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TREAS.
HJ
10
. A13P4
v.297
U. S.Department of the Treasury
PRESS RELEASES
Report to Congress
on the
Depreciation of Horses
Department of the Treasury
March 1990
Report to Congress
on the
Depreciation of Horses
Department of the Treasury
March 1990
DEPARTMENT OF THE TREASURY
WASHINGTON
March 1990
ASSISTANT SECRETARY
The Honorable Lloyd Bentsen
Chairman
Committee on Finance
United States Senate
Washington, DC 20510
Dear Mr. Chairman:
Section 201(a) of Public Law 99-514, the Tax Reform
Act of 1986, required the Treasury to establish an office to
study the depreciation of all depreciable assets, and when
appropriate, to assign or modify the existing class lives of
assets. Treasury's authority to promulgate changes in class
lives was repealed by Section 6253 of Public Law 100-647, the
Technical and Miscellaneous Revenue Act of 1988. Treasury was
instead requested to submit reports on the findings of its
studies to the Congress. This report discusses the depreciation
of horses. The legislative history of the Tax Reform Act of 1986
indicates that such study was to be among the first conducted by
Treasury.
I am sending a similar letter to Senator Bob Packwood.
Sincerely,
Kenneth W. Gideon
Assistant Secretary
(Tax Policy)
Enclosure
DEPARTMENT OF THE TREASURY
WASHINGTON
ASSISTANT SECRETARY
~1arch
1990
The Honorable Dan Rostenkowski
Chairman
Committee on Ways and Means
House of Representatives
Washington, DC 20515
Dear Mr. Chairman:
section 201(a) of Public Law 99-514, the Tax Reform
Act of 1986, required the Treasury to establish an office to
study the depreciation of all depreciable assets, and when
appropriate, to assign or modify the existing class lives of
assets. Treasury's authority to promulgate changes in class
lives was repealed by Section 6253 of Public Law 100-647, the
Technical and Miscellaneous Revenue Act of 1988. Treasury was
instead requested to submit reports on the findings of its
studies to the Congress. This report discusses the depreciation
of horses. The legislative history of the Tax Reform Act of 1986
indicates that such study was to be among the first conducted by
Treasury.
I am sending a similar letter to Representative Bill
Archer.
Sincerely,
Kenneth W. Gideon
Assistant Secretary
(Tax policy)
Enclosure
Table of Contents
Chapter 1. Introduction and Principal Findings .................. ............ .................................. 1
A. Mandate for This Study .......................................................................................... 1
B. Principal Findings ................................................................................................... 2
Chapter ll. The Useful Life of Thoroughbreds ................................................................
A. The Hollingsworth Study .................................. .................................................. ...
B. Detennination of the Useful Life of Thoroughbreds ..............................................
C. Distribution of Useful Lives ...................................................................................
5
5
5
6
Chapter ill. The Economic Depreciation of Thoroughbreds .............................. .............
A. The Average Age-Price Profile of Geldings ..........................................................
B. Translating Economic Depreciation into an Equivalent Economic Life .... ............
C. Equivalent Economic Life of Colts/Stallions .........................................................
D. The Treatment of Appreciating Assets ...................................................................
E. The Equivalent Economic Life of Thoroughbred Fillies/Mares ........ .................. ...
F. The Equivalent Economic Life of All Thoroughbreds ........................................ ...
11
11
13
14
18
19
22
Chapter IV. The Implications of the Sale of Older Horses ...... ........ .... ................ ............ 27
Chapter V. Conclusion and Recommendations ............ .......... ............................ .............. 31
Appendix. Exhibits Related to the Congressional Mandate ................ .... .................. ....... 33
Notes .................................................................................................................................. 35
References ........ .............. ...... .............................................................. ........ ................ ....... 39
Acknowledgements ........................................................................................................... 40
-v-
Table of Figures
Figure 1: Distribution of Useful oLives of Thoroughbred Geldings .............................. '"
Figure 2: Distribution of Useful Lives of Thoroughbred Colts/Stallions ........................
Figure 3: Distribution of Useful Lives of Thoroughbred Fillies/Mares .... .................. .....
Figure 4: Selected Age-Price Profiles of Thoroughbred Racehorses ...............................
Figure 5: Age-Price and Tax Basis Profiles for Thoroughbred Geldings ........................
Figure 6: Age-i>rice Profiles for Thoroughbred Colts Used for Breeding .......................
Figure 7: Average Age-Price Profile for Thoroughbred Colts/Stallions ..........................
Figure 8: Age-Price and Tax Basis Profiles for Colts/Stallions, ......................................
Figure 9: Age-Price Profile for Thoroughbred Fillies Used for Breeding .......................
Figure 10: Age-Price and Tax Basis Profiles For Thoroughbred Fillies/Mares ..............
Figure 11: Age-Price and Tax Basis Profiles For All Thoroughbreds .............................
Figure 12: Probability of a Broodmare Auction Sale by Age ..........................................
Figure 13: Equivalent Economic Life and Useful Life of Broodrnares by Age ..............
-Vl-
7
8
9
12
13
16
17
19
20
22
24
28
29
Chapter I. Introduction and Principal Findings
A. Mandate for This Study
This study of the depreciation of horses has been prepared by the Depreciation Analysis
Division of the Office of Tax Analysis as part of its Congressional mandate to study the depreciation
of all assets. This mandate was incorporated in Section 168(i)(1)(B) of the Internal Revenue Code
(IRC), as modified by the Tax Reform Act of 1986 (see Exhibit 1 of the Appendix). This provision
directed the Secretary of the Treasury to establish an office that "shall monitor and analyze actual
experience with respect to all depreciable assets", and granted the Secretary authority to change the
classification and class lives of assets. The Depreciation Analysis Division was established to carry
out this Congressional mandate. The Technical and Miscellaneous Revenue Act of 1988 (TAMRA)
repealed Treasury's authority to alter asset classes or class lives, but the revised IRC Section 168(i)
continued Treasury's responsibility to "monitor and analyze actual experience with respect to all
depreciable assets" (see Exhibit 2 of the Appendix).
The General Explanation of the Tax Reform Act of 1986 (the "Blue Book") indicates that, in
choosing assets for study, the Treasury Department should give priority to those assets that do not
have a class life. An Asset Depreciation Range (ADR) asset guideline class had existed for work
and breeding horses (Asset Class 01.22, Horses, Breeding or Work), with an ADR guideline period
of 10 years. Although Congress assigned in the Tax Reform Act a three-year Modified Accelerated
Cost Recovery System (MACRS) recovery period to racehorses more than two years old when
placed in service and to horses (other than racehorses) more than 12 years old when placed in service
(IRC Section 168(e)(3)(A», no class life exists for racehorses age two or younger, showhorses, and
horses used for cenain other business purposes. 1
Moreover. under IRC Section 263A(e )(2) as promulgated in the 1986 Act, taxpayers electing
to expense the pre-productive costs of raising cenain animals (including horses) were required to
use the Alternative Depreciation System, which calls for the use of straight-line depreciation over
the asset's class life. Assets (such as racehorses) that do not have a class life are assigned a 12-year
life for this purpose (lRC Section 168(g)(2)(C». Believing that a 12 year recovery period is too
long, the American Horse Council asked Treasury to study the depreciation of racehorses. In
addition, the legislative history of the 1986 Act indicated a Congressional desire that Treasury give
priority to a study of racehorses and older horses.2
In view of the priority required to be given to the study of assets not having class lives, the
Depreciation Analysis Division responded to this request by announcing in the Federal Register its
intent to study the depreciation of horses. It also held a public meeting at the Treasury Department
on October 19, 1987 with interested parties (including representatives of the American Horse
- 1-
-2Council) to detennine the best way to collect the required infonnation. While this study was being
prepared, Congress repealed (in T AMRA) the unifonn capitalization rules for certain producers of
animals (including horses). Although this action appears to have addressed the primary concerns
of the horse industry, the Depreciation Analysis Division has continued to carry out its Congressionally mandated responsibility to study the depreciation of horses.
The General Explanation of the 1986 Act indicates that the detennination of the class lives
of depreciable assets should be based on the anticipated decline in their value over time (after
adjustment for inflation), and on their anticipated useful lives (see Exhibit 3 of the Appendix).
Under current law, the useful life of an asset is taken to be its entire economic lifespan over all users
combined, and not just the period it is retained by a single owner. For a group of assets, the
Depreciation Analysis Division calculates the useful life as a weighted average of lives, with each
weight set equal to the probability that members of the asset group will be retired upon attaining
the corresponding life.
The General Explanation also indicates that, if the class life of an asset is derived from the
decrease in market value as a function of its age, such life (which, to avoid confusion, is hereafter
referred to as its equivalent economic life) should be set so that the present value of straight-line
depreciation over the equivalent economic life equals the present value of the decline in value of
the asset (both discounted at an appropriate real rate of interest). This fonnula must be modified
in order to define a single depreciable life for a group of assets. Given that an asset group invariably
possesses a distribution of retirements over several ages, a ponion of the group will inevitably be
retired before the group is fully depreciated for tax purposes. Under current tax law, such retirements
result in loss deductions equal to the retired assets' remaining basis, less any salvage value. From
the perspective of an investor recovering his or her capital costs, such loss deductions are equivalent
to depreciation deductions. Therefore, the deflnition of an equivalent economic life should be
modified to account for these deductions: the present value of all "cost recovery" deductions,
detennined by applying a straight-line fonnula to the equivalent economic life and by taking into
account the probability of retirement of the asset at each age, must equal the present value of the
average decline in economic value of the asset groUp.3
B. Principal Findings
The principal fmdings of this study are that the average useful life of all horses is 8.8 years,
and their average equivalent economic life is 10.6 years. Both estimates assume that horses are
first placed in service and begin depreciating at age two. These fmdings are primarily based on an
analysis of thoroughbred horses acquired as yearlings. However, the available infonnation regarding
the level of investment in older horses, and an analysis of their equivalent economic lives, suggest
-3that the current class life of 10 years for workhorses and breeding stock might reasonably apply to
all horses, regardless of their age when placed in service or the use to which they are put.
Accordingly, the current law three-year recovery period for racehorses and older horses should be
repealed.
Two general issues related to the analysis and estimation of economic depreciation arose
during this study, and their resolution affected the principal fmdings reported above. First, for many
depreciable assets that decline rapidly in value, the application of the equivalent economic life
fonnula is relatively straightforward, and the resulting equivalent economic lives of such assets are
often significantly shorter than their useful lives. For a number of assets, however, the application
of the equivalent economic life fonnula is not as straightforward, and the resulting equivalent
economic lives of these assets may be comparable to or even greatly exceed their useful lives. This
is particularly true in the case of horses. Some horses are very successful, and may greatly appreciate
in value for a good portion of their useful lives, while others may be quite unsuccessful and are
retired very quickly. The early appreciation for the very successful horses is significant enough to
cause their average present value of economic depreciation to be quite small, or even negative.
Where this occurs, the economic equivalent life may not be computable.
The 10.6-year equivalent economic life quoted above was obtained by simply ignoring the
appreciation of certain "highly successful" horses. An alternative estimate of 12.7 years is obtained
when this appreciation is taken into account as "negative economic depreciation." The treatment
of this situation is described in greater detail in Chapter ID.
An additional complication arises from the fact that most horses used for breeding have
initially been used for racing. Under current law, racehorses can generally be depreciated over a
three year recovery period. Because salvage value is no longer a relevant concept for tax depreciation
purposes, these horses can be fully depreciated within a few years after starting their racing career,
even though their market value as a breeding horse can sometimes be many times greater than their
initial acquisition cost. If all racehorses were customarily sold when their use changed from racing
to breeding, the current law distinction between horses used for racing and those used for work or
breeding purposes might still be maintained. The sale would result in the recognition of a market
asset value, and any "excessive" or "deficient" depreciation previously claimed with respect to such
horses would be recaptured or allowed as a loss at the time of sale.
Although sales of shares or interests in horses occur frequently, the Depreciation Analysis
Division was unable to obtain adequate evidence that the complete (or nearly complete) transfer of
the ownership interests in a racehorse at the time its use changes from racing to breeding is the
- 44
general industry practice. Accordingly, the depreciation of horses over their entire careers was
examined for this report; racing horses and breeding horses are thus not regarded as two distinct
assets, in contrast to their classification under current law.
Despite repeated attempts to acquire more complete information from the American Horse
Council, an umbrella organization representing the horse industry, and other industry representatives, the Depreciation Analysis Division was forced to rely on a limited set of publicly available
information: (I) a 1972 article on the useful lives of thoroughbreds by Kent Hollingsworth, past
editor of The Blood Horse (a journal published by the Thoroughbred Owners and Breeders Association), and (2) thoroughbred auction data for various years compiled and published in The Blood
Horse. After a draft of this report was submitted for review to The American Horse Council, they
provided some additional information, including information on other breeds of horses. In addition,
they submitted a letter objecting to various aspects of the methodology used in this study.5 The
Depreciation Analysis Division believes that the additional information submitted does not alter
the conclusions of the draft report. Nevertheless, where appropriate, notes have been added summarizing the views and data presented by the American Horse Council, so that Congress may judge
for itself the extent to which this additional material might affect the principal findings of this report.
Chapter ll. The Useful Life of Thoroughbreds
A. The Hollingsworth Study
In a very informative article entitled "So What is the Economic Useful Life of A Thoroughbred", which was published in The Blood Horse (March, 1972), Kent Hollingsworth reported
the results of a very extensive study that traced the complete racing and breeding careers of all
thoroughbred foals born in the years 1939-41 and registered with the Jockey Club. Because horses
can live to 30 years of age, it was necessary for Hollingsworth to focus on such early vintages of
foals. His study, which was performed with the assistance of the Jockey Club Statistical Bureau
under the sponsorship of the Thoroughbred Owners and Breeders Association, provides statistical
information based on the histories of 19,124 horses. In the absence of alternative data, the statistics
obtained by Hollingsworth relating to the useful life of thoroughbreds are used in this study. Other
data contained in the Hollingsworth study, such as the average lifetime earnings per horse, are likely
to be no longer relevant, and are not used. Because of the growth in the number of horses (from
approximately 6,500 thoroughbreds foaled and registered each year in the 1939-41 period to
approximately 49,500 thoroughbreds foaled in 1988), and the potential impact of the Second World
War on the Hollingsworth results, the useful life data may be somewhat out of date. Nevertheless.
the Hollingsworth study was intended to provide helpful information to the Treasury Department
in 1972 regarding the useful life of thoroughbreds, and should continue to be helpful today.
In obtaining the distribution of useful lives, Hollingsworth distinguished between racehorses
and breeding stock. He also focused only on those racehorses that won race money. Since the
useful life of an asset for tax depreciation purposes now refers to its economic lifespan over all
users and uses, the separate useful life information for racehorses and breeding stock are combined
in this study, as described in the following sections.
B. Determination of the Useful Life of Thoroughbreds
Because thoroughbred horses not trained for racing and those not raced for a full year before
being sold or retired are not likely to be depreciated, such horses are excluded from this analysis.
Although Hollingsworth did not publish statistics on those horses that were not trained for racing,
or on those that did not" start" a race, the American Horse Council provided additional data indicating
that between 30 and 40 percent of the 1939-41 crop of thoroughbred foals studied by Hollingsworth
did not "start".
-5-
-6Based on the assumption that the fraction of "non-starters" applies equally to fillies, colts,
and geldings, Hollingsworth's data imply that about 67 percent of "starting" fillies produce more
than one foal: and thus may be assumed to be used for breeding. While some fillies that do not start
are in fact used for breeding, it is believed that these constitute only a small percentage of all
non-starters. In any event, the neglect of such horses should not significantly affect the results.
Likewise, Hollingsworth's data indicate that 29 percent of all starting colts produce more than 5
6
foals in their lifetime, and thus may be assumed to be used for breeding. The Hollingsworth data
thus generally imply that a fair fraction of starting colts, and a large fraction of starting fillies, are
subsequently used for breeding. 7
The useful lives of those racehorses that are not subsequently used for breeding are determined
from Hollingsworth's data on the ages at which racehorses earn their last race money. Since some
horses may be unsuccessfully raced for a few years after the last race in which they earned race
money, this approach tends to understate their usefullives. 8 On the other hand, it is also assumed
that horses that start racing but do not earn any race money have the same distribution of useful
lives as horses that do earn race money. Since horses that win no race money are more likely to
have shorter useful lives, these two errors tend to offset each other.
In contrast to Hollingsworth's assumption that all racehorses begin racing in the year in which
they win their first money, it is assumed in this study that all racehorses begin their racing careers
at two years of age. Most thoroughbreds do start racing at this age, but more importantly, taxpayers
generally claim that their racehorses are placed in service at this age, even if they do not actually
enter a race until three years of age.
The useful lives of those racehorses that are subsequently used for breeding are determined
from Hollingsworth's data on the ages at which broodmares produce their last foal, and the ages at
which stallions sire their last foal. Because owners may attempt to use a horse for breeding after
it has last been able to produce a live foal, this measure tends to understate the useful life of horses,
and thus also offsets the assumption used in this study by applying the Hollingsworth statistics to
racehorses that do not win any race money.
C. Distribution of Useful Lives
The following figures present useful life distributions for several types of horses. Figure 1
represents thoroughbred geldings, and is based entirely on the ages at which such horses last earn
race money. The average useful life is 6.6 years. As expected, this exceeds the 5.1 "average number
of seasons earned" noted by Hollingsworth, who considered the horse's useful life to begin when
it won its first race money. The distribution of useful lives for colts/stallions is shown in Figure 2.
-7-
In this case, useful lives are determined either by the ages at which they last won race money (for
the 71 percent of the starting colts that were not subsequently used for breeding), or by the ages
when they sired their last foal. The average useful life is 7.9 years. Figure 3 shows the distribution
of useful lives for thoroughbred fillies/mares Here also, useful lives are determined either by the
ages at which they last won race money (for the 33 percent of the starting fillies that were not
subsequently used for breeding), or by the ages when they produced their last foal. The average
useful life is 11.0 years.
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7
8
9
10
11
12
13
14
Useful Lives (in years)
Figure 1. Distribution of the useful lives of starting thoroughbred geldings.
The auction data indicate that male yearlings cost about 16 percent more than female yearlings.
Based on this statistic, and using distributions found in Hollingsworth, the following investment
weights were derived: 39.5 percent for geldings, 14.0 percent for colts/stallions, and 46.5 percent
for fillies/mares. The investment-weighted average useful life for all thoroughbred horses combined
is 8.8 years.
-8-
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1 2 3 4 5 6 7 8 9 10 11 1213 14 15 16 17 18 1920 21 222324 25 26 27
Useful Lives (in years)
Figure 2. Distribution of the useful lives of starting thoroughbred colts/stallions.
- 9-
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10 11 12 13 14 15 16 17 18 19 20 21 22 23
Useful Lives (in years)
Figure 3. Distribution of the useful lives of starting thoroughbred fillies/mares.
- 10 -
Chapter ID. The Economic Depreciation of Thoroughbreds
In this chapter, average age-price profiles, economic depreciation, and equivalent economic
lives are derived separately for geldings, colts/stallions, and fillies/mares. Conceptual issues related
to the treatment of gains and losses upon disposition of horses and the treatment of appreciating
assets are discussed, and their implications for equivalent economic lives are shown. The estimation
of the equivalent economic life of all thoroughbreds is discussed last.
A. The Average Age-Price Profile of Geldings.
Geldings are castrated male horses. In the Hollingsworth study, they outnumber colts by a
ratio of nearly three-to-one. For convenience, it is assumed that the value of all racehorses not
subsequently used for breeding (and this clearly includes geldings) declines linearly with the age
of the horse once it starts racing, which as noted is assumed to occur when the horse is two years
of age. No change in value is assumed to occur between the date of acquisition and the date the
horse is placed in service. It is also assumed that the salvage value of a horse is five percent of the
horse's value as a yearling, and that the imputed price of the horse declines to this value at the end
of its useful life (i.e., when it is at the age at which it has won its last race money). Only the value
of the horse relative to its acquisition cost is needed to determine its economic depreciation per
dollar of investment. Thus, the assumption that the horse's salvage value is proportional to its price
as a yearling allows the age-price profiles of horses of varying acquisition costs to be calculated as
if they all had the same acquisition cost. For convenience, this cost is taken to be $6,500, which is
the median price of all thoroughbred yearlings acquired at auction in 1987. The implications of
investment in older horses will be discussed in Chapter IV.
Based on this $6,500 initial price. a five percent salvage value is $325. This may seem low,
since healthy retired thoroughbred racehorses may be sold for recreational use for several thousands
of dollars. and even lame horses may be sold for slaughter for about $450. On the other hand, the
acquisition cost of some yearlings may exceed one million dollars, and the corresponding $50,000
salvage value may be somewhat high. For a horse costing $35,400 (the mean 1987 yearling auction
price), the calculated salvage value is $1,770, which approximates amounts received for retired
thoroughbred racehorses. A five percent salvage value thus appears reasonable.9
In summary, the age-price profile for all racehorses that are not subsequently used for breeding
is assumed to exhibit a simple straight-line decline (starting at age two) from the assumed $6,500
initial value. However, different horses are assumed to have different straight-line patterns, as
determined by the distribution of their useful lives (although they all have the same assumed $325
salvage value). Selected age-price profiles for geldings, for example, are shown below in Figure 4.
- 11 -
- 12-
The relative fractions of geldings exhibiting each specific pattern is given by the frequency distribution of the useful lives for geldings (see Figure 1). The average age-price profile for all geldings
is shown in Figure 5 below.
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$6,000
S5,000
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$4.000
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2
3
4
5
6
7
8
9
lO
11
12
13
14
15
16
Age of Horse
Figure 4. Selected age-price profiles of starting thoroughbred racehorses that are not subsequently
used for breeding.
This method of estimating the average value of a set of non-homogeneous assets, each of
which declines in value in a straight-line fashion, has been referred to as the Bureau of Economic
Analysis method (see, for example, Hulten and Wykoff [1981 D, and is known to result in an average
age-price profile that resembles that for a single more rapidly declining asset (as is shown in Figure
5). The present value (as of the acquisition date of the horse) of the annual decline in value (i.e.,
"economic depreciation") for thoroughbred geldings is obtained by discounting each year's decline
in the average value (starting at age two) from the middle of the year at a discount rate r:
PV =
(1)
L
[V(i -1) - V(i)]
,c 3 V(1)(1+r)(i-l.5)
- 13 where PV is the present value of economic depreciation, V (1) is the acquisition price of the horse
(assumed acquired as a yearling), and where V(i) is the average value of those horses of age i that
are still racing (as determined from the distribution of useful lives in Figure 1). If a four percent
real discount rate, r, is used, a present value (as of age one) of 0.8058 is obtained.
$7,000
$6,000
<-- Equivalent Tax Basis Curve (6.9 year life)
$5,000
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$4,000
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$3,000
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$2,000
$1,000
$0
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
Age of Horse
Figure 5. Average age-price profile for starting thoroughbred geldings and the corresponding
average equivalent tax basis curve derived from an equivalent economic life of 6.9 years.
B. Translating Economic Depreciation into an Equivalent Economic Life
As noted in Chapter 1, the General Explanation of the Tax Reform Act of 1986 provides a
formula for translating the present value of economic depreciation into an equivalent economic life.
In particular, the equivalent economic life is determined by equating the present value of straight-line
depreciation (over the to-be-determined equivalent economic life) to the present value of economic
depreciation. If this procedure is carried out using the same four percent real discount rate and a
mid-year discounting convention, an equivalent economic life of 5.8 years is obtained for thor-
- 14 oughbred geldings. This result depends on the assumptions that all geldings are considered placed
in service at age two, and that their training and maintenance costs are expensed. It further assumes
that all geldings are identical in that they all retire at the same age.
Without this last assumption, a taxpayer would most likely incur a loss (or gain) when his or
her horse was retired. This gain (or loss) would be measured by the difference between the remaining
tax basis in the horse in the year it was retired and its salvage value. The Depreciation Analysis
Division believes that these gains (which arise if the horse is retired later than "average") and losses
(which arise if the horse is retired sooner than "average") are alternative ways (in addition to
depreciation) of recovering the capital invested in the horse, and should be factored into the analysis.
When this is done, the equivalent economic life of a gelding is found to be 6.9 years, which is close
to its 6.6-year average useful life. The average equivalent tax basis for geldings is also shown in
Figure 5. This curve is obtained by depreciating each horse using a straight-line formula and an
equivalent economic life of 6.9 years, and by calculating appropriate losses and gains according to
the estimated gelding retirement pattern shown in Figure 1. to The areas under the two curves in
Figure 5, when discounted to a common age, are equal.
C. Equivalent Economic Life of Colts/Stallions
The age-price profiles for those colts that start but are not subsequently used for breeding are
assumed to be similar to those for geldings; the relative fraction of such colts in each useful life
class is obtained from the Hollingsworth data on the ages at which colts earned their last race money.
The value of those colts that are subsequently used for breeding are, however, imputed from the
stud fees which these horses can generate.
Following Hollingsworth, a distinction is made between two groups of breeding stallions.
Although only those stallions that sire five or more foals in their lifetime are considered to be used
for breeding, a more limited group of stallions (which shall henceforth be referred to as the "very
successful" stallions) sire ten or more foals in a single season sometime during their life. The
Hollingsworth study notes that only 1.3 percent of all males fall into this category. However, when
both the males assumed not to start (and thus also assumed not to be used for breeding purposes)
and the starting geldings are excluded, this statistic implies that as many as seven percent of the
starting colts become very successful stallions. Likewise, from Hollingsworth's statistic that rough! y
five percent of all males are used for breeding, it may be inferred that about 21 percent of all starting
colts become less than very successful (hereafter referred to as "less successful") breeding stallions.
The ratio of the value of seven-year old breeding stallions to their acquisition cost, RV, is
obtained as the product of four factors:
- 15 (2)
RV
=(Se/AC) x (Sh/Se) xN x (1- ~C),
where (Se/AC) is the ratio of the value of a stallion season (the stud fee for servicing a single mare
in a single season) to the acquisition cost of the horse (adjusted for inflation), (Sh/Se) is the ratio
of the value of a share of the horse (the right to use the stallion to service a single mare each season
for the remainder of the stallion's breeding career) to the value of a season (which reflects the
discounted value of the number of future seasons the stallion is expected to serve), N is the estimated
number of mares serviced per season, and OC is the ratio of the maintenance costs to the stud fees
received.
From the 1988 auction data published by The Blood Horse (January, 1989), it was found that
(Sh/Se), or the ratio of the price of a stallion share to that of a stallion season is about 4.4 for a
seven-year old stallion, but this ratio declines thereafter (initially, at about 4.5 percent per year)
with the age of the stallion. The Hollingsworth data also indicate that the very successful breeding
stallions produce about 10.1 foals per crop at age seven, while the less successful breeding stallions
produce about 2.75 foals per crop at age seven. Although the stud fees received are frequently
contingent upon the birth of a live foal, this was not the case for most of the auction prices noted.
Thus, an adjustment is made to reflect the fact that the number of foals sired might understate the
mares serviced by a stallion in a season. 11 Based on a 69 percent breeding success rate (which the
Hollingsworth data show to be appropriate for a seven-year old broodmare), the very successful
seven-year old stallion appears to service about 14.6 mares per season (i.e., N = 14.6), whereas the
less successful seven-year old stallion services about 4.0 mares per season (i.e., N = 4.0).
It is assumed that the current and future costs of maintaining a breeding stallion are about 20
percent of the fees received by a very successful stallion (i.e., OC = .20), and about 55 percent of
the fees received by a less successful stallion (i.e., OC = .55). Because it was generally not possible
to determine yearling values for those stallions whose seasons were sold at public auction, a less
exact matching was used to estimate the ratio (Se lAC). From the auction data published in various
issues of The Blood Horse, the average price was obtained for all yearlings sired by the stallion's
sire and sold at auction in the year in which the stallion was a yearling.
When this price is substituted for the acquisition cost of the stallion, an average ratio of the
value of a stallion's season to its inflation-adjusted acquisition cost of 11.7 percent is obtained (i.e.,
(Se lAC) = .117). This does not mean that purchasers of every yearling colt can necessarily expect
to obtain such fees in the future. It does mean that, if the acquired colt should prove sufficiently
successful to be used for breeding, and the relationship between prior yearling prices and current
stud fees persists, fees of that magnitude may be expected.
- 16 Insening these factors into Equation (2), the value of a very successful seven-year old breeding
stallion is roughly six times its initial cost. Likewise, the value of a less successful seven-year old
breeding stallion is about 0.9 times its value as a yearling. The decline in value of breeding stallions
with age is taken to be the result of two factors--( I) a decline in the ratio of the value of a share to
that of a season (which reflects the decline in the number of future crops anticipated), and (2) a
decline in the number of mares serviced, as inferred from the Hollingsworth data on the decline
with age in the number of foals sired by active stallions. 12 The resulting age-price profiles of both
the very successful and the less successful breeding stallions are shown below in Figure 6. In
obtaining these profiles, a linear increase (for the very successful stallions) or decrease (for the less
successful stallions) between the value of the horse at age two and its value at age seven is assumed.
$50,000
r-------------------------,
$40,000
o
~
o
$30,000
::c
<-- Very Successful Stallions
1.0-0
o
8
'1:
c..
S2O,000
SIO,OOO
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 1920 21 22 23 24 25 26 2728 29
Age of Horse
Figure 6. Estimated age-price profiles forunretired staning thoroughbred colts that are subsequently
used for breeding stock.
The average age-price profile for all staning thoroughbred colts/stallions is obtained as a
mixture of the values of those staning colts that are not subsequently used for breeding and the
values of those that are so used. However, the retirement of the breeding stallions must also be
considered. Here also, it is assumed that the salvage value of a retired stallion is five percent of its
cost as a yearling. The decline in value of retired breeding stock is assumed to be very sudden; just
- 17 prior to retirement the horse has the value noted in Figure 6, and a value of $325 inunediately
thereafter. The frequency of retirements may be obtained from the Hollingsworth data on the ages
of stallions in the year they sire their last foal; separate statistics are noted for the very successful
and the less successful stallions.
When these factors are taken into account, the resulting
retirement-adjusted average age-price profile shown below in Figure 7 is obtained. The sharp initial
decline in the estimated price is due to the rapid retirement of the less successful racehorses, while
the cusp at nine years of age reflects the assumed peak in the value of very successful stallions.
The present value (as of the date of acquisition, at a four percent real rate, and with mid-year
discounting) of the economic depreciation corresponding to this decline in value is 0.6579.
S7,OOO . . . . . - - - - - - - - - - - - - - - - - - - - - - - - - .
S6,OOO
S5,OOO
~
~
$4,000
'"o""'
8
·c
S3,OOO
~
S2,OOO
SI,OOO
1 2 3 4
5 6 7 8 9 10 11 1213 14 15 16 17 18 19 20 2122 2324 25 26 27 28 29
Age of Horse
Figure 7. Estimated average age-price profile for starting thoroughbred colts/stallions.
If retirements are disregarded, an equivalent economic life for starting thoroughbred
colts/stallions of 17.6 years is obtained. However, a fInite equivalent economic life that accounts
for the gains and losses incurred by taxpayers upon retirement of the horses cannot be obtained:
with depreciation deductions set to zero, the present value of the loss deductions derived solely
from the retirement of colts/stallions is 0.7012, which exceeds the present value of economic
depreciation. Further "negative depreciation allowances" would be required to equate the present
- 18 value of tax deductions with the present value of economic depreciation. This result, when combined
with the equivalent economic life fonnula, implies that thoroughbred colts/stallions should not be
treated as depreciable property. The problem arises due to the significant appreciation in the value
of the very successful stallions and to the relatively rapid retirement of these horses over the frrst
decade of economic life, despite the fact that only about seven percent of the starting colts ultimately
belong in this category. 13
D. The Treatment of Appreciating Assets
The determination of class lives using the fonnula of the General Explanation of the Tax
Reform Act of1986 merits special attention in the case of assets such as very successful colts/stallions
that appreciate over a portion of their useful lives. Although economic depreciation, which is simply
the negative of the change in value of a depreciable asset during the year, may be negative as well
as positive, tax policy considerations may require a distinction be made in the two cases. In the
context of the equivalent economic life formula, negative economic depreciation may be viewed
as giving rise to an effective tax on the taxpayer's accrued, but unrealized, holding gains. This is
reflected in the fact that the asset's equivalent economic life in such cases is typically much greater
.than its useful life. Although this is simply the converse of allowing taxpayers to claim a depreciation
deduction for their accrued but unrealized losses when their assets decline in value, it is not clear
that such treatment reflects Congressional intent.
It clearly is not appropriate for taxpayers to effectively claim depreciation deductions during
that period when their asset is appreciating in value. On the other hand, under current law, which
looks to industry-wide or asset-wide evidence in the determination of a class life, to deny depreciation deductions for an asset such as a horse, which has a finite useful life, may also be viewed
as inappropriate (even if the period over which any specific asset is retained by a given taxpayer
may not be ascertainable).14 The legislative history indicates that both the anticipated decline in
the value of the asset (its "economic depreciation") and its anticipated useful life should be considered in the determination of its class life. The Depreciation Analysis Division generally views
the asset's decline in economic value to be the more important factor, but this position may not be
tenable when, as in the case of colts/stallions, an equivalent economic life based on the decline in
economic value is so different from the asset's useful life.
An alternative approach, which shall be followed in this study, is to treat the value of the very
successful stallions as equal to their initial value until their estimated price fmally declines below
the initial value. More specifically, in applying the fonnula of the General Explanation to thoroughbred colts/stallions, the economic depreciation of the very successful stallions is taken to be
- 19-
zero between ages 2 and 23. When this is done, the average age-price profile of thoroughbred
colts/stallions is that shown below in Figure 8. The cusp-like behavior present in Figure 7 is absent,
and the resulting present value (as of the date of acquisition) of economic depreciation is 0.7570.
$7,000 , - - - - - - - - - - - - - - - - - - - - - - - - - ,
$6,000
$5,000
J
$4,000
e
$3,000
<-- Equivalent Tax Basis Curve (18.5 year life)
'-
o
·C
c..
$2,000
$1,000
I 2 3 4 5 6 7 8 9 10 11 1213 14 IS 16 17 181920 21 222324 25 26 27 28 29
Age of Horse
Figure 8. Average age-price profile for starting thoroughbred colts/stallions, ignoring the appreciation in value of the very successful stallions, and the corresponding average equivalent tax basis
curve derived from an equivalent economic life of 18.5 years.
If asset retirements are taken into account, an equivalent economic life for starting thor-
oughbred colts/stallions of 18.5 years is obtained. The corresponding average equivalent tax basis
curve is also shown in Figure 8. Finally, if both retirements and the appreciation in the value of
the very successful stallions are ignored, the equivalent economic life is 9.3 years.
E. The Equivalent Economic Life of Thoroughbred Fillies/Mares
The detennination of the equivalent economic life of thoroughbred fillies/mares introduces
an additional complication: a fraction of broodmares are sold at auction at varying ages The
availability of such market data, however, makes the estimation of their age-price profile somewhat
more direct. Even in this case, though, the value of the mares must be inferred. Most broodmares
sold at auction are believed to be in foal, and the price paid must thus be allocated between the
- 20potential future weanling and the mare itself. IS In order to do this, the ratios of the average value
of a weanling sired by the same stallion believed to have covered the mare, to the price of the mare
in foal, were examined for a sample of about 250 mares sold at auction in 1988.
From these data, it is found that the average price of a weanling sired by the same stallion
that covered the broodmare is about 43 percent of the average price of the broodmare. As noted,
Hollingsworth's data indicate that live foals are produced by about 69 percent of all active seven-year
old broodmares (this fraction declines with the age of the broodmare). It may thus be inferred that
the value of the broodmare alone is about 70 percent (1.0 - (0.69)(0.43)) of the sales price of the
broodmare. This fraction shall be used over the entire economic life of the broodmare, which tends
to understate the value of the broodmare.
$7,000 , . . . . - - - - - - - - - - - - - - - - - - - - - - - - - ,
$6,000
$5,000
!1)
....
rI)
0
=
$4,000
......
0
!1)
(,)
·c
Q.,
$3,000
$2,000
$1,000
1 2
3
4
5
6
7
8
9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Age of Horse
Figure 9. Age-price profile for unretired starting thoroughbred fillies that are subsequently used
for breeding stock.
From a sample of about 200 broodmares sold at auction in 1988, the price of a seven-year
old broodmare is about 72 percent of the average price paid six-years earlier for female yearlings
- 21 sired by the same stallion that covered the mare, when adjusted for inflation. The average price of
a seven-year old broodmare alone is thus estimated to be about 50 percent of its initial price as a
yearling (0.70 x 0.72).
By regressing the auction prices of broodmares sired by a given stallion against the age of
the broodmare, it is also found that the value of a broodmare (adjusted for inflation) declines with
age from age seven (initially at about seven percent per year). In performing the regression, the
prices of about 175 broodmares sired by some of the most prolific stallions were examined. In this
study, the value of a broodmare is assumed to decline even faster: first by a uniform six percent
per year, and then by a second factor reflecting the decline in fertility of broodmares with age, as
determined from the Hollingsworth data. This procedure results in an average rate of decline in
the price of unretired broodmares in excess of 12 percent annually.16
The resulting age-price profile for those fillies that are ultimately used for breeding (67 percent
of the starting fillies) is shown in Figure 9. A linear decrease in value between ages two and seven
is assumed. As in the case of thoroughbred colts, the average age-price profiles of the 33 percent
starting fillies that are not subsequently used for breeding are assumed to decline in a linear fashion.
Paralleling the treatment of stallions, a fraction of those mares that are used for breeding are assumed
to retire at varying ages, as determined from the statistics given in the Hollingsworth study on the
ages at which broodmares produce their last foal. It is likewise assumed that, when a broodmare
is retired, taxpayers claim a loss (or gain) on the difference between their adjusted tax basis for the
horse and its assumed $325 salvage value.
The estimated average age-price profile for the overall mix of starting racing fillies and
broodmares is shown in Figure 10. The resulting economic depreciation has a present value (using
a real 4 percent discount rate and a mid-year discounting convention) of 0.7569. Taking into account
the gains and losses incurred by taxpayers upon the retirement of their horses, an equivalent economic life for thoroughbred fillies/mares of 12.0 years is obtained. As in the case of the geldings
(but in contrast to that of colts/stallions), the equivalent economic life for fillies/mares is not much
greater than their average useful life (11.0 years). Furthermore, if the taxpayer's retirement gains
and losses are ignored, the equivalent economic life is 9.3 years.
- 22-
$7,000
$6,000
$5,000
<-- Equivalent Tax Basis Curve (12.0 year life)
(I)
~
I-.
0
::t
$4,000
......
0
(I)
(,)
$3,000
'C
~
$2,000
$1.000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Age of Horse
Figure 10. Average age-price profile for starting thoroughbred fillies/mares, and the corresponding
average equivalent tax basis curve derived from an equivalent economic life of 12.0 years.
F. The Equivalent Economic Life of All Thoroughbreds
The data presented in the Hollingsworth study, when used in conjunction with public auction
data, has allowed the equivalent economic lives of thoroughbred geldings, colts/stallions, and
fillies/mares to be separately determined. The 6.9 year equivalent economic life of geldings, whose
business use is confmed to racing, is much shorter than that for colts/stallions and fillies/mares (18.5
years and 12.0 years, respectively, if the appreciation in the value of the very successful stallions
is neglected).
Although it is possible to establish separate asset classes for each type of horse, the use of a
single combined asset class (as under current law) would result in a less complicated asset classification system. Since many taxpayers own both male and female horses for business use, an average
class life based on the economics of horses of both sexes should not unduly disadvantage one group
of taxpayers over another. In determining the combined equivalent economic life for all thoroughbreds, it is appropriate to weight the present values of economic depreciation for each type of
horse by the relative level of investment in that type of horse. As noted, the auction data indicate
- 23 that the average price of male yearlings is 16 percent greater than that of female yearlings. When
this factor is used to adjust the relative numbers of horses of each type, a single weighted average
present value is obtained by:
(3)
WtdAvg.PV = .3946PV(g) + .1398PV(cls) + .4656PV(jlm).
Insening the present values of economic depreciation for geldings, PV(g), colts/stallions,
PV(c Is), and fillies/mares, PV(jlm), into Equation (3) yields an investment-weighted present value
of economic depreciation of 0.7762 if the appreciation in the value of the very successful stallions
is ignored, and 0.7624 if it is not. Equating these present values to those for straight-line depreciation
leads to an overall equivalent economic class life for all starting thoroughbreds of 10.6 years if the
appreciation in value of the very successful stallions is ignored, and 12.7 years if it is not. These
results take into consideration the gains and losses incurred by taxpayers on the retirement of their
horses. Figure 11 below shows the corresponding estimated average age-price profile and the
average equivalent tax basis curve for all starting thoroughbreds. In this illustration, the appreciation
in the value of the very successful stallions is ignored. The 10.6 year equivalent economic life is
not much greater than the current 10 year class life for work and breeding horses. In contrast to
current law, however, this estimated life applies to all starting thoroughbreds.
A 10.6-year equivalent economic life is, of course, an average. Shott-lived horses -- principally those that will not subsequently be held for breeding -- would be almost entirely retired
before being fully depreciated, according to the available data The present value of the deductions
for such horses would be less than the present value of their economic depreciation. Breeding stock,
on the other hand would tend to have useful lives that extended well beyond the tax depreciation
period. These horses, therefore, would be treated relatively favorably. It would be possible, (but
not necessarily desirable) to establish two classes -- distinguished by the horse's breeding status.
For example, it would be straightforward to establish a separate category for geldings having a class
life that reflected the 6.9-yearequivalent economic life found for such horses. This would necessitate
a longer class life for the remaining horses. An analysis of such horses yields an equivalent economic
life of 12.8 years for non-gelded thoroughbreds, if we neglect the appreciation of very successful
stallions, and 16.6 years, if that appreciation is taken into account.
- 24-
$7,000 , - - - - - - - - - - - - - - - - - - - - - - - - - - ,
$6,000
$5,000
<-- Equivalent Tax. Basis Curve (10.6 year life)
II)
[J)
~
~
$4,000
(,o..c
o
8
'C
$3,000
~
$2,000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 2223 24 25 262728 29
Age of Horse
Figure 11. Average age-price profile for all starting thoroughbreds, with neglect of the appreciation in the value of the very successful stallions, and the corresponding average equivalent tax
basis curve derived from an equivalent economic life of 10.6 years.
Establishing a second asset class that included all horses not eventually held for breeding
would be much more complicated. This would require the classification of horses into breeding
and non-breeding horses at the time the horse is placed in service. To prevent abuse, severe penalties
would have to be created for later changing a horse's status from "non-breeding" to "breeding".
Not only would adherence to this scheme place severe restrictions on horse owners, there is a
question of whether such a classification system could be implemented properly and enforced. In
any case, analysis yields an equivalent economic life of 6.4 years for "non-breeding" horses and
15.1 years for "breeding" stallions and mares. If the appreciation in value for certain stallions is
included, this latter figure increases to 20.5 years.
The thoroughbred results are summarized in the table below.
- 25-
Thoroughbred Results
(Lives are expressed in terms of years)
Equivalent Economic Life
(Includes the effects of retirements)
Category
Useful
Life
Disregarding the
Appreciation of
Stallions
Including the
Appreciation of
Stallions
Geldings
6.6
6.9
Colts/Stallions
7.9
18.5
Not Computed
FilliesIMares
11.0
12.0
12.0
Non-gelded Horses
10.3
12.8
16.6
"Breeding" Horses
14.3
15.1
20.5
"Non-breeding" Horses
5.8
6.4
6.4
All Horses
8.8
10.6
12.7
6.9
- 26-
Chapter IV. The Implications of the Sale of Older Horses
The previous analysis has been based on the assumption that horses are acquired as yearlings,
and are held by their owners until retired from racing or, if used for breeding, until retired from the
breeding stock. The assumption that horses are acquired as yearlings appears to be reasonably
validated by the auction records. The Blood Horse (January, 1989) indicates that 9,083 yearlings
were sold at auction in 1988, while only 1,362 weanlings and 3,645 two-year olds were sold.
Moreover, since depreciation cannot generally be claimed until the horse is at least two years old,
the fact that some horses are acquired as weanlings or two-year olds should not appreciably affect
the calculations of their equivalent economic lives. This is so despite the fact that the price paid
for a weanling is expected to be lower than that paid for a yearling, and likewise the price paid for
a two-year old is expected to be higher than that for a yearling. While the average 1988 auction
price for weanlings was $16,044, which is about half of the $31,250 average for yearlings, the
average price for two-year olds was only $16,464. This suggests that horses offered for sale as
two-year olds may not be as promising as those retained by their owner. This problem, which has
been discussed by Ackerlof (1970), is not an easy one to resolve. Although their lower auction
prices make it likely that the equivalent economic lives of horses acquired as two-year olds may be
somewhat shorter than the equivalent economic lives of horses acquired as weanlings or yearlings,
the fact that the Hollingsworth data do not distinguish horses acquired as two-year olds from other
horses precludes any detailed examination of this issue.
The fact that horses acquired as two-year olds may have different useful lives than those
acquired at earlier ages is not, however, the issue that has concerned the horse industry. Rather, it
is the problem of older horses that has long been of interest to this industry. Under the "facts and
circumstances" depreciation system in effect prior to the Economic Recovery Tax Act of 1981, the
period over which an asset was intended to be used by the taxpayer (its "useful life") determined
its depreciation period (its "service life").17 Because older horses are not expected to be used over
as long a period as younger horses (their "useful life" is clearly limited by their mortality), the horse
industry has long believed that the recovery period allowed for older horses should be much shorter
than that for younger horses.
Based on the results of his study, Hollingsworth proposed special treatment for older horses.
More specifically, he suggested that for racehorses acquired as a weanling or yearling, a five-year
useful life be used for colts and fillies, and a six-year useful life for geldings. However, he also
suggested that these useful lives generally be reduced by one year for each year of the horse's age
(above the age of one) at which it was placed in service as a racehorse. Likewise, he suggested a
useful life of 10 years for thoroughbred breeding stock placed in service before the horse is seven
- 27 -
- 28 years old, and that this life also generally be reduced by one year for each year of age (in excess of
six years) at which the horse is placed in service. As noted, current tax law reflects this suggestion
to a limited extent by assigning a three-year recovery period to any horse (other than a racehorse)
that is placed in service when more than 12 years of age.
Although the remaining useful life of nearly all depreciable assets (including horses) generally
declines by one year with each year of the asset's life, it does not necessarily follow that its equivalent
economic life be}:laves in a similar fashion. Nor does it necessarily follow that separate asset classes
should be established for assets differing only by age. If (as appears to be the case for horses) only
a modest fraction of used (older) assets are acquired, it is administratively convenient to factor the
relative investment in these used assets into the calculation of a single class life for all assets of that
type, regardless of their age when acquired. To do otherwise for all assets would require enlargement
of the approximately 125 existing asset classes by a factor of perhaps 25 or more.
3.5 . . . . . - - - - - - - - - - - - - - - - - - - - - - - - - - ,
3.0
2.5
0
-;
...
.--.....-
CI:l
0
>.
~
<:tI
,....
C
11.1
2.0
...CJ
~
.5
'-'
1.5
~
0
....
Q.,
1.0
0.5
3
4
5
6
7
8
9
10 11
12 13 14 15 16 17 18 19 20 21 22
Age of Horse
Figure 12. Estimated probability of an auction sale of thoroughbred broodmares as a function of
the age of the broodmare.
- 29While shares in a limited number of older stallions are sold at public auction (shares in 200
stallions were sold in 1988), only older broodmares appear to be sold at public auction in appreciable
numbers (5,746 in 1988).18 These mares represent less than 10 percent of all active thoroughbred
broodmares (which, for 1985, are estimated by the American Horse Council to total about 65,000).
Based on an analysis of the ages of a random sample of 250 broodmares sold at auction in 1988,
the probability of an active broodmare being sold at any given age is shown in Figure 12. In obtaining
this probability distribution, the growth in the numbers of yearlings registered each year, the relative
numbers of the female yearlings that are ultimately used for breeding, and the fraction ofbroodmares
that remain active at each age (as inferred from the Hollingswonh data on the ages at which
broodmares produce their last foal) have all been considered. From Figure 12, it appears that
broodrnares are sold at all ages, rather than only when they have completed their racing career and
are being converted into breeding stock. 19
15
Economic Equivalent Life -->
10
5
2
3
4
5
6
7
8
9
10 11 12 13
14 15 16 17 18 19 20 21 22 23
Age of Horse When Placed in Service
Figure 13. Equivalent economic life and useful life of a thoroughbred broodmare as a function of
the age of the mare when placed in service.
Even though the level of investment in broodrnares may not be sufficient to warrant the
establishment of separate asset classes for horses placed in service at each age, the potential impact
of these horses on the overall class life merits examination. The estimated useful1ives and equivalent
- 30economic lives of thoroughbred broodmares acquired at ages two to twenty-three are shown in
Figure 13. It may be noted from this figure that, while the useful life declines monotonically with
the age in which the broodmare is placed in service, the equivalent economic life does not exhibit
any particular trend. Indeed, it tends to increase at higher ages. This is due to the increasing
importance of the salvage value relative to the acquisition cost for older horses. This salvage value
provides a "floor" for the price of the horse, and thus limits the rate of economic depreciation. While
alternative assumptions regarding the salvage value might lead to a decline of equivalent economic
lives of thoroughbred broodmares with their age when placed in service, neither the existing evidence
regarding the relative levels of investment in older horses nor the speed of the decline in their
equivalent economic lives provide compelling evidence for modification of the overall 10.6-year
equivalent economic life noted earlier for all thoroughbreds. 20
Chapter V. Conclusion and Recommendations
The analysis has so far focused solely on the useful lives and equivalent economic lives of
thoroughbreds. However, The Blood Horse (January, 1989) reports that about $532 million was
spent in 1988 on the acquisition of thoroughbred weanlings, yearlings, two-year olds, and broodmares through sales at public auction. The Harness Horse (February, 1989) indicates that about
$83 million was spent on auction sales of harness horse yearlings, and perhaps another $350 million
was invested in 1988 on all other business-use horses. Because investment in thoroughbreds thus
appears to account for over half of the total investment in business horses, the picture obtained from
the study of this single breed may be reasonably representative of that for all breeds combined. 21
Other information obtained indicates that the useful lives of horses generally do not exceed
16 years, but does not otherwise provide evidence on either average useful lives nor average
equivalent economic lives. This information includes a letter from Mr. Peter Ruhlen, president of
the Ruhlen Agency, Inc., which is considered to be the largest all-breed insurance underwriter in
North America. The letter indicates that the Ruhlen Agency does not generally insure any horses
over 16 years of age, and that the Ruhlen Agency has developed information indicating that a horse's
productive life ends at 16. Another letter, from Mr. John Darnell, vice president of the First National
Bank of Louisville , states that his bank feels comfortable financing broodrnares, or using broodrnares
as collateral, up to the age of 16. For horses as old as 18 years of age, the bank takes precautions
to minimize its risk.
This study shows that the current law distinction between racehorses and horses used for work
or breeding is at variance with the general criteria established by the 1986 Act for determining class
lives. It also shows that the equivalent economic lives of older broodrnares fail to decline with age,
and that the frequency of their purchase fails to support the establishment of a separate asset class
for older horses.
This study finds that the average useful life of thoroughbreds is 8.8 years, and their average
equivalent economic life is 12.7 years, by using the straightforward application of the General
Explanation method. If, however, the appreciation in horse values is ignored, then this method
yields an average equivalent economic life of 10.6 years. These lives appear to also represent
reasonable approximations to the economic lives of other breeds of horses. An argument for creating
multiple horse classes to reflect the diversity of actual useful lives does not seem compelling in
light of the added complexity such classes would create. Thus, the Treasury Department recommends that the current five MACRS asset classes for horses (01.221,01.222,01.223,01.224, and
01.225; see Rev. Proc. 88-22) be combined into a single class, and that the current 10-year class
life for asset class 01.221 (any breeding or work horse that is 12 years old or less at the time it is
- 31 -
- 32placed in service) be assigned to the single new asset class. This would result in a seven-year
MACRS recovery period for all horses. Treasury also recommends repeal of the current law
assignments of a three-year MACRS recovery period for racehorses placed in service after two
years of age and for horses other than racehorses that are more than 12 years old when placed in
service.
These conclusions may, at fIrst glance, appear unduly harsh, since only a limited fraction of
all horses acquired for business purposes become very successful racehorses, or are used for
breeding. Yet it is the prospect of such success that provides the incentive to invest. The increased
value of these more successful horses, on average, roughly offsets their smaller numbers. Focusing
only on less successful horses, as suggested by the American Horse Council, while allowing a
depreciation pattern more closely matching the experience of the majority of horses, would be
inconsistent with the basic economics of the horse industry.
Appendix
Exhibits Related to the Congressional Mandate
Exhibit 1
Section 168(i)(I)(B) of the Internal Revenue Code as Revised by the Tax Reform Act of 1986
(i) Definitions and Special Rules.
For purposes of this section--
(1) Class Life.
(B) Secretarial authority. The Secretary, through an office established in the
Treasury-(i) shall monitor and analyze actual experience with respect to all depre-
ciable assets, and
(ii) except in the case of residential rental property or nonresidential real
property-(I) may prescribe a new class life for any property,
(II) in the case of assigned property, may modify any assigned item, or
(III) may prescribe a class life for any property which does not have a
class life within the meaning of subparagraph (A).
Any class life or assigned item prescribed or modified under the preceding sentence shall
reasonably reflect the anticipated useful life, and the anticipated decline in value over
time, of the property to the industry or other group.
Exhibit 2
Section 168(i)(I) of the Internal Revenue Code as Revised by the Technical and Miscellaneous
Revenue Act of 1988
(i) Definitions and Special Rules.
For purposes of this section-(1) Class Life. Except as provided in this section, the term "class life" means the class
life (if any) which would be applicable with respect to any property as of January 1,
1986, under subsection (m) of section 167 (determined without regard to paragraph (4)
and as if the taxpayer had made an election under such subsection). The Secretary,
through an office established in the Treasury, shall monitor and analyze actual experience with respect to all depreciable assets.
- 33 -
- 34-
Exhibit 3
Provisions for Changes in Classification from the General Explanation of the Tax Reform
Act of 1986
The Secretary, through an office established in the Treasury Department is authorized to
monitor and analyze actual experience with all tangible depreciable assets, to prescribe a new class
life for any property or class of property (other than real property) when appropriate, and to prescribe
a class life for any property that does not have a class life. If the Secretary prescribes a new class
life for property, such life will be used in determining the classification of property. The prescription
of a new class life for property will not change the ACRS class structure, but will affect the ACRS
class in which the property falls. Any classification or reclassification would be prospective.
Any class life prescribed under the Secretary's authority must reflect the anticipated useful
life, and the anticipated decline in value over time, of an asset to the industry or other group. Useful
life means the economic life span of property over all users combined and not, as under prior law,
the typical period over which a taxpayer holds the property. Evidence indicative of the useful life
of property, which the Secretary is expected to take into account in prescribing a class life, includes
the depreciation practices followed by taxpayers for book purposes with respect to the property,
and useful lives experienced by taxpayers, according to their reports. It further includes independent
evidence of minimal useful life -- the terms for which new property is leased, used under a service
contract, or financed -- and independent evidence of the decline in value of an asset over time, such
as is afforded by resale price data. If resale price data is used to prescribe class lives, such resale
price data should be adjusted downward to remove the effects of historical inflation. This adjustment
provides a larger measure of depreciation than in the absence of such an adjustment. Class lives
using this data would be detennined such that the present value of straight-line depreciation
deductions over the class life, discounted at an appropriate real rate of interest. is equal to the present
value of what the estimated decline in value of the asset would be in the absence of inflation.
Initial studies are expected to concentrate on property that now has no ADR midpoint.
Additionally, clothing held for rental and scientific instruments (especially those used in connection
with a computer) should be studied to determine whether a change in class life is appropriate.
Certain other assets specifically assigned a recovery period (including horses in the three-year
class, qualified technological equipment, computer-based central office switching equipment,
research and experimentation property, certain renewable energy and biomass properties, semiconductor manufacturing equipment, railroad track, single-purpose agricultural or horticultural
structures, telephone distribution plant and comparable equipment, municipal waste-water treatment
plants, and municipal sewers) may not be assigned a longer class life by the Treasury Department
if placed in service before January 1, 1992. Additionally, automobiles and light trucks may not be
reclassified by the Treasury Department during this five-year period. Such property placed in
service after December 31,1991, and before July 1, 1992, may be prescribed a different class life
if the Secretary has notified the Corrunittee on Ways and Means of the House of Representatives
and the Committee on Finance of the Senate of the proposed change at least 6 months before the
date on which such change is to take effect.
Notes
1. Although the conventional age of a horse is usually derived from a fictional January 1 birthdate,
the current classification of horses for depreciation purposes is dependent upon on their true ages.
The analysis contained in this report, however, uses data which is based on the conventional age
classification of horses. Thus, a horse classified as a "two-year old" can have an actual age between
one and three years.
2. See the discussion between Senators McConnell, Ford, and Packwood, as reported in the
Congressional Record of September 27, 1986 (p. SI3953).
3. It is possible ,that retirements will result in additions to income where salvage value is a significant
factor. This is particularly true for retirements that occur after the asset group has been fully
depreciated for tax purposes. Such gains are treated as negative deductions.
4. The American Horse Council points to information from The Blood Horse's Stallion Register
for 1988 , which indicates that about 67 percent of the thoroughbred stallions listed are owned by
a syndicate, and 33 percent are owned by an individual or farm. From these statistics, they conclude
that the ownership of perhaps 75 percent of these stallions may have been transferred at the conclusion of their racing career. Unfortunately, their data do not indicate the fraction of ownership
retained by the owner(s) of the racehorse, nor when the transfer took place. As noted in note 18
below, information from auction sales of stallion shares suggest that these caveats may be important.
Even if the 75 percent figure were accepted, it would imply that, under current law, the owners of
25 percent of the more successful stallions could fully depreciate their horses over a three-year
recovery period, despite their continued value for breeding purposes. Moreover, the establishment
of a single asset class for all horses would not necessarily be inequitable even to those owners that
actually sell their horses when their racing careers are over. As shown in Figure 6 and Figure 9,
the average decline in value of such horses is not expected to be as rapid as the 200 percent declining
balance depreciation over a seven-year recovery period allowed for assets with a IO-year class life
In any case, the greater allowances that might otherwise have been claimed would have been
recaptured when the horse was sold.
5. In particular, the American Horse Council believes this study should only cover racehorses (and
not breeding and workhorses), objects to the inclusion in this study of data relating to the very
successful horses (which they believe do not comprise more than a small fraction of the total
population of racehorses), believes that the ability of taxpayers to claim a loss on the disposition
of their horses should not be factored into the calculation of an equivalent economic life for horses,
and in general believes that the depreciation of horses cannot be studied by an approach of the type
used for other assets, because horses are considered too unlike all other assets. For the reasons
noted in the text, the Depreciation Analysis Division does not concur with these views.
6. The American Horse Council argues that the presumed short economic life of the 40 percent of
the thoroughbred foals that do not start should be considered in detennining the useful life of a
racehorse. (They also provide infonnation that a correspondingly large fraction of standardbred
foals do not start). The Depreciation Analysis Division believes, however, that only assets for which
depreciation may be claimed should be considered when estimating appropriate class lives.
Unfortunately, a breakdown is not available between those horses that are trained for racing (and
are thus placed in service) but do not start, and those that are not placed in service. To the extent
that the non-starters are depreciable business assets with relatively short lives, the useful lives
reported in this study are somewhat overstated.
7. The American Horse Council believes that the fact that a mare produced a single foal does not
necessarily indicate that the mare is being used for breeding purposes. Likewise, it does not believe
that the fact that a stallion sired five foals in its lifetime does not necessarily imply that the stallion
is being used for breeding. In their view, only about 5 percent of all thoroughbred males, 3 percent
of standardbred males, and about 13 percent of quarterhorse males ever become breeding stallions.
- 35-
- 36They admit that a higher percentage of fillies become mares (they provide infonnation showing
that about 70 percent of all quarterhorse fillies and somewhat less than one-half of all standardbred
fillies become mares), but also note that many mares produce relatively few foals. Unlike the
statistics calculated by the Depreciation Analysis Division for thoroughbreds, the percentages
suggested by the American Horse Council are not adjusted to reflect the fact that a significant
fraction of foals do not start, and it is generally only those that do that are subsequently used for
breeding purposes.
8. The American Horse Council believes that very few horses would be allowed to continue to race
long after their last winning race.
9. The American Horse Council believes that it is more appropriate to assume that the salvage
value is independent of the initial value of the horse (although it does not suggest what this value
might be). As noted in the text, the primary motivation for the assumption of a fractional salvage
value was the desire to be able to express the resulting economic depreciation as a fraction of the
initial investment. The Depreciation Analysis Division does not believe that the use of an independent salvage value would have a significant effect on the calculated equivalent economic lives.
Indeed, setting salvage to zero lowers the estimated equivalent economic life for thoroughbreds by
less than one-half year.
10. A half-year convention was employed in applying the straight-line fonnula, i.e., the fIrst year's
deduction was set equal to one-half of the full straight-line deduction. In addition, the initial year's
depreciation and loss deductions were each discounted by a half-year discount factor.
11. The American Horse Council believes that guaranteed breeding fees are less common than
assumed, which suggests that the imputed value of the stallions may be somewhat overstated, and
thus the calculated equivalent economic life also somewhat overstated.
12. The data on number of foals sired were fIrst regressed against age in order to obtain a smoothed
fertility-age curve.
13. Compare the retirement distribution shown in Figure 2 with those of Figures 1 and 3.
14. Of course, even if no depreciation is allowed, the taxpayer can recover his investment by
claiming a loss upon the asset's retirement.
15. The American Horse Council believes that many fillies are bought off the track for breeding,
and are thus not in foal. Since in this study a portion of the value of the mare is assumed to be
allocated to the foal, to the extent this need not be done, the calculated values of the mares are
understated, and the resulting equivalent economic life also understated.
16. The Hollingsworth data show a decline in fertility to age 16 and then a small general upward
trend throughout the remaining life. This increase in fertility was ignored in the calculation of the
age-price profile.
17. For a more detailed discussion of the pre-1981 "facts and circumstances" depreciation system and the concept of useful lives then in effect, see for example, Brazell, Dworin, and Walsh
(1989).
18. Since the ownership of a stallion may be divided into as many as 40 shares, and on average
only one or two shares in each horse was sold at auction, even the sale of shares in 200 horses
represents only a very small transfer of ownership in breeding stallions. It might also be noted that
these 200 horses were of varying ages, with an average age of 13.5 years. See note 4 above, however,
for a contrary view of the extent to which racehorses are sold at the end of their racing career.
19. Notice, however, that the data in Figure 12 imply that only about one-third of all sales of
broodmares occur at ages 3 or above.
- 37 20. The level of investment in older broodmares is not negligible. In 1988, thoroughbred broodmare
auction sales totaled about $166 million out of a total of $532 million in auction sales of all thoroughbreds. Because their salvage value does not decline appreciably with age, however, only
broodmares placed in service at 15 years of age or older have an equivalent economic life appreciably
lower than the 12.4-year life noted for a yearling, as shown in Figure 13. As may be seen from
Figure 9, the estimated price of such broodmares is much lower than for younger broodmares. Thus,
when weighted by the level of investment, the contribution of these much older broodmares to the
overall equivalent economic life of all thoroughbreds is quite small.
21. The American Horse Council suggests that some other breeds of horses, such as standardbreds
and quarterhorses, may have somewhat shorter economic lives than thoroughbreds.
- 38-
References
Ackerlof, George A., "The Market For "Lemons": Quality Uncertainty and the Market Mechanism" ,
Quarterly Journal of Economics, No.3 (August, 1970), pp. 490-500.
Brazell, David, Lowell Dworin, and Michael Walsh, A History ofFederal Tax Depreciation Policy,
OT A Paper 64 (U.S. Department of the Treasury, Washington, D.C., May, 1989).
Hollingsworth, Kent, "So What is the Economic Useful Life of a Thoroughbred?", The Blood Horse,
(Thoroughbred Owners and Breeders Association, March, 1972), pp. 11.01-11.06.
Hulten, Charles R. and Frank C. Wykoff, "The Measurement of Economic Depreciation", in
Depreciation, Inflation, and the Taxation ofIncome From Capital, ed. by C. Hulten, The Urban
Institute (Washington, D.C., 1981), pp. 99-103.
- 39-
Acknowledgements
This repon was prepared by Lowell Dworin of the Office of Tax Analysis. William Strang collected
and compiled the information, Robert Yuskavage and David Brazell reviewed and revised the
manuscript, and Carolyn Greene provided secretarial assistance.
- 40-
Department of the Treasury
Washington, D.C. 20220
Official Business
Penalty for Private Use, $300
Widely Held Partnerships:
Compliance and Administration Issues
A Report to The Congress
Department of the Treasury
March 1990
DEPARTMENT OF THE TREASURY
WASHINGTON
March 1990
The Honorable Dan Rostenkowski
Chairman
Committee on Ways and Means
House of Representatives
Washington, D.C. 20515
Dear Mr. Chairman:
Enclosed is a study of the compliance and administrative
issues posed by publicly traded and other large partnerships.
The study is required by section 10215 of P.L. 100-203, the
Omnibus Budget Reconciliation Act of 1987, and has been prepared
jointly by the Treasury Department and the Internal Revenue
Service.
The study concludes that the requirements of current
law, as they apply to large partnerships, their partners and the
Service, are overly complex and inefficient and that a new system
to address these concerns is warranted. It is strongly believed
that such a new system will significantly benefit all parties.
A copy of the study and a similar letter are being sent
to Representative Bill Archer.
Sincerely,
.
0.~
Ke neth W. Gideon
Assistant Secretary
(Tax Policy)
Fred T. Goldberg,
Commissioner
Internal Revenue Se
DEPARTMENT OF THE TREASURY
WASH INGTON
March 1990
The Honorable Lloyd Bentsen
Chairman
Committee on Finance
United States Senate
Washington, D.C. 20510
Dear Mr. Chairman:
Enclosed is a study of the compliance and administrative
issues posed by publicly traded and other large partnerships.
The study is required by section 10215 of P.L. 100-203, the
Omnibus Budget Reconciliation Act of 1987, and has been prepared
jointly by the Treasury Department and the Internal Revenue
Service. The study concludes that the requirements of current
law, as they apply to large partnerships, their partners and the
Service, are overly complex and inefficient and that a new system
to address these concerns is warranted. It is strongly believed
that such a new system will significantly benefit all parties.
A copy of the study and a similar letter are being sent
to Senator Bob Packwood.
Sincerely,
CJ.L.
Ke eth W. Gideon
Assistant Secretary
(Tax policy)
Fred
Goldberg,
Commissioner
Internal Revenue S
CONTENTS
Page
I.
INTRODUCTION ••.••••.•••••••.••.••••..•.••••..•.•
1
II.
THE GROWTH OF WIDELY HELD PARTNERSHIPS .••.••.•.•
5
III.
CURRENT SYSTEM AND REASONS FOR CHANGE ....•••••..
9
A.
Reporting Compliance.......................
9
B.
Administration of Widely Held Partnerships.
12
1.
2.
Description of TEFRA Partnership
Audit Rules...........................
12
Description of Service Audit Procedures
with Respect to Widely Held
Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . .. 13
3.
IV.
Problems Faced by the Service in
Administering Widely Held
Partnerships. . . . . . . . . . . . . . . . . . . . . . . . . .
21
PROPOSED SIMPLIFIED REPORTING SYSTEM FOR
WIDELY HELD PARTNERSHIPS .•••.••.••••••••••.•.•••
27
A.
Introduction. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
27
B.
Determination of Partnership Items at the
Widely Held Partnership Level ••.•••••••.••.
28
1.
In General .•••••••••••••••••••••••••••
28
2.
Income and Deductions ....••••.••••••••
28
3.
Allocations ............................ 31
4•
Credits. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
32
a.
Consolidated Tax Credit •••••••••••
32
b.
separately-Reportable Credits ••.••• 33
c.
Foreign Tax Credit ••••••••.•••••••
v.
34
V.
5.
Other Reporting Issues ................. 36
6.
Reporting Form ......................... 37
7.
Possible Further Simplification .......
38
8.
Examples. . • • . . . . .. . .. .. .. .. . .. .. . . . .. .. .. .. .. . .. .. .. ..
39
C.
Elimination of Non-Income Items ...•........
41
D.
Magnetic Media Filing......................
42
E.
Treatment of Large Partners ...•.....••.....
42
F.
Summary of Simplified Reporting Issues .....
43
G.
Withh.oldinq...............................................................
44
H.
Ownership Changes..........................
46
1.
Fungibility ...........................
46
2.
Constructive Termination Under
Section 708 .•.•••..•...•.•........•.•.
48
3.
Accounting Conventions ...•..•.•...•...
49
4.
Information Reporting .••..•••.•••.••..
51
PROPOSALS FOR CURRENT ASSESSMENT OF DEFICIENCIES
WITH RESPECT TO WIDELY HELD PARTNERSHIPS.......
53
A.
Ove'rview.. .. .. .. .. .. .. . .. .. . .. .. .. .. .. .. .. .. .. .. . .. .. .. . . . .. .. .. .. .. .. ..
53
B.
House Proposal.............................
54
1.
. t 'l.on ............................................. ..
Oeser 1P
54
2.
Examples .................................................. ..
55
3.
Analysis ............................................... ..
56
Deficiencies with Respect to Widely Held
Partnerships Should be Borne by CUrrent
Partners. . . . . . . . . . . .. . . . . . . . . . . .. . .. . .. .. .. .. . .. . . .
58
Partnership Collection Proposal ••.•••••••••
58
Description. . . . . . . . . . . . . . . . . . . . . . . . . . .
58
C.
D.
1.
vi.
E.
VI.
VIII.
Basis and Capital Accounts .........
3•
Overstatements and Amended Returns ....
60
4.
Insolvent Partnerships ............... .
61
50
Examples ...•.•••..••..•.••.•..•....•••
63
6.
0'~scuss~on
,
••••• ,. •••..••.•..•...•..•.•.
64
Alternative Proposals......................
68
1.
Partner Collection Method •.•.•.....•..
68
2.
Non-Flowthrough Method ...•............. 70
3.
Nonrefundable Credit .•......•...•..•..
72
4.
Elective Payment of Deficiencies by
Partnerships ••.•...•..••...•.•.•.•....
73
0
••
60
F.
Comparison to Deficiency Dividend Procedures
73
G•
Audit Procedures...........................
74
PENALTIES.......................................
77
A.
Overview................................... 77
B.
Accuracy-Related Penalty ..•••.••.••.•..•.•.
77
1.
Backqround. • • • • • • • • • • • • • • • • • • • • • • • • • • • •
77
2.
Negligence ••••..•••........•••••.•••.••
78
3.
Substantial Understatement of
Income Tax.............................
79
4.
Substantial Valuation overstatement ••••
81
Fraud Penalties............................
82
C.
VII.
2•
SCOPE OF THE PROPOSALS--DEFINITION OF A WIDELY
!lELD PARTNE'RSHIP................................
83
EFFECTIVE DATE CONSIDERATIONS ••••••••..••.•••...
85
Appendix I - proposals for Amendments to TEFRA Rules
Appendix I I - Description of TEFRA Rules
vii.
SECTION I. INTRODUCTION
section 10215 of the Omnibus Budget Reconciliation Act of
1987 directs the Treasury Department to conduct a study of (1)
the issues of treating publicly traded limited partnerships (and
other partnerships which significantly resemble corporations) as
corporations for federal income tax purposes, including disincorporation and opportunities for avoidance of the corporate tax,
and (2) the issues of compliance and administration with respect
to publicly traded partnerships and other large partnerships.
This report, which is the product of a joint Treasury and
Internal Revenue Service study, addresses the second set of
issues in the requested study. It describes the compliance by
and administration of widely held partnerships under current tax
law, and discusses the problems faced by the Internal Revenue
Service (the "Service" or "IRS") in monitoring compliance,
determining additional tax due, and collecting tax deficiencies
attributable to such partnerships and their partners. It concludes that the requirements of current law, as they apply to
widely held partnerships, their partners and the Service, are
overly complex and inefficient and that a new system to address
these concerns is warranted. It is strongly believed that such a
new system will significantly benefit all parties.
The report first sets forth the Treasury's analysis of the
existing situation, and the reasons to provide new procedures in
order to insure collection of tax attributable to the partners
who are members of widely held partnerships.
The report then
recommends the adoption of a new administrative system, applicable only to widely held partnerships. In general, the term
"widely held partnership" would include partnerships with 250 or
more partners, except for service partnerships such as accounting
or law partnerships. See section VII of this report for a more
complete discussion of the definition of a widely held partnership. This report also discusses matters relating to withholding
at the widely held partnership level, but does not recommend such
withholding at this time. In addition, the report includes as
Appendix I proposed revisions to the unified partnership audit 2
rules applicable to all partnerships with more than 10 partners.
lThe omnibus Budget Reconciliation Act of 1987, Pub. L. No.
100-203 (the "1987 Revenue Act"), added section 7704 to the
Internal Revenue Code of 1986, as amended (the "Code" or
"I.R.C."). Section 7704 treats certain publicly traded
partnerships as corporations for federal income tax purposes.
This report discusses the administrative treatment of widely held
partnerships that are not treated as corporations for federal
income tax purposes.
• R. C. SS 6221 ~ §eg. The unified partnership audit
rules also apply to certain partnerships with 10 or fewer
partners.
2I
2
The proposed administrative system for widely held
partnerships would have two principal features. First, widely
held partnerships would use a simplified system for reporting
income to the Service and partners. The current Schedule K-l
reporting form would be replaced by a new Form l099-K on which
widely held partnerships would report certain specified and
limited information. Elections now made by partners would be
made at the partnership level. Rules applicable in calculating
taxable income, such as limitations on certain deductions, would
be applied at the partnership level wherever possible. Transmissions to the Service would be made by magnetic media. The
second principal feature of the system would be a consolidation
of the tax audit and administration procedures at the partnership
level, including payment of any tax deficiencies, interest and
penalties at the partnership level.
Because of the administrative difficulties currently posed
by widely held partnerships, it is reasonable to conclude that
there may be significant loss of revenue to the government. This
revenue loss is partially attributable to income reported by the
partnership which is not included on a partner's return, whether
through inadvertence, confusion, or conscious failure to report
income. The revenue loss is also partially attributable to the
underreporting of income by the partnership itself. We do not
believe that clearly erroneous reporting positions are commonly
taken by large partnerships. However, to a significant degree,
our voluntary reporting system antiCipates an adversarial
relationship between taxpayers and the Service. A taxpayer may
report a transaction or event as he or she deems appropriate and,
if the Service disagrees with the taxpayer's analysis, the
Service has the right and obligation to challenge the taxpayer's
position. The unwieldy administrative rules currently applicable
to widely held partnerships make it difficult for the Service to
fulfill this role, and hampers the proper functioning of the
voluntary reporting system.
It is reasonable to assume that the government will receive
increased revenue as a result of a simplified reporting system
and more efficient rules governing audits of widely held partnerships. We estimate that implementation of a new reporting system
with respect to partnerships with 250 or more partners would
raise between $85 million and $140 million over a five-year
period, and implementation of a streamlined audit and assessment
proposal would raise between $100 million and $200 million over a
five-year period.
Moreover, apart from revenue considerations, there are sound
tax policy reasons to alter the tax administration system with
respect to widely held partnerships. CUrrent law and procedures
were developed in an era when partnerships were generally
relatively small, and, to a significant degree, these procedures
treat partnerships as aggregations of individual taxpayers. This
3
approach makes little sense in an era where partnerships may have
500, 1,000, or an even larger number of partners. An individual
partner's relationship to the partnership is similar to that of a
shareholder to a large corporation. We do not assert that widely
held partnerships should be taxed as corporations; however, we do
believe that today's large partnerships represent a new type of
entity that requires a new set of rules. These rules should be
grounded on the similarity between widely held partnerships and
corporate entities, and the need to achieve efficient administration. Like corporations, widely held partnerships should use
a simplified system for reporting to the service and their
partners, and audits and assessments of deficiencies should be
conducted at the entity level.
SECTION II.
THE GROWTH
or
WIDELY HELD PARTNERSHIPS
In recent years, the number of widely held partnerships has
significantly increased. In 1978 some 671 partnerships had 500
or more partners; by 1987 the number had grown to 1,735. The
greatest portion of the increase was attributable to partnerships
with over 1,000 partners, the number of which grew from 288 in
1978 to 1,224 in 1987. During this period, there was a corresponding increase in the percentage of partners who held their
interests in large partnerships. In 1978 only 15.1 percent of
all partners held their interests in partnerships with 500 or
more partners; by 1987 this percentage was 46.9 percent. Again,
most of this growth was attributable to partnerships with 1,000
partners or more, which accounted for 44.6 percent of all
partners in 1987, nearly four times the figure of 10.8 percent in
1978. Although comparable 1978 numbers are not available, in
1987 there were 3,459 partnerships with 250 or more partners
accounting for 50.4 percent of all partners and 6,845 partnerships with 100 or morj partners accounting for 53.2 percent of
all partners in 1987.
In 1987, sales of publicly offered partnership interests
reached record levels.' Although sales since 1987 have declined
sharply, they still are substantial in terms of dollars. Sales
of partnership interests in public offerings, including traded
and untraded interests, declined 44 percent from 1987 to 1989 and
publicly traded interests in master limited partnerships declined
a SUbstantial 79 percent ($2.9 to $.6 billion). Total sales of
all such partnership interests were $13.5 billion for 1987 and
$7.6 billion for 1989. 5 Despite the decline in the rate of
growth, sales of this magnitude will continue to m,terially
increase the growing number of large partnerships.
lInternal Revenue Service, Statistics of Income--Partnership
Returns: 1978 and 1980. 1987 figures from unpublished IRS data.
'~ "Record Public Partnership Sales in 1987" The Stanger
Register, February 1988,
p. 13.
5~ Table 1 "Public Partnership Sales" for 1988-1989 ~
Stanger Register, February 1990, p. 35.
'There are also SUbstantial sales of partnership interests
in private placements (so-called regulation D offerings exempt
from certain securities and Exchange Commission filing
requirements). The estimated sales of such offerings for 1987,
1988 and 1989 amounted to $1.5 billion, $2 billion, and $1.4
billion, respectively (Source: Robert A. stanger & Co.).
Privately offered partnerships probably have less impact on the
issues discussed in this report because they are less commonly
widely held partnerships as the term is used herein.
6
This growth in the number of widely held partnerships is
not surprising. Operating a business or investment activity in
partnership as opposed to corporate form offers significant tax
advantages, including the avoidance of an entity-level tax and
the ability of the members to deduct losses from the activity on
their own tax returns (subject to certain restrictions). Despite
these advantages, a number of factors traditionally hampered use
of the partnership form by widely held entities. Among these
factors were the administrative complexity for the entity and
members of applying the partnership tax rules to a widely held
entity, the reluctance of small investors to invest through the
less familiar partnership form, and a relative lack of liquidity
for partnership interests.
In the late 1970s and 1980s, these limiting factors began
to weaken. Computer programs and other procedures were developed
for applying the partnership tax rules to widely held partnerships. Investors became more familiar and comfortable with
limited partnership investments. In addition, the use of tax
~helters greatly expanded in the late 1970s and early 1980& and
widely held partnerships became an increasingly popular investment vehicle, in part because they made shelters accessible to
smaller investors. Finally, a number of widely held partnerships
began to offer partners a significant degree of liquidity, either
through the offering of redemption or remarketing programs or,
more notably, through the listing of partnership interests on
stock exchanges. Prior to 1980, no partnerships were listed on
any major stock exchange; as of December 31, 1989, 126 were
listed.
The forces encouraging the growth of large partnerships
have not been unchecked. In particular, the desirability of
these investments has been limited by a series of tax law
changes culminating in the enactment of the passive loss rules
Which limifed the deductibility of losses by partnership
investors, and the enactment of section 7704 of the Code which
limited the ability of publicly traded entities to qualify as
partnerships for tax purposes.
Nonetheless, as long as income earned through partnerships
is subject to a lower effective tax rate than income earned
through corporations, we believe that the number of widely held
partnerships will continue to grow. Moreover, we believe that
interests in many of the widely held partnerships will experience
significant levels of trading. For example, section 7704 grandfathers all existing publicly traded partnerships for a ten-year
period,8 and does not apply to partnerships earning certain
'See. e.g., I.R.C. S 469.
81987 Revenue Act section 10211(c).
7
types of qualifying in,ome, including natural resource and real
estate related income.
Administrative difficulties faced by the Service will be
exacerbated by any growth in the number of widely held partnerships and by significant trading levels of interests in such
partnerships. In light of the recent and anticipated future
growth in widely held partnerships, and the likelihood of
continued significant trading, the issue of compliance and
administration with respect to large partnerships is a timely
and important subject.
,
I.R.C. S 7704(d).
SECTION III.
A.
CURRENT SYSTEM AND REASONS lOR CHANGB
Reporting Compliance
Under current law, a partnership must file Form 1065
~artnership.return of income, for each taxable year. The'return
~s accompan~ed by a Schedule K-1 for each partner, reporting the
partner's share of allocable items of the partnership's income
and deductions, credits and other specified information. A copy
of the Schedule K-1, or a substituted form, is furnished to each
partner to be used in reporting such items on the partner's
income tax return.l~
In the case of many partnerships, such reportings to
partners are voluminous and complex due to the considerable
number of passthrough items. On the 1989 Schedule K-1 there are
nine different categories of passthrough items with more than
forty possible individual amounts to be included in the partner's
return or schedules related thereto. comments received from
taxpayers during various IRS Town Meetings held around the
country during the 1989 filing season invariably included
references to the complexity of the Schedule X-l. Furthermore,
widely held partnerships frequently send out information to
partners in a format which differs from the Schedule X-I. This
is permissible as long as the official Schedule X-I, or an
approved SUbstitute Schedule X-I, is filed with the service and
the required information is provided to the partner. This lack
of uniformity in information reporting forms is also a frequently
mentioned matter of concern expressed when Service representatives meet with practitioner groups. Illustrative of the extent
of this problem is a recently issued prospectus describing the
proposed merger of two partnerships (assets over $300 million)
into a corporation intended to qualify as a real estate investment trust. The prospectus states that one of the principal
benefits of the merger is the ability to provide to investors a
tax information form (Form 1099) which is less complex and easier
to undersrrnd than the Schedule K-l currently required to be
provided.
The complexity of the Schedule X-I as compared to
10Schedule X-l is an information return used to furnish
information to partners pursuant to section 603l(b). The form
lists specific types of income (II entries), deductions (4
entries), 7 types of credits (12 entries), tax preference items
(6 entries), investment interest (3 entries), self-employment
amounts (3 entries), and recapture of investment tax and lowincome housing credits (2 entries).
I1prospectus/proxy Statement of CRl Liquidating BElT, Inc.,
and CRI Insured Mortgage Association, Inc., dated August 17,
1989, pages 1 and 11.
10
interest and dividend reporting on Form 1099s, may in and of
itself discourage proper reporting by the partners.
The Service has insufficient data to determine the
extent of underreporting of income by partners in widely held
partnerships. However, statistics show a material level of
noncompliance in the case of reporting of payments of interest,
dividends and capital qains.'2 While an estimated 99.5 percent
of wages and salaries were voluntarily reported in 1987 by
individuals who filed tax returns, 94.5 percent of interest and
dividends were reported'3 and only 88.3 percent of capital gains
were reported. These figures do not include the failure to
14
report such income by persons not filing a required tax return.
By analogy, it can be inferred that a material percentage of
income from widely held partnerships is not reported by partners.
Furthermore, even in cases where partners make good faith efforts
to report items attributable to widely held partnerships, given
the complexity of the Schedule X-I, it seems reasonable to
conclude that some additional percentage of income attributable
to widely held partnerships is not properly reported.
12A Form 1099 information return is required to be filed by
any person making payments of interest or dividends above a
certain amount and by brokers upon certain sales of assets.
I.R.C. §§ 6042, 6045, and 6049.
13See Table 1-2, "Income Tax Compliance Research: Gross Tax
Gap Estimates and Projections for 1973-1992," Publication 7285
(March 1988) ("Gross Tax Gap Estimates and Projections"). The
94.5 percent compliance figure resulted in underreported interest
and dividends for 1987 of $13.2 billion.
14 The Service is concerned that partners who hold their
interest through nominees may not be receiving Schedule X-Is from
the partnership or the nominees. The Service has anecdotal
information that in the past some brokerage houses holding
partnership interests as nominees destroyed information returns
received from such partnerships instead of forwarding those
returns to their customers. However, such information predates
the enactment of section 603l(c). Section 6031(c), which was
added by the Tax Reform Act of 1986, Pub. L. No. 99-514, requires
any person who holds an interest in a partnership as a nominee
for another person to furnish to the partnership information
concerning such other person to the extent prescribed by the
Secretary. This section is effective for taxable years beginning
after October 22, 1986. section l015(a) of the Technical and
Miscellaneous Revenue Act of 1988, Pub. L. No. 100-647, extended
the section 6722 penalty to cover returns required under section
6031(c) .
11
The Service currently has the technical capability to match
information reported to the Service by partnerships with the
information reported by partners on their returns. However, the
application of the matching program is significantly complicated
by the fact that each partner's Schedule X-l information may
consist of numerous items (over forty separate items possible)
which, in many cases, are limited or modified at the partner
level and are required to be reported in a variety of different
places on the partner's Form 1040 and related schedules.
Furthermore, in contrast to coryrrations that file substantial
numbers of information returns,
widely held partnerships are
not require?,to use magnetic media filing to report Schedule K-l
information
and in almost all cases file such information on
paper returns. The Service must manually transcribe paper
returns before matching can occur. These systemic barriers mean
that matching partnership data is more expensive and time
consuming than matching other types of reported information. 17
The reporting system for widely held partnerships is thus
needlessly complex and inefficient. It is important to solve
these deficiencies in the compliance system, not only to protect
the fisc, but also to provide a system that is workable for the
public and administrable by the service. It is also important to
recognize in our tax system the changing economic and capital
structure of the country and to adapt the system to changes in
order to protect the interests of the public and the government.
15 Not ice
90-15, 1990-7 I.R.B. 23.
l'Publication 1437 (Rev. 1-90).
difficulties in the operation of a matching program
are also faced by the Information Returns Program ("IRP"). An
IRP program involves the matching of data contained in
information returns filed by payors and flow-through entities
with the data reported on tax returns filed by payees and
investors in flow-through entities. An IRP program normally
results in assessment of additional tax in cases where a taxpayer
agrees with the proposed adjustment to his or her reported
income, and issuance of a statutory notice of deficiency in the
event the partner fails to agree or respond. Under the unified
partnership audit rules discussed below, the Service may be
authorized to proceed directly to assessment under its authority
to make a computational adjustment in a case in which a partner
fails to report consistently with the partnership return and
fails to disclose such inconsistency. I.R.C. S 6222. However,
to institute the IRP procedure, the Service would have to locate
and obtain the partners' returns for purposes ,of making the
computational adjustment. The IRP procedure 18 not cost
efficient under current law when applied to widely held
partnerships.
17 The
12
A proposal for a simplified reporting system to help accomplish
these objectives is discussed in section IV below.
B.
Administration of widely Held Partnerships
1.
Description of TEfRA Partnership Audit Rules
Prior to the enactment of unified partnership audit rules by
the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA"),
adjustments to items of income, gain, loss, deduction and credit
relating to a partnership had to be made in separate proceedings
with the respective partners. Similarly, settlements and
judicial determinations were only binding on those partners that
were parties to the agreement or judicial proceeding. This
system was not an efficient means of auditing tax shelters and
other large partnerships, because each partner was entitled to
separate administrative and judicitl review of partnership items
that were common to all partners.
The TEFRA partnership audit
rules consolidate the administrative and judicial review of all
partnership items at the partnership level. Congress, noting the
potential conflict between investors and tax shelter promoters,
balanced the consolidated audit provisions with considerable
protections for individual partners.
The TEFRA partnership audit rules apply to all partnerships,
except for partnerships with ten or fewer partners in which each
partner's share of any partnership item is the same as his or
her share of every other item (e.g., there are no special
allocations) and each partner is
natural person (other than a
1
nonresident alien) or an estate.
The tax treatment of all
partnership items is determined at the partnership level. 20
Generally, all partners must treat items on their individual
t
18~ General Explanation of the Revenue Provisions of the
Tax Equity and Fiscal Responsibility Act of 1982, at 267-68
(hereinafter referred to as "TEFRA General Explanation").
l'l.R.C. 56231(a)(1)(8). All partners of a partnership for
the partnership taxable year under audit generally are subject to
the TEFRA partnership audit rules. However, under certain
circumstances, the inclusion of a partner in a unified proceeding
would interfere with the efficient enforcement of the tax law.
I.R.C. 5623l(c). When special enforcement considerations exist
with respect to a partner, that partner's partnership items will
be treated as nonpartnership items and the partner is removed
from the partnership proceeding. Examples of special enforcement
situations include the filing of a bankruptcy petition naming a
partner as the debtor or the criminal inv~stigation of a partner.
~; Temp. Treas. Reg. 5S 301.6231(c)-4T through 8T.
20
I.R.C. 5 6221.
13
returns consistently with the treatment of those items on the
partnership return 2pnless they notify the Service of an inconsistent treatment.
If the Service challenges a reporting
position of a partnership subject to the TEFRA rules, it conducts
a single administrative proceeding to resolve the issue with
respect to all partners. Similarly, if a partnership decides to
challenge an administrative determinat!fn of the Service, a
single judicial proceeding will occur.
The central figure in a TEFRA partnership proceeding is the
tax matters partner ("TMP"). The TMP is the representative of
the partnership who serves as a liaison between the partnership,
the Service and the court with respect to the unified audit and
litigation proceedings regarding the tax treatment of partnership
items attributable to the partnership. As such, the TMP serves
as the focal point for service of all notices, documents and
orders on the partnership, and concomitantly has many rights and
duties both at the administrative stage of the proceeding and in
the course of litigation. The Code provides that the TMP is the
general partner designated by the partnership to serve as the TMP
or, if there is no such designation, the general partner having
the largest profits interest as of the close of the taxable year
involved. 23 If the Service determines that it is impracticable
to apply the largest profits interest ryje, the Service may
select any partner to serve as the TMP.
The TE~ partnership audit rules are described in detail in
Appendix II.
2.
Description of Service Audit Procedures with Respect to
Widely Held Partnerships
The Service has elaborate procedures for auditing
partnerships and assessing and collecting partner deficiencies
after the amount of the audit adjustment has been finally
determined. This section provides a detailed description of the
steps that are followed in conducting an audit of a large
partnership.
21 I • R • C• S 6222(a) and (b).
22~ I.R.C. S 6226.
23 I.R.C. S 623l(a) (7); Temp. Treas. Reg.
S 30l.623l(a) (7)-lT.
2'~; ~ Rev. Proc. 88-16, 1988-i C.B. 691.
25proposals for amendment of these rules are described in
Appendix I.
14
There are ten Internal Revenue Service centers ("Service
centers") located throughout the country. Each Service Center
processes income tax returns of individuals and entities which
reside (or have their principal place of business) within the
geographical jurisdiction of the center. The Service also has 63
district offices which may have jurisdiction over a single state
or a smaller geographical area in more densely populated states.
The primary functions of each district office are the examination
of tax returns (Examination Division), the collection of delinquent tax (Collection Division), the enforcement of criminal
penalties for tax crimes (criminal Investigation Division), and
the response to taxpayer requests for assistance (Taxpayer
Service Division). The Appeals Division's field function is
organized by region, with branches located in some but not all
district offices. The Appeals Division is responsible for
settlement of disputes between the Examination Division and the
taxpayer based on the merits of a given case as well as the
hazards of litigation. The Appeals Division is also responsible
for settlement of some collection disputes.
When a Service Center receives a partnership return, certain
return information is entered into a service Center computer 27
system2 and transmitted to the Martinsburg computing center.
Partnership returns with high audit potential scores are then
screened by classifiers at the Service cenitr in order to
determine which returns should be audited.
Lists of returns
with high audit potential are transmitted to their assigned
district offices. 29 The district office then obtains the
26After a period of time, depending on the return in
question and on the available space at the Service Center, the
tax returns are transported to one of several Federal Record
centers for further storage and ultimate destruction.
27The Martinsburg Computing Center is responsible for
various data processing functions within the IRS.
28partnership returns are assigned a "Discriminate Function"
or DlF score at the Martinsburg Computing Center based on the
values of various line items and the interrelationships of
certain line items. DIF scores on partnership returns, just as
on individual returns, are a numerical rating of the potential of
significant errors being present on a particular return. If a
return has a OIF score above a certain level, it goes into the
DIF inventory and is ordered out by the Examination function as
work is needed. It is then screened for audit potential by the
Classification Branch at the Service Center where the return was
filed.
29partnership audits are generally assigned to the district
in which the partnership has its principal place of business.
15
original partnership return (with any associated files), and the
case is assigned to a revenue agent of the Examination Division.
The revenue agent sends the TMP a Notice of the Beginning of
the Administrative Proceeding (which is required to be issued at
least 120 days before a notice of Final Partnership Administrative Adjustment is mailed to the TMP).30 The revenue agent then
has 45 days to determine whether the items of the partnership are
correctly reported. 3' If the revenue agent determines that there
should be no changes to items as reported, the Notice of the
Beginning of the Administrative Proceeding must be withdrawn
within 45 days of its issuance (otherwise, a notice of Final
Partnership Administrative Adjustment must eventually be
issued) .32
If the revenue agent determines that an audit is warranted,
he or she reconciles all of the Schedule K-1s with the partnership return. 33 The information drawn from the Schedule K-1s
regarding individual partners is forwa£ded from the district
office to the Examination Support unit of the Service center
with jurisdiction over the partnership return (the "partnership's
Service center"). The Examination Support Unit then enters this
information into the Partnership Control System computer programs, which automatically generates requests for all partner
returns in the Federal Records Centers which are then transferred
to the various Service centers with jurisdiction over each
partner's return (the "partner's Service Center"). 35 It takes
30 I.R.C.
§
6223(d)(1).
3'Temp. Treas. Reg.
§
30l.6223(a)-2T(a).
32 Id .
33copies of the Schedule K-ls are filed with the original
partnership return and continue to be associated with the
original partnership return throughout the audit process. The
reconciliation process involves adding the partner profits
percentage indicated on each Schedule K-l to determine whether
the percentages total 100 percent (in order to ensure that all
partners have been accounted for).
~An
Examination Support unit is located in each of the ten
Service Centers. The units, which are part of the Examination
Division, are principally responsible for coordinating the notice
and assessment procedures with respect to i~divid~al partners of
partnerships subject to the TEFRA partnersh1p aud1t rules.
a partner's return is not currently under examination,
the Examination Support unit of that partner's Service Center may
review this return for possible audit.
l5 If
16
an average of two to three months from the date a return is
ordered to locait and forward the return to the appropriate
service Center.
The Partnership Control System of the
partnership's Service Center generates Notices of the Beifnning
of the Administrative Proceeding to each notice partner.
When the examination of a partnership return is completed,
the revenue agent arranges a conferjice with the TMP and any
other partner who wishes to attend.
Prior to the conference,
the revenue agent issues a preliminary report to the TMP
summarizing the revenue agent's initial conclusions, which
are subject to change as a result of legal or factual arguments
presented at the conference.
At the conference, the revenue agent and the TMP (and any
other partners present) discuss the issues raised in the audit.
Even if the revenue agent and the TMP reach an agreement
regarding a proposed adjustment, by stajute the TMP is only
authorized to bind non-notice partners, 9 and in practice will
rarely exercise that authority. If, as is typically the case in
an audit of a widely held partnership, the revenue agent does not
obtain an agreement regarding a proposed adjustment that covers
all of the partners of the partnership, the agent prepares a
final report containing facts, analysis of law, statement of
taxpayer's position, and the agent's conclusions on each issue.
a partner is itself a pass-through entity, the
procedure must be repeated with respect to its members. It takes
approximately four to six months to locate all partner returns
for each tier in a multi-tier partnership.
36 If
partners whose names and addresses have been furnished
to the Service are entitled to receive such notice from the
Service in partnerships having 100 partners or less. I.R.C.
S 6223(a) (1). For partnerships having more than 100 partners,
only partners having a one-percent or greater profits interest or
the designated member of a group of partners who form a fivepercent "notice group" are entitled to receive notice from the
Service. I.R.C. S 6223(b). The TMP is under an obligation to
forward such notices to non-notice partners (with certain
exceptions including indirect partners who have not been
identified to the TMP). Temp. Treas. Reg. S 30l.6223(g)-lT(a).
37 All
laThe burden of notifying all partners of the conference is
placed on the TMP. Temp. Treas. Reg. S 30l.6223(2)-lT(b) (1) (i).
39 I
•R•C. S 6224(C) (3) (A). However, under section
6224(C) (3) (B), a non-notice partner may file a statement with the
Service providing that the TMP is not authorized to enter into a
settlement on such partner's behalf.
17
This report may be reviewed by the Quality Review staff'O in the
district office responsible for the partnership audit.
The Quality Review Staff then prepares a "60-day letter
package" and forwards it to the Examination Support unit of the
partnership's Service Center. The Examiration Support Unit then
mails a copy of the package to the TMP.
The 60-day letter
package contains a letter notifying the partners of the time
period to protest the proposed adjustments to the Appeals
Division. The package also contains a copy of the revenue
agent·s report and an agreement form for use by the partner in
the event he or she decides to accept the proposed adjustments.'2
The TMP files his or her protest with the Quality Review
staff of the district responsible for the partnership audit.
Other partners must file their protests with the Examination
Support Unit of the partnership's Service Center. The
Examination Support Unit forwards any protests it receives to the
Quality Review Staff, which in turn forwards all protests to the
Appeals Division office with jurisdiction over the partnership's
district.
If no protest is. received, the Quality Review Staff of the
partnership's district office prepares a notice of Final
Partnership Administrative Adjustment, which is reviewed by the
District Counsel office for the district. copies of the notice
are mailed to the TMP and each notice partner or the desiqnated
member of each notice group by the partnership's Service Center.
The TMP is required to forward copies of the notice to each
non-notice partner within 60 days after the mailing by the
Service,,3
If a protest is received, an Appeals Division settlement
conference is held at which any partner is entitled to
participate. If a settlement covering all of the partners is not
reached at the conference, the Appeals Officer prepares a
settlement package which the Examination Support unit of the
partnership's Service Center mails to all partners who have not
40 The Quality Review Staff is a branch of the Examination
Division with responsibility for review of completed audit
reports in order to determine whether proper procedures have been
followed and to review revenue agents' determinations.
'1The
TMP would then be responsible for notifying nonnotice partners. Temp. Treas. Reg. S 30l.6223(g)-lT(b) (1) (ii).
,2A copy of the 60-day letter and the agreement form (Form
870-P or 870-L) is sent to all notice partners.
'3 Temp .
Treas. Reg. S 301.6223(g)-lT(a) (2).
18
yet settled."
If not all partners accept the proposed
settlement, the Appeals Division office prepares a notice of
Final Partnership Administrative Adjustment, which is reviewed by
District Counsel and sent to the TMP. Copies of the notice of
Final Partnership Administrative Adjustment are mailed to each
notice partner or the designated member of each notice qroup by
the EXAitnation Support Unit of the partnership's service
Center.
Although the Appeals Division may have developed a
settlement position (under the above-described procedure), the
notice of Final Partnership Administrative Adjustment generally
will reflect the litigatiir position of the Service (rather than
the settlement position).
The TMP has 90 days from the date of mailing of the notice
of Final Partnership Administrative Adjustment to file a
petition with the Tax Court, the Claims Court, or a federal
district court."
If the TMP fails to file a petition within the
90-day period, any notice partner or any qroup having in the
agqregate a five-percent interest in profits may file a peiition
during the 60 days following the end of the 90-day period.
Every partner of the partnership is treated as a party to an
action brought by the TMP or notice partner (or five-percent
group), and is entitled to participate in the action, unless the
partner's partnership items have been converted to nonpartnership .
items or the statute of limitations has expired with respect to
that partner.
After a final determination has been made with respect to a
partnership level adjustment, the Examination Support Units
located in the partners' Service Centers are responsible
for assessing deficiencies against the partners. The tax must be
assessed with respect to each partner within one year of the date
"The Appeals Division may determine in certain situations
that it is not efficient to mail settlement packages to nonnotice partners.
'5 I.R.C. S
6223(a} (2).
"If any settlement was entered into between a partner and
the Service, any other partner may still obtain consistent terms
by making a request within a prescribed time period. ~ I.R.C.
S 6224(c)(2}.
" I.R.C.
,e I • R • C.
S 6226(a).
S 6226(b) (1).
The "five-percent group" for
purposes of filing a petition need not be the same partners that
were members of a five-percent "notice group." Temp. Treas. Reg.
S 30l.6223(b)-lT(e).
19
on which the adjustment became final as to that partner. t ' Each
of these Service Centers reviews the returns of the partners
within their jurisdiction, computes the deficiency, and mails a
notice of computational adjustment to the partners. A computer
generated notice of assessment and demand for payment is then
mailed to each partner from the various partners' service Centers
within 60 days of the date of assessment of that partner.
Payment is due within 10 days of the mailing of the first notice
and demand for payment. If a partner fails to make payment
within that time period, a tax lien is created by operation of
law at the end of the li day period. The lien relates back to
the date of assessment. 0 Shortly after the 10 day period,
computer generated notices are transmitted to the partners who
have not yet paid. Two to five notices (including the abovementioned notice of assessment and demand for payment) are
transmitted depending on the amount of money involved. The last
notice, identified as "Final Demand and Notice of Intent to
Levy," must be issued before enforced collection by levy can
occur and must either be sent by certified mail to the partner's
last known address, hand-delivered to ire partner, or left at the
partner's home or place of employment.
Absent exigent circumstances which would support the making of a jeopardy levy
(usually the same circumstances that would support a termination
or jeopardy assessment), the Service cannot levy for 30 days from
the date of the final notice.
