or practicable, then, alternatively, one or more of the following modifications are suggested: 1. The amount of percentage depletion in excess of cost could be removed from the list of tax preference items. This proposal would eliminate the potentially harsh impact of the minimum tax on mining companies.

Since percentage depletion is specificially intended to encourage the development of our natural resources, including it as a tax preference item obviously operates to reduce indirectly the effectiveness of the intended incentive. Furthermore, the whole purpose of the minimum tax is to insure that all taxpayers make some significant contribution to the support of the government by preventing the use of certain devices which can eliminate or shelter income. Some of the tax preference items (for instance, those which provide for accelerated depreciation) can be used to shelter income from any source, and thereby reduce or eliminate tax on income having no relation whatsoever to the activity or income giving rise to the preference. On the other hand, since percentage depletion is limited to 50 percent of the "taxable income from the property", which means the "gross income from the property" less all allowable deductions attributable to the property other than percentage depletion, obviously it can never be used to eliminate all of the income from the property, much less to shelter income from any other source. Percentage depletion simply does not possess the flexible tax avoidance potential of other preference items."

2. The tax could be made a true minimum tax, rather than an additional tax, by providing that a corporation's tax will be the income tax, or the minimum tax, whichever is greater, but not both. This proposal would remove most of the inequities but still assure some substantial tax payment by corporations granted tax preferences.

3. The amount of minimum tax paid could be carried forward for a reasonable period (perhaps 7 years) as a credit against future ordinary income tax (or ordinary income tax paid could be carried back for a reasonable period). This would provide relief to those taxpayers who have substantial minimum tax liabilities in early years similar to the relief presently granted to taxpayers whose ordinary income tax payments in early years may be carried forward to offset significant minimum tax liabilities which arise in later years.

Present law permits taxpayers whose ordinary income tax payments in any year exceed the amount of their tax preference income minus $30,000 to carry the amount of that excess forward for a period of up to 7 years to offset future tax preference income. This provides sensible and fair relief to those taxpayers who have substantial income tax liabilities and small amounts of preference income in early years, but substantial amounts of preference income and small income tax liabilities in later years. There is no conceivable reason why similar relief should not be provided to taxpayers who experience the same kind of bunching of these items, but in a reverse pattern.

Permitting, in addition to the present 7 year carry-forward of ordinary income tax paid, the carryforward for some reasonable period of minimum tax paid as a credit against future income tax liability, in years in which there is no minimum tax liability, will eliminate the remaining discriminatory consequences resulting from year-to-year fluctuations of income tax liability and tax preference income. Such a correction should be made effective as of the original effective date of the minimum tax. Of course, this would be of no assistance to a company which is subject to the minimum tax each year.

4. The income tax liability before, rather than after, reduction by credits could be subtracted from the items of tax preference in order to obtain the tax base. Although the relief granted by this proposal is not very substantial and although it does not remove many of the present inequities, it creates more equitable results when foreign income is involved and tends to restore the incentives intended by Congress in adopting the Job Development Investment Credit and the Work Incentive Program Credit.

20 At the very least, the amount of percentage depletion in excess of cost should be included as a tax preference item only where the person claiming the deduction is not directly engaged in the drilling or mining operation which created the deduction. In this way the minimum tax would not penalize those who are making active investments which create depletion deductions for good business reasons and for the purposes specifically intended by Congress in enacting the depletion deduction provisions, but it instead would be limited to those passive investors who may be motivated principally by tax considerations.