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Statement of 
Investment Company Institute

Revenue Raising Provisions in the 
Administration’s Fiscal Year 1998
Budget Proposal

Submitted to 
Committee on Ways and Means
U.S. House of Representatives

March 26, 1997

The Investment Company Institute (the "Institute")1 submits for the Committee’s consideration the following comments regarding proposals to (1) require sellers of securities to calculate gains and losses using an average cost basis, (2) increase the penalties under section 6721 for failure to file correct information returns, and (3) modify section 1374 of the Internal Revenue Code2 to require current gain recognition on the conversion of a large C corporation to an S corporation.

I. Average Cost Basis For Securities

Background
Taxpayers who sell stocks or other securities generally calculate gain or loss on disposition by either specifically identifying the securities sold (the "specific identification" method) or treating the shares held longest as sold first (the "first-in-first-out" or "FIFO" method). Dispositions of shares in a regulated investment company ("RIC") also may be accounted for using either the single-category or double-category average cost basis method. Under the single-category average cost method, the basis of shares sold is calculated by adding together the amounts paid for all of the shareholder’s investments in the RIC (total cost basis), subtracting the amount of basis attributable to prior redemptions and dividing the remainder by the total number of shares owned by the shareholder immediately prior to the redemption.3

Proposal

The President’s Fiscal Year 1998 budget includes a proposal which would require taxpayers to calculate gains and losses on dispositions of substantially identical securities, including shares of a RIC, using the single-category average cost basis method. The proposal would apply to securities sold more than 30 days after enactment of the proposal.

Recommendation

The Institute strongly opposes the average cost basis proposal. The proposal would increase taxes on securities investors, reduce incentives to save, discourage capital investment and complicate tax calculations.

By eliminating the present law option to specifically identify the securities sold, the proposal would increase taxes on securities investors. Millions of middle-income investors saving for retirement and other long-term objectives (such as college tuition for their children) would be disadvantaged by this proposal. By increasing taxes on investors, the proposal would reduce incentives to save and discourage capital investment. Moreover, the proposal would discourage reinvestment in successful companies, but would have no effect on those who purchase a particular type of security only once.

Requiring use of the average cost basis method also would complicate, rather than simplify, tax calculations. For example, if a RIC investor purchased shares and reinvested quarterly dividends for ten years, the investor’s cost basis for a single share would not be the price paid for that share, but would instead be an average of 41 different purchases occurring over a ten year period. Holding RIC shares for longer time periods and/or purchasing shares more frequently, such as through a monthly periodic purchase plan or participation in a monthly dividend reinvestment plan, would increase significantly the complexity of these calculations.4

Complexity also would arise from the attribution rules that would be needed to prevent avoidance of the average cost basis requirement through the use of related persons and controlled entities. For example, attribution rules would be required to prevent avoidance by (1) having securities held by the taxpayer’s children or other relatives, (2) holding securities in joint accounts, and (3) establishing separate partnerships, trusts and other entities to hold securities.

The proposal’s effective date, applying to all securities sales more than 30 days after date of enactment, would retroactively affect in an adverse manner every investor who purchased securities when the specific identification method of determining cost basis was permissible. By applying to securities already held as well as shares purchased in the future, millions of RIC shareholders would be required to perform these detailed and cumbersome calculations. While many RICs now provide average cost basis information to their shareholders, they typically do so only for accounts opened after (or shortly before) the implementation of a system for providing average cost basis information. The provision of average cost basis information to new accounts reflects the fact that RICs, as a practical matter, cannot accurately determine the average cost basis with respect to old accounts (1) from which shares were redeemed prior to the establishment of the system to calculate average cost basis5 or (2) for which less than all of the cost data is stored in machine-readable format.6 In addition, in many cases a RIC would not be able to provide average cost basis calculations to investors who acquire shares by gift or inheritance, or to investors who otherwise did not purchase the securities from the RIC seeking to provide the average cost basis calculations. Thus, it is erroneous to assume that the necessary average cost basis calculations will be provided to all RIC investors. Those many investors who do not receive average cost information will be burdened with new, time consuming mathematical computations.

II. Increased Penalties for Failure to File Correct Information Returns

Background

Current law imposes penalties on payers, including RICs, that fail to file with the Internal Revenue Service ("IRS") correct information returns showing, among other things, payments of dividends and gross proceeds to shareholders. Specifically, section 6721 imposes on each payer a penalty of $50 for each return with respect to which a failure occurs, with a maximum penalty of $250,000.7 The $50 penalty is reduced to $15 per return for any failure that is corrected within 30 days of the required filing date and to $30 per return for any failure corrected by August 1 of the calendar year in which the required filing date occurs.

Proposal

The President’s Fiscal Year 1998 budget contains a proposal which would increase the $50-per-return penalty for failure to file correct information returns to the greater of $50 per return or five percent of the aggregate amount required to be reported correctly but not so reported. The increased penalty would not apply if the total amount reported for the calendar year was at least 97 percent of the amount required to be reported.

Recommendation

The Institute opposes the proposal to increase the penalty for failure to file correct information returns. Information reporting compliance is a matter of serious concern to RICs. Significant effort is devoted to providing the IRS and RIC shareholders with timely, accurate information returns and statements. As a result, a high level of information reporting compliance is maintained within the industry.