After the notices have been transmitted, if the amount of
the deficiency is below a set tolerance level, no action is taken
by Service personnel; however, any potential levy sources (such
"The one-year assessment period must be calculated on a
partner-by-partner basis, because some partners may settle their
cases separately on different dates while other partners may
choose to await the outcome of the litigation.
any person fails to pay the tax (including any related
interest or penalty) after notice and demand, a statutory lien is
created in favor of the united states upon all property and
rights to property of that person. I.R.C. 5 6321. The lien
imposed by section 6321 arises as of the date of assessment and
continues until the liability is paid or becomes unenforceable by
reason of lapse of time (usually due to the running of the
statute of limitation on collection six years after assessment).
I.R.C. 55 6322 and 6502.
50 If
SlAt this stage, the debt is classified as a "taxpayer
delinquent account." The average cost to the Service to close
such accounts during 1986, 1987 and 1988 was $196.04, $198.48 and
$234.00, respectively. The amount of tax owed thus must be
relatively substantial for collection of these accounts to be
cost effective.
20
as refunds due) are identified by computer, and the amount of any
such refund will be offset by the outstanding liability. A
delinquent account with a balance due above the tolerance level
is then entered into the Automated Collection System computer,
which sets collection priorities based on potential yield (the
amount of the liability is only one of several factors considered). After priorities have been set, revenue representatives of the Collection Division located at 21 locations
throughout the country commence efforts to collect the liability.
The revenue representatives telephone, and in some cases
correspond with, the partners. Any information obtained from the
partner or third party sources is entered into the Automated
Collection System computer for future reference. If a revenue
representative identifies a levy source, be or she may issue a
notice of levy or file a notice of federal tax lien.
If the partner still has an outstanding liability at the
conclusion of the above-described process, the account is placed
into an automated queuing system. The automated queuing system
is a computerized listing of outstanding accounts with priorities
based on expected amounts of collection. If the amount of
expected collection is bigh enough, the case is automatically
transferred to the district where the partner resides and
assigned to a revenue officer. Even if the amount of expected
collection is not high enough to be immediately transferred to
the district, the amount may be transferred and assigned later if
circumstances warrant. However, many smaller accounts (even
though above the set tolerance level) are never assigned to a
revenue officer and therefore the amount due generally would not
be collected.
After an account has been assigned to a revenue officer, the
officer contacts the partner in an effort to collect the amount
due. If this contact does not lead to payment of the liability,
the revenue officer is empowered to take various collection
actions, including seizure of the partner's property. If all
efforts to collect are unsuccessful, a determination may be made
that the debt is currently uncollectible.
The Service has similar, although less well developed
procedures, for handling Requests for Administrative Adjustment
("RAA"), which are the TEFRA equivalent of a refund claim or an
amended return. An RAA could be filed in the many situations in
which a partnership level deficiency flowed through to partners
in a TEFRA proceeding and leads to
related overpayment in
another year for all such partners. 2 Many of the steps
discussed above would essentially have to be repeated in such a
case.
r
52~ section III (B) (3) (6) .
21
3.
Problems Faced by the Service in Administering
Widely Held Partnerships
The ~rese~t audit and assessment system applies to all
partnersh1ps w~th more than ten partners (and in certain cases to
even smaller partnerships). Because of the breadth of its
coverage, the system provides procedural protections and rules
that are generally desirable for partnership administration, but
that may not be appropriate when applied to the type of widely
held partnerships that are becoming common today. The sheer
number of partners in a large partnership (one for instance had
more than 90,000 partners in its first year of operation) may
cause a myriad of problems in the areas of filing, audit,
settlement, litigation, assessment and subsequent proceedings.
The following is a summary of these problems.
(1) Partners may take filing positions inconsistent with
the partnership return. Although in widely held partnerships
this right may not be frequently exercised because the partner
does not have adequate information to take such a position, the
possibility does exist. If the Service is not notified by the
partner as required, the inconsistent treatment in most cases
will never be detected. If notified, the Service may challenge
the inconsistency and conduct a partnership audit or deal with
the items as nonpartnership items. In either case, there is a
significant potential burden in trying to monitor inconsistent
positions of partners in widely held partnerships absent a
mandatory magnetic media filing requirement with a fully
implemented matching procedure.
(2) To conduct an audit of a widely held partnership, the
Service must obtain and monitor information concerning each
individual partner. The actual audit of a large partnership's
books and records ordinarily proceeds in a manner similar to an
audit of a large corporation; however, in a corporate audit, the
Service is not required ti develop and track information concerning each shareholder. 3 In a partnership audit, the service
must first identify each partner. To do so, the service must
reconcile individual Schedule K-ls to determine that it has
accounted for 100 percent of the interests in profits and losses
in the partnership. This process is especially difficult in a
publicly traded partnership because there may be numerous
transfers ot partnership interests during any taxable year.
Furthermore, information provided by the partnership regarding
53Generally, jurisdiction of the Service centers is based on
the residence of the partners (or principal place of business in
the case of corporate partners). Several (and possibly all)
Service centers would necessarily become involved in auditing,
assessing and collecting deficiencies from the partners of a
widely held partnership.
22
individual partners is often incomplete or incorrect, thus
requiring the Examination Division to expend considerable
resources (particularly in the case of larger partnerships) in
order to determine the proper identity of the partners and to
develop sufficient information to make assessment possible.
The Service must then obtain the individual returns of all
partners. It takes an average of two to three months to obtain
the return of a partner once it is ordered from the appropriate
Federal Records Center. If a partner is itself a passthrough
entity, the process must be repeated. It takes approximately
four to six months to obtain all partner returns for each tier of
a multi-tier partnership. The Service also must keep track of
the statute of limitations for every partner, because, for a
variety of reasons, partners may have differing statutes of
limitation. Thus, the Service is required to obtain and monitor
a significant amount of information concerning each partner. In
the audit of a large partnership, the cumulative effect of these
monitoring and information-gathering activities offsets the
efficiencies afforded the Service by the TEFRA rules.
The TMP is authorized to extei1 the statute of
limitations on behalf of all partners.
However, if the
Service is unable to obtain a consent from the TMP which binds
all partners to an extension of the statute of limitations for
assessme~t, the Service must solicit a consent from each
partner. 5 If one partner fails or refuses to extend the statute
of limitations for assessment, the Service is forced to issue a
premature notice of Final Partnership Administrative Adjustment
(applicable to all partners) or else allow the statute of
limitations to expire as to the nonconsenting partner.
(3)
settlement agreement entered into with the TMP will
not be binding on notice partners and will only bind non-notice
partners if the TMP expressly makes the settlement binding on
such partners. Since the TMP of a widely held partnership will
rarely, if ever, elect to bind other partners, the Service
generally must deal with the individual partners if it desires to
settle the entire case. As a result, as the size of the
partnership increases, there is less incentive on the part of the
Service to actively attempt to settle the case. This is because
the Service cannot realistically expect to reach an agreement
with all of the partners in a widely held partnership, even if
the TMP agree. to the settlement offer. Since the refusal of
just one partner to settle could force the Service to litigate
the case, it would be in the service's best interests to take a
hard-line position in settlement negotiations. Consequently, in
(4) A
5'I.R.C. S 6229(b) (1)(8).
55~ I.R.C.
S 6229(b) (1) (A).
23
the,cont 7xt of a widely held partnership, the existing rules are
~n ~mped~ment to resolving the dispute through settlement and
~ncrease the likelihood of litigation.
If the Service does enter into a settlement agreement with
any partner with respect to partnership items, any other partner
may re9U7st consistent settlement terms within (1) 150 days of
the ma~l1ng of the notice of Final Partnership Administrative
Adjustment ("FPAA") to the TMP or, (2) if lifer, within 60 days
after the settlement agreement was reached.
This right
continues even if all settlement offers have subsequently been
withdrawn. In widely held partnerships, if the service follows a
de minimis approach by not pursuing small adjustments, those with
greater tax deficiencies may contend they are entitled to the
same treatment of no adjustment. Thus, the consistent settlement
rules add to the administrative complexity of dealing with widely
held partnerships.
(5) Because each partner has the right to participate in
both administrative and judicial proceedings, the Service may be
faced with numerous representatives in a single partnership
proceeding. This may result in considerable complexity and cause
confusion both to the Service and the taxpayers' representatives.
(6) Once adjustments are finalized at the partnership level,
the Service must compute the tax for each partner, including
indirect partners, i.e., those holding an interest through a
passthrough entity or nominee. After the notices are issued, a
partner who disagrees with the computational adjustment must pay
the tax, and then may file a claim for refund followed by a
refund suit if the claim is disallowed. This again raises the
potential for multiple actions resulting from a single partnership adjustment, although such actions ai' limited to the
computational aspects of the adjustment.
(7) Deficiencies in one year will frequently give rise to
refund claims in subsequent years. This can result, for example,
from timing differences or basis adjustments. The claims may be
filed by each partner for the overpayment years, thus again
opening up the possibility of handling large numbers of
56 I • R • C• S 6224(c) (2); Temp. Treas. Reg.
S 30l.6224-3T(c)(3)(ii). The TMP is required to forward a copy
of the notice of FPAA to all non-notice partners within 60 days
of the date the notice of FPAA was mailed to the TMP. The TMP is
also required to provide non-notice partners with information
regarding the service's acceptance of any settlement offer within
30 days of receiving information of such acceptance. Temp.
Treas. Reg. S 301.6223(g)-lT(b).
5'I.R.C. S 6230(c).
24
individual cases that relate to a single or a few partnership
adjustments.
(8) Penalties attributable to a taxpayer's investment in a
TEFRA partnership must be asserted in separate proceedings with
the respective partners followjng the conclusion of the
partnership-level proceeding. 5
The assertion of penalties
against the investors in a widely held partnership is administratively burdensome and significantly increases the inventory of
cases both under audit and in the Tax Court. Moreover, since
these penalty proceedings are generally duplicative, conducting a
separate proceeding with each partner is an inefficient use of
resources at both the administrative and judicial level and
seriously undermines one of the principal objectives of having a
unified, partnership-level proceeding to determine the tax
treatment of items flowing from the partnership.
In summary, the audit and administrative procedures were not
designed for nor do they effectively accommodate widely held
partnerships. These procedures reflect a balancing between
certain entity concepts and individual partner protections. This
balancing is appropriate when applied to small to medium size
partnerships, in which the number of partners is manageable from
an administrative standpoint and where there is a substantial
likelihood that most partners will have a significant investment
in the partnership. However, when applied to widely held
partnerships, the individual partner protections seem disproportionate to the rights in need of protection, and present
significant administrative obstacles.
Widely held partnerships resemble large corporations in
their method of operation and capitalization, i.e., a large
number of partners contributing capital to a centralized
operating organization. Each partner of a widely held partnership generally has an investment comparable to that of a
shareholder in a comparably sized corporation in terms of dollars
invested, role in management and rights under state law. In
auditing a corporation, the Service does not need to deal with
shareholders directly, but in auditing a widely held partnership,
the service must deal directly with hundreds or thousands of
partners in order to complete an examination that results in even
the simplest adjustment. Moreover, adjustments to the income of
a widely held partnership that in the aggregate are substantit,
are relatively small when applied to the individual partners.
'II.R.C. S 6230(a) (2) (A) (i); N.C.F. Energy Partners v.
Commissioner, 89 T.C. 741 (1987).
"The relative cost of making an adjustment with respect to
a widely held partnership is likely to increase under the present
system. In past years, partnership audits were mainly directed
25
The present system, when applied to widely held partnerships,
creates a burden on and results in an inefficient use of the
valuable ~nd limited resources of the Service. Partners in these
partners~1~s should be treated for administrative purposes in a
man~er s1m1lar,to that of s~areholders in a corporation (which is
subJect to ent~ty-~evel aud~t), rather than receiving the same
procedural protect10ns accorded partners in small to medium size
partnership~.
Accordi~glv, a proposal for a new administrative
system appllcable to wldely held partnerships is discussed in
section v,
at tax shelters in which the average annual deficiency per
partner was substantial (the average deficiencies for tax
shelters audited from 1983-87 ranged from approximately $18,500$22,000). As post-1986 years become subject to audit, due in
large measure to the enactment of the passive loss rules of
section 469, tax shelter audits will be reduced and should be
replaced by audits of partnerships generating income, including
widely held partnerships. In that setting, although overall
partnership deficiencies may be substantial, the average
deficiency on a per partner basis is likely to be relatively
small. The average size of deficiencies may be further reduced
with respect to partners in widely held partnerships that are
actively traded in that interests are often held for short
periods of time.
SECTION IV.
A.
PROPOSED SIMPLIFIED REPORTING SYSTEM FOR WIDELY HELD
PARTNERSHIPS
Introduction
In order to simplify reporting for widely held partnerships,
encourage correct reporting by partners and aid the Service in
its compliance monitoring, a simplified system of reporting by
widely held partnerships is recommended. Such reporting to the
partners and Service would be accomplished by use of a Form
l099-K designed for use bv widely held partnerships in lieu of
the current Schedule K-l.'O
The present Schedule K-l is used by all partnerships to
report their partners' distributive shares of partnership income,
gain, loss, deduction or credit. The Schedule K-l form and
instructions are complex and result in voluminous amounts of
paperwork being filed with the Service and sent to partners by
widely held partnerships. While magnetic media filing of
information returns is permissible, and generally required for
corporations, few widely held partnerships use magnetic media to
file with the Service. The volume of Schedule K-l information
and the manner in which it is reported on each partner's Form
1040 does not lend itself to efficient integration into the
matching programs presently maintained by the Service. The use
of a Form 1099-K with limited categories of information, as
described in detail below, would encourage compliance due to its
simplicity. In addition, reporting limited information would
ease the reporting burden on widely held partnerships and
requiring magnetic media filing would provide the Service with a
more effifient means of matching partnership data with partner
returns.
'Osection 60ll(b) currently requires that partners be
furnished with either a Schedule K-l or substituted form by the
due date of the partnership return (April 15 for a calendar year
partnership unless extended). If the proposal for the Form
l099-K is adopted, it is recommended that the due date for
furnishing the Form l099-Ks to partners be the same as provided
in section 60l1(b), rather than the January 31 due date
applicable to other information returns.
'lAlthough only the term "magnetic media" is used, it is
meant to encompass any future improvements to include information
transferred in machine readable form by other means, such as
electronic filing.
28
B.
Determination of Partnership Items at the widely
Held Partnership Level
1.
In General
The key to simplification of the reporting of partnership
income is reduction of the number of items that must be separately reported to partners. Under current law, the Code and
requlations specifically enumefrte many items that must be passed
through separately to partners , and under regulations, any item
not enumerated must also be passed through if separate treatment
would affe
the calculation of the partner's income tax
liability.
lr
In the simplest of passthrough systems, an entity such as a
widely held partnership could in theory pass through a single
item of income or loss. In such a system, information reporting
would be as simple as the reporting of interest and dividends
under current law. For a number of reasons, this level of
simplicity is not realistically achievable (and may not be
desirable) at the present time for widely held partnerships.
However, we believe it would be possible and desirable to
significantly reduce the number of items to be separately passed
through to partners of widely held partnerships.
Set forth in this section is an outline of a proposed
simplified system for determining and reporting the distributive
items of widely held partnerships. We recognize that legislation
amending many sections of the Internal Revenue Code would be
necessary to implement such a system and that the proposed
changes would have a substantive impact on the calculation of a
partner's tax liability. We also recognize that this outline
does not address all questions that would arise in developing the
system and in identifying legislative changes that will be
required to allow for the simplified system. However, we believe
that implementation of the general approach articulated below
would represent a significant step towards rationalizing the
reporting system for widely held partnerships.
2.
Income and Deductions
Under the proposed approach, all income and expense,
including capital gains and losses, would be netted at the
partnership level. In calculating a partnership's net income,
the application of any limitation with respect to a deduction
would be determined at the partnership level. For example, under
current law an election may be made under section 194 to amortize
62~
I.R.C. 5 702(a) and Treas. Reg. 5 1.702-1.
63Treas. Reg. 5 1.702-l(a) (8) (ii).
29
certain reforestation expenditures over a seven year period. The
maximum ~~ount eligible for the election in any taxable year is
$10,000.
In the case of a partnership, this maximum is
applicable at both the partnership and the partner level.'S
Consequently, a partnership must separately report amortization
deductions under section 194 to permit partners to calculate
their individual limitations. Under the simplified reporting
approach, the section 194 limitation would apply solely at the
widely held partnership level. Thus, amortization deductions
under section 194 would be reflected in the widely held
partnership's net income reported to partners, and would not be
separately reported.
Any elections relevant to deductible items would be made by
the widely held partnership. For example, section 617 allows a
taxpayer to elect to deduct certain mining exploration expenses.
If the election is made and the mine eventually reaches the
producing stage, the expenses must be "recapturi~" by inclusion
in income or by denial of depletion deductions.
Under current
law, each partner independently decides whether to make the
election under section 617.'7 Under the simplified reporting
approach, the section 617 election would be made by the widely
held partnership, and recapture of section 617 expenses would be
determined at the partnership level. Thus, any deduction or
recapture of section 617 expenses would be reflected in the
widely held partnership's net income.
Where a limitation on a deduction results in a carryover of
a deduction, the amount would be carried over at the widely held
partnership level. For example, under section 175 a taxpayer is
permitted to deduct soil and water conservation expenses.
However, the deduction may not exceed 25 percent of the taxpayer's qross income from farming; any excess is carried over
until the taxpayer has sufficient gross income from farming. 8
Therefore, a partnership ir,required to separately report its
gross income from farming.
Under the simplified reporting
approach the 25 percent limitation and any resulting carryover
would be determined at the widely held partnership level.
"65 I.R.C.
S 194(b)(I).
66 I.R.C.
S 617(b).
67 I.R.C.
S 617(b)(2).
6. I.R.C.
S 175(b).
I.R.C. S 194(b) (2) (B).
6'~ Treas. Reg.
S 1.702-I(c) (l)(iv).
30
Most interests in widely held partnerships are held by
limited partners who are subject to the passive loss rules of
section 469 because they do n~~ materially participate in any of
the partnership's activities.
Under current law, a widely held
partnership's operations may be multiple activities for purposes
of the passive loss rules. In that case, the partnership must
separately report items of income and deduction from each of its
activities. One reason separate reporting is necessary is that a
partner who holds both passive and nonpassive activities through
a partnership takes only the items from the passfve activities
into account in applying the passive loss rules. 1 In addition,
a partner cannot compute the suspended loss allowed on the fully
taxable disposition of the partner's entire interest in a passive
activity conducted through the partnership unlesf the partnership
has separately reported items from the activity. 2
Under the simplified system, a limited partner's interest in
a widely held partnership would be treated as a single activity
for purposes of section 469. For passive limited partners, all
items of income and deduction from widely held partnerships will
be either passive or portfolio.'3 Thus, the only information the
limited partner would need to apply section 469 would be the net
passive income or net passive loss for the partnership as a
whole, and the partnership would report this information rather
than separately reporting items from multiple activities.
Portfolio income (e.g., interest and dividends) would be
reported separately from other income, and would be reduced by
Treas. Req. S 1.469-5T provides that a limited
partner's participation in an activity is material only if it
exceeds 500 hours during the taxable year or satisfies one of two
other tests that consider multi-year participation. It may be
appropriate to provide that a limited partner's interest in a
widely held partnership is always passive.
10Temp •
71This is a minor consideration in the case of limited
partners because, as noted above, they typically do not
materially participate in any of the partnership's activities.
is a concern only if the partnership is not publicly
traded. Under section 469(k), the activities of a publicly
traded partnership are treated as a single activity for purposes
of this rule.
12This
73Expenses that are not treated as passive activity
deductions under Temp. Treas. Reg. S l.469-2T(d) (2) and are not
portfolio items under section 469(e) (1) would be treated as
passive deductions for this purpose. For example, charitable
deductions of a widely held partnership would be treated as
passive.
31
portfolio deductions and allocable investment interest expense.
Further, to reflect the 2 percent floor limitation imposed on
miscellaneous itemized deductions at the individual level, it
will be necessary to reduce such deductions by an arbitrary
amount (~, 50 percent). To the extent there is excess
investment interest, it would be carried over at the partnership
level.
Netting of capital gains and losses would occur at the
widely held partnership level. Thus, capital gains would be
consolidated with other reported income, and an individual
partner would not be able to net partnership capital gains and
losses on his or her individual income tax return. Any excess of
capital losses over capital gains would be carried over at the
widely held partnership level. Therefore, an individual partner
would not receive the benefit of the limited annual offset of
capital loss against ordinary income allowed under current law.
If a capital gains preference is enacted, a widely held partnership should be able to take advantage of a preferential rate
without reporting its capital gains separately. If a deduction
(or exclusion) is permitted for long term capital gains, as under
pre-1987 law, the partnership would determine its long term
capital gains, compute the appropriate deduction, and reduce net
income to be flowed through to partners.
Alternative minimum tax adjustments and preferences would be
combined and allocated to partners. To apply the passive loss
rules, it will be necessary to report portfolio income minimum
tax items separately from other minimum tax items. Tax-exempt
interest would be shown as a passthrough information item because
of its significance in the taxation of social security benefits.
3.
Allocations
Under the simplified reporting system, a single amount of
net taxable income or loss would be reported to each partner.
Therefore, widely held partnerships would not be able to report
to partners specially allocated items of income or deduction.
This does not mean, however, that widely held partnerships would
be required to allocate all items on a pro rata basis. Pro rata
allocations would deprive partnerships of any flexibility in
income allocations, and would cause serious transitional
difficulties for existing partnerships.
A degree of flexibility could be achieved by allowing
special allocations of those items which are separately reported
on the Form l099-K. n Taxable income would therefore be
nAllocations would, of course, be required to satisfy the
rules of section 704(b) and the regulations thereunder (e.g., the
substantial economic effect test).
32
allocable on a bottom line basis. For example, assume
Partnership X has $10 million of rental income, $3 million of
depreciation deductions attributable to its rental activities,
and no other items. On a bottom line basis, it would allocate $7
million of passive income among its partners. Portfolio income
could similarly be allocated on a bottom line basis. Alternative
minimum tax adjustments would be allocated in accordance with the
allocation of passive and portfolio taxable income. Tax exempt
interest and credits would be reported separately, so that
separate allocation of these items should be feasible under the
simplified reporting system.
Further flexibility could be achieved by allowing widely
held partnerships to allocate gross income (whether portfolio or
passive) and total allowable deductions as determined at the
partnership level. Partnership X could therefore allocate the
$10 million rental income and the $3 million depreciation
deductions independently, although each partner would still be
reported a single item of passive income or loss. Where a
limitation on a deduction applies at the partnership level, it
would reduce the total allowable deductions. This approach would
permit a particular deduction to be effectively allocated to a
particular class of partners, without requiring reporting of the
deduction separately from the partners' share of other income or
deductions reported on the Form l099-K.
4.
Credits
a.
Consolidated Tax Credit
Under the proposed simplified approach, credits would
generally be determined at the partnership level and would be
passed through to partners as a single combined item on the Form
I099-K. Each credit typically has its own set of special rules
(~, carryover provisions); these rules would have to be
examined and altered where necessary to apply at the partnership
level. We believe that in most cases it will be possible to
restructure credit limitations to permit consolidation. In the
ease of credits which are consolidated for reporting purposes,
recapture would necessarily occur solely at the partnership
level, as a partner would not be able to determine his or her
recapturable aaount upon disposition of a partnership interest.
Thus, recapture of any type of nonseparately-reported investment
credit ai9ht OCcur if the partnership disposed of the property,
but would not occur upon disposition of any partner's interest.
It would alao be possible to deem the transfer of a specified
percentaqe of interests in a partnership to be a recapture event,
:l~:::htth~a approach would not be consistent with entity-level
re er: 0 WidelY-held partnerships. The partnership could
:~y~ reeapf~::t c r edit recapture against current credits, satisfy
e 1 i ability itself, or could increase taxable income
33
in the year of recapt'Jre by the amount necessary to recapture the
credit assuming a par~ner-level tax rate.
It should be possible tc consolidate many credits for
reporting as a single item. However, at least three credits (low
income housing credit, rehabilitation credit, and credit for
withheld taxes) may require separate reporting. The foreign tax
credit also poses a number of particular issues. These credits
are discussed below.
b.
Separately-Reportable Credits
The low income housing credit and the rehabilitation credit
are su~ect to special favorable treatment under the passive loss
rules.
It would be impossible for partners to take advantage
of these rules without separate reporting of each credit. On the
other hand, most widely held partnerships will not generate these
credits. To keep the Form l099-K as simple as possible in most
cases, only partnerships which are significantly engaged in
activities anticipated to generate these particular credits
should be permitted to report them as separate items. For
example, unless a partnership's assets are substantially comprised (e.g., at least 50 percent) of low income housing, it
would not be permitted to separately report the low income
housing credit. Similarly, unless a partnership's assets are
substantially comprised of real property, it would not be
permitted to separately report the rehabilitation credit. If a
partnership not substantially engaged in the relevant activity
were to generate one of these two credits, it would. report the
credit together with any other credits as part of the general tax
credit (line 5) reported on the Form l099-K.
Under the Partnership Collection Proposal, a partner may be
entitled to a credit for partnership payments which would be
refundable to the extent it creates an overpayment. U The
refundability feature would distinguish this credit from other
credits, and would require the credit for partnership payments to
nSection 469(i) exempts these credits from the passive
credit limitations to the extent they are equivalent in their
effect on tax liability to a specified amount of deductions. The
deduction equivalent of the credits allowed under this rule is
generally $25,000, but the $25,000 amount is reduced by the
amount of losses and the deduction equivalent of other credits
allowed under section 469(i) and, in the case of the
rehabilitation credit, by 50 percent of the amount by which
adjusted gross income (computed with certain modifications)
exceeds $200,000.
USee section V (D) of this report.
34
be reported separately.n Since it will not be common for
partnerships to have such a credit, the Form l099-K will report
this item only for partnerships that have had a final
determination during the taxable year.
c.
Foreign Tax Credit
Under current law, taxpayers have the option of choosing to
deduct or claim a credit against u.s. tax for certain foreign
taxes paid or accrued by the partnership.~ Most taxpayers
choose to credit their foreign income taxes against u.s. income
tax. The credit option is subject to a complex set of limitations. Under section 904, creditable foreign taxes must be
allocated to a specific basket or category of income, and within
each basket the foreign tax credit is subject to a ceiling that
is determined by reference to the amount of income in that
basket. In determining the amount of income in each basket and
the amount of foreign taxes paid or accrued with respect to that
income, a partner of a partnership is treated as directly earning
his or her distributive share of the partnership's income and
directly paying the foreign tax, i.e., a partnership generally is
treated as an "aggregate" rather than as an "entity" for this
purpose. Under current law, each partner's distributive share of
foreign taxes paid or accrued by the partnership is separately
stated on Schedule K-l, in order to provide the partner with the
information necessary to combine foreign taxes paid or accrued by
the partnership with other foreign taxes paid or accrued by the
partner in computing his or her foreign tax credit limitation.
Partnership Level Credit. In order to avoid the complexity
associated with a separate listing of foreign taxes and income on
Form l099-K, the foreign tax credit limitations should be applied
at the widely held partnership level. All elections and
computations concerning foreign tax credits would then be
determined at the partnership level, as are other elections and
computations under the simplified reporting system. A widely
held partnership would have an annual election to deduct or
credit foreign taxes paid or accrued; any carryovers of such
items would be at the partnership level. In order to apply this
concept, the credit for foreign taxes paid or accrued would be
determined by using an assumed U.S. tax rate for the partnership.
The amount of foreign taxes paid or accrued by the partnership
which could be claimed as a credit against U.S. tax on the income
in a particular foreign tax credit limitation basket would be
limited to an amount equal to U.S. taxes (calculated at the
n The same issue would arise if in the future partnership
withholding were to be instituted. See section IV (G) of this
report.
~I.R.C. §§ 901 and 903; I.R.C. i
164(a) (3).
35
assumed rate) on the foreign source income in that basket. All
partnership income would be reported at the partner level as
having a u.s. source.
This approach could be applied by using all of the
limitations and separate baskets provided under current law. The
foreign tax credit passed through to the partners would be the
sum of all the separate foreign tax credit limitations. This sum
would be included as part of the consolidated tax credit on the
partners' Form I099-Ks, and reported by partners directly on
their tax returns.'9 The choice of an assumed tax rate for the
partnership in making the foreign tax credit calculation would
have a substantial effect on the partners. A low assumed rate
would reduce the amount of foreign tax credits available to
offset U.S. income tax liability of the partners and would be
detrimental to those partners whose marginal rate is higher than
the assumed rate. Conversely, if a higher assumed rate were used
by the partnership, those partners who actually are subject to a
lower marginal rate would receive the benefit of foreign tax
credits to which they would otherwise not be entitled.
Partner Level Credit. As an alternative method, foreign
income and foreign taxes paid could be reported separately to
partners on the Form l099-K. An additional line on the Form
l099-X would show the foreign source portion of any income item,
and another line would show the amount of foreign tax paid or
accrued (the amount which results from netting lines 17(e) and
17(f) of the current Schedule X-1).
As stated above, foreign taxes paid or accrued generally are
creditable only against U. s. income tax on the specific baskets
of income to which the foreign taxes relate. Special rules apply
to limited partners (and corporate general partners) who own
less than 10 percent of the value of the partnership (based on
profits or capital interests). These partners must treat their
distributive shares entirely as passive income for foreign tax
credit purports, regardless of the type of income earned by the
partnership.
There are two exceptions under current law to
passive income treatment which it may be possible to eliminate in
order to facilitate simplified partner level reporting. Under
the first exception, the distributive portion of each partner's
interest income which is "high withholding tax interest" continues to be treated as such for foreign tax credit purposes.
Under this rule, interest income which would otherwise be in the
passive basket is placed in a separate basket if such income is
subject to a foreign withholding tax of 5 percent or more. The
7'With respect to the treatment of foreign partners of a
widely held partnership, see footnote 104.
'°Treas. Reg. S 1.904-5(h).
36
effect of the high withholding tax basket is generally unfavorable to taxpayers, because tax credits associated with such
income cannot be used to offset u.s. tax on low-taxed or untaxed
income in the passive basket. While some revenue loss would
result from eliminating this exception, the effect would not be
large if the proposal were applied only to a limited class of
partnerships. Under the second exception to passive income
treatment under current law, a distributive share from a partnership interest held in the ordinary course of the partner's active
trade or business receives look-through treatment for purposes of
section 904. This exception generally applies to small corporate
general partners in the oil and gas industry, and is a special
relief provision for those taxpayers. Eliminating this exception
would adversely affect a small number of taxpayers. If these
exceptions were eliminated for partners owning less than 10
percent of the partnership interests, reporting of foreign source
income and foreign taxes would requiie no more than two
additional lines on the Form 1099-K. 1
s.
other Reporting Issues
As proposed, the Form 1099-K would not require the separate
reporting of unrelated business taxable income ("UBTI"). Under
curre~f law, all income of a publicly traded partnership is
UBTI,
but this is not the case for other widely held partnerships. To prevent evasion of the UBTI rules, it might be
necessary to require separate reporting of income that would be
UBTI to tax exempt partners or treat all income of any widely
held partnership as UBTI.
oil and gas issues present special concerns, in large part
because of the unique treatment of oil and gas properties held by
partnerships. Under the Code, percentage depletion is disallowed
to certain taxpalrrs, and is significantly restricted for all
other taxpayers.
Partnerships must allocate basis in and
alThese exceptions should probably not be eliminated for
partners holding 10 percent or more of the interests in a widely
held partnership. Thus, the treatment of the foreiqn tax credit
may have an impact on whether large partners should be excluded
from the simplified reporting system. See section IV eEl.
a2 I • R • C• S S12(c)(2).
a3Reta ilers and refiners are prohibited from claiming
percentage depletion with respect to oil and gas properties.
I.R.C. S 6l3A(d). Other taxpayers are permitted to claim
percentage depletion on production not in excess of the
taxpayer's depletable oil quantity of 1,000 Darrels of production
per day, subject to a number of other restrictions. I.R.C.
S 6lJA(c).
37
·
·
.
pro d uct~on
from
o~l and gas propert~es
to par t ners. 8' I n
addition, partnerships must report a significant amount of
information on a property-by-property basis to each partner to
permit the partner to calculate his or her depletion limitation.'s These allocation rules are inconsistent with the basic
goals of the simplified reporting proposal.
Detailed reporting of oil and gas items could be avoided by
prohibiting the use of percentage depletion by widely held
partnerships, and instead require cost recovery of their
properties to occur through the generally less favorable cost
depletion method. Alternatively, partnerships could be permitted
to claim the amount of percentage depletion permitted a single
taxpayer, with any remaining depletion calculated under the cost
method. This alternative would allow the benefit of percentage
depletion to partners who would not otherwise be eligible with
respect to the partnership's properties, either because, for
example, a partner is ineligible for percentage depletion or the
partner's share of production from other properties exceeded the
maximum allowable depletable production. This effect would,
however, be relatively minor with respect to any partner, as a
widely held partnership's percentage depletion deductions would
be spread among its many partners. Under either method, items
relating to depletion would not be reported separately. However,
this would not allow depletion to be calculated by each partner,
as under current law.
.
To permit partners in widely held partnerships to calculate
percentage depletion separately as under current law, it would be
necessary to design a special reporting form for widely held
partnerships engaged in oil and gas exploration and production.
standards would have to be established to determine eligibility
for this special reporting. The unique tax treatment of oil and
gas properties held by partnerships may justify a more complex
reporting form.
6.
Reportina FOrm
To summarize, the following categories or spaces would
appear on the simplified reporting Form 1099-K:
(1)
(2)
(3)
(4)
Pas.ive income (loss)
Portfolio income (loss)
Passive AMT adjustments and tax preferences
(one amount)
Portfolio AMT adjustments and tax preferences
(one amount)
·'I.R.C. S 6l3A(c) (7)(0).
'5~ ~ Prop. Treas. Reg.
S 1.6l3A-3(j).
38
(5)
(6)
Tax credit
Tax-exempt interest
All widely held partnerships would be required to provide a
standard Form 1099-K to their partners. No substitute or
alternati~e v 7rsions of the form would be permitted.
Thus,
partners ~n w~dely held partnerships would receive uniform
information documents.
7.
possible further Simplification
The simplified system discussed above represents a general
approach to determining and reporting partnership income for
widely held partnerships that would substantially reduce the
reporting burdens of partnerships and their partners and the
administrative burden of the Service. The particular items
listed on the proposed Form 1099-K are illustrative of the
suggested simplification. The list of separately reported items
could of course be expanded, although at the cost of additional
complexity. On the other hand, the number of items on the
l099-K could be further reduced. For example, the "Tax credit"
line could be eliminated by converting the credit amounts into
deductions. The net credit amount would be "grossed up" into a
deduction at the partnership level by using an assumed tax rate.
Thus, if a partnership had credits of $5,000, the grossed-up
deduction would equal $22,727 if 22 percent were used as the
assumed tax rate for this pu~ese (midway between the 15 percent
and the 28 percent brackets).
This amount would be treated the
same as any other partnership deduction and would be reflected as
an adjustment to taxable income reported to partners on the Form
1099-K.
The "Tax-exempt Interest" item could also be eliminated, but
only by treating such interest as taxable. If interest is taxexempt, separate reporting is essential in order to provide
individual taxpayers receiving social security benefits wi}h the
data necessary to calculate their separate tax liability.
Hence, the -Tax-exempt Interest" item could only be eliminated by
removing the tax exemption on such interest for partners of these
partnership. .and by treating interest that is currently tax
exempt in the same manner as other taxable interest includible in
portfolio income. Separate reporting of the low income housing
credit and the rehabilitation credit could also be prohibited for
widely held partnerships, even those substantially engaged in
"A higher assumed tax rate would result in a larger
grossed-up deduction and a lower rate would result in a smaller
deduction.
"Social security benefits become taxable when certain
income levels are reached.
39
these activities. This would prevent partners from taking
advantage of the special treatment afforded these credits under
the passive loss rules. The resulting inability of partners to
take advantage of the current law favorable treatment of taxexempt interest and the low income housing and rehabilitation
credits illustrates that there may be adverse consequences to
further simplification of the reporting form.
8.
Examples
The following examples illustrate the operation of the
simplified reporting system in a number of fact patterns.
EXAMPLE 1
Assume the individual taxpayer receives a Schedule
K-1 under present law which indicates the following items:
Ordinary income
$ 400
Net rental loss
Oividends
Interest
Net short-term capital
losses
Net long-term capital
gains
300
55
125
Investment interest
expense
$90
Charitable contribution 5
Misc. portfolio
deductions
20
500
400
The individual is a limited partner and the ordinary income and
rental loss result from passive activities. The capital losses
and gains result from assets held for investment purposes and the
miscellaneous deductions are subject to the 2 percent limitation.
Assuming the net capital loss, charitable contributions and
miscellaneous deductions can be fully deducted on the
individual's.feturn, taxable income of $65 would result under
current law.
Under the proposal, the only reportable items
would be passive income of $9i,and portfolio income of $80, for a
total taxable income of $175.
The difference of $110 ($175-65) in the calculation of
taxable incom. under current law and the proposal is due to the
net capital 10•• of $100, which under the proposal carries over
at the partnership level and can be used in a later year, and $10
representing the SO percent adjustment to the miscellaneous
deductions not allowed under the proposed treatment.
Both of
"CUrrent law:
$400-300+(55+125)-(500-400) less (90+5+20) =$65.
"proposal: $400-300-5-$95 Passive.
$55+125-90-l0(20x50')-$80 Portfolio.
,oThis represents an adjustment to reflect the 2 percent
floor limitation on miscellaneous itemized deductions.
40
these items, the capital loss and the miscellaneous deduction,
mayor may not be deductible at the taxpayer level due to various
limitations. In this example, two items would be reported on
Form l099-K versus nine on the present Schedule X-l.
~XAMPLE 2
The individual is a partner in a publicly traded
partnership and the Schedule X-I under present law indicates the
following items:
Ordinary loss
Net rental loss
Dividends
Interest
$ 200
500
400
300
Misc. portfolio deductions$100
Investment interest
expense
800
The losses are passive and taxable income or loss under both the
current and proposed system would be zero. There would be a
passive activity loss carryover of $700 in both cases and an
investment interest expense carryover of $200 under current law
to the indivi~ual partner assuming no other interest to offset
the expense.
Under the proposal there would be a carryover of
$150 to the partnership due to the excess investment interest
(because of ire 50 percent allowance for miscellaneous
deductions).
In this example, two items would be reported on
Form 1099-K versus six on the present Schedule X-1.
EXAMPLE 3
The individual is a partner in a publicly traded
partnership and the Schedule X-I under present law indicates the
following items:
$ 700
ordinary loss
100
Net rental loss
70
Sec. 179 expense
20
Targeted job credit
Recapture of low-income
10
housing credit
Foreign taxes paid
$ 5
Foreign source income 150
(included in ordinary
loss)
The losses are passive and under current law the partner would
report a passive activity loss of $870 (including the $70 section
179 deduction) and a disallowed passive activity credit of $20.
The foreiqn tax credit is not subject to the passive 1088 rules.
91current law: $200+S00-$700 Passive 10S8.
$400+300-100-(800-200 carryover)- $0 Portfolio.
92proposa1: $200+S00-$700 Passive loss.
$400+300-50(100xSOt)-(800-150 carryover) - $0 Portfolio.
41
The partner would incur a current recapture tax of $10.'3 Under
the proposed system, the reportable items would include a
disallowed passive loss of $875 and a disallowed passive activity
credit of $10 (asf~ing the recaptured credit was offset against
the jobs credit).
In this example, two items would be reported
on Form 1099-K versus seven on the present Schedule K-l.
c.
Elimination of Non-Income Items
The present Schedule K-l reports a substantial amount of
non-income information. Items A through J of Schedule X-l report
information concerning each partner, including whether the
partner is general or limited, a domestic or foreign person, the
type of entity, the partner's share of liabilities, the partner's
percentage interest and acquisition date. In addition, the form
requests the following information about the partnership: where
the return was filed, Tax Shelter Registration Number, if any,
whether publicly traded, foreign countries to which taxes were
paid, and whether the current Schedule K-l is an amended one. As
proposed, none of these items would be reported on the Form
1099-K. The only non-income information reported on the Form
l099-K would be the taxpayer's name, address and taxpayer
identification number and the same information for the
partnership. 95 Any additional relevant information could be
furnished upon examination or on separate schedules with the
partnership return of income.
Item K on the present Schedule K-l records the partner's
capital account activity for the year. The amounts in the
capital account analysis reflect various additions and deductions
to the account during the taxable period, including contributions of capital and distributions to the partner, as well as
taxable income or loss and other amounts reflected on the
return. The capital account information is probably not
necessary for an individual partner's computation of his or her
separate tax liability. In contrast, it is necessary for
partners to maintain information as to the bases of their
partnership interests. Although neither basis nor capital
account information is included on the Form 1099-K, partnerships
"CUrrent law: $800+70-$870 Passive loss. This assumes the
section 179 deduction is not limited by section l79(b) at the
partner level.
"proposal: $700+100+70+5-$875 Passive loss.
$20-10-$10 Disallowed credit. The result in the example assumes
that the partnership has elected to deduct foreign taxes paid.
"We recognize that in implementing this proposal certain
other non-income items may be determined necessary for inclusion
on the Form l099-K.
42
should be required to separately provide basis information.
Similarly, partnerships should be required to reflect any section
743(b) adjustments in computing the partners' shares of taxable
income. Even without
a specific requirement " however we assume
.
that partnersh~ps would generally provide the information
necessary for partners to compute and rubstantiate their tax
bases in their partnership interests.'
D.
Magnetic Media Filing
Each widely held partnership would be required to provide
Form 1099-K data to the Service by magnetic media. Partnerships
are now,fermitted, but not required, to use such means for
filing.
Once a partnership is required to file using magnetic
media under this provision the requirement would continue
indefinitely, as a partnership that meets the definition of a
widely held partnership will continue to be treated as such until
the Commissioner grants permission for a change in status.'s
The instructions for the Form 1099-K would cover the
items mentioned above and key each item, where appropriate, to a
specific line on Form 1040 and its schedules or to a special
schedule which would be used to accumulate Form 1099-K
information from partnerships and thus facilitate the matching of
information from widely held partnerships to the partner's
return.
E.
Treatment of Large Partners
It is not clear whether partners holding significant
percentage interests in a widely held partnership should
participate in the simplified reporting system. Interests held
by such partners are exc,uded from the current assessment system
proposed by this report, ' but the considerations are somewhat
different under the reporting system. . The calculation of taxable
"CUrrently, no complete basis information is provided to
the partners. The capital account information included on the
Schedule X-1 may correspond to a partner's tax basis (excluding
the partner' • •hare of liabilities) in his or her partnership
interest.
"Although this recommendation of mandatory filing by
magnetic media would apply only to widely held partnerships, no
inference should be drawn with respect to whether such filing may
be required of other partnerships in the future.
"See Section VII of this report.
"see discussion at section v (D) (1) and V (D) (5) of this
report.
43
income may become substantially more complex if the income
reported to partners with at least a five or ten percent interest
is determined separately from the income reported to the
remainder of the partners. On the other hand, if large partners
were allowed to use the simplified reporting system, they might
in some cases be able to use widely held partnerships to avoid
various restrictions. For example, depending on the manner in
which the foreign tax credit is calculated by widely held
partnerships, taxpayers may derive a material advantage from
generating certain income through such a partnership. until the
precise rules of the simplified reporting system have been
formulated, it is difficult to predict the extent to which
simplified reporting for large partners would present opportunities for tax abuse. Accordingly, this report makes no
recommendation with respect to the treatment under the simplified
reporting system of partners holding significant interests in
widely held partnerships.
F.
Summary of Simplified Reporting Issues
The potential advantages of a simplified reporting system
are threefold:
(1) The widely held partnership would experience a
significant reduction in the number of forms and correspondence
sent to the Service and to partners with a corresponding
reduction in associated costs.
(2) The partner would receive a one page form, similar to
other information forms such as a Form W-2 for wages or the Form
1099 used for interest, which would be familiar and relatively
simple. Such a system would be more understandable than the
present system and would thus encourage compliance.
(3) The Service would receive data by magnetic media which
would be used to provide a more efficient matching of data to the
information reported by partners on their returns and would
thereby enhance compliance with reporting requirements.
By implementing a simplified reporting system, the
calculation of income and related items would be altered with
respect to widely held partnerships. The goal of these proposed
changes is not to increase or decrease the overall tax due with
respect to such partnerships. Rather, the goal is to produce a
simplified system that, within the constraints of a radically
simplified Schedule X-I, approximates the current law calculation
of taxable income and related items as closely as possible.
Nonetheless, we recognize that the total income tax attributable
to a partnership subject to the simplified reporting system would
almost certainly vary to some degree from the total income tax
under the current rules. This raises two principal concerns.
44
The first concern is that, given the recent history of tax
law changes that have adversely affected investment partnerships,
the redefinition of the calculation of a widely held partnership's income will be structured to increase the overall tax due.
That is not the intent of the proposed simplified reporting
system. The goal of the proposal is to simplify the reporting
system rather than to raise revenue, other than revenue
attributable to improved compliance.
The second concern is that certain partnerships will be
able to take advantage of any variations in income calculation by
selecting the most beneficial system. For example, a partnership
with 200 partners might restrict entry of new partners if it
feared that the simplified reporting system would significantly
increase overall taxable income. If the system is properly
designed, any income calculation advantage or disadvantage to a
partnership will be minimal, thus reducing r~s incentive to
target growth for a marginal tax advantage.
Furthermore, once
a partnership becomes subject to the simplified reporting system
as a widely held partnership, it will not be able to wir~draw
from the system without permission of the Commissioner. 1
Therefore, partnerships will not have the ability to move in and
out of the simplified system at will. These factors should
minimize the impact of any variations in income calculation that
may arise under the simplified reporting system.
G.
withholding
As a general matter, in tax administration, it is axiomatic
that if third parties report to the service the income they pay
to individuals, compliance in reporting that income markedly
improves. Withholding of tax at the source has generally proven
to be an even more effective means of assuring compliance. At
present, withholding is mainly imposed on certain limited categories of items, including wages, tips, supplemental unemployment
benefits, and gambling and lottery winnings. Dividends and
interest are subject to information reporting, but not
holding unless the backup withholding provisions apply.
Not
Yllh-
100Nonetheless, as noted above, the possibility of
differences in income calculation may necessitate the exclusion
of large partners from simplified reporting.
101See section VII of this report.
102 I • R • C• 5 3406. In certain instances, withholding is
voluntary (e.g., pension distributions, annuity payments, sick
pay). I.R.C. 5S 3402 and 3405.
45
surprisingly, Service studies indicate that complt8pce levels are
highest in areas in which withholding is imposed.
partnership distributions are different from wages, interest
or dividends, in that partnership distributions may consist not
only of current income, but also advances on estimated income
(drawings), or return of capital. Under current law, neither
income nor distributions of a domestic partnership arrolubject to
withholding, except as to nonresident alien partners.
l03Gross Tax Gap Estimates and Projections, at 5-6.
lOt"Inbound transactions," that is transactions giving rise
to income from U.s. sources paid to foreign persons, are subject
to a reporting and payment system which operates in addition to
and independently of the reporting system applicable to partners
generally. The reporting and withholding system applicable to
foreign partners is beyond the scope of this report and will not
be affected by the proposals made herein.
section 1446, as amended in 1988, currently requires a U.s.
or foreign partnership with effectively connected taxable income
allocable to a foreign partner to pay a u.s. withholding tax with
respect to that partner's allocable share of that income in the
time and manner prescribed by the Service. Rev. Proc. 89-31,
1989-20 I.R.B. 136 (May 15, 1989), implements this section and
provides that affected partnerships must generally pay a
withholding tax, without regard to distributions, on a quarterly
basis based upon 28 or 34 percent of the effectively connected
taxable income allocable to foreign noncorporate and corporate
partners, respectively. The Revenue and Reconciliation Act of
1989 amended section 1446 to clarify that the Service is
authorized to apply the corporate estimated tax rules and
penalties to partnerships to compute and enforce the quarterly
payment requirement. Publicly traded partnerships are allowed to
withhold on distributions at a flat 28 percent rate, but these
partnership•. may elect to make quarterly payments without regard
to distributions.
section 1446 withholding overrides section 1445(e) (1)
withholding. Under section 1445(e) (1), a dome.tic partnership is
required to withhold 34 percent of a foreign partner's net gain
attributable to the partnership's disposition of a U.S. real
property interest. Generally, section 1445(e) (1) withholding is
to be made by the partnership within 20 days of tha disposition
of u.S. real property, but publicly traded partnerships and any
other partnerships with mora than 100 partners qenerally defer
the payment of the section 1445(e) (1) withholding tax until a
distribution attributable to the sale proceeds is aada.
46
We do not recommend withholding for widely held partnerships
at this time. Under the proposed reporting system with required
magnetic media filings, it is expected that the Service will be
able to include the Form l099-K information in its document
matching program and the Information Returns Program procedures.
Moreover, the ability of partnerships and the Service to
determine the identity of persons holding interests has been
significantly improved through the er~ctment of the nominee
reporting system of section 6031(c). 5 Thus, the service should
be able to more efficiently match Form l099-K information with
that reported on the partner's return.
The Service continues to evaluate the level of compliance
by partners of widely held partnerships and the possibility of
recommending the institution of withholding, if necessary, to
ensure that adequate standards of reporting and collection are
maintained.
H.
ownership Changes
The issues arising under subchapter K of the Code that have
particular relevance to widely held partnerships generally relate
to the tax impact of ownership changes of interests in these
partnerships. The ownership change issues are especially important to publicly traded partnerships because interests may be
frequently traded and must remain fungible in the marketplace.
This section will briefly discuss the subchapter K issues with
respect to (1) fungibility, (2) constructive terminations,
(3) accounting conventions for allocations of income, and
(4) information reporting.
1.
FUngibility
For partnership interests to be fungible, any interest
purchased must possess the same tax characteristics to the buyer,
regardless of the tax characteristics that interest had in the
hands of the seller. Under current law, application of certain
technical rules of subchapter K can result in buyers holding
l05Under I.R.C. S 6031(c)(1), any person who holds an
interest in a partnership as nominee for another person is
required to furnish to the partnership the name and address of
such other person, and any other information for such taxable
year as may be prescribed by form and regulation. The nominee is
also required to furnish such other person with the information
provided by the partnership on the Schedule X-1.
47
partnership interests that are identical, as an economic matter,
but that possess substantially differing tax characteristics
depending on the identity of the seller of each interest.
In general, under subchapter K, the purchaser of a
partnership interest takes a basis in partnership assets equal to
his or her pro rata share of the partnership's basis in those
assets. If an election is made under section 754, however, the
purchaser's basis in partnership assets will be adjusted under
section 743(b) to reflect the purchase price of his or her
partnership interest. The basis adjustment is made with respect
to the purchaser only, and does not affect any other partner's
proportionate share of basis in partnership assets. Under the
regulations for section 743(b), the purchaser partner's share of
basis in partnership assets prior to adjustment is determined by
reference to the transferor partner's share of basis in those
assets. Publicly traded partnerships typically make a section
754 election so that purchasers will not inherit tax attributes
(e.g., unrealized appreciation) unrelated to the purchase price
of their units. Moreover, under current law, a section 754
election may be necessary to prevent different units in a
publicly traded partnership from having different tax attributes,
i.e., to make the units fungible.
Under section 704(c), income, gain, loss, and deduction with
respect to contributed property must be shared among partners so
as to take account of the variation between the basis of the
contributed property in the partnership and its fair market value
at the time of contribution. The object of that section is to
prevent gain or loss inherent in property at the time of
contribution from being shifted from the contributing partner to
noncontributing partners.'~
As a result of section 704(c),
partnership units may have different tax attributes because they
are subject to different allocations under section 704(C). A
basis adjustment under section 743(b), however, generally will
eliminate any difference between partnership units caused by
section 704(C) unless the "ceiling rule" has affected the
application of section 704(C).
The "ceiling rule" of section 1.704-1(c) (2) of the
regulations .ay prevent section 704(c) allocations from eliminating the disparity between adjusted basis and fair market value
'~he principles of section 704(c) are also to be applied
when a partnership revalues its property for purposes of section
704(b) upon the occurrence of certain events, including the
admission of a new partner. Treas. Reg. S 1.704(b)-l(b) (4) (i).
~ Also Treas. Reg. SS 1.704(b)-l(b) (2) (iv)(!) and (g).
Allocations made pursuant to such a revaluation are frequently
referred to AS "reverse section 704(C) allocations," and the
discussion herein applies equally to such allocations.
48
of contributed property over time. Under the ceiling rule, the
total depreciation, depletion, or gain or loss allocated to the
partners ~annot exceed the amount of gain or loss realized by the
partnershlp or the depreciation or depletion allowable to the
part~ership.
If the ceiling rule applies, allocations under
sectlon 704(c) cannot prevent gain or loss inherent in
contributed property from being shifted to noncontributing
partners. Moreover, a basis adjustment under section 743(b)
cannot eliminate differences between partnership units caused by
the application of the ceiling rule. Accordingly, if the ceiling
rule limits the allocations that may be made under section
704(c), different units carry different tax characteristics even
after section 743(b) adjustments have been made, and the units
thus are not fungible.
Regulations under section 704(c) may address the problems
caused by application of the ceiling rule.
2.
Constructive Termination Under section 708
section 708(b) (1) (Bl provides that a partnership will be
considered as terminated 0 if within a 12-month period there is
a sale or exchange of 50 percent or more of the total interests
in partnership capital and profits. The regulations 0 clarify
that multiple sales of the same interest during the 12-month
period are treated as the sale of a single interest for purposes
of applying the 50 percent rule. In addition, a disposition of a
partnership interest by qift, bequest or inheritance, or the
liqUidation of a partnership interest is not a sale or exchange
for purposes of section 70B(b) (1) (B).
Because it is generally impractical for publicly traded
partnerships to match transferors and transferees of particular
units traded on the securities market, publicly traded
partnerships in many cases will be unable to determine whether a
termin~tion under section 708 has occurred during a given
year. 19 Moreover, the administrative proposals recommended
107Trea.~
Reg. 5 1.708-1(b) (1) (iv) provides that in a
constructive termination under section 108(b) (1) (B) there is a
deemed distribution ot all partnership property and a deemed
contribution of such property to a "new" partnership.
l08Treas • Reg. S 1.108-1(b) (l)(i).
109 Publ icly traded partnerships qenerally will be unable to
determine whether a particular unit has been transferred more
than once during a year, or whether a transfer was mada by gift,
bequest or inheritance. In certain situations, however, publicly
traded partnerships will be able to determine whether a
termination under section 708(b)(l)(B) has taken place (e.g., if
49
herein disregard terminations under section 708(b) (1) (8) for
audit and collection purposes. Accordingly, consideration should
be given to narrowing or eliminating the application of section
708 to widely held partnerships.
3.
Accounting Conventions
Under section 706(c) (2), the taxable year of a partnership
closes with respect to a partner who disposes of his or her
entire interest in the partnership. section 1.706-1(c) (2) (ii) of
the regulations provides that the distributive share of a partner
whose entire interest is sol~~ay be computed either through an
interim closing of the books 1 or, b~ aqreement among the
partners, through a proration method. 11 Under section 70G(d),
added by the Tax Reform Act of 1984, each partner's share of
income, gain, loss, deduction or credit must be determined by
taking into account his or her varying interests in the
there was a large block transfer of over 50 percent of the
interests durinq the year, or if less than 50 percent of the
interests were transferred during the year).
110undar the interim closing of the books method, the
partnership traces all partnership items to the particular
seqment of the partnership taxable year in which such item arose.
l11Under the proration method, partnership items are
allocated to portions of the taxable year (e.g., days, months) by
prorating the entire year's items regardle.s of when the item
arose. The regulation provides that the proration may be based
on the portion of the taxable year that has elapsed prior to the
sale (i.e., a daily convention) or "under any other method that
is reasonable."
50
partnership during the partnership taxable year. 112 certain
items are required to be allocated on a daily basis. 113
It appears that most widely held partnerships have adopted a
monthly convention for determining when a purchaser of a unit
becomes a partner both in the case of partial and complete
dispositions of partnership interests. Thus, widely held
partnerships typically treat transfers of interests occurring at
any time within a month-long period as if all sycf transfers had
occurred on a specified day within that period. 1
An interim
closing of the books or use of a daily convention is probably
impractical in the context of publicly traded partnerships.
Because publicly traded partnership interests are normally
transferred in anonymous transactions over a securities market,
there does not appear to be significant potential tax avoidance
resulting from the use of a monthly convention as long as the
convention is uniformly applied. Partnerships that are not
publicly traded within the meaning of section 7704(b) typically
will not have sufficient trading activity to create material
distortion. To provide for the unusual case where tax avoidance
is of concern, the Conference Committee Report to the 1984 Act
states that the Service "may deny the use of any convention when
the occurrence of significant, discrete events (e.g., a large,
unusual gain or loss) would mean that use of a convention could
result in significant tax avoidance." Regulations might also
prevent the application of a convention to large block transfers
112 The Conference Committee Report to the 1984 Act expresses
an expectation that regulations under section 706(d) will provide
for a monthly convention, apparently only with respect to
dispositions of less than an entire partnership interest.
H.R. Rep. No. 861, 98th Cong., 2d Sess. 858 (1984). In News
Release IR 84-129, the service permitted the use of a semimonthly convention in the case of a partial disposition of a
partnership interest for partnerships using the interim closing
of the books method. The news release did not change the general
requirement of a daily convention for partnerships using the
proration method. The Blue Book to the 1984 Act, referring to
dispositions of less than an entire partnership interest, stated
that the use of any "reasonable convention" would be permitted
until regulations are issued under section 706(d). staff of the
Joint committee on Taxation, General Explanation of the Revenue
Provisions of the Deficit Reduction Act of 1984, 221-222 (1984).
ll3 I • R• C• S 706(d) (2).
ll'The specific methods vary among partnerships. For
example, some partnerships treat all transfers during a month as
occurring on the first day of that month or the first day of the
following month.
51
(e.g., transfers in excess of 5 percent of outstanding interests)
where the potential for tax avoidance may exist in connection
with an extraordinary transaction.
4.
Information Reporting
It is difficult or impossible for widely held partnerships,
and especially publicly traded partnerships, to comply with a
number of information reporting and gathering requirements
applicable to partnerships generally. Under section 6050R and
the regulations thereunder, upon certain transfers of partnership
interests subject to section 751, a partnership is required to
file Form 830flieporting both the transferor and transferee of
the interest.
This requirement cannot be satisfied for
transactions occurring on an exchange because the buyer and
seller of any given interest cannot be matched. Similarly,
widely held partnerships may be unable to comply with certain
requirements imposed under the tax shelter registration rules.
For example, the seller of an interest in any partnership which
is classified as a tax shelter under section 6111 must furnish a
document containing specified information to the purchaser of the
interest; this requirerert cannot be satisfied for a transfer on
a securities exchange. 1 Additionally, any partnership subject
to registration under section 6111 is required to maintain a list
of all investors in the partnership which must be availr.ble for
inspection within 10 days of a request by the Service. 7 The
10-day requirement cannot be satisfied by any partnership in
which interests are owned through nominees. To the extent these
provisions continue to be imposed by the code,118 consideration
115Treas. Reg. S 6050K-l(b) (1). Under Treas. Reg.
S 1.605K-l(a) (2), a partnership need not file a Form 8038 with
respect to any transfer which must be reported under Code section
6045 (reporting by brokers, ~.). However, many types of
transfers are exempted from reporting under section 6045. ~
Treas. Reg. S 5f.6045-l(c) (3).
116Temp • Treas. Reg. S 30l.6lll-1T, Q & A 51 ~ seg. In
addition, the required tax shelter list must specify the
transferor of any interest held by a transferee partner. Temp.
Treas. Reg. S 30l.6ll2-1T, Q & A 17. Again, this type of
matching of buyers and sellers is not possible for a publicly
traded entity.
117 Temp •
Treas. Reg. S 30l.6ll2-lT, Q & A 21.
recently completed study of civil tax penalties made
no recommendation with respect to the tax shelter registration
rules, concluding that the "area sho~ld continue,to be monitored
to assure that the registration requ7rement contl~ues to be
needed." Report on Civil Tax Penaltles by Execut~ve Task Force,
118 The
52
should be given to amending the regulations so that widely held
partnerships will be able to comply.
Commissioner's Penalty study, Internal Revenue Service, 1989, at
VI-28.
SECTION V.
A.
PROPOSALS POR CURRENT ASSESSMENT OF DEFICIINCIES WITH
RESPECT TO WIDELY HELD PARTNERSHIPS
Overview
Much of the administrative inefficiency and complexity
facing the Service in the administration of widely held
partnerships stems from the fact that a deficiency must be
assessed against taxpayers who were partners in the year in which
the understatement of tax liability arose. This requires the
Service to locate and monitor the returns of all taxpayers who
were partners in that year, and eventually assess each former
partner's share of the deficiency. If an adjustment covers
several years, the complexity of the task is compounded.
These administrative burdens could be partially alleviated,
from the point of view of the Service, by requiring the
partnership to perform many of the tasks required to convert a
partnership level adjustment into assessments with respect to
individual partners. The partnership could be required to file
amended returns for the years to which the adjustment relates,
and issue amended Form I099-Ks, including penalties and interest,
to the partners in those years. The filing of amended returns
and the issuance of amended Form I099-Ks would be required within
a reasonable period from the date of the final determination. As
under current law, taxpayers who had related adjustments in subsequent years would be entitled to file refund claims based on
their overpayments of tax in those years.
This approach cannot be viewed as a satisfactory means of
improving the administration of widely held partnerships.
Although part of the burden of tax administration would be
shifted to partnerships and partners under this approach, the
Service would still face the prospect of handling claims for
refund from thousands of partners upon an adjustment with respect
to any sizable partnership, and would be responsible for
monitoring compliance by both partnerships and partners.
Furthermore, there would be no net reduction in the overall
effort necessary to achieve assessment and collection of
deficiencies with respect to widely held partnerships.
The key to streamlining the assessment of deficiencies with
respect to widely held partnerships is to devise an assessment
system that significantly reduces this overall effort. This
section of the report reviews proposals for achieving this goal.
The first proposal discussed was considered in connection with
the formulation of the 1987 Revenue Act; this report concludes
that this proposal would not materially reduce complexity and
thus should not be enacted. Other proposals, the Partnership
Collection Proposal and the alternative current assessment
proposals, have been developed in the preparat~on of thi~ report.
While this report concludes that the Partnersh1p Collect10n
54
Proposal is the preferred approach, it is believed that the
enactment of any of these current assessment proposals would
produce a system under which it would be feasible to conduct
audits of widely held partnerships.
B.
House Proposal
1.
Description
The bill originally passed by the House of Representatives"9
during formulation of the Revenue Act of 1987 contained a proposal for collecting deficiencies from certain partnerships (the
"House Proposal"). Under the House Proposal, underpayments of
tax resulting from "applicable return adjustments" with respect
to certain partnerships would have been collected either from the
partnership or from each partner. For this purpose, an "applicable return adjustment" meant a final partnership administrative
adjustment (if no court proceeding had been timely commenced), a
court decision that had become final, an amended return filed by
the partnership, or a settlement agreement binding on the
partners. Any "shortfall" (i.e., any understatement of taxable
income, overstatement of taxable loss, overstatement of credits,
or any combination thereof for a given partnership taxable year)
resulting from an applicable return adjustment would have been
subject to notice and demand by the Service in the same manner as
if the tax were originally imposed on the partnership. The
partnership would have been required to pay tax at the highest
rate (individual or corporate) applicable for the taxable year of
the shortfall. The amount of the shortfall would have been
reduced to the extent the partnership could have proven that a
partner had reported consistently with the applicable return
adjustment in the partner's original or amended return.
Under the House Proposal, the payment of tax by the
partnership would have been treated as payment of tax by each
partner of his or her allocable share of the payment determined
in accordance with his or her interest in the partnership in
the year to which the adjustment related. To the extent the
payment by the partnership created an overpayment with respect to
any partner (~, where the partner's marginal tax rate was
lower than the rate paid by the partnership), that partner would
have been entitled to file a claim for credit or refund of the
overpayment. The partnership would have had the right to recover
the amount of payment made on behalf of a partner from that
partner.
Neither the House Bill nor the House Ways and Means
Committee Report specified the capital account or basis
',9 H.R. Rep. No. 3545, looth cong., 1st Sess.
(1987).
ss
adjustments to be made in connection with a partnership payment.
Presumably, the partners' capital accounts would have been
adjusted for the redetermined amounts of income, deductions, or
credits in the year of the shortfall. The payment of tax by the
partnership presumably would have been treated as a partnership
distribution, with the partners in the year to which the adjustment related receiving a credit for the amount of tax paid. The
House Proposal treated adjustments on a year-by-year basis, with
no reference to related offsetting adjustments in other years.
The House Proposal did not include any provision for the payment
of interest and penalties with respect to a partnership
deficiency.
The House Proposal would have applied to any partnership
with interests required to be registered under federal or state
laws regulating securities, or sold under an exemption from
registration requiring the filing of a notice with a federal or
state agency regulating the offering or sale of securities. 120
2.
Examples
The following examples illustrate the application of the
House Proposal.
EXAMPLE 1
In its return for the 1992 taxable year, partnership
X understates its income by $1 million, with no offsetting
adjustments in later years. In 1998, a final assessment is made.
X would pay tax at the highest applicable rate for 1992 (assume
34 percent for purposes of these examples). The applicable
return adjustment would be allocated among X's 1992 partners in
accordance with their interests in the partnership. The 1992
partners would be entitled to file a claim for refund for any
excess tax paid on their behalf (e.g., amounts attributable to
marginal tax rate differentials). X would have a right to seek
reimbursement from partners, including former partners, of tax
paid on their behalf by X. The partners' bases and capital
accounts would presumably be adjusted to reflect the allocation
of additional income. Presumably, the payment of tax by X would
be treated as a deemed distribution to the partners. The net
effect of these adjustments would be to increase the adjusted
bases of the partnership interests as of the end of 1992.
consequently, any 1992 partner who sold an interest in the
partnership between 1992 and 1998 presumably would be entitled to
file a claim for refund of tax for the year of sale to reflect
reduced qain or increased loss from the sale.
EXAMPLE 2
In 1992, Partnership Y reports a deduction of $1
million that should have been reported in its 1993 taxable year.
In 1998, a final assessment is made. Because the House Proposal
120~
56
applies on a year-by-year basis, it would not permit an offset of
underpayments and related overpayments occurring in different
years. Thus, the results would be identical to those described
in Example 1 above, with Y paying tax on the deficiency for 1992
at the highest rate in effect for that year (34 percent). Y's
1993 partners would be entitled to file claims for refund for
their overpayments in that year.
EXAMPLE 3
In 1992, Partnership Z deducts $1 million that
should have been amortized on a straight-line basis over ten
years. In 1998, a final adjustment is made. The result would
generally be the same as in Example 2 above. The applicable
return adjustment to be paid by Z for 1992 would equal $900,000
($1 million minus $100,000 allowable amortization). Z's partners
from 1993 through 1997 would be entitled to file claims for
refund for their overpayments (attributable to Z's $100,000
deduction understatement in each year) in those years.
3.
Analysis
The House Proposal attempted to address problems that
exist under current law in assessing and collecting deficiencies
from partners of widely held partnerships by collecting the
deficiency directly from the partnership. Under the House
Proposal, the tax paid by the partnership would have been treated
as paid by persons who were partners during the year to which the
adjustment related, and any partners who had a marginal tax rate
that was less than the maximum tax rate applicable under sections
1 or 11 would have been entitled to file claims for refund.
Since the maximum corporate rate currently exceeds the maximum
individual rate, apparently all individual partners would have
been due such refunds. In addition, the proposal would not have
offset understatements of income with directly related overstatements of income, resulting in refunds due to partners who
had a directly related negative adjustment to income in a
different taxable year. Thus, thousands of potential refund
claims would have been created with respect to partnerships with
substantial numbers of partners. A significant paperwork burden
would have been imposed on the service and taxpayers to the
extent these refund claims were pursued; to the extent the refund
claims were not pursued, the proposal would have resulted in the
collection of more tax than the government was due. The House
Proposal would have imposed further record maintenance responsibilities on the Service by permitting a reduction of a shortfall
to the extent the partnership could have demonstrated that its
partners reported the matter on their own returns consistently
with the applicable return adjustment. Thus, while the House
Proposal provided greater assurance of collection of partnership
deficiencies, it might have actually increased the Service's
paperwork burden. Furthermore, because it involved collection of
deficiencies directly from the partnership, the House Proposal
would have created the same partnership liquidity problem
57
discussed below in connection with the Partnership Collection
Proposal.
The House Proposal endeavored to continue to impose the
burden of payment of the tax deficiency on the partners who
originally benefited from the understatement of income. This was
accomplished by providing that the partnership would be entitled
to recover from those persons who were partners in the year to
which the adjustment related any amounts paid on their behalf.
We do not believe it appropriate for the Internal Revenue Code to
grant a private right of action. Furthermore, it often would
have been difficult or impossible for a widely held partnership
to obtain reimbursement from former partners for tax payments.
The difficulty and expense of locating these partners, combined
with the partners' probable unwillingness to reimburse the
partnership voluntarily, would have likely rendered the right of
reimbursement merely theoretical in most cases. Thus,
notwithstanding the reimbursement provisions under the House
Proposal, the tax on deficiencies would have been borne chiefly
by the persons who held partnership interests during the year in
which the final partnership adjustment occurred, and not those
who held interests during the year to which the shortfall
related. Yet the House Proposal did not provide the partners in
the year in which a final adjustment occurred with any credit for
tax paid or with any increase in the bases of their partnership
interests. Thus, the House Proposal would have had the effect of
attributing income to current partners without providing the
adjustment to basis normally afforded partners who recognize
income.
Furthermore, the House Proposal did not eliminate the
administrative difficulties of assessing and collecting tax
deficiencies of partners in partnerships covered by the
proposal--it merely shifted the initial burden of dealing with
these difficulties to the partnership. In cases where the amount
of the deficiency for the average partner was small, partnerships
would have been unlikely to have sought reimbursement from former
partners, and partners with potential refund claims would have
been unlikely to have filed them. Just as the Service may avoid
the administrative problems of current law by not attempting to
assess deficiencies with respect to widely held partnerships,
such partnerships and their partners would have been expected to
avoid them under the House Proposal by acquiescing in the
collection of excessive amounts of tax. In cases where
partnerships and partners would have decided to pursue refund
claims, the Service would have continued to be faced with a
paperwork burden that is similar to that existing under current
law. For these reasons, we do not recommend that Congress adopt
the House Proposal.
58
c.
Deficiencies with Respect to widely Held Partnerships
Should be Borne by CUrrent Partners
The House proposal would not have materially reduced
complexity because it retained the current law approach of
looking back to prior-year partners as ultimately responsible for
adjustments. This approach may be logical with respect to
smaller partnerships, which correspond to the traditional view of
partnerships as aggregations of individual taxpayers; however,
widely held partnerships are best viewed as entities in this
context and it is not necessary to treat the adjustments as
personal to prior partners. The present system has the effect of
isolating current partners from the impact of adjustments made
with respect to the business of the partnership. Contrast this
with the treatment of a shareholder in a large corporation.
Assume that a shareholder owns stock from 1990 through 1992 in a
corporation Which substantially understates its taxable income
for 1990. In 1993, a deficiency is assessed, and causes the
value of the corporation's stock to drop materially. Meanwhile,
the original shareholder has sold his stock. The cost of the
deficiency is borne by the stockholder who purchased in 1992.
This report proposes an assessment structure for widely held
partnerships which treats partners in a manner roughly comparable
to the treatment of current and former shareholders in corporations. A current partner would bear the risk of tax adjustments
relating to prior years; if a partnership interest is purchased
without knowledge of the possibility of a substantial tax
adjustment, the purchaser may pay too much for the partnership
interest. It is important to note, however, that the basis
adjustment rules of section 705 would mitigate both the
"windfall" to the former partner and the unanticipated burden to
the purchasing partner. Any deficiency to be collected from
current partners would be adjusted to take into account
offsetting adjustments in years other than the year of the
shortfall. Offsetting related adjustments would greatly simplify
the administration of widely held partnerships.
This proposal would involve a significant departure from
traditional subchapter R prinCiples. However, we believe that
such a departure is warranted in view of the substantial costs
and difficulties faced by both the Service and partnerships in
applying these subchapter K principles to widely held
partnerships.
D.
Partnership Collection Proposal
1.
Description
The central features of the Partnership Collection Proposal
are: (1) the treatment of a partnership shortfall in a prior
year as a current item of income in the year in Which a final
59
determination of the adjustment is made; (2) the collection of
tax, interest, and penalties with respect to the shortfall
directly from the partnership; and (3) the netting of related
adjustments in other years. As under the House Proposal, a
shortfall is defined as any understatement of taxable income,
overstatement of taxable loss, overstatement of credits, or any
combination thereof for a given taxable year.
Under the Partnership Collection Proposal, a widely held
partnership would be treated as the taxpayer with respect to any
partnership shortfall. The partnership would pay tax and
interest as if it were a corporate taxpayer subject to tax at the
highest rate applicable under section 1 or 11 for the year of the
final determination. In computing the tax, interest, and
penalties that would be paid by the partnership with respect to a
partnership shortfall, the Partnership Collection Proposal would
allow an offsetting adjustment for any directly related overstatement of taxable income, understatement of taxable loss, or
understatement of credits for any other taxable year intervening
between the taxable year to which the shortfall relates fpd the
year in which the final partnership adjustment is made. 1
The
offsetting adjustment would be computed by treating the partnership as if it were a corporate taxpayer that had paid tax on the
related overstatement at the maximum rate applicable under
section 1 or 11 of the Code for the year of the final
determination.
The Partnership collection Proposal would treat a
partnership shortfall attributable to an understatement of
taxable income or an overstatement of taxable loss (less any
offsetting adjustment) as a positive adjustment to the taxable
income of the partnership for the taxable year in which the final
partnership adjustment is made. Each partner's share of the
adjustment would be reported on the partner's Form l099-K and
included in the partner's income for such year. The income would
be deemed to have arisen pro rata throughout the year, so that
all partners during the year of the final determination would
share the income. Any tax paid by the partnership with respect
to such shortfall would be treated as tax paid by such partners,
effectively treating the tax paid by the partnership as a credit
allowable to the partners which would be refundable to the extent
an overpayment can be established. Thus, although tax would be
withheld at the maximum rate (and interest would be calculated on
such basis), the tax would actually be imposed at the marginal
rates of the partners in the year the final adjustment is made.
The partnership would also pay interest and penalties with
respect to the shortfall based on tax calculated at the maximum
rate. Interest and penalties would not be refundable and would
be nondeductible by the partners.
121See I.R.C. S 660l(f).
60
A constructive termination of a partnership under section
708(b) (1) (B) would not affect the Service's right to make an
entity-level assessment against the partnership for a taxable
year preceding the year of termination. In addition, regulations
would be authorized to govern the application of these rules to
partnerships that have been liquidated, and exclude partnerships
or their partners from the operation of these rules in appropriate or abusive situations. Partners holding a significant
percentage of interests (e.g., at least five percent or ten
percent) in a partnership in the year of the understatement
would be excluded from the current assessment system. Thus,
such partners would continue to be responsible for their allocable share of deficiencies even if they sold their interests prior
to the final determination. The remainder of the deficiency
would be allocated among all other current partners.
2.
Basis and Capital Accounts
For purposes of maintaining the partners' capital accounts
and determining the bases of their partnership interests, a
partnership shortfall would usually be treated as a poStfive
adjustment to the partners' capital accounts and bases,
any
tax paid by the partnership would be treated as a distribution of
cash to the partners, any interest or penalty paid by the
partnership would be treated as a nondeductible partnership
expense.
3.
overstatements and Amended Returns
If an audit determines that an overstatement was made in
reporting a prior year's taxable income, the adjustment could
also be treated as a current item by allowing a deduction in the
year of the final determination. Related understatements would
be offset against overstatements to produce a single adjustment.
Interest due on such an overpayment (determined after application
of section 6601(f» would be calculated on the basis of an
assumed rate and paid directly to the partnership. Appropriate
basis and capital account adjustments would be made.
122partners' bases and capital accounts would not be
adjusted where a final determination relates to an item that has
already been reflected in their bases and capital accounts. For
example, when a partnership reports tax exempt interest, a
partner's basis and capital account are increased by his or her
share of the interest. See I.R.C. S 705(a) (1) (B). Therefore,
upon a determination that the interest was not tax exempt, no
further basis or capital account adjustment would be appropriate.
61
Amended partnership returns 123 would pose a number of issues
under the Partnership Collection Proposal, regardless of whether
the amended returns sought to increase or decrease previously
reported income. If a partnership were allowed to treat an
adjustment resulting from an amended return as a current item,
partnerships arguably would have a measure of flexibility in
determining when to claim a deduction or to report income. For
example, if it were known that tax rates would increase in the
next year, a partnership might fail to claim a deduction in the
current year and then amend its return the next year to claim the
deduction when it was worth more to its partners. This tactic
would probably be successful only where there existed some
legitimate uncertainty concerning the allowance of the deduction
in the initial year, as the initial return might otherwise be
found to contain a false statement. However, it is not improbable that in certain situations partnerships would be able to
manipulate the system to use amended returns to their advantage
if such returns were to produce a current adjustment. On the
other hand, if adjustments arising from amended returns were to
relate back to prior year partners, management of a partnership
might be faced with a conflict of interest if it were aware at
the commencement of an audit that a reporting position in a prior
year is likely to result in an adjustment, regardless of whether
the adjustment were an increase or decrease in taxable income.
If management were to file an amended return, the adjustment
would accrue to prior owners, while if the audit were allowed to
run its course the adjustment would accrue to current owners.
One possible solution would provide that amended returns would
relate back to prior years, but that no such return could be
filed after an audit has commenced. This WOUld, however, place a
great deal of significance on the commencement date of the audit.
If the Partnership Collection Proposal is enacted, specific rules
would be needed to deal with amended returns.
4.
Insolvent Partnerships
A mechanism for collection from partners is necessary for
situations in which a widely held partnership is unable to
satisfy a deficiency. Our recommended approach would permit the
Service to proceed against both current and former partners to
collect the amount owed, but would also take into account the
partners' tax status in determining ultimate liability. Under
this approach, current partners would be required to pay amounts
of tax liability not collected from the partnership, in effect
requiring them to pay tax on the deficiency at a 34 percent rate.
The amounts could be collected either by sending the current
partners notices of deficiency or by reporting the liability as
noted above, an RAA is the procedure applied under the
unified partnership audit rules for filing an amended return or
refund claim.
123 As
62
an amount owed on the Form l099-K. This flat percentage
liability would be collected from all current partners, including
tax exempt partners, regardless of their personal tax rates. A
procedure should also be established to take into account the
partners' individual tax status. This might be accomplished, for
example, by having the partners add their share of the deficiency
to their income for the year of the final determination or a
subsequent year, and allowing a refund to the extent their
payment exceeded the amount of tax owed on that income computed
at their actual marginal tax rate.
If within a specified time period the amount of tax
collected from the partnership and current partners was less than
the amount owed by the partnership using the 34 percent rate,
taxpayers who were partners in the year of the understatement
(and who had since sold their interests) would be liable for
their f.hare of the amount owed (again applying a 34 percent tax
rate). 24 In addition, a rule could be provided under which a
former partner who was neither a partner in the year of the
understatement or in the year of the final determination would be
liable if his or her interest was transferred to a dummy or in
any other transfer designed to reduce the overall tax liability
or to avoid payment of the deficiency. The procedure would be
similar to that described for current partners. Tax would be
collected at the flat percentage tax rate based on their
interests in the partnership, and a mechanism would be provided
to take into account their actual tax status. While the
collection approach described above would be somewhat cumbersome,
it would permit COllection of deficiencies with respect to
insolvent partnerships even when interests are held at the time
of determination by dummy or sham partners. 125
Under the proposed collection approach, a general partner
would essentially be treated the same as the other partners.
Thus, the general partner would not be liable for more than the
share of the underpayment attributable to his or her interest in
124This would apply to partners other than those holding a
significant percentage interest in the year of the shortfall. As
discussed above, those partners would be excluded from the
current assessment system.
125There are, of course, alternative approaches for
proceeding against partners directly. If the Service is unable
to fully collect a deficiency from the partnership, the current
partners could be responsible for payment of any additional
amounts owed under rules similar to the partner collection method
discussed below. The current partners' tax liability would then
be entirely determined by their individual tax status. Under
this approach, collection against former partners probably would
only be pursued in cases involving abusive transfers.
63
the partnership 126 and would not be liable for unpaid taxes on
behalf of all current partners. 127
5.
Examples
The following examples illustrate the application of the
Partnership Collection Proposal.
EXAMPLE 1
In its return for the 1992 taxable year, partnership
X understates its income by $1 million, with no offsetting
adjustment in a later year. In 1998, a final assessment is made.
X would pay a tax at the highest applicable rate for 1998 (assume
for purposes of these examples that the maximum tax rate is 34
percent), plus interest from 1992. In XiS partnership return in
1998, $1 million would be added to partnership income, and the
partners would be treated as having received a distribution of
cash equal to the amount of tax paid ($340,000). The partners'
bases and capital accounts would be adjusted to reflect the
allocation of additional income and interest expense and the
deemed distribution. The partners also would be given a
refundable credit for the tax paid on their behalf. Thus, a
partner whose marginal tax rate is less than 34 percent would use
this credit to satisfy his or her tax liability on other income
or would claim a refund.
EXAMPLE 2
In its return for the 1992 taxable year, partnership
Y reports a deduction of $1 million that should have been
reported in its 1993 taxable year. In 1998, a final assessment
is made. No additional liability for tax would be imposed in
1998. However, Y would pay the interest imposed on the
underpayment of tax in 1992 under section 6601, taking into
account any credit against the underpayment under section 660l(f)
as a result of the overpayment of tax in 1993. Any interest on
12'Of course, in certain cases, the rules described above
regarding transferee liability would apply to general partners
following a transfer of partnership assets out of partnership
solution.
127 Even though not personally liable for an underpayment of
a deficiency, a general partner could have increased exposure to
personal liability for partnership business obligations as a
result of collecting the tax from the partnership. For example,
partnership funds used to satisfy the deficiency would not be
available to satisfy other debts of the partnership for which the
general partners might be personally liable. Analogously, the
collection of deficiencies from the partnership may have a
disproportionate impact as between classes of limited partners
with different interests in partnership allocations and
distributions.
64
the 1992 underpayment would be treated as a nondeductible
partnership expense.
EXAMPLE 3
In its return for the 1992 taxable year, partnership
Z reports a deduction of $1 million for an expenditure that
should have been amortized on a straight-line basis over 10
years. In 1998, a final assessment is made. The understatement
of taxable income by Z for 1992 would be offset in part by Z's
overstatement of taxable income for the taxable years 1993
through 1997. The adjustment in tax would equal 34 percent of
the amounts previously expensed and not yet properly amortized
($400,000). In addition, Z would pay the interest imposed on the
underpayment of tax in 1992 under section 6601, takinq into
account any credit against the underpayment under section 660l(f)
as a result of the overpayment of tax in 1993 through 1997. In
Z's partnership return for 1998, $400,000 would be added to
partnership income, and the partners would be treated as having
received a distribution equal to the amount of tax paid
($136,000). The partners' bases and capital accounts would be
adjusted to reflect the allocation of additional income and
interest expense and the deemed distribution. The partners also
would receive a refundable credit for the tax paid. Any interest
on the 1992 underpayment would be nondeductible.
6.
Discussion
In General. The Partnership Collection Proposal would
simplify the administrative process by treating a prior year
deficiency and any related overstatements as an adjustment for
the year of the final determination of the deficiency. The
Partnership Collection Proposal may also offer the Service
greater assurance than under current law that a tax deficiency
attributable to a widely held partnership will in fact be paid.
As in the case of full withholding, partner-level noncompliance
would be avoided by collecting tax directly from the partnership.
In addition, the Partnership Collection Proposal may be preferred
by some partnerships to the "partner collection" method discussed
below because of the fact that tax attributable to prior years
would not be imposed directly on current partners.
Shifting of Tax Liabilities and Manipulation Concerns.
Under the Partnership Collection Proposal, tax liabilities would
follow ownership of a partnership interest and would not, as
under current law, be personal to the owner of the interest in
the year of the understatement. This approach would represent a
divergence from normal partnership tax principles. The most
significant consequence of this divergence is the potential
shifting of tax liability among taxpayers. This raises two
principal concerns.
The first concern is that such a rule appears to give a
windfall to a partner who held a partnership interest in the year
65
income was understated and to impose an unfair burden on a
partner buying,into the tax liability. Although this is a valid
concern, the w~ndfall and burden are less than initially appear.
Because the fa1lure to report income generally will result in an
understated basis, the windfall to the sellinq partner is limited
to a change in the character of income and deferral of the tax
from the year of thel¥rderstatement to the year of the sale of
his or her interest.
Similarly, the burden to the purchasing
partner generally will be limited to the interest and any
penalties imposed on the understatement, the delay in utilizing
the tax benefit represented by the positive basis adjustment
produced by the allocation of income, and possible character
differences. This burden is not fundamentally different from
that resulting from other liabilities that are assumed by a
partner purchasing a partnership interest (including unaccrued
tax liabilities on items such as built-in gains of a partnership
that has not made a section 754 election). As a result of these
basis adjustments, the detriment to a partner who buys into a tax
liability of a widely held partnership under the current
assessment approach would be less than the detriment to a
shareholder who buys into a corporation with a similar tax
liability.
The second concern is that taxpayers may be able to
manipulate the rules to avoid payment of tax. As an initial
matter, it should be noted that it would not be possible to avoid
taxes by simply distributing partnership assets. Since widely
held partnerships would be treated comparably to corporate
taxpayers for this purpose, the partnership level deficiencies
should have the same status as deficiencies with respect to
corporate taxpayers. Thus, for example, in order to collect a
deficiency from a widely held partnership, the Service could
apply the summary assessment, levy and seizure procedures of
section 6331. In addition, section 6901 would be amended to
provide that transferees of partnership assets (including
partners) would be subject to transferee liability. Hence,
distribution of partnership assets wO~1d not prevent the
government from collecting taxes due. 9
128Under section 705, a partner's basis in his partnership
interest is increased by the allocation of both taxable and taxexempt income. Consequently, if a partnership, rather than
underreporting income, mischaracterizes taxable income as
tax-exempt, the selling basis will not be understated and his or
her windfall will not be so limited.
129 As discussed in section V(O) (4) above, we recommend that
procedures be adopted to collect from,current a~d former partners
when the partnership is unable to satlsfy a deflciency.
66
Since in general the amount of liability under the
Partnership Collection Proposal is ultimately dependent on the
tax status of the partners in the year of the final
determination, the central manipulation concern would be the
potential for shifting of tax liabilities from high bracket
taxpayers to low bracket taxpayers. To achieve a material
reduction in a widely held partnership's tax liability, a
significant portion of the interests would have to be transferred
to lower bracket taxpayers (including tax exempts). The
likelihood of such transfers would be reduced by the exclusion
from the current assessment approach of any partner holding a
significant percentage of interests (e.q., at least five percent
or ten percent) in a widely held partnership in the year of the
understatement. As under current law, such a significant owner
would be liable for his or her allocable share of a deficiency
even if the interest were sold prior to the year of final
determination. The remainder of the deficiency would be
allocated among the current partners. The Service would be able
to administer adjustments with respect to the large partners
covered by this eXClusion. Because these partners will be more
likely to know of an impending adjustment and to arrange
transfers to lower bracket taxpayers, opportunities for
manipulation will be reduced if these partners are not permitted
to shift tax liability by transferring their interests.
Even though adjustments with respect to interests held by
large partners will be excluded from the current assessment
system, a problem would arise if a significant portion of
interests were transferred to lower-bracket taxpayers, and in
particular tax-exempt entities, through normal market transactions. Existing constraints reduce the likelihood that
tax-exempt entities would acquire a significant percentage of
interests in a widely held partnership through such transactions.
If the partnership is publicly traded (within the meaning of
section 7704), tax-exempt investment would be discouraged by
section 512(c) (2), which characterizes all income from a publicly
traded partnership as unrelated business taxable income. If a
widely held partnership is not publicly traded, section 7704 in
many cases would discourage the transfer of a significant
percentage of partnership interests in any given year.'~
Even with the adoption of anti-manipulation rules such as
those discussed above, it is possible that the collective tax
rate of partners in the year of final determination would be
130 See Notice 88-75, 1988-27 I.R.B. 29.
However, under
section 7704, partnerships which derive substantially all of
their income from certain types of investment activity (e.g.,
real estate, oil and gas) will not be taxed as a corporation even
if they are publicly traded.
67
somewhat lower than that in the year of an understatement.
Collection of interest on deficiencies at the partnership level,
calculated on the assumption of a high effective rate of tax,
would reduce the impact of such a rate shift. It would also be
possible to impose a punitive interest rate on deficiencies, as
is done under the Regulated Investment Company ("RIC") and Real
Estate Investment Trust ("REIT") deficiency dividend rules, to
further minimize the effect of a rate shift.I~l
section 704(b). Adjustments under section 704(b) may
present difficulties under the Partnership Collection Proposal;
while certain partners would effectively have their distributive
shares of income increased, the corresponding decrease in other
partners' distributive shares would result in no overall
partnership level deficiency (except as to any differential in
interest rates on deficiencies and overpayments). One answer
would be to simply conclude that section 704(b) adjustments would
have to be handled under current law. However, if enforcement of
section 704(b) with respect to widely held partnerships must
proceed under an extremely unwieldy system while other
adjustments that arise under audit can be processed through a
simplified system, the government might be essentially forfeiting
enforcement of section 704(b) in these cases. If the Partnership
Collection Proposal were to be enacted, further consideration
will need to be devoted to the treatment of section 704(b)
adjustments under the system.
Liquidity Issues. Because it involves entity-level
collection, the Partnership Collection Proposal might create
liquidity problems for certain partnerships. Liquidity problems
are of particular concern to rental real estate partnerships,
many of which experience deficits in the early years of operation, are highly leveraged, and have insufficient cash reserves
to finance tax liabilities without selling off partnership
assets. Some partnerships would presumably be able to borrow
against assets; in some cases, however, a partnership could be
forced to sell assets to satisfy a deficiency. A forced sale of
assets at an inopportune time could result in significant losses
to the partnership. While this may be a significant concern for
partners in existing partnerships, partnerships formed after the
effective date C?¥.rd presumably establish reserves for possible
tax liabilities.
131~ I.R.C. S 860(c) (1).
Under these rules, interest is
calculated based on the amount of the deficiency, rather than
based on the amount of tax owed.
13l See
issues.
section VIII of this Report concerning effective date
68
summary. The Partnership Collection Proposal would
eliminate several fundamental problems that severely hamper the
Service's ability under current law to audit and collect
deficiencies attributable to widely held partnerships. The
proposal would eliminate the need to obtain and monitor the
individual returns of partners for the year to which the audit
relates and to assess and attempt to collect deficiencies for
that year. It would also avoid creating offsettinq refund claims
in later years. Collection of deficiencies would be greatly
simplified. Adoption of the proposal would dramatically reduce
the Service's burden in auditing widely held partnerships.
E.
Alternative Proposals
Much of the simplification offered by the Partnership
Collection Proposal could be achieved under a number of
alternative current assessment approaches. The adoption of any
of the approaches discussed below would siqnificantly improve the
administration of widely held partnerships.
1.
Partner Collection Method
The treatment of deficiencies with respect to widely held
partnerships as current income items could also be implemented by
collecting deficiencies directly from current partners. This
approach is referred to in this report as the "partner collection" method. In most respects, these rules would parallel those
discussed above in connection with the Partnership Collection
Proposal. The following discussion focuses on areas where the
two approaches would differ.
Under the partner collection approach, understatements
arising from erroneous reporting positions taken by a partnership
in prior years (less any offsetting adjustments) would be: (1)
included as an income item on the partnership's return (Form
1065) in the year a final adjustment is made; (2) included on the
Form l099-Ks sent to the partners in that year; and (3) reflected
as an item of income on the partners' income tax returns (Form
1040 or 1120) in that year. Thus, under the partner collection
approach, tax on prior year partnership deficiencies would be
paid by the partners in the year of the final determination at
the marginal tax rates in effect in that year. To the extent tax
rates changed between the year of the understatement and the year
of the final determination, the tax owed with respect to a
deficiency would likewise vary from that which would have been
due had the income been properly reported in the year of
understatement. A shortfall reflecting an overstatement of
credits in a given year (less any related understatement of
credits in a different year) would be included as a separate item
on the partnership's return in the year a final determination is
made and would be similarly included in the partners' Form
69
I099-Ks in that year. Thus, the partners in the year of the
final determination would be responsible for the repayment of
credits as part of their separate tax liability.
Interest and penalties with respect to a deficiency could
either be passed through to partners or paid directly by the
partnership. If interest and penalties were to be passed through
to partners along with the underlying deficiency, a system could
be devised under which each partner's interest and penalties were
calculated with respect to the partner's actual tax on the
deficiency. However, this would require the partnership to
provide the partner with an interest rate and a penalty rate to
be applied to the partner's tax. While this approach would
tailor each partner's interest and penalties to his or her actual
tax, deficiency income would need to be reported to partners
separately from other income and guidance would be required to
determine the amount of each partner's total tax liability that
would be treated as attributable to the deficiency income. Only
then could the partner use the special interest rate and penalty
rate to determine his or her interest and penalties. It is not
clear that this approach could be efficiently administered within
the partnershj ~'s iprmal reporting system. Furthermore, it would
not be possible to apply computer matching to these amounts since
the Service would not be independently reported the amount of any
partner's interest and penalties. The alternative approach to
passing interest and penalties through to the partners would be
to calculate the amount of interest and penalties by assuming a
partner-level tax rate and showing the resulting interest and
penalties as tax due on the partners' Form l099-Ks. The Service
would be able to match these amounts. However, while partners
would be likely to properly report additional income shown on a
Form l099-K, they are more likely to be confused by and object to
a Form l099-K that reports additional tax attributable to
interest and penalties attributable to a prior year deficiency.
ThUS, this approach could result in new compliance problems. It
would also require partners not otherwise subject to tax to pay
penalties and interest on a deficiency.
The passthrough of interest and penalties to partners is
perhaps the most significant barrier to designing a pure
passthrough of partnership deficiencies and related items. An
alternative would be to have partnerships pay interest and
penalties, while deficiencies were flowed through to partners.
This would lessen the administrative savings from passing
deficiencies through to partners as part of the normal deficiency
process and would require the use of an assumed tax rate.
Assumin~ partners were not permitted to seek refunds of penalties
and interest this approach would be relatively simple.
Therefore if the partner collection method were to be adopted,
it would be preferable to have partnerships pay interest and
penalties.
70
For purposes of maintaining the partners' capital accounts
and determining the bases of their partnership interests, an
increase in taxable income would be treated as a positive
adjustment to the partners' capital accounts and bases of their
interests, and any interest or penalty paid by the partnrffhip
would be treated as a nondeductible partnership expense.
Interest or penalties paid by a partner would be treated as any
other interest or penalties paid by a taxpayer with respect to a
tax deficiency.
Like the Partnership Collection Proposal, the partner
collection method would simplify the administration of widely
held partnerships by providing for a single entity level
determination that would eliminate the need for the Service to
obtain and monitor returns of each prior year partner, and by
combining related adjustments as a single current item. The
partner collection approach would not offer the Service the
opportunity to satisfy a deficiency from a single source. It
would also raise a number of the same concerns as the Partnership
Collection Proposal, including questions of rftnSferring tax
liability and fairness to incoming partners.
On the other
hand, the partner collection method would not pose the concerns
raised by illiquid partnerships under the Partnership Collection
Proposal, although payment of interest and penalties by the
partnership would raise such issues to a lesser degree.
Furthermore, it is arguable that the partner collection method
would represent less of a shift from current law as the
collection of deficiencies could be entirely subsumed within the
normal reporting procedure.
2.
Non-Flowthrough Method
The current assessment system could also be implemented by
collecting deficiencies from the partnership without treating the
adjustment as current income. The partnership would pay tax at a
fixed rate (~, the maximum individual rate). Income would not
flow through to partners, no partner-level credit would be
133~ I.R.C.
S l62(f); Treas. Reg. S 1.162-2l(b) (1) (ii).
13'Under the partner collection method, the possibility
exists that an understatement of income for an earlier year could
result in a tax liability for the current partners that exceeds
the value of their partnership interests. This could also occur
under the Partnership Collection Proposal in the case of an
insolvent partnership. In the case of widely held partnerships,
we believe this possibility is remote. Partners in these
partnerships are unlikely to incur a tax liability that is
disproportionate to the size of their investment (particularly
where related amounts are offset). Moreover, a special rule
could be provided for such a situation.
71
allowed for taxes paid by the partnership, and no adjustments
would be made to the bases of partners in their partnership
interests (although capital accounts would be adjusted).
This non-flowthrough approach would be relatively simple to
administer, because partnerships would need to make few adjustments as a result of a partnership deficiency. As a consequence
of the absence of basis adjustments, however, the approach could
cause partnership income with respect to a deficiency to be taxed
twice. conversely, allowing a partnership to claim a refund
under this method for an overstatement of partnership income
could result in a double benefit to the partners.
Double taxation of a deficiency could be avoided by using
the non-flowthrough method with basis adjustments. Deficiency
income would not flow through to partners, and partners would not
receive a credit for their allocable share of taxes paid by the
partnership. However, partners would receive a basis adjustment
for their share of the deficiency income, less tax paid by the
partnership. Although at first glance it might appear anomalous
to adjust a partner's basis even though the partner was not
allocated taxable income, similar adjustments are made under
current law for certain items that are not reflected in a
partners~ir's taxable income (e.g., tax-exempt interest
income).
Basis adjustments would also prevent a double
benefit to partners if refund claims are treated as giving rise
to current adjustments.
Whether or not basis adjustments are made, the nonflowthrough approach would tax a partnership's deficiency income
at a single rate, regardless of the rates of its partners. By
not taking the varying tax rates of its partners into account,
this approach would not seek to place the partnership and its
partners in approximately the same position they would have been
in had the income been properly reported initially. As a result,
unlike the Partnership Collection Proposal, it would not permit
the reduction of tax due by a shift in the composition of the
partners toward tax exempt entities or other lower bracket
taxpayers. In addition, the non-flowthrough method would
establish a fixed amount of tax due (independent of partner tax
rates) which could be collected first from the partnership,
second fro~ the current partners, and third from former
partners. 1 6
135~
I.R.C. S 705(a)
(1)
(B) and (C).
13'unlike the Partnership Collection Proposal, no adjustment
procedure would be required to reflect the partners' actual
marginal tax rates.
72
By taxing deficiency income at a single rate, the
non-flowthrough approach would, to a certain degree, reflect an
entity treatment of widely held partnerships. If basis
adjustments were permitted, the approach would recoqnize the
flowthrough nature of a partnership and would not tax deficiency
income twice, nor provide a double benefit for a refund on an
overstatement. On the other hand, basis adjustments would add a
measure of complexity to an otherwise extremely simple entityoriented system.
On balance, we believe an assessment method that taxes a
deficiency at the rates of the partners is the preferable
approach, and have therefore recommended the Partnership
Collection Proposal. However, as discussed above, taxing a
deficiency at the partners' rates opens up the possibility that
deficiency income may escape taxation through a shift in the
composition of the partners. If it is. concluded that the antimanipulation rules discussed in connection with the Partnership
Collection Proposal will not act as sufficient deterrent, serious
consideration should be given to the non-flowthrouqh approach to
taxing deficiencies of widrtr held partnerships, either with or
without basis adjustments.
3.
Nonrefundable Credit
The current assessment approach could also be implemented
with a nonrefundable partner-level credit for taxes paid by the
partnership with respect to a deficiency, in contrast to the
refundable credit under the Partnership Collection Proposal.
Under the nonrefundable credit approach, taxes would be collected
from the partnership at a single rate. Income attributable to a
deficiency would flow through to partners and would be reported
on their Form l099-Ks, along with a nonrefundable credit for the
partner's share of tax paid by the partnership with respect to
the deficiency. Partners would have their bases and capital
accounts adjusted to reflect the additional income (less tax paid
by the partnership).
This method is similar in effect to the non-flowthrough
method discussed above, except that taxable investors with a rate
lower than the rate at which the partnership paid tax would be
able to use the nonrefundable credit to offset tax on other
income during the year, and, if the credit could be carried to
other years, to offset tax on income in other years. Thus, under
a system using a nonrefundable credit, depending on their
individual circumstances and whether the credit could be carried
137 A
rule could be provided that basis adjustments would
only be made with respect to deficiencies exceeding a certain
size.
73
over, taxable partners might be able to achieve full use of the
credit (at least over time). Fully tax-exempt partners would
nev 7r,be ab~e to benefit from the credit. Thus, a partnership's
def~c~ency ~ncome would be taxed at a rate which might exceed the
collective tax rate of its partners.
4.
Elective Payment of peficiencies by Partnerships
It might also be possible to combine the Partnership
collection Proposal and the partner collection method by making
payment of deficiencies by the partnership optional. Thus, if a
partnership were determined to have a relatively small
deficiency, management might prefer to pay the deficiency
directly rather than allocate it as income to the partners. In
cases where management determined that this was not a viable
alternative, such as in the case of an illiquid partnership, the
deficiency could be flowed through to partners as additional
income. This approach might, however, create conflict of
interest issues for the management of a partnership. If an
election approach were adopted, it would be necessary to determine whether the election could be made on a case-by-case or
year-by-year basis or whether it would be a more general (perhaps
binding) election. It would also be necessary to provide
specific rules for making the election and notifying the Service.
F.
Comparison to peficiency pividend Procedures
While the treatment of adjustments as current items would
represent a departure from subchapter K principles, the Code does
provide analogous treatment of other widely held passthrough
entities. This section discusses the deficiency dividend rules
of section 860 of the Code under which the tax attributable to a
prior year's deficiency is borne by current investors. Under
these rules, a RIC or a REIT may declare a dividend in the year
in which a deficiency is finally determined with respect to a
prior year.1~ A deficiency dividend is treated as if it had been
paid in the prior year for purposes of determining the dividends" deduct~on of the RIC or RE IT f or t h
'
.
pa~d
e pr~or
year. 139 Th ~s
permits the RIC or REIT to ensure it has satisfied the applicable
minimum distribution requirements with respect to the prior year
and to avoid any corporate level tax for t h at year. 140 Th'~s
procedure places the cost of the prior-year deficiency on current
RIC or REIT shareholders. For example, assume that a RIC determines that for 1984 its ordinary income prior to allowance of a
deduction for dividends paid is $900. The RIC distributes $900
1~ I.R.C.
§
860( f ).
1~I.R.C.
§
860(a).
14° 1
. R. C.
§ 852 (a) (1) •
74
to shareholders, thus apparently reducing its taxable income to
zero. X, who owns 1 percent of the stock in the RIC, sells his
stock to Y on December 31, 1985. In 1986, when Y still owns the
stock, the RIC is determined to have understated its income for
1984 by $100. The RIC declares in 1986 a deficiency dividend of
$100, which is taken into account in determining the RICls
dividends-paid deduction for 1984 and allows the RIC to satisfy
the distribution requirement and to reduce its taxable income to
zero. If the RICls 1984 income had been properly reported, X
would have received a distribution of $1 more than he actually
received, and the value of XiS interest in the RIC would have
been correspondingly reduced by $1; therefore, the incorrect
reporting position permitted X to convert $1 of ordinary income
to capital gain on the sale of the stock. Meanwhile, the
distribution of the deficiency dividend causes y to recognize $1
of ordinary income in 1986 and creates an unrealized $1 capital
loss in yls RIC stock (assuming no other change in asset value).
Furthermore, interest and penalties with respect to the
deficiency must be Daid by the RIC, which further reduces the
value of yls stock.'4'
Under the deficiency dividend procedure, current
shareholders in a RIC or REIT bear the tax cost of a prior year
deficiency. While not providing an exact analogy to the
Partnership Collection Proposal or any of the alternatives, these
rules demonstrate that federal income tax already employs a
current assessment approach for certain passthrouqh entities.
G.
Audit Procedures
Under the Partnership Collection Proposal or any of the
alternatives discussed above, deficiencies with respect to widely
held partnerships would be determined and assessed on an entitywide basis rather than on a partner-by-partner basis. To
facilitate this process, it will be necessary to provide a new
audit system which is separate from and independent of the
current TEFRA partnership audit rules of Code sections 6221
through 6233. This new audit system would be applicable only to
widely held partnerships which are subject to current assessment,
and would not otherwise affect the application of the TEFRA audit
procedures. This section briefly outlines the approach to be
followed under such an audit system.
14'A RIC or REIT utilizing the deficiency dividend procedure
is subject to a penalty interest charge. Specifically, interest
and penalties are charged on the gross amount of the dividend,
rather than on the additional tax that would be imposed on
receipt of the dividend. I.R.C. § 860(c) (1).
75
In general, the authority of the TMP to act as the
partnership's representative in tax matters would be qreatly
expanded while the rights afforded each partner under the TEFRA
rules generally would be eliminated. Partners would be required
to report. consistently with the partnertpip return, and a penalty
would be 1mposed for failure to do so.
Notification of the
commencement of an administrative proceeding and of a final
adjustment would be provided only to the TMP, who would no longer
be required by the Code to keep partners informed of proceedings.
Partners would have no right to participate in administrative
proceedings. Partners would have no right to file suit
independently or otherwise participate in proceedings before a
court. They would have no right to seek a refund independently
with respect to a partnership item.
Only the TMP would be permitted to participate in the
decision to extend the statute of limitations. The TMP would
control any litigation relating to partnership deficiencies and
refund claims. Settlements of administrative or jUdicial proceedings with respect to partnership items could be made only by
the TMP, and would be binding on all partners. Thus, the TMP
would no longer have the option to refuse to bind other partners,
and other partners would no longer have the right to prohibit the
TMP from settling on their behalf. Naturally, it would be
necessary to provide protections for partners and the partnership
in the event a designated TMP failed to take certain actions or
in the event there was a conflict of interest between the TMP and
the other partners.
It is unlikely that the removal of these statutory rights
and protections would render individual partners powerless in the
determination of deficiencies. First, the TMP undoubtedly would
have a duty to treat other partners reasonably and fairly.
Second, it is likely that partnership agreements will replace
these statutory rights with comparable contract rights. ThUS, a
partnership agreement might require the TMP to keep all partners
informed of administrative or judicial proceedings. A partnership agreement might also provide for a committee to advise or
control settlement actions of the TMP. All partners might have
the right to .have some input through the committee in settlement
or litigation decisions. It is possible that such provisions
would complicate the task of the TMP, but if complexity is
l'2 It would be necessary to provide some type of relief from
the consistent reporting rule for taxpayers who receive a clearly
erroneous Form 1099-K (e.g., a Form l099-K incorrectly reflects a
partner's ownership of 60 partnership units rather than his or
her actual ownership of 50 units)., This,exception.w?uld apply
only if the partner disclosed the ~ncons~stent pos~t~on, and only
to items relating to a partner's pe:so~al tax position and not to
items relating to overall partnersh~p ~ncome.
76
inherent in the system it should burden the partnership and the
TMP rather than the Service.
These proposals would invest significant power and
responsibility in the TMP. This would in turn exacerbate the
problems that have been caused under normal TEFRA ~es where
there is confusion as to which partner is the TMP,
or where a
partner has been unwilling to serve as TMP.144 Furthermore, the
increased power of the TMP would add to the conflict
interest
issues that face the Service when it appoints a TMP.l
fl
By limiting the authority of each partner to act
independently of the partnership as to the reporting and
determination of partnership items, this type of audit system
would reflect the fact that a widely held partnership should be
treated as a single entity for purposes of deficiencies. Such an
audit system is essential to the implementation of the Partnership Collection Proposal or any of the alternative current
assessment approaches.
143 See . e.g., PAE Enterprises v. Commissioner, 55 TCM 875
(1988); Sente Investment Club v. Commissioner, 55 TCM 1565
(1988).
14'See. e.g., Computer Programs Lamba Ltd. y. Commissioner,
90
T.C. 1124 (1988).
145~ I.R.C. S 6231(a) (7); Rev. Proc. 88-16, 1988-1 C.B.
691.
SECTION VI.
A.
PENALTIES
Overview
A significant amount of the administrative cost and
difficulty in performing an audit of a widely held
partnersh1p stems from the fact that penalties are not
partnership1ifems and thus are not covered by the TEFRA audit
procedures.
Penalties must be applied to the partners
individually, and therefore must be asserted on a partnerby-partner ~t.Fis through the use of the statutory notice
procedures.
Furthermore, the assertion of penalties must
await the completion of the related TEFRA proceeding. 1.' The
implementation of a system for the efficient administration of
widely held partnerships should include provisions to facilitate
the imposition of penalties where appropriate.
logistica~
erroneous reporting position, as to a matter of either
law or fact, that leads to, the assertion of penalties in the
widely held partnership context is realistically the position
taken by the partnership. In almost all cases, a partner in a
widely held partnership will not have sufficient information to
reasonably take a position different from that of the partnership. The Partnership Collection Proposal and the alternative
current assessment approaches each represent a shift away from an
aggregate approach and towards an entity approach with respect to
the administration of widely held partnerships. Consistent with
this shift in focus, it is recommended both from the standpoint
of fairness and efficiency that penalties related to underpayments of tax by partners of widely held partnerships generally
be determined and imposed at the entity level.
An
B.
Accuracy-Related Penalty
1.
Background
The Omnibus Budget Reconciliation Act of 1989, Pub. L. No.
101-239 (the "1989 Act") consolidated into one part of the cf~e
the major penalties relating to the accuracy of tax returns. 9
The penalties consolidated as the "accuracy-related penalty" were
the negligence penalty, the substantial understatement penalty,
and the valuation penalties. These consolidated penalties were
1.'~ I.R.C. S 623l(a) (3).
14'I.R.C. S 6230(a) (2) (A) (i).
148N. C• F . Energy Partners v. Commissioner, 89 T.C. 741
(1987); Maxwell v. Commissioner, 87 T.C. 783, 792 (1986).
1.9 I.R.C. S 6662.
78
also coordinated with the fraud penalty.150 The accuracy-related
penalty is imposed at a rate of 20 percent and, as relevant to
widely held partnerships, applies to the portion of any underpayment that is attributable to (1) negligence, (2) substantial
understatement of income tax, or (3) substantial valuation
overstatement.
This section will discuss the accuracy-related penalty as
related to widely held partnerships. In general, it is
recommended that the penalty be determined at the partnership
level and imposed against the partnership. The amount of the
addition to tax would be determined by applying the 20 percent
penalty against the partnership underpayment attributable either
to negligence, substantial understatement or substantial valuation overstatement. The amount of the partnership underpayment
would be deemed to equal the product of the net adjustment to
partnership income or deductions multiplied by the maximum tax
rate (either individual or corporate) for the year of the final
determination.
2.
Negligence
If part of an underpayment is due to negligence or disregard
of rules or regulations, a penalty is impose? on the portion of
the underpayment attributable to negligence. 51 Negligence
includes any careless, reckless, or intentional disregard of
rules or regulations, as well as any failure to make a reasonable
attempt to comply with the provisions of the Code. 152 In
addition, the 1989 Act repeals the presumption under prior law
that an underpayment is attributable to negligence if the
underpayment is due to a failure to include on an income tax
return an amount shown on an information return.15~
Under current law, even following the enactment of the 1989
Act, the penalty for negligence is determined at the partner
level. This treatment seems inappropriate when applied to
partners of widely held partnerships who report their income
consistently with the partnership return. In that case, the
penalty relates to the position taken or course of conduct of the
partnership, and should be assessed at the partnership level and
collected from the partnership. In certain instances, however,
the penalty for negligence should continue to be imposed on the
lS0 I • R • C •
S 6663.
151 I • R • C • S 6662(b) (1).
152 I • R. C. S
6662
(c) •
153 Such presumption was formerly included in I.R.C.
S 6653 (9) •
79
partners directly. A partner of a widely held partnership
generally should be subject to a negligence penalty (and possibly
a fraud penalty in some cases) if he or she fails to report
partnership income on a return or takes a position on a return
that is inconsistent with that taken by the partnership. 5'
3.
Substantial Understatement of Income Tax
The accuracy-related penalty also applies to underpayments
attributable to a ··substantial understatement" of income tax. IS5
An understatement qenerally means the excess of the amount of tax
required to be shown on a return over the amount of tax which is
shown on the return. 156 A "substantial understatement" is
defined as an understatement that exceeds the greater of 10
percent of the tax required to be shown on the return or $5,000.
In the case of a corporation (other than an S corporation or a
personal holdinq comrany), the test is applied by substitutinq
$10,000 for $5,000. 1 7 As applied to a partner in a partnership,
the determination of whether an understatement exists and whether
that understatement is substantial is based on the partner's
individual or corporate overall tax liability, rather than on the
taxable income qenerated by the partnership.
The amount of the understatement is reduced by the portion
thereof attributable to (1) the tax treatment of an item as to
which there is or was substantial authority, or (2) any item with
respect to which there was adequate disclosure of the relevani58
facts on the return or in a statement attached to the return.
For this purpose, disclosure of the tax treatment of 1f/rtnership
items is generally made on the partnership's return.
The test
relating to adequate disclosure does not apply to a tax shelter
investment. The term "tax shelter" includes a partnership or
other entity whose principal purpose is the avoidance or evasion
15'As discussed above, it would be necessary to provide some
type of relief to a partner who receives an erroneous l099-K in
certain cases.
155 I • R • C4 S 6662(b) (2).
156 I • R • C • S 6662(d)(2).
157 I • R • C • S 6662(d)(1).
158 I • R • C • S 6662(d)(2)(B).
159Treas. Reg. S 1.6661-4(e). Because the statute has not
been changed on this point, the regulation probably reflects
current law. A partner may also make adequate disclosure with
respect to a partnership item by attaching a statement to his or
her return.
so
of federal income tax. In the tax shelter context, the taxpayer
must demonstrate that (1) sUbstantial authority exists or existed
for the position taken on the return, and (2) the taxpayer
reasonably believed that the position taken onl~s or her return
was more likely than not the correct position.
The determination of whether a partnership item is related to a tax shelter
is based
the principal purpose of the partnership, not the
1
partner.
with respect to tax shelters, the actions taken by
the partnership will be deemed to have been taken by the partner
and will be considered in deciding whether the partner reasonably
believes that the tax treatment of an item is more likely than
not the proper tax treatment. 162
fP
Under section 6664{c) (1), no accuracy-related penalty will
be imposed with respect to any portion of an underpayment if it
is shown that there was reasonable cause for such portion and
that the taxpayer acted in good faith. In the case of an understatement related to a partnership item, the good faith (or lack
thereof) eJ the partnership generally will be imputed to the
partner. 1
Most of the issues relating to the imposition of the
accuracy-related penalty related to substantial understatements
are resolved at the partnership level. In particular, the
partnership makes the determination as to whether a reporting
position is supported by substantial authority. Nevertheless,
the penalty currently is applied separately with respect to each
partner. In view of the administrative difficulties this treatment creates with respect to widely held partnerships, the
penalty for sUbstantial understatements (like the other relevant
parts of the accuracy-related penalty) should be treated as a
160 I
. R. C• S 6662(d)(2)(C).
161Treas. Reg. S 1.6661-5(a) (1) and (2).
162Treas. Reg. S 1.6661-5(e). In general, a taxpayer may
establish reasonable belief if (1) the taxpayer analyzes the
relevant facts and authorities and reasonably concludes that
there is a qreater than 50 percent likelihood that the tax
treatment will be upheld in litigation if challenged; or (2) the
taxpayer in qood faith relies on the opinion of a professional
tax advisor, provided the opinion is based on the tax advisor's
analysis of the pertinent facts and authorities and unambiquously
states that the tax advisor concludes that the tax treatment of
an item will be upheld if challenged. Treas. Reg.
S 1.6661-5(d).
163
Treas. Reg. S 1.6661-6(b). Any good faith imputed to a
partner as described above may be refuted by other factors
showing the partner's lack of good faith. ~
81
partnership item for partners of widely held partnerships, and
the partnership should in effect be treated as a taxpaying
entity.
Under either the Partnership Collection Proposal or the
other approaches, the penalty would be collected from the
partnershtf, and treated as a nondeductible expense by the
partners.
Determinations with respect to the reasonable cause
exception (and imposition of the penalty with respect to tax
shelters) would be made at the partnership level. For purposes
of applying the penalty to widely held partnerships, an
"understatement" would be defined as the net adjustment to
partnership income or deductions, multiplied by the highest
marginal rate under section 1 or section 11. The test applied
with respect to corporations in section 6662(d) (1) (B) (substituting $10,000 for $5,000 as the threshold level for an
understatement to be deemed substantial) would be used to
determinf,~hether the partnership would be subject to the
penalty.
4.
Substantial Valuation Overstatement
The accuracy-related penalty includes an addition to tax fOf
underpayments of tax attributable to valuation overstatements. 6
A valuation overstatement is deemed to occur if the value of any
property or its adjusted basis claimed on any return is 200
percent fr more of the amount determined to be the correct
amount. l 7 The valuation overstatement penalty does not apply
unless the underpayment of tax attributable to the valuation
overstatement exceeds $5,000 ($10,000 in the case of a
164Alternatively, under the partner collection method, the
penalty could continue to be payable by partners, although the
applicability of the penalty would be determined at the
partnership level.
l'5Because the penalty would be imposed at the partnership
level, income and deductions from a widely held partnership would
not be taken .into account in determining a partner's separate
liability for the penalty based on other investments.
16'Like other portions of the accuracy-related penalty, the
addition to tax for substantial valuation overstatements equals
20 percent of the underpayment.
167Under section 6662(h), the rate of the general accuracy
penalty is doubled (to 40 percen~) in the case of gr~ss valuation
misstatements. As relevant to w~dely held partnersh1ps, a gross
valuation misstatement is a valuation overstatement claimed on a
return that is 400 percent or more of the amount determined to be
the correct amount.
82
other than an S corporation or a personal holding
company). 8 A valuation overstatement by a partnership flows
through to the returns of the individual partners. Thus, an
underpayment of tax on an individual partner's return resulting
from a valuation overstatement by a partnership is treated as an
underpayment of tax attributable to a valuation overstatement.
As is generally the case with respect to the accuracy-related
penalty, no penalty will be imposed if it is shown that there was
a reasonable cause for the underpayment attributable to the
valuation or adjusted basis citJmed on the return and that such
claim was made in good faith.
corporati?~
The applicability of the accuracy-related penalty with
respect to valuation overstatements should be determined at the
partnership level with respect to widely held partnerships and
the penalty imposed on the partnership. Individual partners are
unlikely to have had any involvement in valuing partnership
property. Therefore, the valuation penalty should be a partnership item. Under this approach, for purposes of applying the
penalty to a widely held partnership, the term "underpayment"
would be defined to include the net adjustment to partnership
income and deduction attributable to a substantial valuation
overstatement by the partnership multiplied by the maximum tax
rate (either the individual or corporate rate). The underpayment
of tax attributable to sUbstantial valuation overstatements would
be subject to the $10,000 threshold generally applicable to
corporations under section 6662(e) (2). The partnership would be
treated as the taxpayer for purposes of determining whether the
reasonable cause exception of section 6664(c) should apply.
C.
Fraud Penalty
Under section 6663, if any portion of an underpayment is due
to fraud, a penalty is imposed equal to 75 percent of such
portion. The accuracy-related penalty is not to apply to any
portion of an underpayment on which the fraud penalty is imposed.
Like the accuracy-related penalty, the fraud penalty should be
assessed at the partnership level and collected from the
partnership.
168 l . R • C•
S 6662(e).
16'I.R.C. S 6664(c).
SECTION VII.
SCOPE OF THE PROPOSALS--DEFINITION OF A WIDELY HELD
PARTNERSHIP
The definition of a widely held partnership should satisfy
three criteria. First, it should cover partnerships with
numerous partners, because it is these partnerships that present
the most serious administrative difficulties under current law.
Second, it should provide a bright line, so that partnerships and
the Service will be able to determine with certainty whether any
given partnership is subject to the simplified reporting and
current assessment system. Third, the definition of a widely
held partnership should exclude service partnerships such as
accounting or law firms. In a service partnership, each partner
is likely to be an active member of the business, making full
entity treatment less appropriate. 70
The following definition should satisfy these criteria. A
widely held partnership is any f:artnership (i) with 250 or more
partners during a taxable yearl 1, and (ii) in which interests
are required to be registered under federal or state laws
regulating securities or have been sold under an exemption from
registration requiring the filing of a notice with a federal or
state agency regulating the offering or sale of securities. 72
In determining the number of its partners during a taxable
year, a partnership will be entitled to rely on the number of
partners properly reported to the partnership by nominees under
170Although all publicly traded partnerships will presumably
be treated as widely held partnerships, the uncertainty inherent
in the definition of a publicly traded partnership under section
7704 makes it unsuitable as a threshold test for application of
the proposals made herein. Moreover, there is a sizable
population of partnerships that have numerous partners but are
not publicly traded partnerships under section 7704.
171Pursuant to section 60ll(e) of the Code, the Service may
not require the filing of information returns by electronic or
magnetic media unless the filer is required to file at least 250
of the particular information return. Therefore, this appears to
be an appropriate bench mark for required participation in the
simplified reporting system.
172This definition is similar to that under the House
Proposal except that it is restricted to relatively large
partnerships. We believe the scope of the definition under the
House proposal was considerably broader than necessary.
84
section 603l(c}.173 Any partnership that actually has 250 or
more partners in a taxable year will be subject to audit under
the current assessment procedure, as well as any partnership that
' 1 '1 f'1ed sys t em. 17.
reports und er the s~mp
Partnerships with less than 250 partners may wish to enter
the simplified system. This would be acceptable as long as the
system is restricted to partnerships that have a relatively larqe
number of partners. The fewer the number of partners, the easier
it would be to take advantage of any variations in the calculation of taxable income resulting from the simplified system.
Therefore, partnerships with at least 100 partners should be
allowed to elect into the system.
A partnership that becomes subject to the simplified system,
either because it is a widely held partnership or because it
elects in, will be required to remain in the system unless it
receives permission of the Commissioner to be removed. It is
expected that such permission would be granted only in rare
cases, such as where a partnership suffered a severe diminution
in size. It may also be necessary to consider aggregation rules
for situations where series of partnerships are structured to
avoid the 250 partner limitation.
nominee holding a partnership interest on behalf of
another person during a partnership's taxable year is required to
furnish the partnership with the name, address, and taxpayer
identification number of the owner within one month of the close
of the taxable year. Temp. Treas. Reg. S 1.6031(c)-lT.
173A
17·A partnership might be subject to the widely held
partnership audit system and not the simplified reporting system
for a given year. This would occur if, for example, at the time
a partnership mailed Form 1099-Ks to its partners, it did not
have information indicating that it had at least 250 partners due
to lapses in nominee reporting. If it is subsequently determined
that the partnership had 250 or more partners in that year, the
partnership would be subject to the widely held partnership audit
system, but would not be required to file an amended return and
transmit Form 1099-Ks to its partners. It might be necessary to
provide a rule for situations in which the Service inadvertently
applies the wrong audit and assessment procedure under these
circumstances. Consideration should be given to whether any
other problems would result from a partnership being subject in a
single taxable year to the widely held partnership audit system
and not to the simplified reporting system.
SECTION VIII.
EFFECTIVE DATE CONSIDERATIONS
Effective date considerations differ somewhat for the
current assessment system and the simplified reporting system.
The simplified reporting system should probably apply to all
widely held partnerships as soon as practicable after the passage
of implementing legislation, taking into account the time
necessary for partnerships to develop new accounting and
reporting procedures.
There are a number of possible approaches to implementing
the proposed audit and assessment system for widely held partnerships. First, the new rules could be made effective only for
partnerships formed after a certain date. This would permit
partnerships to take the new rules into account in structuring
their partnership agreements. However, it would delay the true
effective date of the provision for many years. Such a delay may
be unacceptable in view of the Service's current difficulties in
administering widely held partnerships. Alternatively, the audit
and assessment system could be made applicable to audits
commenced after a given date. While this would make the rules
quickly applicable, it would place significant pressure on
determining the exact date an audit is commenced. It also might
be viewed as unfair to impose a new system on partnerships that
have not had any time to prepare for it. Therefore, the best
approach would be to make the prf~osal effective for taxable
years ending after a given date. 5 The date selected should
allow partnerships enough lead time to amend their partnership
aqreements should they choose to do so.
The simplified reporting system and the revised audit
procedures could be effective in differing taxable years, as the
implementation of either is not dependent on the other. However,
if the necessary lead time for the simplified reporting system is
comparable to that needed under the audit and assessment system,
both should be made applicable in the same taxable year.
reference to taxable years ending after rather than
before a given date is preferred due to occasional uncertainty
conc~rning the date a partnership's taxable year commences.
17S The
APPENDIX I
Proposals for Amendments to TEFRA Rules
The unified audit and litigation provisions that were
enacted with respect to partnerships as part of the Tax Equity
and Fiscal Responsibility Act of 1982 (TEFRA) and extended to S
corporations by the Subchapter S Revision Act of 1982, represented a radical change in the way that audits and litigation
relating to these entities and their investors were conducted.
As can be expected with respect to any change of this magnitude,
the transition has been difficult and the procedures have not
always worked in practice the way that they were envisioned.
However, we are in favor of retaining these provisions, at least
with respect to partnerships that would not be subject to the new
procedures recommended by this study. On the other band, based
upon our experience in administering these provisions, we
recommend that certain changes be made. A summary of the TEFRA
rules is provided in Appendix II.
1.
Boundary Issues
A SUbstantial problem area exists with respect to whether
the TEFRA partnership procedures or the regular deficiency
procedures apply to a particular taxable year, a particular
taxpayer, or a particular adjustment. This determination can be
very technical and difficult to make, and the consequences of an
incorrect choice can be severe because if the Service applies the
wrong procedure, the statute of limitations applicable to the
correct procedure may have expired by the time that the problem
is discovered. The situations giving rise to this problem are
generally described as presenting "boundary issues."
One example of a boundary issue arises in the context of the
small partnership exception contained in section 6231(a) (1) (B).
Pursuant to that section, the partnership audit provisions do not
apply to a partnership that has 10 or fewer partners, each of
whom is a natural person (other than a nonresident alien) or an
estate, and each partner's share of each partnership item is the
same as that partner's share of every other partnership item.
Several pitfalls exist in applying this provision. Specifically,
if an incorrect determination is made regarding whether there
were ever more than 10 partners in the partnership at anyone
time during the year, or whether a person is a nonresident alien,
or whether any special allocations were made during the year, the
Service may inadvertently apply the wrong procedures.
Similarly, boundary issues may be encountered as a result of
the operation of the special enforcement provisions of section
6231(c). For example, Temp. Treas. Reg.
SS 301.6231(a) (7)-1T(1) (4) and 301.6231(C)-7T(a) provide that
upon the filing of a petition naming a partner as a debtor in a
bankruptcy proceeding, that partner's partnership items are
converted to nonpartnership items, and if the debtor was the tax
2
matters partner (TMP), such status terminates. These rules are
necessary because of the automatic stay provision contained in 11
U.S.C. S 362. However, problems arise because the Service is not
auto~ati~allY notified of every bankruptcy filing.
When the
Serv1~e ~s unaware that a partner is in bankruptcy, the service
may m1s~akenly treat the debtor as a party to a partnership
proceed1nq and allow the statute of limitations with respect to
the partner's nonpartnership items to expire. In such a case, a
st~tu~ory no~ice of deficiency adjusting the converted partnerSh1P 1tems w1ll be barred, even though the Service could have
timely issued such a notice if the Service had been aware of the
bankruptcy filing. Likewise, if unbeknownst to the Service the
TMP goes into bankruptcy, the Service may issue a notice of final
partnership administrative adjustment (FPAA) to the bankrupt TMP,
which may be determined to be invalid because the debtor's status
as TMP was automatically terminated by the filing of the
bankruptcy petition.
Another boundary issue arises in the context of tiered
partnerships. In particular, if the source (operating) partnership is non-TEFRA and the tier (investor) partnership is
TEFRA, or vice versa, it is unclear whether the TEFRA procedures
or the deficiency procedures should be applied. The Service has
taken the position that it is the source partnership's status
that controls with respect to any adjustments relating to items
flowing from the source partnership. However, to the extent that
the tier partnership generates income or expense items attributable to its own activities, any adjustment to those items must
be made at the tier level. When dealing with multiple tier
situations, such determinations are very difficult and mistakes
are bound to be made. As a result, many of these adjustments may
be in jeopardy if it is subsequently determined that the wrong
procedures were applied. To alleviate this problem, the interplay between the TEFRA and deficiency procedures in the context
of tiered partnerships should be clarified.
As the above discussion illustrates, boundary issues present
hidden traps and create substantial administrative difficulties
for the Service, which must frequently decide at its peril
whether to apply the TEFRA procedures or the deficiency procedures and run the risk that if it chooses incorrectly, the
adjustments may be barred. Since the revenue loss may be substantial, we recommend that legislation be enacted which would
mitigate the effect of boundary issues. One approach would be to
resolve each boundary issue separately. If that is not feasible,
another approach would be to provide that if the Service erroneously makes a determination regarding the proper procedure to
apply and timely issues the appropriate n~tice in acc~rdance with
that determination, i.e., a statutory not1ce or ~ not1ce of,FPAA,
then the statute of limitations for assessment w1ll not exp1re
before 1 year after a court determines that the wrong procedure
was followed and that determination becomes final. A legislative
3
proposal along these lines is attached. One potential benefit to
this latter approach is that it will cover all boundary issues,
even those that have not yet been identified. As a result, this
approach should eliminate the need to seek additional legislation
concerning boundary issues in the future, if new boundary issues
are identified.
Additionally, we have two proposals concerning
partnership exception that should reduce the number
ships that are subject to the unified, entity-level
and eliminate some of the boundary issues discussed
the small
of partnerprocedures
above:
A. The "natural person (other than a nonresident alien) or
an estate" requirement should be eliminated from section
6231(a) (1) (B) (i) (1) and replaced with a "no pass-thru entity"
requirement. Under this proposal, a partnership with 10 or fewer
partners that has a subchapter C corporation as a partner would
still qualify for the small partnership exception, but a partnership having an S corporation, a trust, another partnership
(tier), or a nominee as a partner would not be eligible for the
exception.
B. The same share requirement contained in section
6231(a) (l)(B) (i)(ll) should be eliminated. When dealing with a
partnership that has 10 or fewer partners, we do not believe that
the mere existence of a special allocation causes sufficient
problems to warrant subjecting the entire partnership to the
TEFRA procedures. It should be recognized, however, that if this
proposal is adopted, a potential for inconsistent treatment of
partners may be created if a reallocation of items becomes
necessary.
2.
Treatment of Partnership Items in Deficiency Proceedings
In Munro v. Commissioner, 92 T.C. 71 (1989), the Tax Court
upheld the validity of a statutory notice that disallowed net
losses from TEFRA partnerships before computing the deficiency
amount, but ruled that it was impermissible for the Service to
disallow the partnership losses in the statutory notice even if
this was done solely for computational purposes and was not
intended to be a substitute for issuing a notice of final
partnership administrative adjustment (FPAA) as required by
section 6225. The court held that the partnership items (whether
income, loss, deduction or credits) included on a taxpayer's
return should be completely ignored in determining whether a
deficiency exists that is attributable to nonpartnership items.
Hence, under Munro, the Service may not assume the correctness of
its proposed adjustments to partnership items for computational
purposes in determining a deficiency, and taxpayers may not
offset net partnership losses against their taxable income for
purposes of deficiency proceedings.
4
Prior to the Munro case, it was the Service's practice to
treat all partnership items as if they were correctly reported
for purposes of the deficiency proceeding· under Munro the
partnership items a~e el~minated from the'taxpayer's r~turn.
However, in Munro s~tuat~ons, where the taxpayer is oversh~ltered, i.e., losses entirely offset the taxpayer's income,
th~s procedure would not have permitted any adjustment to the
nonpartnership items. It was these unusual facts that led to the
Munro opinion.
In most of the cases that are either currently in litigation
or under audit, net losses from TEFRA entities are claimed and
used to only partially offset income from non-TEFRA sources.
Since under normal circumstances the TEFRA proceeding progresses
more slowly than the deficiency proceeding, computing the
deficiency under Munro will result in a greater deficiency being
asserted in the deficiency proceeding than would have been
asserted under the Service's practice prior to the Munro opinion.
Consequently, under Munro, the taxpayer will not get the benefit
of the partnership losses until the losses are determined to be
allowable in a TEFRA proceeding, even though the factual scenario
that gave rise to the Munro opinion is relatively unusual.
While we believe that the Tax Court's opinion is technically
correct in that the deficiency procedures and the TEFRA procedures were intended to be totally separate, the solution proposed
by the Tax Court is unworkable as a practical matter. In the
typical case, computing the tax liability without reference to
partnership items will have the same effect as though those
partnership items were disallowed. If the partnership items were
losses, the effect will be a greatly increased deficiency for the
nonpartnership items. If, when the partnership proceeding is
completed, the partner is ultimately allowed any part of the
losses, the partner will receive part of the increased deficiency
back in the form of an overpayment. However, in the interim, the
partner will have been subject to assessment and collection of a
deficiency inflated by items still in dispute in the partnership
proceeding. In essence, implementation of MUnro in the typical
case means loss of a prepayment forum for TEFRA partnership
adjustments •. As a policy matter, we view this result.as an
inappropriate and unintended consequence of implement~ng Munro.
In light of the above, and other problems which have been
identified with respect to the implementation of Munro, we
strongly endorse the legislative proposal that has been worked
out with the staffs of the Joint committee and House Legislative
Counsel. In essence, this proposal would enable the Service to
continue using its prior practice for most cases but provides a
special rule covering oversheltered situations such as existed in
Munro. with respect to the oversheltered cases, the proposal
provides that partnership items shall be disregarded in determining whether a deficiency exists for purposes of the deficiency
5
proceeding and any adjustment in that proceeding shall be taken
into account in determining the amount of any computational
adjustment following the completion of the partnership
proceeding. A copy of this proposal is attached.
3.
Relationship Between the Limitations Periods Provided
By sections 6229 and 6501
section 6501 provides a limitations period with respect to
any tax imposed by title 26. This period is determined with
reference to the filing of the taxpayer's return. section 6229
provides a limitations period with respect to any tax imposed by
subtitle A that is attributable to any partnership item or
affected item. This period is determined with reference to the
filing of the partnership's return. Under the existing statutory
scheme, it is unclear whether these two sections create separate
statutes of limitations, i.e., section 6501 applies with respect
to nonpartnership items and section 6229 applies with respect to
partnership and affected items, or whether section 6229 simply
extends the limitations period with respect to partnership and
affected items in situations where the section 6501 period has
otherwise expired. since both of these interpretations are
supportable under current law but each approach presents conceptual difficulties, legislation clarifying this area should be
enacted. In addition, the issue of whether an extension of the
statute of limitations that is obtained pursuant to section
6501(c) (4) and does not make specific reference to partnership
items applies to partnership items that subsequently convert to
nonpartnership items, should also be addressed.
4.
Suspension of the Statute of Limitations During the
Pendency of Bankruptcy Proceedings
As discussed with respect to the boundary issues, a
partner's partnership items convert to nonpartnership items upon
the filing of a petition naming the partner as a debtor in a
bankruptcy proceeding. Section 6229(f) provides that the period
for assessing tax with respect to items that convert to nonpartnership items shall not expire before the date which is 1 year
after the date that the items become nonpartnership items.
Section 6503(i) provides for the suspension of the limitations
period during the pendency of a bankruptcy proceeding. However,
this provision only applies to the limitations periods provided
in sections 6501 and 6502. Since the limitations period
pertaining to converted items is governed by section 6229(f)
rather than section 6501, the suspension of the limitations
period provided by section 6503(i) will not apply with respect to
partnership items that convert to nonpartnership items by reason
of the filing of a petition naming the partner as a debtor in a
bankruptcy proceeding. As a result, the limitations period will
continue to run during the pendency of the bankruptcy proceeding,
notwithstanding that the Service is prohibited from making an
6
assessment against the debtor because of the automatic stay
imposed by section 362(a} of the Bankruptcy Code. Moreover,
under certain circumstances it is possible for the normal 3 year
l~m~tat~ons per~od to be shortened to 1 year or for the
11m1tat10ns pe~10d to arguably expire prior to the filing of the
return for a g1ven year. Consequently, either a provision
similar to section 6503(i) should be enacted to cover the
.
limitations period provided in section 6229(f} or section 6503(i)
should be amended to extend the suspension provision to the
section 6229(f) period. The suspension provision should also be
extended to the limitations period provided in sections 6229(a)
and 6229(d) relating to the time for making a computational
adjustment following default or judicial review of a notice of
final partnership administrative adjustment (FPAA).
5.
Exclusion of Partial Settlements From the 1 Year
Assessment Period
section 6231(b) (1) (e) provides that the partnership items of
a partner for a partnership taxable year shall become nonpartnership items as of the date the Service enters into a settlement
agreement with the partner with respect to such items. As discussed previously, under section 6229(f), the limitations period
for assessing any tax attributable to converted items shall not
expire before the date which is 1 year after the date on which
the items become nonpartnership items. This rule creates a
problem in situations where a settlement agreement is entered
into with respect to some but not allot the issues in the case.
The reason for this is that a 1 year assessment period will apply
with respect to the settled items whereas the remaining items
will be governed by the normal assessment period under section
6229(a). If issues are settled at several different stages of
the proceeding, the problem can become severe.
The fractured statute problem can be illustrated by the
following example:
Assume that five issues are raised in connection with the
examination of the 1984 return for the ABC Partnership. While
the case is still being handled by the Examination function, the
Service and all partners enter into a specific matters closing
agreement whereby all parties agree that a deduction was erroneously claimed. The case then goes to Appeals where the service
concedes the second issue. After the case is docketed but before
the trial, the parties settle the third adjustment. Pursuant to
a court order, the parties file a stipulation of Settled Issues
with the court evidencing their agreement with respect to the
third adjustment. The remaining two issues are tried but the
partnership concedes the fourth issue on brief. The last issue
is decided by the court.
7
Under the above scenario, the partners in the ABC
Partnership will be subject to five different limitations
periods for assessment with respect to their investment in the
ABC partnership for the 1984 taxable year. Making five separate
computations with. respect to each partner for a single taxable
year is extremely burdensome and creates a drain on the Service's
limited resources. Moreover, the fractured statute poses a
significant tracking problem for the service, which may result in
many, if not most, of the assessments not being made within the
relevant time period. On the other hand, if the assessments are
timely made, the partners in the ABC partnership may become
angered or confused when they receive multiple notices of
assessment with respect to the same taxable year.
In light of the above, it is recommended that even though
partnership items covered by a settlement agreement will convert
to nonpartnership items, if the agreement constitutes only a
partial settlement, it should not trigger a 1 year assessment
period. Instead, legislation should be enacted to provide that
the 1 year assessment period will not begin to run until all
issues in the case are disposed of. As applied to the above
example, this would not occur until the decision of the court
became final. One possible way to accomplish this may be to
provide that for purposes of the statute of limitations on
assessment, a settlement must be comprehensive, i.e., if a
settlement is limited to selected items, it will not be treated
as a settlement, and hence, it will not commence a 1 year
assessment period with respect to those settled items. On the
contrary, the assessment period with respect to the settled items
will be governed by section 6229(a). Thus, the assessment period
with respect to the settled items will be the same as the
assessment period for the items that have not been settled.
6.
Forum For Contesting the Applicability of the Increased
Rate of Interest Under Section 6621(c)
section 6621(c) provides for an increased rate of interest
with respect to any substantial underpayment attributable to tax
motivated transactions. Jurisdiction to determine the applicability of section 6621(c) was granted to the Tax Court in
section 6621(c)(4), but said jurisdiction is limited to those
proceedings in which the Tax Court also has jurisdiction over the
deficiency to which the increased rate of interest relates. When
the issue arises in connection with an investment in a TEFRA
partnership, the applicability of section 6621(C) is treated as
an affected item that requires partner-level determinations. As
a result, under section 6230(a)(2), the application of section
6621(c) must be determined in separate proceedings at the partner
level following the completion of the partnership-level
proceeding. Unfortunately, since in an affected item proceeding
the Tax Court does not have jurisdiction over the underlying
deficiency, the Tax Court similarly lacks jurisdiction to
8
determi~e the ~ppl~cability of section 6621(c) in such a
proceed~ng.
L1kew1~e, a par~ner cannot contest the applicability
of sect10n 6621(c) 1n a sect10n 6230(c) refund suit because such
actions are es~en~ially limited to computational disputes.
consequently, 1t 1S recommended that a judicial forum be provided
for partners to challenge the imposition of the increased rate of
interest und~r section 6621(c) relating to deficiencies attributable to the1r investment in a TEFRA partnership. It is noted,
however, that if proposal 13 regarding the determination of
penalties and the increased rate of interest at the partnership
level is adopted, no further action with respect to this proposal
will be necessary since a forum under section 6230(c) will be
provided.
7.
Forum For Raising Innocent Spouse pefense
Under section 6013(e), an innocent spouse may be relieved of
liability for tax, penalties and interest if certain conditions
are met. However, existing law does not provide the spouse of a
partner in a TEFRA partnership with a judicial forum to raise the
innocent spouse defense with respect to any tax or interest that
relates to an investment in a TEFRA partnership. Since the
innocent spouse defense requires SUbstantive determinations, a
refund suit under section 6230(c) would not be permissible.
Similarly, since innocent spouse is an affirmative defense that
will only be raised by a taxpayer, the taxpayer will only be able
to assert the defense in the Tax Court if the Service issues an
affected items statutory notice to the taxpayer. If such a
notice is not issued to the taxpayer, there does not appear to be
a judicial forum available in which to raise the innocent spouse
defense. Accordingly, it is recommended that a judicial forum be
provided for a spouse of a partner in a TEFRA partnership to
raise the innocent spouse defense insofar as it relates to a
liability that is attributable to an investment in the TEFRA
partnership.
8.
Suspension of the Statute of Limitations Upon the
Filing of an Untimely Petition
In a deficiency case, section 6503(a) provides in pertinent
part that if a proceeding in respect of the deficiency is placed
on the docket of the Tax Court, the period of limitations on
assessment and collection shall be suspended until the decision
of the Tax Court becomes final, and for 60 days thereafter. The
counterpart to this provision with respect to TEFRA cases is
contained in section 6229(d). That section provides in pertinent
part that the period of limitations shall be suspended ~or the
period during which an action mar be brought,under s~ct10n 6226
and, if an action is brought dur1ng 8ueb per10d, unt1l the
decision of the court becomes final, and for 1 year thereafter.
As a result of this difference in language, the running of the
statute of limitations in a TEFRA case will only be tolled by the
9
filing of a timely petition whereas in a deficiency case, the
statute of limitations is tolled by the filing of any petition,
regardless of whether the petition is timely. Consequently, if
an untimely petition is filed in a TEFRA case, the statute of
limitations can expire while the case is still pending before the
court. To prevent this from occurring, the Service must make
assessments against all of the investors during the pendency of
the action and if the action is in the Tax Court, presumably
abate such assessments if the court ultimately determines that
the petition was timely. Hence, the statute creates a trap for
the unwary and necessitates an inefficient use of resources on
the part of the Service. Accordingly, section 6229(d) ahould be
amended to make the suspension provision concerning the filing of
petitions in TEFRA cases consistent with the rule under section
6503(a) pertaining to deficiency cases.
9.
Administratiye Adjustment Requests
A.
Refund Suits Under section 6228
(BAA>
Section 6230(a) (2) (A) (ii) provides that deficiency
procedures apply to items which have become nonpartnership items.
An exception to this rule is provided with respect to items that
convert by reason of a settlement agreement. Pursuant to section
6231(b) (1) (B), a partner's partnership items become nonpartnership items upon the filing of a suit under section 6228(b).
Since items that convert pursuant to section 6231(b) (1) (B) will
already be the subject of a judicial proceeding, the deficiency
procedures should not apply. Accordingly, this situation should
be excluded from the rule under section 6230(a) (2)(A)(ii).
B.
Extension of Time Within Which to File an
BAA
section 6227(a) provides that a partner may file a request
for an administrative adjustment of partnership items within 3
years after the later of the date of the filing of the partnership return or the last day for filing the partnership return
(determined without regard to extensions), but before the service
mails a notice of FPAA to the TMP. section 6511(c) provides that
if an agreement is entered into under section 6501(c) (4) to
extend the period for assessment, the period for filing a claim
for credit or refund or for making a credit or refund if no claim
is tiled, shall not expire prior to 6 months after the expiration
of the period within which an assessment may be made pursuant to
the agreement under section 6501(C)(4). It is recommended that a
provision similar to section 6511(c) be enacted with respect to
the filing of an RAA where an agreement extending the statute of
limitations relating to partnership and affected items is entered
into under section 6229(b).
10
C.
Allowance of Credits or Refunds After the Expiration of
the Time For Filing an BAA
The rules pertaining to credits or refunds attributable to
partnership items and affected items are set forth in sections
6227, 6230(c) and 6230(d). These rules are fairly complex. As a
result, there is confusion regarding the allowance of credits or
refunds where no RAA has been filed and the time for doing so has
expired, but the statute of limitations under section 6229 is
still open or the time for filing a claim or suit under section
6230(c) has not yet expired. This situation frequently occurs
when the TMP extends the statute of limitations under section
6229 and after the time for filing an RAA has expired, a partner
makes an advance payment of tax to stop the running of interest.
Under these circumstances, it appears as if a partner should be
able to obtain a credit or refund, but it is unclear from the
statute whether the making of such a credit or refund would be
permissible. Consequently, it is recommended that this point be
clarified.
D.
RAAs Filed By the Tax Matters Partner in Overpayment
situations
section 6227(b) (1) provides that if the TMP files an RAA on
behalf of the partnership and requests substituted return
treatment, the Service may treat the changes shown on the request
as corrections of mathematical or clerical errors appearing on
the partnership return. If an RAA filed by the TMP on behalf of
the partnership is not treated as a substituted return, under
section 6227(b) (2) the Service may, without conducting any
proceeding, allow or make to all partners the credits or refunds
arising from the requested adjustments; conduct a partnership
proceeding; or take no action on the request. In light of the
above, it appears as if substituted return treatment is only
available where additional tax is due; if the requested
adjustments would give rise to a credit or refund for the
partners, the RAA must be handled under section 6227(b)(2). It
is unclear, however, whether in an overpayment situation the
partners' right to a credit or refund is protected by the filing
of an RAA by the TMP, or whether the partners must file separate
RAAs in order to preserve their respective rights to file a
refund suit under section 6228. Section 6228(a) (4) seems to
indicate that the partners are protected if the request is not
allowed and the TMP files suit, since the partners will be
treated as parties to the action and they are e~titled to
participate. On the other hand, it,appears as 1f ~e part~ers
will not be protected if the TMP fa1~s to timelr f1l~ a sU1t
since only the TMP is permitted to flle a peti~lon Wlth respect
to an RAA filed under section 6227(b). Accordlngly, it is
recommended that the partners be provided with an add~tional
period of time within which to file a petition regardlng the RAA,
in the event that the TMP fails to file such a petition. This
11
would be similar to the provisions under section 6226 concerning
the filing of a petition with respect to a notice of FPAA. Such
a rule would be beneficial both to the partners and the Service
because it would eliminate the need for the partners to file
separate RAAs and the Service would not have to expend its
limited resources processing those requests.
10.
Application of Section 6223(e) in the context of a
Tiered Partnership
If the service fails to provide a notice of the beginning of
an administrative proceeding (NBAP) or a notice of final partnership administrative adjustment (FPAA) to a partner who ia
entitled to such notice, section 6223(e) permits the partner to
make certain elections. In a tiered partnership, the pass-thru
partner (tier) will normally be a notice partner. Under current
law, it is unclear whether the section 6223(e) election may be
made by the pass-thru partner and would be binding on the
indirect partners (the investors in the tier) or whether the
indirect partners are entitled to make separate elections.
Additionally, if both the tier and an indirect partner make
elections, it is unclear which election should be given effect.
Thus, legislation clarifying these points would be helpful. In
this regard, it is noted that sections 6224(c) (1) and 6224(c) (3)
provide rules concerning the effect of settlement agreements
entered into by a pass-thru partner or the tax matters partner
(TMP) on indirect partners and nonnotice partners, respectively.
Similar rules pertaining to section 6223(e) elections may be
appropriate.
11.
Application of the TEFRA Partnership Provisions to a
Partner WhO is a Member of a Consolidated Group
When a partner in a TEFRA partnership is a member of a
consolidated group, several problems arise if the partner is not
the common parent of the members of the consolidated group. The
primary reason for this is that Treas. Reg. S 1.1502-77 provides
that the common parent is the sole agent for each subsidiary in
the group with respect to all matters relating to the tax
liability for the consolidated return year, and that no subsidiary shall have the authority to act for or to represent
itself in any such matter. On the other hand, the TEFRA
partnership provisions grant many rights to the tax matters
partner (TMP), such as the authority to extend the statute of
limitations on behalf of all partners and to enter into a
settlement agreement that may bind certain other partners. In
this regard, it is noted that the other members of the consolidated group are treated as partners under section 6231(a) (2) (B)
because their income tax liability will be determined in part by
taking into account indirectly partnership items of the TEFRA
partnership. Hence, in light of these conflicting provisions, it
is unclear whether the actions taken by the TMP will be binding
12
on t~e c~nsolidated group. Some guidance concerning the proper
appl1cat~on of the TEFRA partnership provisions in this context
would be helpful.
12.
Dismissal of Premature Petitions
s~ction 6226 sets forth the rules concerning judicial review
of not~ces of final partnership administrative adjustment (FPAA).
Pursuant to section 6226(a), the tax matters partner (TMP) is
given the exclusive right to file a petition for a readjustment
of partnership items within the gO-day period after the issuance
of the notice of FPAA. Pursuant to section 6226(b) (1), if the
TMP does not file a petition within the gO-day period, notice
partners are permitted to file a petition within the 60-day
period after the close of the gO-day period. If more than one
petition is filed under section 6226(b), that section sets forth
ordering rules for determining which action goes forward and
provides in paragraph (4) for the dismissal of all other actions.
section 6226(h) provides that if an action is dismissed other
than under subsection (b) (4), the dismissal shall be treated as a
determination that the notice of FPAA is correct. This provision
creates a problem in cases where a petition is filed within the
90-day period by a person who is not the TMP. Since such a
petition is filed under section 6226(a) rather than under section
6226(b), the dismissal is technically not pursuant to section
6226(b) (4). Hence, pursuant to section 6226(h), the dismissal of
the premature petition would have the effect of upholding the
notice of FPAA. Such a result is inappropriate. Consequently,
it is recommended that legislation be enacted to correct this
inequity, which clearly was not intended.
13.
Determination Qf Penalties at the Partnership Level
section 6231(a) (3) limits the definition of partnership
items to those items required to be taken into account UDder any
provision of .ubtitle A. Since penalties are contained in
subtitle F, they cannot be partnership items. Instead, penalties
are treated as affected items that require partner-level
determinations. As a result, under section 6230(a)(2), penalties
may only be asserted against a partner through the application of
the deficiency procedures following the completion of the
partnership-level proceeding. These penalty only cases create an
undue burden for the Service and have the potential of si9Oificantly increasing the Tax Court's inventory., Mor~over, the
requirement of conducting a separate proceed~ng W1th each partner
greatly increases the likelihood of disparate,t:eatment. Hence,
the major goals of the TEFRA partnership pro~~s10ns, namely
administrative and judicial economy and cons1stent treatment of
partners, are not being accomplished with respect to penalties
that are attributable to an investment in a TEFRA partnership.
Accordingly, it is recommended that p~nalties be determined at
the partnership level and imposed aga1nst the partners as a
13
computational adjustment. However, it is also recommended that
section 6230(c) be amended to provide the partners with a refund
forum to raise any partner-level defenses that they may have with
respect to the imposition of the penalty. This proposal should
also be made applicable to the increased rate of interest under
section 6621(c).
14.
Repeal of the Unified Procedures For S corporations
The Subchapter S Revision Act of 1982 added aectiona 62416245 to the Code. These provisions generally made the unified
audit and litigation procedures for partnerships applicable to
S corporations. Notwithstanding the repeal of General utilities
as part of the Tax Reform Act of 1986, which has made the use of
S corporations more popular, the Service is in favor of repealing
the unified procedures for S corporations. Historically,
S corporations have not generally been used as a vehicle to
market abusive tax shelters and the Service did not experience
any significant difficulties in auditing S corporations or
litigating at the shareholder level. Furthermore, for
S corporation taxable years the return for which is due on or
after January 30, 1987 (determined without regard to extensions),
Temp. Treas. Reg. S 301.6241-1T(c) (2) provides for a small
S corporation exception for S corporations with five or fewer
shareholders, and it is our understanding that the vast majority
of both existing and newly formed S corporations qualify for that
exception. Hence, it appears as if the repeal of the unified
procedures for S corporations is justified.
14
section 6229 PERIOD OP LIMITATIONS POR MAKING ASSESSMENTS.
*
*
*
(h) Special Rule When Secretary Brroneou.ly applies
Deficiency Proce4ur••• - If the Secretary erroneously determines
that subchapter C of this chapter does not apply to a partnership
taxable year and consistent with that determination timely mails
a notice of deficiency to a partner pursuant to sections 6212 and
6501, which includes adjustments to partnership items (or
affected items) of the partnership, the period of limitations
provided in this section shall not expire before the date which
is 1 year after the date that the determination of a court that
the incorrect procedure was followed becomes final.
section 6501 LIMITATIONS OH ASSBSSKENT AND COLLECTION.
*
*
*
Redesignate existing subsection
following:
(0)
as (p) and insert the
(0)
Special Rule When Secretary Erroneously Hakes
Administrative A4justment.- If the Secretary erroneously
determines that subchapter C of chapter 63 applies to a
partnership taxable year and consistent with that determination
timely mails a notice of final partnership administrative
adjustment to the tax matters partner with respect to that
taxable year pursuant to sections 6223 and 6229, the period of
limitations for assessing any tax which is attributable to the
partnership items (or affected items) of the partnership shall
not expire before the date which is 1 year after the date that
the determination of a court that the incorrect procedure was
followed becomes final.
15
Section 6230
ADDITIONAL ADMINISTRATIVE PROVISIONS.
(a) Coordination with Deficiency procee4inqa.-
*
*
*
( 3 ) TREATKDT OP PARTNERSHIP ITBKS III DD'ICIDlCY
PROCEEDINGS.-(A) III GBHZRAL.--In determininq whether there is a
deficiency for purposes of subchapter B, except as provided in
paragraph (2) (A), adjustments to partnership items.ay be .ade
only as provided in this subchapter.
(B) SPECIAL RULES.-(i) III GIIIBRAL.--In any case in which the
taxpayer's return shows a loss or no taxable income and shows a
net loss from partnership items, solely for purposes of
proceedings conducted under subchapter B, partnership items shall
be disregarded in determining whether there is a deficiency. Any
adjustment in such proceedings shall be taken into account in
determining the amount of any computational adjustment.
(ii) EXCBPTIOII POR CZRTAIII ITBKS.--Clause (i)
shall not apply to any partnership item the treatment of which
has been finally determined under this subchapter.
BPPECTIVB DATB--This amendment shall take effect as if such
amendment had been included in the amendments made by section 402
of the Tax Equity and Fiscal Responsibility Act of 1982.
APPENDIX II
Description of TEFRA Rules
Prior to the enactment of unified partnership audit rules by
the,Tax Equi~y and Fis~al Responsibility Act of 1982, adjustments
to 2tems of.2ncome, ga2n, loss, deduction and credits relating to
a partn~rsh2p had to be made in separate proceedings with the
respect2ve partners. Similarly, settlements and judicial determinations were only binding on those partners that were parties
to the agreement or judicial proceeding. This system was not an
efficient means of auditing tax shelters and other large partnerships, because each partner was entitled to separate administrative and judifial review of partnership items that were common
to all partners.
The TEFRA partnership audit rules consolidate
the administrative and judicial review of all partnership items
at the partnership level. Congress, noting the potential conflict between investors and tax shelter promoters, balanced the
consolidated audit provisions with considerable protections for
individual partners.
The TEFRA partnership audit rules apply to all
partnerships, except for partnerships with ten or fewer partners
where each partners' share of any partnership item is the same as
his share of every other item (i.e., there are no special
.
allocations) and each partner i8 a natural person (other than a
nonresident alien) or an estate. 2 The tax treatment of all
partnership items is determined at the partnership level. 3
Generally, all partners must treat items on their individual
returns consistently with the treatment of those items on the
partnership return unless they notify the Service of an
1~ General Explanation of the Revenue Provisions of the
Tax Equity and Fiscal Responsibility Act of 1982, at 267-68
(hereinafter referred to as "TEFRA General Explanation").
. R • C• 5 6231(8) (1) (B). All partners of a partnership for
the partnership taxable year under audit generally are subject to
the TEFRA partnership audit rules. However, under certain
circumstances, the inclusion of a partner in a unified proceeding
would interfere with efficient enforcement of the tax law.
I.R.C. S 623l(c). When special enforcement considerations exist
with respect to 8 partner, that partner's partnership items will
be treated as nonpartnership items and the partner is removed
from the partnership proceeding. Examples of special enforcement
situations include the filing of a bankruptcy petition naming a
partner as the debtor or the criminal investigation of a partner.
~.; Temp. Treas. Reg. 5S 30l.623l(c)-4T through 8T.
2I
3
I.R.C. S 6221.
2
inconsistent treatment.' If a partner takes an inconsistent
position on his or her return and does not provide notice of the
inconsistency, the Service may immediately assess any deficiency
necessary to make the partner's treatment consistent with the
partnership return. Such an fssessment would normally also
include a negligence penalty.
The central figure in a TEFRA partnership proceeding is the
tax matters partner ("TMPtt). The TMP is a representative of the
partnership who serves as a liaison between the partnership, the
Service and the court, with respect to the unified audit and
litigation proceedings regarding the tax treatment of partnership
items attributable to the partnership. As such, the TMP serves
as the focal point for service of all notices, documents and
orders on the partnership, and concomitantly has many rights and
duties both at the administrative stage of the proceeding and in
the course of litigation. The TMP is the general partner designated by the partnership to serve as the TMP or, if there is no
such designation, the general partner having the largert profits
interest as of the close of the taxable year involved.
If the
Service determines that is impracticable to apply the largest
profits interest ,ule, the Service may select any partner to
serve as the TMP.
Each partner is entitled ti participate in all aspects of
the administrative proceedings.
If the Service decides to
initiate a partnership audit, it must furnish both a notice of
the Beginning of an Administrative Proceeding and a notice of
Final Partnership Aiministrative Adjustment to all partners
entitled to notice.
In partnerships with more than 100
partners, only identified partners with a one percent or greater
interest in partnership profits, and designated members of
,I.R.C.
5
S 6222(a) and (b).
I.R.C. S 6222(c) and (d).
~
I.R.C. S 6662(b)(1).
'I.R.C. S 6231(a)(7); Temp. Treas. Reg.
S 301.6231(a) (7)-lT.
7~; ~ Rev. Proc. 88-16, 1988-1 C.B. 691.
8
I.R.C. S 6224(a).
'I.R.C. S 6223(a). Those partners entitled to receive
notice from the Service are generally referred to as "notice
partners." The partners who are not entitled to receive notice
from the Service are referred to as "non-notice partners."
3
"notice groups,"10 are entitled to notice from the Service. ll
All other partners are
be kept informed of the partnership
proceedings by the TMP.
if
The TEFRA partnership audit rules provide the TMP with the
power to make certain decisions on behalf of the partnership.
The period for assessing any tax with respect to any partner that
is attributable to any partnership item (or any item affected by
a partnership item) does not expire before the date that ia three
years after the later of the due date determined WithYft extension or actual filing date of the partnership return.
The TMP
has the a~thority to extend that period with respect to all
partners.' The TMP also has the authority to enter into a
settlement aqreement that binds all non-notice partners,
although any partner may, by notifying the servife, refuse to be
bound by any aqreement entered into by the TMP.
The T.MP may
file an administrative adjustment request (the functional
equivalent of anltmended return or claim for refund) on behalf of
the partnership.
The TMP may also select the forum for litigation by filing a petition, during the first gO days following the
mailing of the notice of Final Partnership Administrative
Adjustment, with either the Tax Court, the Claims Court, or the
United states district court for the district inlfhich the
partnership has its principal place of business.
Partners other than the TMP are provided with significant
protections under the TEFRA partnership audit rules. Notice
partners have the authority to petition for judicial review from
a notice of Final Partnership Administrative Adjustment during
the 60 days following the gO-day period after the mailing of a
Notice of Final Partnership Administrative Adjustment to the TMP
(assuming the TMP fails to file a petition during the gO-day
lOA "notice group" is a group of partners having in the
aggregate a five percent or more interest in partnership profits
who designate one member to receive notice on behalf of the
group. I.R.C. S 6223(b)(2).
ll I • R• C• S 6223(b).
l2 I • R• C• S 6223(g); Temp. Treas. Reg. S 30l.6223(g)-lT.
l3 I • R• C• S 6229(a).
le I . R . C• S 6229(b)(l)
(B).
lSI.R.C. S 6224(c)(3)(B).
l'I.R.C. S 6227(b).
l7 I • R • C •
S 6226(&).
4
period).11 It any partner files a petition in the Tax Court, a
district court or the Claims Court, any partner in the itrtnership may file an election to participate in the action.
It the
TMP fails to execute a consent to extend the statute of limitations, the Service must obtain a consent individually from each
partner or issue a notice of Final Partnership Administrative
Adjustment to the TMP i~ order to suspend the running of the
statute of limitations. 0 An administrative adjustment re~est
may be filed individually by a partner other than the TMP. 1 In
addition, any partner may reach a settlement of his or her own
case individually with the Service, and aay tile a 2i-quest not to
be bound by any agreement entered into by the TMP.
Partners
may individually waive their rights under t~~ TEFRA partnership
audit irles or any restrictions placed on the Service by those
rules.
Any settlement agreement entered into between the Service
and one or more partners, is binding on the parties to the
agreement in the aflence of fraud, malfeasance or misrepresentation of fact.
The TMP cannot bind notice partners. As
noted above, an agreement entered into by the TMP is binding on
non-notice partners (i.e., those partners with less than a one
percent profits interest in partnerships with over 100 partners)
only if the TMP expressly states in the agreement that it binds
the other partners, and the agreement between the Service and the
TMP will not bind any partner who has filed a statement with the
service 2,estricting the TMP's authority to settle on his or her
behalf.
If the Service enters into a settlement agreement with
II
I.R.C. 56226(b).
19
I.R.C. 55 6224(a); 6226(c)(2); Tax Court Rule 24S(b).
20
I.R.C. S 6229(b) (I) (A) and (d).
21 I.R.C. 56227(c).
22I •R•C• 5 6224(C) (1) and (c)(3) (B).
23
I.R.C. 56224(b).
2tA partner holding an interest through one or more passthrough partners is bound by a settlement agreement entered into
by a pass-through partner, unless the indirect partner has been
identified to the Service. I.R.C. 5 6224(C) (1).
25 sut see Tax Court Rule 248. Under that rule, if the case
is docketed in the Tax Court and certain conditions are met, the
court may enter a decision consistent with a settlement entered
into with some of the partners, that would be binding on all
parties to the action, notwithstanding that there may be notice
5
respect to partnership items for a particular taxable year, the
Service generally is obligated ~o offer consistent terms to any
other partner who so requests. 2
The partner's right to reqqest
consistent treatment is subject to certain time limitations. 27
In general, a change in tax liability of a partitr to
properly reflect the treatment of a partnership item is made
through a "computational adjustment." After a final determination
has been reached with respect to a partnership proceeding, the
Service allocates the final adjustment among the partners and
computes their revised tax liability based on return information
in its possession. A computational adjustment may include a
change in tax liability that reflects a change in an affected
item if that change is nece'tary to properly reflect the treatment of a partnership item.
However, changes in a partner's
tax liability with respect to affected items which require
partner-level determinations are not included in a computational
partners, or non-notice partners who filed statements prohibiting
the TMP from entering into settlements on their behalf, who did
not enter into a settlement agreement with the Service.
• R • C• S 6224(c)(2). The Service's obligation to offer
consistent terms only applies if the items subject to the
original agreement were partnership items with respect to the
settling partner at the time of the original agreement. Temp.
Treas. Reg. S 301.6224(c)-3T(b) (1). Furthermore, the items must
be partnership items of the requesting partner at the time of the
request. ThUS, for example, the requesting partner must not have
previously settled these items with the Service or had the items
converted to nonpartnership items by reason of a special
enforcement situation such as the partner's bankruptcy). Temp.
Treas. Reg. S 301.6224(c)-3T(b) (2).
26 I
• R • C• S 6224(c) (2).
S 301.6224(c)-3T(c) (3).
27 I
~
Temp. Treas. Reg.
term "partnership item" means any item required to be
taken into account with respect to a partnership taxable year
under subtitle A of the Code to the extent that regulations
provide it is more appropriately determined at the partnership
level than at the partner level. I.R.C. S 6231(a)(3). ~
Treas. Reg. S 301.6231(a) (3)-1. Partnership income, loss,
deduction, or credit are common examples of partnership items.
28 The
term "affected item" means any item to the extent it
is affected by a partnership item. I.R.C. S 623l(a) (5). A
change in a partner's allowable medical expense deduction due to
the effect of a partnership item on the adjusted gross income
threshold is an example of an affected item.
29 The
6
adjustment, but rather require the issuance of a statutifY notice
of deficiency prior to assessment of the tax liability.
Any partner, or the TMP acting on behalf of,fhe partnership,
may file an "Administrative Adjustment Request."
In general, .
an Administrative Adjustment Request bas the same effect under
the TEFRA partnership audit rules as either an amended partnership or partner return or a claim for refund with respect to the
partnership or the partner. An Administrative Adjustment Request
may be filed with respect to partnership items for a partnership
taxable year (1) within the three year period after the later of
the filing date of the partnership return for that year or the
last day for filing such return (determined without regard to
extensions), but must be filed before (2) the mailing to the TMP
of a notice of Fintl Partnership Administrative Adjustment for
such taxable year.
The TMP may file an Administrative Adjustment Request with
respect to the treatment of partnership items on the original
partnership return. If the TMP asks that the treatment shown on
the request be SUbstituted for the treatment of partnership items
on the original partnership return, the service may treat the
changes shown on the request as correction! of mathematical or
clerical errors on the partnership return. 1 If the TMP files an
Administrative Adjustment Request on behalf of the partnership
which is not treated as a substituted return, the Service may,
with respect to all or part of the requested adjustments: (1)
compute the appropriate tax as to partners and issue refunds; (2)
lOI.R.C. S 6230(a) (2) (A) (i). A partner-level penalty based
on an erroneous partnership deduction is an example of an
affected item that is asserted through a statutory notice of
deficiency.
II
I.R.C. S 6227.
l2 I.R.C.
S 6227(a).
"I.R.C. S 6227(b) (1). If the Service treats the
Administrative Adjustment Request as a correction of mathematical
or clerical errors appearing on the partnership return, the
Service may proceed to assessment of the tax against partners
without carrying on a unified proceeding. ~ I.R.C.
S5 6230(b) (1) and 6225. However, if any partner timely objects,
the correction cannot be made with respect to that partner
without conducting a partnership-level proceeding. I.R.C.
S 6230 (b) (2) .
7
conduct ~,unified partnership proceeding; or (3) not act on the
request.
. If any partner individually files an Administrative
AdJustment Request, the Service may: (1) process the request in
the same manner as a claim for refund with respect to items that
are not partnership items; (2) assess any additional tax
resulting from the request; (3) mail to the partner a notice that
all partnership items of the partner for the partnership taxable
year to which such request relates shall be treated aa
the service fails to act on an Administrative
Adjustment Request made on behalf of the partnership, the TMP may
file a petition for judicial review of the request. I.R.e.
S 6228(a)(1). Such a petition can be filed only after the
expiration of six months from the date of the filing of the
Administrative Adjustment Request and before two years have
elapsed froa the filing date. I.R.e. S 6228(a) (2) (A). However,
no petition . .y be tiled after the Service has issued a notice of
the Beginning of an Administrative Proceeding (unless after
issuance of .uch notice the Service fails to issue notice of a
Final Partnership Administrative Adjustment, in which case the
partner may file a petition within the six-month period following
the expiration of the applicable statute of limitations). I.R.e.
S 6228(a) (2) (B) and (e). These limitation periods may be
extended by agreement of the parties. I.R.e. 6228(a) (2) (0).
Generally, a court in which a petition is filed will only have
jurisdiction over items covered by the Administrative Adjustment
Request that were not allowed by the Service and over items
raised by the Service as offsets to the requested adjustments.
I.R.e. S 6228(a) (5).
3t If
8
nonpartnership items;3S or (4) conduct a unified partnership
proceeding with respect to the items covered in the request. 36
the partner is mailed a notice that allot his or her
partnership items tor the partnership taxable year to which an
administrative adjustment request relates will be treated as
nonpartnership items, the Administrative Adjustment Request is
treated as a claim for credit or refund of an overpayment
attributable to nonpartnership items and the partner . .y bring a
refund action under aection 7422 with respect to such claim
within two years ot the mailing of such notice. I.R.C.
S 6228(b)(1). If the Service tails to grant the requ.st in whole
or in part and doe8 not issue a notice converting the partner's
partnership items to nonpartnership items, the partner .ay
initiate a refund action within the period starting six aonths
following the filing of the request and ending two years after
such filing. I.R.C. S 6228(b)(2)(B). Upon the commencement of
such an action, the partner's partnership it... are treated as
nonpartnership items. I.R.C. S 623l(b)(1)(B). No refund actions
may be brought in a federal district court or the Claims Court
with regard to partnership items except as provided above or as
provided in section 6230(c) (relating to computational adjustment
disputes). I.R.C. S 7422(h).
35 It
36
I.R.C. S 6227(c).
TREASURY NEWS
_lIartment of tile Tnasury • Washington, D.C•• T.""hon. 588-2041
FOR IMMEDIATE RELEASE
April 3, 1990
CONTACT:
LARRY BATDORF
(202) 566-2041
STATUS OF NEGOTIATIONS OF INCOME TAX TREATIES AND TAX
INFORMATION EXCHANGE AGREEMENTS
The Treasury Department announced today the countries with
which it is currently engaged in income tax treaty and tax
information exchange agreement (TIEA) negotiations and invited
comments from interested persons. Comments should be submitted
in writing to Philip D. Morrison, International Tax Counsel, Room
3064, Treasury Department, Washington, D.C. 20220.
I.
INCOME TAX TREATIES
Senate Forei n Relations Committee
ate Aprl
Finland
Germany
India
Indonesia
Spain
Tunisia
Multilateral Convention on Mutual Administrative Assistance in
Tax Matters
B. Active Negotiations; Meetings Scheduled
Mexico--first round held March 12-16; second round tentatively
scheduled for August 13-17
the Netherlands--negotiation of a new treaty continued March
19-23· next round tentatively scheduled for early summer
the USSR-~first round of negotiation of a new treaty held
March 26-30
Israel--negotiation of a protocol to existing treaty (not in
effect) to continue April 23-27
Canada--negotiation of a protocol to existing treaty to
continue May 14-18
Switzerland--negotiation of a new treaty to continue October
22-26
NB-749
-2-
c.
Other Active Negotiations; No Meetings Scheduled
Bangladesh--correspondence on open issues
Belgium--correspondence on open issues
Bulgaria--first negotiations expected to begin in Mayor June
Denmark--correspondence on a protocol to cover 1986 Tax Reform
Act and other changes
France--meeting expected in 1990 to discuss a technical
protocol
Ireland--meeting to resolve open issues likely September
24-28
Italy--negotiation of a protocol to existing treaty
Kuwait--reviewing open issues
Sweden--text of new treaty undergoing final review
Sri Lanka--correspondence on open issues
Thailand--correspondence on open issues; further negotiations
likely this year
Turkey--correspondence on open issues
zambia--correspondence on open issues
D. Negotiations Initiated; No Meetings Scheduled
Austria
Barbados
Malaysia
Portugal
Singapore
Trinidad & Tobago
Yugoslavia
II. TAX INFORMATION EXCHANGE AGREEMENTS
A. In Effect
Barbados (effective November 1984)
Bermuda (effective December 1988)
Dominica (effective May 1988)
Dominican Republic (effective October 1989)
Grenada (effective July 1987)
Jamaica (effective December 1986)
Mexico (effective January 1990)
Trinidad and Tobago (effective February 1990)
B. Signed, But Not Yet In Effect
costa Rica
Peru
st. Lucia
C. Active Negotiations
Bolivia
Colombia
Guyana
Panama
TREASURY NEWS
D• .,artln.nt of til. T.... ury • W.sllington, D.C•• T.Ie.llon. 5 ••. 204t
TEXT AS PREPARED
FOR RELEASE UPON DELIVERY
EXPECTED AT 10:00 A.M.
APRIL 3, 1990
STATEMENT OF FRANK VUKMANIC
DIRECTOR OF THE OFFICE OF
MULTIIATERAL DEVELOPMENT BANKS
DEPARTMENT OF THE TREASURY
BEFORE THE SUBCOMMITTEE ON FOREIGN OPERATIONS
COMMITTEE ON APPROPRIATIONS
U.S. HOUSE OF REPRESENTATIVES
Introduction:
Mr. Chairman: I am pleased to participate in this panel
on global environmental issues and international economic
assistance programs. My statement today will report on
several initiatives that Treasury has taken within the
Multilateral Development Banks over the past year and how we
have sought to shape the policies of those institutions in
this increasingly important area.
We have received an extensive mandate from Congress
directing us to seek more than thirty specific environmental
reforms in the Multilateral Development Banks. These reforms
have included: restructuring and strengthening of
environmental line units: hiring of environmentally-qualified
staff: greater emphasis on staff training on environmental
implications of development: increased coordination with
local community groups and non-governmental organizations;
and the preparation of additional projects that will have a
positive and beneficial effect on the environment. We have
made a concerted and conscientious effort to carry out this
mandate and I believe we have some substantial successes to
report.
Administration Initiatives:
At last year's Economic summit meeting in Paris in July,
President Bush asked other heads of state and government to
join him in encouraging the World Bank and the regional
development banks to integrate environmental considerations
into all aspects of their activities. At the Annual Meetings
of the World Bank and International Monetary Fund last
september, the President encouraged other countries to weigh
environmental considerations more heavily in economic
decision-making, and said that we need to work more
cooperatively together to develop constructive responses to
global warming, specifically emphasizing measures to promote
NB-750
- 2 -
energy efficiency and conservation and greater protection of
tropical forests.
Treasury has pursued the full range of environmental
reform issues in numerous international meetings: meetings
of the Development Committee of the World Bank and IMF in
April 1989 and in September 1989, the Annual Meetings of the
World Bank and IMF last September, and the ministerial meeting of the Organization for Economic cooperation and Development last May. In addition, we have emphasized the
importance of environmental reforms in the annual meetings of
the three regional banks. Such reform issues have been an
important part of u.S. negotiations to replenish the
resources of these institutions, particularly those of the
Inter-American Development Bank (lOB) and the ninth
replenishment of the International Development Association
(IDA-9). We have also raised environmental issues in the
negotiations now going forward for establishment of the
European Bank for Reconstruction and Development (EBRD).
IDA Replenishment:
One of our most significant accomplishments in the IDA-9
negotiations was the inclusion of more stringent
environmental provisions in the replenishment agreement.
That agreement provides for:
Implementation of environmental impact assessment (EIA)
procedures, thereby helping toassu:t"e that environmental
costs and benefits=:are weighed care'fully early in the
project appraisal process.
•
Projects which are expected to have significant
environmental consequences will receive rigorous
technical reviews at sufficiently early stages of
project preparation to ensure that their
environmental impacts are fully factored into
decisions on site selection and project design.
•
As part of this process, environmental impact
assessments will be made available to the Executive
Board at least 180 days in advance of Board action;
Increasing public access to environmental information,
including environmental impact assessments or summaries
of them, thereby promoting participation by local
community groups and n~n-governmental organizations;
Closer collaboration and cooperation with non-governmental organizations in borrowing countries;
~reater
3 -
emphasis on energy efficiency and conservation,
renewable energy technoin borrowing countries;
~nc~uding end-use efficiencies,
log~es, and least-cost planning
More support for debt for nature swaps; and
More rapid progress on environmental action plans.
Environmental action plans will be completed on all IDA
borrowers as soon as feasible.
Progress within the Banks:
A great deal has already been accomplished on a number
of environmental reforms within the Multilateral Development
Banks. Let me cite some specific examples that will
illustrate the progress that has been made over the past
year. At last count, the World Bank had approximately 100
individuals working on various aspects of environmental
issues. This is up from approximately 65 individuals a year
ago. Last September, the Bank adopted an operational
directive for assuring that environmental impact assessments
are completed for projects that will have a significant
effect on the environment.
In January, the Inter-American Development Bank
established an environmental line unit and assigned fifteen
professionals to carry out the functions of the unit. In
February, the Bank adopted environmental classification and
impact assessment procedures. It has also continued its work
with non-governmental organizations and local community
groups, sponsoring a conference on environmental issues in
the hemisphere last year and inviting many organizations and
groups from borrowing member countries to participate.
The Asian Development Bank has continued its efforts to
integrate environmental considerations more effectively into
the project appraisal process -- setting up a comprehensive
review system that produces environment reports on specific
projects at six stages of the appraisal progress. The Bank
has also sought to involve non-governmental organizations
from developing countries in identification and preparation
of specific project proposals. Projects that have benefited
from this NGO involvement include two from the Philippines,
one from Nepal and one from Bangladesh. In June, 1989, the
ADB also sponsored a consultative meeting with nongovernmental organizations from the region. It is pursuing
other work on NGO institutions and capabilities and a study
on the possibilities for debt for nature swaps.
The African Development Bank has been working closely
with three U.S. non-governmental organizations -- the Sierra
Club, the Natural Resources Defense Council, and the American
- 4 -
Farm Trust -- to increase its cooperation and coordination
with non-governmental organizations in Africa. An initial
meeting -- involving a number of African organizations
was
held last September in Abidjan. We have encouraged this
process and hope that the u.s. organizations will be able to
continue their activities in this area. The African
Development Bank has also developed an environmental policy
paper to guide its lending activities as they affect the
environment. The paper is-currently under review by a
committee of the board of executive directors of the Bank.
All of the Multilateral Development Banks are reporting
continuing increases in the number of environmentally
beneficial projects and of projects with environmentally
beneficial components. There has also been a rapid rise in
technical assistance programs for preparation of
environmentally beneficial projects and strengthening of
environmental institutions in borrowing countries.
We are pleased with the progress achieved thus far. At
the same time, we recognize there is much more that remains
to be done. We will encourage the Asian Development Bank and
the African Development Bank to increase the number of
environmentally-qualified staff. We will continue the
emphasis we have already placed on energy efficiency and
conservation measures and programs to protect tropical
forests. We will increase our efforts to assure that the
agreements we have reached are implemented effectively.
In the World Bank, implementation of environmental
impact assessment procedures over the next two years will be
a difficult and time-consuming task. We are consulting with
Department of state, USAID, the Environmental Protection
Agency, and the Council on Environmental Quality about the
possibility of detailing u.s. experts to assist in this
process. We are also asking other countries to consider
seconding experts for this purpose as well. In the regional
development banks, this task will be even more daunting, and
will almost certainly require additional efforts by us and
other developed countries.
Protection of Tropical Forests:
•
In legislation
that was passed last year, this subcommittee emphasized the importance of programs for
protecting tropical forest resources. This is an area which
we have watched closely and one where we have had serious
concerns for several years. Members may recall that the
Treasury Department in 1988 adopted standards for u.s.
evaluation of Multilateral Development Bank projects that may
adversely affect tropical moist forests. At our urging, the
World Bank announced plans to adopt its own standards for
-
5 -
such projects. We expect those standards to be put in place
later this year. We hope that they will provide a suitable
framework for the Bank's projected increase in lending for
tropical forestry projects.
The Administration has also supported the work of the
Tropical Forestry Action Plan (TFAP). This Plan, led by the
WO:ld Bank~ the Food and Agriculture Organization and the
Un1ted Nat10ns Development,Program, seeks to provide an
overall framework -- institutional, policy and loan strategy- for preserving and replenishing tropical forest resources
in developing countries. It undertakes forestry sector
reviews in individual countries and identifies specific
projects that may be funded by both bilateral and
multilateral donors.
We believe that the conceptual approach being taken by
TFAP is correct. However, we have encountered some problems
with the development of specific loans under the TFAP
program. In particular, we are concerned that there be a
better balance between timber programs and the preservation
and protection elements of individual loans. In many cases,
the TFAP process has also been too much of a closed process,
excluding the participation of forest dwellers and NGOs.
Accordingly, we have encouraged reforming and strengthening
of TFAP programs, urging greater emphasis on building up
institutional capacities for park management and forestry
preservation in borrowing countries and involving nongovernmental organizations in all stages of planning and
implementation.
We are working closely with non-governmental
organizations such as World wildlife Fund in this area. We
are also working closely with these organizations on
evaluating specific MOB loan proposals that may present
problems. In June of 1989, we were successful in making
changes in a forestry loan to Sri Lanka from the World Bank.
In December, we undertook a particularly close review of a $8
million forestry project in Guinea, urging the World Bank to
put more weight on protection and preservation elements in
the loan. We are now conducting an even more searching
review of an $80 million loan to IVOry Coast because of
similar concern~.
Debt for Nature Swaps:
In 1988, Treasury encouraged the World Bank Group to
playa more active role in promoting debt for nature swaps.
Unfortunately, progress in this area has not ~een as rapid as
we had first hoped. One recent encouraging s1gn has been a
proposal to preserve an important tract of Atlantic rain
forest in Paraguay. The tract extends over 69,000 hectares
- 6 -
and is a virgin, humid, semitropical rainforest of
particularly rich biodiversity. It is the last large
privately-owned tract of this unique vegetation type in Latin
America.
The International Finance Corporation, which acquired
the tract a number of years ago through foreclosure, is
working with USAID and Nature Conservancy to transfer title
to an appropriate Paraguayan institution and establish a
nature reserve in the area. The parties are also seeking to
finance the recurrent costs associated with reserve
management. Our understanding is that USAID is willing to
provide $500,000 for the proposal and that other funding
would come from Nature Conservancy and other private
organizations. Although an agreement is not assured at this
time, we are hopeful that the project will go forward under
World Bank auspices and that it will be a model for future
debt for nature transactions.
Energy Efficiency and Conservation:
Energy efficiency and conservation measures are another
important area in which we have received a significant
legislative mandate from this sub-committee. During the past
year, Treasury formed an informal working group comprised of
experts from USAID, the Environmental Protection Agency, the
Departments of State and Energy, and several NGOs to 'exchange
views on how we might encourage greater emphasis on energy
efficiency and conservation in the Multilateral Development
Banks. Much of the specificity that we were able to achieve
in the IDA-9 Agreement grew out of the work of this group.
Treasury has also been an active member of the Committee
on Renewable Energy, Commerce, and Trade (CORECT), which
seeks to encourage greater reliance on renewable energy
technologies in developing countries. We have helped to
draft a financing paper for the committee emphasizing the
role of the World Bank in encouraging this process. The
World Bank, itself, is now working with the Department of
Energy to identify and help implement innovative mechanisms
for financing renewable energy and conservation services for
small energy consumers in deVeloping countries. This
project, Financ~ng of Energy Services for Small-scale Energy
Users, also known as FINESSE, is being targeted initially at
four southeast Asian countries --Indonesia, Malaysia,
Philippines and Thailand. A workshop is scheduled to be held
in Kala Lumpur in the spring of 1991. This week, the World
Bank and USAID are sponsoring a seminar on use of wind energy
for large scale ~lectric power production.
- 7 -
We have also encouraged the World Bank to work more
closely with USAID in developing least-cost energy plans in
borrowing countries and in coordinating their overall
programs in energy efficiency and conservation. The Energy
section Management Assistance Program (ESMAP) is expected to
put more emphasis on integrating the results of their studies
and assessments into the capital lending programs of the
Bank. A high level review of ESMAP is also underway and more
specific recommendations are expected in the near future. In
the regional development banks, we are also asking for
greater emphasis on renewable energy technologies, end-use
efficiencies and least-cost planning.
Conclusion:
Mr. Chairman, I believe we are making good progress on
the full range of environmental reforms in all of the
Multilateral Development Banks. We have been particularly
encouraged by the adoption of procedures for environmental
impact assessment in both the World Bank and the InterAmerican Development Bank. We look forward to adoption of
similar procedures in the other banks. Effective
implementation of these procedures will be difficult and
time-consuming and require technical support from us and
other member countries.
Energy efficiencies and conservation and protection of
tropical forests are two other key areas which clearly need
additional attention from us. We are making a good start in
both of these areas -- ~n reviewing the 'Energy Sector
Management Assistance Program (ESMAP) in the World Bank and
in working to reform and strengthen the mandate of the
Tropical Forestry Action Plan (TFAP). We have had important
support in these areas from other agencies in the U.s.
Government and from non-governmental organizations that are
interested in these issues. I am convinced that we will
continue to make important progress in the year ahead.
TREASURY NEWS
Dellartm.nt of til. T....u., • Wa.hlngton. D.C.• T.... hon.188-20.1
FOR RELEASE AT 4:00 P.M.
April 3, 1990
CONTACT:Office of Financing
202/376-4350
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice, invites
tenders for two series of Treasury bills totaling approximately
$16,400 million, to be issued April 12, 1990.
This offering
will provide about $1,150 million of new cash for the Treasury, as
the maturing bills are outstanding in the amount of $15,255 million.
Tenders will be received at Federal Reserve Banks and Branches and at
the Bureau of the Public Debt, Washington, D. C. 20239, prior to 1:00
p.m., Eastern Daylight Saving time, Monday, April 9, 1990.
The two series offered are as follows:
91-day bills (to maturity date) for approximately S8,200
million, representing an additional amount of bills dated
January 11, 1990,
and to mature
July 12, 1990
(CUSIP No.
912794 UU 6), currently outstanding in the amount of $ 7,825 million,
the additional and original bills to be freely interchangeable.
182-day bills for approximately $8,200 million, to be dated
April 12, 1990,
and to mature October 11, 1990
(CUSIP No.
912794 VE 1).
The bills will be issued on a discount basis under competitive
and noncompetitive bidding, and at maturity their par amount will
be payable without interest. Both series of bills will be issued
entirely in book-entry form in a minimum amount of SlO,OOO "and in
any higher $5,000 multiple, on the records either of the Federal
Reserve Banks and Branches, or of the Department of the Treasury.
The bills will be issued for cash and in exchange for Treasury
bills maturing April 12, 1990.
In addition to the maturing
13-week and 26-week bills, there are $9,075
million of maturing
52-week bills. The disposition of this latter amount was announced
last week. Tenders from Federal Reserve Banks for their own account
and as agents for foreign and international monetary authorities will
be accepted at the weighted average bank discount rates of accepted
competitive tenders. Additional amounts of the bills may be issued
to Federal Reserve Banks, as agents for foreign and international
monetary authorities, to the extent that the aggregate amount of
tenders for such accounts exceeds the aggregate amount of maturing
bills held by them. For purposes of determining such additional
amounts, foreign and international monet~ry authorities are conSidered to hold S784
million of the orig1nal 13-week and 26-week
issues.
Federal Reserve Banks currently hold S1,014 million as
agents for foreign and international monetary authorities, and $5,745
million for their own account. These amounts represent the combined
holdings of such accounts for the three issues of maturing bills.
Tenders for bills to be maintained on the book-entry records of the
Department of the Treasury should be submitted on Form PD 5176-1
(for 13-week series) or Form PD 5176-2 (for 26-week series).
NB-7S1
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 2
Each tender must state the par amount of bills bid for,
which must be a minimum of $10,000. Tenders over $10,000 must
be in multiples of $5,000. Competitive tenders must also show
the yield desired, expressed on a bank discount rate basis with
two decimals, e.g., 7.15%. Fractions may not be used. A single
bidder, as defined in Treasury's single bidder quidelines, shall
not submit noncompetitive tenders totaling more than $1,000,000.
Banking institutions and dealers who make primary
markets in Government securities and report daily to the Federal
Reserve Bank of New York their positions in and borrowings on
such securities may submit tenders for account of customers, if
the names of the customers and the amount for each customer are
furnished. Others are only permitted to submit tenders for their
own account. Each tender must state the amount of any net long
position in the bills being offered if such position is in excess
of $200 million. This information should reflect positions held
as of one-half hour prior to the closing time for receipt of
tenders on the day of the auction. Such positions would include
bills acquired through "when issued" trading, and futures and
forward transactions 3S well as holdings of outstanding bills
with the same maturity date as the new offering, e.g., bills
with three months to maturity previously offered as six-month
bills. Dealers, who make primary markets in Government securities and report daily to the Federal Reserve Bank of New York
their positions in and borrowings on such securities, when submitting tenders for customers, must submit a separate tender for
each customer whose net long position in the bill being offered
exceeds $200 million.
A noncompetitive bidder may not have entered into an
agreement, nor make an agreement to purchase or sell or otherwise dispose of any noncompetitive awards of this issue being
auctioned prior to the designated closing time for receipt of
tenders.
Payment for the full par amount of the bills applied for
must accompany all tenders submitted for bills to be maintained
on the book-entry records of the Department of the Treasury.
A cash adjustment will be made on all accepted tenders for the
difference between the par payment submitted and the actual
issue price as determined in the auction.
No deposit need accompany tenders from incorporated banks
and trust companies and from responsible and recognized dealers
in investment securities for bills to be maintained on the bookentry records of Federal Reserve Banks and Branches.
8/89
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 3
PUblic announcement will be made by the Department of the
Treasury of the amount and yield range of accepted bids. Competitive bidders will be advised of the acceptance or rejection
of their tenders. The Secretary of the Treasury expressly
reserves the right to accept or reject any or all tenders, in
whole or in part, and the Secretary's action shall be final.
Subject to these reservations, noncompetitive tenders for each
issue for $1,000,000 or less without stated yield from anyone
bidder will be accepted in full at the weighted average bank
discount rate (in two decimals) of accepted competitive bids
for the respective issues. The calculation of purchase prices
for accepted bids will be carried to three decimal places on the
basis of price per hundred, e.g., 99.923, and the determinations
of the secretary of the Treasury shall be final.
Settlement for accepted tenders for bills to be maintained
on the book-entry records of Federal Reserve Banks and Branches
must be made or completed at the Federal Reserve Bank or Branch
on the issue date, in cash or other immediately-available funds
or in Treasury bills maturing on that date. Cash adjustments
will be made for differences between the par value of the
maturing bills accepted in exchange and the issue price of the
new bills.
If a bill is purchased at issue, and is held to maturity,
the amount of discount is reportable as ordinary income on the
Federal income tax return of the owner for the year in which
the bill matures. Accrual-basis taxpayers, banks, and other
persons designated in section 1281 of the Internal Revenue Code
must include in income the portion of the discount for the period
during the taxable year such holder held the bill. If the bill
is sold or otherwise disposed of before maturity, any gain in
excess of the basis is treated as ordin.ary income.
Department of the Treasury Circulars, PUblic Debt Series Nos. 26-76, 27-76, and 2-86, as applicable, Treasury's sinqle
bidder guidelines, and this notice prescribe the terms of these
Treasury bills and govern the conditions of their issue. Copies
of the circulars, guidelines, and tender forms may be obtained
from any Federal Reserve Bank or Branch, or from the Bureau of
the PUblic Debt.
8/89
TREASURY NEWS
D.llartm.nt of til. T.... ury • wa.llinaton, D.C•• T....llon ••••. 20.'
FOR RELEASE AT 4:00 P.M.
April 4, 1990
CONTACT:
Office of Financing
202/376-4350
TREASURY TO AUCTION $7,500 MILLION OF 7-YEAR NOTES
The Department of the Treasury will auction $7,500 million
of 7-year notes to refund $4,831 million of 7-year notes maturing
April 15, 1990, and to raise about $2,675 million new cash.
The public holds $4,831 million of the maturing 7-year notes,
including $761 million currently held by Federal Reserve Banks
as agents for foreign and international monetary authorities.
The $7,500 million is being offered to the public, and any
amounts tendered by Federal Reserve Banks as agents for foreign
and international monetary authorities will be added to that
amount. Tenders for such accounts will be accepted at the
average price of accepted competitive tenders.
In addition to the public holdings, Federal Reserve Banks
for their own accounts hold $223 million of the maturing securities that may be refunded by issuing additional amounts of the
new notes at the average price of accepted competitive tenders.
Details about the new security are given in the attached
highlights of the offering and in the official offering circular.
000
Attachment
NB-752
HIGHLIGHTS OF TREASURY
OFFERING TO THE PUBLIC
OF 7-YEAR NOTES
TO BE ISSUED APRIL 16, 1990
April 4, 1990
Amount Offered:
To the public •.•.••••••••••••.•• $7,500 million
Description of Security:
Term and type of security •••...• 7-year notes
series and CUSIP designation .•.• E-1997
(CUSIP No. 912827 YT 3)
Maturity date ......•.••••••••••• April 15, 1997
Interest rate .....•••••••••••••• To be determined based on
the average of accepted bids
Investment yield .••.••••.••••••• To be determined at auction
Premium or discount .••••.••••••• To be determined after auction
Interest payment dates .••..••••• October 15 and April 15
Minimum denomination available •• $1,000
Terms of Sale:
Method of sale .•.••.•.•.•••••.•• Yield auction
Competitive tenders .••.••.•••.•• Must be expressed as an
annual yield, with two
decimals, e.g., 7.10%
Noncompetitive tenders
Accepted in full at the average price up to $1,000,000
Accrued interest
payable by investor
None
. .. .. . . . . .. ..
Payment Terms:
Payment by noninstitutional investors
Deposit guarantee by
designated institutions
Full payment to be
....... .. submitted
with tender
........ . Acceptable
Key Dates:
Receipt of tenders ••••.•..•.•••• Wednesday, April 11, 1990,
prior to 1:00 p.m., EDST
Settlement (final payment
due from institutions):
a) funds immediately
Monday, April 16, 1990
available to the Treasury
Thursday, April 12, 1990
b) readily-collectible check
TEXT AS PREPARED
NOT FOR RELEASE UNTIL DELIVERY
Expected at 10;00 a.m.
Thursday, April 5, 1990
TESTIMONY OF DAVID C. MULFORD
UNDER SECRETARY OF THE TREASURY FOR INTERNATIONAL AFFAIRS
BEFORE
THE COMMITTEE ON BANKING, BOUSING AND URSAN AFFAIRS
OP TBE
UNITED STATES SENATE
APRIL 5, 1990
INTRODUCTION
I am pleased to be here today to discuss the Government's
efforts to achieve national treatment for u.s. financial firms
abroad. In your invitation, you expressed concern that American
firms may be losing their competitive edge in international
finance, and questioned the -equity of regulatory practices~ in
the United States and major foreign financial centers. The
competitiveness issue of U.S. financial firms is of great
interest to this Administration and particularly to the Treasury
Department.
You have aptly pointed out that this'. issue has many
dimensions of which worldwide regulatory equity is only one.
Secretary Brady, as you may be aware, has asked the Treasury to
examine related aspects of competitiveness in a comprehensive
study on the cost of capital. I will focus my remarks today, as
you requested, on the extent to which our national treatment
policy has been successful, especially in Japan and the European
Community. I will also comment on increased foreign penetration
of U.S. financial markets, the diminished role of U.S. financial
firms abroad, and the tendency of other aajor financial countries
to adopt reciprocity or retaliatory powers.
NATIONAL TREATMENT POLICY
First, I would like to emphasize that the principle of
national treataent, as embodied in the International Banking Act
of 1978 and the OECD National Treatment Instru.ent and Codes of
Liberalization, remains the cornerstone of Treasury's belief
that everyone benefits from open financial markets which are
NB-753
-2-
accessed easily by domestic and foreign participants. We firmly
believe that it is not sufficient simply to remove blatant
discriminatory barriers. Foreign firms should effectively enjoy
the same competitive opportunities as domestic firms. Despite
moments of frustration and mounting pressure we have not strayed
from this principle.
National Treatment Studies
Our efforts to implement national treatment have included
national treatment studies and financial market talks. We
continually monitor foreign financial markets and have
intensified our scrutiny in the course of preparing the national
treatment reports to the Congress in 1979, 1984 and 1986. We are
currently preparing the most extensive study thus far, which the
1988 Trade Act requires the Treasury Secretary to submit to the
Congress later this year.
This study will be broader in scope and depth than previous
studies. It will report on the treatment accorded U.S. banks and
securities firms in foreign markets and describe our efforts to
reduce discriminatory treatment. We will prepare detailed
country chapters and also report on the activities of foreign
financial institutions in the U.S. In fact, this study will
attempt to provide more complete answers to many of the questions
you have raised. In my remarks today, I do not want to prejudge
its conclusions.
Financial
~arket
Talks
The success of open U.S. financial markets prompted the
Treasury to urge other countries to adopt national treatment.
We have engaged in a series of financial market talks aimed at
opening foreign markets and creating a level playing field for
U.S. firms. For example, we have met with our counterparts from
Japan, Canada, the European Community, Taiwan and Korea to
discuss a wide range of financial market issues. We have also
raised financial market issues with Latin American officials.
Since you have expressed particular interest in Japan and the Ee,
let me turn briefly to our efforts in these markets.
Japan
perhaps the most notable progress has been in Treasury's
financial discussions with the Japanese. The so-called
Yen/Dollar group, now known as the U.S.-Japan Working Group on
Financial Markets, has met thirteen times since early 1984.
These talks, which I l~ad on the U.S. side, have contributed to
substantially greater access for U.S. firms to Japanese financial
markets -- to their stock exchanges, government securities
markets, the Euroyen market and, to a lesser degree, Japanese
domestic money markets.
-3-
This is not to say our work is complete. We are continuing
to press for more rapid interest rate deregulation and the
development of a short-term money market as well as further
progress across a range of issues. These include examining
Japanese laws which frustrate foreign financial firms in offering
innovative products and services to Japanese investors. Progress
has been steady, but slow. The Japanese have recently indicated
their intention to expand use of the auction process in the
government securities market, increase the number of seats on the
Tokyo Stock Exchange and accept applications for investment trust
management licenses. We intend to continue these discussions in
Tokyo next month.
European Community
We have also worked with our colleagues in the European
Community as they have drafted legislation to establish an
integrated market in banking and securities by the end of 1992.
We expressed particular concern about a potential mirror-image
reciprocity provision which was initially included in the Second
Banking Directive and a similar provision in the directive on
investment services. These directives are part of the major
liberalization and regulatory framework for the 1992 market. The
EC subsequently revised the Second Banking Directive to provide
for reciprocal national treatment and effective market access,
although it still provides for sanctions when third countries do
not provide national treatment. We will continue to monitor
developments in this area to avoid potential discrimination
against firms from non-EC countries.
General Outcome
Overall, our efforts have been successful, if in varying
degrees. Our talks with the Canadians produced a landmark
financial services agreement, as part of the 1989 U.S.-Canada
Free Trade Agreement, which removed many discriminatory
practices. We are moving forward slowly but steadily with Taiwan
and Korea. During our financial policy talks in February, the
Koreans agreed to several measures which should enhance foreign
banks' access to local currency funding in the Korean money
market. The Koreans also agreed to abide by the scheduled
opening of the securities sector to foreign firms. We now are
waiting for evidence to support Korea's intentions.
In Latin America we have made the least progress. Nevertheless, we will continue to urge financial market reforms and
more liberal investment policies in Latin American countries,
especially in conjunction with development bank lending. Some
of these countries, such as Venezuela and Mexico, have adopted a
new openness in trade which I hope will spread to their financial
sectors. It is difficult to justify that major debtor countries
-4-
recelvlng support from a variety of sources under the
strengthened debt strategy should maintain financial systems
that remain substantially closed to the world financial
community. We intend to have follow-up discussions with
these and other markets as we pursue our efforts. The 1990
National Treatment Study, currently underway, will help
identify problem areas.
The Uruguay Round
Finally, let me comment on financial services in the
Uruguay Round. This facet of the Uruguay Round is a relatively
new effort to improve opportunities for u.s. financial
institutions in foreign markets. At Treasury's initiative,
finance officials have begun to craft an agreement which would
contain legally binding obligations calling for both market
access and national treatment for financial institutions. The
OECD countries have already made considerable progress in this
area. The Uruguay Round provides an opportunity to pursue
liberalization in a wider range of countries, including the
newly industrializing economies of Asia and Latin America.
COMPETITIVENESS OF U.S. BANKS
You expressed concern that the position of U.s. banks
has steadily declined while other foreign banks, particularly
Japanese banks, have rapidly gained strength and market share.
I agree that U.s. banks have lost their position of world
dominance. Not only has their position declined worldwide, it
has also declined in the United States. Meanwhile, Japanese
banks have increased their market share around the world and
their penetration in the United States~ This has occured while
U.S. banks have acquired only a negligible share of the Japanese
market and have not enjoyed the same ease of access the Japanese
banks have enjoyed in the United States.
There are a number of factors which account for U.s.
banks drawing back from foreign markets. Some result from
international developments, including exchange rate changes,
while others stem from u.s. domestic considerations. One
difficulty facing U.S. banks has been the political and
legislative uncertainties surrounding the future landscape of
the U.s. financial system. The ability of u.s. banks to compete
on all fronts with foreign banks abroad has, in part, been
hampered by U.S. restrictions on their activities. Limitations
in the United States have also curtailed u.s. banks' activities
domestically including inter-state banking. Nevertheless,
without going into statistical detail (1988 is the last full
year for which complete internationally comparative data are
available), I agree, that for a variety of reasons, U.S. banks
have lost a major competitive position.
-5NATIONAL TREATMENT VERSUS RECIPROCITY
To return to our original discussion, I believe the United
States has been well served by our policy of national treatment.
At home, the U.S. domestic market has benefited and abroad we
have made some significant strides in opening markets, although
usually as a result of arduous negotiations. National treatment
has its limitations, but they may be less dangerous than those
associated with other alternatives.
Since at the Federal level we offer national treatment in
u.S. markets, we do not have a test to determine whether a
foreign financial firm should be allowed to enter or increase
the scope of its activities in the United States based on the
openness of its home country. In this regard, we are
increasingly in a minority in the international community.
OECD Countries
For example, in 1984, the OECD found that 11 of the 24 OECD
members had some form of reciprocity powers available. Since
then, other countries have added reciprocity powers. With the
adoption of reciprocal national treatment that will become
operative on January 1, 1993 under the ECls Second Banking
Oirective, at least 18 out of 24 OECO members will have
reciprocity powers. We have pressed our concerns about the
consistency of these new reciprocity measures with OECD members.
On the other hand, we have also seen substantial progress
towards national treatment in OECO countries since 1984. This
is true in the Scandinavian countries, in Australia, Canada,
Japan, Switzerland, many other European countries, and even under
the EC Second Banking Directive, provided that it operates in a
non-discriminatory manner.
.
You inquired specifically about Japan and the European
Community.
Japan
Broadly speaking, we understand that Japan does not, in
practice, require reciprocity beyond a general assurance that
its firms have a right of establishment in foreign countries.
However, Japan's banking law does contain language which requires
the Minister of Finance, in reviewing a foreign institution's
banking license application, to examine whether Japanese banks
are entitled to equivalent status in the foreign country. In
effect, this is a provision for reciprocity. However, Japan's
Ministry of Finance appears to apply this standard flexibly,
focusing only on markets which specifically prohibit the presence
of Japanese banks. On the securities side, there are no
statutory or regulatory reciprocity provisions.
-6-
The European Community
EC officials maintain that on January 1, 1993, the EC will
move to a unified banking market which places less restraint on
what financial institutions can do than exists in the United
States or Japan. Given the EC's repeated desire to maintain open
markets, it 3eems unlikely that the gC's reciprocity powers ~nder
the Second Banking Directive would be used in the present
environment against U.S. financial institutions. We will
continue to monitor the implementation of this and other
directives.
Nevertheless, in a listing of significant worldwide practices
where the EC sees room for improvement, EC officials question the
appropriateness of 1933 Glass-Steagall restrictions on universal
banking in the global financial markets of the 1990s. They also
note that the McFadden Act restricts geographical expansion and
that certain states deny national treatment and discriminate
against banks from other states whose parent banks are not
U.S.-owned. They cite Federal Reserve limits on daylight
overdrafts which they claim place foreign banks at a competitive
disadvantage in U.S. markets. EC officials maintain that those
who oppose reciprocity and urge national treatment abroad should
be careful to ensure that their own domestic practices are beyond
criticism.