The Internal Revenue Code’s information reporting penalty structure was comprehensively revised by Congress in 1989 to encourage voluntary compliance. Information reporting penalties are not designed to raise revenues.8 The current penalty structure provides adequate, indeed very powerful, incentives for RICs to promptly correct any errors made.

III. Conversions of Large C Corporations to S Corporations

Background

Section 1374 generally provides that when a C corporation converts to an S corporation, the S corporation will be subject to corporate level taxation on the net built-in gain on any asset that is held at the time of the conversion and sold within 10 years. In Notice 88-19, 1988-1 C.B. 486, the IRS announced that regulations implementing repeal of the so-called General Utilities doctrine would be promulgated under section 337(d) to provide that section 1374 principles, including section 1374’s "10-year rule" for the recognition of built-in gains, would be applied to C corporations that convert to RIC or real estate investment trust ("REIT") status.

Notice 88-19 was supplemented by Notice 88-96, 1988-2 C.B. 420, which states that the regulations to be promulgated under section 337(d) will provide a safe harbor from the recognition of built-in gain in situations in which a RIC fails to qualify under Subchapter M for one taxable year and subsequently requalifies as a RIC. Specifically, Notice 88-96 provides a safe harbor for a corporation that (1) immediately prior to qualifying as a RIC was taxed as a C corporation for not more than one taxable year, and (2) immediately prior to being taxed as a C corporation was taxed as a RIC for at least one taxable year. The safe harbor does not apply to assets acquired by a corporation during the C corporation year in a transaction that results in its basis in the assets being determined by reference to a corporate transferor’s basis.

Proposal

The President’s Fiscal Year 1998 budget proposes to repeal section 1374 for large corporations. For this purpose, a corporation is a large corporation if its stock is valued at more than five million dollars at the time of the conversion to an S corporation. Thus, a conversion of a large C corporation to an S corporation would result in gain recognition both to the converting corporation and its shareholders. The proposal further provides that Notice 88-19 would be revised to provide that the conversion of a large C corporation to a RIC or REIT would result in the immediate recognition of the corporation’s net built-in gain. Thus, the Notice, if revised as proposed, would no longer permit a large corporation that converts to a RIC or REIT to elect to apply rules similar to the 10-year built-in gain recognition rules of section 1374.

Recommendation

Because the safe harbor set forth in Notice 88-96 is not based upon the 10-year built-in gain rules of section 1374, the repeal of section 1374 for a large C corporation should have no effect on Notice 88-96. The safe harbor is based on the recognition that the imposition of a significant tax burden on a RIC that requalifies under Subchapter M after failing to qualify for a single year would be inappropriate. Moreover, the imposition of tax in such a case would fall directly on the RIC’s shareholders, who are typically middle-class investors.

The Institute understands from discussions with the Treasury Department that the proposed revision to section 1374 and the related change to Notice 88-19 are not intended to impact the safe harbor provided by Notice 88-96.

Should the Congress adopt this proposal, the Institute recommends that the legislative history include a statement, such as the following, making it clear that the proposed revision to section 1374 and the related change to Notice 88-19 would not impact the safe harbor set forth in Notice 88-96 for RICs that fail to qualify for one taxable year:

This provision is not intended to affect Notice 88-96, 1988-2 C.B. 420, which provides that regulations to be promulgated under section 337(d) will provide a safe harbor from the built-in gain recognition rules announced in Notice 88-19, 1988-1 C.B. 486, for situations in which a RIC temporarily fails to qualify under Subchapter M. Thus, it is intended that the regulations to be promulgated under section 337(d) will contain the safe harbor described in Notice 88-96.

ENDNOTES

1 The Investment Company Institute is the national association of the American investment company industry. Its membership includes 6,226 open-end investment companies ("mutual funds"), 443 closed-end investment companies and 10 sponsors of unit investment trusts. Its mutual fund members have assets of about $3.627 trillion, accounting for approximately 95% of total industry assets, and have over 59 million individual shareholders.

2 All references to "sections" are to sections of the Internal Revenue Code.

3 Treas. Reg. section 1.1012-1(e).

4 For example, an investor holding 41 different blocks of shares would compute an average cost basis by adding together the purchase prices for each of the 41 blocks of shares and dividing by the number of shares owned. Each additional purchase would require an additional calculation, which would increase the likelihood of arithmetic error.

5 In this case, because the RIC does not know which shares the taxpayer claimed on his or her tax return to have redeemed, the RIC does not know the cost basis of the remaining shares. For example, if a shareholder purchased 100 shares at each of three prices ($10, $11 and $12) and later redeemed 100 shares before the average cost program were implemented, the average cost of the remaining 200 shares would be: (1) $10.50, if the $12 shares had been redeemed, (2) $11, if the $11 shares had been redeemed or (3) $11.50, if the $10 shares had been redeemed.

6 Any data that does not exist on a firm’s current computer system (such as because it is stored only on paper or on paper and old computer tapes incompatible with the current system) would have to be inputted manually into the new system before cost basis calculations could be performed. Both the time commitment and the likelihood of error would be significant if manual input were required.

7 Failures attributable to intentional disregard of the filing requirement are generally subject to a $100 per failure penalty that is not eligible for the $250,000 maximum.

8 In the Conference Report to the 1989 changes, Congress recommended to IRS that they "develop a policy statement emphasizing that civil tax penalties exist for the purpose of encouraging voluntary compliance." H.R. Conf. Rep. No. 386, 101st Cong., 1st Sess. 661 (1989).