United States
I must admit that in the United States we often fail to
realize how our own highly regulated and fragmented markets are
viewed overseas. Even though at the federal level we pursue a
policy of national treatment, at the state level there are
denials of national treatment. When ~oreign firms or foreign
Governments bring specific complaints to the Treasury's
attention, we act on them, writing to the states in question,
requesting that national treatment be given, but we cannot force
it.
Moreover, we should not forget that in addition to Federal
requirements, the 50 states each have securities and banking
laws that must be observed. This is not a denial of national
treatment, but while normal to us, it might appear daunting to a
foreigner.
CONCLUSION
To conclude, I would like to emphasize my support for this
Committee's concern about the absolute need for open markets
and equal access to competitive opportunities in our rapidly
integrating financial world. As I have stated, the Treasury has
been actively pursuing national treatment for U.S. financial
-7-
firms in foreign markets through discussions with other
countries. In different fora, we have engaged in financial
market talks with Japan, the European Community, Korea, Taiwan,
and Canada. We have also raised our concerns with Latin American
officials. We have worked with the OE20 to strengthen the Codes
of Liberalization with respect to the financial services sector
and to upgrade the National Treatment Instrument. In addition,
we are rapidly moving forward in our preparations for the 1990
National Treatment Study -- a comprehensive study which will
thoroughly analyze the treatment of u.s. financial institutions
abroad.
In this context, we have studied with interest the "Fair
Trade in Financial Services Act of 1990 a (5.2028). We certainly
appreciate its objective of promoting progress in opening foreign
markets for u.s. financial firms. However, the Administration
must oppose this bill for the same reasons that it has opposed
and expressed concern about reciprocity in the European
Communities' financial services directives.
The U.S. objection to even limited reciprocity is the risk
that reciprocity would be used and retaliation would follow. The
impact could be devastating to confidence in world financial
markets and established patterns of monetary and capital flows.
The President has clearly stated his opposition to measures that
might restrict the flow of capital or increase protectionism -the market place should be free to allocate resources. The
Department of Justice has constitutional concerns about certain
provisions of this bill which it will address in a separate
letter. Thus, in seeking progress, the Administration prefers to
encourage other countries to open and liberalize their markets,
to our mutual advantage, rather than threaten to deny foreign
firms access to our own.
TREASURY NEWS
FOR IMMED!ATE RELEASE
April .;, 1930
CONTACT: Art Siddon
1202, 566-5252
TREASURY UPDATES ESTIMATE OF FINANCING REQUIREMENTS
The Treasury Department announced that market borrowing
requirements estimated for the April-June quarter have been
revised upward. Treasury estimates that market borrowing will be
in a range of $10 billion to $15 billion during the April-June
1990 quarter, with a cash balance of $30 billion on June 30.
The revised borrowing estimate compares with a paydown of $5
billion to $10 billion, leaving a $35 billion cash balance,
announced in Treasury's financing press conference of Jan. 31,
1990. The increase in Treasury's borrowing need is largely
attributable financing the working capital needs of the
Resolution Trust Corporation.
The Treasury will announce the terms of the regular May
quarterly refunding on May Z, 1990, when it will update
Treasury's market borrowing requirement estimate for the
April-June quarter. A preliminary range of estimates for the
July-September quarter will be announced at that time.
NB-754
TREASURY NEWS
D...artment of the Treasury • WaShington, D.C. • TeleDhane S88.20.t
FOR IMMEDIATE RELEASE
April 4, 1990
CONTACT:
Desiree Tucker-Sorini
(202) 566-8773
Statement by
Nicholas F. Brady
Secretary of the Treasury
I am pleased the Senate has confirmed Tim Ryan for,
Director of the Office of Thrift Supervision.
I also apprec~ate
the Senate's expeditious consideration and thorough review of
this nomination.
NB-755
TREASURY NEWS
CONTACT: Office of Financing
202/376-4350
FOR IMMEDIATE RELEASE
April 5, 1990RESULTS OF TREASURY'S 52-WEEK BILL AUCTION
Tenders for $9,766 million of 52-week bills to be issued
April 12, 1990,
and to mature
April 11, 1991,
were accepted
today. The details are as follows:
RANGE OF ACCEPTED COMPETITIVE BIDS:
Discount
Investment Rate
Rate
(Equivalent Coupon-Issue Yield)
Low
High
Average -
92.214
92.184
92.194
8.30%
8.33%
8.32%
7.70%
7.73%
7.72%
Tenders at the high discount rate were allotted 63%.
Location
TENDERS RECEIVED AND ACCEPTED
(In Thousands)
Accepted
Received
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
TOTALS
$
34,810
22,040,650
21,455
42,735
48,110
30,760
1,598,045
22,815
21,540
66,660
26,025
818,865
412,050
$
34,810
8,621,870
21,455
42,735
46,260
30,760
175,695
20,445
11,540
66,660
16,025
266,165
412,050
$25,184,520
$9,766,470
$21,714,250
1,110,270
$22,824,520
$6,296,200
1,110,270
$7,406,470
2,200,000
2,200,000
160,000
$25,184,520
160,000
$9,766,470
Type
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
NB-756
Price
PUBLIC DEBT NEWS
Department of the Treasury • Bureau of the Public Debt • Washington, DC 20239
FOR RELEASE AT 3:00 PM
April 5, 1990
Contact: Peter Hollenbach
(202) 376-4302
TREASURY ANNOUNCES ACTIVITY FOR
SECURITIES IN THE STRIPS PROGRAM FOR MARCH 1990
The Department of the Treasury announced activity figures for the month of March 1990, of
securities within the Separate Trading of Registered Interest and Principal of Securities program,
(STRIPS).
Dollar Amounts in Thousands
Principal Outstanding
(Eligible Securities)
$408,865.583
Held in Unstripped Form
$312,650,853
Held in Stripped Form
$96,214,730
Reconstituted in March
$2,948,560
The accompanying table gives a breakdown of STRIPS activity by individual loan description.
The balances in this table are subject to audit and subsequent revision. These monthly figures are
included in Table VI of the Monthly Statement of the Public Debt, entitled "Holdings of Treasury
Securities in Stripped Form." These can also be obtained through a recorded message on
(202) 447-9873.
000
PA-l
TABLE VI-HOLDINGS OF TREASURY SECURITIES IN STRIPPED FORM, MARCH 31,1990
(In thousands)
26
Principal Amount Outstanding
Loan DescroptlOn
Maturity Date
PortIOn Held in
Unstripped Form
Total
Portion Held in
Stripped Form
~
This Month'
$6,658,554
$5,373,754
$1,284,800
$24,000
· .. . 2115/95
6,933,861
6,401,381
532,480
11-114% Note 8-1995 .
· .... 5115195
7,127,086
5,nl,406
1.355,680
-0-0-
1().112% Note C-1995 .
'" .8115195
7,955,901
7,311,101
644,800
16,000
7,318,550
6,471,350
&47,200
-0-
· ... . 2115/96
8,575,199
8,322,399
252,800
-0-
· .... 5115/96
20,085,643
19,864,643
220,800
-0-
20,258,810
19.958,810
300,000
-0-
9,921,237
9,852,037
69,200
-0-
9,362,836
9,362,836
-0-
-0-
9,808,329
9,792,329
16,000
9.159,068
9,156,428
&40
-0-0-
... ...
11-518% Note C-1994 .
· ... 11115/94 . . ...
11-114% Note A-I995
~112%
Nole 0-1995
... 1"'5195
6-718% Note A-1996 .'
..
.,'
7-318% Note C- I 996
7-114% Note 0-1996 ..
6-1/2% Note A-1997 .'
.
.
...
· .... "115/96 . ..'
· .... 5115197
6-518% Note 8-1997 . ., ..
· .... 8115197
... . -
6-718% Note C-1997 ..
6-118% Note A-1998
· .... 11115197 ..
.'
.... .. - ....
· ... . 2115/98 . ....
..
· .... 5115198 . ....
9% Note 8-1998
~ 114% Note C-1998 .
..... 8115/98
9.165,387
9.135,387
30,000
-0-
",342,646
" ,214,646
128,000
-0-
9,902,875
9,896,475
6,400
-0-
· ... 2115199
9,719,628
9,716,428
3,200
-0-
· .... 5115199
10,047,103
9,197,503
849,600
-0-
6% Note C-1999
.... .8115199
10,163,644
10,081,644
82,000
-0-
7-718% Note 0-1999
..... 11115/99 ..
10,n3,960
10,769,160
4,800
-0-
6-112% Note A-2000 .
· .... 2115/00
10,673,033
10,873,033
-0-
-0-
11-518% Bond 2004
..... 11115104 .
8,301,806
3,nS,606
4,523,200
73.600
6-718% Note 0-1998 .
6-7/8% Note A-I999 ..
~118%
· .... "115198 . ..
. .....
., "
Note 8-1999 .. ....
12% Bond 200S ...
.
.. .. ....
. . . .. . .
I ().314% Bond 2005 ..
....
9-316% Bond 2006.
...
11-314% Bond 2OQ9.14
.. .......
..
4,260,758
1,907.708
2,353,050
-0-
... .. 8115105
9,269,713
8,295,313
974,400
38,000
.2115106
4,755,916
4,755,916
-0-
-0-
6,005.564
2.660,7&4
3,344,800
86,400
12,667,799
2,345,399
10,322,400
35,zlO
7,149.916
1,863,516
5.286,400
97,1120
6,899,859
2,328,659
4.571,200
48,000
648,eoo
..... 11115114.
· .... 2115115
1()'5I8% Bond 2015. .. .....
..... 8115115
~718%
Bene 2015
· .... ,",51,5.
~1/4%
Bono i016
."
7-114'1\1 Bond 2016. .......
..
.... ......
7-1/2% Bond 2016. ........... .....
8-314% Bond 2017.
..
..... . .. ....
8-718% Bond 2017. . " .........
~118%
Bond 2018 ...
9% Bond 2018. . . . . . .
6-718% Bond 2019 ...
..... ........
. . . . . . . . ... ....
..........
..
... .. 5115105
11-114% Bond 2015 .. ... ..... . ..
........... ...
'
.
....
..... 2115116
7,266,854
6,202,854
1,064,000
18,823,551
16,732,351
2,091,200
118,zlO
· .... I 1115116
18.864,448
10,862,208
8.202,240
228,480
· .... 5115117
18.194,169
7.294,969
10,899,200
108,1140
. . ... 8115117
14,016,858
9,493,658
4,523,200
212,800
..
8,708.639
3,982,239
4.726,400
-0-
· .... 11"51'8 .. " .
9,032,870
2.050.870
8,982,000
58,eoo
5115116 . ...
..... 5115118
. .... 2115119
19,250.793
7,533,993
11.716.800
381,600
6-118% Bond 2019 ... ..... ..... . .....
· .... 8115119
20,213,832
14,101,192
6.112,&40
81U20
6-112% Bond 2020 ...
... .. 2115120
10,228.868
8,335,668
1,893,200
-0-
408,865.583
312,650,853
96.214,730
2,948,580
Total
...
. ... ...... .....
lEIfec:1ive May 1,1987. MCUritiea hetd in strlppecllonn _ e eligible lor reconstitution to their unstripped form.
Note: On the 4th workday 01 each month a recording 01 Table VI will be available after 3:00 pm. The telephornl numbe, is (202) 447-9873.
The baIancea in this table are aubject to audit and subsequent adlustments.
OPO_
TREASURY NEWS
Departm.nt of til. TNasu., • • •Sllinaton, D.C .• T....hone •••. 204'
FOR IMMEDIATE RELEASE
April 5, 1990
CONTACT: Cheryl Crispen
566-8773
Statement by
Nicholas F. Brady
Secretary of the Treasury
We are pleased with the positive movement that has taken
place to date in the Structural Impediments Ini tiati ve talks.
The Interim Report reflects substantial progress. We welcome the
commi tment by the Government of Japan to tackle the structural
impediments in their economy and we have committed to address our
own.
We must continue our efforts to eliminate structural
impediments in both our economies and we look forward to more
progress in the coming months as we work toward the final report.
000
NB-757
April 5, 1990
STRUCTURAL IMPEDIMENTS INITIATIVE (SIll
Key Elements of SII Interim Report
In accordance with the agreement reached between President Bush
and then Japanese Prime Minister Uno when they launched the
Structural Impediments Initiative (511) in July 1989, agreement
was reached during talks on April 2-5 on an SII Interim Report.
For the purpose of this interim assessment, substantial
progress was made on the structural impediments identified in
the Japanese economy and in the US economy.
Many of the measures in the interim report should contribute to
the goals of opening markets, reducing trade and current
account imbalances, and promoting consumer interests. However,
additional progress is needed in subsequent SII talks to
develop the plans and actions more fully in some areas. The
effectiveness of the measures and commitments will depend upon
achieving greater specificity in the commitments and,
ultimately, on the actual implementation of measures to reduce
or eliminate the structural impediments.
Attached is a summary list of the policy commitments made by
the Japanese and US Governments, as contained in the Interim
Report.
-1-
ley Elements of SII Report - Japanese Commitments
During the Structural Impediments Initiative Talks, the
Japanese Government committed itself to:
I.
Saying and Inyestment Patterns
Increase substantially investment in infrastructure in
order to reduce the shortage of investment relative to GNP
and help to reduce Japan's current account surplus;
Start immediately on the fo~mulation of a new lO-year
comprehensive plan of public investment to achieve this
increase;
Specify the aggregate ezpenditures in this new
comprehensive investment plan in the final report;
Prepare on a fast track basis eight new larger, long-term
sectoral plans in key infrastructure areas, such as
housing, airports and port facilities, parks, and sewers
and provide positive and specific targets for these plans
in the final report.
II.
Land Use
Conduct a comprehensive review of land tazation on the
basis of such principles as equity, neutrality, and
simplicity, and submit reform legislation to the Diet by
end-FY1990. This will include review of tazation of
certain agricultural land, with a view to addressing the
ezemption (deferment) system for the property and
inheritance taxes;
Rationalize assessments for the inheritance taz, bringing
asse.sments closer to market value;
Launch a new larger, long-term plan for investment in
housing;
Review zoning designations and espand special Urban
Promotion Areas (UPA's) to accommodate growing housing
demands.
Deregulate various land use policie., including zoning
limits on building heights and housing density.
-2-
III.
Distribution
A~opt
a goal of -24 hour- customs clearance;
Improve infrastructure for imports, including airports,
harbors and roads;
Ease restrictions in the distribution area, e.g., liquor
licenSing, trucking, premium offers and general
pharmaceutical goods;
Substantially liberalize the Large Scale Retail Store Law
including ~hortening the approval perio~ to 18 months,
,
falling to 12 months within one year, and increasing the
transparency of the approval process, with emphasis on
consumers rather than competitors;
Strengthen antitrust enforcement aqainst anticompetitive
practices in the distribution sector.
IV.
Exclusionary Business Practice
Make enforcement of the Antimonopoly Act more vigorous,
including amending the Act to make penalties effective and
making penalties public so that violators do not escape
public notice;
Make private remedies for violations of the Act more
effective;
Make -administrative quidance- pro-competitive and more
public and consumer-oriented;
Issue quidelines to ensure that business practices in the
distribution area and among keiretsu firm. do not hinder
fair competition;
Reduce the average time required fQr the ezamination of
patents to international levels within five years;
Review all industry -fair competition codes- to remove
anticompetitive effects of restrictions on the use of
premiums with a priority on those that affect foreign trade
or investment;
Encourage transparent, non-discriminatory procurement by
private Japanese companies with respect to foreign
companies and goods.
-3-
y,
leiretsu Relationships
M.ke keiretsu more open and transparent;
Restrict cross-shareholding or require divestiture of
shares where cross-shareholding among keiretsu firms is
found to lead to anticompetitive practices;
Strengthen enforcement of the Antimonopoly Act and Fair
Trade Commission monitoring of transactions within keiretsu
groups;
Ezamine enhancement of financial disclosure requirements
with a specific plan to enhance disclosure of related party
transactions and report specific conclusions due by final
report;
Conduct regular Japan Fair Trade Commission analyses of
various aspects of keiretsu groups, with a special emphasis
on the role of trading companies.
Liberalize Japan's policies on foreign direct investment,.
including amending the Foreign Ezchange and Foreign Trade
Control Law to:
VI.
o
relaz or abolish the prior notification requirement
for foreign direct investment and importation of
technology into Japan: and
o
limit the broad authority of the Government of Japan
to block foreign direct investment and the importation
of technology on broad economic grounds.
Erictng Mechanism
Establish a Government-LOP Joint Headquarters for
Adjustment of Price Differentials which is implementing a
siz-point program, with 52 specific measures to redress
unwarranted price differences. Information will be
proyided to Japanese consumers on price differences.
Ea.-ple. of actions to be taken relevant to unreasonable
price differentials are:
o
Deregulation of the distribution system, including
addr.ssing the problems of the Large Scale Retail
Store Law, and strengthening of antimonopoly
enforcement;
-4a
Increased infrastructure spending relative to the size
of the Japanese economy, emphasizing distribution and
import systems;
o
Fostering greater availability of land, particularly
in metropolitan areas;
o
Encouragement of open procurement policies in the
public and private sectors.
Instruct government agencies to obtain information on price
differentials through price surveys, and promote
comprehensive policy measures -- including the full range
of deregulation and pro-competitive measures covered by the
other five 511 areas -- in order to reduce unreasonable
price differentials and enhance consumer welfare through
unfettered competition.
-1-
IV II_ants of SIX Btport.-tl.S. CgnpitJpeAt.
Belov i. a list of the principal commitments made by the U.S.
Government durinq the Structural Impediments Initiative (SII)
talks.
I.
Sayings and Investment Patterns
A. Federal Budget Deficit
o
The Administration's top priority is to eliminate the
~ederal budget deficit by 1993 and to reduce government
.ndebtedness. The deficit is being reduced within the
context of the GRH process and the Social Security
Integrity and Debt ~.d'3etion Furv'1,
o
Ceticit reduction vill be achieved through spendinq
restraint and economic qrowth.
o
The Administration has made several proposals which would
tacilitate deficit reduction, including: a .econd
sequester; the requirement of a .upermajority vote to
cancel savings from .equestration, and support for
enhanced re.ci.sion authority.
8. Low friftte SaYiAq late.
The Adaini.tration haa proposed several initiative. to
.t~ulate private aaving and inveatment, including:
o
o
o
Introduction of Family Savings Account.
Enhanc. .ent of Exiatinq I~
Lower the Tax Rate OD capital GaiD~ to 'reaote Long-term
Inveataent.
CprporatioQ toyw.taeot tstiyit i •• ep4 SgpplJ CAaaeity:
IpprgY?7AAt of g.s. Cgspetitiywp•••
A. ADti-1'J:Uat bfom
The &dainiltratioD aupport.
l~i.lation
that would reduce
UDcertainty abOut antitru.t law for productioD joint..oture. that enhance competition, while retaininq
appropriate .afeguards for conluaer ••
8. 'E'Oduct Liability aefora
The 're.ident hal approved the Council of
coapetitivene•• ' recommendation. to aUpport .tronqly
legislation which would contribute to uniforaity of
product liability lawa aaong the State. and ltait damaqe
avarela.
-2-
c.
Corporate Behavior
III.
IV.
Policy -roward Foreiqn Direct Ingeataent
The Administration reaffirms its open foreign
investment policy and its commitment to resist ~
attempts to hinder the free international flows o~
investment capital.
o
The Administration supports policies such as reduction of
the.t~x on cap~tal gain3, savings incentives, and budget
def~c~t reduct~on that would lower the cost of capital
for U.S. corporations and, thus, encourage greater
investment.
o
The Department of Treasury is studying how the
relationship between managers and institutional investors
affects long-term competitiveness.
GoDrnmMt Regulation
A. Export Derequlation
.
The U.S. and its allies on the Coordinating Committee for
Multilateral Export Controls (COCOH) have agreed to
streamline export controls. The O.S. i. reviewing and
will consider changing its export control sch. .e to allow
exports of .trategic product. and technology by countries
such .s J.p.n which impose strict export control on tho ••
it. .s without O.S. re-export license, irrespective of
their destination.
B. !!Derqy Zzporte
Tbe O.S. b.s made significant progress in eliain.ting
many energy tr.de b.rriers, including controls on .xports
of refined products, Cook Inlet crud. oil/ and cert.in
Alaskan n.tural gas product ••
c.
v.
~rt LiberalizatioD
Tbe O.S. ia gr.du.lly ph.sing out volunt.ry re.tr.int
.gr....nt. (VRA) on ate.l. ~ on . .chin. tools .re due
to expire on December 31, 1990.
R.,HEM 'nd P9Dlopmant
o
Th. Adaini.tration in its FY 1991 budg.t propos.d •
number of initiatives to .dvance o.s. r •••• rcb and
development by both the public .nd priv.te .ectors,
including the proposal to •• ke pe~ent tb. R'E tax
credit.
o
A new position of Undersecret.ry for Technology h.s been
established in the Department of Commerce.
-3-
o
VI •
The Department of Commerce has issued an updated "Metric
Conversion Policy for Federal Agencies" which should
further encourage private sector use of the metric
system.
Export Promotion
o
The Department of Commerce has developed a special export
program aimed specifically at increasing u.s. exports to
Japan. Commerce is also expanding export promotion
activities to other countries.
ViI. Workforce Education and Training
o
The President and the Nation's Governors recently agreed
on national educational goals that stress excellence in
education and scholastic aChievement.
o
The Labor Department has initiated a seven-point action
plan to improve the quality of the workforce.
JOINT PRESS RELEASE
INTERIM REPORT AND ASSESSMENT
of the
U.S. - JAPAN WORKING GROUP
on the
STRUCTURAL IMPEDIMENTS INITIATIVE
••*.**•••••
••
••*.*.*.*.*
*•••*.*.* . .- -•
.*.***
April 5, 1990
Joint Press Release
The U.S.-Japan Working Group on the Structural Impediments
(SII) reaffirms its continuing commitment to
ldentlfy and solve structural problems in both countries which
stand as impediments to trade and to balance of payments
adjustment.
In that regard, the Working Group provides the
attached interim report on the Structural Impediments
Initiative.
~niti~tive
Since the U.S. and Japanese Heads of State agreed to
launch the Structural Impediments Initiative in July, 1989, the
SII Working Group has studied and identified structural
problems in both countries that impede trade and balance of
payments adjustment. The structural problems which were
identified by the Government of Japan in the U.S. economy were
in the following areas: u.S. Savings and Investment Patterns,
Corporate Investment Activities and Supply Capacity, Corporate
Behavior, Government Regulations, Research and Development,
Export Promotion and Workforce Training and Education. The
structural problems identified by the U.S. Government in the
Japanese economy were in the following areas: Japanese Savings
and Investment Patterns, Land Use, Distribution System,
Exclusionary Business Practices, Keiretsu Relationships and
Pricing Mechanisms.
Plenary meetings of the SII Working Group were held in
September and November, 1989, and February 1990.
In September
and November, the SII Working Group identified and discussed
specific structural impediments.
In February, the SII Working
Group exchanged productive ideas for possible policy changes
which would accelerate the adjustment process and contribute to
the reduction of trade and current account imbalances, open
markets, and improvement of competitiveness. Both the U.s. and
Japanese Governments have already taken steps, some of which
are identified below, as an indication of their commitment to
the SIr process and to solving the problems that have been
identified. Both governments believe that the interim report
represents substantial progress to date and is a product of
determined, earnest efforts to achieve structural improvement
in both countries. Both governments agreed that further
progress will be required in order to address structural
problems before the final report. Matters concerning
implementation and the follow-up phase of the report will also
be dealt with by the time of the final report.
u.s. -
JAPAN STRUCTURAL IMPEDIMENTS INITIATIVE
INTERIM REPORT BY THE U.S. DELEGATION
APRIL 5, 1990
Structural Impediments in the U.S. Economy
The Government of Japan has identified several conditions in the U.S. economy
which may impede balance of payments adjustment and long-term competitiveness and
has offered helpful suggestions to remedy these conditions. Below is a review of U.S.
initiatives that address the issues raised by the Government of Japan.
I. Saving and Investment Patterns
Raising U.S. saving rates would help to reduce the nation's current account
imbalance. Increasing the pool of domestic saving would contribute to lower U.S. interest
rates, thereby facilitating domestic capital formation, productivity and economic growth.
The Administration is taking action to promote saving by both the public and private
sectors.
Public Sector: Deficit Reduction and Government Saving
The top priority is to eliminate the Federal budget deficit by 1993 and to reduce
government debt. The deficit is being reduced within the context of the Gramm-RudmanHollings (GRH) process.
Federal Budget Deficit
o
Substantial progress has already been made on the Federal budget deficit.
It has been reduced from 6.3% of GNP in FY 1983 to 2.9% in FY
1989.
In the budget plans submitted by the President, the deficit is expected
to fall from 2.3% of GNP in FY 1990 to 1.1% in FY 1991.
o
Deficit reduction will be achieved through spending restraint and continued
growth.
o
Following the procedures in the GRH law, the President ordered a sequester
in FY 1990 and demonstrated his fiscal resolve by announcing his willingness
to operate with the sequester for the entire fiscal year, if necessary and by
not canceling the budget savings achieved through the sequester. This
reversed past practice and set a strong precedent for future fiscal discipline.
The Budget Process
o
The President's FY 1991 budget calls for a stronger Gramm-RudmanHollings (GRH) law, one which would close loop-holes and strengthen the
process of deficit reduction. For example:
the President's budget proposes an automatic second sequester that
would be imposed if targets are not met later in the budget period;
the technical feasibility of using revised economic assumptions for the
purpose of calculating the budget proposals for the second sequester
is being studied;
a requirement for a super-majority vote to cancel the savings from
sequestration once achieved; and
automatic off-set rules for supplemental funding requests.
o
The President strongly supports a form of enhanced rescission authority
called legislative line-item veto proposed in late 1989 by a group of Senators.
In the absence of a line-item veto amendment to the Constitution, enhanced
rescission would give the President a realistic opportunity to seek to eliminate
from appropriations bills special interest items that he deems unworthy, while
offering Congress full protection through a vote on each rescission.
2
Social Security Surpluses
o
The Administration has proposed in the FY 1991 budget a Social Security
Integrity and Debt Reduction Fund (SSIDRF) to ensure that anticipated
surpluses in the Social Security program are not spent for other purposes.
Instead, they would be applied to reduce the Federal government's
outstanding debt.
o
By retiring government debt and, in effect, balancing the non-Social Security
budget, anticipated surpluses would be injected into the Nation's capital
markets. Thus, the Federal government would become a net saver -- a
source of funds for enhanced growth.
Once the SSIDRF is fully phased in, the Federal government would
pay from the general operating budget into the SSIDRF each year an
amount equal to the projected surplus on the Social Security trust
funds during that year. The payments into the fund could be used
only to reduce outstanding Federal debt held by the public. These
payments would be counted as a standard outlay in the budget.
To preclude Federal borrowing as a method to finance these
contributions, the current GRH law would be amended to require a
balanced budget in 1994 and thereafter. Payments into the SSIDRF
would be exempt from the sequester in the GRH law.
In the near term, saving allocated to the SSIDRF would rise quickly,
from 0.3% of GNP in 1993 to 1.5% of GNP in 1995.
The Director of the Office of Management and Budget, testified
before the Senate Finance Committee on February 8, 1990 to explain
the Administration's SSIDRF proposal.
3
Revenue Developments
o
Federal revenues have grown steadily during the current, 8-year economic
expansion. In each year since the expansion began, Federal revenues have
exceeded the average of 18% of GNP experienced during the 1950-1979
period. Revenues are projected to increase by 9% in FY 1991 and to total
19.9% of GNP.
o
The projected increase in revenues in FY 1991, comes largely from a
projected increase in incomes, but additional steps are being proposed which
would affect revenues. For example, the President's budget for FY 1991
proposes:
Extending social security retirement coverage to those state and local
employees not currently participating in public employee retirement
programs. This measure would provide coverage for approximately
4 million state and local employees. This extension of coverage is
expected to yield revenues of $2.1 billion in FY 1991, and more in
future years.
Providing coverage for all state and local government employees
under the Medicare Hospital Insurance program. This proposed
extension, to take effect on October 1, 1990, would yield an
anticipated $1.7 billion in FY 1991.
Reducing tax rate on capital gains will increase Federal revenues (see
Lower Capital Gains Tax Rates, below).
Raising a variety of aviation user fees. The air passenger tax would
be increased to 10%, the air freight tax to 6.25%, the non-commercial
aviation gasoline tax to 15 cents per gallon, and the non-commercial
jet fuel tax to 17.5 cents per gallon. It is anticipated that these
proposals would raise $500 million for the Airport and Airway Trust
Fund in FY 1991, and more in future years.
Making permanent the 3% communications excise tax. If enacted,
this extension would yield an estimated $1.6 billion in FY 1991, and
more in future years.
4
o
In addition to these revenue measures, the IRS has identified several
management reforms and opportunities for increased enforcement that are
expected to yield more revenue. Some of these are listed below.
Resources will be reallocated to accelerate the examination process
for tax shelter cases, making it possible to close such cases more
quickly. Significant cases will be prioritized and given expeditious
handling. It is estimated that this reallocation of resources will yield
an additional $349 million in FY 1991.
Settlement authority for appeals will be delegated to the examiners
of the Coordinated Examination Program on the basis of historical
appeals settlement precedents. The result will be an acceleration of
the receipt of taxes, penalties, and interest. The effect on FY 1991
revenues is estimated to be $547 million.
Resources will be shifted to conduct actuarial examinations of small
retirement plans, increasing the number of examinations in this area
from the previously planned 700 to 18,000. The revenue effect begins
in FY 1990, with additional collections of $64 million. An additional
$602 million is anticipated for FY 1991.
Resources will be reallocated from examinations staff to appeals staff
in order to help close targeted large cases in the appeals process.
The IRS plans to target between 30 and 50 cases in FY 1991, yielding
collections of approximately $1 billion in that year.
5
Private Sector: Incentives to Save and Invest
Though still below historical levels, the personal saving rate in the U.S. seems to be
improving. It reached 5.4% in 1989, up from a trough of 3.2% in 1987, and it now
appears to be moving higher. The Administration's Working Group on Savings and the
Cost of Capital considered numerous options to stimulate personal savings. As a result
of this review and analysis, the Administration has proposed to Congress several initiatives
designed to stimulate private saving and investment further.
Family Savings Accounts
o
The Administration has proposed the introduction of Family Savings
Accounts (FSAs). FSAs would stimulate private saving by allowing tax-free
eaming.s on contributions to these accounts.
Individuals would be able to make non-deductible contributions of up
to $2500 per year and couples up to $5000 per year, provided the
taxpayer's adjusted gross income is less than $60,000 per year (less
than $100,000 for heads of households, and less than $120,000 for
married couples filing joint returns).
Contributions to FSAs would be allowed in addition to contributions
to qualified pension plans, IRAs, 401(k) plans, and other tax-favored
forms of saving.
Earnings on contributions retained in the FSA for at least seven years
would be eligible for full tax exemption upon withdrawal. Withdrawals
of earnings allocable to contributions retained in the FSA for less than
three years would be subject to both a 10% excise tax penalty and to
income tax. Withdrawals of earnings allocable to contributions
retained in the FSA for three to seven years would be subject only
to income tax.
o
On March 27, 1990, the Assistant Secretaries of the Treasury for Tax Policy
and Economic Policy testified before the Senate Finance Committee to
explain the Administration's proposal to establish Family Savings Accounts.
6
Individual Retirement Accounts
o
The Administration has proposed improving existing Individual Retirement
Accounts (lRAs) by making them more attractive to savers.
Withdrawals of up to $10,000 per taxpayer would be allowed for
eligible home purchases.
The 10 percent excise tax on early withdrawals would be waived for
eligible taxpayers.
Eligibility for penalty-free withdrawals would be limited to individuals
who did not own a home in the last three years and are purchasing
or constructing a principal residence that costs no more than 110%
of the median home price in the area where the residence is located.
Lower Capital Gains Tax Rates
a
The Administration has proposed lowering the effective tax rates on capital
gains. The proposal would induce more saving and investment by raising
after-tax rates of return, especially for long-term investment.
When fully effective in 1992, the exclusion on capital gains would be
30% for assets held 3 years or more, 20% for assets held at least 2
years (but less than 3 years), and 10% for assets held at least one
year (but less than 2 years).
The holding period requirements are phased in. For dispositions of
assets in 1990, the 30 percent exclusion applies to all assets held at
least 1 year. For dispositions in 1991, assets held 2 years receive the
30 percent exclusion, and assets held 1 year receive a 20 percent
exclusion.
The proposal would apply to all individual capital assets except
collectibles (eg., works of art, antiques, gems, etc.).
Excluded capital gains are included in the alternative minimum tax.
As a result of these exclusions, the effective tax rates applicable to
capital gains on qualified assets by a taxpayer in the 28 percent tax
bracket would be, respectively, 19.6 percent, 22.4 percent, and 25.2
percent.
7
o
On March 28, 1990, the Chairman of the President's Council of Economic
Advisers and the Assistant Secretary of the Treasury for Tax Policy testified
before the Senate Finance Committee to explain the Administration's
proposal to reduce tax rates on capital gains.
Other Incentives to Save and Invest
o
In addition to the saving initiatives described above, eligible U.S. workers
can still participate in 401(k) savings plans. These plans, which are similar
to the Japanese "ZAIKEI", involve the deduction of a predefined proportion
of an employee's pay. These funds are deposited into a savings or
investment account. The employee is not taxed on these funds until they
are withdrawn. A penalty is assessed for withdrawals prior to retirement.
o
The Secretary of the Treasury has testified against the double taxation of
dividends. The Department of the Treasury is currently studying this issue.
Best efforts will be made to complete this study by the time of the final SII
report. No legislation is expected in 1990.
8
II.
Corporation Investment Activities and Supply Capacity: Improvement of U.S.
Competitiveness
Investment in U.S.-based production capacity would enhance the competitiveness of
exports from the United States. Changes in certain U.S. laws and regulations, as well as
the continued openness of the United States to foreign investment, will facilitate productive
investment in the United States.
Anti-trust Reform
o
The Administration supports legislation which would reduce uncertainty
about the treatment of production joint-ventures under the anti-trust laws.
The legislation would promote production joint-ventures that enhance
competition, while retaining appropriate safeguards for consumers.
o
When an anti-trust lawsuit is filed against a production joint-venture, the
courts would be required to take into account the competitive benefits of
the venture as well as its costs.
o
For production joint-ventures that are notified to the government, anti-trust
liability would be limited to actual damages rather than the current treble
damage liability.
o
All stages -- from the beginning stage of joint R&D activities to the final
stage of joint production -- would be covered by either the proposed
legislation or the 1984 National Cooperative Research Act. U.S. Government
guidelines, either those in effect or those to be issued, will clarify the
treatment of joint research and production activities under the Antitrust
Laws.
9
Product Liability Reform
o
The Council on Competitiveness, chaired by the Vice President, has endorsed
legislation that would reform product liability laws. This legislation would
contribute to uniformity in all 50 states and limit damage awards.
It is designed to restore basic principles of fairness: adequate
compensation for accident victims; fault-based liability; and dispute
resolution.
The result would be to cut down on excessive litigation and the cost
of doing business in the U.S. It would also lessen disincentives to
develop new products and other innovations.
o
The President has approved the Council of Competitiveness' recommendation
to make product liability reform a top priority.
o
The Administration is also working with groups from all sectors of the U.S.
economy to reform U.S. product liability laws. The Administration recognizes
that reform is necessary to remove burdens on innovation and to improve
U.S. competitiveness, while still ensuring protection for injured parties.
Policy Toward Foreign Direct Investment
o
United States policy toward foreign direct investment has long recognized
that a free flow of investment capital across borders benefits both host and
investor countries. The United States generally provides foreign investors
non-discriminatory treatment under U.S. laws and regulations. It is in the
interests of U.S. consumers, workers, and investors to maintain this open
policy.
o
In his Economic Report transmitted to the Congress in February 1990,
President Bush stated:
To serve the interests of all Americans, we must open markets here
and abroad, not close them. I will strongly resist any attempts to
hinder the free international flows of investment capital, which have
benefitted workers and consumers here and abroad.
10
o
Consideration is being given by the Administration to the issuance of a more
detailed policy statement reaffirming the Administration's strong commitment
to an open direct investment policy.
o
For over 200 years, the United States has welcomed foreign investment and,
at the same time, protected vital national security concerns. The U.S.
restricts foreign investment only to protect the national security. The ExonFlorio provision of the Omnibus Trade Act, which authorizes the President
to prohibit foreign acquisitions that threaten to impair the national security,
is consistent with this long-standing policy.
o
The President delegated his authority to review foreign acquisitions that
might impair the national security to the Committee on Foreign Investment
in the United States (CFIUS). As of April 1990, CFIUS reviewed over 300
transactions, formally investigated seven, and referred four to the President
for a decision. In only one case has the President prohibited a transaction
pursuant to Exon-Florio.
o
In line with the Administration's open investment policy and the provision
of the law, the Exon-Florio authority will be used only when no other
measures are adequate or appropriate to protect the national security.
o
The Government of Japan has raised a question regarding the U.S. position
on H.R. 5 (the Bryant Bill). This bill would require registration and
The
disclosure of foreign direct investment in the United States.
Administration strongly opposes this bill.
Tax Treatment of Foreign Investors
o
The U.S. and Japan have entered into a tax treaty that provides for nondiscriminatory treatment of business enterprises of the two countries.
Other Measures to Build Supply Capacity
o
In order to reduce U.S. reliance on oil imports, the President's FY 1991
budget includes proposals for tax credits to encourage the discovery of new
oil and gas fields and the reclamation of old ones.
o
Capital investment in productive capacity will also be encouraged by the
Administration's proposals that would lower the cost of capital.
11
III. Corporate Behavior
The productivity of U.S. workers and the competitiveness of U.S. corporations are
affected by the decisions of corporate managers. These managers, in tum, are influenced
by the behavior of company shareholders. The Administration is pursuing policies which
will encourage managers to take decisions that will benefit their companies in the longterm.
o
Long-term investment (as well as short-term) might be discouraged by the
high cost of capital in the United States, and by a tax system which penalizes
certain forms of saving and investment.
o
The Bush Administration is pursuing policies to lower the cost of capital.
Such policies include lowering the tax rate on capital gains, promoting private
saving, and eliminating Federal dis-saving. These policies are intended to
lower the cost of capital for American companies, thereby encouraging longterm investment and long-term planning by management.
o
The Administration's Working Group on Savings and the Cost of Capital
continues to review proposals that could result in a lower cost of capital for
U.S. companies.
o
In addition to efforts to reduce the cost of capital, the Administration
continues to seek ways to foster a long-term investment horizon on the part
of corporate managers.
The Treasury is conducting a study of how the relationship between
managers and institutional investors of U.S. corporations affects longterm competitiveness. The study is expected to be completed by
early summer.
The Secretary of the Treasury also supports efforts to address
regulatory fragmentation in the securities and futures markets. This
is intended to promote innovation and increase investor confidence
by more effective enforcement and steps to improve the operation of
markets (including, among others: harmonization of margins;
coordinated circuit-breakers; and improved clearance and settlement
procedures).
o
As part of its review of factors that affect corporate competitiveness, the
Treasury is examining how compensation packages influence the time
horizons of executives and of other employees.
12
IV.
Government Regulation
Certain government regulations discourage international trade and competItion.
Progress is being made to deregulate controls on both exports and imports.
Export Deregulation
o
In view of the changing strategic situation, the U.S. and its allies on the
Coordinating Committee for Multilateral Export Controls (COCOM) have
agreed to streamline export controls. COCOM is discussing the streamlining
of licensing systems for machine tools, telecommunications and computers
as a first step to reduce the number of controlled goods.
o
COCOM has also agreed to guidelines for member countries to eliminate
most licensing requirements for trade among COCOM member countries.
The United States plans to implement its new system in the near future.
o
In July 1989, the U.S. removed all controls on the re-export of dual use
goods and technologies (except supercomputers and electronic listening
devices) into and among CO COM member countries (and Finland and
Switzerland), as provided in Section 774.2(k) of the Export Administration
Regulations.
o
New export administration regulations issued in October 1989 eliminated the
requirement for U.S. re-export authorization for exported U.S. goods that
are incorporated as parts and components and comprise less than up to 25
percent of the end product. This liberalization eliminated re-export controls
on large numbers of telecommunications, electronics and instrumentation
equipment imported into European nations and Japan from the U.S.
o
The U.S. Government is reviewing and will consider changing its export
control scheme to allow exports of strategic products and technology by
those countries such as Japan which impose strict export control on those
items without U.S. re-export license irrespective of their destination.
13
o
The U.S. has significantly reduced trade impediments resulting from short
supply export controls. The Administration has revised U.S. short supply
policy with regard to agricultural commodities. The Administration has
proposed in the Uruguay Round that GAIT-contracting parties should be
prohibited from restricting exports of agricultural food products for reasons
of short supply. The United States is working with its major trading
partners, including Japan, to gain support for elimination of GATT Article
XI 2.(a).
Energy Exports
o
The U.S. has made significant progress in eliminating many energy trade
barriers.
In 1985, controls on exports of refined petroleum products were
eliminated as part of the renewal of the Export Administration Act
of 1979.
Exports of crude oil produced in the state waters of Alaska's Cook
Inlet were allowed in 1986, pursuant to the Energy Policy and
Conservation Act (EPCA) of 1976.
Exports of crude oil to Canada were substantially decontrolled in
1985, as authorized by both the EPCA and the Mineral Leasing Act.
From 1988 to 1990, the Administration removed legal and regulatory
barriers to the development of a project to export Alaskan LNG to
Pacific rim energy markets, as authorized by the Natural Gas Policy
Act.
The Commerce Department recently completed a study for Congress
(as required by Section 2424 of the Omnibus Trade and
Competitiveness Act of 1988) on the benefits and costs of exporting
California heavy crude oil and recommended a partial relaxation of
the ban on exports. This matter is pending; the Commerce
Department will offer testimony before the House Foreign Affairs
Committee on Thursday, April 5, 1990 with respect to this issue.
14
Import Liberalization
o
On July 25, 1989, President Bush announced the Steel Trade Liberalization
Program to phase out the voluntary restraint agreements (VRA) after two
and a half years and to negotiate the elimination of subsidies and other
trade distorting practices affecting steel.
This program reflects his
commitment to a meaningful international consensus and to freer and fairer
trade in steel on a global basis.
As part of this extension and in keeping with overall Administration
policy regarding adjustment measures, major U.S. steel companies
must make substantial commitments to reinvestment in modernization
for enforcement authority to continue. In addition, each of the major
steel companies is required to commit at least one percent of net
cash flow for worker retraining.
Since the inception of VRAs on steel in 1984, the major U.S. steel
producers have spent $8.0 billion on steel-related expenditures,
including plant and equipment, research and development, worker
retraining, and other efforts to adjust and modernize. These
companies have modernized their production facilities, eliminated
excess capacity, and drastically reduced their production costs.
o
VRAs on machine tools, which began on January 1, 1987, are due to expire
on December 31, 1991.
As with steel, and reflecting Administration policy on adjustment,
there is a domestic action plan in place which is intended to facilitate
the revitalization of the U.S. machine tool industry.
Despite thin profits, the machine tool industry has increased
expenditures on research and development and product engineering
and design.
Combined spending on research and new product development
totalled $143 million in 1988 (the most recent data available), or
4.2% of gross sales. By comparison, profits were only 2.1% of sales
in 1988.
During the last two years, many machine tool companies have
introduced major new models of machining centers, milling machines,
lathes and punching machines.
15
v.
Research and Development
A steady stream of innovative ideas and technological development will enable the
United States to remain a formidable competitor in international markets. To maintain
this technological flow, the United States must strengthen its research and development
efforts. The Administration has proposed several initiatives to advance U.S. research and
development by both the public and private sectors.
Federally-supported Research and Development
o
The President's FY 1991 budget calls for a $4.5 billion increase in Federal
funding for research and development, to a record high of $71 billion.
Support for civilian R&D will increase by 12% and defense-related R&D
will increase by 4%.
o
A 22% proposed increase for Federal civil space activities includes a 72%
increase for the development of the commercial potential of space, a 47%
increase for manned exploration, a 36% increase for space station
development, and a 22% increase for scientific exploration.
o
Part of the $4.5 billion expansion in Federal R&D spending is devoted to
a 14% funding increase for the National Science Foundation.
The
Administration remains committed to doubling the NSF budget by 1993.
o
The President demonstrated his commitment to promoting technological
development in the United States by establishing the position of
Undersecretary for Technology at the Commerce Department.
The
President's nominee for this position testified before the Senate Commerce,
Science and Transportation Committee on March 26, 1990, and is now
awaiting confirmation by the Senate.
16
Private Research and Development
o
The Omnibus Budget Reconciliation Act of 1989 modified the Research and
Experimentation (R&E) credit and extended it for the first nine months of
1990. The R&E credit is 20% of qualified research expenses that exceed
a company's base amount (the product of the company's average gross
receipts during the previous four years and the ratio of the company's 198488 R&E to its 1984-88 gross sales).
o
The President's FY 1991 budget would make permanent the R&E credit,
and would revise R&E expense allocation rules. These changes would
encourage firms to establish and expand research facilities by assuring them
that tax incentives will still be available when research is carried out.
o
Private research and development would also be bolstered by lowering the
cost of capital and reducing regulatory and legal barriers to investment (see
policy initiatives described above).
Adoption of the Metric System
o
The Commerce Department has revised and issued for public comment an
updated "Metric Conversion Policy for Federal Agencies" under the Code of
Federal Regulations. The update, to be issued in final form by June 1990,
includes stronger guidance for agency metric implementation, suggestions for
agency metric organization and requirements for agencies to report metric
progress to Congress.
o
Commerce officials continue to meet with standards groups, trade
associations and business advisory groups to encourage use of the metric
system in the private sector.
o
The Secretary of Commerce wrote to each state governor in December 1988
alerting them to the 1988 Trade Act requirements for Federal agencies to
convert to metric in grants, procurement, publications and other businessrelated activities by the end of FY 1992. He urged them to plan similar
initiatives at the state level and to name a senior official to the National
Council on State Metrication. Response from the states was encouraging.
17
o
The General Services Administration (the principal buyer for the U.S.
Government) obtained public comment on their planning for metric
conversion and will publish their plan in the Federal Register this week.
The plan calls for Federal procurement to be conducted in a manner that
will stimulate U.S. industry to rapidly develop greater metric capability.
o
The House Committee on Science, Space and Technology, Subcommittee on
Science Research and Technology, will hold hearings on Federal agency
compliance with the metric provisions of the 1988 Trade Act on April 24,
1990. These hearings, in reaction to a recently completed GAO study on
the matter, demonstrate the urgency with which metrication is viewed by the
Congress. Senior officials of the Departments of Commerce, Defense,
Energy, and Education, the General Services Administration and NASA are
scheduled to testify.
o
At Federal agency urging, most U.S. technical standards organizations are
revising their policy on metric use to develop more aggressively the metric
standards needed by U.S. business and industry in their transition to metric.
o
The Department of Commerce continues to study ways for the private
sector to significantly expand and increase the use of the metric system.
18
VI.
Export Promotion
The President has clearly stated that trade and the competitiveness of U.S. business are
high priorities of his Administration. To this end, the Administration has been working
hard to make U.S. export promotion efforts more effective.
o
The FY 1991 budget proposed $159 million for the Commerce Department's
export promotion efforts, an increase of $10 million over 1990.
o
The Department of Commerce has developed a special export program
aimed specifically at increasing U.S. exports to Japan.
This program focuses on long-term commitments by U.S. firms to the
Japanese market and capturing a larger share of Japan's public
infrastructure and overseas development projects.
It also provides services tailored to the needs of small and medium-
sized U.S. exporters seeking to enter the Japanese market.
Successful implementation and operation of this program will provide
a model for the development of trade promotion plans for other
countries and regions.
o
The Department of Commerce is expanding its export promotion activities
in several geographical areas:
Commerce has developed a 3-tiered program to help U.S. companies
respond to the opportunities presented by the integration of the
European Community (EC) into a unified market in 1992.
For Eastern Europe, the Commerce Department has been active in
promoting U.S. business opportunities through a number of trade
missions and, most recently, by establishing the Eastern Europe
Business Information Center.
The Commerce Department developed an education program to
inform the U.S. business community, particularly small businesses,
about the new trade and investment opportunities created by the
U.S.-Canada Free Trade Agreement.
19
VII.
Workforce Education and Trainins:
Improving the education and training of the U.S. workforce would heighten America's
competitiveness. The Administration has set ambitious goals to improve the quality of
education and training in the United States.
Workforce Education
o
The President and the Nation's governors recently agreed on a package of
six national educational goals for achieving scholastic excellence and
providing U.S. students with skills to compete in a rapidly changing world.
o
These goals, to be reached by the year 2000, include: a high school
graduation rate of 90% or more; preeminence in the world in math and
science scholastic achievement; full adult literacy; ensuring that all schools
are free of drugs and violence; and (in grades four, eight and twelve)
achieving competency in key subject areas such as English and mathematics.
o
The President's FY 1991 budget includes a $500 million increase (36%) for
programs which prepare children to learn, provide remedial assistance to the
disadvantaged, and stress math and science education.
o
The Educational Excellence
the U.S. educational system.
Senate on February 7, 1990.
million to support programs
o
The Administration has proposed, as part of the Educational Excellence Act
of 1989, an alternative teacher certification process.
Under the
Administration's plan, gifted professionals would be certified to teach
elementary and secondary school, even if they had not followed the
traditional course for teacher certification.
Act of 1989 contains programs to reinvigorate
The Administration's bill was approved by the
The President's FY 1991 budget provides $401
proposed in the Act.
20
Workforce Training
o
The programs provided for under the Job Training Partnership Act (JTPA)
are considered highly effective, and the President's FY 1991 budget proposes
spending approximately $4 billion to fund them.
o
The Administration proposed amendments to the JTP A in 1989 which are
intended to revise eligibility criteria to ensure that the program targets the
most disadvantaged; provide more intensive and comprehensive services to
participants; and improve coordination among Federal, State and local
human resource programs. Hearings have been held in both the House and
Senate on these amendments. House "mark-up" is scheduled for after
Easter. The Administration expects legislative action this Congressional
session.
o
In addition to the growing commitment of the private sector to workforce
education, the Labor Department has initiated a seven-point action plan to
improve the quality of the workforce. A series of pilot programs will be
launched this spring to expand work-based training.
o
The Labor Department has awarded a grant for demonstration projects to
the Human Resources Development Institute, the research arm of the AFLCIO, to upgrade training for current employees in several industries. The
unions and the Department of Labor will use the experience gained in these
projects in expanding this approach to other industries.
o
Another demonstration project is developing methods to support structured
work-based training in small firms. Such firms typically lack the necessary
expertise and resources for training on their own. The demonstrations will
experiment with effective methods for overcoming barriers to training.
o
The Secretary of Labor has recently published a booklet, "Work-based
Learning: Training America's Workers", as part of the Administration's effort
to build a positive perception of, and thereby encourage, work-based
training. This booklet proposes a national work-based training board and
improvements in the national apprenticeship system. The National Advisory
Board on work-based training will provide guidance on expansion of
structured work-based training and on development of a voluntary system for
accelerating such training.
21
o
The Labor Department is in the process of testing alternative uses of
unemployment insurance (UI) funds to accelerate jobless workers' return to
work. Three experimental projects are studying the effectiveness of offering
UI claimants a cash incentive to obtain a job early in their jobless stage.
Two others are designed to help UI recipients set up their own business and
provide entrepreneurial training, counselling, and a self-employment
allowance.
o
Towards the objective of increasing U.S. private investment in human
resource development, the Department of Labor will examine options to
increase investment in skills training by conducting research and
demonstration projects which:
study the effectiveness of existing incentives for both employer and
employee-financed training;
examine incentive policies in other countries, including Japan; and
form partnerships with industry groups to promote and implement
structured workplace training programs.
o
In 1990, the U.S., in cooperation with Japan, will exchange visits of experts
and host a symposium on comprehensive human resource development.
22
JAPAN - U.S. STRUCTURAL IMPEDIMENTS INITIATIVE
INTERIM REPORT BY THE JAPANESE DELEGATION
APRIL 5, 1990
Saving and Investment Patterns
I.
Basic Recognition
Reduction in the Current Account Surplus
As a result of appropriate policies pursued to sustain solid economic
growth led by a strong domestic demand, Japan's current account surplus
has been reduced remarkably from 4.5 percent of GNP in FY 1986 to an
estimated 2.2 percent in FY 1989, which is less than half the level of FY
1986. This ratio in FY 1990 is projected to be less than 2 percent.
Impressive growth of imports, along with increases in overseas
travel expenditures by the Japanese people, reflecting in part an increased
emphasis on leisure, has contributed to this positive trend. U.S. exports to
Japan have increased faster than U.S. exports to the rest of the world.
To make further progress on the basis of this positive trend, the
Government of Japan will continue to undertake economic policies aimed
at promoting sustained non-inflationary growth led by domestic demand.
The Government of Japan recognizes the need to continue to reduce
its current account surplus and reaffirms its commitment to work
actively toward that end. The Government of Japan also recognizes that a
reduction of the imbalance between domestic savings and investment is
important to that process. This will help further a reduction in the
current account surplus.
1.
2.
Recognition of the Need for and Importance of Social Overhead
Capital Improvement
The Government of Japan recognizes that there remain areas where
Japan is still behind other major industrialized countries in terms of the
levels of social overhead capital accumulation, though the pace of
improvement has been rapid -- partly as Japan was historically a slow
starter in this field -- with annual public investment (Ig) four times as
large as that of the U.S. measured against the GNP.
Under these circumstances, the Government of Japan will continue
to pursue its policies to increase and promote steady accumulation of
social overhead capital, based on the keen recognition of the need for and
importance of social overhead capital improvement.
This would, through sustained non-inflationary growth of domestic
1
demand, facilitate further reduction in the current account surplus.
II.
Measures to be Taken
1. Positive Measures in the FY 1990 Budget
(1) The Government of Japan declared in the "Economic Outlook and
Basic Policy Stance of Economic Management for FY 1990," manifest of
guiding principles for the budget, that much emphasis should be placed, in
compiling the FY 1990 Budget, on the improvement of the social overhead
capital, especially those directly related to the quality of life, in order to
further substantiate the foundation for a better life of the people.
(2)
Based on that principle, the expenditures for public works, at
7,444.7 billion yen, surpasses the historic high level of the previous
fiscal year, despite the revenue constraint caused by unsuccessful sales
of NTT stocks in the previous fiscal year, and notwithstanding the
vigorous expansion of the economy expected in FY 1990 which does not
warrant additional stimulus.
Furthermore, the public works expenditure by local governments
financed entirely by themselves (in the Local Public Finance Program) as
well as the expenditures of the public work executing agencies financed
through the FILP (Fiscal Investment and Loan Program) are expected to
rise 7 percent, respectively, in FY 1990.
In sum, the investment by the public sector on GNP basis (Ig) would
add up to 26.3 trillion yen.
(3)
While there are currently fifteen long-term plans for specific
categories of social overhead capital designed to improve them in a
systematic manner, it is expected that total cumulative expenditures in
seven out of eight such plans, which are to expire at the end of FY 1990,
will exceed the projected target expenditures as a result of further
emphasis placed on social overhead capital in the FY 1990 Budget.
2.
Toward Further Improvement
(1 ) The Government of Japan intends to increase and promote steady
accumulation of social overhead capital, from a medium to long term
perspective, as the nation heads for an aging society toward the twentyfirst century.
For that purpose:
(i)
The ministries concerned will expedite preparations, at
2
this early juncture, for formulating new long-term plans
on eight categories of social overhead capital -including housing, sewers, parks, airports and port
facilities -- whose current plans are to expire at the
end of FY 1990 (Le., March 1991), in order to indicate
positive and specific targets for larger long-term plans
for the major areas by the final SII report.
It is envisaged that the current long-term plans
for certain other key areas will also be augmented on a
scale similar to that for these plans.
(i i) The Government of Japan will start formulating
immediately a new comprehensive plan of public
investment for the coming ten years. In this plan, real
aggregate investment in infrastructure will be increased
substantially above current levels for the ten years to
boost domestic investment, improve social overhead
capital and reduce the shortage of investment relative
to savings and to the size of the Japanese economy.
This should, along with other measures, facilitate
further reduction in the current account surplus.
Toward these ends, the Government of Japan will
specify the aggregate amount of expenditures of the plan
in the final SII report.
Through these efforts, the accumulation of
social overhead capital in Japan will be considerably
enhanced and advanced.
(iii)
The yearly expenditure for social overhead capital
should be decided flexibly considering the prevailing
economic and fiscal conditions, paying due attention to
avoiding inflation and overheat of the economy as well,
given the significant role that the public investment
plays as a counter-cyclical measure in Japan.
In allocating the expenditure among various types of social overhead
(2)
capital, utmost consideration should be given, as much as possible, to
those closely linked to the improvement of the quality of life.
(3) The Government of Japan will make effective use of the legislative
form of the budget that authorizes contracts incurring treasury liabilities
over the succeeding fiscal years, in order to secure maximum efficiency in
3
executing public investments within the constitutional framework of the
single year budget system.
(4) The Government of Japan will make more effective use of the FILP
(Fiscal Investment and Loan Program) funds to improve social overhead
capital. Such effective use would include financing urban redevelopment
projects through the Japan Development Bank. In allocating the FILP
funds, utmost consideration should be given, as much as possible, to
housing and other projects contributing to enhancement of the quality of
life of the people.
(5) The Government of Japan will see to it that overall efficiency be
increased in promoting the complex multi-jurisdictional development
projects like the Kansai International Airport and the Tokyo Bay Area
Development, by ameliorating systems for securing better communication
and closer cooperation among the related ministries.
(6) Land Use, Deregulation, etc.
(i)
The Government of Japan will give due consideration to
effective utilization of publicly held lands in
metropolitan areas for urban facilities, urban
ensure
redevelopment, and public housing projects to
smooth implementation of public works. The Government
of Japan sees to it that the discharged track yard site
in Shiodome should be highly utilized as mUltifunctional urban space responding to the needs arising
from internationalization, and as a regional
transportation hub. Related urban infrastructures
including subways and roads should be furnished as well.
(i i) The Prime Minister's Office will be central in
vigorously promoting utilization of super-subterranean
space (about 50 meters below surface or deeper in
metropolitan areas) for social overhead capital
including urban infrastructures in metropolitan areas
and thus securing more effective use of land. Wideranging issues--Iegal, safety, and environmental--need
to be addressed carefully in the process.
(iii)
More active use of various resources in the private
sector, such as financial resources, technologies and
know-hows, is important for the improvement of social
overhead capital, as seen in such cases as the Kansai
4
International Airport and the Trans Tokyo Bay Road
Project. The Government of Japan will continue to
promote further deregulation and to provide various
incentives as needed in order to make the best use of
these private sector resources in the social overhead
capital improvement.
(iv) The Government of Japan will effectively activate the
special act which aims at promoting organized
development of housing sites and railways in greater
metropolitan areas, thereby improving the quality of
life of the residents and promoting orderly development
of the region.
For example, discussions are being held on the
formation of the basic plan, including the appropriate
form of managing entities, for a new railway line called
the "Joban New Line."
(7) The Government of Japan will sincerely implement the U.S.-Japan
Major Projects Arrangements aiming at facilitating the U.S. firms to gain
expertise in the Japanese construction market.
3.
Encouraging Consumption in the Private Sector
(1 ) As to curtailing work hours, the Government of Japan will launch a
trial, starting this April, of 40 hour weeks for those government
employees on shift work schedules, to pave a road to complete 5 day
weeks for al\ government employees, and will encourage curtailing work
hours in the private sector.
(2) As to improvement of consumer credit convenience, study on the
credit sales industry in the future, including the issue of allowing
revolving credit function to the credit cards issued by bank affiliated
companies, is now in progress by the Council on Credit Sales, paying due
attention to consumer protection, equal footing for competition and
maintenance of an orderly credit system. Efforts will be made to reach a
conclusion of the Council by the final SII report.
(3) The Government of Japan will welcome business decisions of the
financial institutions to lengthen operating hours of their teller machines
when they so decide based on their own commercial considerations, while
there are no restrictions on the operating hours at present.
5
Land Policy
Basic Recognition
The land problem is one of the most serious domestic problems
facing the Government of Japan. The Government of Japan has, as a first
step, already enacted the Basic Land Act (*) last December. Recognizing
the need such as for the increase of supply of housing and residential land,
the Government of Japan will implement a wide range of specific
measures as set forth in guidelines such as the Priority List of Land
Policies, also announced last December, and as set forth below.
Due to these measures, it is expected that housing and other demand
will be boosted, leading to greater import opportunities.
1.
Promotion of further supply of housing and residential
land in metropolitan areas.
2.
Comprehensive review of the land taxation system.
3.
Greater utilization of land owned by the central or local
governments or other public land.
Improvement of infrastructure necessary to facilitate
4.
increase in the supply of housing and residential land.
5.
Review of the Land Lease Law and the House Lease Law.
6.
Review of divisions between Urbanization Promotion Areas
and Urbanization Control Areas and promotion of specific
deregulation measures.
7.
Rationalization of the official assessment of land value.
I.
(*)
(a)
(b)
(c)
II.
The Basic Land Act stipulates:
basic principles regarding land such as giving priority
to public welfare;
responsibilities of the central and local governments,
private enterprises and individuals; and
basic elements concerning land policies.
Measures to be Taken
1.
The Government of Japan will take the following measures and
submit necessary legislation to the Diet by the end of FY 1990.
6
(1)
Improvement of the existing system to enable the formulation of
master plans regarding the supply of housing and residential land across
two or more prefectures,
(2) Establishment of a new system for identifying and promoting the
utilization of, idle land such as unused plant sites.
(3) Improvement of current city planning and other systems in order to
facilitate the conversion of agricultural land within urbanization
promotion areas to residential land.
Through these measures, substantial increase of the supply of
housing and residential land in metropolitan areas would be expected.
2.
(1)
The Government of Japan will conduct a comprehensive review
on the land taxation system on the basis of such basic principles of
taxation as equity, neutrality and simplicity, and in accordance with the
principles expressed by the Basic Land Act and with other land policies. A
study will be initiated by a SUb-commission to be established this spring
under the Government Tax Commission. Taking into consideration the
results of this study, the Government of Japan will submit the necessary
legislation to the Diet by the end of FY 1990.
(2)
With respect to the taxation system on agricultural land within
urbanization promotion areas of the major metropolitan areas, the
Government of Japan, together with necessary adjustments and
improvements in the related policies, will conduct a review with a view
to addressing the deferment system of payment of the inheritance tax and
the fixed assets tax, in accordance with the Comprehensive Land Policy
Plan, so that the results will be smoothly implemented from FY 1992.
(3)
In addition to the establishment of the new system for idle land
mentioned in 1. (2), a review will be made with regard to the possible
strengthening of the special land holding tax on idle land.
3.
The Government of Japan will examine, by the end of FY 1990, the
utilization of State-owned land in the major metropolitan areas and try to
enable the land to be utilized for, through sales and other arrangements,
appropriate private projects of urban district development, urban
facilities, urban redevelopment and public housing projects, except those
cases where preservation of land for public use is necessary. The
Government of Japan will urge local governments to take similar
measures with regard to local government-owned land.
7
Effective utilization of the extensive land owned by the Japanese
National Railways Settlement Corporation in metropolitan areas will also
be ensured.
4.
In order to increase the supply of housing and residential land,
installation of the required infrastructure will be steadily pursued. In
this context, the Government of Japan is committed as specified in
Section II. 2. (1) (i) of "Saving and Investment Patterns" chapter to
indicate a positive and specific target for a larger long-term plan for
housing (as well as other major areas whose plans are to expire at the end
of FY 1990) by the final SII report. The "eminent domain system" will also
be utilized. Studies will be conducted on the system concerning public use
of the deep underground in order to encourage its utilization.
5.
In order to meet the changed circumstances and to improve the legal
relationship between lessors and lessees, a review of the Land Lease Law
and the House Lease Law has been conducted, and an outline of the draft
amendment of these laws may be ready by as early as the end of FY 1990.
The Government of Japan will then submit the necessary legislation to the
Diet without delay. These measures are expected to induce a more
appropriate use of land and an increase in the supply of good quality
houses for lease.
6.
In order to encourage effective utilization of land, the Government
of Japan will conduct timely and appropriate review of divisions between
Urbanization Promotion Areas and Urbanization Control Areas, and zoning.
It· is expected that Urbanization Promotion Areas will be expanded to
provide for the growing housing demands. Specific deregulation measures,
including the relaxation of limits on building heights, total floor area
ratio, and coverage ratio will be pursued for quality projects contributing
to the increase of housing supply and the formation of a better urban
environment.
7.
In order to rationalize the official assessment of land value, the
Government of Japan will:
(1) rationalize the land value assessment for inheritance tax calculation
as soon as possible, taking into account the nature of the tax with a view
to making the assessment reasonably closer to the market value; and
8
(2) give guidance to local governments to rationalize their land value
assessment for fixed assets tax calculation at the time of the
reassessment of the land valued in FY 1991; and advise them to make
public the land values of the standard points.
9
Distribution
I.
System
Basic Recognition
Concerning the distribution system in Japan, the Government of
Japan attaches great importance to the enrichment of consumer life in
Japan through further improving efficiency, ensuring market access, and
building physical infrastructures. Based upon such recognition, the
Government of Japan will promote the implementation of a broad spectrum
of measures:
1.
The distribution of import freight will be accelerated and its cost
will be reduced by the improvement of airports, harbors, and other import
i nfrastructu res.
2.
Customs clearance procedures and other import procedures will be
further expedited to correspond to the increasing trade volume, while
maintaining such functions as realizing a proper and fair sharing of the
tax burden, and ensuring the health and safety of the people.
3.
Deregulation of the distribution system will be further promoted
with regard to a variety of laws and regulations, such as the Large-Scale
Retail Store Law, with a view to enriching consumer life in Japan.
4.
As to trade practices concerning distribution, an improved
environment will be sought from the standpoint of promoting competition
and securing market openness.
5.
Wide-ranging measures with lasting, structural impact wi" be
implemented in order to expand imports, thereby improving the efficiency
of Japan's market structure including the distribution system.
II.
Measures to be Taken
1.
(1)
Improvement of Import-related Infrastructures
Airport Improvement
10
(a)
(b)
Based on the Fifth Five-Year Plan for Airport
Improvement (FY 1986-90), the improvement of the New
Tokyo International Airport, the off-shore expansion of
the Tokyo International Airport and the improvement of
the Kansai International Airport are being vigorously
promoted as the three most important projects. In
particular, completion of the second phase construction
of the New Tokyo International Airport and the first
phase construction of the Kansai International Airport
will double the cargo handling capacity as the cargo
handling area will expand from about 20 hectares at the
New Tokyo International Airport alone to about 50
hectares at the two airports combined. This expansion
of capacity, together with the improvement and the
expansion of the regional airport and airport-related
cargo handling facilities, is a significant step toward
the goal of ensuring airport capacity sufficient to meet the
demand for international air services for some time to come.
The airport-related cargo handling facilities at the New Tokyo
International Airport and at the Baraki Terminal are being
improved and expanded responding to the increasing demand for
international air cargo handling. Considerable efforts are also
being invested in the improvement of local airport facilities:
For instance, the construction of the New Hiroshima
Airport is now vigorously under way with December, 1993
as the target inauguration date.
Regarding the Sixth Five-Year Plan for Airport
Improvement, the Minister of Transport referred the
matter to the Aviation Council on March 15. The
Ministry of Transport will request formulation of a new
five-year plan after receiving an interim report of the
Council in August. A major goal of the review is to
ensure that Japan's airport facilities can meet the
medium-to-Iong term growth of demand in international
air transportation. To this end, a number of airport
improvements, including the expansion plan of the Kansai
International Airport (its overall concept) and
increased use for international service of regional
11
airports, will be discussed in the process.
(c)
Improvement of roads related to import is being promoted
in line with the Tenth Five-Year Plan for Road
Improvement (FY 1988-92).
(2)
Harbor Improvement
Harbors are being improved in line with the Seventh Five-Year Plan
for Harbor Improvement (FY 1986-90). ·In order to be able to respond to
increasing imports, the improvement of container terminals for overseas
trade and large scale multi-purpose terminals for overseas trade will be
given high priority in the Eighth Five-Year Plan now being prepared.
Concerning warehouse facilities, the Government of Japan is promoting
private investment in facilities through such means as low-interest loans
by the Japan Development Bank (JOB) and favorable tax measures. Since FY
1989, special emphasis is being placed on promoting the improvement of
warehouse facilities dealing primarily with imported goods through a
special low-interest loan facility. Thanks to these measures, warehouse
companies in the Tokyo and Osaka metropolitan areas plan to expand their
facilities by 160/0 by the end of FY 1991.
2.
Expeditious and Proper Import Procedures
In order to ensure rapid entry of normal cargo imports into the
Japanese distribution system, the Government of Japan goal is 24 hours
clearance (from presentation of import declaration to import permit)
through entry procedures for imports by 1991. The Government of Japan
will ensure adequate budget resources and make regulatory changes
necessary to accomplish this goal.
(r) Customs Clearance Procedures
Automated Processing System will be introduced for customs
clearance of sea cargoes from 1991 to 1992. In addition, the Japanese
Customs will further improve and rationalize the customs clearance
procedures, in accordance with the report by the Japan-U.S. Customs
Experts Group. This will include efforts for achieving, within a few years,
the implementation of upgrading of NACCS (Nippon Air Cargo Clearance
System), expansion of the scope of the Provisional Examination System
and its procedural simplification, and introduction of the Automated Risk
Judgement System supported by the Customs Data Base.
(2)
Import Procedures other than Customs Clearance Procedures
A Japan-U.S. Experts Group, consisting of officials of the agencies
12
concerned, will be set up in order to make import procedures more
expeditious and proper. This Group will submit a report including
recommendations for improvement by the time of the final report of the
SII.
3.
(1)
Deregulation
Large-Scale Retail Store Law
As dynamic changes are called for in the distribution industry,
deregulation measures will be taken in order to meet new needs of
consumers, to enhance the vitality of the distribution industry and to
ensure smooth procedures for opening new stores. Deregulation measures
will be put into place by both the central Government and local public
authorities.
The following deregulation measures will be implemented by the
Government of Japan.
(a)
Deregulation measures that will be immediately taken
(such measures as those for an appropriate
implementation of the law)
(i)
In order to ensure smooth coordination procedures and to
facilitate the opening of new stores and expansion of
existing stores, the following deregulation measures for
an appropriate implementation of the law will be in
effect by the end of May this year, subsequent to the
deliberation by the relevant council. These are the
maximum measures which are legally possible under the
current Large-Scale Retail Store Law (LSRSL).
(aa) Shortening of coordination processing period for
opening stores:
The coordination processing period wi" be less
than one and a half years.
(bb) Exceptional measures concerning floor space for
import sales:
Regarding floor space for import sales,
coordination procedures will be exempted for an
increase up to a specific scale (approximately
100m2 of the floor space).
(cc) Exemption of coordination procedures for the
13
(ii)
increase of a certain increase in floor space:
Coordination procedures will be exempted for
certain cases such as a floor space increase up to
a specific scale (whichever is the smaller, 10 % of
the existing floor space or 50m2).
(dd) Relaxation of the scope of regulation on closing
time and the number of business holidays:
Closing time under regulation will be relaxed from
"after six o'clock p.m." to "after seven o'clock
p.m." The number of business holidays will be
relaxed from "less than four days a month" to "less
than 44 days a year".
(ee) Enhancement of transparency in the coordination
procedures:
Transparency of the coordination procedures will be
improved through such measures as further
disclosure of the outcome of the deliberation in
the Council for Coordinating Commercial Activities,
regular publication of the status of coordination
activities and receipt and processing of the
inquiries by the interested parties including those
wishing to open stores.
It is confirmed that, as has been the case in
the past, the ongoing coordination procedures will
not prevent other procedures required by other laws
and regulations (such as Building Standards Law and
City Planning Law) from being pursued in parallel
nor will they prevent those wishing to open stores
from advertising for potential tenants. It is also
confirmed that in case of acquisition of existing
retail outlets through corporate acquisition
(including those by foreign firms), the
coordination procedures are not required.
Regarding separate regulation by local public
authorities, the central Government, together with the
above measures, will make its utmost efforts by, for
example, directing local public authorities to take
necessary corrective measures in the light of objectives
14
of the law.
(i i i)
In order to ensure an appropriate implementation of the
law and of separate regulation by local public
authorities, the Government of Japan will take necessary
follow-up steps including the checking of the status of
implementation of the above measures. The institutional
system will be put into place to achieve the abovementioned objective by establishing the headquarters for
follow-up both in the Ministry of International Trade
and Industry (MITI) Headquarters and in regional Bureaus
and Department.
(iv) In order to ensure an appropriate implementation of the
above measures thus to expedite the processing of the
coordination procedures, the fiscal 1990 budget will
establish a new division called the Distribution
Industries Division in the MITI and will increase by ten
the number of officials concerned. Further efforts will
be made to expand and strengthen the institutional setup.
(v)
In order to accelerate changes in the distribution
industry and to expand manufactured imports, together
with the above measures, steps will be taken to help
promote imports by the distribution industry including
small and medium distributors. To achieve this
objective, the budget, the fiscal loans and investment
plan, and the tax reform proposal of the FY 1990 will
establish tax incentive measures to promote manufactured
imports, promote grass-root import expansion activities
of small and medium distributors, promote international
comprehensive distribution centers, expansion of import
promotion fairs by local retailers, and others. Further
efforts will be exerted to expand and reinforce such
measures.
(b)
Amendment of the law which is to be submitted to the
Japanese Diet during the next regular session
The Government of Japan will immediately start
preparation for the amendment of the law aiming at
submitting the bill during the next regular session of
15
the Japanese Diet, by initiating the deliberation of the
relevant council.
(i)
Standpoint of the amendment
(aa) Sufficient consideration upon consumer interest.
(bb) Ensuring expedited processing of the coordination
procedures.
(cc) Ensuring the enhanced clarity and transparency of
the procedures.
(dd) Consideration upon international request to Japan
to increase imports.
(i i) Items considered as the elements of the amendment.
(aa) Introduction of exceptional measures of
coordination procedures concerning the floor space
for import sales aiming at more import expansion.
(bb) Shortening of coordination processing period for
opening stores. (The objective of efforts is to
shorten the period to approximately one year.)
(cc) Enhancing clarity and transparency of coordination
procedures for opening stores.
(dd) Restraining local public authorities' separate
regulations.
(ee) Others.
(c)
Review after the above-mentioned amendment of the LSRSL
The LSRSL shall be reviewed further two years after the
above-mentioned amendment of the LSRSL. This study will
include an analysis of the law's impact on consumers and
competition in the retail sector and, based thereon, the
need for a basic review of the law and further action.
In order to make the first point clear, the abovementioned amendment shall include a provision stating
that the effectiveness of the implementation of the
amendment will be examined and that, based on this
result, examination will be made on matters including
removal of regulations applied to specific geographical
areas.
(2)
Regulation concerning premium offers and advertisement
The regulation of premium offers by the Act Against Unjustifiable
Premiums and Misleading Representation, including that by Fair
16
Competition Codes, is designed to ensure fair competition in the market
place and to protect consumer interests. Obviously, it is not intended to
be an impediment to new entry by foreign or domestic firms.
The Fair Trade Commission (FTC), however, is currently reviewing
all existing Fair Competition Codes on premium offers so that they will
not work as impediments to new entry by foreign or domestic firms,
giving priority to Codes relevant to foreign trade or investment. The FTC
will relax, as part of such an undertaking, the regulation of nine Codes as
early as possible this year.
Of the nine Codes, the contents of regulation by the Fair Competition
Code on Premium Offers in Chocolate Industries will be relaxed for the
second time by this June. Newspaper advertisements with coupons will be
allowed by this summer.
In reviewing the Codes, the FTC will hear the opinions of foreign
firms and foreign businessmen.
Guidance on Fair Trade Conferences by the FTC will be tightened lest
they should take any action beyond their proper objectives.
(3)
Regulation concerning liquor sales and other businesses
(a) The Guidelines for Liquor Sales Licensing were amended,
and their implementation has been improved since last
September by such measures as the easing of the
licensing criteria for large retail shops and the
simplification and clarification of those for averagesized liquor shops. Concretely, liquor sales licenses
are planned to be issued to all the large retail shops
(with a floor space of more than 10,000m2 ) and to about
5,000 average-sized shops by 1994. Moreover, the
Government of Japan will seek the possibility of frontloading licensing to large retail shops, which are
expected to sell more imported liquors, and will reach a
conclusion before the final report of the SII is
submitted.
(b) On trucking business, a law was approved by the Diet at
the end of last year and the Government of Japan has
decided to promote deregulation. The revised law altered
the method of entry regulation from the licensing system
to a permit system while abolishing the supply-demand
adjustment regulation, and changes the permit system for
17
(c)
(d)
4.
fare regulations to a notification system. (The revised
law is due to take effect on December 1 this year.)
With regard to the Pharmaceutical Affairs Law regulation
concerning general sales of pharmaceuticals, the
Government of Japan plans to decide on deregulation
measures by mid-May which will include the reduction of
items general pharmacies should be equipped with to
about one third of the present number.
In NTT, introduction of discounts for bulk contractors
of the "free dial" (toll-free calls) is under
consideration with a view to introduction by this June.
Reduced postal rates have been made available for direct
mails and catalogues sent out in large numbers for
business purposes. These have become possible by the
introduction of the advertising mail service in October
1987 and the catalogue parcel service in September 1989.
Improvement of trade practices
(a) The Fair Trade Commission (FTC) has held meetings of
the Advisory Group on Distribution Systems, Business
Practices and Competition Policy, consisting of scholars
and business experts, in order to formulate a guideline
clarifying the criteria regarding the enforcement of the
Antimonopoly Act vis-a-vis the marketing policies of
manufacturers towards distributors and of distributors
towards manufacturers. The Advisory Group is due to
issue a recommendation this June. The Fair Trade
Commission, after receiving the recommendation, will
formulate and publish the guideline. The FTC will strictly
enforce the Antimonopoly Act according to this
guideline so that business transactions among companies
,will not hinder fair competition.
The FTC will intensify information gathering on illegal
activities under the Antimonopoly Act, and will strictly
eliminate such activities. For that purpose, the FTC
will endeavor to enhance its investigation system.
(b)
The Ministry of International Trade and Industry (MITI)
is now examining its policies on such matters as the
18
ways and means of encouraging the industries concerned
to take positive measures to improve trade practices.
After consulting with the Industry Structure Council,
the Ministry will formulate a guideline for improving
trade practices aiming at simplification, clarification
and increased transparency of trade practices. M ITI will
start the process of formulating the guideline this
spring and will try to reach a conclusion by the time of
the final report of the SII. In that process, the
Ministry will hear the opinions of foreign business
organizations in Japan. MITI will present the guideline
to the industries concerned and encourage them to take
necessary steps. Contact points for processing
complaints from foreign businesses will be established
both in MITI and in the industries concerned.
5.
Import Promotion
The Japanese Government has introduced a new package of
comprehensive import expansion measures in order for Japan to become a
world leading importing nation. It includes:
(a)
creation of tax incentives to promote manufactured goods
imports;
(b)
considerable increase in budget allocation for import
expansion measures such as the establishment of an
information network for the promotion of imports and the
dispatch of experts to western countries and other forms
of human exchanges in search of products to be exported
to Japan;
(c)
strengthening and expansion of the low-interest loan
facilities for import promotion;
(d)
elimination of tariffs on more than 1,000 products.
These measures are to be implemented after Parliamentary
approval in this Diet session.
Regarding concrete complaints by foreign firms concerning the
standards and certification system, the Office of Trade Ombudsman (OTO)
will continue to receive them and promptly respond to those claims. OTO
will continue to hold meetings of the members of the OTO Advisory
Council as well as the members of the Special Grievances Resolution
19
Meeting with the members of the foreign Chambers of Commerce in Japan,
including the members of the American Chamber of Commerce in Japan
(ACCJ) at the latter's request. This will continue to provide opportunities
for the latter to express their opinions on the improvement of access to
the Japanese market including issues relating to the standards and
certification system. Appropriate government agencies concerned will
study these opinions with a view to improving the openness of the
Japanese market and will report back the results of their consideration.
The Government of Japan will initiate a new review in the area of
standards, certification and testing, where it will review existing
regulations and practices with regard to standards, certification and
testing, including matters connected with industry association standards,
to ensure that processes are transparent and that standards and testing
are performance based where appropriate. As a first step, this new
review will take up standards, certification and testing which are raised
by ACCJ, other foreign chambers of commerce and other interested parties
through the O. T.O and other appropriate channels.
20
Exclusionary
I.
Business
Practices
Basic Recognition
Maintenance and promotion of fair and free competition is an
extremely important policy objective, which not only serves the interest
of the consumers but also increases new market entry opportunities
including those of foreign companies. Based upon such recognition, the
Government of Japan will implement wide-ranging measures.
1.
Enhancement of the Antimonopoly Act and its enforcement.
2.
Greater transparency and fairness in administrative
guidance and other government practices.
3.
Encouragement of transparent and non-discriminatory
procurement procedures by private companies.
4.
Facilitation of patent examination disposals including a
shorter examination period.
II.
Measures to be Taken
1.
Enhancement of the Antimonopoly Act and its Enforcement
The Government of Japan or the Fair Trade Commission (FTC) will
take the following action, including legislative action, which are
necessary or appropriate to achieve the goals acknowledged in the Report
regarding enhancement of the Antimonopoly Act and its enforcement.
(1 )
Resorting More to Formal Actions
The Fair Trade Commission (FTC) will strictly exclude illegal
activities violating the Antimonopoly Act by resorting more to formal
actions under the Act. This will be realized by enhancing the FTC's
investigation system and by expanding its capacity to collect evidence of
illegal activities.
In addition, an Ombudsman system will be newly established in the
FTC to deal promptly with information and complaints from foreign
businessmen and foreign firms concerning such cases as violation of the
Antimonopoly Act.
(2)
Ensuring Greater Transparency
21
In order to ensure transparency, to enhance deterrent effect and to
prevent similar illegal activities from occurring, the contents, including
the names of the offenders, the nature of the offense and circumstances
surrounding it, of all formal actions such as recommendations and
surcharge payment orders will be made public. Warnings will also be
made public other than in exceptional cases.
(3)
Increase in Budgetary Allocation
In the FY 1990 Budget Proposal, the Government of Japan has decided
to substantially increase the number of personnel in the FTC investigation
department and create new divisions:
(a)
allocate 25 new officials (129 - 154), resulting in a
20% increment in staff,
(b)
establish one new office for strengthening violation
detection (1 - 2 offices ),
(c)
establish two new divisions for enhancing investigative
functions (6 - 8 offices),
(d)
establish one new division in the Osaka Local Office for
enhancing investigative functions of local offices
(1 - 2 offices).
The Government of Japan will continue with its efforts to steadily
improve and strengthen the FTC.
(4) Surcharges
In order to enhance the deterrent effect against violations, the
Government of Japan plans to revise, within the FY 1991, the
Antimonopoly Act to raise surcharges against cartels so that they are
effective. Moreover, group boycotts will also be regulated as cartels if
they substantially restrain competition, and will be subject to surcharges
if they influence prices.
(5)
Resorting to Criminal Penalties
The FTC will resort to more criminal penalties through criminal
prosecution triggered by its indictments.
The FTC will more actively indict illegal activities when deemed
necessary taking account of the degree of its maliciousness and the
importance of its social impacts. For that purpose, the FTC will improve
its criminal indictment system through such measures as establishing
indictment standards and internal administrative procedures, and will
make public the FTC's policy on criminal indictment.
In addition, the Ministry of Justice and other relevant governmental
22
agencies will coordinate in enhancing systems to cope adequately with
any cases violating the Antimonopoly Act.
(6)
The Damage Remedy System
A study on the effective use of the current damage remedy system
provided in the Section 25 of the Antimonopoly Act is currently
undertaken by a study group set up in the FTC, in order that any individual
party suffering damage from violation of the Antimonopoly Act can resort
effectively to damage remedy suits. The FTC plans to receive and make
public the results of the deliberations of the study group by June this
year. Upon the publication of the study, appropriate measures will be
taken so that the current damage remedy system will be effectively
utilized.
2.
Government Practices
(1)
Deregulation will be further promoted on the basis of the
recommendations issued by the Provisional Council for the Promotion of
Administrative Reform.
(2) Administrative Guidance
In order to ensure transparency and fairness of administrative
guidance, the Government of Japan will see to it that administrative
guidance is not intended to restrict market access nor to undermine fair
competition. The Government of Japan will implement its administrative
guidance in writing as far as possible, and unless there are good reasons
not to do so, it will make the administrative guidance public when it is
implemented.
(3)
Advisory Committees and Study Groups
The Government of Japan confirms the following principles:
(a)
The results of the deliberations of government sponsored
"industry advisory committees and study
groups"shall be made public.
(b)
Where subjects of discussions are related to consumer
interests, the committees and study groups shall invite,
as members, those who can effectively represent consumer
interests.
(c)
The substance discussed in the committees and study
groups shall not be anti-competitive.
(d)
The "visions" developed by the Government shall not be
used to enhance the competitive position of particular
23
companies in the Japanese market.
(e)
In the "visions" involving trade matters, the
significance of imports shall be emphasized.
(4) The exemptions from the application of the Antimonopoly Act should
be at a minimum, and the necessity of existing exemptions will be
reconsidered with a view to promoting competition policy. The scope of
exemptions will also be reviewed, even in cases where they will be
maintained.
No recession cartel based upon the Antimonopoly Act is currently in
effect.
3.
Procurement Practices of Private Firms
(1)
The Government of Japan confirms its view that procurement by
private firms should be left to the decisions of the buyers and the efforts
of the suppliers under free competition at the market place, and that any
action in violation of the Antimonopoly Act hindering market competition
must be resolutely eliminated.
(2)
The Government of Japan believes that, as a matter of course,
procurement by private firms should be non-discriminatory against
foreign goods.
(3)
The Government of Japan, therefore, will encourage, from an
international viewpoint, private firms to make their procurement
procedures transparent and non-discriminatory against foreign goods as
soon as possible.
4.
Effective Patent Examination
Regarding the patent system, consideration on the harmonization of
patent systems has been under way in multilateral fora such as WIPO and
GATT. The Government of Japan, together with the U.S. Government, will
actively participate in, and contribute to, the discussions there.
The Government of Japan has vigorously promoted comprehensive
policy measures to expedite patent examination disposals, which include
the continual increase in the prescribed number of patent examiners (by
30 persons each in FY 1989 and in FY 1990), as well as the submission of
the revision of the Patent Law before this session of the Diet for the
commencement of the electronic filing of patent applications. Through
such measures, the situation of the patent examination delay has already
started to be improved.
24
Through further intensive accumulation of such measures, the
Government of Japan will make the patent examination period of Japan
internationally comparable within five years. Apart from the ordinary
examination procedure, the accelerated examination system which
terminates the examination in a short period, has been introduced and is
expected to be utilized.
25
Keiretsu
I.
Relationships
Basic Recog nitio n
Certain aspects of economic rationality of Keiretsu relationships
notwithstanding, there is a view that certain aspects of Keiretsu
relationships also promote preferential group trade, negatively affect
foreign direct investment in Japan, and may give rise to anti-competitive
business practices. In order to address this concern, the Government of
Japan intends to make Keiretsu more open and transparent. The
Government of Japan will take measures in its competition policy and
enforce the Antimonopoly Act strictly, so that business transactions
among companies with the background of Keiretsu relationship would not
hinder fair competition.
The Government of Japan will also promote a wide range of policies
to facilitate the entry of foreign enterprises into the Japanese market.
II.
Measures to be Taken
1.
Strengthening the Function of the Fair Trade Commission
(1)
The Fair Trade Commission (FTC) will strengthen its monitoring of
transactions among Keiretsu firms, including but not limited to, those
which have cross shareholding relationships, to determine whether these
transactions are being conducted in a way that impedes fair competition.
If such monitoring reveals that competition is substantially restrained in
any particular field of trade by the cross shareholding, the FTC will take
appropriate measures - including restrictions on cross shareholding or
transfers of shares held in the cross share- holding - to remedy the
illegal situation, and further, if the same monitoring reveals that anticompetitive practices are occurring, the FTC will take appropriate
measures to prevent and remedy the anti-competitive practices.
In this connection, the FTC has established the "Advisory Group on
Distribution Systems, Business Practices and Competition Policy,"
consisting of scholars and business experts, in order for the FTC to set up
a guideline which will clarify the criteria regarding the enforcement of
the Antimonopoly Act with respect to the exclusiveness of transactions
among companies in the same Keiretsu group, whether or not cross
shareholding is involved. The Advisory Group is scheduled to issue a
26
recommendation this June. On the basis of the recommendation, the FTC
will set up and publish a guideline to ensure that the transactions among
companies in Keiretsu groups will not hinder fair competition, and thereby
contributing to the promotion of fair and more open transactions among
them without any discrimination against foreign firms. The FTC will
strictly enforce the Antimonopoly Act according to the guideline.
(2)
The FTC will conduct regularly, roughly every two years, close
analysis of various aspects of Keiretsu groups, including suppliercustomer transactions, financing arrangements among group firms,
personal ties, and special emphasis on the role of general trading
companies in Keiretsu groups. The results of these analyses will be
published. The FTC will take steps, including stricter enforcement of the
Antimonopoly Act, to address anti-competitive and exclusionary practices
uncovered in the FTC analyses.
2.
Foreign Direct Investment
The Government of Japan is considering issuance of a policy
statement on the openness of Japanese foreign investment policy.
(1)
The Government of Japan will reexamine the Foreign Exchange and
Foreign Trade Control Law with a view to submitting an amending bill in
the next ordinary Diet session.
The current Foreign Exchange and Foreign Trade Control Law enables
the Government of Japan to restrict the foreign direct investment and
importation of technology into Japan in any industrial sector on the
grounds that the investment and the importation of technology might
adversely and seriously affect similar domestic business activities or the
smooth performance of the Japanese economy.
The Government of Japan will revise these provisions of the law on
the recognition that these provisions are neither appropriate nor fit to the
present practices of the law, and that such restrictions are not needed on
a general basis.
The bill will contain the relaxation or abolition of the provisions
relating to prior notification requirements for foreign direct investment
and importation of technology into Japan.
(2)
The low-interest loan facility offered exclusively to foreign
companies and Japanese affiliates of foreign companies by the Japan
Development Bank (JOB) and the Okinawa Development Finance Corporation
is to be drastically expanded. In addition, a corresponding facility is to be
27
established in the Hokkaido-Tohoku Development Finance Corporation.
Furthermore, advisory offices for the promotion of foreign direct
investment in Japan are to be set up in the overseas representative
offices of the JOB in order to support foreign companies investing in
Japan in cooperation with Embassies, Consulates-General and JETRO
offices. Appropriate offices of JETRO or these advisory offices in
cooperation with Embassies and Consulates-General provide information
useful in arranging beneficial ventures between foreign firms and
Japanese companies and arrange seminars and missions for potential
investors (JETRO offices only).
3.
Revision of the Take-Over Bid System
Regarding the take-over bid (TOB) system, the Government of Japan
is planning to submit, at this Diet session, a bill calling for abolition of
the prior notification requirement for TOB's and prolongation of the takeover period.
4.
Enhancement of the Disclosure Requirements
(1)
In order to introduce the so-called 5 percent rule, which requires
the disclosure of substantial ownership in shares, the Government of
Japan is planning to submit a bill at this Diet session, together with the
revision of the TOB system. The new rule would also require continuing
reporting as investors above the five percent threshold acquire or dispose
of blocks of' shares in an amount equal to one percent or more.
(2)
With respect to the disclosure requirements related to the Keiretsu
problem, the Government of Japan will examine areas in which
improvements are needed for their further enhancement, taking into
account the disclosure requirements in the U.S. and Europe, and will reach
a conclusion before the final SII report is submitted. It is envisaged that
improvements in disclosure requirements will include enhanced reporting
of related-party transactions as well as consolidated financial
information.
5.
Reexamination of the Company Law
The Committee on Legislation will reexamine the Company Law with
a view to enhancing the disclosure requirements and to simplifying
mergers and acquisitions procedures.
28
Pricing
I.
Mechanisms
Basic Recognition
Based upon the recognition that it is undesirable, in realizing a high
quality of life, for large and unreasonable price differentials between
domestic and overseas markets to continue to exist for a long time, the
Government of Japan will implement the following policies to adjust the
differentials:
1.
Obtaining information on price differentials and
providing it to consumers and industries;
2.
Deregulation and strict enforcement of the Antimonopoly Act;
3.
Promotion of imports and improving productivity;
4.
Formation of more appropriate land prices;
5.
Setting of public utility prices at more appropriate
levels.
II.
Measures to be Taken
1.
Implementation of Measures to Adjust Price Differentials between
Domestic and Overseas Markets
The Government and the Liberal Democratic Party (LOP) established
on December 4 last year the Government-LOP Joint Headquarters for
Adjustment of Price Differentials between Domestic and Overseas
Markets to promote comprehensive policy measures for the adjustment of
the price differentials from a consumer-oriented standpoint. The
membership consists of the Prime Minister as Chairman, with the Minister
of State of Economic Planning Agency, the Minister of International Trade
and Industry, the Chief Cabinet Secretary and the Chairman of Policy
Affairs Research Council of the LOP as Vice Chairmen, and other Cabinet
Ministers and LOP leaders concerned. The Headquarters decided on 52
items as concrete measures to be taken for the adjustment of price
differentials between domestic and overseas markets in its second
meeting held on January 19 this year.
These concrete measures can be grouped into the following six
pillars:
(1)
The government agencies concerned will endeavor to obtain
information on price differentials through such means as surveys of price
29
differentials of goods and services between domestic and overseas
markets, and, where needed, to take necessary measures such as providing
the industries concerned with the information on price differentials in
order to adjust and narrow the gap.
(2) The government agencies concerned will endeavor to improve the
competitive condition in the distribution system by such means as
deregulation and strict enforcement of the Antimonopoly Act.
(3)
The government agencies concerned will endeavor to further promote
import and/or improve productivity of the relevant industries for the
purpose of contributing to the adjustment and narrowing of the price
differentials between domestic and overseas markets.
(4)
Efforts will be made to set prices for public utilities at more
appropriate levels by further improving productivity of the industries
concerned and by examining from an international perspective their cost
compositions and other elements of price formation.
(5)
Based upon the deliberations of the Ministerial Conference for Land
Policies, efforts will be made to rationalize land prices, especially in
metropolitan areas, through close coordination among the government
agencies concerned.
(6)
The government agencies concerned will promote other policy
measures which will contribute to the adjustment of price differentials,
such as further deregulation, strict enforcement of the Antimonopoly Act
and the dissemination of relevant information to the consumers.
The government agencies concerned will steadily implement the 52
measures included in the above six pillars and publish the state of
implementation each time any measure is implemented.
2.
Continuous Implementation of Domestic and Overseas Price
Surveys and the Dissemination of Information to Consumers and
Industries
The Ministry of International Trade and Industry (MITI) has
repeatedly carried out price surveys, including the Japan-U.S. joint price
survey, to grasp the present conditions of price differentials between
domestic and overseas markets.
MITI decided to continuously conduct domestic and overseas price
surveys, and requested for necessary resources in the supplementary
budget for FY 1989 and the FY 1990 budget. Specifically, price surveys on
130 items, including a wide range of consumer items, are under way since
30
March this year, based upon the supplementary budget for FY 1989. Two
series of price surveys on 60 items will be conducted, based upon the FY
1990 budget. Based upon the results of these surveys, MITI will provide
detailed information to consumers and industries. The dissemination of
comparative price information will not be done in a manner which
discriminates against imports or interferes with individual firm pricing
decisions.
MITI also held a discussion meeting, with consumers and industrial
representatives on February 6 this year and heard their views on the
problem of price differentials between domestic and overseas markets.
Similar meetings have been held in eight major cities since then. MITI
intends to hold such meetings based upon the results of domestic and
overseas price surveys.
3.
Promotion of Deregulation
The Provisional Council for the Promotion of Administrative Reform
made an extensive study on deregulation, and the Government of Japan has
been engaged in the promotion of deregulation based upon the
recommendations of the Council.
Specifically, the Cabinet decided, in December 1988, on the General
Plan for the Promotion of Deregulation to promote the reform of public
regulations, basing its decision on the recommendations made by the
Council. In addition, the Government of Japan decided to continue active
promotion of deregulation in its Administrative Reform Plan of 1990
(Cabinet Decision, December, 1989), and the agencies concerned have been
making the utmost efforts in accordance with this decision.
As the Council is planned to be dissolved on April 19 this year, the
Government of Japan will consider the most effective scheme thereafter
for the continued promotion of administrative reform, including
deregulation.
4.
Further Steps Based on the Interim Report of the SII
In addition to the measures listed above, the Government of Japan
will take concrete steps with respect to the structural problems
identified in this interim report.
Some of them are described below, and it is expected that those
steps will allow price mechanisms to work more effectively in the
Japanese market.
31
These measures will be implemented in conjunction with the six
policy pillars and 52 measures decided in December 1989 and January
1990 by the Government-LOP Joint Headquarters.
(1)
Deregulation of the distribution system, including the Large-Scale
Retail Store Law, liquor sales, trucking and other businesses
The government agencies concerned will endeavor to improve
conditions for free and fair competition in the distribution system
through various measures. These will include the immediate relaxation of
implementation and subsequent amendment of the Large-Scale Retail
Store Law and the Government of Japan encouragement to private firms to
make their procurement transparent and non-discriminatory.
(2)
Promotion of fair and free competition in the market through the
enhancement of the Antimonopoly Act and its enforcement
The Government of Japan plans to raise surcharges against cartels,
so that surcharges will be effective. The FTC will resort to more criminal
penalties. Appropriate measures will be taken so that current damage
remedy system will be effectively utilized.
(3)
Increase of Japanese overhead capital
The Government of Japan notes that these efforts will include the
substantial increase in social overhead capital, including that which
relates to the entry and distribution of imported products in Japan. In the
new ten-year plan, real aggregate investment in infrastructure will be
increased substantially above current levels for the ten years to boost
domestic investment, improve social overhead capital and reduce the
shortage of investment relative to savings and to the size of the Japanese
economy.
(4) The Government of Japan will implement a wide range of measures
with respect to the land problem. These include measures which
encourage increased supply of available land, including the establishment
of a new system for identifying and promoting the utilization of idle land
(such as unused plant sites), reviewing the land taxation system, and
reviewing the Land Lease Law and the House Lease Law in order to improve
the legal relationship between lessors and lessees.
(Note) Full and precise contents of the measures above are described in
the related part of this interim report.
32
Japan / U.S. Structural Impediments Initiatives
Comments of the Japanese Delegation
on the
Inter~ Report by the U.S. Delegation (*)
1.
In the Interim Report produced through the Structural
Impediments Initiatives (SII) talks, policies to be taken by the
U.S. Government on each of the seven areas which are recognised as
the U.S. structural problems are specifically identified.
These
policies are aimed at fundamental changes of the U.S. economy
based on the recognition that extreme importance should be
attached to the necessity of strengthening the competitiveness of
the U.S. economy. The Japanese side appreciates the U.s.
Government's position on these policies.
2.
Substantial portion of these U.S. measures put into the
Interim Report are those proposed in the 1990 State of the Union
Message and the 1991 Presidential budget proposal which included
many of the Japanese suggestions made in the course of the SIr
talks.
President Bush himself has shown deep interest in
structural reforms as well as in the progress of the SII talks
themselves aimed at strengthening U.S. competitiveness.
(*)
These comments constitute solely the views of the Government
of Japan. on progress to date and areas for further progress.
1
3.
The Government of Japan expects that, under the continued
strong leadership of President Bush, these proposals will be put
into effect without delay, thereby strengthening the U.S. economy.
Further, the Government of Japan hopes that further efforts
will continue to be made with a view to making yet more progress
on structural reforms of the u.s. economy.
Some comments on the u.S. Interim Report from these
viewpoints are as follows.
2
Sayings and Investment
1.
The United States of America, both politically and
economically, is the biggest and most important country in the
world.
Also, the U.S. dollar is a key currency in the
international monetary system.
It is therefore important for the economic stability of the
world that the U.S. economy and its competitiveness be
strengthened.
2.
From this viewpoint, we welcome the U.S. Government's
initiative in identifying the savings and investment patterns of
its own economy as a structural impediment to trade and external
adjustment, and by taking a series of actions to boost savings
both by the public and private sectors.
3.
Specifically, it is noteworthy that the clear message of the
SII talks is that the Administration is placing Federal Budget
deficit reduction as a top priority.
We expect that the targets
of the deficit reduction under the Gramm-Rudman-Hollings procedure
will be met in each fiscal year.
We also welcome the series of initiatives by the
Administration including the reinforcement of the Gramm-RudmanHollings Budget Process.
We sincerely hope that these measures
will be enacted as early as possible with the understanding and
cooperation of the Congress.
3
4.
Secondly, on private sector savings, we highly appreciate the
recent decision by the U.S. Administration to propose incentives
to save, which we hope will accelerate the recent upward trend of
the savings ratio of individuals.
We also hope that these measures will be put into effect as
soon as possible.
5.
The studies on savings and investment in the corporate
sector, being conducted by the Treasury Department, will yield an
important foundation for formulating the U.S. policies necessary
for enhancement of the long-term competitiveness of U.S.
corporations.
We are looking forward to seeing potentially historic results
of these very important initiatives.
4
Improvement of the U.S. Economy's Competitiveness
Tackling with structural distortions both at the public
sector level as well as at the private sector level in the U.S.
would bring about the further vitalization of industrial sector
and improve the international competitiveness of the U.S. itself.
The Government of Japan would welcome the forceful implementation
of specific measures by the U.S. Government aimed at this
objective.
The Government of Japan strongly hopes that the
u.s.
Government continues to make efforts on each of the following
areas identified as structural problems in the U.S. economy;
corporate investment activities and supply capacity, corporate
behavior, government regulation, R&D, export promotion and
workforce education and training.
In order to enlarge the production capacity of the U.S.
manufacturing industry, measures to increase investment should
occur and statement welcoming foreign direct investment would
en'courage such helpful activity.
It is requested that the U.S.
avoid taking tax enforcement measures aimed unfairly at foreign
companies.
As to the U.S. corporations, further specific measures are
expected to be taken by the U.S. Government to encourage corporate
managements to take a longer-term perspective.
Government regulations such as re-export licensing system
which prevent the U.S. corporations from becoming more competitive
in the foreign markets are expected to be reviewed.
5
Efforts should be made with a view to establishing guidelines
on implementation of laws pertaining to Anti-Trust Act in order to
strengthen the activities of joint R&D and of production jointventure by the U.S. manufacturing industry.
Further, necessary
measures are expected to be taken for the thorough implementation,
also by the private sector, of international standards of weights
and measures, i.e. metric system, so that the exports of U.S.
products will be increased.
Fundamental export promotion policies should be established
and implemented to encourage export activities by U.S. industries
and increase u.S. exports.
Effective cooperation is welcomed between the Ministry of
International Trade and the Industry of Japan and the U.S.
Department of Commerce in export promotion.
It is expected that studies should be conducted to find
existence of any impediments for parallel import to Japan in the
U.S., and that, if there are any, appropriate measures should be
taken.
In order to improve further the quality of workforce, it is
expected that efforts should be made to strengthen the U.S.
education systems particularly in mathematics and science as well
as vocational education and training programs.
6
U.S./JAPAN STRUCTURAL IMPEDIMENTS INITIATIVE
COMMENTS OF THE U.S. DELEGATION
on the
INTERIM REPORT BY THE JAPANESE DELEGATION
*
The Government of Japan's interim report reflects
substantial progress at this stage of the Structural
Impediments Initiative (SII) talks. The united States
Government appreciates the hard work and leadership on the part
of the Japan SII Working Group and the Government of Japan that
produced this report. Many of the measures in the interim
report should contribute to the goals of opening markets,
reducing trade and current account imbalances, and promoting
consumer interests.
The measures and commitments in the interim report are, in
many respects, welcome plans for action. Additional progress
is needed in subsequent SII talks to develop the plans and
actions more fully in some areas. The effectiveness of the
measures and commitments will depend upon achieving greater
specificity in the commitments, and, ultimately, on the actual
implementation of measures to reduce or eliminate the
structural impediments.
Saving and Investment Patterns
A principal objective of the SII talks is the reduction of
trade imbalances and current account imbalances of Japan and
the United States. The u.S. Government welcomes the
significant reduction which took place in Japan's current
account surplus in 1989 to $57 billion from a peak of $87
billion in 1987, along with the further reduction in the U.S.
deficit. Reducing the gap between saving and investment in
Japan is essential for the further reduction of the current
account imbalance.
The U.S. Government, therefore, welcomes the commitment of
the Government of Japan to reduce the shortage of investment
relative to savings and thereby to further the reduction of the
current account surplus. Of particular importance to the
achievement of that goal are the following specific commitments
by the Government of Japan in the interim report:
o
*
To increase substantially real aggregate investment in
infrastructure above current levels in a new comprehensive
plan of public investment which would last 10 years, thus
reducing the shortage of investment relative to saving and
to the size of the economy.
These comments constitute solely the views of the U.S.
Government on progress to date, and areas for further
progress.
-2-
o
To start immediately formulating this new comprehensive
plan.
o
To specify the aggregate amount of expenditures of this
plan in the final report.
o
To prepare on a fast-track basis eight new larger,
long-term sectoral plans in key infrastructure areas,
including housing, airports and port facilities, parks and
sewers whose current plans are to expire at the end of FY
1990. This offers a concrete mechanism for meeting
Japan's social overhead capital needs, for improving the
quality of life of the Japanese people, and helping reduce
Japan's current ac~ount surplus.
o
To provide positive and specific targets for these
sectoral plans in the final SII report.
o
To welcome the voluntary extension of the operating hours
of bank automated teller machines to increase consumer
convenience.
These decisions represent sUbstantial progress for the
purposes of the interim assessment. However, further action
and specification will be needed in order to ensure a
substantial increase in investment relative to saving and as a
share of GNP. Only when the Government of Japan provides
positive and specific targets for the timing and levels of
funding for public investment will it be possible to assess the
effects on the pattern of Japanese saving and investment, and
on the current account surplus.
Land Use
The U.S. Government welcomes the Government of Japan's
basic recognition of the seriousness of the land use problem,
and its commitment to address this problem through a wide range
of policy measures. Of particular importance, the Government
of Japan has already taken, or has committed to take, the
following actions in the interim report:
o
Passage of the Basic Land Act in December, 1989, outlining
principles which will guide the government's efforts to
reform land taxation and to improve land use policies.
o
To establish a system for identifying and promoting the
utilization of idle land and to conduct a review with
regard to the possible strengthening of the special
land-holding tax on idle land.
o
To conduct a comprehensive review of land taxation, and to
submit reform legislation to the Diet by end-FY 1990, with
a view to revising land taxation on the basis of
principles such as equity, neutrality and simplicity.
-3-
o
To review the taxation of agricultural land within
Urbanization Promotion Areas (UPAS), with a view to
addressing the deferments system of payments of the
inheritance and fixed asset (property) taxes.
o
To rationalize the land value assessment values for the
inheritance tax, taking into account the nature of the
tax, with a view to bringing assessments closer to market
value.
o
To install urban infrastructure, and, in this context, to
indicate a positive and specific target for a longer-term
plan for housing by the final SII report.
o
To review the Land and House Lease Laws and then to submit
draft reform legislation to the Diet in order to improve
the legal relationship between lessors and lessees.
o
To review the UPA zoning designations, and to expand UPAs
to accommodate growing housing demand.
o
To pursue specific deregulation measures, including the
relaxation of limits on building heights and housing
density.
The U.S. Government believes that it is essential that the
Government of Japan build on these actions and achieve further
progress.
Studies will need to be completed and positive
action taken on the basis of these studies.
Further action will be needed in a number of areas,
including:
progress toward the elimination of the property and
inheritance tax exemptions (deferrals) for agricultural land in
urban areas; imposition of penalty taxes on idle land, pending
the completion of efforts to make tax policies neutral;
reduction in capital gains tax rates; correcting the legal
imbalances between lessees and lessors; progress in
implementing the Government of Japan's commitments to convert
idle land to productive use, to install urban infrastructure
and to implement the deregulation measures cited above.
Distribution System
The United States Government shares the Government of
Japan's assessment that, in order to increase import
opportunities and improve the quality of life for the Japanese
consumer, improved infrastructure, deregulation and enhanced
anti-monopoly enforcement are all necessary in the distribution
sector. The U.S. Government welcomes the Government of Japan's
commitment to:
o
Improved infrastructure for imports, including airports,
harbors, and roads.
-4o
The goal of "24 hour" import clearance, as a useful step
which should contribute to faster clearance procedures.
o
Measures to ease restrictions in the distribution area,
including rules on liquor licensing, trucking, premium
offers and general pharmaceutical goods, and review of
standards, certifications. and licenses which are impeding
imports.
o
Shortening the approval period for new store openings
under the Large Scale Retail Store Law and seeking
legislative changes which would further liberalize that
law.
'
o
Measures to improve trade practices in the distribution
sector, including stronger enforcement against
anticompetitive practices.
o
Implementing a program of incentives, including tax
credits, to increase imports, as well as measures to
enable small stores to carry more imported goods.
Many of the proposed actions of the Government of Japan
are not yet possible to appraise because they are still under
study and review. These include future plans for airport
expansion, improvements in procedures to expedite import
clearance, guidelines for anti-monopoly actions of
manufacturers towards distributors, and guidelines for
improving trade practices. The U.S. Government looks forward
to rapid completion of these reviews, which we hope will lead
to a more open Japanese distribution system.
The U.S. Government expects the relaxation of the Large
Retail Store Law and its revision in the coming year to result
in a substantial increase in the availability of foreign
products and a more competitive distribution sector. We
believe this objective could be further enhanced by exempting
certain geographic areas from the law's application and hope
that this measure will be taken in the near future.
Finally, the U.S. Government has been told by the
Government of Japan that the measures that have been proposed
will significantly open the distribution system of Japan.
If
this is borne out in the implementation phase, then many of the
key problems related to the opening and expansion of stores
would have been addressed without complete abolishment of the
Large-Scale Retail Store Law itself.
Should this, however, not
prove to be the case, then the U.S. Government will return to
its original view about the need for more drastic legislative
solution.
-5Exclusionary Business Practices
The United States Government shares the view of the
Government of Japan that fair and free competition in the
Japanese market is essential for the market entry opportunities
of foreign companies and the benefit of Japanese consumers.
In
particular, the Antimonopoly Act should be enhanced and
enforcement made more effective; government actions should be
transparent and market-oriented; the procurement policies of
private companies should be transparent and nondiscriminatory;
and the patent system should be improved.
The U.S. Government appreciates the efforts that the
Government of Japan has made in most areas; in particular, its
commitments to:
o
Strengthen substantially enforcement of the Antimonopoly
Act, including increased staff and budget; more formal
actions, resulting in more public disclosures of
violations and violators; public disclosures of
"warnings"; and more criminal prosecutions.
o
Impose more effective penalties, including proposing
legislation for higher fines (surcharges).
o
Implement actions to make private remedies more effective.
o
Issue guidelines to ensure that business practices in the
distribution area and among keiretsu firms do not hinder
fair competition.
o
Minimize exemptions from the Antimonopoly Act.
o
Implement government-wide policies to make "administrative
guidance," "visions" and the results of study groups more
pro-competitive and consumer-oriented; and, in general,
public and in writing.
o
Encourage transparent, nondiscriminatory procurement by
private Japanese companies with respect to foreign
companies and goods.
o
Reduce, within five years, the average time required for
the examination of patents to coincide with international
levels.
o
Review all industry "fair competition codes" to remove
anticompetitive effects of restrictions on the use of
premiums, with a priority on codes that affect foreign
trade and investment.
We support and encourage, and will continue to support and
encourage, the increased role of the Fair Trade Commission in
the Japanese economy and increases in its budget and staffing
that are designed to increase enforcement.
-6-
The commitments and measures are welcome plans for
action.
It is important, however, that these plans be
substantiated by greater specificity and actual implementation
in order to eliminate exclusionary business practices in
Japan. The U.S. Government will discuss these commitments and
measures, and their implementation, in the course of the SII.
We are especially interested in further clarification and
specificity regarding:
the extent of increases in surcharges
and the effectiveness of other enforcement measures; steps to
enhance the effective utilization of private remedies;
effective deregulation of sectors and restrictions (such as
those on premiums) that can affect foreign trade and
investment; demonstrable progress in reducing patent
examination delays; pro~competitive government actions; and the
removal of other exclusionary practices that operate as
barriers to trade and investment.
Keiretsu Relationships
The united states Government is of the view that keiretsu
relationships can promote preferential group trade, negatively
affect foreign direct investment in Japan, and give rise to
anticompetitive business practices. The U.S. Government is
encouraged, therefore, by the Government of Japan's clear
statement of its intention to address this concern.
In
particular, we welcome the following specific commitments
contained in the interim report:
o
To make keiretsu more open and transparent;
o
To take steps to improve the climate for foreign direct
investment in Japan;
o
To strengthen monitoring by Japan's Fair Trade Commission
of keiretsu transactions and enforcement of the
Antimonopoly Act, taking steps to remedy anticompetitive
practices;
In this connection, the FTC will publish a guideline
to ensure that keiretsu transactions do not hinder
fair competition, and will strictly enforce the
guideline;
o
To begin addressing the cross shareholding issue by
restricting cross shareholding relationships between
keiretsu firms where FTC monitoring reveals that the cross
shareholding leads to substantial restraint of
competition;
o
To conduct regular FTC analysis of various aspects of
keiretsu groups, with special emphasis on the role of the
general trading company.
-7-
o
To examine disclosure areas in which improvements are
needed, and to complete, before the final report, a study
of further improvements with a view to enhancing
disclosure of related-party transactions;
o
To encourage foreign direct investment in Japan by
amending the Foreign Exchange and Foreign Trade Control
Law to:
relax or abolish prior notification requirement for
foreign direct investment and the importation of
technology into Japan, and
revise the provisions enabling the Government of Japan
to restrict foreign direct investment and the
importation of technology on broad economic grounds,
recognizing that such restrictions are not needed on a
general basis;
o
To promote foreign direct investment in Japan, including
the establishment of overseas advisory offices and the
activities of JETRO;
o
To submit legislation abolishing the prior notification
requirements for takeover bids; and
o
To issue a policy statement welcoming foreign investment
in Japan.
The U.S. Government believes that it is essential for the
Government of Japan to build on the commitments enumerated
above through additional actions and commitments in a number of
areas, including: issuance of a broader policy statement
encouraging the loosening of keiretsu ties; further actions to
address the cross shareholding issue; measures to encourage
opening of keiretsu procurement practices; further steps to
relax or 9bolish the broad authority of the Government of Japan
to restrict foreign direct investment and the importation of
technology on broad economic grounds; and measures to bolster
shareholders' rights in Japan.
Pricing Mechanisms
The U.S. Government believes that action by the Government
of Japan is appropriate, given that "large and unreasonable"
gaps between foreign and Japanese prices are a structural
adjustment problem with significant adverse impact on Japanese
consumers. The U.S. Government welcomes:
o
The decision to establish a Government-LOP Joint
Headquarters for Adjustment of Price Differentials as an
indication of the very high priority attached to the
problem.
-8-
o
The broad scope of the 52 point program outlined by the
group, although several items, designed to enhance
Japanese productivity, are not germane to the SII
discussions.
In the distribution sector, this list includes
amending the regulations and guidelines on the
Large-Scale Retail Store Law; relaxation of licensing
and the regulations for retail distribution of liquor
tobacco, salt, and medical supplies; and specific
examination of business practices affecting
distribution of processed food products.
The plan includes eight steps to rationalize public
utility charges including airfares,
domestic/international telephone rates.
It also calls for formulation of land policies,
including promoting housing supply, and revising the
land tax system to promote more appropriate land
prices.
o
The broad scope of this list clearly reflects that past
policies and practices in these areas are at the root of
the price problem.
The u.s. Government believes that continuing attention to
price levels in Japan suggests price changes may be a useful
device for monitoring efficacy of SII reforms in other areas.
The U.S. Government notes that many of the actions listed
above require further elaboration and specific commitments
before an assessment can be made of their effectiveness in
reducing Japanese prices. The Japanese program requires
further attention to timetables for implementation and to the
elimination of regulations which attempt to manage markets by
restricting entry. The nexus between the Japanese
Government-LDP program and the SrI undertakings in this and
other sections should lead to more specific solutions to
problems of deregulation and market entry with particular
implications of eliminating unreasonable price differentials.
It is essential that price surveys be designed and presented in
a broad-based, representative and unbiased fashion to ensure a
fair and accurate determination of the reason for the price
differences, and not focus unfairly on prices and practices of
foreign products or producers. We expect that survey data will
not be used for purposes which inhibit competition or the
operation of market forces.
TREASttRY::N EWS
D....rtment of til. T....UIY . . . . . .In.ton, D.C•• T.....llon• •88-20.t
DEPT. OF THE TREASURY
FOR IMMEDIATE RELEASE
April 6, 1990
CONTACT: Larry Batdorf
Phone: (202) 566-2041
Dan Snow, Kingwood, Texas Sentenced for
Violations of the Cuba Embargo
On April 6, 1990, Mr. Dan Snow of Kingwood, Texas, was
sentenced in the u.S. District Court of the Southern District
of Texas, Houston, by Judge Sim Lake to serve 90 days in jail,
perform 1,000 hours of community service, pay $5,300 in fines,
and undergo 5 years supervised release.
Snow arranged, promoted, and conducted pleasure fishing trips
to Cuba, under the guise of bass research. He was convicted by
a jury on January 26, 1990, on five counts of organizing
tourist travel to Cuba in violation of the Trading with the
Enemy Act, the Cuban Assets Control Regulations, and the aiding
and abetting sections of Title 18 of the united states Code.
He was also convicted on one count of criminal contempt.
On February 11, 1985, Snow had been ordered by the Federal
court in Houston to cease these activities and on December 11
in the same year was found to be in civil contempt of that
order. The criminal convictions of Snow on January 26, 1990,
resulted from further acts engaged in by him in violation of
the 1985 court order, which were uncovered and investigated by
the Enforcement Division of the Office of Foreign Assets
Control, which is charged with administering and enforcing the
embargo against Cuba. Snow's illegal activities resulted in
the transfer of hard currency to the Castro regime, in
violation of u.s. foreign policy embodied in the embargo.
Cuban travel transactions are permitted by U.S. residents for
official government business, gathering news, making news or
documentary films, engaging in professional research, and
visiting close family members. Snow contended unsuccessfully
that he was leading a group of professional bass researchers.
Richard Newcomb, Director of the Office of Foreign Assets
Control, stated that the Snow prosecution is an example of the
united states Government's continuing resolve to fully enforce
the Cuba economic embargo and to prosecute those who willfully
violate the law. Specific questions concerning the Cuban
Assets Control Regulations may be addressed to the Office of
Foreign Assets Control, at 202-376-0392.
NB-758
~1,/f
STATEMENT OF THI GROUP OF SEVEN
....-.The Finance Miaisters and Centra. Bank Oovernors of Canada, France, the
Federal RepubHc or Germany, Ital)" Japln, the United Kinldom and the United States, met on
April 7, 1990, in Paris, for an exchanae of viewl on current Ilobel economic and financial
issues. The Man_linl Director of the IMF participated in the multilateral surveillance
di1cu5sions.
The Ministers and Governors reviewed their economic policies and prospects.
They noted tbat since their last meetina, economic Irowth had been .lowina in se"erl' countries
to more sustainable levels. However, overall Irowth prospects remain lood, with strona
investment providins a major stimulus to their economies, inflltjon remains contained and
external imbalances have been redueed although urlevenly.
The Ministers and Goverrlors expresset1 the need for continued close coordination
of their macro-economic: and structural policies, to obtain sustained growth, low .inflation and
areater stabilitY of exehanle rites. In this respeet, they Ilfeed that current inflation ntcs
require continued vililance. They _,reed thlt countries with (iseal Ind current account deficits
should reduce bud set deficits and increase private savinss. They also 'sreed. that countries with
external surpluses should, at the same time, continue to contribute to external adjustment by
promotinl non-inflationary ,rowth of domestic demand, throuah appropriate macro-economic
and structural policies. They al$o aareed that savinss should be promoted in all countries
through the use of appropriate structural policies.
The Ministers and Governors discussed developments in Ilobal financial markeu,
especially the decline or the yen against other ~urrencies, and its undesirable consequences for
the Ilobal adjustment process, anci Ilreed to keep these de\lelopments under review. They
reaUirmeci their commitment to eeonomic policy c;:oordination, ineludina cooperation in
exchange markets.
The Ministers and Governors welcomed the rerorms in Eastern Europe towards
market oriented economies which. they believe, Ire the most profound in decades. They
expressed cheir wiUinlness to contribute to the lucc;:ess of the ollioini process. throulh
appropriate bilateral and multilateral usisrance, throua h helpiaa countries underloin, reforms
to remove obstac;:les to private capital flows, and exehanle gf information and expertise. They
reviewed and assessed the possible effects or theae reforms. They noted thar Oerman economic
and monetary union could contribute to improved Ilobal arowth and to I reduction oC external
imbalances in Europe.
TREASUR¥ooruEWS
D...artm.nt
a. t ... T.....UIY 'PR'ft'ftl~~ton. D.C• • T.......On.....2041
.
0 I I CONTACT: Off~ce of F~nanC'i.ng_
202/376-4350
DEPT. OF THE TREASURY
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $ 8,213 million of I3-week bills and for
of 26-week bills, both to be issued on April 12, 1990,
RANGE OF ACCEPTED
COMPETITIVE BIDS:
Low
High
Average
I3-week bills
maturins Jul:z: 12, 1990
Discount Investment
Rate
Rate 1/
Price
7.77"1.
7.80%
7.80%
8.04"1.
8.07%
8.07%
98.036
98.028
98.028
$
8,223 million
were accepted today.
26-week bills
maturins October lIz 1990
Discount Investment
Price
Rate 1/
Rate
7.78"1.
7.81%
7.80"1.
8.21%
8 • 2 4"1.
8.23%
96.067
96.052
96.057
Tenders at the high discount rate for the 13-week bills were allotted 97%.
Tenders at the high discount rate for the 26-week bills were allotted 18%.
TENDERS RECEIVED AND ACCEPTED
(In Thousands)
Received
Acceeted
Received
55,630
25,598,500
26,200
56,965
45,220
37,330
1,569,270
46,600
21,140
42,825
35,770
897,885
769 z705
55,630
$
6,872,925
26,130
56,635
38,220
37,330
166.195
27,450
11,140
42,825
25,770
82,885
769 z 705
48,740
$
22,949,110
18,820
52,995
52,155
37,010
1,435,820
34,665
21,410
69,325
36,695
906,385
631 t 900
Acce2ted
48,740
$
7,086,570
18,820
52,995
52,155
35,135
68,620
23,025
13,210
69,315
26,695
95.685
631 2 900
$29,203,040
$8,212,840
$26,295,030
$8,222.865
$25,653,445
1 2 647 2 495
$27,300,940
$4,663,245
1 2 647 z495
$6,310,740
$22,581,780
l z 378 z 220
$23,960,000
$4,509,615
1 z378 z220
$5,887,835
1,795,430
1,795,430
1,775,000
1,775,000
106 2 670
106 2 670
560 z030
560 z030
$29,203,040
$8,212,840
$26,295,030
$8,222,865
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
TOTALS
1Il!!.
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
$
An additional $26,030 thousand of 13-week bills and an additional $147,370
thousand of 26-week bills will be issued to foreign official institutions for
new cash.
1/
Equivalent coupon-issue yield.
NB-759
FOR RELEASE AT 4:00 P.M.
April 10, 1990
CONTACT:
Office of Financing
202/376-4350
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice,
invites tenders for two series of Treasury bills totaling approximately $16,400 million, to be issued April 19, 1990. This offering
will result in a paydown for the Treasury of about $26,900 million,
as the maturing bills total $43,303 million (including the 247-day
cash management bills issued August 15, 1989, in the amount of
$15,020 million and the 16-day cash management bills issued
April 3, 1990, in the amount of $13,004 million). Tenders will be
received at Federal Reserve Banks and Branches and at the Bureau of
the Public Debt, Washington, D. C. 20239-1500, prior to 1:00 p.m.,
Eastern Daylight Saving time, Monday, April 16, 1990. The two
series offered are as follows:
91-day bills (to maturity date) for approximately
$8,200 million, representing an additional amount of bills dated
January 18, 1990, and to mature July 19, 1990 (CUSIP No. 912794
UV 4), currently outstanding in the amount of $7,646 million, the
additional and original bills to be freely interchangeable.
182-day bills for approximately $8,200 million, to be dated
April 19, 1990, and to mature October 18, 1990 (CUSIP No. 912794
VF 8).
The bills will be issued on a discount basis under competitive
and noncompetitive bidding, and at maturity their par amount will
be payable without interest. Both sertes of bills will be issued
entirely in book-entry form in a minimum amount of $10,000 and in
any higher $5,000 multiple, on the records either of the Federal
Reserve Banks and Branches, or of the Department of the Treasury.
The bills will be issued for cash and in exchange for Treasury
bills maturing April 19, 1990. Tenders from Federal Reserve Banks
for their own account and as agents for foreign and international
monetary authorities will be accepted at the weighted average bank
discount rates of accepted competitive tenders. Additional amounts
of the bills may be issued to Federal Reserve Banks, as agents for
foreign and international monetary authorities, to the extent that
the aggregate amount of tenders for such accounts exceeds the
aggregate amount of maturing bills held by them. Federal Reserve
Banks currently hold $3,184 million as agents for foreign and
international monetary authorities, and $4,211 million for their
own account. These amounts represent the combined holdings of such
accounts for the four issues of maturing bills. Tenders for bills
to be maintained on the book-entry records of the Department of the
Treasury should be submitted on Form PO 5176-1 (for 13-week series)
or Form PO 5176-2 (for 26-week series).
NB-760
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 2
Each tender must state the par amount of bills bid for,
which must be a minimum of $10,000. Tenders over $10,000 must
be in multiples of $5,000. Competitive tenders must also show
the yield desired, expressed on a bank discount rate basis with
two decimals, e.g., 7.15%. Fractions may not be used. A single
bidder, as defined in Treasury's single bidder guidelines, shall
not submit noncompetitive tenders totaling more than $1,000,000.
Banking institutions and dealers who make primary
markets in Government securities and report daily to the Federal
Reserve Bank of New York their positions in and borrowings on
such securities may submit tenders for account of customers, if
the names of the customers and the amount for each customer are
furnished. Others are only permitted to submit tenders for their
own account. Each tender must state the amount of any net long
position in the bills being offered if such position is in excess
of $200 million. This information should reflect positions held
as of one-half hour prior to the closing time for receipt of
tenders on the day of the auction. Such positions would include
bills acquired through "when issued" trading, and futures and
forward transactions as well as holdings of outstanding bills
with the same maturity date as the new offering, e.g., bills
with three months to maturity previously offered as six-month
bills. Dealers, who make primary markets in Government securities and report daily to the Federal Reserve Bank of New York
their positions in and borrowings on such securities, when submitting tenders for customers, must submit a separate tender for
each customer whose net long position in the bill being offered
exceeds $200 million.
A noncompetitive bidder may not have entered into an
agreement, nor make an agreement to purchase or sell or otherwise dispose of any noncompetitive awards of this issue being
auctioned prior to the designated closing time for receipt of
tenders.
Payment for the full par amount of the bills applied for
must accompany all tenders submitted for bills to be maintained
on the book-entry records of the Department of the Treasury.
A cash adjustment will be made on all accepted tenders for the
difference between the par payment submitted and the actual
issue price as determined in the auction.
No deposit need accompany tenders from incorporated banks
and trust companies and from responsible and recognized dealers
in investment securities for bills to be maintained on the bookentry records of Federal Reserve Banks and Branches.
8/89
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 3
Public announcement will be made by the Department of the
Treasury of the amount and yield range of accepted bids. Competitive bidders will be advised of the acceptance or rejection
of their tenders. The Secretary of the Treasury expressly
reserves ~he right to accept or reject any or all tenders, in
whole or ~n part, and the Secretary's action shall be final.
Subject to these reservations, noncompetitive tenders for each
issue for $1,000,000 or less without stated yield from anyone
bidder will be accepted in full at the weighted average bank
discount rate (in two decimals) of accepted competitive bids
for the respective issues. The calculation of purchase prices
for accepted bids will be carried to three decimal places on the
basis of price per hundred, e.g., 99.923, and the determinations
of the Secretary of the Treasury shall be final.
Settlement for accepted tenders for bills to be maintained
on the book-entry records of Federal Reserve Banks and Branches
must be made or completed at the Federal Reserve Bank or Branch
on the issue date, in cash or other immediately-available funds
or in Treasury bills maturing on that date. Cash adjustments
will be made for differences between the par value of the
maturing bills accepted in exchange and the issue price of the
new bills.
If a bill is purchased at issue, and is held to maturity,
the amount of discount is reportable as ordinary income on the
Federal income tax return of the owner for the year in which
the bill matures. Accrual-basis taxpayers, banks, and other
persons designated in section 1281 of the Internal Revenue Code
must include in income the portion of the discount for the period
during the taxable year such holder held the bill. If the bill
is sold or otherwise disposed of before maturity, any gain in
excess of the basis is treated as ordinary income.
Department of the Treasury Circulars, Public Debt Series Nos. 26-76, 27-76, and 2-86, as applicable, Treasury's single
bidder guidelines, and this notice prescribe the terms of these
Treasury bills and govern the conditions of their issue. Copies
of the circulars, guidelines, and tender forms may be obtained
from any Federal Reserve Bank or Branch, or from the Bureau of
the Public Debt.
8/89
o
v
E
R
5
I
H
G
T
o
B
A
R
D
RESOLUTION FUNDING CORPORATION
JOR IMMEDIATE RELEASE
April 10, 1990
(OB 90-24)
CONTACT:
Diane Casey
202-376-5477
REFCORP ANNOUNCES RESULTS OF AUCTION OF 40-YEAR BONDS
The Resolution Funding Corporation has accepted $3,501 million of
$8,903 million of tenders received from the public for the 40-year
bonds, Series B-2030, auctioned today.lI The bonds will be issued
April 17, 1990, and mature April 15, 2030.
The interest rate on the bonds will be 8 7/8%. The range of
accepted competitive bids, and the corresponding prices at the 8 7/8%
interest rate are as follows:
Low
High
Average
yield
PriceY
8.86%
8.94%
8.89%
100.162
99.293
99.834
Tenders at the high yield were allotted 10%.
TENDERS RECEIVED AND ACCEPTED (In Thousands)
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
st. Louis
Minneapolis
Kansas city
Dallas
San Francisco
Totals
Accepted
Received
$
$
8,463,750
10
3,316,750
10
3,000
3,000
332,005
2,000
177,505
2,000
1,000
1,000
101,000
1,000
$8,902,765
$3,501,265
The $3,501 million of accepted tenders includes $126 million of
noncompetitive tenders.
1/
The minimum par amount required to strip the REFCORP bonds is
$1,600,000. Larger amounts must be in multiples of that amount.
y
In addition to the auction price, accrued interest of $0.48497
per $1,000 for April 15, 1990, to April 17, 1990, must be paid.
D....ran.nt
of til. T. . .sury •
FOR IMMEDIATE RELEASE
April 11, 1990
W•• llinaton, D.C•• T.....llon ••••-2eNt
APR I Zsa ann ~ ? .9
coNtACT. Office of Financing
202/376-4350
DEPT. OF THE THEASURY
RESULTS OF AUCTION OF 7-YEAR NOTES
The Department of the Treasury has accepted $7,520 million
of $19,442 million of tenders received from the public for the
7-year notes, Series E-1997, auctioned today. The notes will be
issued April 16, 1990, and mature April 15, 1997.
The interest rate on the notes will be 8-1/2%.
The range
of accepted competitive bids, and the corresponding prices at the
8-1/2% interest rate are as follows:
Yield
Price
8.62%*
Low
99.379
8.63%
High
99.328
8.62%
Average
99.379
*Excepting $18,000 at lower yields.
Tenders at the high yield were allotted 47%.
TENDERS RECEIVED AND ACCEPTED (In Thousands)
Location
Received
Accepted
Boston
$
10,561
$
10,561
New York
18,010,201
7,028,731
Philadelphia
7,500
7,500
Cleveland
13,107
13,099
Richmond
11,900
11,900
Atlanta
12,612
12,612
Chicago
897,397
327,347
19,275
st. Louis
15,275
5,294
5,294
Minneapolis
17,212
17,212
Kansas city
6,025
4,495
Dallas
63,445
428,745
San Francisco
2,035
2,035
Treasury
$19,441,864
$7,519,506
Totals
The $7,520
million of accepted tenders includes $414
million of noncompetitive tenders and $7,106
million of competitive tenders from the public.
In addition to the $7,520 million of tenders accepted in
the auction process, $100 million of tenders was awarded ~t the
average price to Federal Reserve Banks as agents for fore1gn and
international monetary authorities. An additional $223 million
of tenders was also accepted at the average price from Federal
Reserve Banks for their own account in exchange for maturing
securities.
NB-761
Dellartm.nt Of til. Tr•• surr • AWa.hln.ton, D.C •• Telephone 588-2041
uPR J b jU 0 0 S3 9
a
DEPT. OF THE TREASURY
FOR IMMEDIATE RELEASE
April 12, 19913
CONTACT:
Barbara Ann Clay
(2132)566-21341
MOROCCAN AGREEMENT WITH COMMERCIAL BANKS
secretary of the Treasury Brady welcomes the agreement in
principle between the Kingdom of Morocco and the Steering
Committee of its commercial bank creditors on a two-phase
financial package that involves debt and debt service
reduction options. This agreement provides a strong
medium-term financial framework to support Morocco's ongoing
economic reform efforts. We look forward to Morocco
entering into a medium-term economic program so as to
benefit at an early date from the debt and debt service
reduction options contained in phase two of the financial
package.
NB-762
FOR IMMEDIATE RELEASE
April 16, 1990
CONTACT:
DEPT. OF THE TREASURY
OFFICE OF FINANCING
202-376-4350
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $8,218 million of 13-week bills and for $8,215 million
of 26-week bills, both to be issued on April 19, 1990,
were accepted today.
RANGE OF ACCEPTED
COMPETITIVE BIDS:
Low
High
Average
I3-week bills
maturing: July 19, 1990
Discount Investment
Rate
Rate 1/
Price
7.68%
7.72%
7.71%
7.94%
7.98%
7.97%
26-week bills
maturing: October 18, 1990
Discount Investment
Rate
Price
Rate 1/
7.73%
7.76%
7.75%
98.059
98.049
98.051
8.16%
8.19%
8.18%
96.092
96.077
96.082
Tenders at the high discount rate for the 13-week bills were allotted 11%.
Tenders at the high discount rate for the 26-week bills were allotted 61%.
TENDERS RECEIVED AND ACCEP~ED
(In Thousands)
Received
Received
Acce2ted
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
TOTALS
!1E.!.
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
!/
$
50,315
23,121,160
20,315
44,645
46,470
34,040
1,807,450
32,150
26,905
38,980
35,110
801,420
526,830
50,315
6,822,360
20,315
44,645
46,470
33,040
335,200
12,150
18,005
38,980
25,660
244,180
526,830
$
40,195
18,077,145
19,945
29,470
38,120
41,280
1,546,075
29,125
28,905
55,240
30,400
876,440
562,365
$
40,195
6,.923,145
19,945
29,470
38,120
41,280
226,575
22,345
28,905
55,240
25,400
201,990
562,365
$26,585,790
$8,218,150
$21,374,705
$8,214,975
$22,859,435
1,41° 2 595
$24,270,030
$4,491,795
1,410,595
$5,902,390
$17,380,710
1,221,995
$18,,602,705
$4,220,980
1,221,995
$5,442,975
2,242,760
2,242,760
2,000,000
2,000,000
73,000
73,000
172,000
772 ,000
$26,585,790
$8,218,150
$21,374,705
$8,214,975
Equivalent coupon-issue yield.
NB-763
$
Acce2ted
TREASURY NE'WS
Dellartment of the Treasury. Washington, .8~.U ~ lt~I~i.il.~n. S•• -204t
DEPT. OF HIE TREASURY
FOR RELEASE UPON DELIVERY
EXPECTED AT 9:30 A.M.
OPENING REMARKS BY
NICHOLAS F. BRADY
SECRETARY OF THE TREASURY
BEFORE THE
WHITE HOUSE CONFERENCE ON SCIENCE AND ECONOMICS
RESEARCH
RELATED TO GLOBAL CHANGE
TUESDAY, APRIL 17, 1990
Good Morning.
I am pleased to welcome this distinguished
assembly of delegates to the White House conference on global
change.
This is the first international conference to bring together
experts in the disciplines of economics, science and the
environment. Over the next two days we will have the opportunity
to explore and discuss the relationship of these disciplines
to the issue of global change.
We meet here to acknowledge and explore our common interest
in improving and preserving the environment in the face of everincreasing demands placed on it by the forces of expanding
populations, economic growth and development and technological
advances.
We have gathered here because we recognize that
success in managing global environmental issues will only be
attained when we have developed coherent policies which fully
integrate environmental solutions with economic realities.
Only
when we have achieved this integration of science and economics
can we be assured that we are pursuing policies in the best
interest of the peoples of the world.
Our challenge is made all the greater by a lack of consensus
among experts as to the true nature, rate and extent of changes
in the global climate projected for the future.
We cannot
resolve these issues in the next two days, but we can advance and
clarify the world's understanding of the relationship between the
NB-764
2
scientific and economic aspects of the environmental challenges
we face.
Our work here is the natural extension of work we have
already begun in other forums.
Our purpose is to complement the
efforts of the Intergovernmental Panel on Climate Change as it
strives to identify what is known and what is still uncertain in
the science of global change.
Here in the united states President Bush has taken the lead
in focusing national attention on global climate change issues-"We face," he said, "The prospect of being trapped on a boat
that we have irreparably damaged -- not by the cataclysm of war,
but by the slow neglect of a vessel we believed to be impervious
to our abuse."
The Bush Administration has formulated general guidelines on
issues concerning global change.
First, nations can't afford to
wait for a final resolution of the scientific uncertainties
before they act. Second, while we wait for scientific advances,
nations should take those actions already justified on economic
and other grounds.
Third, any action considered should be
specific, focused on a clear goal, and cost-effective.
Fourth,
the most effective actions will be those that both protect the
environment and allow continued economic development.
Here in the United States we are pursuing this policy
framework with concrete actions.
The President has asked
Congress for $1 billion in the next fiscal year to study global
change.
We estimate this represents more than half of all the
money spent on global change research worldwide.
A key element
of this research is an ambitious 1S-year program to gather more
accurate data.
This includes plans to develop new polar
orbiting satellites that will improve our understanding of
oceans, clouds and land masses.
The u.s. National Oceanic and Atmospheric Administration of
the Department of Commerce also supports a range of work in
international climate monitoring and modeling, under The World
Meteorological Organization -- work that holds the potential for
greater accuracy in predictions of climate trends.
The united states
is committed to phasing out
chlorofluorocarbons by the year 2000.
The u. s. Environmental
Protection Agency is working with industry to find alternatives
to CFC I S and to control emissions of carbon tetrachloride and
methyl chloroform.
EPA has also extended its assistance to
several developing countries who are seeking to reduce their CFC
emissions, in conformance with the Montreal Protocol.
3
By the year 2050, well over half of greenhouse gas emissions
are expected to come from developing countries. It is clear that
these countries must be a part of any solution to global climate
problems.
The United States has urged their attention to these
issues
and we welcome developing countries to this
conference.
We have sought to promote the integration of
environmental considerations into the lending programs of the
World Bank and the regional development banks.
We have
encouraged the completion of environmental impact assessments for
projects financed by the banks.
At the September 1989 annual meetings of the World Bank and
IMF, President Bush called for more emphasis on the environment
in national policy making, especially in promoting energy
efficiency and conservation and greater protection of tropical
forests.
In keeping with the President's instructions, U.S. officials
have pursued environmental reforms with the OECD, World Bank, the
regional development banks, the UNEP and UNDP.
In addition, the
U. S. has strongly advocated an environmental emphasis for the
programs of the European Bank for Reconstruction and Development.
The united States has also supported the use of debt-for-nature
swaps to preserve forests and wetlands. In the recent past, such
swaps have been signed in Ecuador, costa Rica, the Philippines,
and Madagascar.
A swap recently arranged in Zambia will help
protect two of Africa's most important wetlands.
While the
dollar amounts involved in these swaps have been small, an
important principle has been established. We have encouraged the
World Bank to play a more active role in facilitating these
swaps. We hope the Bank will do so. We believe debt-for-nature
swaps can be used more innovatively to help address climate
change issues.
As these initiatives demonstrate,
economic issues are
intrinsically and inextricably linked to environmental concerns.
We wish to preserve the environment to improve and sustain a
certain quality of life for all the peoples of the world. But we
must recognize that a great part of that quality of life also
rests on economic development and growth.
It is largely through
economic growth that we can bring the nations of the world
freedom from hunger,
lower infant mortality,
longer life
expectancy and liberation from oppressive poverty.
Thus we must
carefully balance and evaluate the relationship between proposals
to address global climate change and economic activities and
policies.
4
Our meetings here can make a valuable contribution to
establishing a common understanding and assessment of the issues.
Let us work together to establish a consensus that will allow us
to advance our ability to make the important decisions in the
future.
Let us reach agreement on areas of opportunity for
cooperative action in scientific and economic research.
Let us
plan to integrate scientific and economic research into the
policy process.
Let us begin to build partnerships for pursuing
that research.
If we can achieve agreement on these issues we
will have taken an important step towards meeting the challenge
of global climate change.
And as we pursue these goals, let us do so in the spirit of
the words spoken by an American Indian chief, "We do not inherit
the earth from our ancestors; rather, we borrow it from our
children."
I welcome
together.
you
and
look
forward
to
what
we
can achieve
EWS
DEPT. OF THE TREASURY
FOR RELEASE AT 4:00 P.M.
April 17, 1990
CONTACT:
Office of Financing
202/376-4350
TREASURY'S WEEKLY BILL OFFERING
. . The Department of the Treasury, by this public notice,
1nv1tes tenders for two series of Treasury bills totaling approximately $16,400 million, to be issued April 26, 1990. This offeri~g ~ill result in a paydown for the Treasury of about $9,250
m1ll10n, as the maturing bills total $25,638 million (including
the 52-day cash management bills issued March 5, 1990, in the
amount of $10,177 million). Tenders will be received at Federal
Reserve Banks and Branches and at the Bureau of the Public Debt,
Washington, D. C. 20239-1500, prior to 1:00 p.m., Eastern Daylight
Saving time, Monday, April 23, 1990. The two series offered are
as follows:
91-day bills (to maturity date) for approximately $8,200
million, representing an additional amount of bills dated
January 25, 1990, and to mature July 26, 1990 (CUSIP No. 912794
UW 2), currently outstanding in the amount of $7,640 million,
the additional and original bills to be freely interchangeable.
182-day bills (to maturity date) for approximately
million, representing an additional amount of bills dated
October 26, 1989, and to mature October 25, ·1990 (CUSIP No. 912794
UR 3), currently outstanding in the amount of $9,769 million, the
additional and original bills to be freely interchangeable.
$8,~00
The bills will be issued on a discount basis under competitive and noncompetitive bidding, and at maturity their par amount
will be payable without interest. Both series of bills will be
issued entirely in book-entry form in a minimum amount of $10,000
and in any higher $5,000 multiple, on the records either of the
Federal Reserve Banks and Branches, or of the Department of the
Treasury.
The bills will be issued for cash and in exchange for
Treasury bills maturing April 26, 1990. Tenders from Federal
Reserve Banks for their own account and as agents for foreign
and international monetary authorities will be accepted at the
weighted average bank discount rates of accepted competitive
tenders. Additional amounts of the bills may be issued to Federal
Reserve Banks, as agents for foreign and international monetary
authorities, to the extent that the aggregate amount of tenders
for such accounts exceeds the aggregate amount of maturing bills
held by them. Federal Reserve Banks currently hold $2,944 million
as agents for foreign and international monetary authorities, and
$3,386 million for their own account. These amounts represent
the combined holdings of such accounts for the three issues of
maturing bills. Tenders for bills to be maintained on the bookentry records of the Department of the Treasury should be submitted on Form PO 5176-1 (for 13-week series) or Form PD 5176-2
(for 26-week series).
NB-765
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 2
Each tender must state the par amount of bills bid for,
which must be a minimum of $10,000. Tenders over $10,000 must
be in multiples of $5,000.
Competitive tenders must also show
the yield desired, expressed on a bank discount rate basis with
two decimals, e.g., 7.15%.
Fractions may not be used. A single
bidder, as defined in Treasury's single bidder guidelines, shall
not submit noncompetitive tenders totaling more than $1,000,000.
Banking institutions and dealers who make primary
markets in Government securities and report daily to the Federal
Reserve Bank of New York their positions in and borrowings on
such securities may submit tenders for account of customers, if
the names of the customers and the amount for each customer are
furnished.
Others are only permitted to submit tenders for their
own account.
Each tender must state the amount of any net long
position in the bills being offered if such position is in excess
of $200 million. This information should reflect positions held
as of one-half hour prior to the closing time for receipt of
tenders on the day of the auction.
such positions would include
bills acquired through "when issued" trading, and futures and
forward transactions as well as holdings of outstanding bills
with the same maturity date as the new offering, e.g., bills
with three months to maturity previously offered as six-month
bills.
Dealers, who make primary markets in Government securities and report daily to the Federal Reserve Bank of New York
their positions in and borrowings on such securities, when submitting tenders for customers, must submit a separate tender for
each customer whose net long position in the bill being offered
exceeds $200 million.
A noncompetitive bidder may not have entered into an
agreement, nor make an agreement to purchase or sell or otherwise dispose of any noncompetitive awa~ds of this issue being
auctioned prior to the designated closing time for receipt of
tenders.
Payment for the full par amount of the bills applied for
must accompany all tenders submitted for bills to be maintained
on the book-entry records of the Department of the Treasury.
A cash adjustment will be made on all accepted tenders for the
difference between the par payment submitted and the actual
issue price as determined in the auction.
No deposit need accompany tenders from incorporated banks
and trust companies and from responsible and recognized dealers
in investment securities for bills to be maintained on the bookentry records of Federal Reserve Banks and Branches.
8/89
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 3
Public announcement will be made by the Department of the
Treasury of the amount and yield range of accepted bids. Competitive bidders will be advised of the acceptance or rejection
of their tenders. The Secretary of the Treasury expressly
reserves the right to accept or reject any or all tenders, in
whole or in part, and the Secretary's action shall be final.
subject to these reservations, noncompetitive tenders for each
issue for $1,000,000 or less without stated yield from anyone
bidder will be accepted in full at the weighted average bank
discount rate (in two decimals) of accepted competitive bids
for the respective issues. The calculation of purchase prices
for accepted bids will be carried to three decimal places on the
basis of price per hundred, e.g., 99.923, and the determinations
of the Secretary of the Treasury shall be final.
Settlement for accepted tenders for bills to be maintained
on the book-entry records of Federal Reserve Banks and Branches
must be made or completed at the Federal Reserve Bank or Branch
on the issue date, in cash or other immediately-available funds
or in Treasury bills maturing on that date. Cash adjustments
will be made for differences between the par value of the
maturing bills accepted in exchange and the issue price of the
new bills.
If a bill is purchased at issue, and is held to maturity,
the amount of discount is reportable as ordinary income on the
Federal income tax return of the owner for the year in which
the bill matures. Accrual-basis taxpayers, banks, and other
persons designated in section 1281 of the Internal Revenue Code
must include in income the portion of the discount for the period
during the taxable year such holder held the bill. If the bill
is sold or otherwise disposed of before maturity, any gain in
excess of the basis is treated as ordinary income.
Department of the Treasury Circulars, Public Debt Series Nos. 26-76, 27-76, and 2-86, as applicable, Treasury's single
bidder guidelines, and this notice prescribe the terms of these
Treasury bills and govern the conditions of their issue. Copies
of the circulars, guidelines, and tender forms may be obtained
from any Federal Reserve Bank or Branch, or from the Bureau of
the Public Debt.
8/89
Pl"BLIC ;\FF.URS
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8EPT. 0, I HE Il\[:}~u:d
FOR IMMEDIATE RELEAsE
AG
TUESDAY, APRIL 17, 1990
202-633-2107
202-786-5731
('1'00)
PROBI ANNOUNCED OP
u.s. BANI ACCOUNTS USED BY
DRUG
LORDS
WASHINGTON, O.C.--Attorney General Dick Thornburqh and
Treasury Secretary Nicholas Brady announced today that 173 banks
in 23 states have been ordered to produce records of more than
754 bank accounts into which nearly $400 million in illegal
Colombian drug profits were deposited.
OVer three quarters of
these accounts, 684, were orderQQ frozen pending the initiation
of forfeiture proceedings by the qovarnment .
• The action taken today against the Medellin Cartel,
Which marks Phase IV of Operation Polar Cap, seeks to lift the
veil of secrecy over the financial network of these narcoterrorists including Pablo Escobar and Jorge Ochoa,· Attorney
General Dick
Thorr;u~gh
life blood.
If we Cdn seize it or disrupt its
said. 'Money is the drug-traffickers'
flo~,
we can
stranqle their operdtions.·
Secretary Brady said tOQay's action -is one of the most
siqnificant law enforcement undertakinqs involvinq bank account
seizures in
u.s.
history •
• These bank records will alloW us to continue the hunt
for more laundered drug money through further tracing of these
accounts.
For the first time, we have b ••n able to trace cash
(MORE)
O~'11'90
prBLIC :\FF.HRS
12:30
......
P.~
~002 ·oo~
- 2 -
proceeds directly from cocaine and crack sales on the streets of
American cities to foreiqn gank accounts owned by the Medellin
Cartel,· Brady said.
The Attorney General and the Treasury Secretary pointed
out that this latest initiative of federal law enforcement
aqencies in this operation was 'the result of an unprecedented
level of cooperation given gy eiqht foreiqn qovernments
cooperation which was unheard of even a year ago.
"The message from us today is that tbe world
community's outrage has unified our efforts to oust the drug
trafficking cartels.
The message to drug tratfickers is that the
world is qoing to be a smaller place for them to hide,'
Thornburgh said.
The Attorney General praised the qovernments
which have assisted in the operation and added that once the
United Nations Vienna Orug Law convention was ratified and fully
implemented
by all
nations, 'we will have
t~e
necessary tools for
these kinds ot operdtions against the drug =artels on a worldwide
basis."
Phase IV e=anateQ from a March 6, 1989, indictment in
Atlanta by a federal grand jury in which mel:bers of the Medellin
cartel were eharged with cocaine and marijuana trafficking and
the
launderi~9
of the cash proceeds from these druq sales.
Phases I, II, and III of Polar cap showed that drug sale profits
of over $1
~illion
were launQered mainly through New York banks
(HORE)
'C202
6~3
Pt"BLIC ..\FHIRS
5331
~ ....
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- 3 -
into foreign accounts controlled cy the Cartel mostly in Panama,
Uruguay, and elsewhere.
Through investigation of these New York and other
u.s
accounts, formal requests were made to the qovernments of
Colombia, Panama, trrucruay, Luxembourg, Switzerland, United
Rinqdom, Canada and Austria tor records of accounts believed to
b. under the control of the Medellin cartel.
In January, 1990, after the ouster of Manuel Noreiqa,
federal agents travelled to Panama and requested the Attorney
General of Panama. to take the necessary steps under Panamanian
law to obtain records of Panamanian bank accounts identified as
having been used
by
cartel money launderers.
ExaJnination of the Panamanian and other foreign
accounts showed that between 1987-89 almost $350 million was
wire-transferred back to
u.s. banks, primarily in New York and
Florida, which are included in today's court order issued
federal district
cc~rt
in Atlanta.
believed. never to ha'w'e left
u.s.
by
the
Another $5Q million is
accounts.
'The Cartel needs these secret
u.s. accounts in order
to run their illegal business bare,' Thornburgh said.
'The
massive scope of the cocaine trade in the U.S. requires large
amounts of capital for the operation of the Cartel'. daily
activities, as well as to maintain the company's payroll.
Our
ability to examine these bank records may will be the key to
(HORE)
·o~·
17 9U
PlBLI( AffAIRS
12:31
--- fA
.(.
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- 4 -
unlocking the totality of the secret financial arranqements ot
the cartel in the U. S • •
The Attorney General c01llmended the j oint efforts of the
o. s. customs Service, the
Druq Enforcement Administration, the
Internal Revenue service, and the Federal Bureau of Investiqation
for the continued success in Operation Polar cap.
Thornburgh praised u.s. Attorneys Ray Rukstele
(Acting), Northern District of Georqia; Otto Obermaier, southern
District of New York; Dexter Lehtinen, Southern District of
Florida and Assistant
u.s.
Attorney Wilmer 'Buddy' Parker, the
Northern District of Georgia, for their work on Phase IV of Polar
Cap.
The first results of Operation Polar Cap were announced
by
Thornburgh
an~
Bracy in February 1989.
largest drug money-laundering
Unite~
Polar Cap is the
investigatio~
states law enforcement agencies.
ever conducted by
As a result of Polar
Cap, 127 persons have been charq.a, and more than a ton of
cocaine was confiscated along with mora than 19,000 pounds of
marijuana and $l05
~illion
in casb, jewelry, and real estat•.
More arrests as a result of collateral investiqations are
expected.
The united Nations Vienna Orug Law Enforcement
Convention, vhich was ratified DY the U.S. Senate last year and
drafted by ever 100 nations, will boost international lav
(MORE)
uu ..
APR-17-19SC
09:37
FROM
JCC WASM DC 2C2-633-J699
97866433
TO
P.06
- s enforcement efforts in the area. of Boney launderinq,
international transportation of precursor chemicals used to
produce illegal
illegal-drug
~rugs,
tra~e
the tracing
seizure of
profits of the drug cartels
extradition of dru; criminal •.
f."
90-162
an~
.n~
1.undere~,
the worldwide
For Release Upon Delivery
Expected at 2:00 p.m.
April 18, 1990
Statement of the Honorable
Nicholas F. Brady
Secretary of the Treasury
before the
Committee on Ways and Means
United States House of Representatives
April 18, 1990
Mr. Chairlt'an and Members of the Committee:
I am pl~ased to appear today to discuss developments in
Eastern Europe, the European Community, and foreign i.nvestment in
the United states. Developments in these areas will have an
important bearing on the U.s. economy for the rest of this
century and beyond.
EASTERN EUROPE
In Eastern Europe, economic conditions have been a critical
factor behind the political changes that have swept across the
region during the past year. Most of the Eastern European
countries are undertaking comprehensive, market-oriented reform
programs. To encourage their efforts, the U.s. Government is
providing financial and technical assistance and is negotiating
trade, investment, and tax treaties.
Financial Assistance
The United States responded quickly with financial assistance
to the developments in Eastern Europe. In fiscal year 1990, the
Support for Eastern European Democracy (SEED) Act provided $418
million in aid to Poland and Hungary. The United States, along
with other donor countries, organized a $500 million multilateral
bridge loan for Poland, which has already been repaid. In
addition, the United States coordinated a $1 billion multilateral
Stabilization Fund for Poland to p~ovide support for the Polish
zloty as the economic reforms -- including limited convertibility
-- were implemented. This year the Administration has proposed
legislation to expand our assistance effort to all of the
emerging democracies of Eastern Europe, requesting $300 million
in fiscal year 1991 for this purpose. Finally, a large variety
of activities are being undertaken to support private sector
development in Eastern Europe, including the establishment of
Enterprise Funds for Poland and Hungary under the SEED Act.
Under U.s. leadership, multilateral institutions are also
engaged in helping the region. Both the International Monetary
Fund (IMF) and the World Bank are actively supporting economic
reform in Poland and other countries that are members of the Fund
NB-766
-2and Bank: Hungary, Romania, and Yugoslavia.
The magnit~de of
this support is impressive.
The IMF has committed more than $1.5
billion under stand-by arrangements with Poland, Yugoslav~a, and
Hungary.
The World Bank is extending project and non-proJect
loans to these three countries at the rate of almost $2 billion
per year.
Recognizing the key role played by these institutions,
Czechoslovakia and Bulgaria have recently applied to become
members.
European Bank for Reconstruction and Development
A new institution positioned to provide significant funds for
Eastern Europe is the European Bank for Reconstruction and
Development (EBRD).
The Bank is the response of the Western
countries to demonstrate their political and economic commitment
to and solidarity with the Eastern European countries that had
decided to undertake the transition to multi-party democracy and
market-oriented economies.
The Bank is also viewed as a vehicle
which could, through its borrowing in capital markets, leverage
contributed funds into larger loanable resources to support much
needed economic reforms in these Eastern European countries.
This "leveraging" will enable the EBRD to lend about $12 billion
in support of Eastern Europe at a total budgetary cost to the
United States of only $350 million over the next five years.
The
u.s. share of the Bank's $12 billion capitalization will be 10
percent, making the United States the largest shareholder.
The United States supported the concept of a multilateral
Bank that would facilitate the transition of the borrowing
countries to democracy and pluralism and a market-oriented
economy. We saw a development bank for Eastern Europe as a
unique institution and insisted that these concepts be an
integral part of the EBRD's charter.
This the first time these
principles have been included in a development bank charter.
The charter of the EBRD also requires that at least 60
percent of the EBRD's aggregate annual lending and its lending by
country for the first five years be to the private sector or
state-owned enterprises that are shifting to private ownership
and control.
While the Soviet Union is eligible to be a borrowing member
of the EBRD, its borrowing will be limited for a three-year
period to the amount of their paid-in subscriptions to the Bank
and will be confined to loans for the private sector or to help
enterprises operating competitively and moving to a market
orientation. Any expansion of Soviet borrowing after the
three-year period will require agreement by members holding
85 percent of the voting power.
Technical Assistance
Our technical assistance to Eastern European countries is
likely to be more important in the long run, however, than our
-3-
financial assistance. These countries need technical .assistance
in virtually every sector of their economies. For example, they
need help in setting up business schools to teach enterprise
managers how to operate in a market economy. They need foreign
expertise to set up effective farm credit programs, and to
establish a legal framework for private ownership of property.
The importance of technical assistance has been recognized by
the United states and other western countries, and is reflected
in last year's SEED Act and the Administration's proposal for
assistance to Eastern Europe in FY 1991. As part of the overall
interagency coordination of economic policy with Eastern Europe,
a wide-ranging program of technical assistance to Eastern
European countries has been developed. We in the Treasury are
giving particular attention to financial sector reform, and we
are chairing an interagency task force to guide our efforts in
this area.
Trade and Investment
The United states has entered into discussions with Eastern
European countries aimed at reaching agreements to improve trade,
business, and investment conditions. The investment discussions
are intended to result in treaties or agreements that include
provisions for stable, market-oriented policies towards foreign
investment, free transfers of capital and returns on investment,
fair dispute settlement procedures, and discipline over the use
of performance requirements.
The first treaty, a business and economic relations treaty
with Poland, was signed last month. It will be submitted to the
Senate for approval in the near future. This treaty goes beyond
the areas in our model bilateral investment treaty by extending
protection to commercial activities, such as representative
offices of U.s. companies seeking sales in Poland. The treaty
also includes important commitments by Poland with regard to the
protection of intellectual property, expropriation, and
investment screening.
We had preliminary discussions with Hungary on investment
issues prior to its recent elections. We will propose
negotiating with the new government a business and economic
relations agreement similar to that recently concluded with
poland.
Last week, we signed a trade agreement with Czechoslovakia
that mutually applies GATT rules on trade, provides for
protection of intellectual property, and guarantees
non-discriminatory treatment in access to currency and banking
accounts. Our investment treaty discussions with Czechoslovakia
are underway, but are not near agreement.
-4-
Tax Treaties
We have income tax treaties currently in effect with some
Eastern European countries, and we hope to begin negotiations
soon on treaties with others.
These treaties form an important economic link with Eastern
Europe, as with other countries, because they facilitate
bilateral investment flows and business opportunities.
Specifically, such treaties reciprocally raise the thresholds of
business activity necessary for a foreign country's income tax
system to apply.
They also reduce foreign taxes on investment
income, such as dividends, interest and royalties earned by u.s.
residents.
In addition, and often of equal importance, the
treaties provide for the elimination of double taxation, through
a reciprocal guarantee of a foreign tax credit or similar
mechanism and through harmonizing technical rules.
Finally,
treaties establish a government-to-government tax dispute
resolution system to which taxpayers can turn.
By undertaking treaty negotiations promptly with the
countries of Eastern Europe where treaties do not now exist or
need revision, we will make it more attractive for u.s. investors
to enter those markets.
Other industrial countries, such as
France, Germany, Japan, and the United Kingdom have been
concluding modern tax treaties with Eastern Europe. We want U.S.
investors to operate under conditions no less favorable.
We have income tax treaties with Romania, Poland, and
Hungary.
These have been in effect for more than a decade, and
are close to our model and the OECD model for income tax
treaties.
They have stood the test of time fairly well.
In the
restructuring of their economies, Eastern European countries may
enact new laws, or modify existing laws, in such a way that
revision of the tax treaties becomes necessary.
Because the
treaties are close to our model, howev.er, many changes toward a
more typical income tax system by these countries will be
adequately accommodated by the existing treaties.
We expect to meet with representatives of Bulgaria later this
spring to begin negotiations. We hope to begin similar talks
with Czechoslovakia soon thereafter, and to resume negotiations
with Yugoslavia once their tax reforms are completed.
Treaty
issues with East Germany depend on the progress and nature of
unification with the Federal Republic of Germany.
-5-
EUROPEAN COMMUNITY
The United states strongly supports European economic
integration. The reinvigoration of the EC's efforts towards the
eventual goal of economic and monetary union has significant
implications for the United States and world economy. Treasury
has followed closely the full range of issues with a focus on
financial and investment issues.
Banking and Finance
The EC's plan to liberalize European financial markets would
essentially create a single EC capital market and banking systems
that permit universal banking. It takes steps towards mutual
recognition of EC national financial supervisory systems. These
changes would lead to more efficient and competitive capital
markets and a more efficient allocation of capital, providing
benefits throughout the EC economy.
We have worked with our EC colleagues engaged in preparing EC
banking and securities directives to take effect January 1, 1993.
Early in the process it appeared possible that the banking
directive and investment services directive would contain strict
reciprocity provisions which could damage U.S. interests. The EC
subsequently revised the directives, substantially alleviating
our concerns.
Investment
The Administration is reviewing the investment implications
of EC 1992. Our tentative conclusion is that the EC 1992 rules
on mergers and acquisitions will enhance U.S. investment
opportunities. However, the manner in which the EC implements
the new rules will be the determining factor. We will monitor
implementation closely.
We also are monitoring developments to assure that national
treatment of foreign-owned firms in the EC is not abridged by the
process of creating a single market. We anticipate that
U.S.-owned subsidiaries will be treated as EC-country companies
for all purposes within the single European market, just as we
accord EC and other foreign-owned companies national treatment in
the United States. We expect the same treatment of U.S.
companies within the EC.
Taxes
With regard to taxes, we are closely following tax issues
associated with EC 1992. The pace of harmonization in the area
of taxation, particularly income taxation, is slow. This is to
be expected, considering that the EC member states have strongly
held and diverse views on tax issues, and that EC tax directives
require unanimous consent. In many cases, EC members have a
-6system of bilateral tax treaties with other EC members that
resolve many conflicts.
In July of this year, remaining capital controls within the
Community will be removed by most EC countries.
Some EC member
states and the EC Commission have been concerned about the effect
of free capital movement on their tax revenues. We have had
informal and preliminary talks about a multilateral response to
these difficult issues.
within the EC, authority in the area of taxation is retained
by each individual state.
The member states have not developed a
multilateral tax treaty for use with the rest of the world.
Therefore, the United States will continue its current policy of
negotiating and concluding income tax treaties with individual
states. A single tax treaty between the United States and the EC
is not a realistic possibility in the foreseeable future.
Monitoring Developments
The financial, monetary, and tax issues relating to EC
economic integration will be of paramount importance.
Therefore,
I established an Economic policy Council (EPC) policy Group on
European Monetary Reform and Financial Liberalization with
participation from the key economic agencies and relevant
financial regulators.
This group will report to the EPC on the
macroeconomic and financial implications of economic and monetary
union.
The Treasury is currently coordinating a National Treatment
Study on financial services. This study, mandated by the 1988
Trade Act, is due this December.
It will be more extensive than
any previously prepared.
FOREIGN INVESTMENT
We welcome foreign direct investment and encourage other
countries to do likewise. U.S. policy is based on the conviction
that when capital is free to flow to its most efficient use, the
results are greater productivity and enhanced international
competitiveness.
The benefits of an open investment policy are not just a
matter of economic theory; they are tangible.
Foreign direct
investment provides benefits in the forms of advanced technology,
new management skills, jobs, and larger payrolls.
These are
important at the national level in terms of the overall health of
this economy, as well as at the factory gate.
At at time of relatively
investment helps us maintain
so important to our economic
Administration is to improve
low domestic savings, foreign
high levels of investment which is
performance. A major goal of the
national savings and domestic
-7-
capital formation.
Foreign Investment and National
Secu~ity
The United States has consistently provided foreign investors
non-discriminatory treatment as a matter of law and practice. We
maintain exceptions to such treatment only as necessary to
protect national security.
The 1988 Trade Act included the Exon-Florio provision which
empowers the President to investigate and to prohibit or suspend
foreign acquisitions that threaten to impair the national
security. The President delegated his authority to investigate
transactions to the Committee on Foreign Investment in the united
States (CFIUS), an interagency committee which I chair.
The Committee will continue to implement the Exon-Florio
provision to fulfill its spirit and intent. This will be done
within the context of a continued commitment to an open
investment policy.
TAX POLICY ON INBOUND INVESTMENT
Our tax policy toward foreign investment in the United states
is to tax foreign investors fairly, reasonably, and in accordance
with international norms that reduce tax barriers to
international transactions. While we must continue to monitor
new developments, we believe in general that our tax policy
toward foreign investment is sound and effectively serves the
United States' best interests.
Tax Treaties
In discussing the United States' overall policy on foreign
investment, it is important to note that u.s. investors own
extremely large amounts of foreign assets. Thus, the decisions
we make about foreign investment in the United states will affect
the large volume of U.s. investment abroad.
To promote bilateral trade, investment and cultural
relations, we have entered into a broad network of tax treaties.
These treaties conform substantially to standards
well-established in the international community. The value of
this tr~aty network to U.S. businesses and investo~s is discussed
above in my remarks on Eastern Europe. This network helps u.s.
businesses and u.s. investors achieve the same "open door" that
we are willing to offer foreign subsidiaries here, both through
treaties and domestic legislation.
Taxes on Investment Income
An important aspect of our tax policy toward international
investment is that investment income generally should be subject
to a relatively low tax rate in the country where the income has
-8its source.
This principle is reflected primarily in our income
tax treaties, but also in the Code for certain types of income,
such as most types of interest income and gains from sales of
securities.
Low withholding taxes promote a more efficient world-wide
allocation of capital with respect to both foreign capital
invested in the United States and U.S. capital invested abroad.
Low withholding taxes on investment income is a good general
policy because residence country taxation is often a more
accurate means of determining, on a world-wide basis, the
investor's overall income, expenses, gains, and losses.
A policy
of low withholding taxes on investment income does not, of
course, dictate a zero level of withholding.
Taxes on Interest Income
An important issue concerning source country taxes on
investment income that has received attention recently, both in
Europe and in the United States, is the question of withholding
taxes on interest income.
The issue was debated in 1984, when
Congress enacted the "portfolio interest" rules.
These rules
exempt from U.S. tax much of the interest paid from U.s. sources
to unrelated foreign lenders.
Treasury supported this
legislation on the grounds that it would help to provide U.S.
borrowers more efficient access to the Eurobond market, to lower
domestic borrowing costs, and to promote valuable capital inflows
directly to the United States.
Thereby, it would contribute to
capital formation and substantial economic growth in the United
States.
We continue to support these rules.
Questions have nevertheless persisted about the proper
general treatment of interest payments to foreign investors.
These questions relate to concerns about revenue, as well as
capital flight and tax evasion.
There are no simple answers to
these questions.
However, we believe that issues such as these
are best addressed through multilateral discussions.
We believe,
in general, multilateral agreements offer the best hope for
solutions to many difficult international tax problems.
Overriding Tax Treaties
Finally, I would like to address what internationally may be
the single most controversial issue concerning U.S. tax policy
toward foreign investors -- the increased willingness of Congress
in recent years to override our treaty obligations.
Although we are encouraged by recent developments,
particularly the willingness of the Congress to improve the
treaty posture of the "earnings stripping" provision in last
year's Reconciliation Bill, we continue to be concerned.
Treaty
overrides have resulted in threats of retaliation and, more
tangibly, in the clear prospect of less desirable outcomes for
the United States in recent treaty negotiations.
Foreign
-9-
negotiators insist on greater concessions from us than would
otherwise be fair or balanced when they are uncertain whether or
not our side of the bargain will be kept.
I believe the solution to this problem lies in regular
consultation with Congress. Such consultations should assure
that legitimate legislative goals will not be frustrated by a
rigid or antiquated tax treaty program, while at the same time
permitting our treaty program to continue to meet changing
conditions and needs.
TREASURY J~EWS
,.partlnent of the T....ury • wa.llln.ton, D.C. • T..... llon••88-20.'
FOR IMMEDIATE RELEASE
APR 2usa 0 0 l b 0 5
April 18, 1990
The Treasury Department today released U.S. reserve assets data
for the month of March 1990.
As indicated in this table, U.S. reserve assets amounted to
$76,303 million at the end of March, up from $74,173 million in
February.
U.S. Reserve Assets
(in millions of dollars)
End
of
Month
Total
Reserve
Assets
Gold
stock
Feb
74,173
Mar
76,303
Special
Drawing
Rights ~/ll
Foreign
Currencies !I
Reserve
Position
in IMF ~I
11,059
10,216
43,913
8,985
11,060
10,092
46,424
8,727
1:/
1990
II
Valued at $42.2222 per fine troy ounce.
~
Beginning July 1974, the IMF adopted a technique for valuing the SDR
based on a weighted average of exchange rates for the currencies of
selected member countries.
The U.S. SDR holdings and reserve
position in the IMF also are valued on this basis beginning July
1974.
II
Includes allocations of SDRs by the IMF plus transactions in SDRs.
!I Valued at current market exchange rates.
NB-767
FOR RELEASE AT 4:00 P.M.
April 18, 1990
Office of Financing
202/376-4350
TREASURY TO AUCTION $10,500 MILLION OF 2-YEAR NOTES
The Department of the Treasury will auction $10,500 million
of 2-year notes to refund $9,826 million of 2-year notes maturing
April 30, 1990, and to raise about $675 million new cash. The
public holds $9,826 million of the maturing 2-year notes, including
$750 million currently held by Federal Reserve Banks as agents for
foreign and international monetary authorities.
The $10,500 million is being offered to the public, and any
amounts tendered by Federal Reserve Banks as agents for foreign and
international monetary authorities will be added to that amount.
Tenders for such accounts will be accepted at the average price of
accepted competitive tenders.
In addition to the public holdings, Federal Reserve Banks, for
their own accounts, hold $1,434 million of the maturing securities
that may be refunded by issuing additional amounts of the new notes
at the average price of accepted competitive tenders.
Details about the new security are given in the attached
highlights of the offering and in the official offering circular.
000
Attachment
NB-768
HIGHLIGHTS OF TREASURY
OFFERING TO THE PUBLIC
OF 2-YEAR NOTES
TO BE ISSUED APRIL 30, 1990
April 18, 1990
Amount Offered:
To the pub 1 ic . . . . . . . . . . . . . . . . . . . $10,500 million
Description of Security:
Term and type of security ..••••• 2-year notes
series and CUSIP designation •.•. Y-1992
(CUSIP No. 912827 YU 0)
Maturi ty date . . . . . . . . . . . . . . . . . . . April 30, 1992
Interest rate ..•..•.•..•..•...•. To be determined based on
the average of accepted bids
Investment yield ••......•....... To be determined at auction
Premium or discount ............ . To be determined after auction
Interest payment dates ........•. October 31 and April 30
Minimum denomination available .. $5,000
Terms of Sale:
Method of sale .........•........ yield auction
competitive tenders •••••••...... Must be expressed as an
annual yield, with two
decimals, e.g., 7.10%
Noncompetitive tenders
Accepted in full at the average price up to $1,000,000
Accrued interest
payable by investor
None
Payment Terms:
Payment by noninstitutional investors
Deposit guarantee by
designated institutions
Full payment to be
submitted with tender
Acceptable
Key Dates:
Receipt of tenders .............. Wednesday, April 25, 1990,
prior to 1:00 p.m., EDST
Settlement (final payment
due from institutions):
a) funds immediately
available to the Treasury
Monday, April 30, 1990
b) readily-collectible check
Thursday, April 26, 1990
EMBARGOED FOR RELEASE
AT 4:00 P.M. EDT
APRIL 18, 1990
DEPARTMENT OF THE TREASURY
Report to the Congress
on
International Economic and Exchange Rate Policy
April 1990
EMBARGOED FOR RELEASE
AT 4:00 P.M. EDT
APRIL 18, 1990
DEPARTMENT OF THE TREASURY
Report to the Congress
on
International Economic and Exchange Rate Policy
April 1990
TABLE OF CONTENTS
part I
Introduction
1
Part II
Economic Situation in the Industrial Countries
and the u.s. Balance of Payments
2
Part III
Foreign Exchange Market Developments
9
Part IV
Economic Policy Coordination
13
Part V
Asian Newly Industrialized Economies (NIEs)
15
Part VI
Conclusion
27
APPENDIX
Tables
31
PART I:
INTRODUCTION
Section 3005 of the Omnibus Trade and Competitiveness Act
of 1988 (Pub. L. 100-418) requires the Secretary of the Treasury
to submit to the Committee on Banking, Housing and Urban Affairs
of the Senate and the Committee on Banking, Finance and Urban
Affairs of the House of Representatives an annual report each
October 15 on international economic policy, including exchange
rate policy. In addition, Section 3005 requires that the
Secretary shall provide a written update of developments six
months after the initial report. Annual reports, pursuant to
Section 3005, have been submitted in October of 1988 and 1989.
The first written update of developments was submitted in April
1989. This report represents the second written update of
developments submitted to Congress.
Part II of this report reviews the economic situation in
the industrial countries, including the U.S. economic and
balance of payments situation. Part III analyzes the situation
in the foreign exchange markets, including the dollar's movement
in terms of the currencies of major U.S. trading partners and
U.S. foreign exchange market intervention. Part IV reviews
efforts by the major industrial countries to coordinate economic
policies. Part V provides a status report on negotiations with
Korea, which was considered in the October 1989 report to be
"manipulating" its exchange rate, within the meaning of the
legislation. It also reviews developments in Taiwan. The final
part provides conclusions on the principal issues discussed in
the report.
-2-
PART II: ECONOMIC SITUATION IN THE INDUSTRI·AL
COUNTRIES AND THE U.S. BALANCE OF PAYMENTS
o
Overview
The economic expansion in the industrial countries
continued through its seventh consecutive year in 1989, at an
average rate that was, as expected, somewhat below the very
strong pace of 1988. Aggregate real GNP growth is expected to
ease a bit further this year, to a still satisfactory rate of
about 3.0 percent, with a greater divergence in the performance
of individual countries reflecting both policy measures and
cyclical factors. Prospects for continued steady growth remain
good.
Substantial progress was made last year in reducing the
trade and current account imbalances of the United states and
Japan. However, the external imbalances of other major
countries, such as Germany and the United Kingdom, increased
further in 1989, and the underlying pace of the overall
adjustment process appears to have slowed in some important
respects. Nevertheless, market opening measures in Eastern
Europe and, particularly, the economic integration of west and
East Germany, could provide substantial impetus to the external
adjustment process over time, especially within Europe.
Consumer price inflation in the industrial countries rose
by approximately one percentage point in 1989, to an average
rate of about 4.5 percent. The increase, which was broadly
consistent with expectations, in part reflected the influence of
some special, transitory, factors during the first half of the
year. Since then, however, price pressures have generally
moderated or stabilized, and the average inflation rate is
likely to slip back marginally to slightly below 4 percent in
1990. (See Table 1.)
o
Economic Growth
Basic developments in real GNP and its components were
remarkably uniform in the major industrial countries in 1989.
Specifically, after GNP growth rates picked up strongly in 1988
(to what, for several countries, were decade highs), there was a
broadly shared slowdown in 1989. Japanese growth dipped to 4.9
percent (still the strongest rate in the G-7), and U.S. growth
to 3.0 percent; the largest declines were registered for the
United Kingdom and Canada (to 2.3 and 2.9 percent,
respectively); only in Germany was GNP growth stronger in 1989
than in 1988 (4.0 percent vs. 3.6 percent). Aggregate GNP
growth for the G-7 countries was an estimated 3.4 percent last
year, after 4.5 percent in 1988. Domestic demand followed a
similar course, with G-7 growth easing from 4.7 percent in 1988
to 3.4 percent in 1989.
-3-
Two major factors accounted for the bulk of last'year's
domestic demand slowdown. First, while investment activity
remained generally strong, there was a fairly widespread easing
from the unexpectedly high growth rates in 1988. Contributing
to the slowdown were a moderate scaling back of investment plans
in the wake of the large increases in recent years, narrowed
profit margins, and anticipation of a period of somewhat weaker
demand growth ahead. Second, private consumption growth
declined in each of the G-7 countries in 1989, pulling the
aggregate growth rate from 3.7 percent in 1988 to about 3
percent; among the contributing factors were the limiting
effects of selected tax and social payment increases and higher
inflation on real disposable income gains, as well as, in some
cases, higher household saving.
Aggregate macroeconomic developments in the United States
and Japan continued to provide solid support for the current
account adjustment process. In the United States, domestic
demand grew more slowly than GNP for the third consecutive year,
and improving net exports once again provided a significant
growth impetus. The reverse was the case in Japan, where
domestic demand growth again substantially exceeded GNP growth
and net exports declined significantly. In Germany, however,
domestic demand growth weakened appreciably (due in part to
fiscal tightening), and lagged GNP growth by a considerable
margin; rising net exports were thus an important source of
overall growth. Macroeconomic developments in the United
Kingdom (with a very large current account deficit) moved
strongly in the direction of adjustment in 1989 as domestic
demand growth cooled from its unsustainably high rate in 1988.
Nevertheless, domestic demand growth in the United Kingdom (as
well as in Canada) remained in excess of GNP growth.
Macroeconomic trends are expected to be broadly supportive
of external adjustment within the G-7 again this year. As
domestic demand growth eases further in the largest deficit
·countries (the united States, the United Kingdom and Canada),
net exports should also improve. Although domestic demand
growth in Japan is not likely to be as strong as in 1989, it
should again exceed GNP growth, with net exports contracting
further. Modest real external adjustment is likely in Germany
as well this year, as a tax cut and economic integration with
the German Democratic Republic boost domestic demand. Over the
longer .term, German economic and monetary union should have a
positive and substantial effect in reducing Germany's external
imbalances.
o
Trade and Current Account Developments
World trade in 1989 largely reflected the macroeconomic
developments discussed above: trade volume growth was not quite
as robust as in 1988 (at 9.1 percent, the best year of the
decade), but nevertheless remained quite strong (about 7.5
percent). Thus, the relationship between trade and output
growth continues to track well with historical experience
(roughly a 2:1 ratio).
-4-
The external imbalances of the two largest economies, the
United States and Japan, declined substantially in 1989. Latest
available data indicate that the U.S. current account deficit
fell about an additional $21 billion in 1989, from $126.5
billion to $105.9 billion (2.0 percent of GNP); the trade
deficit fell to $113.2 billion (2.2 percent of GNP). Japan's
current account surplus declined from $79.6 billion in 1988 to
$57 billion in 1989 (2.0 percent of GNP), and its trade surplus
from $95 billion to $77.1 billion (2.7 percent of GNP). The
aggregate current account surplus of the European Community (ECl
fell to nearly zero last year after having been as high as $51
billion in 1986.
However, the overall external adjustment of the EC conceals
some major imbalances that have developed among Community
members. In particular, Germany's trade and current account
surpluses continued to rise in 1989; at $72 billion and $53
billion, respectively, the German imbalances represent 6.5 and
4.4 percent of GNP, the largest such ratios in the G-7. The
bulk of the increase in German surpluses has come in trade with
other EC member countries, with which Germany's surplus has more
than tripled since 1985. However, the impact of the growing
German surpluses on the overall external position of the EC has
been essentially offset by rising deficits in other member
countries, especially the United Kingdom and Spain. The trade
and current account deficits of the united Kingdom increased
somewhat further in 1989, to $37 billion (4.5 percent of GNP)
and $33 billion (4 percent of GNP), respectively.
These external account trends in 1989 partly reflect
developments in the relative growth rates of exports and imports
in individual countries. In the United States, real exports of
goods and services (measured on the national accounts basis)
increased nearly 11 percent (the third consecutive year of
double digit growth) while import growth was 6.4 percent.
Import growth of 21 percent in Japan again exceeded export
'growth (about 15 percent), though the latter strengthened
substantially last year. In Germany, however, export growth
accelecated to just over 10 percent, exceeding import growth of
about 7 percent; and while import growth in the United Kingdom
slowed and export growth strengthened, the former still exceeded
the latter by about 7 percent to 4 percent.
Thus, underlying trade flows present a mixed picture of
adjustment. U.S. trends continue to favor adjustment, though
the pace of export growth has cooled; in Japan, import growth
remains strong, but export growth has revived considerably;
export growth revived strongly as well in Germany, but imports
picked up only marginally.
Against the background of these underlying trends, and in
light of the macroeconomic projections reviewed above, further
external adjustment in the industrial countries is expected this
year, but the composition and extent of the adjustment is open
-5-
to question. In the United States and Japan, where adjustment
has been the greatest in recent years, additional progress is
likely to be much smaller and a modest widening of nominal
imbalances cannot be excluded. Basic developments have
brightened the adjustment prospects for Germany, but the very
large existing imbalances suggest that substantial imbalances
will remain.
However, developments in Europe could provide substantial
impetus to the industrial country adjustment process over the
next few years, with early signs perhaps beginning to emerge
later this year. The unification of the two German economies is
likely to be especially significant. The large population
inflow into West Germany is already raising German domestic
demand, due in part to the fiscal stimulus associated with
higher transfers and infrastructure outlays. The additional
demand can be met without undue inflationary consequences by
diverting West German exports to domestic uses and by increasing
imports. The net effect, over time, could thus be a significant
reduction in the German surplus and a substantial increase in
trade opportunities for non-German suppliers.
o
Inflation
The increase in average inflation rates in the industrial
countries in 1989 reflected the combined impact of several
developments, including higher oil prices, excise tax increases
in various countries, and generally higher capacity utilization
rates. However, the bulk of the price runup occurred during the
first half of the year, and for most countries inflation rates
have tended to level off or subside since then.
A number of other factors appear likely to reinforce this
more recent trend, which should push inflation moderately lower,
on average, this year. Slower output and demand growth, coupled
with the vigorous investment activity of the past few years,
. should ease pressures arising from higher capacity utilization
and wage demands; and, the monetary and fiscal authorities are,
for the most part, likely to continue to pursue a fairly
restrictive course.
As a result, consumer price inflation is forecast to ease
somewhat in each of the major industrial countries this year and
to decline to slightly below 4 percent in the industrial
countries in aggregate. Japan, Germany and France are expected
to remain at the lower end of the G-7 group, with the united
States and Canada in the middle, and Italy and the united
Kingdom at the upper end.
-6-
U.S. Balance of Payments Developments and Trends
o
Developments in 1989
The U.S. trade deficit, after declining markedly (by $32
billion) to $127 billion in 1988, fell further in 1989 to $113.2
billion. The 1989 trade deficit was the lowest since 1984. The
improvement occurred largely in the first half of the year as
the pace of adjustment slowed over the course of 1989.
The continued, but slowed decline in the trade deficit
reflected moderation in both export and import growth. In 1989,
exports rose 13.4 percent in value (11.8 percent in volume),
well below the corresponding performance in 1988 when export
values had surged 27.6 percent (23.5 percent in volume). Most
commodities shared in the rather general, small slowing of
export value growth in the latter half of 1989. The largest
changes occurred in foods, feeds and beverages, and in the
typically "lumpy" completed civilian aircraft sector. Import
growth also slowed -- from 8.8 percent (6.5 percent in volume)
in 1988 to 6.4 percent (5.6 percent in volume) in 1989. (See
Table 2.)
Two on-going phenomena affected 1989 imports, and are
likely to continue to influence U.S. trade data. Petroleum
imports were up by $10.9 billion in value, to $50.2 billion in
1989, their highest level since 1985. Oil prices rose 19
percent; quantities were up 7.75 percent to 8.06 million barrels
per day, a figure not seen since 1979. Total automotive imports
actually declined in 1989; those from Japan declined for the
third consecutive year. Along with a softening of demand for
autos generally, the increases in production and sales by
foreign-owned auto producers in the United States were a major
factor slowing automobile imports.
Geographically, the 1989 decline in the trade deficit was
concentrated in Western Europe; that bilateral trade deficit
dropped $12.1 billion to $3.6 billion. Deficits with other
countries or regions fell by lesser amounts: the deficit with
the newly industrialized countries of the Far East fell $4.3
billion, to $25 billion; that with Japan dropped $2.9 billion,
to $49.7 billion; and that with Canada by $2.4 billion to $8.5
billion. The only major bilateral trade deficit to increase was
that with OPEC which was up $8.4 billion to $17.1 billion.
The 1989 deficit on the balance on current account was also
the lowest since 1984. It stood at $105.9 billion, down $20.6
billion from $126.5 billion in 1988. For the year as a whole,
the reduction in the trade deficit accounted for about
two-thirds of the current account decline (some $14 billion),
while an improved position on services (see below) accounted for
the remaining third (about $7 billion).
-7-
The difference between the trade balance and the ,balance on
current account largely reflects u.s. performance in services.
The surplus on service transactions had peaked in 1981 at $43.8
billion; until 1986, the balances generally indicate an
underlying deterioration in these accounts. However, in 1988
and 1989, the services surpluses were $15.4 and $22 billion
respectively. Last year, services trade shifted from
approximate balance in the first half to a surplus of almost $22
billion in the second. But that shift incorporated a swing from
capital losses (some $8 billion) in the first half to capital
gains (also $8 billion, for a total swing of $16 billion) in the
second. Those losses and gains reflect the effects of exchange
rate changes on the conversion of u.s. foreign investors'
foreign currency profits to dollars. Whether, therefore, the
full-year figure for 1989 services trade suggests some reversal
of the previous declining trend in that position remains
uncertain.
The recorded net inflow of capital in 1989 was $125.7
billion; unrecorded transactions (the statistical discrepancy)
were $34.9 billion. Major contributors to the gross inflow were
a record amount of inward direct investment ($61.3 billion, up
from the previous high of $58.4 in 1988), and foreign private
purchases of u.s. securities ($40.3 billion). On the outflows
side in 1989, there was a substantial increase ($25.3 billion)
in u.s. official reserve assets, reflecting exchange market
intervention activity; direct investment outflows rose strongly
(by $14.8 billion) to $32.3 billion, while purchases of foreign
securities nearly trebled to $22.6 billion. (See Table 3.)
Prospects for 1990
As has been discussed, the u.s. trade deficit continued to
decline in 1989, following its significant fall in 1988 from its
1987 peak. However, the pace of external adjustment slowed.
The outlook for 1990 is difficult to project with
certainty. Most model-based forecasts project a modest widening
in the u.s. current account deficit, although some project
little change or even a slight improvement. These projections,
however, are influenced by assumptions such as no policy
changes, constant exchange rates, and unchanged structural
characteristics of the U.S. and other major economies.
While conventional models provide very important
information, they cannot capture the full range of factors at
play in a dynamic world economy. For example, these models for
the most part do not take into account the structural
implications of recent developments in Eastern Europe and the
prospective reunification of the two German economies. Also,
they do not take into account the most recent exchange market
developments, nor do they explain the strong role foreign direct
investment may be playing in producing longer term and
continuing adjustment of the current account. Furthermore,
important developments that have taken place in the performance
of the U.S. services account are less well understood than the
merchandise trade accounts.
-8-
Despite our view that positive factors are at wdrk in
encouraging medium term external adjustment and that these
factors are not captured by conventional models, it would appear
that further improvement in the U.S. current account position in
1990 is likely at best to be very modest. Furthermore, the
possibility of deterioration in the current account cannot be
excluded.
-9-
PART III:
o
FOREIGN EXCHANGE MARKET DEVELOPMENTS
Overview
Over the past six months, foreign exchange market activity
was characterized by an appreciation of the German mark in late
1989 and a depreciation of the yen in early 1990.
Since the October 1989 report, the German mark has
appreciated by 10 percent against the dollar, while the Japanese
yen depreciated by 11 percent (as of April 10). Against the
mark, the yen depreciated by 19 percent. Continental European
currencies generally mirrored the movement of the mark against
the dollar. The British pound ended the period little changed.
Early in this period, the market perceived the G-7 as favoring a
lower dollar and remained generally wary of dollar intervention
sales. (See Table 4.)
The period since the October 19B9 report can be subdivided
into two parts. The first, from October 1989 to January 1990,
was characterized by appreciation of the mark in the aftermath
of the September 1989 G-7 Statement and in response to
developments in Eastern Europe, including East Germany. The
second, from January through mid-April, was highlighted by a
sharp depreciation of the Japanese yen.
In market intervention,
between October and January.
u.s.
October 1989 through January 1990:
authorities sold $2.5 billion
OM Appreciation
In the October-January period, the exchange value of the
German mark rose in the aftermath of the September 1989 G-7
Statement, in response to changes in monetary policies in
Germany and the United States, and in reaction to favorable
perception of political changes occurring in Eastern Europe,
notably the opening of the East German border and growing
prospects for German unification, which were seen as providing
attractive opportunities for real investment. During this time,
the u.s. economy showed signs of slowing, and participants
anticipated that changes in interest differentials would tend
toward favoring placements in foreign currencies. However,
foreign investor interest in German assets paused after the turn
of the year, as uncertainties regarding German Economic and
Monetary Union (GEMU) raised concerns about its potential
inflationary risks. Such concerns moderated somewhat after the
East German election in mid-March.
Foreign exchange markets were impressed by the forcefulness
of the September 23, 1989, statement of the G-7, which noted:
-10-
"The Ministers and Governors considered the rise'in
recent months of the dollar inconsistent with
longer-run economic fundamentals. They agreed that
a rise of the dollar above current levels or an
excessive decline could adversely affect prospects
for the world economy. In this context, they
agreed to cooperate closely on exchange markets."
The G-7 monetary authorities intervened aggressively in the
weeks immediately following the Statement.
Following the G-7 statement and coordinated intervention,
participants anticipated changes in official interest rates that
would reinforce the desired trend in exchange rate movements.
In the event, the Bundesbank raised its official rates by
1 percentage point (discount rate to 6 percent, Lombard rate to
8 percent) on October 5, 1989. The Bank of Japan raised its
discount rate by 1/2 percentage point to 3-3/4 percent on
October 11, 1989, and to 4-1/4 percent on December 25, 1989.
The Federal Reserve eased reserve conditions in successive
steps, with the result that the Fed funds rate fell from 9
percent at the end of September to 8-1/4 percent by the end of
December.
With these changes in the relative stances of monetary
policies, around mid-November, German interest rates neared U.S.
interest rates, and this narrowing of interest rate
differentials supported the mark's appreciation in late 1989.
Meanwhile, indications of slowing U.S. economic activity
fostered market expectations of moderating growth, diminished
price pressures, and further declines in U.S. yields. (The
October 13 stock market drop only sharpened market participants'
focus on the perceived weakening in U.S. economic fundamentals,
and by early December, the softness in the economy was viewed as
confirmed by the U.S. November employment data.)
Elsewhere, economic activity remained more buoyant, and the
West German economy in particular was thought to be operating
near capacity. The opening of the East German border in early
November was seen as likely to provide a further stimulus to
growth and investment and, consequently to raise real yields on
DM assets. German monetary officials welcomed the DM's rise
against the dollar. Also, in late October, German monetary
officials reportedly had begun expressing interest in a
revaluation of the DM within the European Monetary System (EMS),
and this contributed to the rise of the DM into early January,
when the Italian lira was realigned in the EMS and Italy joined
the narrower ~2-1/4 percent band.
Around mid-January, however, flows from dollars into marks
stalled as the market grew increasingly concerned about the
potential inflationary implications of GEMU. Meanwhile, flows
into dollars were supported by some perceptions of a pickup in
U.S. economic activity. The mark then began trading within a
moderate range, slightly off its January highs, with its
movements against the dollar at times influenced by developments
in Eastern Europe and the Soviet Union.
-11-
February - April:
Bearishness Toward the Yen
Between October and January, the yen traded in a fairly
narrow range against the dollar. However, the yen had already
declined considerably against the German mark in late 1989, as
market concern about the inflation of Japanese asset values
became evident. Substantial flows from Japan into German
equities were registered at that time, although the effect on
Japanese asset values was masked by the climb of Japanese stock
prices to record levels by end-December.
Since mid-February, the yen has weakened substantially
against other major currencies more generally, including the
dollar, in response to to political uncertainties in Japan,
market perceptions about the stance of official Japanese
interest rate policy, and unease associated with the decline in
Japanese equity markets. The decline of the yen became
particularly pronounced in March. Also, during this period,
u.S. interest rates rose and some participants took the view
that U.S. economic growth might be "bottoming out."
Sentiment towards the yen in late January and early
February was affected by political uncertainties ahead of the
mid-February elections and the reluctance to tighten monetary
policy further. The depreciation of the yen accelerated after
the Japanese monetary authorities did not hike interest rates in
the wake of the ruling Liberal Democratic Party's February 18
election victory and as Japanese equity markets declined.
Market perceptions that an opportunity to raise official rates
had been missed seemed to crystallize pessimism toward the yen.
Subsequently, bearishness toward the yen increased rapidly in
light of the market's concerns about Japanese economic policy
and political conditions. Market perceptions of U.S.-Japan
trade tensions were also bearish for the yen.
In this period, expressions of concern about yen
by leading Japanese monetary officials, and about
attendant risks to Japanese inflation and trade adjustment, were
outweighed in the market's eyes by the absence of a change in
the discount rate and the political uncertainties. Moreover,
some Japanese monetary authorities repeatedly suggested that,
barring a sharp drop of yen, they would rely on intervention
rather than interest rates to support the yen. At the same
time, nowever, the market came to believe increasingly that the
yields on yen assets should be adjusted upward. A 1 percentage
point discount rate hike (to 5-1/4 percent on March 20) came
amid active buying of dollar assets that kept the yen, and
Japanese stocks and bonds, under pressure throughout March.
This hike had been largely discounted in advance, and the market
looked for another hike in the near term.
d~preciation
In early March, President Bush and Prime Minister Kaifu
reaffirmed cooperation on exchange rates. Later, market
participants concluded that a meeting between u.s. Treasury
Secretary Brady and Japanese Finance Minister Hashimoto did not
produce commitments to support the yen. However, reports that
the G-7 would meet on April 7 instilled caution into the
markets.
The G-7 Ministers and Governors stated at their April 7
meeting that the decline of the yen against other currencies was
having undesirable consequences for the global adjustment
process. After appreciating slightly immediately following the
G-7 announcement, the yen eased back to levels slightly below
those prevailing prior to the meeting.
During the February through April period, the DM has traded
narrowly against the dollar. Despite market concerns over the
implications of GEMU in this period, participants felt GEMU
would also support German growth. They also reacted favorably
to the mid-March election outcomes in East Germany.
-13-
PART IV:
ECONOMIC POLICY COORDINATION
In recent years, the major industrial countries have
developed the G-7 economic policy coordination process to put in
place the consistent and compatible economic policies necessary
for sustained growth with low inflation, reduced external
imbalances and greater stability of exchange rates. Under this
process, substantial progress has been made in achieving the
G-7's shared objectives.
The economic expansion has been sustained for eight
consecutive years. Economic growth is slowing in several
countries this year to more sustainable levels. However,
overall growth prospects remain good. Inflation remains
contained, reflecting the vigilance of authorities as well as
the subsiding of temporary factors last year. External
imbalances have been reduced, particularly in Japan and the
united states.
These favorable developments have occurred in part due to
the important role of the coordination process in promoting
greater stability of the international monetary system in the
face of significant changes, at times, in the world economy.
Since the October report, further significant fundamental
changes have taken place, including most notably the efforts of
Eastern European countries to restructure political and economic
life, and developments in global financial markets, particularly
in Japan. Economic policy coordination, including cooperation
in exchange markets, represents the most effective means of
assuring that these profound changes now underway are managed in
an orderly manner that contributes to the G-7's shared
objectives.
Against this background, the G-7 Finance Ministers and
Central Bank Governors met in Paris on April 7 to take stock of
. these changes and to review economic and financial developments
in their countries. They noted that the major countries will
need to continue their close cooperation on macroeconomic and
structural policies and remain vigilant against current
inflation rates. Both surplus and deficit countries have a
shared responsibility to promote an open and growing world
economy. Deficit countries, including the United States, should
further reduce budget deficits and increase private savings.
Surplus countries must contribute to external adjustment by
promoting non-inflationary growth of domestic demand.
The depreciation of the Japanese yen has occurred in the
context of a significant adjustment in Japanese equity prices as
well as a correction in other Japanese asset values. The yen's
weakness is a matter of concern, with undesirable consequences
for the global adjustment process. The G-7 will keep these
developments under review.
-14-
The restructuring of Eastern European economies 'away from
central planning towards market-orientation will represent one
of the key challenges of the 1990s. In this regard, the
prospective unification of the German economies should
contribute to improved global growth, to increased investment
opportunities, and to a further reduction of external
imbalances. strong German domestic demand growth and a reduced
current account surplus would be most welcome, especially in
light of Germany's extremely large current account surplus and
forecasts suggesting this surplus could widen further this year
to roughly $65 billion, equivalent to nearly 5 percent of GNP.
-15-
PART V:
ASIAN NEWLY INDUSTRIALIZED ECONOMIES tNIES)
Overview
Since the release of the October 1989 report, both Korea
and Taiwan's exchange rate have depreciated against the dollar.
The New Taiwan (NT) dollar was stable following the October
report, depreciated in early March, and has since firmed
slightly. On balance, NT dollar depreciation since October has
totaled 2 percent. The Korean won has steadily depreciated
since the October report by a total of 5 percent against the
dollar. Over the longer term, however, the NT dollar has
strengthened by 54 percent and the Korean won by 27 percent
since the plaza Agreement in September 1985. (See Table 5.)
The Treasury Department began discussions with the Asian
NIEs in summer 1986 on their exchange rate and related policies
against the backdrop of their rising external surpluses,
particularly their surpluses with the United States. The U.S.
merchandise trade deficit with the Asian NIEs as a group -Korea, Taiwan, Hong Kong, and Singapore -- peaked in 1987 at
$34.1 billion and has declined a total of 29 percent since then.
In 1989 alone, the trade deficit with the Asian NIEs fell $3.9
billion to $24.3 billion, a 14 percent decline from 1988. This
compares to an 8 percent decline in the overall U.s. trade
deficit from 1988 to 1989. As a proportion of the overall U.S.
trade deficit, the deficit with the NIEs fell from 24 percent to
22 percent in the same period.
Under Section 3004 of the 1988 Trade Act, the Secretary of
the Treasury is required to "consider whether countries
manipulate the rate of exchange between their currency and the
U.S. dollar for purposes of preventing effective balance of
payments adjustments or gaining unfair competitive advantage in
international trade." It was concluded in the October 1988 and
April 1989 reports that both Taiwan and Korea "manipulated"
their exchange rates, within the meaning of the legislation.
Pursuant to Section 3004, the Treasury was required to initiate
bilateral negotiations with Taiwan and Korea for the purpose of
ensuring that these two economies regularly and promptly adjust
the rate of exchange between their currencies and the U.s.
dollar to permit effective balance of payments adjustment and to
eliminate the unfair advantage. Subsequently to the October
1988 report, the Treasury Department initiated bilateral
negotiations with both Taiwan and Korea on their exchange rate
policies, as well as continuing talks with them on their
associated macroeconomic and structural policies.
In October 1989, in view of the change in Taiwan's exchange
rate system that had occurred during the course of the
negotiations, and certain other factors, the Treasury concluded
that there were no clear indications that Taiwan was
"manipulating" its currency for competitive advantage within the
-16-
meaning of the legislation. We also indicated, however, that we
would continue to monitor Taiwan's exchange rate policy closely,
in view of the importance of such policy in furthering the
adjustment of Taiwan's large external surpluses. Regarding
Korea, the Treasury determined that there were indications of
continued exchange rate "manipulation."
Following is a summary of the economic and exchange rate
developments in Taiwan and Korea since our October 1989 report.
Taiwan
The appreciation of the NT dollar since 1985 has been a
central element in the decline of Taiwan's external trade
surpluses. In the past year, the NT dollar's appreciation has
stalled, although other factors -- rising wages, inflationary
pressures, and reduction of trade barriers -- have contributed
to lowering the external surpluses. We expect this adjustment
process to continue.
o
Exchange Rate Developments
Since the October 1988 report, Taiwan's exchange rate has
appreciated by 10 percent, more than that of any other major
trading partner. Much of this appreciation occurred in a short
period following the April 1989 report. The NT dollar thereupon
fluctuated within a narrow range from May 1989 until early March
of this year. At that time, the exchange rate depreciated by
1 percent. It has since rebounded slightly and stabilized.
The recent depreciation of the NT dollar was the result of
a number of factors. Most importantly, there has been
widespread attention in the local foreign exchange market to
political uncertainties, especially prior to the March
Presidential election. As such, large net capital outflows were
reported in the first quarter of this year. The depreciation of
the NT dollar was slowed by sizable sales of U.S. dollars by
Taiwan's Central Bank.
There is some domestic pressure in Taiwan to depreciate the
NT dollar. This view, however, ignores the fact that the recent
depreciation was mostly due to speculators seizing on factors
that may be short term. In this regard, the Central Bank has
rightly noted that depreciation may not reflect Taiwan's still
strong economic fundamentals and would have some adverse
consequences. For one, the external surpluses, although
declining, are still at unsustainably high levels. Real GNP
growth also remains strong. Moreover, any potential benefit to
exporters from devaluation would likely be negated by a fueling
of inflation. Inflation, which has climbed primarily due to the
build-up of excess liquidity generated by the large external
surpluses, currently may pose the greatest threat to the
economy. In addition, depreciation would send the wrong signals
to producers by not encouraging the move toward higher
value-added goods and weakening the role of domestic demand in
economic growth.
-17-
o
Trade and Economic Developments
In absolute terms, Taiwan's global current account surplus
rose 9.5 percent in 1989 to $11.2 billion. As a proportion of
GNP, this surplus translated into a decline to 8 percent from
8.S percent in 1988 and 18.1 percent in 1987. Taiwan's overall
trade surplus (cif basis) increased by 27 percent to $14
billion. Our bilateral trade deficit with Taiwan grew 3 percent
last year to $13 billion.
The above data include extraordinary purchases of $2.5
billion of gold from the United States by Taiwan's Central Bank
in 1988. If these one-time purchases are excluded, the trend in
the external accounts continued downward in 1989. For example,
the current account surplus fell 15 percent last year, if the
1988 gold purchases are excluded, and the U.S. bilateral trade
deficit with Taiwan declined by 14 percent.
These surpluses, whether including or excluding the 1988
gold purchases, are excessively high.
The appreciation of the NT dollar from 1985 to 1989 has had
an overall positive impact on the restructuring of the economy.
Appreciation has encouraged the production of higher value-added
goods and the movement of lower value-added production offshore.
In addition, domestic demand has replaced exports as the main
source of growth for the economy, with Taiwan's consumers
benefiting from years of high savings. At the same time,
unemployment, at 1.7 percent, is at an historical low.
Following years of very rapid growth, real GNP growth has
been at a more sustainable level since 1988. Last year growth
fell slightly to 7.2 percent. Inflation climbed from 1.3
percent in 1988 to 4.4 percent last year. Despite credit
tightening measures and capital outflows, inflationary pressures
continue to be a serious problem.
As a result of a rise in net capital outflow, Taiwan posted
its first overall balance of payments deficit since 1977 last
year. This led to a slight fall in foreign exchange reserves to
$73 billion, the world's second largest stock at the end of
1989.
In the first three months of this year, Taiwan's overall
trade surplus declined by 35 percent over last year to $1.8
billion. In February there was an overall trade deficit of $300
million, although this owed much to special factors including
imports delayed during end-January's Chinese New Year holiday
and the delivery of a passenger airplane.
According to Taiwan's data, the trade surplus with
United states was down by 23 percent to $1.9 billion in
first quarter of this year. Over the last three months
which U.S. data are available (November 1989 to January
the
the
for
1990),
-18-
our trade imbalance with Taiwan at $3.4 billion is lower by 18
percent from the same period in the previous year and by 29
percent from the preceding three-month period. If this latest
quarter were annualized, it would still lead to a large
bilateral trade imbalance of $11.3 billion.
o
Exchange Rate System
Taiwan instituted a new exchange rate system at the time of
the April 1989 report that significantly reduced the
authorities' ability to manipulate the rate. The system allowed
for most foreign exchange transactions to be freely determined.
Thereafter, Taiwan took a number of measures to further
liberalize the system and reduce capital controls.
Currently there is no evidence that the Central Bank has
been substantially intervening directly in the market to gain
competitive advantage. In fact, as noted earlier, the Central
Bank has recently intervened in the market to control downward
pressure on the NT dollar.
In the October 1989 report, a number of remaining
impediments to liberalization of the Taiwanese financial system
were identified. Since the October 1989 report, Taiwan has
addressed several of these impediments.
The ceiling on a
foreign exchange bank's short (oversold) position in spot
transactions was doubled in December. Taiwan also raised the
limit on foreign liabilities of foreign exchange banks by
30 percent, effective March 10. This should permit banks to
increase their foreign exchange activities.
Taiwan also established the Foreign Exchange Development
Foundation in late February to operate the interbank foreign
exchange market and the new U.S. dollar call market, which
reduces the cost of short-term foreign exchange funds.
Taiwanese authorities are developing a plan to introduce foreign
exchange dealers into Taiwan in one or two years.
In another positive step, the limit on annual foreign
exchange inflows was raised to $1 million per entity in
November. This limit, however, is still one-fifth the size of
permissible capital outflows and impedes market forces. Given
that there has been no surge in capital inflows and the NT
dollar is stable, there is little justification for not soon
raising the limit to at least the level of that for outflows.
Despite the recent relaxation of ceilings on "long" and
"short" foreign exchange positions, their existence, plus the
method of calculating the foreign exchange positions of a bank,
effectively prevents a forward foreign exchange market from
functioning_ Contrary to international practice, Taiwan shifted
from an accrual to a cash basis for calculating a bank's foreign
exchange position in 1987 to discourage speculation on an
-19-
appreciating NT dollar. On a cash basis, forward foteign
exchange positions are not calculated. In addition, although
the ceilings have not been reached they also discriminate
against foreign banks since they are based on local assets.
These assets are relatively small since Taiwan has restrictions
on foreign banks' operations and branches.
o
Assessment
We are encouraged by the fall -- albeit modest -- in
Taiwan's external surpluses (adjusted for the 1988 gold
purchases) over the past year and the continued liberalization
of the exchange rate system, which more accurately reflects
market forces. On balance, we are of the view, as expressed in
the October 1989 report, that there is no evidence of direct
exchange rate manipulation for competitive purposes.
We remain concerned, however, about the persistence of
Taiwan's large external surpluses. Moreover, it can be argued
that, despite the lack of evidence of direct eXChange rate
"manipulation," Taiwan's remaining exchange and capital controls
-- recent liberalization notwithstanding -- constitute a
mechanism for indirect "manipulation" by distorting supply and
demand in the market. These factors underscore the importance
of continued liberalization of remaining exchange and capital
controls and, more generally, of exchange rate policy in
contributing in the months ahead to the necessary further
reduction of Taiwan's unsustainably large external surpluses.
Korea
The Korean won has depreciated about 6 percent in nominal
terms against the u.s. dollar since the won's strongest point in
April 1989, but remains some 27 percent stronger against the
dollar than it was at the time of the plaza Agreement in
September 1985. In 1988, the won began to strengthen
significantly against other G-7 cu~rencies, particularly the
yen, resulting in broad appreciation on a trade-weighted basis.
These currency movements, aided by wage and other developments,
contributed to a substantial decline in Korea's external
surpluses in 1989. A further, but smaller, decline is possible
this year.
Notwithstanding the decline in Korea's external surpluses
in 1989, exchange rate policy continues to have an important
role to play in Korea's external adjustment, including the
needed further reduction of the trade imbalance between the
United States and Korea. In this context, the steady
depreciation of the won against the U.S. dollar since April 1989
raises some concerns. Introduction of the new "market average
rate" system of exchange rate determination on March ?, 1990, is
an important development. The eventual success of thlS system,
however, depends on how it is implemented. In parti~ular,
liberalization of pervasive foreign exchange and capltal
controls is necessary to give greater scope to the forces of
supply and demand in the exchange market.
-20-
Another development since the October 1989 report was the
initiation of Financial Policy Talks between the Ministry of
Finance and the Department of the Treasury. These talks provide
a possible mechanism for addressing problems that u.s. banks and
securities firms face in gaining access to the Korean financial
services market. The initial round of these talks was held in
late February, but much remains to be done before u.s. banks and
securities firms can compete on an equal footing with their
Korean counterparts.
o
Exchange Market Developments
New Exchange Rate System (MAR)
The "market average rate" (MAR) system of exchange rate
determination was introduced on March 2. Under this system, the
won/dollar exchange rate at the beginning of each business day
is equal to the weighted average rate of transactions in the
inter-bank market on the preceding business day. Exchange rates
between the won and third currencies are set in accordance with
dollar rates in international currency markets.
During each business day, the won/dollar inter-bank rate is
permitted to fluctuate within a band of +0.4 percent. Foreign
exchange banks, including 53 foreign banK branches, are free to
set customer rates within bands of +0.4 percent for won/dollar
telegraphic transfer (TT) transactions and +0.8 percent for
dollar-third currency TT transactions. A +I.5 percent band is
established for cash customer transactions:
Recent Exchange Rate Movements
During the the first five weeks of operation of the MAR
system:
The won depreciated 1.8 percent against the u.s. dollar
in nominal terms and 1 to 4-1/2 percent against most
other G-7 currencies and the new Taiwan (NT) dollar.
The won appreciated 3.6 percent against the yen,
reflecting the weakness of the yen in international
markets, offsetting on a trade-weighted basis most of
the won's appreciation against the other currencies.
Foreign banks accounted for the majority of
transactions in the inter-bank market.
The Bank of Korea (BOK) was not a direct participant in
the market; and other government-owned banks accounted
for a small share of inter-bank activity.
-21-
Since late April 1989, when the won reached its.strongest
point at 665/U.S. dollar, the won has depreciated nearly
6 percent against the u.s. dollar, 2-8 percent against the
British pound and Canadian and NT dollars, and 15-16 percent
against the German mark, French franc, and Italian lira. In the
same period, however, the won has appreciated 13 percent against
the yen, reflecting the generalized depreciation of the yen.
Thus, on a trade-weighted basis, the won is virtually unchanged
from its April 1989 level.
Given these developments, the wan's cumulative nominal
appreciation against the U.S. dollar since the plaza Agreement
in September 1985 has fallen to 27 percent. For the same
period, the wan's cumulative nominal appreciation now totals 6
percent against the Canadian dollar and 4 percent against the
British pound. The won remains roughly 18-20 percent weaker in
nominal terms than the yen, the French franc, Italian lira, and
NT dollar, and 26 percent weaker than the German mark in nominal
terms than it was in September 1985. Taking these various
currency movements into account, the won is estimated to be
roughly equal to its September 1985 level in trade-weighted
terms.
Recent Changes in Foreign Exchange Controls
The government eased some foreign currency and capital
controls as of March 1 to: allow certain Korean companies to
purchase and hold up to $10 million in foreign currencies; raise
the limits on overseas investment by Korean securities firms
from $30 million to $50 million and by Korean insurance and
investment and trust companies from $10 million to $30 million;
and allow Korean banks for the first time since 1987 to obtain
up to $2 billion of long-term capital from foreign banks or from
the issuance of bonds in foreign markets.
o
Trade and Economic Developments in 1989
GNP Growth
Economic performance in 1989 was weak by Korean standards,
but strong by any other. Real GNP grew 6.7 percent. This
compares with over 12 percent in each of the three previous
years and was the lowest rate since 1981's 5.9 percent.
Construction boomed (up 15.4 percent), but manufacturing was
weak (up 3.7 percent) and agriculture declined (- 0.7 percent).
On the expenditure side, consumption was up 9.5 percent,
surpassing for the first time in several decades the rate of
growth of GNP. Investment remained healthy, increasing 16.2
percent, including a 12.3-percent increase in plant and
equipment. Inflation eased from 7.1 percent to 5.7 percent.
Unemployment remained virtually unchanged at 2.6 percent.
-22-
Wages increased 21 percent on average for the 30'largest
manufacturing companies through end-october, compared with
increases of 12 percent and 20 percent in 1987 and 1988,
respectively. Labor-management unrest lowered productivity
gains to 7.1 percent in 1989, compared with 12 percent in 1987
and 1988, and resulted in production losses equal to an
estimated 3.1 percent of GNP.
External Accounts
The current account surplus dropped 64 percent to $5.1
billion (2.5 percent of GNP), compared with $14.2 billion
(8.4 percent of GNP) in 1988. The trade surplus also fell -61 percent to $4.5 billion, compared with $11.4 billion in 1988.
Exports grew only 2.7 percent in value and declined 5.4 percent
in volume. Footwear, toys, and especially automobiles accounted
for most of the volume decline. Textiles, machinery and
electronics, which account for more than half of exports, showed
volume growth -- about 7 percent in the latter case. It is
estimated that labor-management disputes were responsible for
export losses of $1.4 billion. Imports expanded 17.8 percent in
value and 14.3 percent in volume. Consumer goods, however,
accounted for only 14 percent of the total import growth, with
raw materials (54 percent) and capital equipment (32 percent)
accounting for the rest of the import growth.
According to U.S. customs data, the U.S. trade deficit with
Korea has shown no significant growth since the first quarter of
1988. In 1989, it declined 30 percent to $6.3 billion. This
decline reflects a 19 percent increase in U.S. exports to Korea
(compared with 39 percent in 1988) and a 3 percent drop in U.S.
imports from Korea (compared with a 19 percent increase in
1988).
Korea's gross external debt declined to $29.4 billion in
1989, equal to only 14 percent of GNP, compared with 28 percent
o£ GNP as recently as 1987 and 52 percent of GNP in 1985. Total
interest and amortization payments as a ratio of exports of
goods and services declined from 14 percent in 1988 to only
10 percent in 1989. Excluding Korea's voluntary prepayments of
principal, the 1989 debt service ratio was only 8 percent.
with the increase in international reserves to $15.2
billion (3.2 months' import coverage) and in other foreign
assets, Korea's net external debt declined to only $3.0 billion
by end-1989.
o
Trade and Economic Developments in 1990
preliminary BOK data indicate that Korea registered a $646
million current account deficit in January-February 1990,
compared with an $888 million surplus in the same period in
1989. This included a $722 million trade deficit for the two
months ($694 million trade surplus in January-February 1989).
-23-
Exports fell 12 percent in value in January but rose -6 percent
in February, compared with the same months in 1989, while
imports grew 6 percent and 23 percent, respectively. Further
trade and current account deficits appear likely in March.
According to U.S. customs data, the U.S. bilateral trade
deficit with Korea declined a further 33 percent to $455 million
in January 1990 (the latest month for which data are available).
This was based on a 23 percent increase in U.S. exports to Korea
to $1.2 billion, while U.S. imports from Korea were unchanged at
$1.6 billion. For the latest three months (November 1989 to
January 1990), the U.S. trade deficit with Korea stands 44
percent lower than it did in the same period in 1988-89.
Wage demands in the first quarter were less than half the
level in the first quarter of 1989. The number of strikes is 79
percent lower so far this year. These developments should have
a favorable impact on both growth and the external accounts.
Indeed, production and export losses are only 3-4 percent of
what they were in the first quarter of 1989. On the downside,
inflation is creeping up to a 12-13 percent annual rate. The
government is forecasting stronger economic performance in the
second half of the year, and has not changed its projections for
6-7 percent real GNP growth and a $2 billion current account
surplus for 1990 as a whole. The government also expects that
Korea will be a net international creditor by end-1990.
The recent merger of three leading political parties to
create the new, ruling Democratic Liberal party and the
subsequent changes in leadership at the economic ministries
have created public expectations in Korea that "growth-first"
measures to stimulate the economy, and exports in particular,
will be reemphasized. It is also expected that policies
designed to improve social welfare and income and wealth
distribution, while not neglected, will receive correspondingly
less attention.
The new economic policy package announced on April 4, which
builds on measures adopted in December 1989, bears out these
expectations. To stimulate investment and exports, the package
includes:
Subsidized interest rates, higher credit ceilings, and
tax incentives for investment and R&D in manufacturing
and, particularly, exports; lower corporate income tax
rates for manufacturing, as compared with services;
streamlined government approval procedures for new
manufacturing/export investments; and funds for
technology development and training, especially aimed
at small and medium-sized enterprises.
-24-
Other recent policy measures include:
Indefinite postponement of introduction of the
requirement to use real names in conducting financial
transactions.
Higher taxes, tighter credit, and possible economic
and social sanctions to discourage "professional" or
"habitual" real estate speculators.
Tax reform to ease the burden on low-income wage
earners along with other measures to increase
incentives for construction of rental or low-income
housing, employee education, and other benefit
programs.
Wage guidelines and controls and reductions in charges
on public utilities.
Tight restrictions on consumer credit, higher excise
taxes, income tax assessments based on observed
"standard of living" rather than reported income, and
restraints on overseas travel expenditures (December
1989 policy package).
o
Financial Policy Talks
Korea's impressive economic growth in recent years has not
been matched by comparable development and liberalization of its
financial system. Despite some steps to liberalize controls and
provide national treatment to u.s. and other foreign financial
institutions, the system remains characterized by pervasive
government intervention in financial intermediation and
significant constraints on the ability of u.s. and other foreign
financial institutions to compete on an equal footing with
Korean institutions.
With these problems in mind, the Treasury Department and
the Korean Ministry of Finance initiated a new series of
Financial Policy Talks in late February. These talks will
provide a mechanism for addressing specific market access
problems that u.s. banks and securities firms face in doing
business in Korea and also allow a dialogue on the need for
broader liberalization of Korea's financial, capital, and
exchange markets.
In the first round, the Korean government gave positive
signs of its willingness to address some specific issues, but
necessary follow-up actions remain to be taken. We will be
continuing these talks in the period ahead. The October 1990
report on International Economic and Exchange Rate Policy and
the December 1990 report to the Congress on Foreign Treatment of
U.S. Financial Institutions provide target dates for achieving
substantial progress on these matters.
-25-
o
Assessment
Korea has achieved a large and welcome reduction in its
current account surplus, from 8.4 percent of GNP ($14.2 billion)
in 1988 to 2.5 percent of GNP ($5.1 billion) in 1989. Also, the
u.s. bilateral trade deficit with Korea declined by 30 percent
in 1989 to $6.3 billion. These imbalances, although sharply
reduced, remain large and there is room for further reductions.
In this regard, it is noteworthy that Korea's current account
registered a deficit for the first two months of this year,
although a surplus is expected for the year.
The won has depreciated 5 percent against the dollar since
the October report, and by 1.8 percent since the introduction of
the new exchange rate system on March 2. The depreciation
against the dollar in the latter period, however, appears
largely attributable to Korea's trade and current account
deficits in the first two months of this year and capital
outflows associated with concerns about the possible
introduction of the "real name" financial system (now
indefinitely postponed). Moreover, on a trade-weighted basis,
the won's value has not significantly changed in this period.
There is no evidence of the government conducting transactions
in the inter-bank market for the purpose of directly influencing
the exchange rate.
In view of these developments in Korea's external accounts
and in its exchange markets, there are no clear indications at
this time that the Korean won continues to be directly
"manipulated," within the meaning of the legislation, by the
authorities to gain unfair competitive advantage.
Nonetheless, exchange rate policy continues to have an
important role to play in fostering external adjustment.
Introduction of the "market average rate" system of exchange
rate determination was a positive step forward. The real
Significance of this step, however, will depend on the
government's willingness to ease the pervasive controls on
capital flows and the types and amounts of permissible foreign
currency transactions that give it effective tools for
indirectly "manipulating" supply and demand in the currency
market and, thus, the exchange rate itself. In this regard, the
recent liberalization of controls on certain foreign currency
transactions by large Korean corporations and on overseas
investments of Korean financial institutions should increase
pressure for the won to depreciate. Controls on capital inflows
should be liberalized to offset this effect. It is not clear,
however that the net impact of the allowable $2 billion in
foreign'borrowing by Korean banks will accomplish this. If the
proceeds of these borrowings are on-lent in foreign currencies
for the overseas expenses of Korean corporations, there may be
little effect on the exchange rate.
-26-
Despite the lack of evidence of direct governmen~
"manipulation" of the exchange rate via transactions in the
market, we remain concerned about the won'S nominal depreciation
against the u.s. dollar since April 1989 (although, in
trade-weighted terms, there appears to be little change). By
raising the cost of Korea's dollar-denominated imports,
including its oil imports, depreciation will add to inflation,
the increase in which is already a concern to policymakers. The
resulting loss of real purchasing power could well lead to
higher wage demands over the long-term, offsetting any
beneficial short-term impact of depreciation on competitiveness.
Moreover, as the United States is Korea's largest export market,
depreciation against the dollar is likely to encourage the
inefficient production of certain lines of exports in which
Korea has already been losing competitiveness relative to lower
wage-cost Asian competitors.
The recent policy measures signal greater government
intervention in the economy and add to our concern. While we
understand the government's concern about the sharpness of the
declines in Korea's external surpluses in 1989, this reflects
largely the long delay in beginning the adjustment process (the
won did not begin to appreciate significantly against the dollar
and, especially, the major non-dollar currencies until 1988).
On balance, the new policies appear likely to delay the
adjustment process. Aimed at increasing exports and suppressing
domestic demand, the new measures may reinforce Korea's
dependence upon exports as a source of growth and jeopardize the
encouraging shift that appeared to have begun in 1989 toward
greater reliance upon domestic demand as a source of growth.
In the period ahead, we will continue to monitor Korea's
trade developments and the operation of the new exchange rate
determination system closely. In the Financial Policy Talks, we
will continue to encourage liberalization of Korea's financial,
capital, and exchange markets as well as seek improved treatment
for u.s. financial institutions.
-27-
PART VI:
CONCLUSION
This report has provided an update of developments since
October 1989, when the second annual report on international
economic and exchange rate policies was submitted to Congress.
Global economic performance has remained favorable since
the October 1989 report. The eConomic expansion in the
industrial countries has been sustained for eight consecutive
years. Economic growth is slowing in several countries, but to
more sustainable levels. Strong investment is providing a major
stimulus to the G-7 economies, and the prospects for overall
growth remain good. Inflation remains contained, reflecting the
vigilance of authorities and the subsiding of several temporary
factors, last year, which placed upward pressures on inflation
rates.
substantial reductions in external imbalances have been
achieved, particularly in Japan and the united States. The u.s.
trade deficit fell further in 1989, by nearly $14 billion to
$113 billion, and the current account deficit fell by some $21
billion to $106 billion. The pace of global external adjustment
has slowed, however. Despite our view that positive factors are
at work in encouraging medium term adjustment and that these
factors are not captured by conventional models, further
improvement in the U.S. current account position in 1990 is
likely at best to be modest. Furthermore, the possibility of
deterioration in the current account next year cannot be
excluded.
The economic policy coordination process has contributed
importantly to the favorable performance of the world economy in
the current expansion. Continued economic policy coordination,
including cooperation in exchange markets, will be essential in
assuring that the profound changes underway in the world economy
~- most notably, the changes in Eastern European political and
economic life and developments in global financial markets -are managed in an orderly manner that contributes to sustained
growth, low inflation, and reduced external imbalances.
Both surplus and deficit countries have a shared
responsibility in this regard. Surplus countries must
sustain non-inflationary growth of domestic demand.
Deficit countries should further reduce budget deficits
and increase private savings.
All countries should promote appropriate structural
reforms.
-28-
The depreciation of the Japanese yen has occurred in
the context of a significant adjustment in Japanese
equity prices as well as a correction in other Japanese
asset values. This depreciation is a matter of
concern, with undesirable consequences for the
adjustment process. The G-7 will keep these
developments under review.
The restructuring of Eastern European economies towards
a market basis and the reunification of the German
economies should contribute to improved global growth
and to a reduction of external imbalances. This will
be a most welcome development, especially in light of
Germany's massive and growing external surpluses.
Other economies have a clear and complementary
responsibility in promoting sustained non-inflationary world
growth and adjustment of external imbalances. In the October
1988 and April 1989 reports on International Economic and
Exchange Rate Policy, it was determined that Taiwan and Korea,
within the meaning of Section 3004 of the Omnibus Trade and
Competitiveness Act of 1988, were "manipulating" their exchange
rates against the u.s. dollar to prevent effective balance of
payments adjustment or gain unfair competitive advantage in
international trade. In the October 1989 report, it was
concluded that there were no clear indications Taiwan was
"manipulating" its currency within the meaning of the
legislation, but that there were indications of continued
exchange rate "manipulation" by Korea.
Taiwan, last April, instituted an exchange rate system that
allowed for most foreign exchange transactions to be freely
determined. Since last October, a number of impediments to
liberalization of the Taiwanese financial system have been
addressed.
The appreciation of the NT dollar since 1985 has been a
central element in the decline of Taiwan's external surpluses in
recent years. Last year, however, Taiwan's global current
account surplus rose by 9.5 percent to $11.2 billion and as a
share of GNP it declined slightly to 8 percent. The u.s.
bilateral deficit with Taiwan also rose in 1989. The rise in
Taiwan's external surpluses in 1989 in part reflected the
effects of extraordinary purchases of $2.5 billion of gold from
the united states in 1988. Excluding these one-time purchases,
Taiwan's current account surplus fell 15 percent and our
bilateral deficit with Taiwan fell 14 percent. Nonetheless,
these surpluses, whether including or excluding the 1988 gold
purchases, remain excessively high.
-29-
Between May of 1989 and early March of this yea~; the NT
dollar fluctuated narrowly against the U.S. dollar.
Subsequently, it depreciated by 1 percent, before rebounding
slightly. The decline reflected a number of factors, including
significant capital outflows in response to continuing political
uncertainties, and was resisted by the Central Bank. There is
no evidence that the Central Bank has been intervening directly
in the market to gain unfair competitive advantage. Moreover,
the Central Bank has rightly noted that NT dollar depreciation
does not reflect Taiwan's still strong economic fundamentals and
would have some adverse consequences.
On balance, we remain of the view, as expressed in the
October 1989 report, that there is no evidence of exchange rate
"manipulation" by Taiwan. There is still reason, however, to be
concerned about Taiwan's unsustainably large external surpluses.
The adjustment process must continue. Liberalization of
remaining exchange and capital controls and, more broadly,
exchange rate adjustment need to playa role in this process.
The Treasury Department will continue to monitor the situation
carefully.
Korea has achieved a large and welcome reduction in its
current account surplus, from 8.4 percent of GNP ($14.2 billion)
in 1988 to 2.5 percent of GNP ($5.1 billion) in 1989. Also, the
U.S. bilateral trade deficit with Korea declined by 30 percent
in 1989 to $6.3 billion. Korea's current account registered a
deficit for the first two months of this year, although a
surplus is expected for the year as a whole.
Korea introduced a new "market average rate" system of
exchange rate determination on March 2. Since this system's
introduction, there is no evidence that the government is
conducting transactions in the inter-bank market in order to
directly influence the exchange rate.
The won has depreciated 5 percent since the October 1989
report, and by 1.8 percent against the dollar since the
introduction of the new exchange rate system. But the
depreciation in the latter period appears largely attributable
to Korea's trade and current account deficits in the first two
months of this year and capital outflows associated with
concerns about the possible introduction of the "real name"
financial system (now indefinitely postponed). In
trade-weighted terms, the won appears to have changed little
since April 1989.
In view of these developments in Korea's external accounts
and exchange market, there are no clear indications at this time
that the Korean won continues to be "manipulated," within the
meaning of the legislation, by the authorities to gain unfair
competitive advantage.
-30-
Nonetheless, exchange rate policy continues to have an
important role to play in fostering external adjustment. In
particular, the government needs to allow supply and demand to
function more freely in the exchange market. The government's
pervasive controls on capital flows and the types and amounts of
permissible foreign currency transactions give it effective
tools for indirectly influencing supply and demand in the
currency market and, thus, the exchange rate itself. Thus,
these controls should be rapidly liberalized. The recent easing
of controls on certain foreign currency transactions by large
Korean corporations and on overseas investments of Korean
financial institutions, however, could increase pressure for the
won to depreciate. There should be a corresponding
liberalization of controls on capital inflows to offset this
effect.
Although there is a lack of evidence of direct government
"manipulation" of the exchange rate, we remain concerned about
the won's depreciation. Recent policy measures, aimed at
increasing exports and suppressing domestic demand, add to our
concerns. They are likely to delay the adjustment process,
jeopardizing the encouraging shift that appeared to have began
in 1989 toward greater reliance upon domestic demand as a source
of growth.
In the period ahead, we will continue to monitor Korea's
trade developments and the operation of the new exchange rate
determination system closely. In the Financial Policy Talks, we
will continue to encourage liberalization of Korea's financial,
capital, and exchange markets as well as seek improved treatment
for u.s. financial institutions.
-31-
APPENDIX
TABLES
1.
Economic performance of Major Industrial Countries
2.
Summary of u.S. Trade and Current Account
3.
Summary of u.S. Capital Account
4.
Measurements of Dollar Movements Versus G-7 Currencies
5.
Asian NIEs:
Trade and Currency Changes
TABLE 1
Economic Performance of
Major Industrial Countries
GNP 1/
U.S.
Japan
Germany
France
U.K.
Italy
Canada
G-7
Y
Domestic Demand l /
1988
1989
1990
1988
1989
1990
4.4
5.7
3.6
3.4
4.5
4.2
5.0
3.0
4.9
4.0
3.4
2.3
3.2
2.9
2.4
4.6
3.2
3.1
1.3
3.0
1.6
3.3
7.6
3.7
3.9
7.4
4.3
5.8
2.4
5.7
2.8
3.2
3.9
3.7
5.2
2.2
4.8
3.1
3.2
0.0
3.4
1.6
4.5
3.4
2.8
4.6
3.4
2.7
Inflation 1/
Current Account i/
1988
1989
1990
1988
1989
1990
U.S.
Japan
Germany
France
U.K.
Italy
Canada
4.1
0.7
1.3
2.7
4.9
5.0
4.0
4.8
2.3
2.8
3.5
-7.9
6.3
5.1
4.0
1.7
2.5
3.1
5.5
4.9
-2.6
2.8
4.0
-0.4
-3.1
-0.6
-1.7
-2.0
2.0
4.4
-0.4
-4.0
-1.1
-2.9
-2.0
2.0
4.9
-0.3
-3.1
-1.0
-2.7
G-7 Y
3.3
4.5
3.8
7.2
* Data for 1988 and 1989: national sources and International
Monetary Fund. Data for 1990:
For U.S. - Administration
projections; for other countries - International Monetary Fund,
World Economic Outlook (forthcoming).
l / Annual average rates in real terms.
Y Average of indivdual country rates, weighted
by GNP.
dI Consumer prices; annual average.
!I Calculated as percent of GNP; negative indicates deficit.
Table 2
SUMMARY OF U.S. TRADE AND CURRENT ACCOUNT DEVELOPMENTS
($ billion, seasonally adjusted)
YEARS
1987
Exports
Agricultural
NonAgricultural
Imports
Petroleum & Prods
NonPetroleum
TRADE BALANCE
Net Investment Income
Direct Investment
(of which: Capital
Gains/Losses on US
Investments Abroad)
Portfolio Investment
Net Other Services
Hi litary
Travel & Fares
Other Transport
Fee, Royals & Misc
Unllat Transfers
Remits & Pensions
Government Grants
NET INVISIBLES
CURRENT ACCOUNT BALANCE
Source:
1989
1988
01
02
03
76.447
9.021
67.426
78.471
9.40S
69.066
80.604
9.927
70.677
83.729
9.789
73.940
-409.766
-42.944
-366.822
-446.466 -47S.120 -109.893 -109.882
-39.309 -SO.250 -10.068 -10.248
-407.157 -424.870 -99.825 -99.634
-110.943
-9.775
-101.168
-115.748
-9.218
-106.530
-159.500
-127.215 -113.248
250.266
29.547
220.719
1988
319.251
38.142
281.109
1989
361.872
41.433
320.439
04
01
87.783
10.777
77.006
02
03
91.284
10.879
80.410
90.691
9.683
81.008
04
92.114
10.099
82.015
-116.138 -118.813 -119.249 -120.920
-10.845 -13.424 -13.018 -12.963
-105.293 -105.389 -106.231 -107.957
-33.446
-31.411
-30.339
-32.019
-28.355
-27.529
-28.558
-28.806
22.284
45.256
2.229
31.S17
1.029
36.164
2.795
8.490
-2.465
4.927
-2.590
5.567
4.489
12.533
-2.484
5.984
-6.104
3.070
2.860
11.647
6.757
15.463
16.174
-0.144
-.394
0.858
-2.487
-2.585
4.069
-3.512
-4.626
3.182
4.562
-22.972
-29.288
-35.135
-5.695
-7.392
-8.157
-8.044
-8.468
-9.174
-8.787
-8.706
7.731
-2.857
-6.252
-1.073
17.913
13.096
-4.607
-1.923
-0.711
20.337
20.616
-5.662
1. 176
,.384
25.486
1.969
-0.964
-1.496
-0.358
4.787
3.291
-1.033
-0.493
-0.226
5.043
3.964
-1.006
-0.039
-0.116
5. 125
3.872
-1.604
0.105
-0.011
5.382
3.934
-1.498
-.229
-.057
5.718
4.461
-1.518
.095
.007
5.877
6.271
-1.175
.766
-.249
6.929
5.950
-1.471
.544
-.085
6.962
-14.213
-4.063
-10.150
-14.657
-4.280
-10.377
-14.277
-4.029
-10.248
-3.364
-1. 131
-2.233
-2.899
-0.971
-1.928
-3.376
-1.088
-2.288
-5.018
-1.090
-3.928
-3.487
-1.147
-2.340
-2.829
-.972
-1.857
-3.485
-.975
-2.510
-4.476
-.935
-3.541
IS.800
.667
7.378
1.400
-2.074
-2.001
3.342
-2.036
-4.470
5.649
-126.548 -105.870
-32.046
-33.485
-32.340
-28.677
-30.391
-31.999
-22.909
8.235
.
"-20.571
-143.700
SURVEY OF CURRENT BUSINESS, March 1990
Details may not sum to totals due to rounding.
4/17/90
Table 3
SUMMARY OF U.S. CAPITAL FLOWS
Inflows(+) Outflows (-) Billions
1988·
1988
QI
-25.293
1.036
-3.566
2.999
1.503
-1.673
0.039
-0.829
-7.380
2.001
2.272
3.499
-4.000
0.869
-12.095
-.254
-5.996
.543
-3.202
-. 121
7.369
-1.396
10.660
-1.913
]8.882
30.215
-3.109
11.776
24.631
20.689
-1.547
5.489
5.895
7.238
-1.776
0.433
-2.234
-3.106
-0.459
1.331
10.589
5.393
0.672
4.524
7.478
1. 371
7.143
-1.036
-5.201
-7.219
.433
1.585
12.097
6.653
4.515
.929
-7.005
-2.203
-1.411
-3.391
Banks, net:
Claims
Liabilities
10.739
-47.244
57.983
14.351
-54.461
68.832
-1.871
15.266
-17.137
17.853
-12.602
30.455
-2.938
-26.229
23.291
1.301 -8.871
-30.916 -22.132
32.223
13.261
5.816
27.238
-21.422
4.471
-20.700
25.177
9.317
-31.650
40.967
Securities, net
Foreign Securities
U.S. Treas. Securities
Other u.S. Securities
4].220
-22.551
29.411
36.360
36.230
-7.846
20. 144
23.932
2.689
-4.539
5.928
1.300
14.937
1.333
5.458
8.146
9.271
-1.592
3.422
7.441
9.334
-3.047
5.336
7.045
14.057
-2.568
8.590
8.035
4.476
-5.737
2.252
7.961
11 • 106
-10.392
12.714
8.784
13.581
-3.854
5.855
11 • 580
U.S. oir. Invest. Abroad
Reinvested Earnings
Equity & Inter-Co. Debt
-28.290
-21.437
-6.853
-15.017
-15.170
.154
-5.476
-3.901
-1.575
.612
-2.721
3.333
-4.899
-4.489
-.409
-5.254
-4.058
-1.196
-4.962
-3.856
-1. 106
-6.613
-3.619
-2.994
-8.642
-9.575
.933
-8.07]
-4.387
-].686
For. Dir. Invest. in U.S.
Reinvested earnings
Equity & Inter-Co. Debt
61.262
3.363
57.898
58.436
6.560
51.875
9.616
1.774
7.842
13.885
1.357
12.528
11 .896
2.083
9.814
23.038
1.347
21.692
19.161
0.208
18.953
13.267
1.807
11. 460
12.436
1. 189
11.247
16.397
• 159
16.238
.921
.608
.313
4.814
-1.684
6.558
1.500
-0.065
1.565
-6.502
-6.443
-0.059
2.605
0.255
2.350
7.271
4.569
2.702
4.687
1.835
2.852
-3.315
-2.954
-.361
-.451
1.127
-2. 178
70.964
137.199
30.919
45.891
8.324
52.056
28.419
-3.919
25.570
20.894
34.914
-10.641
-3. 364
-12.015
28.603
-23.865
-2.425
]5.807
2.285
-.753
105.87B
126.548
27.556
)].875
36.926
28. 191
25.994
31.888
27.855
20. 141
YEARS
1989
Q2
Q3
04
1989
Ql
Q2
Q3
Q4
u.s.
Reserve Assets
(incr(-) decr (+) 1
Other U.S. Govt Assets
Foreign Official Assets:
Industrial
OPEC
Other
Other U.S. Corp.,net
Claims
Liabi lities
NET CAPITAL FLOWS
Statistical Discrepancy
TOTAL
Sources:
SURVEY OF CURRENT BUSINESS. March 1990.
Table 4
Measurements of Dollar Movements (for key dates)
Versus G-7 Currencies
Percent dollar appreciation (+) or depreciation (-)
As of April 10, 1990
Value of the
Dollar in
Terms of:
Si nce
Dollar
Peak
26-Feb-85
to date
Si nce
Plaza
Accord
20-Sep-85
to date
Dollar
Lows
31-Dec-87
to date
Japanese yen
-39.6
-34.8
+30.0
+19.0
+9.6
German mark
-51. 3
-41. 4
+7.1
-9.9
-11.1
British sterli ng
-36.2
-17.2
+14.5
+3.7
-4.9
French franc
-46.5
-35.5
+ 6.1
-10.4
-12.0
Italian lira
-42.7
-36.0
+ 6.4
-9.9
-10.6
Canadian dollar
-17.1
-15.6
-10.6
-1.8
-1.0
Source:
Over
Last Year
10-Apr-89
to date
New York 9:00 a.m. exchange rates
Since
Previous
Report
13-0ct-89
to date
TABLE 5
ASIAN NIES:
TRADE AND CURRENCY CHANGES
Cumulative Change against US$ as of April 10, 1990
(Plaza)
9/20/85
from:
end-86
end-87
-0.11X
21.89X
15.49X
35.08X
1.29X
15.71X
-O.sOX
12.13X
6.15%
8.64X
-21.55%
-4.73%
.------
HKS
Won
SingaporeS
NTS
Yen
OM
*
0.21X
26.59X
17.16X
54.19X
53.69X
n.20%
(Report)
10/14/88
end-89
Rate on 4/10/90
--------
-------
---------------
0.19X
0.52X
7.57%
9.97%
-19.76%
7.66%
0.08X
-3.95%
1.12%
-0.44%
-8.83%
0.90%
HKS 7.80
w 706.60
ss 1.88
NTS 26.28
Y 157.56
OM 1.68
[-] signifies depreciation against the U.S. dollar.
U.S. Trade Balance with Asian NIEs
(U.S. S Billions)
Hong Kong
Korea
Singapore
Taiwan
[1]
1985
1986
1987
1988
1989
-5.6
-4.1
-O.B
-11. 7
-5.9
-6.4
-1.3
-14.3
-5.9
-8.9
-2.1
-17 .2
-4.6
-B.9
-2.2
-12.6
-3.4
-6.3
-1.6
-13.0
-22.1
-27.B
-34.1
-2B.2
-24.3
-132.1
-152.7
-152.1
-11B.5
-108.6
--------TOTAL NIEs
Total U.S,.
Trade Balance
NIEs as % Total
U.s. Trade Bal.
[1]
17%
18%
22%
24%
U.S. customs value data, not seasonally adjusted.
Totals may not equal sum of components due to rounding.
22X
PREPARED STATEMENT OF THE HONORABLE CHARLES ~JL pAT.T-A~~;,~:!::.·
ASSISTANT SECRETARY OF THE TREASliR¥' \ . 0 I -~n~
FOR INTERNATIONAL AFFAIRS
on the
U. S. -JAPAN STRUCTURAL :IMPEDIMENTS INITIATIVE
before the
SUBCOMMI'rrEE ON ASIAN AND PACIFIC AFFAIRS
and
SUBCOMMITTEE ON INTERNATIONAL ECONOMIC POLICY AND TRADE
COMMI'rrEE ON FOREIGN AFFAIRS
U.S. HOUSE OF REPRESENTATIVES
WASHINGTON, D. C •
April 19. 1990
Introduction
Mr. Chairman and Members of the Committee, I am pleased to
have this opportunity to discuss the U.S.-Japan structural
Impediments Initiative (511).
It has been just two weeks since the U.s.-Japan Working Group
completed its interim report and assessment of progress to date
in the SII. This report followed nine months of intensive
research and negotiations with the Japanese aimed at identifying
and implementing solutions to structural problems in both
economies that impede trade and balance of payments adjustment.
The interim report contains a number of commitments from the
Japanese covering a wide range of structural problems in their
economy -- from the distribution system to inadequate levels of
'infrastructure investment, from business practices that exclude
outsiders to a policy toward foreign direct investment which is
too restrictive. These structural impediments are generally
systemic in that they run through the Japanese economy and cut
across many sectors. They are deep-seated and complex, and will
take time to fully correct.
Actions to address these rigidities are a matter of urgency.
We believe that the Japanese commitments reflect SUbstantial
progress at this stage of the 511 talks. They represent
important plans for action and, if fully implemented, they should
contribute to the goals of opening markets and reducing trade and
current account imbalances.
It is important to bear in mind, however, that the
undertakings spelled out in the interim report are in large part
commitments to act rather than actions themselves. It is
critical that these commitments be fleshed out in the final
report that they be extended and strengthened in some areas, and
that they be fully implemented on a timely basis. This will
require some form of ongoing monitoring and follow-up efforts,
the details of which will be worked out before the final report.
-2-
Of course, from the very start, the SII talks have been a
two-way street.
If they are to be successful, Japanese action on
their structural impediments must be complemented by U.S. action
on our structural impediments, particularly our inadequate level
of public and private savings. The commitments made by the U.s.
Government in the interim report reflect the Administration's
clear awareness of structural problems in the U.S. economy and
our determination to resolve these problems.
In the interim
report, the Administration outlined a broad range of initiatives
-- from steps that would increase national saving to an action
plan for improving the quality of education and training in the
united States. These initiatives, many of which are contained in
the President's budget for FY 1991, address many of the concerns
raised by the Japanese Government in the SII talks. These
measures should improve the competitiveness of the U.S. economy
while contributing to a reduction in our trade and current
account deficits.
Origins of the SII
For a number of years, the united States, Japan, and other
industrialized countries have been engaged in a cooperative
effort to reduce ~lobal payments imbalances through the
macroeconomic POl1Cy coordination process. This process has been
successful in beginning to reduce global imbalances. Changes in
domestic demand patterns and a significant realignment of
exchange rates since 1985 have produced considerable improvement
in global payments imbalances.
Nevertheless, the imbalances remain large, and it was clear
to us as we surveyed the situation a year ago that our trading
position with Japan had been more rigid than that with other
countries.
It appeared that there were numerous structural
barriers in the Japanese, as well as the U.S., economies that
were obstructing trade and slowing the process of reducing trade
imbalances. The SII talks were designed to complement the more
traditional efforts to address the macroeconomic roots of trade
and current account imbalances, as well as to open markets. Our
experiences with both the economic policy coordination process
and sectoral trade negotiations suggested that structural
impediments were particularly serious in Japan, often cutting
across many key product sectors and slowing the process of
reducing. their surplus and our deficit.
We recognize that macroeconomic factors (in the u.S. and
elsewhere) are very important in affecting a nation's overall
trade and current account balances, especially in the long run.
Thus exchange rate movements and the rate of U.S. domestic demand
growth relative to GNP have a major effect on U.S. imports, while
growth in trading partner countries has a major effect on u.s.
exports. However, the u.S. trade position is also affected by a
wide range of other factors, including tariff barriers,
-3-
non-tariff obstacles to effective competition by U.S. exporters,
as well as the structural impediments that are the focus of this
initiative.
It is important to note that the structural reforms to be
adopted under the 511 involve a mixture of macroeconomic and
microeconomic changes. In the case of saving and investment
patterns, we are actually settinq a goal for a shift in these
macroeconomic variables, although we have also suggested some
microeconomic/structural measures to facilitate achievement of
this goal. stronger Japanese government infrastructure
investment should help to reduce the amount by which Japanese
investment falls short of Japanese saving, thus helping to reduce
Japan's current account surplus. In other areas, we are seeking
microeconomic/structural changes, which will eventually affect
macroeconomic variables in the desired direction. For example,
changes in distribution practices would allow u.s. firms to sell
u.s. goods more effectively as well as to charge more competitive
prices by reductions in distribution costs.
The 511 process has been a joint effort, with certain
agencies taking the lead in researching and negotiating
particular issues. I would like now to summarize briefly the
principal commitments made by the Government of Japan in the
areas for which the Treasury Department has had primary
responsibility. I am sure my colleagues will do the same for the
areas in which they have taken the lead. In describing the
measures to be taken by the Japanese Government, I included
where appropriate a discussion of the proposed timing for
implementation of each of these measures, as well the expected
effect of these actions on our trade and current account
positions.
saving and Investment Patterns
A principal objective of the SIt talks is the reduction of
trade imbalances and current account imbalances. By definition,
a nation's current account balance is equal to the difference
between domestic saving and investment. As with other surplus
countries, Japan's external surplus is equal to the gap between
domestic investment and saving. Thus a reduction in the shortage
of investment compared to saving in Japan is a necessary
corollary to a reduction in the nation's current account surplus.
We proposed to the Japanese Government that they do this by
increasing public investment in domestic infrastructure, which
will help improve the quality of life in Japan, facilitate
correction of other structural problems (such as improvement of
the distribution system), and reduce the trade and current
account surpluses.
In light of this close relationship between domestic and
external imbalances, we are encouraged by the Japanese
Government's commitment in the SII interim report to reduce the
shortage of investment relative to savings in Japan and thereby
-4-
contribute to a reduction of the nation's current account
surplus. Specifically, the Japanese agreed to:
o
Increase substantially investment in infrastructure in
order to reduce the shortage of investment relative to GNP
and help to reduce Japan's current account surplus.
o
start immediately on the formulation of a new lO-year
comprehensive plan of public investment to achieve this
increase.
o
Specify the aggregate expenditures in this new
comprehensive investment plan in the final report.
o
Prepare on a fast-track basis eight new long-term sectoral
plans to replace the existing plans when they expire at
the end of Japanese fiscal year 1990, i.e., on March 31,
1991. These plans cover key infrastructure areas such as
housing, airports and port facilities, parks and sewers.
o
This program would both reduce the shortfall of public
investment compared to public saving and create
infrastructure which could be used for importing and
distributing foreign goods and services.
These commitments represent substantial progress for the
purposes of the interim report in the area of saving and
investment. Further action and specification will, of course, be
needed in order to ensure a SUbstantial increase in investment in
Japan relative to saving, and as a share of GNP.
Land Use
Existing Japanese tax and urban policies hinder balance of
payments adjustment by contributing to Japan's shortage of land
for residential, commercial and public investment and by
constraining demand for housing-related goods such as consumer
durables. The resulting high land prices make establishment of
new businesses in Japan prohibitively expensive for both Japanese
and foreign entrants. At the same time, existing businesses
enjoy an advantage because they are able to borrow against the
increased value of land-holdings.
In the interim report, the Government of Japan made a number
of commitments that will help to correct distortions created by
current tax and urban policies related to land. Specifically,
the Japanese have committed to:
o
Conduct a comprehensive review of land taxation on the
basis of such principles as equity, neutrality, and
simplicity. This will include a review of taxation of
agricultural land in urban areas, with a view to
addressing the exemption (deferment) system for the
property and inheritance taxes. The Government of Japan
-5-
will submit reform legislation to the Diet by the end of
fiscal year 1990.
o
Rationalize property assessments for the inheritance tax,
with the goal of bringing assessments closer to market
value.
o
Review leasing laws, in order to improve legal
relationships which greatly favor tenants at the expense
of landlords, discouraging the construction of housing and
office space.
o
Survey idle land in metropolitan areas, introduce by the
end of fiscal year 1990 a reform package of measures
designed to convert such land to productive use. The
Japanese Government will consider strengthening the
penalty tax on idle land.
o
Expand the area under the Urban Promotion Areas CUPAs)
zoning designations, to accomodate growing housing demand.
o
Launch a new, larger, long-term plan for investment in
housing.
o
Deregulate various land use policies, including relaxation
of limits on building height and housing density.
While we welcome these commitments tQ reform land use
policies, the Japanese Government must demonstrate progress in
implementin9 them. The Japanese will need to ensure that studies
of land P011CY result in meaningful reforms in the near future.
Further action will be needed in order to: make tax policies
more neutral; eliminate tax exemptions for agricultural land in
urban areas; reduce capital gains tax rates on the sale of idle
land; strengthen penalty taxes on idle land, pending progress to
make tax policies more neutral; convert idle land to productive
use; correct the legal imbalances between lessors and lessees;
provide budget figures for the installation of urban
infrastructure; and implement the deregulation measures cited
above.
Keiretsu Relationships
Keiretsu are the large groupings of Japanese companies which
extend through many sectors of the economy. These disparate
companies are tied together through a network of formal and
informal links such as cross shareholding and personnel
exchanges. For example, the Mitsubishi group, which alone
accounted for 2.9 percent of total sales in Japan in 1987,
includes among its members Japan's largest chemical company and
its largest brewery, as well as the nation's fifth largest bank
and its fifth largest automobile company. Keiretsu ties foster
preferential group trade at the expense of outside suppliers,
-6-
hinder forei9n direct investment in Japan, and may give rise to
anticompetit1ve business practices.
The Japanese Government had been reluctant to acknowledge
keiretsu as a structural problem, arguing that long-term keiretsu
ties are economically rational and have made a positive
contribution to Japan's economic development. Nevertheless, in
recognition of the u.s. concern, the Japanese have now declared
its intention to make keiretsu more open and transparent.
This
is the first time that the Government of Japan has committed
itself to action of any kind to address the keiretsu issue.
We
hope this reflects the Japanese Government's fundamental
recognition of the seriousness of the keiretsu problem and its
commitment to deal with this issue.
to:
Specifically, we are encouraged by the Japanese commitments
o
Strengthen monitoring by Japan's Fair Trade Commission
(FTC) of keiretsu transactions and enforcement of the
Antimonopoly Act, including publication and strict
enforcement of a guideline to ensure that keiretsu
transactions do not hinder fair competition.
o
Restrict cross shareholding or require divestiture of
shares where FTC monitoring reveals that the cross
shareholding leads to anticompetitive practices.
o
Conduct regular FTC analyses of various aspects of
keiretsu groups, with special emphasis on the role of the
general trading company.
o
Improve financial disclosure requirements, and complete,
before the final report, a study of further improvements,
with a view to enhanced disclosure of related-party
transactions.
As I mentioned earlier, one of the effects of keiretsu
relationships is to hinder foreign direct investment in Japan.
The level of foreign investment in Japan falls far short of that
in other OECD countries. Thus, while reaffirming the
Administration's commitment to an open investment climate, we
stressed the need for the Japanese Government to take steps to
encourage foreign direct investment in Japan.
In this light, we
welcome 'the Japanese commitments in the interim report to:
o
Liberalize Japan's policies on foreign direct investment,
including amendment of the Foreign Exchange and Foreign
Trade Control Law to:
relax or abolish the prior notification requirement for
foreign direct investment and the importation of
technology into Japan; and
-7-
limit the broad authority of Japanese officials to
block foreign direct investment on broad economic
grounds such as a potential threat to "the smooth
operation of the Japanese economy."
o
Submit legislation abolishing the prior notification
requirement for takeover bids.
o
Issue a policy statement welcoming foreign investment in
Japan.
We expect the Japanese Government to build on these
commitments in the areas of keiretsu and foreign direct
investment by adopting additional actions and commitments in a
number of areas, including: issuance of a broader policy
statement encouraging the loosening of keiretsu ties; further
actions to address the cross shareholding issue; measures to
encourage opening of keiretsu procurement practices; further
steps to relax or abolish the authority of Japanese officials to
restrict foreign direct investment on broad economic grounds; and
measures to bolster shareholders' rights in Japan.
u.S. Commitments
We cannot focus only on structural problems in Japan if we
are to overcome impediments to balance of payments adjustment.
We must also confront our own problems. We have stressed from
the start that the SII talks are a two-way street, enabling the
governments of both countries to suggest ideas that would improve
the economic structure and global competitiveness of the other.
In our discussions of the u.S. economy, it has become clear
that we and the Japanese agree on the essentials. Foremost among
these is the need to boost national saving. The surest way to
boost saving in the United States i~ to reduce Federal dis-saving
-.~ that is, to cut, then eliminate, the Federal budget deficit.
The Japanese argue that we must reduce the budget deficit, and we
know that they are right. Many of the ideas presented by the
Japanese throughout the SII talks have concerned deficit
reduction. We responded to this Japanese concern by making it
clear that the Administration is committed to reducing the
Federal budget deficit. The President's budget for FY 1991
proposes that deficit reduction be achieved through a combination
of:
o
spending restraint -- setting priorities for government
expenditures and sticking to them;
-8-
o
strengthening the Gramm-Rudman-Hollings Budget Law by
closing its loopholes; and
o
enhanced rescission authority for the President.
The Japanese Government also stressed the need to stimulate
private saving and investment in the United states, both to
reduce the current account imbalance between our two countries
and to promote the long-term competitiveness of firms in the
United states through a lower cost of capital. Elements of the
Savings and Economic Growth Act (SEGA), which the President has
forwarded to the Congress, address these Japanese concerns. For
example, SEGA proposes:
o
lowering the effective tax rates ~n capital gains,
particularly for long-term investments;
o
enhancing the attractiveness of saving with Individual
Retirement Accounts; and
o
creating a new type of tax-advantaged saving vehicle,
Family savings Accounts.
By expanding the pool of savings in the United states and
enhancing after-tax returns on capital for U.s. investors, we
encourage domestic capital formation, which we need to be
competitive in the long term.
Members of the Japanese delegation have commented on certain
u.s. laws and regulations which raise the cost of doing business
in this country and discourage domestic production. The
Administration reaffirmed its support for legislation that would
reform antitrust treatment of production joint ventures. We
cited the President's support for reform of the product liability
laws.
The Japanese Government was concerned that some in the united
states wished to impose restrictions on foreign direct
investment. We reaffirmed the Administration's strong commitment
to an open direct investment policy, and we agreed to consider
issuing a detailed policy statement to that effect.
In the area of trade, we reviewed recent progress made to
deregulate exports. We hope that further progress will be
possible in liberalizing export controls as the changes in our
strategic position become clear. We hope that recent gains in
loosening energy export controls will also continue. Our export
efforts will be buttressed by the Commerce Department's new
promotional program, which is aimed specifically at increasing
U.s. exports to Japan.
The long-term competitiveness of the United states depends on
the ingenuity of our people and our ability to put our
innovations to work. The Japanese delegation urged us to support
-9-
domestic research and development efforts, to encourage workforce
training and to boost scholastic achievement. The u.s.
commitments in this area included:
o
plans outlined in the President's FY 1991 budget to
support research and development;
o
a seven-point action plan drawn up by the Labor Department
to promote workforce training:
o
proposals outlined in the President's FY 1991 budget to
spend public funds to supplement private sector efforts on
workforce training:
o
the Administration's ongoing work with the states and
local authorities to achieve the ambitious goals for
education agreed upon by the President and the nation's
Governors at the Education Summit.
As I said earlier, the SII talks work two ways: balance of
payments adjustment requires action by both the Government of
Japan and the Government of the United States. We cannot expect
the Japanese to undertake structural reform in their economy if
we do not seek to remedy our own problems with equal vigor. The
Administration can and is providing leadership on these issues,
but we need support from the Congress. At our most recent round
of talks, the Japanese delegation appeared to be impressed by our
proposals for reform. It is necessary that we follow through on
our commitments just as we expect the Japanese to follow through
on theirs.
Closing Remarks
In closing, let me say that the interim report represents a
good first step in the SII process. But we recognize that much
work remains to be done by both Japan and the United states. The
structural issues raised in these talks will require persistent
effort by both countries if this process is to contribute to the
reduction of our trade and current account imbalances and to the
promotion of sustained, non-inflationary growth in the united
states.
Thank you very much for your attention.
STATEMENT OF THE HONORABLE
DAVID C. MULFORD
UNDER SECRETARY OF THE TREASURY
FOR INTERNATIONAL AFFAIRS
BEFORE THE
COMMITTEE ON BANKING, HOUSING AND URBAN AFFAIRS
SUBCOMMITTEE ON INTERNATIONAL FINANCE AND MONETARY POLICY
UNITED STATES SENATE
APRIL 19, 1990
Mr. Chairman and members of the Committee:
It is a great pleasure to be here today to discuss with you
the Department of the Treasury's report on international
economic and exchange rate policy. This report and the
consultations with Congress on U.S. international economic
policy have proven to be highly effective in broadening
understanding of the world economy and in advancing U.S.
international economic objectives.
I would like to examine two aspects of U.S. international
economic policy. First, the economic policy coordination
process and our efforts to promote a strong and smoothly
functioning world economy. Second, developments in Korea and
Taiwan, two economies with an important role to play in the
international adjustment process, in view of their sizable
external surpluses and growing responsibilities in the world
economy.
Economic Policy Coordination
The economic policy coordination process has contributed
. importantly to the strengthened performance of the world economy
over the past years. This process has helped policymakers to
better understand the international ramifications of their
domestic policies. It has al~o.helped them to put in ~lace the
consistent and compatible pol~cles necessary for sustalned
global growth, low inflation, and reduced external imbalances.
NB-770
-2-
The G-7's record of success in this regard is quite
impressive.
The economic expansion is now being sustained into
its eighth consecutive year.
Inflation has been substantially
reduced from the high levels of the late seventies and early
eighties. World trade growth has been robust, facilitating
external adjustment. Also, I would note Mr. Chairman -- and
this is a point which often does not receive adequate attention
-- that the major countries have put in place policies to rein
in public spending, reform tax regimes, liberalize financial
markets, and reduce excessive red-tape and government regulation
in general.
1989 represented another solid year of performance for the
G-7 economies.
Growth, after recording an extremely vibrant
increase of 4.4 percent in 1988, eased to a still healthy and
strong 3.4 percent in 1989. Though consumer price inflation
rose approximately 1 percentage point in 1989, to an average
rate of about 4-1/2 percent, much of this increase took place in
the first half of the year and was associated in part with
special one-time factors.
Recent data indicate that inflation pressures persist for
the G-7 countries as a group, although for some countries the
recent increases in large measure reflect temporary commodity
price developments more than underlying problems. We continue
to expect that important factors -- such as moderating demand
growth and the unwinding of some of the negative influences that
adversely affected the January and February price indices (oil
and food) -- will dampen price pressures this year. As these
influences move through the markets into consumer prices, the
core rate of inflation is expected to return to previous levels.
Nevertheless, it is clear that continued vigilance will be
required.
External imbalances again declined substantially in the
United States and Japan in 1989.
In the United States, the
current account deficit fell by a further $21 billion to $106
billion, the lowest deficit since 1984, and substantially down
from the $144 billion deficit in 1987. Japan's current account
surplus declined from roughly $80 billion in 1988 to $57 billion
in 1989 and the overall surplus of the European Community has
been reduced to nearly zero.
Moreover, the prospects for G-7 performance in 1990 remain
quite favorable.
Overall growth prospects remain good, with
growth in the major countries projected to ease only slightly
from the rate recorded in 1989. World trade should continue
expanding solidly.
Despite these achievements, I do not wish to seem
complacent.
Challenges lie before us in the period ahead.
-3-
External imbalances remain large and the adjustment process
slowed over the course of 1989. In Europe, significant external
imbalances have emerged, with Germany registering a massive
current account surplus of $53 billion in 1989, or 4.4 percent
of GNP, the largest such ratio in the G-7. Current account
trends are difficult to project with certainty, but it would
appear that any further improvement in the u.s. current account
position in 1990 will at best be very modest, and the
possibility of a deterioration in the current account cannot be
excluded.
Also, over the past six months, significant changes in the
world economy have taken place. These include the changes in
Eastern European political and economic life and developments in
global financial markets, particularly in Japan. The G-7
Finance Ministers and Central Bank Governors met against this
background in Paris on April 7. They reaffirmed their
commitment to economic policy coordination as the best means of
addressing these developments.
In this context, the Ministers and Governors noted the
shared responsibility of surplus and deficit nations in
promoting sustained growth, reduced external imbalances, and
greater stability of exchange rates. The United States is doing
its part. We have achieved significant progress in reducing the
u.s. budget deficit. From a peak of 6.3 percent of GNP in FY
1983, the Federal budget deficit was reduced to 2.9 percent in
FY 1989 and is projected to decline further to 2.3 percent in FY
1990. Combining Federal, state, and local governments, our
deficit in FY 1990 is projected to be around 1 to 1-1/2 percent
of GNP. Personal saving is returning to the historical average
level in the United States and the Administration has made a
number of proposals to improve the national saving rate. The
most important step in this process is to continue to reduce the
budget deficit.
Developments in Eastern Europe and efforts to achieve
.arket-oriented economies in this region are among the most
profound and welcome events in decades. Also, the prospective
reunification of the German economies should contribute to
improved global growth and to a reduction of external
imbalances. This will be a most welcome development,
particularly in light of Germany's massive surpluses.
The Japanese yen has depreciated sharply in recent months
against the world's major currencies. This is an important
matter of concern, and one that may have undesirable
consequences for the global adjustment process. The weakness of
the yen, and Japanese financial market developments more
broadly, must be viewed in the context of the sharp appreciation
in Japanese asset values over the past several years. These
financial market developments may have been further accentuated
by the lack of a deep and liquid money market for
yen-denominated instruments. We will continue to address these
issues in our yen/dollar talks which take place again in late
May.
-4-
On balance, the underlying fundamentals of the Japanese
economy remain sound.
Nonetheless, the depreciation of the yen
and Japan's relatively closed markets are not sustainable over
time as their continuation would pose important risks for the
world economy. We will be keeping these developments under
close review and we will continue to cooperate with other G-7
countries on exchange markets.
Asian Newly Industrialized Countries
Other economies have an obligation to assume a greater
responsibility for contributing to the reduction of the world's
external imbalances and promoting a sound and growing world
economy.
In particular, the newly industrialized economies of
Asia are playing an increasingly important role in the world
economy.
Some of these economies have sizable external
surpluses.
The Omnibus Trade and Competitiveness Act of 1988
recognized that undervalued currencies can be unfairly exploited
to build up sizable external surpluses.
The Treasury Department
concluded in its October 1988 report on International Economic
and Exchange Rate policy that Korea and Taiwan "manipulated"
their exchange rates within the meaning of the legislation.
Following this report, we initiated bilateral negotiations with
Korea and Taiwan, aimed at assuring that their exchange rate and
other policies contributed to the adjustment of global
imbalances.
In October 1989, we concluded that there were no
clear indications at that time that Taiwan was "manipulating"
its currency for competitive advantage within the meaning of the
legislation, given the introduction of its new exchange rate
system and certain other factors.
Regarding Korea, however, the
Treasury determined there were indications of continued
manipulation.
We have achieved progress in our bilateral negotiations and
discussions with Korea and Taiwan.
Both Korea and Taiwan have
instituted more market-based systems for determining the
exchange rate.
Korea's external surplus has sharply declined
and Taiwan's gives evidence of moving in the right direction.
We still have concerns, however, which 1 will discuss in the
remainder of my testimony.
Since the October 1988 report, the New Taiwan dollar has
strengthened by 10 percent against the U.S. dollar, more than
that of any major trading partner.
Between May 1989 and early
March of this year, the exchange rate fluctuated narrowly
against the u.S. dollar.
Subsequently it depreciated by
1 percent, before strengthening slightly.
The depreciation was
the result of short-term speculation and capital outflow in
response to political uncertainties.
The Central Bank resisted
the depreciation, recognizing that it did not reflect Taiwan's
strong economic fundamentals and would fuel inflation.
-5-
In absolute terms, Taiwan's global current account surplus
rose by 9.5 percent last year to $11.2 billion. The U.S. trade
deficit with Taiwan also increased by 3 percent in 1989 to
$13 billion. If, however, one-time extraordinary purchases of
gold from the United States by Taiwan's Central Bank in 1988 are
excluded, the Taiwanese current account surplus and the U.S.
bilateral trade imbalance with Taiwan fell by
15 percent and 14 percent, respectively, last year.
Following our bilateral negotiations last year, Taiwan
instituted a new and liberalized exchange rate system in April
1989. Most foreign exchange transactions under the system are
now freely determined and the authorities' ability to manipulate
the rate has been greatly reduced. Since the october 1989
report, Taiwan has taken further steps to liberalize the system,
although remaining capital and foreign exchange restrictions
continue to limit supply and demand in the exchange market.
In light of these developments, we remain of the view that
there are no clear indications that Taiwan is "manipulating" the
exchange rate for competitive advantage. Taiwan's large
external surpluses, however, remain unsustainably high. The
Taiwanese authorities need to recognize the need for the further
reduction of the surpluses and the continued importance of the
exchange rate and of the liberalization of remaining capital and
exchange controls in advancing this adjustment process. We will
continue to monitor the situation closely.
Since the release of the October 1988 report, the Korean
won has appreciated by only 1/2 percent in nominal terms against
the u.s. dollar. From the won's strongest point, shortly
following the April 1989 report, it has depreciated by about
6 percent in nominal terms against the dollar. Since the
October report, however, the won has appreciated 25 percent
against the yen, including 13 percent since April 1989. Thus,
on a trade-weighted basis, the won has appreciated an estimated
7 percent since the October 1988 report.
Following the introduction of a new exchange rate system on
March 2, the won has depreciated by 1.8 percent against the
dollar, but has appreciated over 3 percent against the yen.
These developments largely reflect Korea's trade and current
account deficits in the first two months of this year, and
capital outflows prompted by the possible introduction of a
"real name" financial system (which has now been indefinitely
postponed).
Korea made considerable progress last year in reducing its
external surpluses. The current account surplus fell 64 percent
to $5.1 billion compared to the same period last year. This is
equal to 2.5 percent of GNP, following a 8.4 percent ratio in
1988. Also, our bilateral trade deficit with Korea declined by
30 percent to $6.3 billion. On a quarterly basis, our bilateral
trade deficit with Korea has shown no significant growth since
the beginning of 1988. These declines continued in
January-February of this year and the prospects are for somewhat
lower imbalances this year than last.
-6-
These welcome declines reflect a number of factors.
The
won'S past currency appreciation, both against the dollar and
non-dollar currencies, is a principal cause.
Large wage
increases in 1988-89 exceeding productivity gains are another
important factor, contributing both to higher export prices and
to higher import demand.
Korea's on-going trade liberalization
program also facilitated import growth.
Severe labor-management
disputes also played an important role in restraining Korea's
export growth last year.
Korea's introduction of a new "market average rate" system
of exchange rate determination in March is an important
development.
Under this system, the won/dollar exchange rate at
the beginning of each business day is set equal to the weighted
average interbank rate on the previous day'S transactions.
This
system's success, however, will depend on how it is implemented.
The liberalization of pervasive foreign exchange and capital
controls is especially necessary to allow market forces to play
a greater role.
Also of significance, the Treasury and Korea's Ministry of
Finance initiated Financial Policy Talks in late February. We
hope to make progress in these talks on problems facing u.s.
banks and securities firms in gaining access to the Korean
market.
The initial round of these talks produced some
indications of flexibility in some areas, but follow-up actions
have yet to be taken and much more remains to be done in
subsequent meetings.
Since introduction of the new exchange rate system, there
is a lack of evidence of continued direct government
"manipulation" of the exchange rate, within the meaning of the
legislation, particularly in view of the developments in the
Korean external accounts. We nonetheless remain concerned about
the won's nominal depreciation against the dollar.
The recent
policy measures which aim to increase exports add to our
concerns as they could delay the adjustment process. We will,
therefore, continue to monitor Korea's trade and exchange rate
developments carefully and press for further liberalization of
the financial, capital, and exchange markets in the Financial
Policy Talks.
Conclusion
The United States is committed to cooperating with its
major trading partners to promote the sound world economy and
stable financial system on which all countries' prosperity
rests.
The success of this effort will also require that the
Executive Branch and the Congress work closely to deal with
difficult domestic issues.
Our dialogue on the international
aspects of u.S. economic and exchange rate policies is an
important element in this effort.
Thank you, Mr. Chairman.
TREASURY NEWS
.partment of ttle Treasury - washlnlton, D.C .• Telellhone S••. 1041
Prepared for Delivery
Expected at 2:00 p.m.
Contact:
Cheryl Crispen
566-5252
April 19, 1990
Statement by
John E. Robson
Deputy Secretary of the Treasury
Today I am pleased to announce the publication of the Final
Report of the G-7 Financial Action Task Force on Money
Laundering. The report is being published today simultaneously
in the Task Force member countries. I was privileged to serve as
the head of the u.s. Delegation to the Task Force.
This Task Force was convened at the direction of the 1989 G-7
Economi~ Summit in Paris.
The ~eads of state and government of
the G-7 gave the group a mandate to study measures that have been
taken to prevent utilization of financial institutions by money
launderers and to make recommendations on how to improve
international cooperation against money laundering. The report
will be addressed at the upcoming G-7 Economic Summit in Houston
in July.
As Chair of the 1989 Economic Summit, France also chaired the
Task Force. I want to commend the work of French Finance
Minister Pierre Beregovoy and his staff, most notably, Denis
samuel-Lajeunesse who served as Chairman of the Task Force. Our
French hosts encouraged the orderly and frank exchange of views
that resulted in this excellent report being accepted by the
members and finished ahead of schedule.
The Task Force consisted of sixteen members: The seven Summit
participants, eight other industrialized countries, and the
European Community. The Task Force was unique in bringing
together participants from finance ministries, financial
institution regulatory agencies, foreign and justice ministries,
and law enforcement agencies of the membe,r countries.
Contained in the report are 40 action recommendations, which when
implemented by the member countries, should establish a network
of comprehensive programs to address money laundering and will
facilitate greater cooperation in i~ternational investigations,
prosecutions, and property seizures.
NB-771
-2-
At the same time, the recommendations reflect a recognition that
law enforcement objectives need to be balanced with burdens on
the financial system.
The Financial Action Task Force was born of the ideas that
narcotics trafficking and money laundering are inextricably
connected and that money laundering is an international problem
that requires an international solution.
Countries must link
together to have strong domestic anti-money laundering programs
for detection and prosecution and must cooperate freely with each
other in the many cases that cross international borders.
As long as there are weak links in this chain -- countries whose
legal or regulatory systems make their financial institutions
vulnerable to money laundering -- we will have a difficult time
getting control of this problem.
The Task Force recognized that money laundering is a complex
economic crime that cannot be effectively attacked by
conventional law enforcement methods alone.
Law enforcement
authorities, finance ministries, financial institution
regulators, and financial institutions themselves must work as
partners to prevent financial institutions from being used by
money launderers, with financial institutions as the first line
of defense.
The Task Force acknowledged that this partnership cannot flourish
if financial institution secrecy laws are erected as barriers to
effective anti-money laundering efforts.
Specifically, the Task
Force recommends that, as in the united States, financial
institutions must be able to report suspicious transactions to
law enforcement, in good faith, free from fear of liability under
secrecy laws.
Suspicious transaction reporting has proven to be
very valuable to u.S. law enforcement.
Among the other important recommendations of the Task Force was
that financial institutions must have procedures in place to
identify and know their customers.
The Task Force also
recognized that both for domestic and international enforcement
it is essential that financial institutions maintain adequate
records about customers and transactions, including currency
transactions, for use in future criminal investigations and
prosecutions. with money laundering cases being investigated
months and even years after transactions take place, adequate
recordkeeping is essential.
-3-
Where do we go from here? Recognition by the Task Force member
countries of the need for a united front against money laundering
is a major step, but only a first step. The United states is
committed to playing a leadership role in seeing that an
effective global anti-money laundering network is established.
The Task Force recommendations will be a solid foundation for
this network.
In closing, congratulations are in order to the many people who
contributed to the success of this endeavor: I was ably assisted
as head of the United States delegation by former Treasury
Assistant Secretary for Enforcement Salvatore R. Martoche. Under
Secretary for International Affairs David Mulford played a major
role as the Summit Sherpa who laid the ground work for convening
the Financial Action Task Force. Robert Mueller, Assistant to
Attorney General Thornburg, performed excellent work as Chairman
of the Legal Questions Working Group.
The U.S. delegation consisted of representatives from Treasury
Departmental Offices, the U.S. customs Service and Office of the
Comptroller of the Currency, the Department of State, the
Department of Justice, including DEA and FBI, and the Federal
Reserve Board. Everyone of my colleagues on the delegation is
to be commended for working so effectively to insure that the
United States positions were presented and that the final product
is one of which they can be justifiably proud.
FINANCIAL ACTION TASK FORCE
ON MONEY LAUNDERING
REPORT
SUMMARY
1 - REPORT
INTRODUCTION
p. :
I - EXTENT AND NATURE OF THE MONEY
LAUNDERING PROCESS
A -
EXTENT
B - METHODS
p. 3
p. 6
II - PROGRAMS ALREADY IN PLACE
TO COMBAT MONEY LAUNDERING
A - INTERNATIONAL INSTRUMENTS
p. 9
B - NATIONAL PROGRAMS
p. I I
III - RECOMMENDATIONS
A - GENERAL FRAMEWORK OF THE RECOMMENDATIONS
p.
B - IMPROVEMENT OF NATIONAL LEGAL SYSTEMS
TO COMBAT MONEY LAUNDERING
p. 16
C - ENHANCEMENT OF THE ROLE
OF THE FINANCIAL SYSTEM
p. 18
0- STRENGTHENING OF INTERNATIONAL COOPERATION
p.24
CONCLUSION
2 - SYNOPSIS OF THE FORTY RECOMMENDATIONS
OF THE REPORT
14
p. 27
INTRODUCTION
The Heads of State or Government of seven major industrial nations and the
President of the Commission of the European Communities met in Paris in July 1989 for the
fifteenth annual Economic Summit. They stated that the drug problem has reached devastating
proportions. and stressed the urgent need- for decisive actions. both on a national and
international basis. Among other resolutions on drug issues. they convened a Financial Action
Task Force (FA TF) from Summit Participants and other countries interested in these problems.
to assess the results of the cooperation already undertaken to prevent the utilization of the
banking system and financial institutions for the purpose of money laundering, and to consider
additional preventive efforts in this field. including the adaptation of the statutory and
regulatory systems to enhance multilateral legal assistance. They decided that the first meeting
of this Task Force would be called by France, and that its report would be completed by April
1990.
In addition to Summit Participants (United States, Japan, Germany, France,
United Kingdom. Italy, Canada, and the Commission of the European Communities>, eight
countries (Sweden, Netherlands, Belgium. Luxemburg. Switzerland. Austria. Spain and
A ustralia). were invited to join the Task Force. in order to enlarge its expertise and also to
reflect the views of other countries particularly concerned by. or having particular experience
in the fight against money laundering. at the national or international level.
France held the presidency of the Task Force. Several meetings were held in
Paris and one meeting in Washington. More than one hundred and thirty experts from various
ministries, law enforcement authorities, and bank supervisory and regulatory agencies. met and
worked together. The work of the Task Force, in itself, has improved the international
cooperation in the fight against money laundering: contacts were established between experts
and law enforcement authorities of member countries. and a comprehensive documentation on
money laundering techniques, and national programs to combat them has been compiled. As a
result, Task Force countries have already improved their readiness and ability to fight against
money laundering, and to cooperate to this end .
To facilitate the work of the TaSk Force. and to take advantage of the expertise
of its participants, three working groups were created, which focused respectively on money
laundering statistics and methods (working - group I, presidency: United Kingdom). on legal
questions (workinl - aroup 2, presidency: United States), and on administrative and financial
cooperatioD (workiDS - group 3, presidency: Italy). Their comprehensive reports constitute
part of the backlround material of this report, and of possible future work.
Building upon this substantial preparation, the Task Force report begins with a
thorough analysis gf the money layndering process, its extent and methods (part 1) ; then, it
presents the international instryments and national prolrams already in place to combat mODey
laundering (part II) ; and it devotes its most extensive and detailed developments to the
formulation of action recommendatigns, on how to improve the national legal systems, enhance
the role of the financial system, and strenathen international cooperation against money
launderinl (part III).
I - EXTENT AND NATURE OF THE MONEY LAUNDERING PROCESS
A-
EXTE~T
The financial flows arising from drug trafficking might theoretically be estimated
directly or indirectly.
A direct estimation would consist of measuring these flows from the international
banking statistics and capital account statistics for the balance of payments. This could be done
through an analysis of errors and omissions and other discrepancies. The task force asked the
IMF and the BIS to conduct this work. Their conclusion was that although deposits covered by
international banking statistics may include a substantial amount of drug money, there is no
way in which this aspect can be singled out and it probably accounts for only a small
percentage of the totals. The data for banks' liabilities suffers from insufficient coverage of
offshore financial centers.
Indirect methods estimate the value of production or sales of narcotics, based on
the fact that financial flows arising from drug trafficking are initially the counterparts of flows
of drugs themselves. The parties involved in illegal narcotics trransactions inevitably come to
hold cash or balances in financial institutions whose connections with illicit activity they will
wish to conceal. There is currently insufficient information to evaluate, on the basis of
estimates of the value of drug sales, the level of these balances resulting from money
laundering.
.
Three indjreCl methods of estimation were used to assess the scale of financial
Dows arising from dryg traffic. They are based on estimations of drug production or
consumption, valued using the retail price of drugs. Only a part of the calculated amounts are
profits available to be laundered: production estimates must be modified by estimates of local
consumption and losses in the production and distribution chain.
I - The first method is based on estimations of world dru8 production. The
United Nations estimated drug trafficking proceeds(l) worldwide at S 300 billion in 1987. This
estimation remains very uncertain.
The role of each kind of drug in the generation of proceeds available for money
laundering is also difficult to assess. Estimates of US street yield are in the range of S29 billion
for cocaine, SIO billion for heroin, and S67 billion for cannabis. Some drugs generate huge
profits for the oraanisations controlling the traffic. making money laundering of large amounts,
throup complicated financial channels, a necessity, while some others generate profits mainly
for the retailen, who may facilitate the laundering of these profits through very simple
finlDCiaJ opentioDS. for instance by bartering drugs for stolen goods, and selling these goods
for cub.
----------------------------------------------~------------------------------------For purposes of estimating the scale of money lalnderina as discussed above, ·proceedsmeans the value of the final sale of illegal drulS, without deduction of costs and without
respect to whether payment is made with money or thinas of value.
For purposes of estimatina the scale of money launderinl as discussed above, ·profitsmeans the value of drug sales less costs incurred by the trafficken (U, the cost of acQuiring
the drugs themselves, the cost of any precursor or essential chemicals, packaging materials,
costs of uallJporlQtion, costs of corruption, legal fees paid to defense lawyers, etc ... ).
(1)
Opium and its derivatives (e.g. heroin) originate mainly from Southeast .l,SIJ :~::'
Golden Triangle) and Southwest Asia (the Golden Crescent) and ~exico. Proceeds irom the 5J.~
of this multi-source drug are partly laundered through a sophisticated network of undergrounj
financial channels. Retail distribution networks are nonetheless largely controlled by persons
loclted within Task Force countries.
I
Coca shrubs are cultivated in the Andean countries of South America I e.g.
Bolivia. Colombia. Peru). and are converted into the most marketable form. cocaine
hydrochloride. predominantly in Colombia. Several cartels are known to control the processing
of cocaine hydrochloride in Colombia. Colombian nationals are also known to be invohed in
organising and controlling distribution networks in other countries. This means that there IS l
flow of funds destined to Colombia originating in Task Force countries.
The total global crop of cannabis is extremely difficult to estimate. as it
grows uncultivated in many of the producing areas. Nevertheless, in many countries. major
cannabis import, wholesale. and retail distribution organisations provide a structure which may
also be used for distribution of heroin and cocaine. Large canabis seizures from offshore supply
vessels, and bulk consignments of cannabis packed with heroin or cocaine are becoming more
common in Europe. There is a rapid and troublesome growth in the size, power, and money
laundering capability of some cannabis distribution organisations, raising the spectre of cartels
developing in this area. Hence, in law enforcement and money laundering terms, cannabis
trafficking constitutes a very serious problem requiring urgent attention.
Although a large part of heroin. cocaine and cannabis production is consumed in
industrialized countries, important quantities are also consumed in producting countries.
especially heroin. where they also generate profits.
Finally, psychotropic substances such as amphetamines/metnamphetamines
and LSD are produced in clandestine laboratories. including some within Task Force countries.
Large amounts of cash are derived, although not on the same scale as for cocaine and heroin.
However, the production-based method of estimation does not provide for an
identification of financial nows within individual countries. Accordingly, all that can be said
for certain is that the bulk of proceeds arises at- the retail level within the Task Force area.
2 - A second method of estimating laundered drug proceeds is based on the
consumption needs of drug abusers. But the information regarding drug use obtained through
surveys is freQuently of doubtful reliability since the activity is illegal: sample populations
surveyed for example in homes or schools may miss a significant proportion of drugs users.
3 - A third method of estimating uses data concerning actual seizures of illicit
9..r.w. and projects the total amounts of drugs available for sale by the application of a
multiplier to recorded seizures. which is estimated on the basis of a law enforcement seizure
rate varying between 5 % and 20 % according to the type of drug considered. and which. on a
weighted average. could be approximately of 10 %. This approach, too. raises significant
methodological problems.
Using these methods. the group estimated that sales of cocaine. heroin and
cannabis amount to approximately S 122 billions per year in the United States and Europe, of
which 50 % to 70 % or as much as $ 85 billion per year could be available for laundering and
investment. One Task Force member estimated global profits at the main dealer level. which
might be most subject to international laundering. to be about S 30 billion per year.
B· METHODS
It would be impossible to list the entire range of methods used to launder money
Nevertheless. the Task Force reviewed a number of practical cases of money laundering. It
stated that all of them share common factors. regarding the role of cash domestically. of various
kinds of financial institutions, of international cash transfers, and of corporate techniQues.
These common factors indicate clearly where the efforts of the fight against money laundering
should focus.
- Cash intensiveness
The form of the money obtained through drug trafficking must be changed in
order to shrink the huge volumes of cash generated: unlike the proceeds of some other forms
of criminal activity, drug cash usually comes in the form of large volumes of mixed
denomination notes, and at least in the case of heroin and cocaine, the physical volume of notes
received from street dealing is much larger than the volume of the drugs themselves;
Drugs criminals are faced with major difficulties when in possession of large
amounts of cash, and when large transactions cannot be performed in cash without arousing
suspicion. A completely cashless economy where all transactions were registered would create
enormous problems for the money launderers. Similarly, a rule that cash transactions were
illegal above a certain amount for all but certain types of business regularly operating in cash
would also create problems for launderers.
This is not to say that the cash intensiveness in one country is by itself correlated
with the importance of money laundering. The cash intensiveness of Task Force economies
varies greatly between countries. In countries like Switzerland, Germany, the Netherlands,
Japan, Belgium and Austria. the cash/GOP ratio lies in the range 6,9 - 8,9 %, whereas at the
other extreme are economies such as the UK. and France with cash/GOP ratios at about
3 - 4 %. Important cash transactions are increasingly monitored in some countries, such as the
United States and Australia, and were recently prohibited in France over 150.000 francs per
transaction.
Another observation is that it is' easier for the launderer if the cash in which he
operates can be directly accepted abroad as a means of exchange. The US dollar in cash is
acceptable as a means of exchange in large amounts in many parts of the world: Federal
Reserve Board staff have estimated that adult residents of the US held only II • 12 % of issued
U.S. notll aDd coins in 1984. The remainder were held by legitimate and illegitimate business
entef1'riaes. residents of foreign countries, and persons less than 18 years old.
2 - Role of formal and informal financial institutions.
a) Role of formal financial institutions
Banks and other deposit-taking financial institutions are the main transmitters of
money both within the Task Force area and internationally. Clearly the stage of depositing
money In institutions is a key one for money launderers. Whether a currency reporting system is
in place. or whether the laws in the country only allow or require the reporting of suspicious
transactions. many of the Task Force countries have measures in place which would make large
cash deposits likely to be brought to the attention of the authorities. Therefore, deposits have ro
be disguised. In countries where there is cash transaction reporting. deposits have to be broken
up into sizes which are lower thin the threshold for that reporting ("smurfing"). in order to
escape this reporting.
For criminals to avoid suspicion. the reduction of deposit size below reporting
requirements is not enough. Deposits may be made in the name of a company whose beneficial
owners do not have to be disclosed in the country in which it is headquartered. Those with
signing authority for the company in a Task Force country -or receiving payments- do not
necessarily know who the beneficial owners are. In some countries. bank accounts can also be
opened in the name of trustees. and the beneficiaries under the trust may be kept secret.
Deposits may be made by the legal profession in the name of clients to whom the rules of
attorney confidentiality may apply.
Even if identity requirements were comprehensive and uniform. it is possible
that officials of banks may become corrupt and accept deposits from persons with false
identities. Most reputable banks do not open accounts without knowing their customer. But they
may be less careful about cash transactions in foreign exchange over the counter. or in
providing cashier's cheques or wiring money for non-depositors. It is not believed that
automatic teller machines (A TMs) operated by banks cause any particular difficulty at present.
But automatic foreign exchange changing machines - already in use in Europe - can provide
anonymity during the laundering process. Similarly. any future ATMs which automatically and
anonymously convert low value notes into high value ones would also facilitate money
laundering.
b) Role of informal financial inStitutjoD!
It is of course not necessary for criminals to use licensed deposit-taking financial
institutions or to establish companies to help deaJ with their problems. Informal and largely
unrelu1ated financial institutions. which can not legally accept deposits, can also be used. The
fint Cltqory of these are Bureaux de Chanae, which accept money in one currency and
CODvert it iIlto another. This still leaves the cash problem open. but a first transformation has
takeD place which makes it more difficult to detect the orilin of the funds. If informal
financial iD!titutioDS provide this service, they may not record the identity of transactors.
Cheque cashers who provide a service mainly after bank hours. if unscrupulous. can work in
reverse: sellinl cheques at a premium for cash.
-
Informal bankers, including -Hawalla· bankers exist mainly in countries with
direct connections with Asia. They are often involved in the gold bullion. gold jewelry or
currency exchange business. and may be a member of a family with similar businesses in
several countries, or, at the other end of the scale, a itreet corner confectionery shop. Bona fide
employees of foreiln banks may operate such systems outside banking houn.
3 - Cash shioments abroad
-Drugs proceeds can be deposited abroad in jurisdictions where the banking
system is insuffiCiently regulated and where the establishment of "letter bo~" companies IS
permitted. Such jurisdictions may include, for instance, small countries who wish to establish J
financial serVices industry as a supplementary source of income ·the sale of banking licenses
can constitute a major source of revenue to the authorities· and employment for the population
Such JurlsdictlOns are sometimes also tax havens.
These jurisdictions are part of the world payments system without any
restriction. So long as this is the case, cash exports will tend to go to these countries for
integration into the financial system there and return by means of wire transfers. This means
that detection of the outflow of cash becomes especially important when internal avenues have
been blocked.
4 • Corporate techniques
Drug dealers must conceal the true ownership and origin of the money while
simultaneously controlling it. To this end, they can use various corporate techniques.
Offshore companies can be used by launderers in ways other than simply as
depositories for cash. Launderers can set up or buy corporations. perhaps in a tax haven using
a local lawyer or other person as a nominee owner, with an account at a local bank. They can
then finance the purchase of a similar business at home through a loan from their corporation
abroad (or the bank), in effect borrowing their own money and paying it back as if it were a
legitimate loan.
The technique of "double invoicing" can be used whereby goods are purchased at
inflated prices by domestic companies owned by money launderers from offshore corporations
which they also own. The difference between the price and the true value is then deposited
offshore and paid to the offshore company and repatriated at will. Variants of the "double
invoicing" techniQue abound.
•
•
•
All these techniques, however, involve loinl through stages where detection
is possible. Either cash hI! to be exported over a territorial frontier and then deposited in a
foreilD financial institution, or it requires the knowing or unknowing complicity of someone at
home not connected with the drug trade, or it requires convincing a domestic financial
institution that a large cash deposit or purchase of a cashier's cheque is legitimate. Once these
hurdles have been cleared, the way is much easier inside the legitimate financial system.
Hence. key staaes for the detection of money launder ina operatjons are those
where cash eOteD ioto the domestic financial system. either formally or informally. where it is
sent abroad to be integrated into the financial systems of rexulatoD havens. and wbere it is
repatriated in the form of transfers of Ielit;mate appearance.
II - PROGRAMS ALREADY IN PLACE TO COMBAT
MONEY LAUNDERING
A - INTERNATIONAL INSTRUMENTS
Various international organisations or groups. including the Council of Europe(l).
INTERPOL. among EEC members the Mutual Assistance Group between customs
administrations and the TREVI group between ministers in charge of security, as well as the
Customs Cooperation Council. have already devoted much attention to the money launderinl
problem. Besides, two international instruments currently address this issue from different
viewpoints: the United Nations Vienna Convention against Illicit Traffic in Narcotic Drugs and
Psychotropic Substances (hereinafter ·Vienna Convention"), and the Statement of Principles of
the Basel Committee on Bankinl Regulations and Supervisory Practices (hereinafter Basel
Statement of Principles), concerninl the ·prevention of criminal use of the banking system for
the purpose of money laundering."
a) The Vienna Convention
This Convention. which was adopted in Vienna on December 20. 1988, focuses
on drul trafficking in general. including of course, but not exclusively, drug money laundering.
On this last issue. it lays firm ground for further progress in the following directions:
- it creates an obligation to criminalize the laundering of money derived from
drug trafficking, thereby facilitating judicial cooperation and extradition in this field. which
today are hampered. given the principle of dual criminality. by the fact that many countries do
not presently criminalize money laundering;
- several parts of the Vienna Convention deal with international cooperation. Its
implementation would substantially facilitate international investigations ;
• it makes extradition between signatory States applicable in money laundering
cases ;
- it sets out principles to facilitate cooperative administrative investigations ;
- it sets forth the principle that banking secrecy should not interfere with
criminal investilations in the context of international cooperation.
----------------------------------------------.--------.------------------_.-------The Committee oC Ministers to the Member States of the Council of Europe adopted on
(1)
June 27. 1980, a recommendation concerning measures against the transfer and the sheltering of
criminally originated funds.
More than eighty countries have signed this convention. including all Task For.:~
countries. So far. only ChIna. Senegal, the Bahamas and ~i8eria have rarIfied it. Twent:v
ratifications are necessary for this convention to be brought into force. Given the compluity or'
the ratification and implementation process. in some countries. its entry into force could take
5e veral years.
b)
The Basel Statement of Princioles
This document. which was agreed to on December 12. 1988. states that public
confidence in banks may be undermined through their association with criminals. and outlines
some basic principles with a view to combat money laundering operations through the banking
system. in the following directions:
- customer identification;
- compliance with laws and regulations pertaining to financial transactions, and
refusal to assist transactions which appear to be associated with money laundering ;
- cooperation with law enforcement authorities, to the extent permitted by
regulations relating to customer confidentiality.
All Task Force countries, except Australia, Austria. and Spain, were part of the
group that agreed to the Basel Statement of PrinCiples. The bank regulators and supervisors of
these three countries. however, have expressed that they consider this Statement as also
applicable to their supervised banking systems.
Although it is not in itself a legally binding document. various formulas have
been used to make its principles an obligation. notably a formal agreement among banks that
commits them explicitly (Austria. Italy, Switzerland), a formal indication by bank regulators
that failure to comply with these principles could lead to administrative sanctions (France.
United Kingdom), or legally binding texts with a reference to these principles (luxemburg).
In spite of the fact that the Statement of Principles is a recent text, and
furthermore thar it was very recently established as an obligation for banks. practical measures
have already been taken in many countries. such as the appointment of a compliance officer in
each bank, in charge of the application of the·.~nternal programs against money laundering.
Most Task Force countries have set detailed guidelines for banks, making the Principles precise
and practica! obligations.
It should be noted that certain of these Principles have been applied in most
couDtria for a IOD8 time. as for instance the principles of customer identification and retaining
of records of transactions.
8 - NATIONAL PROGRAMS
Awareness oi the problem oi money laundering is recent. However. natIOnal
programs to combat it are already in place in some Task Force countries. although mu,h
remains to be done in most of them.
The group agreed to the following working definition to describe the process of
money laundering conduct or behaviour:
- the conversion or transfer of property. knowing that such property is deri \led
from a criminal offense. for the purpose of concealing or disguising the illicit origin of the
property or of assisting any person who is involved in the commission of such an offense or
offenses to evade the legal consequences of his actions;
- the concealment or disguise of the true nature, source. location. disposition.
movement. rights with respect to, or ownership of property. knowing that such property is
derived from a criminal offense;
- the acquisition, possession or use of property, knowing at the time of receipt
that such property was derived from a criminal offense or from an act of participation in such
offense(l).
- Money laundering offense
Money laundering is already a specific criminal offense in seven Task Force
countries (Australia, Canada, France. Italy, luxemburg, United Kingdom, United States), and
there is pending legislation to create this offence in four additional Task Force countries
(Belgium, Germany. Sweden, Switzerland), In the other Task Force countries (Netherlands.
Spain, Austria, Japan), there is currently no specific money laundering offense, although. for
some of them the general legislation pertaining to the proceeds of crime covers money
laundering offenses.
Some differences appear in the scienter requirements, whereas most countries
only criminaJjze intentional money laundering, other countries also criminalize neglisence
leading to money laundering.
The criminal penalties for these offenses are heavy fines, imprisonment up to 20
years, and sometimes prohibitions against engagina in certain professions.
-----------------------------------------------------------------------------------
Most. delegates consider that the final paragraph of the definition. drawn from the Vienna
Convention, does not describe money laundering per se, but an economic aspect of crime which
must be addressed in any comprehensive scheme agaiost money laundering, whereas a few
delegates understand this paragraph as being included in the concept of money laundering.
(1)
2 - Freezing. seizyre and confiscation of assets
Most Task Force countries have provisional measures concerning freezing.
seizure. and/or procedures for asset confiscation relating to drug offenses. However. not all the
.:ountries that have established money laundering offenses permit these procedures in relation to
money laundering.
The definition of property subject to freezing. seizure and confiscation is
generally similar from one country to another. because. in most countries, it also extends to all
proceeds of crime, which would normally cover indirect as well as direct profits or proceeds of
drug trafficking. In a few countries, it also utends to the property laundered. the
instrumentalities used in the crime, or property of corresponding value.
Most Task Force countries allow freezing, seizure or confiscation of assets related
to drug trafficking in execution of a formal request of a foreign state. in the framework of
their domestic laws, or provided a treaty exists. and subject to additional conditions.
Nevertheless. the existing domestic laws and mutual legal assistance treaties do not provide for
each Task Force country to obtain freezing. seizure or confiscation of drug-related assets in all
other member countries.
3 - Bank secrecy laws and reporting reQuirements
a) Customer identification
None of the Task Force countries allows anonymous accounts, although Austria
allows limited forms of anonymous bearer accounts. Most Task Force countries require the
identification of customers using safe deposit facilities. Only in some Task Force members
(Australia. Luxemburg, Sweden, Switzerland) does the obligation to jdentify extend to the
beneficial owners.
b) Internal records of transactions
All countries' banks must keep account books and records of transactions. for the
purpose of prudential supervision. statistics and tax control. In a few countries. banks must also
retain internal records of transactions (either a-U transactions, and/or large cash transactions
and/or international transactions). for the purrx>se of combatting money laundering and other
crimes.
The cODditions of access of law enforcement authorities to these records are
extremely varied among countries. In most cases, judicial proceedings are necessary to overcome
bank secrecy rules.
c) Detection of suspicious
tr3nsaction~
·The detection of suspicious transactions occurring through the financial system.
in Task Force countries having specific detection programs. is broadly based on different
systems. which can be complementary.
The responsibility for initially detecting suspicious financial nows falls mainly to
financial institutions themselves. In some countries. such as Canada. banks have taken on this
responsibility; in other countries. such as the UK. banks have been indirectly obliged to take
on this responsibility in order to avoid possible prosecution for money laundering; while in
other countries. SUCh as the US and Australia. this responsibility has been imposed by
regulation. The banker. to avoid the risk of being involved in money laundering operations. sets
up internal programs to detect suspicious transactions. and declares his suspicions to the
competent authorities. Under either system. when banks bring a questionable transaction to the
attention of these authorities. they will be protected against judicial actions brought by their
customers for failure to respect banking confidentiality. These systems also require confidential
relations between bankers and these authorities. Although these systems are recent. the number
of declarations -from several hundreds to several thousands each year- received by the
competent authorities of countries which apply them. is an indication of their efficiency. In
most other Task Force countries. bank secrecy rules do not allow bankers to make such
declarations. In some other countries where the reponing of suspicious transactions is
mandatory, such as the United States. failure to report suspicious transactions carries
administrative penalties.
In addition to mandatory suspicious transaction reporting, competent
administrative authorities in two countries rely on the systemactic gathering and analysis of
information related to cash movements. This is the system in place in the United States and
Australia. In this system. financial institutions report routinely all deposits, transfers and
withdrawals of cash over S 10.000. These reports, together with report of large international
transfers of cash and similar instruments over S 10,000, are fed into a computerized database.
with an artificial intelligence system. enabling the detection of questionable transactions. In the
United-States. about 6 millions reports are made annually under this system, with a cost for the
financial institutions estimated at US S 17 for each report. In the US, currency reports serve a
number of purposes beyond identifying suspicious transactions. The reports are used in many
ways to support investigations. prosecutions and confiscation .
•
•
•
Although recent, there are signs that these programs against money laundering, in
countries baving such programs. have effective results, by creating increased risks for money
laund.ren. For instance. in the United States, money laundering ·commissions· asked by
laund,ren, which amounted to 2 % to 4 % per transaction in the early 1980's, commonly reach
6 % to a % now.
Recommendation
numbers
III - RECOMMENDATIONS
A - GENERAL FRAMEWORK OF THE RECOMMENDA nONS
Many of the current difficulties in international cooperation in drug money
laundering cases are directly or indirectly linked with a strict appiicatioa of bank secrecy rules.
with the fact that, in many countries, money laundering is not today an offense. and with
insufficiencies in multilateral cooperation and mutual legal assistance.
1
Some of these difficulties will be alleviated when the Vienna Convention is in
effect in all the signatory countries, principally because this would open more widely the
possibility of mutual legal assistance in money laundering cases. Accordingly, the group
unanimoulsy agreed as its first recommendation that each country should, without further
delay, take steps to fully implement the VleaDi Coaventloa, aDd proceed to ratify 1'-(1)
2
Concerning bank secrecy, it was unanimously agreed that f1undal iastitutioD
secrecy laws should be conceived so as Dot to iahibit implemeatuloD of the recommeadatioas
of this aroup.
3
Finally, aD effective money lauDderinl enforcement prOlram should iDclude
increased multilateral cooperation aud mutual leeal assistaac:e iD mODey lauDderine
iO\lestilations and prosecutions and extradition iD money lauDderiul cases, where possible.
Nevertheless, this should not be the end point of our efforts to fight this
phenomenon. Additional measures are necessary, for at least two reasons:
- the need for rapjd and touRh actions
As the purpose of the Vienna Convention is the fight against drug trafficking in
general, including of coune, but not exclusively. the fight against drug money laundering, some
countries could have difficulties in ratifying and implementing it for reasons that are not
related to the issue of money laundering. It remains crucial, whatever the difficulties may be on
legal and technical grounds, to ratify and implement the Convention fully and without delay.
Rapid progress on the issue of money launderin8 is necessary. Hence. the Task
Force's recommendation" include important steps that are implied by this Convention.
Furthermore, even on the topics mentioned by the Vienna Convention, it seemed to the group
that the grOwing dimeasion and increasing awareness of the problem of money laundering,
would justify a reinforcement of its provisions applicable to mopey laundering issues.
----------------------------------------------------_.---------------- .. -----------
(1) However. the Task Force did not undertake to determine what steps would be adequate to
meet the requirements of the Vienna Convention. So,~ the adoption of the proposals and
recommendation" of the Task Force would not neees$lrily constitute full compliance wjth the
obligations assumed by Task Force countries as parties to the U.N. Vienna Convention.
- the need for practical
mea.sure~.
Any discrepancy between national measures to fight money laundering can be
used potentiall)! by traffickers. who would move their laundering channels (0 the countries lnd
financial systems where no or weak regulations exist on this matter. making the detection of
funds of criminal origin more difficult. To avoid such a risk. these national measures.
particularly those concerning the diligence of financial institutions. have to be conceived in a
way that builds upon and enhances the Basel Statement of Principles. and to be harmonized In
their most practical aspects. which is not provided for in the Statement.
On these bases, we recommend action steps that. in our view, could constitute a
minimal standard in the fight against money laundering for the countries participating in this
Task Force, as well as for other countries. Some of these recommendations reflect the view of a
majority of delegates. rather than unanimity, so that they are not limited to the weakest existing
solution in the participating countries on each topic. Cases where a minority held a significantly
different view are also mentioned. Accordingly, the minimal standard we recommend can be
viewed as rather ambitious. Nevertheless, it should in no way prevent individual countries from
adopting or maintaining more stringent measures against money laundering. Furthermore, as
money laundering techniques evolve, anti-money laundering measures must evolve too : our
recommendations will probably need periodic reevaluation.
These action steps against money laundering focus on improvements of national
legal systems (8), enhancement of the role of the financial system (e), and the strengthening of
international cooperation (0).
B - IMPROVEMENT OF ~ATIONAL LEGAL SYSTEMS
TO COMBAT MONEY LAV~DERING
I - Definition of the criminal offense of money laundering
4
Each country should take such measures, as may be necessary, includiDI
leaislathe ones. to enable it to criminalite drua money launderinl IS set forth in che Vienna
Convention.
However, the laundering of drug money is frequentely associated with the
laundering of other criminal proceeds. Given the difficulty to bring evidence of drug money
laundering specifically, an extension of the scope of this offense. for instance to the most
serious offenses. such as arms trafficking. etc .• might facilitate its prosecution.
5
6
7
Accordingly. each country should consider exteadinl the offense of drul money
lauDderinl to any other crimes for which there is a link to narcotics; aD alteraache approach
is to crimiallize moaey Ilunderine based on all serious orfenses, aad/or OD all orreases that
leDerate a silniricant amount of proceeds. or OD certain serious offeases.
The group agreed that. as provided la the VleaDa CoanatioD, the offeDse of
money lauaderiDI should apply at least to knowinl money launderinl acthUy. ladudlDI the
concept that know-Iedae mlY be Inferred from objectlYe factual clrcumstaaces. Some delegates
consider that the offense of money laundering should go beyond the Vienna Convention on this
point to criminalize activity where a money launderer should have known the criminal origin of
the laundered funds. As already mentioned, a few countries would impose criminal sanctions
for negligent money laundering activity.
In addition, the group recommends that, where possible, corporatioas themselns
-not only their employees- sbould be subject to crimiDal liability.
2 - Provisional measures and confiscation
The Vienna Convention provides for provisional measures and confiscation in
cases of drug trafficking and laundering of drug money. These measures are a necessary
condition to an effective fight against drug money laundering, notably because they facilitate
the execution of sentences and help reduce the financial attractiveness of money laundering.
8
Accordingly. (OuDtries should adopt measures simUar to tboH set lorth iD the
VlenDa COD,.adoD, u may be necessary, ladudinl lellslathe oatl, to ealble their competeat
authorltle. to (Oanscat. property lauDdered, proceeds hom, instrumeatalltles used iD or
intended for UH ia the commission 01 any mOlley lauaderlal orreDse, or property of
correspoDdlDI value.
Such measures should inc:lude the authority to : 1) identiry. trace. and e, .. lu.lt,
property which Is subject to confiscation; 2) carry out provisional measures. such a freezing
aDd seizin., to pre"eat any dUlinl. transfer. or disposal or such property and 3) take .n~
appropriate Ia.vestllathe measures.
In addition to confiscation and criminal sanctions. countries also should consider
mODftar), and chil penalties. andlor proceedinis includina civil proceediDls, to void COD tracts
entered by parties, where parties knew or should have known that as a result or the contract.
the state would be prejudiced in its ability to recover financial claims, e.I., throulh
confiscation or collection or fines and penalties.
~ - ENHA;-":CE~fE~T Of THE ROLE Of THE FlNA~CIAL SYSTEM
In addressing the subject of money laundering, the group has kept in mind the
necessity to weigh the impact of its recommendations on financial institutions, and to preserve
the efficient operation of national and international financial systems.
- Scope of the following recommendations
The entry of cash into the financial system is of crucial importance in the drug
money laundering process. This may occur through the financial system (banks and ocher
financial institutions), and also through certain other professions dealing with cash, which are
unregulated or virtually unregulated in many countries.
9
Accordingly. recommendatioDS 12 to 29 of this paper should apply aot oDly to
banks, but also to non-bank financial Institutions.
10
For maximum effectiveness, these recommendations need to cover as many
organisations as possible that receive large value cash payments in the course of their business.
Therefore. the appropriate national authorities should take steps to ensure that tbese
recommendatioas are implemented on as broad a front as Is pratlcally possible.
Nevertheless, excessive variation among the national lists of these non-bank
financial institutions and other professions dealing with cash, subject to the following
recommendations, could potentially facilitate the activity of money launderers. To avoid that,
some delegates prefer that a common, minimum list of these financial institutions and
professions be accepted by all the countries. As examples of non-bank financial institutions,
savings societies including postal savings societies, Joan societies, building societies, security
brokers and dealers, credit card companies, check cas hers, transmitters of funds by wire, money
changers I bureaux de change. sales finance companies, consumer loan companies. leasing
companies. factoring companies, and gold dealers were mentioned.
11
It was agreed that, a worklD' IrQup should further examiae the possibility of
establishinl a COIDIDOD lDiDimal Ust of DOD-baDk fiuncial lastitutlolls and other professioDs
dealiDI with casb subject to these recommeDdatioDs.
2 - Customer ideptification and record keep;n. rules
Crucial in the right against money laundering through the financial system, are
the abiUry of financial in.uitutions to screen undesirable customers. and the ability for law
enforcement authorities to conduct their enquiries on the basis of reliable documents about the
transactions and the identity of clients.
~
12
Hence. (luDcial iastltutlons should Dot keep IDOIl)'mous aceOUDU or aceOIiDU iD
obtiously fictitious Dames: they should be required (by law, by relulatioDI, by alreelDeDU
betweeD supenisory authorities aDd flDaaelat iDstitUtiODI or by self -relutatory a.retlDeats
amODa fiDaaeial iastitutioDs) to IdeDtlfy, oa tbe basil of aD official or other reUablt
IdeDtlfylDI doculDtat. a.d record the IdeDtity of. tbel~ clleDts, eitber oc:casloDal or usual, wbe.
estabUshial buslaess relatloDI or coaductlD, traDsaettoDI (ID particular optDiDI of aeCOUDU or
passbooks, eateriDI IDto fiduciary traDlaetiAs, reatlal of lI(edepoalt boxes, performlal la'1t
cash trallsactioDs).
Furthermore, layerinl of funds of illicit orilin is often facilitated by nominee
accounts in financial instirutions and shareholdinlS in companies, where beneficial ownenhip is
disluise d
13
14
Hence, financial institutions should take reasonable measures to obtain
information about the true identity of the persons on whose behalf an account is opened or a
transaction is conducted if there are any doubts as to whether these c1ieots or customers are
not actlnl on their own behalf. in particular, in the case of domlcillar~ ;ompanles (i.e.
institutions, corporations, foundations, trusts, etc., that do not conduct any commercial or
manufactorina business or Iny other form of commercial operation in the country where their
reaistered office is located).
Financial Institutions should maintain, for at least five years, all necessary
records on transactions, both domestic or International, to enable them to comply swiftly with
information requests from the competent authorities. Such records must be sufficient to permit
reconstruction of individual transactions (includlnl the amouats and types of currency involved.
if any) so IS to provide, if necessary, evidence for prosecution of criminal behaviour.
Financial institutions should keep records on customer identification (e.a.
copies or records of onicial identificatloD documents like passports, identity cards, driviDa
licenses or similar documents), accouDt mes and business correspondence for at least five
years after the account Is closed.
These documents should be avanable to domestic competent authorities In the
context of criminal prosecutions and investi,ations.
3 - Increased diligence of financial institutions
Identification of customers is generally not sufficient to allow financial
institutions and law enforcement authorities to detect suspicious transactions.
15
Hence, flnaneial IDStltutioDS should pay special aUentioD to all complex,
unusual, larae trlnsactions, and an uDusual patterns of traosactions, which hue no apparent
ecoDomic or visible lawful purpose. The backaround and purpose of such transactlons should,
as far IS possible, be examined, the nndlnls established in writlnl, and be available to help
superYisors, auditors and law enforcement alencies.
Where financial institutions suspect that funds stem from a criminal activity.
bank secrecy rules or other privacy laws which are presently enforced in most countries
prohibit them to report their suspicions to the competent authorities. Thus, to avoid any
involvement in money laundering operations, they have no other choice, in that case, than
denyiDl assistance. severing relations and closing accounts in accordance with the Basle
Statement of Principles. The consequence is that these funds can flow through other,
undetected channels, which would frustate the efforts of competent authorities in the fight
against money laundering.
16
To avoid this risk, the following principle should be established: If fiaaaclal
iastltutloas suspect that fUDds stem from a crlmiaa. a,thlty, they sbould be permitted or
required to report promptly their susplcioDI to the competeat authorities_ Accordla,ly, there
should be le,al provilloal to protect fl.aaclal laltitutioas aad their employees from criminal or
clyll liability for breach of aay restrictloa oa dlsclosure of iDfor.atloa Imposed by coatract or
by aay le,lslathe, relulatory or admlalltrathe profilloa, If they r.port la ,0041 fa1th, la
dlsclolla, suspected crtmiaal acchlty to the compet.... authorities, tveD If they did aot kaow
precilely what the uaderlyial crimiaa. acthity wu, aad re,ardless of whether ilI.,al acchity
actually occured.
There is a divergence of opinion within the Task Force OD whether suspicious
activity reporting should be mandatory or permissive. A few countries strongly believe that this
reportin& should be mandatory, possibly restricted to suspicions on serious criminal activities,
and with administrative sanctions available for failure to report.
·If financial institutions. while making these reports. warned at the same time
their customers. the effect might be similar to a refusal to handle the suspected funds; the
suspected customers and their funds would flow through undetected channels.
17
Hence. nUDdal institutions. their directors and employees. should Dot. or,
where appropriate. should aot be allowed to, WarD their customers when informalion rel.tina
to them is beiDI reported to the competeat authorities.
18
10 the case
a mandatory reportina system, or iD the elSe of a YOluDtary
reportlnl system where appropriate, fiDlDciai Institutions reportiDI their suspicions should
comply with instructions from the competeat authorities.
19
In couDtries where DO oblilatioD or reportlDI these suspicious nist, when a
riDaDcial iDstitution deyelops suspicions about operatioDs of a customer, aud when the fiaaneial
institution chooses to mlh DO report to the competent authorities, II should deay ISsistaDce to
this customer, seYer relatioDs with him and close his accouDh.
or
The group also discussed what actions financial institutions should take when
they learn from competent authorities, even in an informal way, that criminal proceedings,
including international mutual assistance requests and/or appropriate freezing orders, are
pending or imminent. Further examination of the intricate legal and practical aspects of this
Question would be useful, to avoid a premature withdrawal of funds which would unduly
impair the criminal proceedings.
Staff in financial institutions are still only beginning, in most countries. to
become aware of money laundering. This is of Ireat help to money launderers. In some
countries. complicity of staff may be also a problem.
20
Hence, fhiaaeial iDstitutlons should develop prOlrams alalDst moaey lauaderlDI.
These prOlrams should IDclude, as a mlDlmum :
a) the dnelopmeat of laterDal policies, procedures aDd cODtrols, lDc:JudlDI tbe
desilaatloD of compllnee office" at maDllemeat leyel, and adequate screniDI procedure. to
easure bllh stiadard.l whea hlrlDI employees ;
b) . . o_coiDI employee traiDiDI procra. ;
c) aa audit 'uDctloD to test the sy.te••
4 - Measures to cope with the problem of countries with
launderjnl measures.
DO
or insufficjent anti money
The strengthening of the fight against money laundering in some countries could
lead to a simple move of the money launderinl channels to countries with insufficient money
laundering measures, in a process akin to regulator shoppinl·
Frequently, a money laundering operation would involve the following stages.
- - drugs cash proceeds \4'ould be exported from regulated .:ouncnes to unregula[c":
ones;
- this cash would be laundered through the domestic formal or informal financial
system of these havens;
- the subsequent stage would be a return of these laundered funds to regulated
countries with safe placement opportunities, particularly through wire transfers,
While sovereignty principles make it difficult to prevent this type of
displacement of money laundering channels, and other laundering operations using regulation
havens, the following principles should be applied by financial institutions in regulated
countries:
21
- fiaaadal iastitutioDs should live special atteatloa to buslaess rel.Cloas aad
traasaedons with persoas, includini companies and financial institutions, rrom countries which
do aol or iDsuCCicieDtly apply these recommendatloDs. Whene.er these transactions hue ao
appareaC economic or visible lawrul purpose, their backlrouad and purpose should, as far as
possible, be examined, the flndlnas established ia writlDC, aad be a ..ilable to help supervisors,
auditors and law enforcement aleneies.
22
- finaacial Institutions should ensure that the priaciples meatioDed abo.e Ire
also applied to branches and majority owned subsidiaries located abroad. especially ia couatries
which do not or insufCieienlly apply these recommendaUoDs, to the exteat that local applicable
laws and reculations permit. When local applicable laws and relulatloas prohibit this
implemeotatlon, compeleat authorities ia the country oC the mother institutloD should be
iaformed by the finaacial institutions that they cannot apply these recommendations,
Within the context of relations between regulated and unregulated countries, the
study of a system to monitor cash movements at the border is of special importance (see point S
hereunder).
5 - Other measures to avoid currency laundering
It was recolnised that the stage' of drugs cash movements between countries is
crucial in the detection of money laundering. A few delegates stroDgly support the proposal that
a system of reportins of all large international transportations of currency or cash equivalent
bearer instrumen1S to I domestic central !seney with a computerized data base available to
domestic judicial or law enforcement authorities should be established for use in money
lauuderiDa cases. But this opinion is not shared by the majority of the sroup.
23
Nevertheless, the group acknowledged that tbe f,ulblllty of lDeuures to detect
or 1D0alto, call at til. border should be studied, subject to strict safeauardJ to talure proper
use of laformatlOD aDd without ImpedlDI la aD)' way the freedom of capital mo.emeDts.
The detection of suspicious cash operations also could potentially be facilitated if
law enforcement authorities were in a position to be informed and to analyu all large cash
transactions occuring within their country.
~
For that purpose, one sUllestld solution is that these transactions be routinely
reported by financial institutions to competent authorities.
However, the efficiency of such a system, which currently exists in two
participating countries, is uncertain. The majority of the group was not convinced of the :OSl
effectiveness.of this system at this time, and expressed fears that it could lead financial
institutions to feel less responsible for the fight against money laundering. On the other hand. i:
is the view of a few members that a comprehensive program to combat money laundering must
include such a currency reporting system together with the reporting of international
transportation of currency and currency equivalent instruments.
24
2S
Nevertheless. the group agreed that couDtries should consider the feasibility and
utility of a system where banks and other financial institutions and intermediaries M·ould report
all domestic and Internltlonll currency transactions abote • fixed ImouDt, to I DatioaaJ CeDtral
asency with a computeriud dlta base, available to competent authorities for use in money
launderini cases, subject to strict slfesuards to ensure proper use or the informltioD.
Furthermore, given the crucial importance of cash in drug trafficking and drug
money laundering. and despite the fact that no clear correlation could be established between
the cash intensiveness of a country's economy, and the role of this economy in international
money laundering, countries should rurther eDcouraie In lenera' the denlopmenl of modera
and secure techaiques of mODey maUlement, includinl Increased use of checD, paymeat
cards, direct deposit of salary checks, aad book entry recordlas or securities, as a meaa. to
encourlse the replacement of cash trlnden.
6 • Implementation, and role of regulatory and other administrative authorities
Effective implementation of the above recommendations must be ensured.
But the authorities supervising banks and other financial institutions have
currently, in many countries, no competence to participate in the fight against criminal
activities. because their mission is primarily a prudential one, and because of professional
secrecy or other rules.
26
27
28
Accordingly. in each member country. the competeat authorities superl'isial
baaks or other flaandal InstltutioD' or iaaermedlarles, or other competeat authorities, should
easure that the supen-ised institutions han Idequate prOlrlms to luard Ilainst money
lauaderinl. These authorities should cooperate aad lead expertise spoDtaaeously or on request
with other domestic Judicial or law eaforcement authorltles in money lauDderiD& In~estllatioDs
aDd ,l'OMClltiOU.
The effective implementation of the above mentioned recommendations in other
professioDS dealing with cash is hampered by the fact that. in many countries. these professions
are virtually unregulated. Hence, competent authorities should be desilDated to ensure aD
effeethe Imple.tatatloa of all these recommendatloa., tbroulb administrative suptnlsioD aad
reaulatioD, la ocher prolesslons deaJiDI with casb as deriDed by each country.
The establishment of programs to combat money laundering in financial
institutions and other professions dealinl with cash. would require the support of these
competent authorities. particularly to make these institutions and professions aware of facts that
should normally lead to suspicions. Accordingly, tbeTtompetfDl authorities sbould establlsb
,uideliael wbleh will asslst fl.aaeial Institutions I. detectlnl suspldous patterns of btba.iour
by tbelr custolDen. It II uadentoocl tbat lueh luldellae. mUll dffelop o.er time, aad will Dll'er
be exhaulthe. It I. further undentood thaC sucb luldeliDeI will primartly sene as a.
edueatloaal tool for nn.aclal InICltutloD.' penolael.
29
Furthermore, the competent authorities uauluiDa or superylSiDI flllucial
IDstitutlons should take the necessary le,al or reaulator), measures to luard aaalDst cODtrol or
acquisition of--. sianincaDt participation in financial institutions by criminals or their
confederates.
The group acknowledged the risk that. outside the financial sector. industrial or
commercial companies also could be acquired by criminals with the aim to use them for money
laundering purposes.
D - STRENGTHENING OF
INTERNATIONAL COOPERATION
The study of practical cases of money laundering clearly demonstrated that
money launderers conduct their activities at an international level. thus exploiting differences
between national jurisdictions and the existence of international boundaries. Therefore.
enhanced international cooperation between enforcement agencies. financial institutions. and
financial institution regulators and supervisors to facilitate the investigations, and prosecution of
money launderers, is critical.
- Adminjstrative cooperation
a) E2Schange of general information
A first step is to improve the knowledge of international flows of drug money.
noticeably cash flows, and the knowledge of money laundering methOds, to enable a better
focus of international and national efforts to combat this phenomenon.
30
Accordingly, DatloDal admiDistratioDs should cODsider recordlal. at least ID the
allrelate, iDteraatioaal flows of cash iD whatuer currency. so that estimates can be made of
cash flows and reflows from various sources abroad. wheD this Is comblDed with ceatral baDk
iaformatloa. Sueh iaformatloa should be made available to the IMF aad BIS to facilitate
iDternatioDal studies.
31
InternatioDal competeDt authorities, perhaps IDterpol aDd the Customs
CooperatioD CouDeil, should be Ihea respoasibility for latheriDI aDd dlssemiaatiDI
iaformatioD to competeDt authorities about the latest developmeats iD moaey launderiDI and
mODey lauDderiDI techniques. CeDtral banks aDd baDk relulators could do the same 00 their
Detwork. NaUODal authorities ia various spheres, iD coasultatioD with trade associatloas, could
thea disseminate this to flDandal lastitutions iD IDdivldual couDtrles.
b) Exchange of information relating to suspicioys transactions
Present arrangements for international administrative cooperation and
international exchanae of information relating to identified transactions are aknowledged to be
insufC"lCient. At the same time, this exchange of information must be consistent with national
and international provisions on privacy and data protection. Furthermore. several couDtries
consider that exchange of information relating to individual money laundering cases should take
place only in the context of mutual legal assistance.
32
It was agreed that each COUDtry should make efforts to Improye a spoDtaneous or
"upon request"' lateraatlonal InformatioD nchaale relatlal to suspicious transactloaa, penoas
and corporaUons lnyohed la those traDsactloDI betweea competent authorities. Strict
saCeluards should be established to easure that this nchaale of laformatioD Is coasisteat with
aational aad international provisions on prhacy aDd data protectioa.
2 - Cooperation between legal Authorities
a) Basis and means for cooperation in confiscation. mutual assistance. and
extradition
A necessary condition to improve mutual legal assistance on money laundering
ClSes, is that countries acknowledge the offense of money laundering in other countries as an
Jc;eptable basis for mutual legal assistance. The group agreed that countries should consider
extending the scope of the offence of money laundering to reach any other crimes for which
there is a link [0 narcotics, or to all serious offenses, and let the definition for this wider
money laundering offense open between different options. Furthermore, it agreed that:
- countries should adopt a definition covering the offense of drug money
laundering compatible with the definition of the Vienna Convention.
33
- couDtries should try to eDsure, on a bilateral or multilateral basis, that
different knowledae standards in natioaal definitioDs -i.e. dlffereDt standards coacernial the
intentional element of the infraction- do nOI affect the ability or willlDIDess of couDtries to
provide each other with mutual leeal assistance.
34
Furthermore, international cooperation should be supported b)' a aetwork of
bilateral aad multilateral alreemeats aDd arraalemeats based Oil leaerall), shared lelal
coacepts with the aim of provldiDI practlcal measures to affect the widest possible raale of
mu tual assistaace.
35
The current works in the framewprk of the Council of Europe. concerning
international cooperation as regards search. seizure and confiscation of the proc:eeds from
crime, could constitute the basis of an important multilateral agreement on this matter.
Accordingly. countries should encourase lateroational cOD~eDtions such as the draft cODveDtiob
of the Council of Europe oa conflscatloa of the proceeds from offeases.
b) Focus of improved mytual assistance on money launderjng jssues
Experience of international cooperation on money laundering issues shows that
improvements are necessary on the following topics:
36
37
38
39
- Cooperative investigations - Cooperathe IDyestlSltioas amoDI appropriate
competeDt authorities o( couDtries, should be eocouraled.
- Mutual assistance in criminal matters - There should be procedures for mutual
asslstuce I. cri.laal .aUen re,lrdlDI the use of compulsor)' measures lachldlal tbe
prCMllactio. of records by rlDaacial InstitutioDs aad other persoDs, tbe searcb o( penoas aad
pre....., seizure IDd obtaiaiDI of evideace for use ID moae)' lauDderial lanstilltloas aad
proMQdou ad I. related actloas la foreila Jurisdictloas.
- Seizure and confiscation - There should be authority to take expeditious action
ia respoDH to requests by (oreilo coualries to ideatlfy, 'reeu, s!ilt aad coonscate proceeds or
other propert)' of correspoadi_1 "alue to such proceeu, bued OD mODey lauaderlal or the
crimes uaderl)'lal the lauaderial actl.lty.
- Coordination of prosecution actions - To a"old eoanlets of Jurlsdlctloa,
coasideratloa should be Ihea to de"isial aad Ippl),ial mechaaism. for detenalalDI the best
naue for prosecutloD of defeDdaats la the iaterests if. Justice la cues tbat are subject to
prosecutloa In more thaD ODe COUDtry. Similarly, there should be arraalements for coordlDatiDI
seilure aDd CODfiscatioD proceedlDls which ma)' iDclude the sharlDI of cODfiscated assets.
40
- Extradition - Countries should hal'e procedures in place to extradite. where
possible. ladhlduals ch .... ed with a mODey lauDderinl offuse or related offuses. with respect
to Its Datloaa! le,al system. each country should recolnize mODey lauDderinl as an extraditable
oHease. Subject to their lelal framework.s. countries may consider simpllfyinl extraditloD by
allowlnl direct transmission of extradition requests between appropriate ministries. extradltlDI
persoDs based oDly OD warrants of arrests or judaments. extraditina their Datlonals. and/or
introduciDI a simplified extradition of consentinl persons who wahe formal extradition
proceedinls.
CONCLUSION
The delegates to the Financial Action Task Force agreed that the presidency of
the Task Force would address this report to finance ministers of participating countries. which
would submit it to their Heads of State or Government. and circulate it to other competent
authorities.
The group agreed that decisions from the Summit of the Heads of State or
Government of seven major industrial nations. which convened the Financial Task Force.
would be crucial for the implementation of the recommendations and further work and studies.
Political impetus would also be particularly necessary to crystallize strong coordinated overall
international action. and to define the best ways to associate other countries, including drug
producing countries. to the fight against money laundering.
While discussing the most adequate ways by which the follow-up to its works
could be organized. the group emphasized that the wider the number of countries applying
these recommandations (including countries which have weak or no regulations against
money laundering) the greater their efficiency would be. It considered that a regular assessment
of progress realized in enforcing money laundering measures would stimulate countries to give
to these issues a high priority, and would contribute to a better mutual understandiDg and hence
to an improvement of the national systems to combat money laundering.
SYNOPSIS OF
THE FORTY RECOMMENDATIONS
OF THE REPORT
A - GENERAL FRA\tEWORK OF THE RECO.\I\tE~DATIONS
1
Vieona
Each country should. without further dela). take steps to fully implement the
and proceed to ratify it.
Con~ention.
2
Financial institution secrecy laws should be concehed so as not to inhibit
implementation of the recommendations ~f this group.
3
An effective money laundering enforcement program should Include increased
multilateral cooperation and mutual legal assistance in money laundering in~estilatioos and
prosecutions and extradition in money laundering cases, where possible.
B - IMPROVEMENT OF NATIONAL LEGAL SYSTEMS
TO COMBAT MONEY LAUNDERING
Definition of the criminal offense of money laundering
4
Each country should take such measures, as may be necessary, lncludlal
lelislathe ones. to enable it to criminalize drul money launderinl as set forth la tbe Vleaaa
Con.ention.
5
Each country should consider extendlol the offense of drul mon.y launderiog to
any other crimes for which there is a link to narcotics; an alternathe approach is to
criminalize money launderinl based on all serious offenses. and/or on all offenses that
lenera'e a silnificaot amount of proceeds. or on certain serious offenses.
6
As pro.ided in the Vienna Con~entioD, the offense of moaey launderiol should
apply at least to kaowial moaey launderial acthity, includinl the concept tha' knowledle may
be iaferred from objectlu ractual circumstanc~s.
7
Where possible, corporatioas themsel.es -aot only their employees- should be
subject to crimiaal liability.
Pro.lsiona' measures and confiscation
8
Couatries should adopt measures similar to those set forth ia the Vienna
Coan.doD, u may be aecessary, lacludla, lelislathe oaes, to enable their competent
authorides to coaflscate property lauadered, proceeds from, Instrumentalities used ia or
iatended for use la tbe commlssioa of aay money lauaderial offense, or property of
correspoadlal .alue.
Such measures should Include the authority to : 1) Identify, trace, aad "aluate
property which Is subject to coafiscatioa ; 2) carry out proyislonal measures, such a (renial
aad seizial, to pre.eat aay deaUal, traasfer, or 1llsp~al of such property aad 3) take aay
appropriate iayestl,athe measures.
Ia addltioa to coanscatioa aad crimlaal saactioas, couatrles also should coasider
moaetary aad chll peaaUles, aad/or proceedlals lachldial chll proceedlals, to ~old coatracu
eatered by parties, where parties kaew or should han kaowa that u a result of the coatract,
the state would be prejudiced la iU ability to rtcoyer flaaaelat claims, e.I., throulb
C:O.nl~.IID. or eotlKtioa of flaes aad ptaalti".
C - E~HANCE~1E~T Of THE ROLE OF THE FI~A~CtAL SYSTEM
Scope of the following recommendations
9
Recommendations 12 to 29 of this paper should apply not only to baDks. but
also to non- bank financial institu tions.
10
The appropriate national authorities should take steps to ensure that these
recommendatioas are implemented on as broad a front as is pratically possible.
11
A working group should further examine the possibility of establishiDI a
commoa minimal list of non-bank finaacial institutions and other professioas dealing with
cash subject to these recommendations.
Customer identification and record keeping rules
12
Financial institutions should not keep anonymous accounts or accounts In
obviously fictitious names: they should be required (by law, by reaulations, by agreelDeDts
between supervisory authorities and financial institutions or by self-regulatory alreelDtDts
amonl tinanclal instltutloas) to ideatlfy, on lhe basis of aD orrlclal or other reliable
identifying document. and record the Identity oC their clients, either occasioDal or usual, wheD
establishing business relations or conducting transactions (Ia particular opening of accouats or
passbooks, enteriag into fiduciary transac:tions, rentlnl of saredeposit boxes, performina larae
cash transactioas).
13
Financial institutions should take reasoDable measures to obtain information
about the true Identity of lhe persoDs OD whose behalf an accouDt is opened or a traasactioD is
conducted if there are any doubts as to whether these clients or customers are not actlDI oa
their own behal(, ia pardcular, in the case of domiciliary tompanies (i.e. institutions.
(orporations, (oundatloas, trusts, etc., that do aot conduct any commercial or manufactoriDg
business or aay olher (orm oC commerdal operation in the country where their reaistered
office is located).
14
Flaaaelal Institutions should maintain, for at least fhe yean. all aecessary
recordl OD traasactloas. both domestic or international, to eaable thelD to comply swiftly with
iarora.doD requesta (rolD the competent authorities. Such records must be sufficieDt to permit
recoutnctloa of ladiyldual transactions (includlal the amounts aad types of curreacy ia\'ohed,
I( uJ) 10 u to proylde, ir necessary, e\'idence for prosecution of criminal behaviour.
FlDlacial Institutions should keep records on customer IdentincatioD (e.,. copies
or records o( orflclal ldeattrlcatlon documents like pusports, identity cards, drhlaa IiceDses or
similar documents), account flies IDd business correspoaduce for at leut fl\'t yean after the
accouat Is closed.
These documents should be available to domestic competeDt authorities ia the
context of releyant crllDlnal prosecutions aad la\,estllatlons.
~
Increased diligence of financial institutions
15
.Financial institutions should pa~ special attention to all complex. unusual large
transactions, and all unusual patterns of transactions. which ha~e no apparent economic or
~isible lawful purpose. The background and purpose of such transactions should. as far as
possible, be examined, the findings established in writing, and be a~ailable to help super'l'isors.
auditors and law enforcement agencies.
16
H financial institu tions suspect that funds stem from a criminal acthity, they
should be permitted or required to report promptly their suspicions to the competent
authorities. Accordinliy, there should be lelal provisions to protect financial institutions and
their employees from criminal or civil liability for breach of any restriction on disclosure of
information imposed by contract or by any lelislatin, relulatory or administrative provision, if
they report in lood raith, in disclosinl suspected criminal activity to the competent authorities.
even if they did not know precisely what the underlyina criminal acthity was. and rfaardless
of whether iIIelal acthity actually occured.
17
Financial institutions. their directors and employees. should not, or, where
appropriate. should Dot be allowed to, warn their customers wheD iDformation relatinl to tbem
is beinl reported to the competent authorities.
18
In the case of a mandatory reportina system, or in the case of a Yoluntary
reportinl system where appropriate, financial institutions reportina their suspicions should
comply with instructions from the competent authorities.
19
When a financial institution develops suspicions about operations of a customer.
and. when no oblilation of reportinl these suspicions exist. makes no report to the competent
authorities, it should deny assistance to this customer. sever relations with him and close his
accounU.
20
Financial institutions should develop prolrams alainst money launderinl. These
prOlrams should include, as a minimum:
a) the development of internal policies, procedures and controls. lncludlnl the
desiln.tloD of compliance officers at manalement level, aDd adequate screeninl procedures to
ensure hllh stlnurda wheD hirinl employees;
b) an oDlolnl employee traininl prOlram ;
c) •• audit function to test the system.
Measur" to CODe with the problem of countries with no or insufndent
anti money launderln. measures.
-
21
FlnaDel.1 Institutions should Ihe speelal attention to business relations and
transactions with persons, iDcludlnl companies and financial institutions, from countries whicb
do not or Insufficiently apply these recommendations. Whenever these trlnsactions ba.e .0
apparent economic or .Islble lawrul purpose, thelOr ba6;karound aDd purpose should, as far as
possible. be examined. the flndlnls established In wrltlnl. and be available 10 help supe"isors,
audlton and law enforcement aleneies.
Increased diligence of financial institutions
15
.Financial institutions should pa~ special allention to all complex. unusual large
IraDsactlons. and all unusual pallerns of transactions. which hate no apparent economic or
tisible lawful purpose. The background and purpose of such transactions should. as far as
possible, be examined, the findings established in writing. and be available to help supervisors.
auditors and law enforcement agencies.
16
If financial institutions suspect that funds stem from a criminal acthity, they
should be permitted or required to report promptly their suspicions to the competent
authorities. Accordinlly, there should be lelal provisions to protect financial institutions aad
their employees from criminal or chit liability for breach of any restriction on disclosure of
information imposed by contract or by any lelislathe, relulatory or administrath'e provision, if
they report in lood faith, in disdosinl suspected criminal acthity to the competent authorities,
even if they did not know precisely what the underlyinl criminal activity was, and relardless
of whether iIIelal activity actually occured.
17
Financial institutions, their directors and employees, should not, or, where
appropriate, should not be allowed to, warn their customers when informatioa relatinl to tbem
is beial reported to the competent authorities.
18
In the case of a mandatory reportinl system, or in the case of a voluntary
reportinl system where appropriate. financial institutions reportina their suspicions should
comply with instructions from the competent authorities.
19
When a financial institution duelops suspicions about operations of a customer,
and. when no oblilation of reportinl these suspicions uist, makes no report to the competent
authorities, it should deny assistance to this customer, sever relations with him and close his
accounts.
20
Financial hutitutions should develop prOlrams alainst money launderinl. These
prolrams should include, as a minimum:
a) the development oC internal policies. procedures and controls, Includinl the
desilnation of compliance orricers at manalement level, and adequate screeninl procedures to
ensure biab stanciarciJ when hirinl employees;
b) a. o.lolnl employee traininl prOlram ;
c) •• audit fuactlon to test the system.
Measures to CORt with the problem of countries with no or insuCndent
mann I,under'", measures.
-
,"ti
21
Flnanci.1 institutions should ,ive special Ittention to business relations and
transactions with persons. iacludia, companies and flnaneill institutions, Crom couatrles whicb
do not or insurflclently IPPIy these recommendltions. Whenever these trans.ctlons b,.e no
applrent ecoaomic or .isible Ilwrul purpose, their ba6;klround lad purpose should, as fir as
possible, be examined. the (iadinls estlblisMd in writiDl, and be lvallable to help sllpervisors,
,udlton and I,w enforcement I,encies.
22
FIDaDcial institutions should ensure that the principles meatioDed abo~e are .11, '
applied to brauches IDd majority owned subsidiaries located abroad. especially in countries
whicb do not er insufficiently apply these recommendations. to the utent that local applicable
laws aDd reaulatloDs permit. When local applicable laws and resulation prohibit this
implemeatatloa. competent authorities in the country of the mother institution should be
informed by tbe finucial institutions that they cannot apply these recommendatioDs.
Other measures to ayoid currency laundering
23
The feasibility of measures to detect or monitor cash at the border should be
studied, subject to strict safeeuards to ensure proper use of information aDd without impedinl
in Iny way the freedom of capital monments.
24
Couatries should consider the feasibility and utility of a system where baDks aDd
other financial institutions and intermediaries would report all domestic and international
currency transactions aboye a rixed amount. to a national centrll Ilene} with a computerized
data base, aullable to competent luthorities (or use in mooey launderiol cases, subject to
strict saCeeuards to ensure proper use of the informatioo.
25
Countries should further encouraae in ceneral the drrelopment of Moden and
secure techniques o( money mlnaaement, inciudinc im:reased use or checks. paymeat cards,
direct deposit of salary checks, and book entry recordlnl of securities, as a melns to encourale
the replacement of cash transfers.
ImplementatIon. and role of ruulatory Ind oth,r adminls.ratlve .uthoritles
26
The competent authorities superYisiDI banks or other financial institutions or
intermediaries, or other competent .uthorities, should ensure that the supenised institutions
hue .dequlte prolrams to cu&rd Iiainst money Ilunderina. These luthoritles should cooper.te
and leod expertise spontaneously or on request with other domestic judlci.1 or law eDforcement
.uthoritles ia money Ilunderiac iDyestiallions and prosecutions.
27
Competent authorities should be desiinated to ensure aa eUecthe
implemeatatlon of all these recommendations, throulh administratife supenisioa aad
rqulado_, I_ otber professions deallne with cash u defined by each couatry.
28
The competeat authorities should establish auldellnes whicb will assist flnaacial
lastltlltlou I. detectial suspicious patterns or behl\'iour by their customers. It Is uaderstood
that sucb luldellan must de\'elop o\,er time, and will neyer be exhaust"e. It Is furtber
understood that such luldellnes will primarily sene as an eduCltl~aal tool ror flaaaclal
institutions' persoDDel.
29
The competeat authorities reeuillial or super\'islDI (lnaaelal Institutions should
take the aecessary lei" or relulatol')' measures to luud allin.t control or acquisition of a
sl.ameaDt partlclpatloa ia flnaDdal Institutions by en-mlnals ortbelr coarederates.
D - STRENGTHENING OF INTERNATIONAL COOPERATION
Administrathe cooperation
a) EJI;change of general information
30
~ational administrations should consider recordine. at least in the aureeate.
international flows or cash in whatever currency, so that estimates can be made of cash flows
and reflows from various sources abroad, when this is combined with central bank information.
Such information should be made available to the IMF and BIS to facilitate International
studies.
31
Interaational competent authorities, perhaps Interpol and the Customs
Cooperatloa Council, should be iiven responsibility for latherinl and disseminatinl
informatioD to competent authorities about the latest developments iD mODey launderinl and
money launderinl techniques. Ceotr.1 banks and bank reaulators could do the same OD their
network. National authorities in various spheres, in consultation with trade associalioDs, could
then disseminate this to financial institutions in indhidual countries.
b) Exchange of infQrmation relating to suspicious transactions
32
Each country should make efforts to improve a spontaneous or ·upon request"
international information nchanle relatlna to suspicious transactions, persoas aDd corporatloDs
involved in those transactions between competent authorities. Strict safeiuards should be
established to ensure that this nchanae or information is consistent with national and
international proviSions on prhacy and data protection.
Cooperation betwun lelll lurhoritifS
a) Basis and means for cooperation in confiscation. mutual assistance. and
extradition
33
CouDtries should try to ensure. on a bilateral or multilateral buis, that different
kDowledie standards ID national definitions -I.e. dlffereDt standards concerniaa tbe Intentional
element of the IDfrac!loD- do Dot arfect the ability or willlniness of countries to pro,'de each
other with mutual lelal asslst.aDce.
34
lat.natlonal cooperation should be supported by a network of bilateral and
muldlateral .Ir"meats and arraRaements based on .enerally shared lelal concepts with the
aha of proyldlDI pradlcal lIleasures to affect the widest possible ranle of mutual asslstaace.
35
Coaatries should encoura.e lnteraatloul conyenlioDs such u the draft
conventioD of the CouDcll of Europe on confiscation of the proceeds from offeases.
b) focus of improved mutual _,sjstanee on money laundering issues
36
Cooperaliy, layesillations amonl .pprvrlatt competent authorities of couatrles.
should be encouraled.
37
There should be procedures for mutual uslstance In crimlDal matten rtiardlDI
the use or compulsory .euures lacludlnl the productioD or records by fiaaDcial IDstitutioDs
and otber penoDs, the searcb or persoaS aad premises. seizure aad obtalalnl or nldeace for
use ID money lauaderlDI layestllatloas and prosecutloas aad la related actions ia fore liD
etlHl.
j."...
38
There should be authority to take expeditious actlon la respoaH to requesU b)
(oreilD countries to identify. freeze. seize and confiscate proceeds or other property of
correspondiDI ."alue to such proceeds, based on monty launderine or the crimes uDderlyiDe the
launderlnl acthity. There should also be arrangements for (oordinatinl sebure aad
coofiscatioa proceedines which may include the sharing o( confiscated asseu.
39
To avoid conflicts o( jurisdiction. consideralion should be sheD to devisinl aad
applyina mechanisms for determinine the best venue (or prosecution of defendants in the
interests of justice in cases that are subject to prosecution in more than oae couatry. Similarly,
there should be arraaeements for coordinatina seizure and confiscatioa proceedin,s which lDay
include the sharlnt of confiscated ISsets.
40
Countries should have procedures io place to extradite, where possible,
indlylduals charted with a money launderine offense or related offenses. With respect 10 its
natioDal le,al system, each country should recoenize money launderin, as aa extraditable
orrense. Subject to their lelal frameworks. countries may consider slmpllfylal extradltloa by
allowinl direct transmissioll of extradition requests between appropriate miDistries, ntradltiDI
persolls based only OD warrants of arrests or judaments, extradltlal their aatiooals, aad/or
introduclnl a simplified extraclltloa of consentinl persons who waive formal extradltloa
proceedinls.
Background on the Financial Action Task Force on Money Laundering
Mandate
'The Financial Action Task Force was established by the 1989 G-7
Economic Summit chaired by France, sometimes referred to as the
"Summit of the Arch." The language of the Summit communique
regarding the Task Force, under the heading "drug issues," was as
follows:
"Convene a financial action task force from Summit
Participants and other countries interested in these
problems. Its mandate is to assess the results of
cooperation already undertaken in order to prevent the
utilization of the banking system and financial
institutions for the purpose of money laundering, and to
consider additional preventive efforts in this field,
including the adaptation of the legal and regulatory
systems so as to enhance multilateral judicial assistance.
The first meeting of this task force will be called by
France and its report will be completed by April 1990."
Members
The members of the Task Force were the G-7, Canada, France,
Germany, Italy, Japan, the United Kingdom, and the United States,
and Austria, Australia, Belgium, Luxembourg, the Netherlands,
Spain, Sweden, and Switzerland, the European Community.
Organization
The Task Force was organized into three working groups and a
Plenary Group. The Task Force President or Chariman was Denis
Samuel-Lajeunesse, Chef du Service des Affaires Internationales,
Direction de Tresor, French Ministry of Finance. The U.s.
delegation to the Task Force was chaired by John E. Robson,
Deputy Secretary of the Treasury. The Working Groups were as
follows:
Statistics and Methods - Chaired by the United Kingdom
Administrative and Financial Cooperation - Chaired by Italy
Legal Questions - Chaired by the United States
The Final Report was based on the work of the Working Groups.
The Working Groups met four times (October, November, and
December, 1989 and January, 1990) and the Plenary Group met five
times (September, October, and December, 1989 and January, and
-2February 1990).
Publicity
There was a understanding among the Task Force members that in
order to facilitate the work of the group and endorsement of the
report by the member governments the report would not be
discussed in detail until a common, agreed-upon publication date,
which was set as April 19, 1990.
TREASURRYJ8~EWS
Dellartment of the Treasury • Washington, D.C . • Telallhone 5.&-2041
APR
Prepared for Delivery
April 20, 1990, 1:30 P.M.
Z3SU 0 0 I 5 8 Li
DEPT. OF THE TRE,., r~!':t\'
t'"'\y>.., . ,
statement by
Secretary of the Treasury
Nicholas F. Brady
at
Press Conference
Miami, Florida
It's a great pleasure to be here today. I've spent the last
several hours with some of the most important men and women in
this country's fight against drugs -- agents and inspectors of
the united states customs Service.
I had the opportunity to discuss with them their efforts to
stop the illegal flow of drugs into the United States. I can
only repeat to you what I told them: we're in their debt for all
their fine work.
I also had the opportunity to review the money laundering
operations here and to tour the new command, control,
communications and intelligence center as well as the air and
marine operations.
Finally, I've had the opportunity to thank the inspection
and control people for the fine work they do here at the Port of
Miami. They process over 10,000 cargo containers every month.
For the overwhelming majority of people who are honest, lawabiding citizens, it's essential that customs handle their goods
efficiently and expeditiously. I'm extremely impressed by the
entire customs effort here in Florida.
The most important asset we have in the fight against drugs
is cooperation: cooperation between nations, between Federal
agencies, and between Federal, state and local enforcement
authorities.
NB-772
2
Just yesterday the final report from the G-7 Financial
Action Task Force on Money Laundering was released.
This
cooperative effort represents the work of 15 nations that have
agreed on 40 recommendations for effective domestic programs and
international cooperation against money laundering.
Earlier this week, Treasury and Justice announced the fourth
phase of Polar Cap. This extremely successful case has been the
result of a cooperative effort between the Department of Treasury
and the Justice Department. To date Polar Cap has resulted in
127 persons charged and over $105 million in cash and property
seized.
And today we are announcing the Customs Service's seizure of
$6.3 million in cash in a case which involved cooperation between
Customs, the Metro-Dade Police Department, the Coral Gables
Police Department and the Florida Department of Law Enforcement.
Finally, I have a presentation to make.
It's part of a
Customs Service program where assets seized in drug cases are
shared with local law enforcement agencies which participated in
the investigation.
Would Eduardo Gonzalez, Deputy Director of the Metro-Dade
Police Department, please come forward?
Today's check presentation represents two cooperative
investigations between customs and the Metro-Dade Police
Department.
In the First case, during the last half of 1987, the MetroDade Police Department was able to develop information regarding
a money laundering organization.
Metro-Dade requested assistance from the Customs Service and
a joint surveillance and investigation then took place.
On December 9, 1987, due to this joint investigation, the
customs Service was able to seize over $1.5 million in cash, as
well as some 14 kilos of cocaine.
In the second case, Metro-Dade, working with the U.S. Border
Patrol, was able to seize bank records of a known smuggler and
money launderer. Metro-Dade then asked the customs Service to
review these records. Based on that review, on July 20, 1989,
the customs Service was able to seize over $85,000.
3
These two cases typify the fine working relationship between
Customs and the Metro-Dade Police Department.
As part of the u.s. Customs Asset Sharing Program, it gives
me great pleasure to present the Metro-Dade Police Department
with this check for $1,273,887.
000
CONTACT: Office of Financing
202/376-4350
FOR IMMEDIATE RELEASE
April 23, 1990
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $8,231 million of 13-week bills and for $8,216 million
of 26-week bills, both to be issued on April 26, 1990,
were accepted today.
RANGE OF ACCEPTED
COMPETITIVE BIDS:
Low
High
Average
13-week bills
maturing Jul'y 26 1 1990
Discount Investment
Rate
Rate 11
Price
7.75%
7.78%
7.78%
8.01%
8.05%
8.05%
26-week bills
maturing October 25 2 1990
Discount Investment
Price
Rate
Rate 1/
7.88%
7.92%
7.91%
98.041
98.033
98.033
8.32%
8.36%
8.35%
96.016
95.996
96.001
Tenders at the high discount rate for the 13-week bills were allotted 97%.
Tenders at the high discount rate for the 26-week bills were allotted 53%.
TENDERS RECEIVED AND ACCEPTED
<In Thousands)
Received
Received
AcceEted
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
TOTALS
~
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
11
$
35,865
20,067,640
28,135
41,735
35,735
28,410
1,707,415
34,570
6,680
34,150
31,080
737,255
696,380
35,865
6,842,015
28,135
41,735
35,735
28,410
372,790
14,570
6,680
34,150
21,080
73,105
696,380
: $
43,065
16,820,930
18,905
53,095
42,315
26,465
1,613,330
28,245
5,980
41,040
36,635
598,970
554,695
$
43,065
6,930,910
18,905
53,095
42,315
26,465
346,030
20,245
5,980
41,040
29,285
104,420
554,695
$23,485,050
$8,230,650
$19,883,670
$8,216,450
$20,089,020
1,499,370
$21,588,390
$4,834,620
1,499,370
$6,333,990
$16,108,810
1,277,860
$17,386,670
$4,441,590
1,277,860
$5,719,450
1,789,760
1,789,760
1,600,000
1,600,000
106,900
106,900
897,000
897,000
$23,485,050
$8,230,650
$19,883,670
$8,216,450
Equivalent coupon-issue yield.
NB-773
$
AcceEted
~
'Q"
0
S
DEPT. OF THE Tf,;:ASCP,Y
FOR IMMEDIATE RELEASE
April 23, 1990
FEDERAL FINANCING BANK ACTIVITY
Charles D. Haworth, Secretary, Federal Financing Bank
(FFB), announced the following activity for the month of
March 1990.
FFB holdings of obligations issued, sold or guaranteed
by other Federal agencies totaled $135.4 billion on
March 31, 1990, posting an increase of $1.9 billion from
the level on February 28, 1990. This net change was the
result of decreases in holdings of agency assets of
$41.4 million and in holdings of agency-guaranteed debt
of $90.3 million, while holdings of agency debt increased
by $2,013.2 million. FFB made 22 disbursements during
March.
On March 19, the Resolution Trust Corporation began
. borrowing from the FFB under a Commitment Agreement dated
February 23, 1990.
On March 31, the Tennessee Valley Authority redeemed
$500 million principal amount of 12.955 percent Power
Bonds, 1980 Series B.
Attached to this release are tables presenting FFB
March loan activity and FFB holdings as of March 31, 1990.
NB-774
N
<!l
<!l
LO
fI)
fI)
..
CD
co
<!l
'Q"
~
<!l
<!l
LO
CD
lL.
a. u.
Page 2 of 4
MMCH 1990 N::ITVrIY
~
Dt\TE
AK:l.JNI'
FINAL
rnl'J!lW)~
OF~
MA!URI"lY
RATE
(semiaraual)
l!GpCX
INl'ERtSl'
RATE
(other thal1
semi -anruaJ.
rrnr
EXR:Rl'-IMRRl BANK
Hots 183
Hate .84
Nota .85
89,000,000.00
14,000,000.00
517,000,000.00
3/3/97
3/1/04
9/4/90
8.576\
8.644\
8.270\
30,000,000.00
4/4/90
8.161\
1,500,000,000.00
150,000,000.00
200,000,000.00
210,000,000.00
100,000,000.00
396,000,000.00
4/2/90
4/2/90
4/2/90
4/2/90
4/2/90
8.312%
8.296%
8.270\
8.298\
8.245%
8.222\
450,000,000.00
370,000,000.00
3/1/05
10/1/91
8.646t
8.439\
3/31
64 , 000 , 000. 00
3/31/15
8.758%
3/6
3/6
3/12
3/28
256,708.43
6,500.00
38,545.00
2,998.28
3/12/91
3/12/14
5/31/95
7/25/90
8.418%
8.785%
8.801\
8.348%
3/1
3/1
3/1
tM'ICtW.
$
8.486% qtr.
8.831% ann.
s;:ml)I'I UNICN A01INISIF1@CN
Facilill'
+Note .516
3/1
BES:2WITCti 'I&lSI
Note
CIJRR.:FATI~
H2. 90=01
11
1dvanc:e
Advance
Advan.:a
1dvance
Advance
3/19
3/23
3/26
3/28
3/29
3/30
'2
f)
f4
'5
Idvan::a '6
4/2/90
J!GnC'f ASSE'IS
f"la1:ER' s H:'HE btMINIS1FATIOO
RHIF RHIF -
ceo
ceo
.57535
.57536
3/1
3/1
RJP,AL n rrmmCAnCN AtMINISIRATICN
certificates or Beneficial o.mershi.p
CBO 131
CjQ"v'DHID!I - Q..W3ANl'EED IJ:lANS
rEPARIMENr Qf [Ef'UlSE
foreign P1ilitar( Sales
fhiliR>ines 11
'l\lr1<:ey 18
l'bt cx::co 13
Kenya U
... rollover
8.833\
8.617%
ann.
ann.
Page 3
!WO{
1990 ACrIVrIY
AMDn'
OF M:J.lMICE
~
of 4
FINAL
~
IN1'ERESI'
MMURIT'i
RATE
RATE
(sani-
(other than
annual)
sani-anrrual)
3/31/92
12/31/24
3/31/92
12/31/18
8.551%
8.760%
8.832%
8.629%
8.462%
8.666%
8.737%
8.538%
6/29/90
8.24n
RJRAL EllX:.'I'RITICATICN ArH!NtSTAATICN
~tive
Power Asso:;. #1561\
Tele. Util. of E. 0t'eCp1 #256
Old D:minion Electric #267
*Wabash Valley Pcwe.r #206
~
SeYer!
$
2,396,000.00
1,196,000.00
1,204,000.00
837,000.00
VAT Try WIHJRIT'{
states Energy
Nota 1.-90-7
em tur 1ty
3/1
3/12
3/16
3/21
extens ioo
COIl2Q~t1QD
3/30
528,768,794.09
qtr.
qtr.
qtr.
qtr.
Page 4 of 4
Program
Agency Debt:
Export-Import Bank
NCUA-Central Liquidity Facility
Resolution Trust Corporation
Tennessee valley Authority
U.S. Postal Service
sub-total·
Agency Assets:
Farmers Home Administration
DHHS-Health Maintenance Org.
DHHS-Medical Facilities
Rural Electrification Admin.-CBO
Small Business Administration
sub-total·
Government-Guaranteed Lending:
DOD-Foreign Military Sales
DEd.-Student Loan Marketing Assn.
DHUD-Coamunity Dev. Block Grant
DHUD-Public Housing Notes +
General Services Administration +
DOI-Gua. Power Authority
DOI-Virqin Islands
NASA-Space Communications Co. +
DON-Sh1p Lease Financing
Rural Electrification Administration
SBA-Small Business Investment Cos.
SSA-State/Local Development Cos.
TVA-Seven states Energy Corp.
DOT-Section 511
DOT-WMATA
sub-total *
grand total.
*flguresmay not total due torounaung
+does not include capitalized interest
March 31. 1990
$
11,010.5
82.4
2,556.0
15,325.0
6,195.0
FEDERAL FINANCING BANK HOLDINGS
(in millions)
Net Chanqe
February 2B. 1990
3Z1Z90~lJl/90
$
$
10,978.6
105.1
0.0
15,877.0
6,195.0
FY '90 Net Change
1071789-3/31/90
$
31.9
-22.7
2,556.0
-552.0
-0-
26.9
-29.0
2,556.0
-2,142.0
-0-
---------
---------
--------
33,155.7
2,013.2
411.9
52,726.0
74.7
93.0
4/135.2
10.0
--------57,038.9
52,831.0
74.7
93.0
4,071.2
10.3
--------57,080.2
-105.0
-0-064.0
-0.4
--------41.4
-5B5.0
9,958.3
4,880.0
261. 8
1,950.8
372.9
]0.]
25.4
1,095.9
1,672.4
19,221.0
489.5
773.3
2,307.7
24.1
177 .0
10,044.0
4,880.0
264.1
1,950.8
372 .9
31. 0
25.4
1,095.9
1,672.4
19,218.6
500.3
778.1
2,296.1
24.2
177.0
-85.7
35,168.9
4.9
-47.5
-1. 6
-629.2
-230.3
-30.0
-21. 6
-44.5
-5.1
-0.6
-0.5
100.7
-48.2
-53.9
-65.8
-26.1
-0-
-2.3
-0-0-0.6
-0-0-02.4
-10.8
-4.8
11. 6
-0.1
-0-
---------
---------
--------
==========
==========
$ 135,448.3
$ 133,566.7
=========
43,240.5
-0-
43,330.8
12.8
-1).2
-0-
-90.3
$
1,881.6
-426.2
==========
$
-643.6
DEPT. or:
Tfi~ TREASl;;~Y
For Release Upon Delivery
Expected at 10:30 a.m., E.D.T.
April 24, 1990
STATEMENT OP KENNETH W. GIDEON
ASSISTANT SECRETARY (TAX POLICY)
DEPARTKENT OP THE TREASURY
BEPORE THE
COMMITTEE ON WAYS AND KEANS
UNITED STATES HOUSE OP REPRESENTATIVES
Mr. Chairman and Members of the Committee:
I am pleased to have this opportunity to present the views
of the Administration on proposals to repeal and to replace
section 2036(c), relating to "estate freeze" transactions. In
particular, we commend the Committee for circulating the
discussion draft of March 22 so that testimony today could
focus on specific legislative language.
BACKGROUND
"Estate freezes" may be structured in many ways but all
have as their common objective limiting or reducing the value
of an interest in a business or other property includible in a
transferor's estate. Typically, this is accomplished by having
an older-generation transferor retain a non-appreciating
interest in a business (~, prefe..rred stock or a promissory
note) while transferring the equity interest (which will
benefit from future appreciation) to a younger-generation
transferee. 1
The Treasury Department does not object to estate freezes
so long as the value of the business or other property for gift
tax purposes is properly measured. This is because the value
of the right to future appreciation will be taken into account
in setting the current value of the business or other property.
However, during the early 1980s, taxpayers made increasing use
of techniques that were designed to value the various interests
in a business in a way that effectively eliminated the transfer
Illustrations of a variety of freeze transactions
appear in the Appendix.
NB-775
-2-
tax on a significant portion of the fair market value as of the
transfer date.
These techniques usually involved retention by the
transferor of rights which the transferor had discretion to
exercise.
In fact, many of these rights were likely not to be
exercised at all in the family context since their exercise
would undermine the transfer tax benefits of the freeze
transaction, if not undo the freeze completely. However,
because fair market value must normaliy be determined for
transfer tax purposes according to what a willing buyer would
pay a willing seller, these rights were assigned value by
appraisers on the assumption that they would be exercised as if
held by an unrelated third party. This encouraged planners to
include as many of these rights as possible in the retained
interest in order to maximize the value of the retained
interest and minimize the value of the transferred interest.
This, in turn, minimized the gift tax consequences of the
transfer. Thus, virtually the entire value of the business
would be "soaked up" by the discretionary rights retained by
the transferor. For this reason, these features are often
referred to as "soak-up features."
One of the common ways in which this "soak up" was
accomplished was by structuring the right to receive income or
cash flow (e.g., dividends on preferred stock) so that value
could easily be passed to the younger generation. For example,
planners often structured corporate freezes so that the
dividend right on preferred stock was "noncumulative." This
means that if dividends were not paid in a particular year,
there would be no continuing obligation on the part of the
corporation to pay those dividends in'a later year. Because
the decision whether or not to pay dividends often remained in
the control of the older generation after the freeze, the
dividends frequently would not be paid'at all. These passed
dividends would not be included in the transferor's estate, but
would stay in the corporation, thereby increasing the value of
the common stock held by the younger generation, often without
payment of gift tax. Appraisals of the preferred stock for
gift tax purposes, however, generally assigned SUbstantial
value to the right to receive noncumulative dividends,
notwithstanding the likelihood of non-payment in a family
context.
The cumUlative effect of these valuation techniques was
the assignment of virtually the entire value of the business to
the retained interest for gift tax purposes, resulting in
significant understatement of the value of the transferred
interest. When the transferred interest was assigned to the
younger generation, little or no transfer tax would be due,
even though all future appreciation in the value of the
business would inure to the transferred interest. Soak-up
-3-
features retained by the transferor otten escaped transfer tax
because of lifetime events, expiration at death, or
inconsistent valuation for estate and gift tax purposes. The
Internal Revenue Service and the Treasury Department consider
such techniques to be abusive.
SECTION 2036(C)
In order to deal with these abuses, Congress enacted
section 2036(C) in 1987. 2 Under section 2036(c), the entire
value of an enterprise is included in a transferor's estate (or
treated as a deemed gift) if the transferor transfers a
disproportionately large share of the potential appreciation in
the enterprise while retaining an interest in the income of, or
rights in, the enterprise. By treating a freeze transaction as
a transfer with a retained interest, section 2036(c) therefore
reaches not only valuation abuses but also includes future
appreciation in the transferor's estate. Serious concerns have
been raised about the possible overbreadth of this result, as
well as about the uncertain operation of the section. 3
While sharing many of these concerns, the Treasury
Department is strongly of the view that the abuses which
Congress sought to remedy by enactment of section 2036(c) are
real and that simple repeal would invite the return of those
abuses. We therefore support repeal of section 2036(c) today
only if a replacement adequate to prevent valuation abuses is
substituted for the repealed provision.
DISCUSSION DRAFT
We believe the standard by which a replacement should be
judged is whether or not it eliminates the abuses described
. above while permitting flexibility in ~ntra-family transfers
consistent with this objective. Stated another way, does the
discussion draft (or any other proposed replacement for section
2
section 2036(C) was enacted as part of the Omnibus
Budget Reconciliation Act of 1987 (P.L. 100-203), and was
amended in the Technical and Miscellaneous Revenue Act of 1988
(P.L. 100-647).
3
The Internal Revenue Service issued Notice 89-99 to
provide guidance as to how the Service would interpret section
2036(C). This notice has allayed some of the concerns about
how the section will be administered. However, the notice does
not address all the underlying concerns about the potential
scope of the section, which can be addressed only through
legislation.
-4-
2036(C»
result in the various interests being valued
appropriately on the date of the freeze transaction, and does
it assure that the subsequent behavior of the various parties
will not cause that value, once determined, to be undermined?
Judged by that standard, we believe that the discussion draft
circulated by the Committee prior to this hearing offers a
constructive and workable approach for such a replacement. 4
The basic mechanism of the draft is straightforward.
In
valuing a transfer of rights in a business among family
members, generally only rights retained by the transferor which
are "qualified fixed payment rights" (nQFP") will be valued.
Discretionary rights such as put or call options or
noncumUlative preferred dividends generally will be
disregarded, because such "soak-up features" have so frequently
been used in cases of valuation abuse~
QFPs are essentially rights to receive payments in
specified amounts at specified times. s Qualified fixed payment
rights are assumed to be paid on schedule for valuation
purposes.
If they are not, the transferor is considered to
have made a "deemed gift" in the amount of the missed payment.
Finally, a minimum valuation rule ensures that the
appreciating equity interest (such as the common stock or a
non-preferred partnership interest) cannot be valued at less
than 20 percent of the total equity in the business, which for
this purpose includes debt owed to the transferor.
Thus, the discussion draft attempts to deal with the
abuses which existed prior to enactment of section 2036(c) in
the following ways:
4
Congress could also require inclusion of gift tax
paid in the transfer tax base (as is already the case for
estate tax purposes), thereby eliminating a SUbstantial
advantage of inter vivos transfers over testamentary transfers.
This WOUld, in turn, eliminate a significant incentive for
freeze transactions.
5
Generally, the valuation of the right to receive
QFPs, such as guaranteed payments from a partnership, will be
made using the standard technique of discounting the payment or
payment stream to present value, using the market rate of
interest or return appropriate for the particular business.
Transferors would be free to set the interest or dividend rate
at whatever rate they choose, including variable interest
rates, recognizing that if the rate selected is below the
market rate for that business, the value of the QFP right will
necessarily be lower as a result.
-5-
o
Discretionary rights (i.e., soak-up features)
generally are not given value in intra-family
transfers.
o
Rights to receive QFPs, such as fixed principal and
interest payments on a note, are given value based on
the assumption that they will be paid. However, if
they are not paid, a deemed gift will result.
o
The minimum value rule prevents taxpayers from
undervaluing the transferred interest, thus ensuring
that the right to future appreciation is
appropriately taken into account.
In addition, the discussion draft contains certain other
rules intended to prevent these basic rules from operating
inappropriately:
o
Explicit rules are included to prevent the same value
from being taxed twice for estate and gift tax
purposes.
o
Transferors may elect to apply the QFP rule to
transactions which would not otherwise qualify (such
as noncumulative preferred stock or real estate
partnerships in which payments are dependent on
income or cash flow) to provide flexibility in
structuring transactions.
o
The deemed gift rule provides a three-year grace
period for corporations and partnerships so that the
failure to make QFPs due to temporary cash flow
difficulties will not trigger a gift.
o
No deemed gift will occur in any event if the QFP
right provides for compound interest and the fully
compounded amount is accounted for when the retained
interest is transferred.
o
Special rules are provided to mitigate the deemed
gift rule if a corporation or partnership that fails
to make QFPs is insolvent or bankrupt.
o
The draft does not change the treatment of minority
discounts; voting rights will continue to be valued
as under current law.
o
The discussion draft would not apply to transfers of
the same class of stock which the transferor retains,
nor would it apply to transfers of interests none of
the rights of which are junior to the retained
interest.
-6o
Explicit exemptions are provided for personal
residences.
The discussion draft also addresses three related
problems: trusts in which the transferor has retained an
interest, joint purchase transactions in which the transferor
purchases a life or term interest while a family member
purchases a remainder interest, and buy-sell agreements.
The primary focus of the trust rule is the grantorretained income trust ("GRIT"). A GRIT is a trust in which the
transferor has retained an income interest for a term of years,
while transferring the remainder interest to another person
(usually a family member). The various interests in a GRIT are
valued according to tables published by the Internal Revenue
Service which assume a rate of return specified by statute. 6
Frequently, however, the property placed in a GRIT either does
not generate any income or does not generate income equal to
the rate of return assumed in these tables. This means that
the interest transferred to the younger generation remainderman
will have been undervalued, which in turn means that the gift
tax paid will have been too low.
Consistent with the approach for corporations and
partnerships, the only interest in such a trust that is
assigned value for gift tax purposes is a QFP.
In the trust
context, a QFP is generally7 defined as the right to receive a
fixed annual payment or an annual payment based on the value of
the assets in the trust (determined annually).8 If the trust
fails to payout the required amount, the transferor is treated
as having made a deemed gift (just as the failure by a
corporation or partnership to make a QFP is treated as a deemed
gift) .
The discussion draft also applies to certain joint
purchases of property. A joint purchase can be structured to
work the same way as a GRIT. Joint purchases subject to the
rule are purchases of a life or term interest by one family
member and the purchase of the remainder interest by another.
The discussion draft therefore does not apply where the family
6
See IRC section 7520.
7
QFPs for trusts also include non-contingent
remainders if all other interests in the trust are QFPs.
8
These trust rules are derived from the rules
governing charitable remainder trusts, which were enacted to
address similar problems of incorrect valuation of the various
interests in such trusts. See IRC Section 664.
-7-
members purchase property either as tenants in common or as
joint tenants with right of survivorship.
The discussion draft generally treats these joint
purchases in the same way it treats GRITs. Thus, only rights
to receive QFPs are valued, and failure to make the required
payments results in a deemed gift.
The draft also contains a provision concerning buy-sell
agreements. Although buy-sell agreements are widely used in
closely held businesses and often hav~ legitimate non-tax
purposes, they also have potential for suppressing the value of
a business interest for transfer tax purposes. The discussion
draft requires that, in order for buy-sell arrangements to be
taken into account in determining the value of the business
interest for estate or gift tax purposes, the buy-sell
arrangement must meet certain conditions. These conditions
include: (1) the business interest must actually be sold
pursuant to the buy-sell arrangement; (2) the purchase price
must have been determined pursuant to a formula which was
reviewed within three years prior to sale: (3) at the time of
review, the formula must have been reasonably expected to
produce a price which would approximate the fair market value
as of the time of sale; (4) the property does not have a
readily ascertainable fair market value: and (5) the property
is not resold to an unrelated party within 6 months of the
transfer or the decedent's death.
COMMENTS ON THE DISCUSSION DRAFT
We commend the committee for the substance of the
discussion draft. We also commend this process of offering
draft statutory language as a focus for public comment. We at
the Treasury have benefitted substantially from the opportunity
to discuss the draft with interested members of the public, and
we have received many constructive comments for improvement of
the draft.
We are prepared to support proposed modifications that
improve the draft in terms of taxpayer flexibility, simplicity
of administration and compliance, and that enhance the overall
workability of the statutory framework. We will oppose,
however, changes which would effectively undermine the premise
of the discussion draft -- proper valuation. We believe that
the discussion draft, by attempting to obtain the appropriate
valuation of the various interests at the time of transfer,
offers the best approach to this problem.
without attempting to offer a complete list at this time,
we believe the following modifications of the discussion draft
would be appropriate:
-8-
o
Allowing transferors to elect to treat percentage
leases and share-of-production royalty interests as
QFPs;
o
clarifying application of the rules to trusts by
separating such rules from the basic rules applicable
to corporations and partnerships; and
o
Clarifying the application of the rules in the case
of generation-skipping transfers.
We are also considering other modifications and we hope to
learn more from the testimony to be offered here today.
REVENUE CONSIDERATIONS
The Treasury's Office of Tax Analysis ("OTA") estimates
that repeal of section 2036(c) would reduce revenues during the
period 1991-95 by $1.021 billion.
(See the attached Table).
The revenue loss from repeal of section 2036(c) arises
because the provision effectively prevents taxpayers from
engaging in freeze transactions. Therefore, interests which
otherwise would have been subject to freeze transactions will
be retained and continue to appreciate in value in the hands of
the older generation. As members of the older generation die
holding such appreciated interests, their gross estates will be
correspondingly larger, thereby increasing revenues.
If
section 2036(c) were simply repealed, freezes would resume
(including abusive freezes which eliminate current value from
the transfer tax base), and the appreciation that would
otherwise be includible in the estates of the older generation
will not be subject to tax.
OTA also estimates that, if the discussion draft in its
current form were enacted to replace section 2036(c), revenues
during the period 1991-95 would be reduced by $50 million from
current law.
(See the attached Table).
CONCLUSION
The Treasury Department looks forward to working with the
Congress and interested members of the public to develop a fair
and workable replacement for section 2036(c). To retain our
support, any proposal must prevent abusive valuations in estate
freeze transactions. We are encouraged by the progress made to
date.
APPENDIX
Illustrations of Common Freeze Techniques
corporate Recapitalization.
In this transaction, the older
generation, owning all or a significant portion of the common
stock, recapitalizes the corporation, exchanging its common
stock for both preferred and common stock. The preferred stock
is structured with non-cumulative dividends and with
discretionary features, such as puts, conversion features,
rights to compel liquidation, etc .• The preferred stock is
typically valued assuming these right~ will be exercised in an
arms-length manner, including the assumption that dividends
will be paid, even though in the family context it is often
unlikely that such rights will ever be exercised. This results
in the value of the common stock being understated. The common
stock is then transferred to the younger generation subject to
little, if any, gift tax. The older generation retains the
preferred stock. All subsequent appreciation in the value of
the business inures to the common stock, effectively freezing
the value of the business in the older generation's estate.
partnership Freeze.
The partnership freeze resembles the
corporate freeze, and can be accomplished either by forming a
new partnership or by restructuring an existing one. In the
typical freeze, the older generation receives a limited
partnership interest, which provides for a preferred return on
the partner's undistributed capital (analogous to dividends on
preferred stock). As with preferred stock, discretionary
features are added to the limited partner's interest in order
to maximize its value and minimize the value of the general
partnership interest, which is then transferred to the younger
generation subject to little, if any, gift tax. These
discretionary features are not likely to be exercised by the
older generation, but nevertheless generally are valued as if
they were. Because the limited partnership interest does not
appreciate, it has effectively been frozen for estate tax
purposes, and all future appreciation would inure to the
younger generation.
Grantor Retained Income Trust (IIGRITII).
A GRIT is a trust in
which the grantor has retained an interest for a term of years.
On expiration of the term, the property passes to the
remainderman (typically a younger generation family member) .
The grantor will typically retain a reversionary interest or
general power of appointment which becomes effective if the
grantor dies during the term. The value of the retained
interest is determined according to tables provided by the IRS
which assume a rate of return equal to 120% of the applicable
federal rate. This typically results in a very small value
being assigned to the transferred interest (and thus a very
small gift tax). Frequently, the property placed in the GRIT
is of the type that produces little or no income but will
appreciate in value (such as growth stock). Since the income
from the trust is less than the rate of return assumed in the
valuation tables, the grantor's retained interest will have
been overvalued and the transferred interest will have been
undervalued. Since no further tax is due when the term
expires, this means that a portion of the initial value will
have been transferred to the younger generation without gift
tax.
Joint PUrchases.
A joint purchase can be structured to work
the same way as a GRIT. However, instead of transferring
property that the older generation already owns, the older
generation will purchase a term interest in property while the
younger generation purchases the remainder interest in the same
property. The property is often the type that pays little if
any income, but which instead appreciates in value. The values
of the respective interests are determined according to the
same valuation tables used in the case of GRITs. Thus, in such
circumstances the interest of the older generation will be
overvalued while that of the younger generation will be
undervalued. When the term expires the property passes to the
younger generation without transfer tax.
Buy-sell Aqreements.
A buy-sell agreement is an agreement
among shareholders or partners (or between such individuals and
the corporation or partnership). The agreement generally
provides for the purchase of the person's stock or partnership
interest on the occurrence of some event, such as death. These
agreements often have legitimate non-tax purposes. They
typically work by fixing the price at which the person's
interest will be purchased, either at a set price or according
to a formula. However, this price is sometimes set far below
what a willing buyer would pay for the interest absent the buysell agreement. In some instances, courts have permitted these
agreements to set value, notwithstanding Treasury regulations
which provide that such agreements will not be taken into
account if the agreement is being used-as a testamentary device
to suppress estate tax values.
selt-cancelinq xnstallment Note.
A common use of this device
involves an older generation which owns all the common stock of
a corporation. The older generation gives a small portion of
the common stock to the younger generation, and then causes the
corporation to redeem its remaining common stock for an
installment note. This would freeze the value of the business
in the hands of the older generation. The installment note
could provide that any payments due after the death of the
older generation are cancelled. If the note had not been fully
paid by the death of the older generation, a portion of the
corporation's value would have passed to the younger generation
free of tax. A similar result could be achieved by use of a
private annuity which expired at death.
Table I
Estimates Related to Estate Freezes
Item
1990-1995
Repeal Section 2036(c)
o
-3
-58
-176
-314
-470
-1021
Discussion Draft Proposal
o
75
123
14
-83
-179
-50
Department of the Treasury
Office of Tax Analysis
April 23. 1990
DEPT. OF THE
FOR RELEASE AT 4:00 P.M.
April 24, 1990
Tr~ci~:JUrd
CONTACT: Office of Financing
202/376-4350
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice, invites
tenders for two series of Treasury bills totaling approximately
S16,800 million, to be issued May 3, 1990.
This offering
will provide about S1,275 million of new cash for the Treasury, as
the maturing bills are outstanding in the amount of SIS,s17 million.
Tenders will be received at Federal Reserve Banks and Branches and at
. the Bureau of the Public Debt, Washington, D. C. 20239, prior to 1:00
p.m., Eastern Daylight Saving time, Monday, April 30, 1990.
The two series offered are as follows:
91-day bills (to maturity date) for approximately S8,400
million, representing an additional amount of bills dated
August 3, 1989,
and to mature August 2, 1990
(CUSIP No.
912794 UN 2), currently outstanding in the amount of $16,682 million,
the additional and original bills to be freely interchangeable.
182-day bills for approximately S8,400 million, to be dated
May 3, 1990,
and to mature November 1, 1990 (CUSIP No.
912794 VG 6).
The bills will be issued on a discount basis under competitive
and noncompetitive bidding, and at maturity their par amount will
be payable without interest. Both series of bills will be issued
entirely in book-entry form in a minimum amount of SlO,OOO and in
any higher S5,000 multiple, on the records either of the Federal
Reserve Banks and Branches, or of the Department of the Treasury.
The bills will be issued for cash and in exchange for Treasury
bills maturing May 3, 1990.
Tenders from Federal Reserve
Banks for their own account and as agents for foreign and international monetary authorities will be accepted at the weighted
average bank discount rates of accepted competitive tenders. Additional amounts of the bills may be issued to Federal Reserve Banks,
as agents for foreign and international monetary authorities, to
the extent that the aggregate amount of tenders for such accounts
exceeds the aggregate amount of maturing bills held by them. Federal
Reserve Banks currently hold S1,617 ~illion as agents for foreign
and international monetary authorities, and $2,735 million for their
own account. Tenders for bills to be maintained on the book-entry
records of the Department of the Treasury should be submitted on Form
PD 5176-1 (for 13-week series) or Form PD 5176-2 (for 26-week series).
NB-776
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 2
Each tender must state the par amount of bills bid for,
which must be a minimum of $10,000. Tenders over $10,000 must
be in multiples of $5,000. Competitive tenders must also show
the yield desired, expressed on a bank discount rate basis with
two decimals, e.g., 7.15%.
Fractions may not be used. A single
bidder, as defined in Treasury's single bidder guidelines, shall
not submit noncompetitive tenders totaling more than $1,000,000.
Banking institutions and dealers who make primary
markets in Government securities and report daily to the Federal
Reserve Bank of New York their positions in and borrowings on
such securities may submit tenders for account of customers, if
the names of the customers and the amount for each customer are
furnished.
Others are only permitted to submit tenders for their
own account.
Each tender must state the amount of any net long
position in the bills being offered if such position is in excess
of $200 million. This information should reflect positions held
as of one-half hour prior to the closing time for receipt of
tenders on the day of the auction. Such positions would include
bills acquired through "when issued" trading, and futures and
forward transactions as well as holdings of outstanding bills
with the same maturity date as the new offering, e.g., bills
with three months to maturity previously offered as six-month
bills. Dealers, who make primary markets in Government securities and report daily to the Federal Reserve Bank of New York
their positions in and borrowings on such securities, when submitting tenders for customers, must submit a separate tender for
each customer whose net long position in the bill being offered
exceeds $200 million.
A noncompetitive bidder may not have entered into an
agreement, nor make an agreement to purchase or sell or otherwise dispose of any noncompetitive awards of this issue being
auctioned prior to the designated closing time for receipt of
tenders.
Payment for the full par amount of the bills applied for
must accompany all tenders submitted for bills to be maintained
on the book-entry records of the Department of the Treasury.
A cash adjustment will be made on all accepted tenders for the
difference between the par payment submitted and the actual
issue price as determined in the auction.
No deposit need accompany tenders from incorporated banks
and trust companies and from responsible and recognized dealers
in investment securities for bills to be maintained on the bookentry records of Federal Reserve Banks and Branches.
8/89
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 3
Public announcement will be made by the Department of the
Treasury of the amount and yield range of accepted bids. Competitive bidders will be advised of the acceptance or rejection
of their tenders. The Secretary of the Treasury expressly
reserves the right to accept or reject any or all tenders, in
whole or in part, and the Secretary's action shall be final.
Subject to these reservations, noncompetitive tenders for each
issue for $1,000,000 or less without stated yield from anyone
bidder will be accepted in full at the weighted average bank
discount rate (in two decimals) of accepted competitive bids
for the respective issues. The calculation of purchase prices
for accepted bids will be carried to three decimal places on the
basis of price per hundred, e.g., 99.923, and the determinations
of the Secretary of the Treasury shall be final.
settlement for accepted tenders for bills to be maintained
on the book-entry records of Federal Reserve Banks and Branches
must be made or completed at the Federal Reserve Bank or Branch
on the issue date, in cash or other immediately-available funds
or in Treasury bills maturing on that date. Cash adjustments
will be made for differences between the par value of the
maturing bills accepted in exchange and the issue price of the
new bills.
If a bill is purchased at issue, and is held to maturity,
the amount of discount is reportable as ordinary income on the
Federal income tax return of the owner for the year in which
the bill matures. Accrual-basis taxpayers, banks, and other
persons designated in section 1281 of the Internal Revenue Code
must include in income the portion of the discount for the period
during the taxable year such holder held the bill. If the bill
is sold or otherwise disposed of before maturity, any gain in
excess of the basis is treated as ordinary income.
Department of the Treasury Circulars, Public Debt Series Nos. 26-76, 27-76, and 2-86, as applicable, Treasury's single
bidder guidelines, and this notice prescribe the terms of these
Treasury bills and govern the conditions of their issue. Copies
of the circulars, guidelines, and tender forms may be obtained
from any Federal Reserve Bank or Branch, or from the Bureau of
the Public Debt.
8/89
FOR RELEASE ON DELIVERY
EXPECTED AT 9:30 A.M.
April 25, 1990
DEPT. OF THE TkcAS":r,y
STATEMENT OF
MICHAEL E. BASHAM
DEPUTY ASSISTANT SECRETARY OF THE TREASURY
(FEDERAL FINANCE)
BEFORE THE HOUSE COMMITTEE ON WAYS AND MEANS
Mr. Chairman and Members of the Committee:
My purpose here today is to discuss H.R. 2972, the proposed
"Drug War Bond Act of 1989". This bill would require the
secretary of the Treasury to issue up to $4 billion of special
bonds in order to raise additional funds for certain Federal
anti-drug activities.
Let me first state that the Treasury Department is committed
to the Administration's efforts to win this drug war. We must do
all we can to promote elimination of this scourge from our
society.
Over the years, the Department has received a number of
proposals to establish new special purpose Treasury borrowing
programs. A few of the more popular requests for special
purpose borrowings have been to build battleships, to fund
various education and energy programs-, to support the
environment, to provide assistance to new democracies, and to
fund the space program. The Department has traditionally opposed
creation of all special purpose borrowing programs, and we feel
our opposition is based upon fundamentally sound budget and debt
management principles.
NB-777
o
As a general principle of effective budgetary control,
Federal receipts from borrowing should not be earmarked
for particular expenditure purposes; instead, these
funds should be available in the general fund for
appropriation by congress to finance current programs
and objectives.
o
with special purpose bond issuance, there is no
certainty that the amount of funds expected to be
raised for the designated purpose will in fact be
raised. This could result in substantial and
2
unintended variations in the amounts provided for the
designated special program. The amounts that would be
available for the program would be determined largely
by the amount of special bonds that are purchased,
which is independent of any analysis of program needs
and sound budget planning.
o
To the extent that buyers of existing Treasury issues
shift their purchases to the new special purpose bonds,
the program would not result in net new borrowings for
the Government.
Instead, amounts which otherwise would
have been available to the general fund to meet current
budget priorities would be earmarked for the designated
purpose.
o
Many special purpose borrowing requests have been
patterned after the savings bonds program.
Each new
special program of this nature would tend only to
confuse the public since the special purpose bonds
would be viewed as a competitor to savings bonds.
o
In addition, a special purpose borrowing done in the
same manner as savings bonds would most likely over
time not generate sUbstantial funds.
In recent years
after accounting for administrative expenses, and the
difference between redemptions and purchases, the
savings bonds program has not raised a significant
amount of new funds.
In fact, when the accrual of
interest is added, the program has resulted in a net
outflow of funds for budget purposes.
o
It is worth mentioning also that there are generally
higher initial and ongoing costs associated with
implementing a special borrowing program, which would
add to the budget deficit.
o
Most importantly, the enactment of even one special
purpose borrowing program would set an undesirable
precedent for financing other Federal programs via
similar special-purpose securities. This would only
compound the problems we described here today.
We at Treasury have had discussions with the sponsors of
H.R. 2972, and we understand that numerous changes will be made
to the bill as introduced which would address most, if not all,
of our specific concerns, including those relating to the budget
and appropriations process. Nevertheless, because of the
Department's longstanding opposition to all special borrowing
programs, the Treasury cannot support H.R. 2972.
3
The Committee should not interpret the Administration's
lack of support for this bill as an unwillingness to finance the
war on drugs or as an absence of commitment to the problem.
For Fiscal Year 1991, the Administration is seeking to expand
funding on drug reduction activities to over $10.6 billion -a 41 percent increase in actual spending in just one year. While
funding, as noted in the President's 1990 National Drug Control
strategy, is not considered the entire solution to the problem
significant increases in assistance have been requested.
The President's National Drug Control strategy includes a
role not only for the Federal Government, but for our State and
local governments, the private sector, and community leaders and
citizens alike, with significant opportunities for grass roots
participation.
This concludes my prepared statement.
answer any questions that you may have.
000
I will be happy to
TREASURY NEWS
D811artment of tile T.e.surv • W •• llln.t9~~8~O-Z If!''DIlOne 588-204'
Prepared For Delivery
Expected at Approx. 1:15 pm (Chicago) DEPT.CFTHETREASURY
REMARKS BY JOHN E. ROBSON
DEPUTY SECRETARY OF THE TREASURY
MID-AMERICA COMMITTEE LUNCHEON
CHICAGO. ILLINOIS
APRIL 25, 1990
Thank you, Barry [ Sullivan, Host of this Mid-America
Luncheon].
It's a pleasure to be back in Chicago and to meet
with the Mid-America Committee.
My topic is Eastern Europe and the historic potential it
presents to those who possess a commitment to political freedom
and an entrepreneurial spirit.
Many in this room already have
visited these newly emerging democracies, as I have.
You
probably also returned with strong impressions of a difficult and
fluid political and economic environment.
The legacy of over four decades of oppression and economic
mismanagement presents a daunting challenge to overcome:
a
deteriorated industrial base; the absence of basic business
skills and commercial institutions; massive debt; environmental
decay;
a tattered economic infrastructure; and,
often,
psychological uncertainty and aversion to risk-taking brought
about by lifetimes of dependence on state-provided and statesubsidized jobs, goods and services.
In large measure the communist governments in Eastern Europe
toppled because they had driven their economies to ruin. And it
is from these ruins that the fledgling and largely untested
democratic governments must guide difficult and uncertain
transitions to political stability and free-market economic
growth.
Nonetheless, as recent elections throughout the region
suggest, and as indicated by the patient reaction of the Poles to
the pain attending their country's bold economic reform, there
is, at the present time, a widespread willingness by these
peoples to confront the challenges and pay the price.
The observations of an anonymous Polish citizen are apt: "No
one has done this before," he said.
"It's messy.
But that's
what freedom is all about, and we may as well get on with it."
NB-778
2
The united states has a significant stake in the success of
these new democracies.
In the interest of European stability we
have in this century fought two world wars and conducted a
protracted cold war struggle to contain communist expansion. But
we cannot now become complacent and permit the reemergence of
communist totalitarianism or allow the region to again become a
tinder box of national rivalry and political instability.
The recognition of America's vital national interest in the
future of the region has led some to question whether we are
doing enough to protect that interest and others to demand a
1990's version of the Marshall Plan for Eastern Europe.
Pol i tically translated, "are you doing enough" means you aren't
spending enough money.
But I believe such criticism is both
inaccurate and reflects a misunderstanding of the nature of the
economic circumstances in Eastern Europe.
First, using the same accounting methods as our allies
employ to tote their assistance to Eastern Europe--that is
counting loans,
credits,
guarantees,
insurance,
and debt
rescheduling in addition to hard cash outlays -- u. S. overall
assistance is among the leaders.
Second, unlike the immediate post World War II situation,
assistance to Eastern Europe is a multilateral undertaking where
we
join powerful and prosperous allies who have equally
sUbstantial stakes in the political and economic stability of
the region.
And third, while Europe in 1947 was devastated, it possessed
the private sector skills and institutions, and the basic
infrastructure to absorb and prosper from massive economic
assistance.
Today, in addition to the need for fundamental
reform of macroeconomic policies, these skills, institutions and
infrastructure in Eastern Europe must be strengthened before
investment and financial aid can effectively take hold. Flooding
the region with money without linking it to structural reform and
technical competence will only retard change and dissipate our
assistance.
So my message is that the road ahead for these transitioning
economic democracies is hard but passable; that we fully
comprehend the importance of their success; and that the u.s. is
assisting in very material ways designed to respond to the
realities of the region and a demonstrated commitment to
political pluralism, meaningful economic reform and respect for
human rights.
The framework for U. s. assistance to the region embraces
several guiding philosophies and objectives which I shall take a
moment to elaborate upon.
3
Foremost, is the recognition that each country in the region
differs from its neighbors so that a "cookie cutter" approach
won't work.
Moreover, the velocity of change is such that we
need maximum flexibility in our ability to respond with custom
tailored assistance when and where needed. And we offer no grand
"Made in America" plan for the ultimate political or economic
profiles of these sovereign nations.
Nothing could be less
practical to achieve or more alien to the concepts of political
pluralism and free-market economics.
We are, first, prepared to offer short term emergency
humanitarian aid to help meet the most pressing shortages of
food, medicine and other necessities.
Next, we are emphasizing technical assistance that will help
build the essential political and economic infrastructure:
assistance to form political parties, hold elections, run
legislatures; establish independent judiciaries; create a free
press; run free trade unions; develop a banking system and
financial
institutions;
create capital markets and the
accompanying regulatory framework; facilitate the privatization
of state-owned enterprises; and foster the broad acquisition of
basic business and financial skills.
Soon, for example, a Treasury-led financial assistance
mission with representation from key U. S. agencies will visit
Poland and other countries in the region to determine precise
needs and develop a delivery plan that will draw substantially on
American private sector expertise.
And in response to an urgent request from Polish Deputy
Prime Minister Balcerowicz, Treasury has arranged to provide ten
two-man management consultant teams to assist Poland in assessing
existing enterprises in key industries for possible restructuring
and early privatization.
They will review production, personnel
management, marketing, and financial management practices. Each
team will have a Polish member to afford an opportunity for
training.
We are drawing the men and women for these consultant teams
from the roster of experienced volunteers who have registered
with the International Executive service Corps. We hope to have
these consultants working in Poland within a few weeks.
4
Over the longer term we will provide transitional economic
assistance to countries prepared to take the strong medicine
associated with conversion from command economies to free market
systems.
This process has already begun in the provision of a
substantial u.s.
contribution to support Poland's currency
convertibility and in the establishment of Enterprise Funds for
Poland and Hungary which will seed entrepreneurial activity.
In legislation now before Congress, we have asked for
expansion of these private sector growth vehicles to all of
Eastern Europe.
We are moving as well to help with the debt
burdens of these countries.
Poland has just received the most
generous terms ever offered for rescheduling its official debt by
the Paris
Club,
and the u.s.
is assisting in Poland's
negotiations on its debt to commercial banks.
Our strategy also contemplates a vi tal role for the World
Bank, the International Monetary Fund and similar institutions.
These bodies are equipped to support economic transitions in
ways that neither governments nor the private sector can--through
structural adjustment financing of social safety nets to help
absorb the dislocations of price deregulation and the dismantling
of state-owned enterprises, and investment in traditionally
public infrastructure such as roads. The newly emerging European
Bank for Reconstruction and Development will add to the
transitional support arsenal.
Underpinning our entire assistance philosophy is the
conviction that the success of these economic transformations
will depend primarily not on the response of government, but of
the private sector and the attraction of investment.
To that
end, programs that encourage and facilitate private investment,
such as the Export-Import Bank and OPIC, are important elements
of our Eastern European strategy.
We have also pointed out to Eastern European leaders and
aspiring entrepreneurs that their laws,
regulations,
and
commercial practices must offer a hospitable environment for
investment and that, in the competition for outside investment,
capital will flow to the places with the most attractive
investment climate.
We have buttressed this with active
negotiations to conclude bilateral trade, investment and tax
arrangements so that U.s. investors may have confidence and
equitable treatment regarding pre-investment approvals,
repatriation of profits, protection of intellectual property,
access to the financial system, tariffs, taxes, and resolution of
disputes.
5
When Poland's Prime Minister was here last month, we signed
a business and economic relations agreement that covers many of
these areas.
And we have just signed a trade agreement with
Czechoslovakia.
These are the governing precepts of the U. S • approach to
fostering democratic capitalism in Eastern European countries.
As one of three coordinators President Bush has appointed to
assist in the process, I might observe that it is not one that
could be described as tidy.
But this should be expected in an
activity that seeks to usefully funnel public resources into
widely disparate and rapidly changing situations, and at the
same time enlist the powerful alliance of our private sector.
But there are encouraging signs.
In Poland the zloty has
remained stable, inflation has significantly declined after an
initial bulge following price deregulation in January.
On the
other hand,
real wages and production have substantially
declined.
Yet the vast majority of Poles stand behind the
economic reform program which one senior official described to me
as "surgery without anesthetics."
In Hungary, private investment has been flowing from major
U. S. corporations.
Other countries are in earlier phases of
economic reform. While it is too soon to make any reliable longterm judgments, there are reasons for optimism.
What should private business do?
there and take a close look.
My advice is to get over
You will see the deficiencies,
the risks and the
uncertainties that I have described.
You will see that some of
these new governments, unsteady on their political feet, may deal
cautiously with economic reform.
You will worry that the
economic situation in the Soviet Union poses a special problem
for the COMECON countries which are still heavily dependent on
the U.S.S.R. for trade and industrial input.
And you will find
that the legal and institutional framework will test your
creativity.
But you will also find a tremendous enthusiasm and eagerness
for American investment and economic presence.
They are very
conscious of our unflagging commitment to political and economic
freedom and they want us there. You will be impressed, I think,
with their determination to create market economies coupled with
a will to act.
And you will find low-wage, relatively well
educated workers, plenty of underutilized industrial capacity I
and good geographic locations to compete in the markets of
Europe.
6
And you will also find hundreds of Germans, French, British,
Swiss, Japanese and other businessmen and women scrambling to get
their firms established.
While I do not subscribe to the idea
that Eastern Europe markets will inevitably be "locked up" by
Western Europe, if American business waits on the sidelines until
the situation looks stable and tidy, it will be too late.
These will not be ventures where you can expect to make a
quick buck.
You will have to take a long view.
But I believe
the potential for profitable investment is there.
And while you will have to decide for yourselves, you cannot
make an informed decision sitting in your offices in Chicago.
Think about it.
Thank you.
TREASURY NEWS
••lIartment of til. T"'Surr • wa.hlngton, D.C.• T.Ie.llone •••. 20.1
FOR IMMEDIATE RELEASE
April 25, 1990
CONTACT:
Office of Financing
202/376-4350
RESULTS OF AUCTION OF 2-YEAR NOTES
The Department of the Treasury has accepted $10,503 million
of $26,124 million of tenders received from the public for the
2-year notes, Series Y-1992, auctioned today. The notes will be
issued April 30, 1990, and mature April 30, 1992.
The interest rate on the notes will be 8-7/8%. The range
of accepted competitive bids, and the corresponding prices at the
8-7/8% rate are as follows:
yield
Price
Low
8 . 88 %*
99 . 991
High
8.91%
99.937
Average
8.90%
99.955
*Excepting $235,000 at lower yields.
Tenders at the high yield were allotted 71%.
TENDERS RECEIVED AND ACCEPTED (In Thousands)
Accepted
Received
Location
$
81,320
S
81,320
Boston
8,525,120
22,752,360
New York
54,910
54,910
Philadelphia
87,045
87,045
Cleveland
163,575
169,955
Richmond
68,145
69,440
Atlanta
535,490
1,498,390
Chicago
95,760
111,050
st. Louis
45,065
45,065
Minneapolis
176,715
182,295
Kansas City
47,060
52,060
Dallas
420,545
818,035
San Francisco
201,845
201,845
Treasury
$10,502,595
$26,123,770
Totals
The $10,503 million of accepted tenders includes $1,906
million of noncompetitive tenders and $8,597 million of competitive tenders from the public.
In addition to the $10,503 million of tenders accepted in
the auction process, $757 million of tenders was awarded ~t the
average price to Federal Reserve Banks as agents for ,fore~gn and
international monetary authorities. An additional $1,434 million
of tenders was also accepted at the average price from Federal
Reserve Banks for their own account in exchange for maturing
securities.
NB-779
TREASURY NEWS
••.,artment of the TNa.ury • wa.lllniton, D.C. • TeleDlione 1"-20. t
April 25, 1990
DAVID C. MULFORD
Under Secretary for International Affairs
U.S. Department of the Treasury
DAVID C. MULFORD was sworn in as Under Secretary (International
Affairs) of the Treasury on May 23, 1989.
Since 1984, Dr. Mulford has been an Assistant Secretary
(International Affairs) of the Treasury. As Under Secretary for
International Affairs, he will continue in his lead role for
international economic policy formulation and implementation. In
particular, he will be responsible for exchange market policies
and will remain the U.S. G-7 Deputy with responsibility for
coordinating economic policies with other industrial nations. In
addition, he will maintain his key concentration on the
international debt strategy and will continue to focus on economic
relations with the newly industrializing economies, trade and
investment matters and preparations for the annual Economic Summit.
Prior to serving at Treasury, Dr. Mulford spent 20 years in the
international investment banking business. He served as Senior
Advisor at the Saudi Arabian Monetary Agency in Riyadh, Saudi
Arabia, as well as a Director of Merrill Lynch, Pierce, Fenner'
Smith (1974-1984); and Director of White, Weld, , Co., Inc.
(1966-1974). Dr. Mulford was a White House Fellow during 1965-66
and served as special Assistant to the Secretary of the Treasury.
Dr. Mulford earned his doctorate from Oxford University in 1965
and his Master's degree from Boston University in 1962,
specializing in African Studies, and also attended the University
of Cape Town. He graduated from Lawrence University with a B.A.
(Cum Laude) in Economics in 1959. During his academic career,
Dr. Mulford held several fellowships and wrote two books, both
published by Oxford University Press.
He received an Honorary
Doctor of Laws Degree from Lawrence University in June, 1984. In
April, 1990, Dr. Mulford was awarded the Legion d'Honneur by the
President of France.
He was born and raised in Rockford, Illinois. He is married,
has two children, and resides in Alexandria, Virginia.
NB-780
TREASURY NEWS
....artm.nt of til. TN.SUPJ • Wasilington, D.C•• T.Ie.."one .88.20.'
EMBARGOED FOR RELEASE UNTIL DELIVERY
EXPECTED AT 10:00 A.M. EDT
TESTIMONY OF PHILIP D. MORRISON
INTERNATIONAL TAX COUNSEL
DEPARTMENT OF THE TREASURY
BEFORE THE
COMMITTEE ON FINANCE
UNITED STATES SENATE
WASHINGTON, D.C.
APRIL 26, 1'990
Mr. Chairman and Members of the Committee:
It is a pleasure to be here today on behalf of the
Administration to reaffirm our support for Senate Bill 712, a
bill "To Provide for a Referendum on the Political Status of
Puerto Rico." The Administration is also represented today by
Assistant Secretary Martin H. Gerry of the Department of Health
and Human Services, who can address the HHS-related expenditure
issues raised by this bill.
Senate Bill 712 would provide for a referendum, to be held in
1991, in which the Puerto Rican people could decide among the
options of statehood, independence, or commonwealth status.
Kenneth W. Gideon, As~istant Secretary for Tax Policy, testified
before this Committee on November 14, 1989 regarding this bill.
Today, I provide a more detailed analysis of the revenue effects
which were presented in that prior testimony, particularly in
light of new economic studies which have subsequently reviewed
this matter. I also summarize the Administration's position on
this bill, which was provided in more detail in the written
statement submitted for the record at the November hearing.
I.
INTRODUCTION
The Administration strongly supports the right of the people
of Puerto Rico to decide for themselves the future status of
their island. Further, as the President has noted a number of
times, he favors the admission of Puerto Rico to the Union as a
state', thereby assuring the people of Puerto Rico equal standing
with other United States citizens.
The Administration believes that the Puerto Rican people
should be given an opportunity to express their will in a manner
that recognizes the historic and fundamentally political nature
of their decision of self-determination. The decision they face
as a people transcends narrow concerns ab~ut specific aspects of
economic or fiscal structures. We recognize, however, that the
significant economic features of the three options must be
NB-781
-2identified to allow an informed choice and to make the proposed
referendum self-executing in its'important features.
The Administration endorses the balance between these two
concerns which was struck in Senate Bill 712 as reported by the
Committee on Energy and Natural Resources.
The bill informs the
Puerto Rican people of the broad outline of the fiscal and
economic structures applicable to each of the three status
options.
Yet it preserves this essentially political choice free
from a welter of details, transitional rules, and administrative
provisions best addressed by Congress after the political choice
is made.
Our prior written statement covered a number of technical
issues, not affecting the basic balance of the bill, that we
believe require clarification or other attention in the drafting
of this bill.
In addition, for many of the bill's fiscal
provisions, we anticipate that further legislation by Congress
will be necessary after the referendum to cover particular
details of the transition. We discussed in our prior written
statement a number of issues that such legislation might cover.
The Administration also believes that the substance of the
proposed tax and economic results under each of the three options
in Senate Bill 712 represents a reasonable resolution of the
difficult policy choices faced by the drafters of this
legislation. We think the bill achieves, to the extent possible,
the three goals set for it by the Committee on Energy and Natural
Resources:
(1) an even playing field, politically, for the three
political parties, (2) a smooth economic transition, and (3) an
adjustment that is budget neutral over a period of time.
It is important to note at the outset, however, that there
are significant limitations in any attempt to quantify with
precision the economic "equivalence" of the three status options.
Economic forecasts out to the year 2000 are only projections, not
guarantees. The prediction of the economic results under each of
the options is further clouded by many intangible factors,
including the reaction of the Puerto Rican people and their
government to the option chosen, the response to that choice by
the business community, and the possibility that Congress will
amend the current tax treatment of Puerto Rico under commonwealth
status.
Each of these factors could significantly alter the
comparative economic forecasts under each of the referendum
options.
One of the primary issues for this Committee is the overall
impact of Puerto Rican status on the federal deficit. With
respect to the commonwealth option, the baseline budget deficit,
of course, already contains the cost of Internal Revenue Code
section 936, which effectively exempts domestic corporations
active in Puerto Rico from u.S. tax.
Treasury's Office of Tax
Analysis (hereinafter, "OTA") estimates that $2.1 billion in net
tax benefits were received by section 936 corporations in fiscal
-3year 1990, projected to grow at about 10 percent a year. Under
statehood, the Administration estimates that while there is a net
increase in the federal deficit under statehood in early years,
there is a substantial net decrease in the federal deficit
beginning in fiscal year 1996. Using expenditure estimates
prepared by the Congressional Budget Office (hereinafter, "CBO")
does not alter the conclusion of an eventual deficit reduction,
but merely shifts the crossover point to fiscal year 1997. These
projections are illustrated in Appendix II.
As an overall legislative package, the current bill reflects
a good and defensible balance among the three status options. It
is not, however, the only alternative that might have been
adopted. For example, a uniform phase-out of section 936 under
both the statehood and commonwealth options would eliminate what
is perceived by some as a bias in the bill toward commonwealth.
Nevertheless, we recognize that section 936 should not be viewed
in isolation from the other costs and benefits affected by this
referendum. Other provisions in the bill can reasonably be
viewed as providing a rough balance to the phase-out of section
936.
Accordingly, the Administration accepts the treatment of
section 936 proposed in the current bill and the related
congressional judgment that the economic provisions set forth for
the three alternatives are fairly equivalent.
Before turning to a review of our economic projections, let
me briefly restate the Administration's position with respect to
each of the bill's major provisions affecting tax policy.
II.
A.
SUMMARY OF ADMINISTRATION'S POSITION ON TAX PROVISIONS
Statehood Option
1.
Deferred Application of Federal Taxes
We support the decision to defer until January 1, 1994 the
application of Federal tax laws, other than those relating to
excise taxes. This provision will give both U.S. and Puerto
Rican tax authorities the necessary time to ensure a smooth
transition to a new Puerto Rican state tax system. In addition,
we believe that it will allow adequate time to develop detailed
transitional rules for Congress to consider enacting before the
January 1, 1994 changeover.
2.
Phase-Out of Section 936
We also believe that the proposed phase-out under the
statehood option of the section 936 credit during the period from
1994 through 1997 reflects a good and defensible balance among
the different interests at stake. We defer to the Justice
Department for the conclusion that continuation of section 936
after statehood for a limited transition period passes muster
-4under the uniformity clause of the u.s. Constitution (Art. I,
sec. 8, cl. 1), which broadly requires taxes to be uniform
throughout the United States. As recommended in the Justice
Department's prior testimony on this bill, we also strongly
encourage specific fact findings by Congress to support a
Congressional determination that providing transitional tax
benefits to Puerto Rico is appropriate and that any section 936
transition adopted is well suited to achievement of Congressional
goals.
3.
Application of Excise Taxes
The bill would extend all federal excise taxes to Puerto Rico
as of its date of admission as a state.
In general, we agree
with this result, but recommend an effective date as of the first
day of the calendar year following admission.
4.
Statehood Grants and Assistance
The bill provides for transition assistance in the form of a
transfer (or "cover-over") to the Puerto Rican Treasury of
federal excise taxes derived from Puerto Rico prior to October 1,
1998, as well as the tax collected from the extension of Federal
internal revenue laws to the State of Puerto Rico in 1994 and
1995. We agree that Puerto Rico should receive sufficient
assistance to ease its transition from commonwealth status. As
discussed in our November written statement, however, the
cover-over mechanism has presented complex administrative
problems in the past. We therefore recommend that Congress
preserve its flexibility to address in future legislation the
appropriate procedures to be used in measuring and remitting the
desired levels of such statehood grants, without restricting its
choice to a direct cover-over of collected taxes.
B.
Independence Option
1.
Elimination of Section 936
The bill would eliminate the benefits of the section 936
credit for income from activity or investments in Puerto Rico
upon the proclamation of independence.
This automatic repeal is
essential to avoid the difficulties that would otherwise arise
with respect to a number of income tax treaty partners of the
United States who have effectively been granted most favored
nation status with regard to tax sparing incentives.
2.
Negotiation of Tax Treaties
The bill provides for a Task Force on Taxation to facilitate
the negotiation of appropriate tax treaties between the United
States and an independent Puerto Rico, which would would be
approved by the two governments in accordance with their
respective constitutional processes.
Due to the economic
integration between Puerto Rico and the United States, we
-5strongly support this goal, al~hough we understand that there may
be technical legal difficulties with this section as drafted and
defer to the Department of Justice on this issue.
3.
Interest on Puerto Rican Government Obligations
The bill would continue the current federal tax exemption for
interest paid on Puerto Rican bonds outstanding upon proclamation
of independence. We recommend clarification that this provision
does not apply to either original issuances or refinancings on or
after the date of independence and that the continued exemption
is subject to the rules governing the exemption for U.S.
municipal bonds, as amended from time to time.
C.
Commonwealth Option
1.
Continuation of Section 936 Benefits
Under the enhanced commonwealth option, the bill would not
result in any changes to the substantive tax laws currently
applicable with respect to Puerto Rico. Accordingly, the
benefits of section 936 would not be phased-out (as under
statehood) or eliminated (as under independence). We believe,
however, that Congress should make it clear that such benefits
cannot be regarded as guaranteed under commonwealth status but
rather should continue to be viewed as incentives which Congress
will, as it has in the past, review and revise as necessary.
2.
Puerto Rican Review of Federal Laws and Regulations
The bill provides for expedited review procedures where the
Puerto Rican government determines that federal laws or
regulations are inconsistent with the enhanced commonwealth
relationship. As described in more detail in our written
statement submitted in November, the Administration has serious
concerns with respect to these provisions.
In the context of
legislation and regulations affecting the tax system, we believe
such special review procedures would unreasonably complicate fair
and efficient tax administration.
The standard Constitutional
and Congressional procedures governing tax legislation and the
rules of the Administrative Procedure Act governing tax
regulations provide reasonable and appropriate protections of
Puerto Rico's interests.
3.
International Agreements
The bill would permit the Governor of Puerto Rico to enter
into international agreements to promote the international
interests of puerto Rico as authorized by the President of the
United States and consistent with the laws and international
obligations of the United States. Currently, Puerto Rico does
not have the authority to negotiate or enter into international
double taxation conventions or similar agreements in its own
-6right.
An outright grant of ind~pendent tax treaty authority to
Puerto Rico would significantly complicate the negotiations of
United States treaties and quite possibly undermine several
existing conventions.
We recommend that Congress explicitly deny
independent tax treaty authority in the commonwealth option.
III.
REVIEW OF REVENUE ESTIMATES AND PROJECTIONS
The revenue estimates and projections which were submitted by
the Administration in November are updated and submitted as
Appendix I to this written statement. As you are aware, two
economic studies have been published subsequent to our testimony
last Fall which raise questions with respect to some of our
conclusions:
Potential Economic Impacts of Changes in Puerto
Rico's status under S. 712, prepared by the Congressional Budget
Office, (April 1990) (hereinafter the I'CBO Study"), and Economic
and Fiscal Impacts of Puerto Rican Statehood, prepared for the
Governor of Puerto Rico by the Policy Economics Group, KPMG Peat
Marwick (February 1990) (hereinafter the "Governor's Study").
In
response to these studies, this testimony describes in greater
detail the assumptions we made in developing our estimates and
projections, and reviews how our conclusions relate to those
reached in the new studies.
As I previously stated, the economic effects of each of the
political options under the bill cannot be estimated with
precision.
Much would depend upon the decisions made by the
government and people of Puerto Rico as they exercise their
rights under each of the options, as well as the response of the
business community with respect to current and future levels of
investment on the island.
The choices made would affect the
Puerto Rican economy and to some extent Federal tax revenues and
outlays.
The conclusions to be drawn from the numbers must
always be weighed together with the admittedly unquantifiable,
though potentially beneficial, effects of the choice of either
the statehood or independence options.
Both of the new studies
recognize this fact and the resulting danger of relying too
heavily on those factors which can be quantified.
A.
Federal Revenue Effects of Phase-Out or Elimination of
Section 936
Both the statehood and independence options under S. 712
assume some form of reduction of the tax incentives currently
provided under section 936. As noted, OTA estimates that $2.1
billion in net tax benefits were received by section 936
corporations in fiscal year 1990, and these benefits are
projected to grow under existing commonwealth status.
Under S.
712, if the statehood option were chosen by the Puerto Rican
people, these benefits would be phased out during the period from
1994 to 1997. Under the independence option, the benefits would
be eliminated upon proclamation of independence.
-7-
As the Governor's Study and the CBO Study agree, the extent
to which the reduction of these" benefits are actually translated
into increased federal tax receipts is the major factor in the
determination of the impact of the bill on federal receipts. The
projected revenue gain from phasing out section 936 tax benefits
represents considerably more than half of the total revenue gain
projected under statehood, and over 90 percent of the gain
projected under independence. The section 936 revenue figures
are also the most controversial, since the Treasury projections
of federal gains from personal taxes and other non-section 936
revenue sources are similar to the projections in the other
studies.
OTA'S estimate of the revenue gains from phasing out section
936 required consideration of several factors. The following
discussion reviews how each of these factors contributed to the
estimates and projections noted in Appendix I.
1.
Developing a Current Law Baseline
As an initial matter, it was necessary to determine a
baseline of the federal tax benefit currently derived from Code
section 936. For this purpose, OTA used the most recent data
available on the income of section 936 corporations in Puerto
Rico, based on tabulations of 1985 tax returns filed with the
Internal Revenue Service by the companies. In comparing the OTA
analysis to the projections in the Governor's Study, it is
important to note that the baseline used in the Governor's Study
relied on Puerto Rican tax data and seems to miss more than 25
percent of the section 936 income actually reported to the IRS.
OTA divided the section 936 income into its two components:
active business income and qualified possession source investment
income (QPSII). In recent years QPSII has accounted for about 15
percent of total section 936 net income. Each of these
components must be analyzed separately because the phase-out of
section 936 would affect them differently. For example, even if
a section 936 company attempted to shift its Puerto Rican
operations to an overseas location after statehood, the financial
component (QPSII) would generally become taxable by the united
States. This is because passive earnings of a u.S.-controlled
foreign subsidiary are generally deemed to be repatriated and
taxed currently at the U.S. shareholder level under subpart F
(Code sections 951-964).
Each of the components of section 936 income were projected
forward to estimate the level of such income under current law to
compare with the phase-out of these benefits under statehood and
their elimination under independence. The active income
component was projected from 1985 to 1988 using data in the
Puerto Rican national accounts on the growth of non-wage income
in manufacturing. A growth rate consistent with previous
historical trends was used for the years following 1988. In
addition, an adjustment was made for the impact of the Tax Reform
-8Act of 1986 on section 936 income.
In particular, the likely
shift by many section 936 companies to the 50-50 profit split
method as a result of the imposition of a royalty floor in the
cost-sharing option was taken into account.
The QPSII component
was projected using recent trends in growth of financial assets.
2.
Effect of Overseas Shift of Current Section 936 Activity
Under the statehood option, if the active business income of
section 936 corporations currently shielded from federal taxation
by the section 936 credit were to continue to be earned either in
Puerto Rico or in any other state,./ the phase-out of section 936
tax benefits would generally be translated dollar-for-dollar into
increased federal tax receipts.
If, however, the activities of
these corporations were shifted outside of the United States,
some portion of the income would not yield increased federal
revenue in the near term.
This is because certain income earned
by U.S.-controlled foreign subsidiaries may be deferred from
federal taxation until repatriated.
Moreover, even when the
income is distributed to the U.S. shareholder, federal tax on
such earnings could be offset by foreign tax credits.
Accordingly, federal receipts under the statehood option could
increase by some figure that is less than the full amount of the
current law section 936 baseline.
The possibility of section 936 operations moving to non-U.S.
locations is therefore one of the most important issues in
projecting the revenue gain from phaSing out section 936.
Estimating the extent of such movement, however, is also the most
difficult step in making this projection.
3.
Factors Considered in Estimating Overseas Shift
OTA's estimate of the extent to which section 936 operations
would move abroad under the statehood option was based on several
considerations. One was the determination for each industry of
the extent to which section 936 income was derived from
intangible assets. A further consideration was the division of
such intangible income between that attributable to marketing
intangibles (such as trademarks) and manufacturing intangibles
(such as patents).
The above distinctions are relevant since they affect the
potential for shifting income-producing activity outside of the
u.S. tax jurisdiction. Under current law, the transfer of either
*/ For the purpose of estimating federal revenues, it is
generally unnecessary to determine how much of the section 936
income would stay in Puerto Rico rather than move back to the
mainland. As long as the state tax and operating costs on the
mainland were comparable to those in Puerto Rico, the federal
revenue pickup would be the same since, either on the mainland or
in Puerto Rico, such income would be subject to federal tax.
-9-
manufacturing or marketing intangibles to an overseas affiliate
would require substantial royalties to be paid to the U.S.
transferor. These royalties must be "arm's length" and
commensurate with the income attributable to the intangible.
Where the output of the offshore affiliate was primarily sold in
the united States (which is currently the case for most section
936 activity), the affiliate would contribute little additional
marketing to the overall income produced and the required royalty
payments would thus offset a substantial portion of the
affiliate's income. With respect to marketing intangibles, the
royalties required would leave very little income offshore. If
section 936 companies do choose to move offshore, such royalties
would reduce the benefits of a low-cost location and increase the
federal revenue pick-up. This, of course, will affect the
decision whether or not to move offshore.
U.S. taxation associated with the repatriation, through
royalty payments, of the income that can be moved overseas could,
however, be somewhat reduced by the u.s. owner's foreign tax
credits. If the section 936 company's parent corporation is in
an overall excess foreign tax credit position, then royalties
paid with respect to intangibles used overseas would generate
foreign source income and could be sheltered from u.S. tax by the
recipient's foreign tax credits. For this reason, the frequency
of excess foreign tax credit positions by industry was also
examined.
This foreign tax credit protection would generally not be
available, however, with respect to income derived from marketing
intangibles related to the U.S. domestic market. Royalties paid
with respect to income derived from such marketing intangibles,
even after their transfer overseas, would retain their character
as u.S. source income and would be fully subject to federal tax.
This important factor was overlooked by the Governor's Study.
Further, for some industries, an offshore location would
offer lower profitability than Puerto Rico quite apart from the
effect of increased royalty payments. This is because the income
allocation rules under section 936(h) often permit section 936
companies to claim a return on intangible assets associated with
a broader "product" than the product actually produced in Puerto
Rico. For example, the section 936 affiliate can often claim all
or a part of the return attributable to an intangible even though
the highly technical part of the process is still performed by
the parent in its U.S. plant. These rules thus permit a greater
portion of income to be attributed to the section 936 corporation
than would be the case for an affiliate operating in alternative
offshore locations. As a result, if such Puerto Rican operations
were moved overseas, some income currently allocated to the
section 936 company would not be able to follow and would shift
to the U.S., even before the imposition of an increased royalty
on the overseas income.
-10The very high rates of return earned by section 936
corporations in the aggregate suggest that intangible assets
account for 75 percent or more of total income.
A review of 198~
tax return data also indicates that marketing intangibles were
significant for a substantial portion of the section 936
corporations.
Under Code section 936(h), a section 936
corporation is allowed no return on its intangible income unless
it elects either the cost-sharing method or the 50-50 profit
split method.
Prior to changes introduced by the 1986 Tax Reform
Act, the cost-sharing method was generally a more beneficial
choice for companies relying on manufacturing intangibles.
The
significant role of marketing intangibles to section 936
operations, therefore, can be seen from the fact that, as of 1985
(before the 1986 changes took effect), 40 percent of section 936
income was received by companies which had elected the 50-50
profit split option rather than cost-sharing.
Information on the present location of U.S.-controlled
operations supplying the u.s. market was also consulted.
For
example, the electronics industry has demonstrated that
substitutes for Puerto Rico appear to be available in the low-tax
countries of the Pacific rim.
Finally, the availability of lowtax alternatives for particular activities such as pharmaceutical
manufacturing was evaluated.
In this connection, OTA consulted
with foreign government and other experts to gauge the extent to
which foreign jurisdictions would offer incentives to section 936
operations.
4.
Conclusion
As a result of examining these factors for each industry, OTA
concluded that, in the long run, about 35 percent of the active
section 936 income in Puerto Rico under the current law baseline
would move offshore to non-U.S. locations. As noted, some of
this income would have to be repaid to the United States in the
form of royalties.
Based on the likely royalties that would have
to be paid and the excess foreign tax credit positions of the
parent corporations in each industry, about 25 percent of active
section 936 income would remain offshore.
Stated another way,
the phase-out of section 936 would result in an addition to the
u.S. tax base of 75 percent of the active section 936 income.
Adding to this the portion of section 936 income that is passive
(the QPSII component) and, as described above, would also not
escape U.S. tax, nearly 80 percent of total section 936 income
would become subject to U.S. tax after the phase-out.
I would like to stress that projecting the amount of income
that would shift to low-tax locations cannot be a simple
mechanical process, but must take a number of factors into
consideration.
For example, the Governor's Study assumed that
any operation that can increase its after-tax return by 5
percentage points by moving offshore would necessarily do so.
Applying the same logic to operations on the U.S. mainland would
lead to the conclusion that virtually no highly-profitable
-11manufacturing would currently ~ake place in the united states. A
low mechanical threshold of this type ignores the benefits now
available in Puerto Rico that would be difficult to replicate in
a foreign location, such as the use of the dollar as the local
currency, protection from expropriation and political
uncertainty, and the ability to obtain legal protection in a u.s.
court.
Furthermore, very few (if any) of the foreign locations
considered to be potential alternatives to Puerto Rico can offer
both the skilled labor force and the proximity to U.S.-based
marketing and R&D personnel that are provided by Puerto Rico.
B.
The Role of Macroeconomic Considerations in the Revenue
Estimates
1.
Reliance on Independent GNP Predictions
In estimating the revenue impact of any change in domestic
tax policy, OTA revenue analysts hold various macroeconomic
variables, such as GNP, employment, total investment, etc., fixed
at those values set by representatives from the Council of
Economic AdVisors, the Office of Management and Budget, and the
Economic Policy Office at Treasury.
Similarly, the Joint
Committee on Taxation staff makes their estimates consistent with
CBO's macroeconomic projections.
This convention serves several useful functions.
First,
although a change in tax policy can affect these macroeconomic
variables, the specific impact will generally depend upon the
reaction of the Federal Reserve Board and other agencies whose
policies may also have macroeconomic effects, and different
analysts may have differing views about the magnitude of both the
direct effect and the response.
Second, without maintaining some
overall constraints, it is easy to overstate the effects of a tax
policy change. Thus, standard rev'enue estimating policy calls
for assuming that the reduced employment (or investment) in an
adversely affected industry will be offset by increased
employment (or investment) elsewhere.
This convention has in general been followed in OTA's
analysis of the revenue effects of S. 712.
The Administration's
forecasts for u.S. GNP, which might be expected to be relevant
for projecting the growth of section 936 operations, was
available only for 5 years, through fiscal year 1995.
However,
other than the brief interruption after 1982 caused by
restrictions in section 936 benefits enacted under TEFRA, P.L.
97-248, the real growth of section 936 income has been relatively
stable over a long period of time.
This long-term historical
growth of section 936 income was thus used to project section 936
income under the current law baseline into the late 1990's.
The representatives of the Council of Economic Advisors, OMB
and Treasury, mentioned above, do not project Puerto Rican GNP
and income.
The OTA projection of increased federal collection
-12of personal and non-section 936 corporate taxes under statehood
assumed continued real growth irt Puerto Rico, but at a very
conservative rate of about 2 percent per year.
Following
standard revenue estimating conventions, no attempt was made to
predict the impact of phasing out section 936 benefits on the
growth of the Puerto Rican economy.
2.
Impact on Puerto Rico's GNP
Employment in section 936 corporations now accounts for 12
percent of total Puerto Rican employment, or about 100,000 to
110,000 jobs, and the income earned by employees of section 936
corporations represents about 16 percent of total Puerto Rican
labor income.
Thus, any reduction in the activity of section 936
corporations and their local suppliers of goods and services
could potentially reduce the personal income of the residents of
Puerto Rico (although, to the extent the activities were
transferred to the mainland, the personal income of the residents
of other states might increase).
Nevertheless, the assumption
made in the Governor's Study that those workers displaced by the
relocation of section 936 activities would remain unemployed,
apparently forever, seems far too pessimistic, since such workers
are among the most skilled.
They can be expected eventually to
find jobs in other activities, although possibly at lower wage
rates.
Estimating the impact on Puerto Rican employment of the
potential relocation of section 936 activities not only requires
determination of the extent to which such relocation would occur,
but is also complicated by the other economic changes which would
accompany statehood.
Federal transfer payments to the residents
of the state would grow significantly, increasing demand in
Puerto Rico.
Thus, the overall impact of statehood upon the
gross national product of the State of Puerto Rico is not readily
estimated.
The CSO Study utilizes a macroeconomic model of the Puerto
Rican economy in order to estimate the impact of statehood and
independence.
The model attempts to capture the impact of the
activities of the section 936 companies on the economy of Puerto
Rico.
The cao Study projects that under statehood the Puerto
Rican economy would continue to grow, but that the rate of growth
may be one to two percentage points slower per year than under
the current commonwealth status.
These projections reflect only
the impact of phasing out section 936 and extending federal
expenditure programs to Puerto Rico, which are the only
consequences of statehood that CSO could quantify. As the cao
Study concedes at page 1, its analysis
cannot take into account the unquantifiable gains from
statehood, such as the effect of reduced uncertainty
about Puerto Rico's future status and increased
awareness of the opportunities that it offers.
These
effects, which generally would work to improve the
-13economic outlook under st~tehood, may be significant,
though CBO can give no estimate of their size.
The impact of phasing out of section 936 benefits will depend
on the response of the Puerto Rican state government. One
possible response is a development incentive to replace section
936.
Treasury's reports to the Congress on the possessions
corporation system of taxation have indicated that section 936 is
a very expensive incentive when measured by the jobs created in
Puerto Rico.
The most recent estimates, those determined for
1983 in the Sixth Report (March 1989), show a revenue cost of
about $18,500 per job, or about 125 percent of average
compensation.
In pharmaceutical manufacturing, which accounts
for half of the revenue cost of section 936, the average cost per
job was about $58,000.
The trend in section 936 income and the
growth of manufacturing employment since 1985 suggest that the
cost per job is at least as high today, despite the post-1987
drop in the U.S. statutory corporate tax rate to 34 percent.
Accordingly, the Puerto Rican state government may well be able
to reproduce the job-creating effects of section 936 by designing
a much more efficient program.
The difficulty in predicting the impact of statehood on the
Puerto Rican economy is further evidenced by the fact that the
Governor's Study, which predicts a much greater reduction in
section 936 activities within Puerto Rico than does the CBO
Study, estimates only a 5 percent reduction in GNP by the year
2000 (although its projection of a 14 percent reduction in
reported personal income is more in line with CBO's projection of
a 10 to 15 percent reduction). The Governor's Study also does
not attempt to quantify the potential indirect benefits resulting
from statehood, nor to examine how these non-quantifiable
benefits may be enhanced by the subsequent decisions of the
government and people of Puerto Rico.
I stated earlier that the OTA forecasts of the increased
federal tax collections of section 936 income under statehood did
not depend to a significant degree on whether those operations
not moving overseas remained in Puerto Rico or moved back to the
mainland.
This difference would, however, have an impact on
Puerto Rico's GNP, although the reduction in section 936
activities on the island does not necessarily translate into a
commensurate reduction in GNP.
Predicting how many U.S.-based operations would move back to
the mainland is very difficult.
It is true that the tax benefits
that attracted most of the section 936 companies in the first
place would be phased out. Nevertheless, many of the companies
now have a substantial investment in physical plant and have
developed a highly competent and cost-eff 7ctive labor,force.
In
view of the relatively long phase-out perlod for sectlon 936
benefits under statehood contemplated in S. 712, it appears that
any actual decline of section 936 operations in Puerto Rico would
take place over a long period of time.
-143.
Impact of Puerto Rico's· Change in GNP on Revenue
Estimates
As I indicated earlier, the OTA projections of increased
federal collections of personal and non-section 936 corporate
taxes under statehood assumed continued real growth (albeit at a
modest level).
The assumed rate of growth was only slightly
lower than the average growth rate projected by CSo using its
low-growth baseline. A reduction in the Puerto Rican growth rate
of the magnitude projected by CSO would change the estimated
total federal revenue increase by only a modest amount.
Even in
fiscal year 2000, by which time the cumulative shortfall in GNP
projected by CSO would be 10 to 15 percent, OTA's projected
increase in federal revenues would be reduced by less than 5
percent.
This is because a reduction in the Puerto Rican growth
rate affects only the increased federal revenues from personal
taxes and non-section 936 corporate taxes, which constitute a
relatively small portion of the overall projected increase in
federal revenues.
Furthermore, the increase in individual income taxes
projected by OTA is even less than that projected by the
Governor's Study.
For example, for fiscal year 1997, the
Governor's Study projects an increase of individual income tax
collections of $914 million in their high relocation scenario in
contrast to OTA's projected increase of only $739 million.
OTA's
projection of increased non-section 936 corporate collections is
lower than the Governor's study estimate as well.
These results
confirm the fact that the projections of increased federal tax
from income now benefiting from section 936, which is not
sensitive to the state of the Puerto Rican economy, is the only
important area of disagreement on revenues.
C.
Net Impact of Puerto Rican Status Referendum on the Federal
Deficit
A major question to be faced by this Committee is whether S.
712 creates an economic balance for any of the three status
options that is likely to increase the federal budget deficit,
decrease it, or keep it roughly the same.
The baseline budget
deficit, of course, already contains the cost of section 936;
thus there would be neither an addition nor a reduction to the
deficit in the commonwealth option. As stated above, however,
OTA estimates that $2.1 billion in net tax benefits were received
by section 936 corporations in fiscal year 1990 and these
benefits are projected to grow at about 10 percent per year under
the existing commonwealth status.
The statehood option, on the other hand, changes the status
quo.
It increases both revenues and outlays. While the net
effect in the early years is a net increase in the deficit under
anyone's estimates, in later years there is a substantial net
-15decrease, whether the outlay figures used are the expenditure
estimates prepared by CBO or by the Departments of Health and
Human Services and Agriculture.
The only difference produced by
using these alternative estimates, resulting from CBO's higher
outlay figures, is the year in which the net figure turns
positive (i.e., the year there is no longer an increase in the
federal deficit due to Puerto Rican statehood and is, instead, a
deficit reduction). Using the expenditure estimates of the
Departments of Health and Human Services and Agriculture, this
"crossover point" occurs in fiscal year 1996; using the CBO
estimates, it occurs in fiscal year 1997. This crossover point
for the Administration's estimates is illustrated in Appendix II.
It is important not to misinterpret the conclusions in the
CBO Study which refer to an $18 billion "net transfer" to Puerto
Rico over the the nine-year period between 1992 and 2000. The
CBO Study states at page 27 that this "net fiscal benefit from
statehood would likely be permanent." These figures are based on
Table 7 in that study, which describes the federal expenditures
to Puerto Rico net of new federal taxes derived from the island.
As stated in a footnote to that Table 7, however, the increase in
federal taxes does not include the additional federal revenues
from the phase-out ~section 936. Rather, the reference to "net
transfers" in the CBO Study's conclusion is limited to the
payments to and from Puerto Rico (which do not include increased
federal taxes paid by domestic corporations formerly benefiting
from section 936).
The focus of this Committee, however, must
cover the full effects of statehood on the federal deficit,
including the very significant revenues to be derived from the
section 936 phase-out. The effect of the section 936 phase-out
thus accounts for the crossover point illustrated in Appendix II
and an eventual net deficit reduction from statehood, even where
"net transfers" to Puerto Rico continue beyond the crossover
year.
D.
Effects of Statehood on Federal Tax Revenues: A Detailed
Analysis
1. Phase-out of Section 936 Benefits
The revenue effects of S. 712 under the statehood option over
the fiscal year period 1992-2000, are presented in Appendix I.
This table indicates that the revenue effects of the phase-out of
the section 936 benefits, described in detail above, is the
largest component during and after the phase-out period (changes
in the federal income taxes under statehood are scheduled to
become effective on January 1, 1994). By fiscal year 2000, the
revenue pick-up from this source is estimated to be nearly $4
billion.
2. Federal Excise Taxes
Puerto Rican residents do not currently pay federal excise
taxes, but would be subject to these taxes under statehood.
This
-16would result in an increase in annual revenues of $200 million to
$400 million, which, under S. 712, would be rebated to the Puerto
Rican government as a statehood grant at least through October 1,
1998.
3. Federal Income Taxes
The extension of the federal income tax to individuals and
corporations in Puerto Rico would result in additional federal
revenues.
Net of the earned income credit, the individual income
tax is estimated to annually raise between $650 million and $850
million during the period between fiscal years 1994 and 2000.
Under statehood, federal corporate taxes would also be collected
from Puerto Rican businesses that do not now fully benefit from
section 936.
This includes locally incorporated as well as
foreign corporations. As shown in Appendix I, these annual
revenues are estimated to range from $250 million to $550 million
between fiscal years 1994 and 2000. As noted in Appendix I,
under S. 712, a portion of these taxes are scheduled to be
"covered-over" to the government of Puerto Rico.
4. Other Federal Revenues
As noted in Appendix I, about $100 million to $175 million
per year in customs duties would continue to be collected between
fiscal years 1994 and 2000.
Beginning in 1994 through at least
October 1, 1998, these revenues would be covered-over to the
government of Puerto Rico.
Rum excise taxes, of about $250
million per year, would also continue to be covered-over to the
government of Puerto Rico until 1998.
5. Interaction of the Federal and Puerto Rican Tax Systems
The government of Puerto Rico collected approximately $900
million in individual income taxes in their 1989 fiscal year,
which is about 5 percent of reported personal income.
Puerto
Rico also collects about $1 billion annually in business taxes,
which represent about 10 percent of business income.
Together
with the federal taxes to which they would be subject, the total
tax burden on Puerto Rican residents would thus be quite high.
As a state, Puerto Rico could design a tax system which would
maintain current tax revenues.
It might also choose to follow
other states in relying more heavily on sales taxes.
Or
alternatively, Puerto Rico can modify both its tax system and the
level of its expenditures, as well as modify the role of
government enterprises in the economy.
E.
Revenue Implications of Independence
Under the independence option, the elimination of the section
936 benefits would also result in increased federal revenues, as
shown in Appendix I.
Some section 936 activities (for example,
those engaged in apparel manufacturing or food processing) might
-17choose to reincorporate as Pue~to Rican corporations, permitting
deferral of the federal tax on a portion of such income until
repatriated to the U.S. owners.
In addition, Puerto Rican taxes
paid with respect to U.S. corporations that retain their Puerto
Rican activity would generate a foreign tax credit (rather than a
state tax deduction as under the statehood option).
For these
reasons, the federal revenue gain from the elimination of the
section 936 benefit is not expected to be as great in later years
as under the statehood option.
As an independent country, federal excise taxes (primarily
that on rum) and customs duties would apply only on goods
imported into the United States; the federal government would not
collect any customs duties on goods imported into Puerto Rico.
Federal income taxes would apply only to the extent income earned
in Puerto Rico were repatriated to the United States (or deemed
to be repatriated under Subpart F rules), and some Federal
withholding taxes might be collected on the payment of income
earned in the United States to Puerto Rican residents.
-18APPENDIX I
ESTIMATED AND PROJECTED FEDERAL REVENUE INCREASES UNDER S.712
The following chart shows the Federal revenue collections
that are estimated to result from implementation of either the
statehood or the independence option under S. 712 through fiscal
year 1995 and projections of revenues for the five fiscal years
thereafter.
Because economic projections are not made by the
Treasury, Council of Economic Advisors, or the Office of
Management and Budget for years after 1995, the projections shown
for 1996-2000 are based on a continuation of the fiscal year 1995
economic forecast in later years.
The section 936 projections,
however, are based on the historic patterns of section 936 tax
expenditure growth which have been significantly in excess of
U.S. economic growth.
Except in the case of customs duties and rum excise taxes,
these figures reflect projected increases in Federal revenue
collections over existing law. As indicated below, many of these
amounts would be subject to a cover-over to the State of Puerto
Rico until either fiscal year 1996 or 1998.
Except as otherwise
indicated, these figures reflect an effective date of 1/1/94 for
Federal tax law changes.
These figures do not assume any change
in Puerto Rican tax law.
(IN $ MILLIONS)
ESTIMATES
PROJECTIONS
FISCAL YEARS
1992
1993
1994
1995
1996
1997
1998
1999
2000
45
128
538
1204
1889
2610
3325
3741
3994
213*
295*
309*
325*
341*
358*
376*
395
414
645
676
707
739
773
809
846
Cover-Over
to P.R.
482*
666*
168*
Net U.S.
Collections
163
10
539
739
773
809
846
STATEHOOD
Phase-Out
Sec. 936
New Excise
Taxes#
Personal Tax
Gross U.S.
Collections
(Net of EIC)
-19ESTIMATES
PROJECTIONS
FISCAL YEARS
1992
1993
1994
1995
1996
1997
1998
1999
2000
Tax
Gross U.S.
Collections
249
427
448
471
495
519
545
Cover-Over
to P.R.
249*
427*
174*
274
471
495
519
545
STATEHOOD
(CONT'D)
Coq:~orate
Net U.S.
Collections
0
Customs
Duties
Rum
Excise Tax
188*
0
97*
134*
141*
148*
155*
163
171
252*
255*
257*
260*
262*
265
268
INDEPENDENCE
Eliminate
Sec. 936**
Rum
. Excise Tax**
45
1501
2579
2738
2876
3095
3327
3555
3816
188
252
255
257
260
262
265
268
'" Taxes subject to cover-over to Puerto Rico in years deSignated by
asterisk.
# Reflects 1/1/92 extension of Federal excise taxes to Puerto Rico
(other than the rum excise tax which already applies).
** Assuming proclamation of independence occurs on 1/1/93.
APPENDIX II
Effect of the Statehood Option on the Federal Budget Based on
Adainistration's Estiaates and projections of Federal Tax Revenue Gains
and Outlay Increases
Fiscal Year
($ Billions)
1993
1994
1995
1996
1997
1998
1999
2000
.1
.7
1.2
2.7
3.8
4.6
5.1
5.4
.8
.9
1.4
2.2
2.6
3.0
3. 3
3.7
4.1
-.7
-.8
-.7
-1.0
+.1
+.8
+1.3
+1.4
+1..3
1992
Tax Revenue Gains**
Outlay Increases***
Increases in Surplus ( + )
or De f i cit (-)
*
I
tv
0
I
*
Less than $50 million gain
**
Revenue gains estimated by Office of Tax Analysis, Department of the Treasury
*** Outlay increases estimated by Departments of Health and Human Services and Agriculture
TREASURY NEWS
Department of the Treasury. washington, D.C•• Tele.,hone S88-204t
FOR IMMEDIATE RELEASE
April 26, 1990
CONTACT: Cheryl Crispen
(202) 566-5252
Press Briefing by
John E. Robson
Deputy Secretary of the Treasury
on the
Caribbean Conference on Drug Money Laundering
It's a pleasure to be here today with Prime Minister Oduber
of Aruba and to express the Bush Administration's support for
the establishment of the Caribbean Conference on Drug Money
Laundering. We salute the Prime Minister and other leaders
in the Caribbean area for this important step in the fight
against drug money laundering.
The Caribbean Conference has been inspired by the success of
the G-7 Financial Action Task Force on Money Laundering. The
G-7 Task Force was convened at the direction of the 1989
Economic Summit in Paris. It was born of the idea that
narcotics trafficking and money laundering are inextricably
linked and that money laundering is an international problem
that must be addressed through international solutions.
Just last week, the final report of the G-7 Task Force was
released around the world by Task "Force member countries.
This effort represents the work of 15 nations to facilitate
greater cooperation in international investigations,
prosecutions and property seizures. They have agreed on 40
action recommendations which, when implemented by the member
countries, should help establish a global network of programs
to attack money laundering.
The report reflects recognition by the G-7 Task Force member
countries that in order to effectively combat international
money laundering, individual countries must have sound
domestic programs to attack money laundering and they must
cooperate with each other in the many cases that cross
international borders.
NB-782
-2-
I am pleased with the accomplishments made by the G-7 Task
Force and I am hopeful that the advances we made in
understanding the problem of international money laundering
and identifying ways to attack the problem will serve as a
solid foundation for the work of the Caribbean Conference.
It is my hope that the countries participating in the
Caribbean Conference will endorse the recommendations
developed by the G-7 Task Force as well as develop other
recommendations that address money laundering problems
specific to their region.
Once again, let me commend Prime Minister Oduber.
Mister
Prime Minister, on behalf of Secretary Brady, I will chair
the u.S. delegation with assistance from the Departments of
Justice and State and our law enforcement and bank regulatory
agencies.
I look forward to working with you and the other
members of the Caribbean Conference in the months ahead.
I
offer you whatever assistance we may provide to help the
Conference develop strong weapons to fight international drug
money laundering.
Thank you.
000
apartment of the Tr•• su" •
wastMII.~ p~
t1 Te.ellllone S"-104t
Testimony of the Honorable John E. Robson
Deputy Secretary of the
Treasury before the Senate Foreign Relations Committee
April 27, 1990
I would like to thank the Chairman and the Committee for this
opportunity to update you on activities of the Department of the
Treasury to combat international money laundering.
My testimony today will touch on the work of the G-7 Financial
Action Task Force on Money Laundering and related initiatives,
measures that the Endara Government in Panama has taken against
money laundering, and current progress in pursuing agreements
under section 4702 of the Anti-Drug Abuse Act of 1988.
The overall message I would like to convey to the Committee is
that we are seeing advances in the international community in
helping countries to understand the nature and global scope of
the money laundering problem and the steps necessary to address
it. The United states is committed to the ultimate goal of a
worldwide network of countries linked together with a common
resolve to close the doors of our financial institutions to money
launderers. We also recognize that forging this chain of dozens
of sovereign nations with different laws, practices, and
financial systems is not quickly or easily achieved.
Treasury Role
Before turning to these matters, I would like to discuss the role
of Treasury in the area of money laundering and financial
enforcement.
Money laundering is a complex economic crime that demands a
thorough understanding of how our financial institutions operate
in order to prevent their abuse. Treasury brings to the problem
the perspective of a law enforcement agency, a financial
institution regulatory agency, and the agency concerned with the
overall condition of our domestic and international financial
systems. Our recent experience with the G-7 Financial Action
Task Force, which I will discuss, demonstrates that Treasury's
understanding of law enforcement and the financial system is very
useful in dealing with our foreign counterparts, many of whom are
grappling with developing anti-money laundering programs for the
first time.
We understand not only law enforcement concerns, but the
NB-783
-2necessity to balance law enforcement needs with other
legitimate considerations affecting the financial system.
Achieving this balance is one of the challenges facing the
Administration and Congress as we seek solutions to the problem
of money laundering.
Among the key elements of anti-money laundering efforts are the
reporting and recordkeeping requirements of the Bank Secrecy Act
so that the trail to the money can be followed.
Treasury has
worked over the years to refine regulatory requirements for
reporting and recordkeeping to reflect changing law enforcement
needs and to enhance compliance by financial institutions.
The currency reporting system has become an essential component
of the u.s. financial enforcement program against money
laundering, tax evasion and other criminal activity.
It is
relied upon by law enforcement agencies, not just to target
suspicious activity, but to support ongoing investigations,
prosecutions, and forfeiture actions in a variety of ways.
The u.S. Customs Service and the Internal Revenue Service (IRS)
have been delegated authority to investigate criminal violations
of the Bank Secrecy Act -- IRS with respect to domestic currency
reporting and Customs with respect to the reporting of
international transportation of currency and monetary
instruments.
Reporting violations are frequently indicative of
money laundering activity, carry severe criminal sanctions, and
can be prosecuted without proof of the source of the money.
Both
Customs and IRS also have authority to investigate the crime of
money laundering.
Among the most successful of international drug money laundering
cases are Operation C-Chase initiated by Customs and Operation
Polar Cap developed jointly by IRS, Customs, FBI, and DEA.
The
details of the cases are well known to the Committee, but the
degree of cooperation from foreign governments in the cases
should be noted.
In Operation C-Chase, involving the Bank of
Credit and Commerce International, Customs was able to meet with
targets in France and the united Kingdom with the knowledge and
assistance of those governments.
The United Kingdom and France
issued search warrants and seizure warrants and the United
Kingdom arrested suspects in London. Similarly, in Operation
Polar Cap, Uruguay arrested a suspect and later extradited Canada
and Switzerland effected seizures.
IRS and Customs report that
there has been a marked upsurge in cooperation in money
laundering cases generally as our allies come to appreciate the
common nature of the money laundering threat.
Based on the success of joint efforts in Operation C-Chase, U.S.,
British, and French Customs have established an arrangement
designated "C-Chase International." This is an informal
arrangement to promote sharing of investigatory information and
-3-
cooperation in all types of Customs cases with special emphasis
on money laundering cases.
Through the Italian American Working Group, Customs also has
created a joint operation with Italy called "Primo Paso" (First
step). U.S. Customs and Italian authorities work together to
identify information about organized crime operating in Italy and
the u.s. Their work is facilitated by on-line access to the
currency reporting information in the Treasury Financial Database
available to our Customs attache in Rome. Our Customs attaches
are working to replicate the success of Primo Paso with similar
operations in other European countries.
Secretary Brady has applied Treasury's years of experience in
financial analysis and investigation in the creation of the
Financial Crimes Enforcement Network, "FinCEN." FinCEN has been
established within Treasury to provide a multi-source data access
and financial analysis service to Federal, State, local and
foreign law enforcement which will assist them in the
investigation and prosecution of money laundering and other
crimes.
FinCEN represents a fresh approach to financial analysis. For
the first time, experts from law enforcement, regulatory agencies
and the private sector will work together routinely to apply
their collective expertise to the issue of money laundering and
other financial crimes. We look forward to testifying in the
future that the creation of FinCEN was a watershed event in the
history of the government's war on drug money laundering.
International Cooperation
G-7 Financial Action Task Force on Money Laundering
Our most important recent initiative was the u.s. participation
in the G-7 Financial Action Task Force on Money Laundering. This
Task Force was convened at the direction of the 1989 G-7 Economic
Summit in Paris. The heads of state and governments of the G-7
gave the group a mandate to study measures that have been taken
to prevent utilization of financial institutions by money
launderers and to make recommendations on how to improve
international cooperation against money laundering.
The Financial Action Task Force was born of the ideas that
narcotics trafficking and money laundering are inextricably
linked and that money laundering is an international problem that
must be addressed through international solutions.
The Task Force met under French chairmanship and consisted of
sixteen members: the seven Summit participants (Canada, France,
Germany, Italy, Japan, the United Kingdom and the United States),
eight other industralized countries, (Australia, Austria,
-4-
Belgium, Luxembourg, the Netherlands, Spain, Sweden, and
Switzerland), and the European Community. The Task Force brought
together over 130 experts from finance ministries, financial
institution regulatory agencies, foreign affairs and justice
ministries, and law enforcement agencies of the member countries.
I had the privilege of serving as the chairman of the U.S.
Delegation which consisted of delegates from Treasury, including
Customs and the Office of the Comptroller of the Currency, the
Department of State, the Department of Justice, FBI, DEA, and the
Federal Reserve Board.
After monthly meetings from September 1989 through February 1990,
under the able direction of our French Chairman, the group issued
an excellent report with 40 action recommendations. The report
was published in the united States last week and will be a topic
of discussion at the Houston Summit this summer. Treasury has
provided the Committee with the report. I would like to submit
the report and its annexes for the record.
These recommendations, as they are implemented by the member
countries, should establish a nucleus of comprehensive programs
to address money laundering and will facilitate cooperation in
international investigations, prosecutions, and forfeiture
actions. I think it is fair to characterize the report as the
single most comprehensive, forceful international declaration on
money laundering to date.
The report reflects recognition by the Task Force members that in
order to wage an effective war against money laundering each
member must have an effective domestic program to attack money
laundering and that we must cooperate with each other in the many
cases that traverse international borders through both formal and
informal mechanisms. The group also recognized that financial
institution secrecy laws should not stand as barriers to
effective financial crimes enforcement.
Most importantly, the Task Force recommendations reflect the
fact that money laundering is a complex crime that cannot be
effectively attacked by conventional law enforcement methods
alone. Law enforcement authorities, finance ministries,
financial institution regulators, and financial institutions
themselves must work together to prevent financial institutions
from being used by money launderers.
With these tenets in mind, the Task Force made a number of
recommendations, including the following:
o
Countries should criminalize drug money laundering and
consider criminalizing other types of money laundering.
o
Countries should adopt effective seizure and forfeiture
-5-
laws.
o
Financial institutions should not have anonymous
accounts and should be required to identify their
customers when accounts are opened and when conducting
transactions, in particular when performing large cash
transactions.
o
Financial institutions should maintain adequate
records of transactions, including currency
transactions, for five years, so as to be able to
provide evidence in future investigations and
prosecutions.
o
Financial institutions should be alert to suspicious
transactions and be able to report such transactions to
law enforcement authorities free from liability under
secrecy laws.
o
Financial institutions should develop comprehensive
anti-money laundering programs with employee training
and audit procedures.
o
Financial institution regulators should cooperate with
law enforcement authorities and insure that financial
institutions have adequate money laundering prevention
procedures.
o
Countries should provide the widest possible assistance
in money laundering cases at every stage from
investigation and prosecution through extradition.
While the Task Force recommendations may cause us to do some fine
tuning of u.s. financial enforcement, by and large the
recommendations reflect policies and programs already in place in
the United States. This is not surprising given the fact that
the United States has been addressing money laundering
enforcement issues for many years longer than most of our allies,
and our system was frequently looked to as a model.
The degree to which the Task Force was able to reach consensus on
the recommendations is worth noting. Some of the
recommendations, such as active participation by bank regulators
and reporting of suspicious transactions, are major departures
from legal and banking traditions in many of the countries.
This is not to suggest that the recommendations rubber-stamp the
u.S. system. For instance, while the report has a number of
recommendations dealing with large cash transactions, and takes
specific note of the u.S. currency transaction reporting system,
the report recommends that each government should individually
consider the feasibility and utility of such a system.
-6-
The United states views routine currency reporting as one of the
important components of our financial enforcement program,
particularly in view of the complexity of our financial system,
the number and diversity of united States financial institutions,
and our geographic size. However, other countries may be able to
achieve an effective enforcement program without routine
reporting through programs that combine currency recordkeeping,
customer identification, the availability of records to law
enforcement authorities, and suspicious transaction reporting.
In time, some of these countries will come to adopt routine
currency reporting, as Australia has.
In the meantime, Treasury has extended an invitation to foreign
government and banking officials to visit us for a demonstration
of the effectiveness of our program. Treasury's Office of
Financial Enforcement regularly arranges multi-day "tours" for
delegations of foreign officials to view Treasury facilities at
FinCEN and elsewhere and to discuss enforcement issues. This
year to date, we have hosted several such delegations from
various countries. In addition, Customs and IRS partiCipate
regularly in bilateral money laundering seminars and training of
foreign officials.
Recognition by the Task Force member countries of the need for a
united front against money laundering is a major step, but only a
first step. We must keep working to encourage other countries -large and small, developed and developing -- to embrace the Task
Force recommendations and move forward to address the problem
from a concerted, multilateral approach.
FATF-Related Initiatives
We shortly will have just such an opportunity to encourage other
countries to endorse the recommendations. President Bush has
accepted the invitation of Prime Minister Oduber of Aruba for the
U.s. to participate in a conference inspired by the success of
the Financial Action Task Force, focusing on money laundering in
the Carribean area. On behalf of Secretary Brady, I will chair
the U.S. Delegation with assistance from the Departments of
Justice and state and our law enforcement and bank regulatory
agencies. We hope that the countries participating will endorse
the recommendations of the FATF as well as deliberate on other
recommendations appropriate to addressing the money laundering
problem in this region. The first organizational meeting of this
Aruban Task Force took place in Washington yesterday.
A related undertaking is underway in the Organization of American
States ("OAS"). On April 17 - 20, 1990, the OAS convened a
Meeting of Ministers on the Illicit Use and Production of
Narcotic Drugs and Psychotropic Substances and Traffic Therein.
This "Alliance of the Americas Against Drug Traffic" unanimously
adopted a resolution for the formation of an Inter-American Group
-7of Experts to draft model regulations in conformity with the U.N.
Convention Against Illicit Traffic in Narcotic Drugs and
psychotropic Substances.
The mandate of this experts group is to develop model legislation
to criminalize drug money laundering to prevent the use of
financial systems for money laundering, to enable authorities to
identify, trace, seize and forfeit illicit proceeds, to change
legal systems to ensure that bank secrecy laws do not impede
effective law enforcement and mutual legal assistance, and,
finally, to study the reporting of large currency transactions to
national governments and to permit the sharing between
governments of such information.
It is expected that the OAS
will soon convene this group and that Treasury will playa
central role in its work.
Panama
Next, I would like to address measures taken by Panama.
Recent history dramatically demonstrated to the Panamanians the
pernicious effect of money laundering on the Panamanian
political, economic and social structure. With this backdrop,
the Endara government has taken a number of steps that show its
resolve to address drug money laundering.
These steps have been
taken with U.S. encouragement, but at the initiative of the
Panamanian government.
In January, the Endara government entered a Mutual Cooperation
Agreement on Narcotics with the United states (a so-called
"Chiles" agreement required under P.L. 100-690). Under the terms
of this agreement, both governments committed to take a variety
of cooperative measures related to narcotic matters, including
steps to combat drug money laundering.
Panama also accepted an
invitation to participate in the Aruban initiative.
Panama has begun to use its anti-narcotics legislation which was
dormant for many years and to interpret its bank secrecy
provisions in drug cases to allow access to bank records by both
domestic and foreign law enforcement authorities.
Following the
fall of the Noriega regime, the Panamanian government froze over
200 bank accounts related to drug and drug money laundering
cases based on information provided by U.s. law enforcement
agencies.
The accounts remain frozen to their owners and the
Panamanian Attorney General has begun to share information about
these accounts for use in U.s. investigations and prosecutions,
including the Noriega case.
These documents were important in
the investigations that led to the freezing last week of a number
of U.s. bank accounts last week arising out of Operation Polar
Cap.
This is to be contrasted with the lack of cooperation U.s.
authorities received from Panama in past years in drug money
laundering cases.
-8-
The Panamanian government also has taken steps to enlist its
banks and bank regulators in the fight against money laundering.
On February 13, 1990, the Panamanian Cabinet issued Decree No.
41, mandating that the National Banking Commission require banks
to identify their customers and to record currency and certain
negotiable instrument transactions in excess of $10,000. The
decree gives authority to the Commission to examine banks for
compliance, and provides for civil penalties and criminal fines
against banks and their directors, officers and employees for
failure to adhere to these requirements.
The provisions of Decree 41 and the regulations that have been
issued under it appear to be a major step forward for Panama to
safeguard banks against money laundering. It also represents the
first time that panamanian regulatory authorities have been
actively engaged in the struggle against money laundering.
Finally, in mid-February 1990, the Endara government approached
the u.s. about its desi~e to enter into an exchange of
information agreement to facilitate the sharing of information
and records, including bank records, in drug and drug-related
investigations and prosecutions, including money laundering. A
joint State, Treasury, and Justice team has been discussing this
agreement with officials of the panamanian government.
While I hope the Committee will understand that we cannot discuss
the details of the course of these discussions, both the U.S. and
Panama are intenSively pursuing an agreement. We can add that we
seek provisions for the sharing of currency recording information
maintained in Panama under Decree 41, and consider this aspect of
the discussions to be under the authority of section 4702.
In summary, the news from Panama is encouraging and reinforces
the Administration's commitment to do everything possible to
assist the Endara government to help stabilize democratic
institutions to insure that the nightmare of the Noriega regime
cannot be repeated. We want to continue to send a message of
trust and friendship to the government and people of Panama.
Section 4702
Next, I would like to turn to an integral part of our
international anti-money laundering strategy, section 4702.
Under Section 4702 of the Anti-Drug Abuse Act of 1988, the
Secretary of the Treasury negotiates with countries that do
business in U.S. currency to require their financial institutions
to keep records of large dollar currency transactions, and to
share those records with u.s. law enforcement authorities upon
request. The Secretary, in consultation with the Attorney
General and the Director of the Office of National Drug Control
-9-
Policy (ONDCP), is to place highest priority on those countries
whose financial institutions may be engaging in transactions
involving the proceeds of international narcotics trafficking,
particularly U.S. drug sales.
On November 18, 1990, the Secretary reports to Congress and to
the President on the status of the negotiations. The President
is to apply sanctions against any country that has not reached an
agreement or is not negotiating in good faith unless he certifies
that sanctions would not be in the national interest. Sanctions
include virtually closing off access to the U.S. banking system
to the financial institutions of a country.
In enacting section 4702, Congress recognized that it is
essential that financial institutions adequately identify those
engaging in large cash transactions, record those transactions,
and make the information available to law enforcement in
drug-related cases.
The Financial Action Task Force Report reached the same
conclusion about the need for financial institutions to keep
records of large currency transactions, to identify their
customers when conducting large transactions, and to share
financial institution records with foreign law enforcement
authorities. In this regard, the Financial Action Task Force
report should serve as a foundation for future section 4702
agreements. If properly implemented in the member countries,
this will facilitate our ability to reach agreements under
section 4702.
Treasury has given priority to the negotiation of these
agreements. Our first accomplishment was the complex task of
assessing which countries should be given highest priority for
negotiation. After solicitating the views of federal law
enforcement and intelligence agencies and our embassies abroad,
and consulting with the Director of ONDCP and the Attorney
General regarding priority countries, and careful review of all
available information, we initially selected eighteen countries
for negotiation of 4702 agreements. Three countries have been
added to the list since our interim report to the Committee last
November for a total of twenty-one. We do not regard the list as
fixed, and we will adjust the list of countries as appropriate.
Next, we determined what resources would be needed to get the job
done. We determined the task could be best accomplished by a
mUlti-agency approach. So, under the direction of the Assistant
Secretary for Enforcement, we have assembled a team to work on
this project. The team includes four full-time international
specialists detailed from IRS and Customs, an administrative
officer, officials from Treasury, (Office of Financial
Enforcement and General Counsel) State (International Narcotics
Matters and Office of Legal Advisor), and Justice (Office of
-10-
International Affairs and the Deputy Assistant Attorney General,
Criminal Division).
Treasury is working closely and meets regularly with the
Departments of State and Justice to discuss our strategies for
section 4702 agreements and to coordinate these initiatives with
other drug and money laundering initiatives, especially any
ongoing or planned Mutual Legal Assistant Treaties (MLATs) with
any of the countries. I think Justice and State would agree
inter-agency cooperation in this project has been excellent.
The negotiations with and approaches to the countries are at
various stages. Our embassies abroad have been very helpful in
making formal approaches to appropriate foreign officials and in
fielding questions for Treasury that these officials pose
regarding currency recordkeeping or the operation of the
agreements. Over the next months, we will send negotiating
delegations to many of the priority countries. Where it might
facilitate the negotiating process, I intend to personally to
visit my foreign counterparts.
This is a major undertaking through often uncharted waters. At
this point, it is not possible to predict the course of any
particular negotiation or a time when we can consider the project
completed. While Treasury will report back to Congress in
November on the status of negotiations, we see the process
continuing beyond that time. However, our goal is clear: an
international network of countries with stong anti-money
laundering programs and broad colloboration among law enforcement
authorities.
Several factors contribute to the uncertainty of these
predictions. First, we are asking countries to adopt
requirements that are often unprecendented for their financial
institutions and governmental authorities. While we take the
currency transaction recording and the connection between
currency and drugs and drug money laundering for granted, there
is an educational process to go through with many of these
countries, which takes time. This is the case even for countries
that are genuinely determined to have effective drug and money
laundering enforcement programs.
Second, we are asking countries in most cases to amend statutory
or regulatory provisions both to require currency recording and
to authorize information sharing. Finally, the U.S. experience
with law enforcement agreements generally is that negotiations
can be protracted. For instance, as the Justice Department can
attest, Mutual Legal Assistance Treaties often take a number of
years to negotiate.
Let me assure the Committee that we are firmly committed to
forging a network of section 4702 agreements. We are optimistic
-11-
that countries will be persuaded to conclude these agreements as
we help them to understand the money laundering problem and the
relation of these agreements to effective enforcement programs.
hope the Committee will understand that, because of the
sensitivity of negotiations and the source of the information
upon which we have based our selection of countries for
negotiation, we cannot now report in more detail on the
discussions or name the countries selected. We believe that to
do so would be harmful to the negotiation process.
I
Conclusion
Our experience has taught us that we cannot make progress against
drug trafficking and the international money laundering that
sustains it with traditional law enforcement methods, applied
within national boundaries. What is needed is painstaking,
sophisticated financial analysis to uncover the tangled web of
financial dealings of drug organizations, followed by determined
action to deprive the otganizations of their holdings. This
cannot be achieved without two partnerships working together -- a
partnership among financial institutions and government
authorities and a partnership among nations. As money launderers
know no national boundaries, countries must work together to
insure that international boundaries will pose no impediments to
enforcement efforts.
TREASUR:'iII\lEWS
FOR RELEASE AT 12:00 NOON
CONTACT: OFFICE OF FINANCING
202/ 376-4350
April 27, 1990
TREASURY'S 52-WEEK BILL OFFERING
The Department of the Treasury, by this public notice, invites
tenders for approximately $10,000 million of 364-day Treasury bills
to be dated
May 10, 1990,
and to mature May 9, 1991
(CUSIP No. 912794 WH 3). This issue will provide about $950
million of new cash for the Treasury, as the maturing 52-week bill
is outstanding in the amount of $9,057
million. Tenders will be
received at Federal Reserve Banks and Branches and at the Bureau
of the Public Debt, Washington, D. C. 20239, prior to 1:00 p.m.,
Eastern Daylight Saving time, Thursday, May 3, 1990.
The bills will be issued on a discount basis under competitive
and noncompetitive bidding, and at maturity their par amount will
be payable without interest. This series of bills will be issued
entirely in book-entry form in a minimum amount of $10,000 and in
any higher $5,000 multiple, on the records either of the Federal
Reserve Banks and Branches, or of the Department of the Treasury.
The bills will be issued for cash and in exchange for
Treasury bills maturing May 10, 1990.
In addition to the
maturing 52-week bills, there are $15,680 million of maturing bills
which were originally issued as 13-week and 26-week bills. The disposition of this latter amount will be announced next week. Federal
Reserve Banks currently hold $1,682 million as agents for foreign
and international monetary authorities, and $6,669 million for their
own account. These amounts represent the combined holdings of such
accounts for the three issues of maturing bills. Tenders from Federal Reserve Banks for their own account and as agents for foreign
and international monetary authorities will be accepted at the
weighted average bank discount rate of accepted competitive tenders.
Additional amounts of the bills may be issued to Federal Reserve
Banks, as agents for foreign and international monetary authorities,
to the extent that the aggregate amount of tenders for such accounts
exceeds the aggregate amount of maturing bills held by them. For
purposes of determining such additional amounts, foreign and international monetary authorities are considered to hold $130
million
of the original 52-week issue. Tenders for bills to be maintained
on the book-entry records of the Department of the Treasury should
be submitted on Form PD 5176-3.
NB-784
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 2
Each tender must state the par amount of bills bid for,
which must be a minimum of $10,000. Tenders over $10,000 must
be in multiples of $5,000. competitive tenders must also show
the yield desired, expressed on a bank discount rate basis with
two decimals, e.g., 7.15%. Fractions may not be used. A single
bidder, as defined in Treasury's single bidder guidelines, shall
not submit noncompetitive tenders totaling more than $1,000,000.
Banking institutions and dealers who make primary
markets in Government securities and report daily to the Federal
Reserve Bank of New York their positions in and borrowings on
such securities may submit tenders for account of customers, if
the names of the customers and the amount for each customer are
furnished. Others are only permitted to submit tenders for their
own account. Each tender must state the amount of any net long
position in the bills being offered if such position is in excess
of $200 million. This information should reflect positions held
as of one-half hour prior to the closing time for receipt of
tenders on the day of the auction. Such positions would include
bills acquired through "when issued" trading, and futures and
forward transactions as well as holdings of outstanding bills
with the same maturity date as the new offering, e.g., bills
with three months to maturity previously offered as six-month
bills. Dealers, who make primary markets in Government securities and report daily to the Federal Reserve Bank of New York
their positions in and borrowings on such securities, when submitting tenders for customers, must submit a separate tender for
each customer whose net long position in the bill being offered
exceeds $200 million.
A noncompetitive bidder may not have entered into an
agreement, nor make an agreement to purchase or sell or otherwise dispose of any noncompetitive awards of this issue being
auctioned prior to the designated closing time for receipt of
tenders.
Payment for the full par amount of the bills applied for
must accompany all tenders submitted for bills to be maintained
on the book-entry records of the Department of the Treasury.
A cash adjustment will be made on all accepted tenders for the
difference between the par payment submitted and the actual
issue price as determined in the auction.
No deposit need accompany tenders from incorporated banks
and trust companies and from responsible and recognized dealers
in investment securities for bills to be maintained on the bookentry records of Federal Reserve Banks and Branches.
8/89
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 3
Public announcement will be made by the Department of the
Treasury of the amount and yield range of accepted bids. Competitive bidders will be advised of the acceptance or rejection
of their tenders.
The Secretary of the Treasury expressly
reserves the right to accept or reject any or all tenders, in
whole or in part, and the secretary's action shall be final.
Subject to these reservations, noncompetitive tenders for each
issue for $1,000,000 or less without stated yield from anyone
bidder will be accepted in full at the weighted average bank
discount rate (in two decimals) of accepted competitive bids
for the respective issues. The calculation of purchase prices
for accepted bids will be carried to three decimal places on the
basis of price per hundred, e.g., 99.923, and the determinations
of the Secretary of the Treasury shall be final.
Settlement for accepted tenders for bills to be maintained
on the book-entry records of Federal Reserve Banks and Branches
must be made or completed at the Federal Reserve Bank or Branch
on the issue date, in cash or other immediately-available funds
or in Treasury bills maturing on that date.
Cash adjustments
will be made for differences between the par value of the
maturing bills accepted in exchange and the issue price of the
new bills.
If a bill is purchased at issue, and is held to maturity,
the amount of discount is reportable as ordinary income on the
Federal income tax return of the owner for the year in which
the bill matures. Accrual-basis taxpayers, banks, and other
persons designated in section 1281 of the Internal Revenue Code
must include in income the portion of the discount for the period
during the taxable year such holder held the bill. If the bill
is sold or otherwise disposed of before maturity, any gain in
excess of the basis is treated as ordinary income.
Department of the Treasury Circulars, Public Debt Series Nos. 26-76, 27-76, and 2-86, as applicable, Treasury's single
bidder guidelines, and this notice prescribe the terms of these
Treasury bills and govern the conditions of their issue. copies
of the circulars, guidelines, and tender forms may be obtained
from any Federal Reserve Bank or Branch, or from the Bureau of
the Public Debt.
8/89
TREASURY NEWSu
D811artment of the Treasury • Washington, D.C . • '~le'';hane·-S''.204t
REMARKS OF
KENNETH W. GIDEON
ASSISTANT SECRETARY OF THE TREASURY FOR TAX POLICY
FIRST ANNUAL ADVANCED INSTITUTE ON CORPORATE TAXATION,
GEORGETOWN UNIVERSITY LAW CENTER
APRIL 30, 1990
Thank you for inviting me to speak at your first annual
Advanced Institute on Corporate Taxation.
I would like to
discuss the loss disallowance regulations that we issued in
March -- to restate our willingness to consider all reasonable
alternatives to the loss disallowance rule, our openness to
proposals
for improvement, and our interest in comments
suggesting appropriate transition rules. Given the number of
misperceptions about the rule and our willingness to consider
alternatives, it is worth taking a moment to explain how these
regulations evolved.
#
First, let me emphasize that -- contrary to many comments
the regulations are not directed solely at the so-called
son-of-mirrors transactions that were promoted following the
Tax Reform Act of 1986. As part of the 1986 Act, Congress
repealed the General Utilities doctrine.
A principal purpose
for the repeal, as expressed by the legislative history, was to
require the payment of a corporate-level tax when assets leave
corporate
solution in a transaction that
results in a
stepped-up basis to the new owner. In connection with the
legislation, Congress by statute explicitly instructed Treasury
to amend the consolidated return regulations to ensure that the
purpose of General utilities repeal could "not be circumvented"
through their application.
Because the investment adjustment rules currently contained
in the consolidated return regulations reflect the application
of the General utilities doctrine as it existed before the 1986
Act, the rules, if applied without modification, could be used
to obtain a stepped-up basis in corporate assets without
payment of a corporate level tax. Ther~fore, in early 1987,
the Internal Revenue Service issued a notice announcing that we
would
amend the investment adjustment rules to "prevent
recognition of losses that are attributable to [a] subsidiary's
recognition of built-in gains." While this notice was viewed
by many as a response to "son of mirrors" transactions, it was
directed at the more general problem of the interaction of the
consolidated return regulations with General utilities repeal
and contained neither a reference nor a limitation to the "son
of mirrors" transaction.
NB-785
-2-
The basic problem is relatively simple to illustrate: if a
consolidated group acquired the stock of a subsidiary for $100
and the subsidiary had an inside basis for its assets of say
$10, the group -- as required by General utilities repeal-would recognize $90 in gain on the sale of the subsidiary's
assets for their fair market value of $100. However, if the
consolidated return investment adjustment rules were allowed to
operate without change as they did before the 1986 Act, the
gain recognized on the sale would increase the group's basis in
the subsidiary's stock from $100 to $190 -- even though the
subsidiary held only the $100 in proceeds from the sale of its
assets.
If the rules continued to permit the group to
recognize a $90 loss on the subsequent sale of the subsidiary's
stock for $100, this loss could offset the $90 gain recognized
on the sale of the subsidiary's assets -- thereby circumventing
General
utilities repeal by effectively
eliminating the
corporate level tax on the sale of the assets.
As this example illustrates, the investment adjustment
rules operate to increase the basis of subsidiary stock to
reflect both a subsidiary's earnings and gain on the sale of
the subsidiary's assets. This basis adjustment occurs even if
the
gain inherent in the subsidiary's
assets when the
subsidiary joins the group -- the so-called built-in gain -- is
already reflected in the group's cost basis in the subsidiary's
stock -- as it typically would be if the stock is purchased.
Accordingly, when the built-in gain assets are sold, the group
would receive an artificial increase to the basis of the
subsidiary stock that would produce a loss when the stock is
sold.
The problem can occur, however, even without the sale of
built-in gain assets.
The investment adjustment rules also
operate to eliminate corporate level tax when a built-in gain
asset
say, an oil well or a piece of equipment -- is
consumed in operations. However, it is extremely difficult to
segregate
investment
adjustments
attributable
to
the
consumption of built-in gain assets from other operating
adjustments.
Over a period of three years, our office and the IRS
explored numerous approaches to resolving these problems. Let
me
briefly summarize the major alternatives and why we
published the loss disallowance proposal.
The first method we considered was the "tracing of assets."
By comparison to the method we proposed, this method would have
increased gain as well as disallowed loss on the sale of
subsidiary stock. Therefore it theoretically would achieve the
most
technically accurate results,
but at an
enormous
-3-
administrative burden to both taxpayers and the IRS. Under a
tracing system, consolidated groups would be required to
appraise all of a subsidiary's assets (including the assets of
any of its lower tier subsidiaries) at the time it was
acquired. Thereafter, whenever a built-in gain asset was sold,
investment adjustments attributable to the built-in gain would
be disallowed. A separate earnings and profits mark-to-market
system would be required to deal with the problem of assets
that are used up in operations. Thus, it would be necessary to
appraise each asset held by a subsidiary and then trace all
built-in gain assets from the time the subsidiary was acquired
until the assets were sold or used up, including following the
assets
if
they
were
transferred
in carryover
basis
transactions.
In such a system, disputes between the IRS and
taxpayers concerning appraisal of assets were likely to be both
frequently recurring and costly.
The IRS was understandably
concerned about the difficulty of administering such a system
and the degree of accuracy it would in fact achieve. Moreover,
taxpayers who commented prior to issuance of the proposal
overwhelmingly rejecteq tracing.
An alternative method would also require appraisals, but
rather than tracing assets, would instead presume that all or
some percentage of the subsidiary's earnings were attributable
to built-in gain assets until an amount of basis adjustments
equal to the built-in gain has been disallowed. Like the
tracing method, this method would apply to gain as well as loss
transactions.
This is the basic approach recommended by the
New York State Bar.
However, because this approach would
potentially produce non-economic results for more taxpayers
than the rule we proposed, the New York State Bar also
recommended that taxpayers be allowed to rebut the presumption
if they could establish that not all the disallowed basis
adjustments were attributable to built-in gain. This approach
would effectively subject taxpayers and the IRS to tracing and
require administration of two systems, because taxpayers would
inevitably have to compare their results under both the
presumption and tracing to determine which produced a lower tax
liability.
Another method, similar in concept to the one we ultimately
proposed, was a loss limitation approach. This approach, like
the one we proposed, would not apply to reduce basis when
subsidiary stock was sold at a gain, but would disallow loss on
the sale of subsidiary stock. However, taxpayers would be able
to avoid disallowance of the loss by establishing that the loss
was not attributable to investment adjustments resulting from
built-in gain assets. Thus, in order to take advantage of the
rule, taxpayers would have to resort to tracing. Moreover,
such an approach would completely disadvantage the revenue
-4-
because taxpayers would be able to use basis adjustments
attributable to built-in gain assets to shelter gain whenever
subsidiary stock was sold at a gain, but still have the
opportunity -- through tracing -- to avoid loss disallowance
when it was sold at a loss.
As the foregoing catalogue makes clear, each of the
alternative models that we explored presented sUbstantial
complexity
and burden for both taxpayers
and the IRS.
Appraisals and tracing are costly for taxpayers and difficult
for the IRS to audit. Arbitrary assumptions concerning amounts
attributable
to built-in gain would
potentially produce
non-economic
results for more
taxpayers than the
loss
disallowance
rule.
And
permitting taxpayers
to rebut
presumptions when they are disadvantaged by the rules would
both effectively require tracing, so that taxpayers could
determine whether they were disadvantaged by the presumption,
and
assure that decisions would always be made to the
disadvantage of the revenue.
Each of these alternatives would have required special
rules to address such problems as fluctuating values, wasting
assets, creeping acquisitions, and nonrecognition transactions.
In addition, because the statutory mandate applies to all
corporations, regardless of when they were acquired, a tracing
regime
would have imposed enormous burdens by requiring
consolidated groups that acquired subsidiaries before 1987
retroactively to identify and obtain appraisals of assets held
by the subsidiary at the time of acquisition.
After struggling with these approaches for some time, we
settled on the pure loss disallowance rule as the most
administrable course. This approach also had the virtue of
being the simplest method.
In most situations, the rule is
beneficial
to taxpayers:
it requires no appraisals; it
requires no tracing; and it permits investment adjustments
attributable to built-in gain to be used to shelter the gain on
the sale of subsidiary stock.
We realized that the rule would result in disallowance of
economic losses in some cases. To provide a measure of relief,
we provided for reattribution of subsidiary losses to the
selling group to the extent of the disallowed loss. We are
quite willing to consider additional meritorious cases for
relief, particularly where it can be demonstrated -- without
undue complexity -- that an economic loss in fact occurred.
Accordingly, we stated in the preamble to the regulations that
we are prepared to consider specific proposals for transitional
-5-
relief for existing subsidiaries and suggestions for specific
mechanisms that would afford relief for economic losses on an
ongoing basis. I am here today to emphasize that we meant what
we said there.
Although we have received some helpful comments, much of
the commentary has simply been directed at opposition to the
rule, without offering alternatives. General opposition to the
rules
we proposed, without constructive
suggestions for
remedies, is not of great help to us in our effort to fashion a
workable rule. To take but one example, a recent submission
stated that an "administratively sound and simple system" could
have been developed, but did not tell which alternative that
might be. In contrast, the report of the New York state Bar,
which was submitted before publication of the regulations and
presented the most thorough analysis of the issue we have
received to date, stated:
"We have identified no perfect or near perfect
method for implementing the objectives of Notice
87-14.
Nor is there a clearly preferable
choice.
Each of the proposals discussed herein
would serve to overtax or undertax taxpayers in
some circumstances, and each would involve some
measure of additional complexity."
We concur. There is "no perfect or near perfect method,"
and progress will be made more quickly if commentators respond
to this reality. We have, throughout this process, indicated
our willingness to consider all fully articulated comments
proposing
modifications to loss disallowance, alternative
approaches to the overall problem, and reasonable transition
relief.
We are quite willing to consider the views of
taxpayers
in making a choice among admittedly difficult
alternatives.
commentators should recognize that corporate level tax may
be eliminated through the operations of the business as well as
by dispositions of assets and that the elimination of such tax
is inconsistent with General utilities repeal.
To be of
greatest aid to us in the process of reviewing and modifying
our proposals, comments should fully ana fairly evaluate the
extent
to which proposed alternatives are consistent or
inconsistent with the objectives articulated in the preamble to
the regulations, including the ways in which the proposed
amendments would apply to specific fact patterns.
Comments
should also address whether the sheltering of built-in gain
permitted by the regulations is appropriate.
-6-
Before I close, I would like to again emphasize that we
would welcome comments proposing mechanisms for transitional
relief.
In closing, let me reiterate that we will consider and
analyze thoughtful comments concerning approaches that would
afford relief from the disallowance of economic loss. We have
already received some such comments.
We look forward to
receiving more.
TR EASUJ~'¥:JN EWS
Department of the , ..a.~,~ ~j~~~~~I"'tan, D.C .• '.Ie.hane 188-20.1
ntll
_\,~J
Contact: Office of Financing
FOR IMMEDIATE RELEASE
'RC:·''0'~'i
202/376-4350
April 30, 1990
DE?1. 0rH\[ \. [.
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $8,442 million of 13-week bills and for $ 8,402 million
of 26-week bills, both to be issued on
May 3, 1990,
were accepted today.
RANGE OF ACCEPTED
COMPETITIVE BIDS:
13-week bills
maturing August 2, 1990
Discount Investment
Rate
Price
Rate 1/
7.88%
7.91%
7.91%
Low
High
Average
8.15%
8.18%
8.18%
26-week bills
maturing November 1, 1990
Discount Investment
Price
Rate
Rate 1/
98.008
98.001
98.001
7.99%
8.05%
8.03%
8.44%
8.51%
8.49%
95.961
95.930
95.940
Tenders at the high discount rate for the 13-week bills were allotted 50%.
Tenders at the high discount rate for the 26-week bills were allotted 33%.
TENDERS RECEIVED AND ACCEPTED
(In Thousand s )
Received
Recei ved
AcceEted
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
$
TOTALS
~
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
1/ Equivalent
NB-786
41,055
25,140,075
20,245
45,900
117,775
32,530
1,727,365
50,785
19,125
43,695
18,425
957,140
176,625
$
41,055
7,473,320
20,245
45,900
42,775
32,530
277,305
34,285
9,125
43,695
18,425
227,140
176,625
$
29, 720
16,797,340
18,050
35,370
48,775
32,340
1,620,365
27 , 765
18,820
55,175
19,385
876,715
95,740
AcceEted
$
29,720
7,418,170
18,050
35,370
48,775
32,340
485,365
27,765
12,120
55,175
19,385
123,715
95,740
$28,390,740
$8,442,425
$19,675,560
$8,401,690
$25,893,395
965,345
$26,858,740
$5,945,080
965,345
$6,910,425
$16,526,620
735,240
$17,261,860
$5,252,750
735,240
$5,987,990
1,500,200
1,500,200
1,560,000
1,560,000
31,800
31,800
853,700
853,700
$28,390,740
$8,442,425
$19,675,560
$8,401,690
coupon~issue
yield.
Contact:Office of Financing
202/376-4350
FOR RELEASE AT 4:00 P.M.
May 1, 1990
TREASURY'S WEEKLY BILL OFFERING
The Department of the Treasury, by this public notice, invites
tenders for two series of Treasury bills totaling approximately
816,800 million, to be issued May 10, 1990.
This offering
will provide about Sl,125 million of new cash for the Treasury, as
the maturing bills are outstanding in the amount of 815,680 million.
Tenders will be received at Federal Reserve Banks and Branches and at
the Bureau of the Public Debt, Washington, D. C. 20239, prior to 1:00
p.m., Eastern Daylight Saving time, Monday, May 7, 1990.
The two series offered are as follows:
91-day bills (to maturity date) for approximately 88,400
million, representing an additional amount of bills dated
February 8, 1990,
and to mature August 9, 1990
(CUSIP No.
912794 UX 0), currently outstanding in the amount of 87,627 million,
the additional and original bills to be freely interchangeable.
182-day bills for approximately 88,400 million, to be dated
May 10, 1990,
and to mature November 8, 1990
(CUSIP No.
912794 VH 4).
The bills will be issued on a discount basis under competitive
and noncompetitive bidding, and at maturity their par amount will
be payable without interest.
Both series of bills will be issued
entirely in book-entry form in a minimum amount of 810,000 and in
any higher S5,000 multiple, on the records either of the Federal
Reserve Banks and Branches, or of the Department of the Treasury.
The bills will be issued for cash 'and in exchange for Treasury
bills maturing May la, 1990.
In addition to the maturing
13-week and 26-week bills, there are S9,057
million of maturing
52-week bills.
The disposition of this latter amount was announced
last week.
Tenders from Federal Reserve Banks for their own account
and as agents for foreign and international monetary authorities will
be accepted at the weighted average bank discount rates of accepted
competitive tenders. Additional amounts of the bills may be issued
to Federal Reserve Banks, as agents for foreign and international
monetary authorities, to the extent that the aggregate amount of
tenders for such accounts exceeds the aggregate amount of maturing
bills held by them.
For purposes of determining such additional
amounts, foreign and international monetary authorities are considered to hold $1,547 million of the original 13-week and 26-week
issues.
Federal Reserve Banks currently hold $1,677 million as
agents for foreign and international monetary authorities, and $6,674
million for their own account. These amounts represent the combined
holdings of such accounts for the three issues of maturing bills.
Tenders for bills to be maintained on the book-entry records of the
Department of the Treasury should be submitted on Form PD 5176-1
(for 13-week series) or Form PD 5176-2 (for 26-week series).
NB-787
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 2
Each tender must state the par amount of bills bid for,
which must be a minimum of $10,000. Tenders over $10,000 must
be in multiples of $5,000. Competitive tenders must also show
the yield desired, expressed on a bank discount rate basis with
two decimals, e.g., 7.15%. Fractions may not be used. A single
bidder, as defined in Treasury's single bidder guidelines, shall
not submit noncompetitive tenders totaling more than $1,000,000.
Banking institutions and dealers who make primary
markets in Government securities and report daily to the Federal
Reserve Bank of New York their positions in and borrowings on
such securities may submit tenders for account of customers, if
the names of the customers and the amount for each customer are
furniShed. Others are only permitted to submit tenders for their
own account. Each tender must state the amount of any net long
position in the bills being offered if such position is in excess
of $200 million. This information should reflect positions held
as of one-half hour prior to the closing time for receipt of
tenders on the day of the auction. Such positions would include
bills acquired through "when issued" trading, and futures and
forward transactions as well as holdings of outstanding bills
with the same maturity date as the new offering, e.g., bills
with three months to maturity previously offered as six-month
bills. Dealers, who make primary markets in Government securities and report daily to the Federal Reserve Bank of New York
their positions in and borrowings on such securities, when submitting tenders for customers, must submit a separate tender for
each customer whose net long position in the bill being offered
exceeds $200 million.
A noncompetitive bidder may not have entered into an
agreement, nor make an agreement to purchase or sell or otherwise dispose of any noncompetitive awards of this issue being
auctioned prior to the designated closing time for receipt of
tenders.
Payment for the full par amount of the bills applied for
must accompany all tenders submitted for bills to be maintained
on the book-entry records of the Department of the Treasury.
A cash adjustment will be made on all accepted tenders for the
difference between the par payment submitted and the actual
issue price as determined in the auction.
No deposit need accompany tenders from incorporated banks
and trust companies and from responsible and recognized dealers
in investment securities for bills to be maintained on the bookentry records of Federal Reserve Banks and Branches.
8/89
TREASURY'S 13-, 26-, AND 52-WEEK BILL OFFERINGS, Page 3
Public announcement will be made by the Department of the
Treasury of the amount and yield range of accepted bids.
Competitive bidders will be advised of the acceptance or rejection
of their tenders. The Secretary of the Treasury expressly
reserves the right to accept or reject any or all tenders, in
who~e or in part, and the Secretary's action shall be final.
~ub]ect to these reservations, noncompetitive tenders for each
~ssue for $1,000,000 or less without stated yield from anyone
bidder will be accepted in full at the weighted average bank
discount rate (in two decimals) of accepted competitive bids
for the respective issues. The calculation of purchase prices
for accepted bids will be carried to three decimal places on the
basis of price per hundred, e.g., 99.923, and the determinations
of the Secretary of the Treasury shall be final.
Settlement for accepted tenders for bills to be maintained
on the book-entry records of Federal Reserve Banks and Branches
must be made or completed at the Federal Reserve Bank or Branch
on the issue date, in cash or other immediately-available funds
or in Treasury bills maturing on that date. Cash adjustments
will be made for differences between the par value of the
maturing bills accepted in exchange and the issue price of the
new bills.
If a bill is purchased at issue, and is held to maturity,
the amount of discount is reportable as ordinary income on the
Federal income tax return of the owner for the year in which
the bill matures. Accrual-basis taxpayers, banks, and other
persons designated in section 1281 of the Internal Revenue Code
must include in income the portion of the discount for the period
during the taxable year such holder held the bill. If the bill
is sold or otherwise disposed of before maturity, any gain in
excess of the basis is treated as ordinary income.
Department of the Treasury Circulars, Public Debt Series Nos. 26-76, 27-76, and 2-86, as applicable, Treasury's single
bidder guidelines, and this notice prescribe the terms of these
Treasury bills and govern the conditions of their issue. Copies
of the circulars, guidelines, and tender forms may be obtained
from any Federal Reserve Bank or Branch, or from the Bureau of
the Public Debt.
8/89
TREASURY NeWS:b
Dellartm.nt of til. T..a.ury • Wa.llinaton, D.C•• T.lellhon. 588-2041
For Release Upon Delivery
Expected at 10: 00 a. m .
May 3, 1990
D:: I~ T. :; -: [;;~ -: .
STATEMENT OF
HARVEY S. ROSEN
DEPUTY ASSISTANT SECRETARY (TAX ANALYSIS)
DEPARTMENT OF THE TREASURY
BEFORE THE
FINANCE COMMITTEE
UNITED STATES SENATE
Mr. Chairman and Members of the Committee:
I am pleased to have this opportunity to present the views
of the Administration on recent trends in corporate tax receipts.
INTRODUCTION
Since its inception in 1913, the corporate income tax has
generated a sizable share of total U.S. tax receipts. As the
Committee has requested, my remarks today focus principally on
the trend in corporate tax receipts, the importance of the
corporate tax in other countries, and the effect of the Tax
Reform Act of 1986 on corporate tax receipts.
HISTORY OF CORPORATE INCOME TAX RECEIPTS
In 1989, the corporate income tax produced $104 billion in
revenue for the u.S. Government. The $104 billion was the most
revenue ever produced by corporate taxes and represented the
sixth consecutive annual increase in corporate tax receipts.
In
general, corporate tax receipts have increased over the past 40
years.
In the 1950's, corporate tax receipts averaged $19
billion per year; in the 1960's, $26 billion per year; in the
1970's, $38 billion per year; and from 1980 to 1986, $56 billion
per year.
Since 1986, corporate tax receipts have averaged $94
billion per year.
The long-run increase in corporate taxes occurred even
though pre-tax corporate profits as a percentage of gross
national product ("GNP") fell sharply.
In the mid-1950'S, when
corporate taxes were at their peak as a perc 7ntage of total
federal tax receipts, pre-tax corporate proflts were about 11
NB-788
2
percent of
percent.
GNP~
by 1986, this percentage had fallen to 5.1
Although the level of federal corporate receipts rose from
the mid-1950's to 1986, they fell as a percentage of total
receipts. But, since 1986, the declining trend in the relative
importance of the corporate tax has been reversed. From 1987 to
1989, corporate taxes accounted for an increasing share of total
tax receipts. In 1989, corporate tax receipts accounted for 10.5
percent of total tax receipts, which is the highest percentage
since 1980. We expect this trend to continue into the future.
By 1995, we expect corporate tax receipts to account for 11.4
percent of total tax receipts.
It is important to note that the level of corporate tax
receipts depends heavily on the strength of the u.s. economy.
When the u.s. economy is growing, as it has been for the past 7
years, corporate profits are strong, and corporate tax receipts
increase. But when the economy is in recession, corporate
profits tend to fall, and corporate taxes decrease. During the
1982-1983 recession, for example, corporate taxes as a percentage
of total receipts fell from 10.2 percent in 1981 to 6.2 percent
in 1983. A significant portion of this decline was attributable
to the fall in pre-tax corporate profits, from $202 billion in
1981 to an average of $178 billion in 1982 and 1983.
CORPORATE TAXES IN FOREIGN COUNTRIES
Because of cultural and historical differences, foreign
countries have a wide variety of tax systems. For example, some
countries have separate individual and corporate tax systems,
similar to the u.s. tax system. Others have integrated tax
systems, which generally relieve part or all of the double tax on
distributed corporate earnings. These differences among tax
systems make it difficult to directly compare corporate tax
burdens across countries. Nonetheless, we can make some general
observations.
In 1987, corporate income taxes accounted for an average of
8 percent of total tax receipts for the 22 countries in the
Organization for Economic Cooperation and Development (the
"OECD") for which we have data. The data pertain to corporate
taxes at both the central government and local levels.
Comparisons of corporate tax receipts for central governments
only would be misleading because some countries have much greater
corporate taxation at the local level than others.
Although u.s. corporate taxes as a percentage of total tax
receipts was 8 percent in 1987, the same as the average for the
22 OECD countries, the U.S. percentage will be higher in
subsequent years if current trends continue. countries that were
above the OECD average in 1987 include Japan at 23 percent, the
3
United Kingdom at 11 percent, and Italy at 11 percent.
countries
that were below the average include Germany at 5 percent, France
at 5 percent, and Switzerland at 6 percent.
In 1980, corporate income taxes also accounted for 8 percent
of total tax receipts in the 22 OECD countries. Thus, there does
not appear to be any general trend toward increased or decreased
reliance on corporate taxes among OECD countries.
THE TAX REFORM ACT OF 1986
The Tax Reform Act of 1986 (the "1986 Act") made significant
changes to the corporate tax system. These changes were expected
to increase corporate tax receipts significantly. Our most
recent estimates indicate that the 1986 Act will increase
corporate tax receipts by $140 billion over the 1987-1991 period.
Corporate Changes in the 1986 Act
The 1986 Act adopted base-broadening measures designed to
increase the overall level of corporate income taxes, even though
the maximum marginal tax rate was reduced from 46 percent to 34
percent. The corporate tax base broadening was accomplished
primarily by repealing the investment tax credit, limiting
depreciation deductions, restricting the use of net operating
losses, enacting the corporate alternative minimum tax, and
adopting important changes in accounting rules, for example, by
requiring uniform capitalization of certain expenditures.
The 1986 Act also made three changes that affect the
taxation of corporations and their shareholders and the
desirability of operating in the corporate form:
(1) the
relative relationship of the top individual and corporate tax
rates was reversed, with corporations now subject to a higher
marginal tax rate than most individuals; (2) the preference for
both corporate and individual capital gains was eliminated; and
(3) the so-called General utilities doctrine was repealed.
Effect on Corporate Tax Receipts
The 1986 Act was expected to be revenue neutral. As we
testified in February, for all practical purposes, the 1986 Act
has been revenue neutral. Our most recent estimate indicates
that the numerous positive and negative provisions of the 1986
Act sum to a total change in receipts of less than 1 percent over
the 1987-1991 period.
The 1986 Act was also expected to increase corporate tax
receipts and lower individual receipts as a percentage of total
income tax receipts. This has also occurred. The pe:centage of
income tax receipts accounted for by corporate taxes lncreased
4
from 15 percent in 1986 to 19 percent in 1989; correspondingly,
the percentage accounted for by individual taxes fell from 85
percent to 81 percent.
ECONOMIC FORECASTS IN THE 1988 BUDGET
The Reagan Administration's first budget produced after
enactment of the 1986 Act was the 1988 budget. In that budget,
corporate tax receipts for 1987-1989 were forecast to average
$117 billion per year; actual receipts averaged only $94 billion
per year.
The Reagan Administration was not alone in overestimating
corporate tax receipts after the 1986 Act. In its first budget
after the 1986 Act, the Congressional Budget Office also
overestimated corporate tax receipts by an average of $21 billion
per year for the 1987-1989 period. Table 1 shows actual
corporate tax receipts for the 1987-1989 period, and compares
them with the Administration and CBO forecasts made for the 1988
budget.
The question then arises: why were corporate tax receipts
between $20 billion and $25 billion lower than forecast after the
1986 Act was enacted? Our analysis of the effect of the 1986 Act
on corporate tax receipts today is both preliminary and
incomplete. It is always difficult to distinguish quantitatively
between the effects of changes in the tax law and other economic
factors, but in this case we face special difficulties. Many of
the important and fundamental provisions of the 1986 Act were
phased-in over time and did not become fully effective until
1988. Large corporations, following their conventional practice,
typically did not file their 1988 tax returns until mid-September
1989. The most recent detailed data on corporate tax payments
are for 1987. Hence, detailed data even for the first year in
which the 1986 Act became fully effective cannot yet be analyzed.
Until more detailed data become available, our judgments and
observations must remain tentative. We do have aggregate data
through 1989 for tax receipts and corporate profits, although the
most recent profits data may be revised.
The Main Explanation - Lower Corporate Profits
We believe that the primary reason why corporate tax
receipts were lower than expected in the FY 1988 budget is that
pre-tax corporate profits came in below expectations. It is
worth noting that although the Administration 1988 budget
overestimated book value profits, it was conservative in its
forecast of economic growth in 1987-89. Specifically, real GNP
was estimated to grow at 3 percent per year during the period,
significantly below the actual 3.7 percent. In the 1988 budget,
pre-tax corporate profits were projected to average $342 billion
5
per year over the 1987-1989 period; actual pre-tax corporate
profits averaged $287 billion per year over this period. The
overestimate of $55 billion in average annual corporate profits
resulted in an average annual overestimate of between $15 billion
and $20 billion in corporate tax receipts.
Wages and Salaries. An important reason for the
overestimate of corporate profits appears to be that actual wages
and salaries were higher than expected. Because wages and
salaries are deductible expenses for corporations, higher wages
and salaries reduce corporate profits.
The 1988 budget projected that wages and salaries would
average $2,376 billion per year over the 1987-1989 period.
Actual wages and salaries for this period averaged $58 billion
more per year than forecast. Although the economy was stronger
than expected during 1987-1989, wages and salaries as a
percentage of GNP were also higher than expected during this
period.
Higher wages and salaries would also have the effect of
raising the taxable income of individuals. The higher-thanexpected level of wages and salaries is reflected in higherthan-expected individual income tax receipts.
In the 1988
budget, individual income tax receipts for the 1987-1989 period
were forecast to average $391 billion per year. Actual income
tax receipts for this period averaged $413 billion per year.
Similarly, in the 1988 budget, individual income tax receipts for
the 1990-1992 period were forecast to average $488 billion per
year.
In the 1991 budget, individual taxes for the period were
forecast to average $526 billion per year.
Interest Rates. Higher-than-expected interest rates also
appear to have been a factor in the overestimate of corporate
profits. Nonfinancial corporations are large net borrowers, so
that higher interest rates result in higher interest payments
and, thus, lower profits. Financial corporations are large net
lenders, but because they generally lend long-term and borrow
short-term, their profits also suffer with higher interest rates.
Actual interest rates for 1987-1989 were generally between 1.5
and 2 percentage points higher than interest rates forecast in
the 1988 budget. Similarly, interest rate forecasts in the 1991
budget for the 1990-1992 period are between 1.5 and 2 percentage
points higher than interest rate forecasts in the 1988 budget for
the same period.
other Explanations
Although lower-than-expected corporat 7 profits explain much
of the underestimate in corporate tax recelpts from the 1988
budget, corporate profits do not explain all of it. Our analysis
6
shows that even if actual corporate profits had reached the
levels forecast in the 1988 budget, corporate tax receipts would
still not reach the levels forecast in the 1988 budget. Several
other factors may account for the overestimate in corporate tax
receipts.
8 Corporations. The changes in the top marginal tax rates
in the 1986 Act caused some taxpayers to prefer the S corporation
form over the corporate form. An S corporation is treated as a
corporation for most legal considerations, but it is treated as a
"passthrough" entity for tax purposes. That is, net income (or
loss) from an S corporation flows through and is taxed directly
to shareholders with no corporate-level tax. In order to elect
this passthrough treatment, a corporation must satisfy certain
requirements. For example, the number of shareholders cannot
exceed 35, and shareholders must be individuals (other than
nonresident aliens) and certain estates and trusts. In addition,
an S corporation can have only one class of stock.
The preliminary evidence on S corporations clearly indicates
a surge in S corporation activity. Filings of the form required
to elect S corporation status increased 67 percent between 1986
and 1987, from 346,000 to 578,000. Since then, the number of
filings has receded somewhat, but the 435,000 filings in 1989
remain well above levels before the 1986 Act.
More importantly for tax receipts, income earned by S
corporations also appears to be rising considerably since 1986.
Net income from S corporations reported on individual returns for
1987 more than doubled, rising by about $12 billion. Advance
information on 1988 returns suggests that substantial growth in
net income has continued. Although no explicit prediction was
made about the use of S corporations, the increased use of S
corporations may be well beyond what was implicitly predicted at
the time the forecast was made.
S corporation profits are accounted for and forecast as part
of corporate profits. Thus, other things being the same, higherthan-expected use of S corporations would not affect the
measurement of corporate profits. S corporation profits,
however, are not taxed at the corporate level, but rather, are
taxed at the individual level. Thus, for a given corporate
profits forecast, if S corporation profits are higher than
forecast, corporate tax receipts will be lower than forecast. In
addition, individual receipts will be greater than forecast. As
we have already discussed, individual receipts have been greater
than forecast.
Higher-than-expected interest
rates contributed to a shift in corporate profits from the taxed
sector to the nontaxed sector. The earnings of the Federal
Reserve System (the "Fed") are reported as part of corporate
Federal Reserve Earnings.
7
profits.
Fed earnings come primarily from the interest earned on
the Treasury securities held by the Fed. Fed earnings have been
higher than forecast, in part because interest rates have been
higher than forecast in the 1988 budget. Thus, for a given
forecast of corporate profits, higher interest rates would cause
Fed earnings to account for a greater share of corporate profits
than had been forecast.
But because Fed earnings are not taxed,
corporate tax receipts would fall short of their forecast levels.
(After paying its operating expenses, the Fed turns all excess
earnings over to the Treasury.) Thus, even if corporate profits
had been at levels forecast by the 1988 budget, corporate tax
receipts would have been several billion less than the forecast
level because of higher than expected Fed earnings.
Possible Explanations
We believe the above reasons are the most compelling, but we
cannot rule out two other possible explanations. There is
currently no evidence that these factors contributed
substantially to the underforecast of corporate tax receipts.
Increased Leveraged Buyouts. Although leveraged buyout
("LBO") activity increased significantly during the 1980's, the
effect of LBOs on corporate profits is unclear.
Because all LBOs
are to some extent financed by debt, increased LBO activity is
generally expected to result in higher corporate interest
payments, which in turn, lower corporate profits. But the
evidence suggests that LBOs had little impact on total corporate
interest payments.
In addition, to the extent that the acquired
firms are managed more efficiently, LBOs may increase corporate
profits and corporate receipts.
I should also add that increased LBO activity may increase
individual income tax receipts. For example, a portion of
capital gains generated by LBOs goes into the individual income
tax base, as does interest received by taxable investors.
Shift from C corporations to partnerships. As discussed
earlier, the 1986 Act made the top corporate tax rate higher than
the top individual tax rate.
It was expected that this change in
relative top tax rates would lead to greater use of the
partnership form, which provides income that is taxed at the
individual level, and lesser use of the corporate form.
Preliminary evidence is mixed, perhaps because the 1986 Act's
limitations on passive activity losses and 1987 legislation on
publicly traded partnerships tended to discourage partnership
activity.
If the use of partnerships has increased, personal
income would increase and corporate profits decline.
8
CONCLUSION
In summary, I would characterize recent trends in corporate
tax receipts as follows:
Corporate tax receipts forecasts made by both the
Treasury and the Congressional Budget Office following
the enactment of the 1986 Act exceeded actual corporate
tax receipts by between $20 billion and $25 billion per
year for the 1987-1989 period.
The Tax Reform Act of 1986 reversed a long-term decline
in the relative importance of corporate taxes in
producing revenues for the u.S. Government. The share
of total taxes paid by corporations has been steadily
rising since 1986. This trend is expected to continue
throughout most of the budget period.
The 1986 Act has been revenue neutral because
individual tax receipts are higher than expected.
Lower than expected corporate profits explain much of
the underestimate in corporate tax receipts.
In short, the 1986 Act was revenue neutral and
significantly increased corporate tax receipts both in absolute
terms and as a proportion of all income tax receipts.
This concludes my prepared remarks. I would be happy to
answer any questions of the Committee. Thank you.
TABLE 1
CORPORATE RECEIPTS FORECASTS
THE REAGAN ADMINISTRATION'S FY 1988 BUDGET VS. ACTUALS
Fiscal Years
($ Billions)
1987
1988
1989
1988 Budget
105
117
129
Actual
84
95
Overestimate in
FY 1988 Budget
104
···········25<
THE CONGRESSIONAL BUDGET OFFICE'S FY 1988 BUDGET VS. ACTUALS
Fiscal Years
($ Billions)
1987
1988
1989
1988 Budget
Actual
Overestimate in
FY 1988 Forecast
Department of The Treasury
Office of Tax Analysis
j"
.
.
101
119
126
84
95
104
17
24
22
I
FOR RELEASE
May 2, 1990
~lJ' ~litMO'R:iiELY, 'AT
PRESS CONFERENCE
CONTACT:
Office of Financing
202/376-4350
TREASURY MAY QUARTERLY FINANCING
The Treasury will raise about $12,375 million of new cash
and refund $18,130 million of securities maturing May 15, 1990,
by issuing $10,500 million of 3-year notes, $10,000 million of
10-year notes, and $10,000 million of 30-year bonds. The $18,130
million of maturing securities are those held by the public,
including $2,268 million held, as of today, by Federal Reserve
Banks as agents for foreign and international monetary
authorities.
The three issues totaling $30,500 million are being offered
to the public, and any amounts tendered by Federal Reserve Banks
as agents for foreign and international monetary authorities
will be added to that amount. Tenders for such accounts will be
accepted at the average prices of accepted competitive tenders.
In addition to the public holdings, Federal Reserve Banks,
for their own accounts, hold $2,102 million of the maturing
securities that may be refunded by issuing additional amounts of
the new securities at the average prices of accepted competitive
tenders.
The 10-year note and 30-year bond being offered today will
be eligible for the STRIPS program.
Details about each of the new securities are given in the
attached highlights of the offering and in the official offering
circulars.
000
Attachment
NB-789
HIGHLIGHTS OF TREASURY OFFERINGS TO THE PUBLIC
MAY 1990 QUARTERLY FINANCING
May 2, 1990
~t
Offered to the Public
De.cription of StEuritx:
Ten. ~ type of ..curity
Series ~ CUSIP designation
CUSIP N08. for STRIPS
C~l8flt.
Iffue date •
Maturl ty date
Interest rate •
Inve.t..nt yield
or di,cOU"lt
Interest pa')'Mnt dates
Mini.u. ~ination available
~t required for STRIPS
Pr_l~
Ie,.., of Sale:
Method of .ale
Ca.petftive tender.
Nonca.pet It i ve tender.
Accrued Intereat
payable by Investor
Paywot Te,..,:
Pay.ent by non-Institutional
Investors • • • • • •
Deposit guarantee by
de.lgnated institutions
Key Oat,,:
Receipt of tender.
• ••
S10,000 .HlIon
S10,000 mill ion
May 15, 1990
May 15, 1993
To be deten.ined ba.ed on
the average of accepted bid!
To be deten.ined at auction
To be deten.ined after auction
Novelllber 15 end May 15
S5,000
Not applicable
10-year notes
Series B-2000
(CUSIP No. 912821 YW 6)
Listed in Attac~t A
of offering circular
May 15, 1990
May 15, 2000
To be detenllined be.ed on
the average of accepted bi d!
To be detenllined at auction
To be detenllined after auction
November 15 end May 15
51,000
To be deten.ined after auction
30-year bonds
Bonds of 2020
(CUSIP No. 912810 EF 1)
Listed in AttachMent A
of offering circular
May 15, 1990
May 15, 2020
To be detenRined based on
the average of accepted bid!
To be detenllined at auction
To be detenllined after auction
November 15 and May 15
51,000
To be detenllined after auction
Yield auction
Must be exprefled a.
en 8lYUIl. yi eld wi th two
deci .. l., e.g., 1.101
Accepted in full at the averege
price up to 51,000,000
Yield auction
Must be expressed as
an arnAIIl yield with two
deci .. l., e.g., 1.101
Accepted in full at the average
price up to S1,000,000
Yield auction
Must be expressed as
en IIIYUIl yield with two
deci .. l., e.g., 7.101
Accepted in full at the averege
price up to Sl,OOO,OOO
None
None
None
Full paYMf'lt to be
.ubmitted with tender
Full pav-nt to be
8uD.itted with tender
Full payment to be
submitted with tender
Acceptable
Acceptable
Acceptable
Tuetdey, May 8, 1990,
prior to 1:00 p••• , EDST
Wednetdey, Mey 9, 1990,
prior to 1:00 p ••• , EDST
Thursday, May 10, 1990,
prior to 1:00 p ••• , EDST
Tuesday, May 15, 1990
Friday, May 11, 1990
Tuesday, May 15, 1990
Friday, May 11, 1990
Tuesday, May 15, 1990
Friday, May 11, 1990
•••• S10,500 .illion
3-year notes
Series T-1993
(CUSIP No. 912821 YV 8)
Not 8pplicable
Settle.ent (final pav-ent
due fra. institutions):
a) funds IMmediately
available to the Trea.ury
b) readily-collectible check
TREASURIj~~ EWS
Department of the Treasury • Washington, D.C•• Telellhone 588-2041
DEPT.
FOR IMMEDIATE RELEASE
MAY 3, 1990
cr "[,u: Tj
•
.. L
... '. .
'.::
:..
CO'NTACT:
OFFICE OF FINANCING
202/376-4350
RESULTS OF TREASURY'S 52-WEEK BILL AUCTION
Tenders for $10,036 million of 52-week bills to be issued
May 10, 1990,
and to mature
May 9,' 1991,
were accepted
today. The details are as follows:
RANGE OF ACCEPTED COMPETITIVE BIDS:
Discount
Rate
Low
High
Average
-
Investment Rate
(Eguivalent CouEon-Issue Yield)
8.04%
8.05%
8.05%
Price
91.871
91.861
91.861
8.68%
8.70%
8.70%
Tenders at the high discount rate were allotted 93%.
TENDERS RECEIVED AND ACCEPTED
(In Thousands)
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
TOTALS
Accepted
Received
Location
$
43,995
27,190,820
22,770
46,045
41,320
25,800
1,688,490
22,405
11,110
57,055
25,325
851,265
381,760
$
43,995
9,184,900
22,770
46,045
41,320
25,800
62,090
18,405
11,040
55,225
15,325
127,065
381,760
$30,408,160
$10,035,740
$26,710,435
1,067,725
$27,778,160
$
~
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
6,338,015
1,067,725
$ 7,405,740
2,500,000
2,500,000
130,000
130,000
$30,408,160
$10,035,740
An additional $70,000 thousand of the bills will be issued
to foreign official institutions for new cash.
NB-790
TALKING POINTS
FOR THE
FINANCING PRESS CONFERENCE
May 2, 1990
Today we are announcing the terms of our regular May
quarterly refunding.
I will also discuss the Treasury's
financing requirements for the balance of the current calendar
quarter and our estimated cash needs for the July-September 1990
quarter.
1.
We are offering $30.50 billion of notes and bonds to
refund $18.1 billion of privately-held notes and bonds maturing
on May 15 and to raise approximately $12.4 billion of cash.
The
three securities are:
First, a 3-year note in the amount of $10.50 billion
maturing on May 15, 1993.
This note is scheduled to be
auctioned on a yield basis on Tuesday, May 8.
The
minimum denomination will be $5,000.
Second, a 10-year note in the amount of $10.00 billion
maturing on May 15, 2000.
This note is scheduled to be
auctioned on a yield basis on Wednesday, May 9.
The
minimum denomination will be $1,000.
Third, a 30-year bond maturing May 15, 2020 in the
amount of $10.00 billion.
This bond is scheduled to be
auctioned on a yield basis on Thursday, May 10.
The
minimum denomination will be $1,000.
We will accept noncompetitive tenders up to $1,000,000 for each
of these issues.
- 2 -
2.
For the current April-June quarter, we estimate a net market
borrowing need of $12.6 billion, assuming a $30 billion cash
balance at the end of June.
We may want to have a higher
balance, depending upon our assessment of cash needs at the time.
Including this refunding, we will have raised $2.6 billion
of the $12.6 billion in marketable borrowing needed this AprilJune quarter.
This net borrowing was accomplished by borrowing
$27.8 billion and paying down $25.2 billion as follows:
$2.5 billion of cash from the 2- and 4-year notes which
settled April 2;
$2.8 billion of cash from the 7-year note that settled
April 16;
$1.5 billion of cash from the 2-year note which settled
April 30;
$6.9 billion of cash in regular weekly bills, including
the bills announced yesterday;
$1.7 billion of cash in 52-week bills;
$25.2 billion paydown in cash management bills; and
$12.4 billion of cash from the refunding issues
announced today.
The $10.0 billion to be raised in the rest of the April-June
quarter could be accomplished through sales of regular 13-, 26-,
and 52-week bills, a 2-year note in May and a 5-year 2-month
note in early June.
Cash management bills may be necessary to
cover the low points in the cash balance.
-
3.
3 -
The $12.6 billion net Treasury borrowing requirement for the
April-June quarter includes Treasury borrowing to finance Federal
Financing Bank lending to the Resolution Trust Corporation.
On
April 12 the Oversight Board of the RTC announced that RTC is
authorized
t~
borrow a maximum of $42.7 billion net from FFB in
the April-June period.
4.
We estimate Treasury net market borrowing needs to be in the
range of $30 to $35 billion for the July-September quarter,
assuming a $30 billion cash balance on september 30.
The
Treasury's July-September borrowing estimate does not include any
allowance for FFB lending to RTC.
Treasury plans to update its
market borrowing estimate for the July-September quarter as soon
as the Oversight Board has reviewed and approved the RTC's
working capital budget for that period.
5.
We anticipate that the next auction of REFCORP bonds will be
announced on July 3 for auction July 10 and settlement July 17.
6.
The notes and bonds announced today will be eligible for
conversion to STRIPS (Separate Trading of Registered Interest and
Principal of Securities) and, accordingly, may be divided into
separate interest and principal components.
Removal Notice
The item identified below has been removed in accordance with FRASER's policy on handling
sensitive information in digitization projects due to copyright protections.
Citation Information
Document Type: Transcript
Number of Pages Removed: 23
Author(s):
Title:
Press Background Briefing by a Senior Treasury Official
Date:
1990-05-03
Journal:
Volume:
Page(s):
URL:
Federal Reserve Bank of St. Louis
https://fraser.stlouisfed.org
PUBLIC DEBT NEWS
Department of the Treasury •
Bureau of the Public Debt • Washington, DC 20239
FOR RELEASE AT 3:00 PM
May 4, 1990
Contact: Peter Hollenbach
(202) 376-4302
PUBLIC DEBT ANNOUNCES ACTIVITY FOR
SECURITIES IN THE STRIPS PROGRAM FOR APRIL 1990
Treasury's Bureau of the Public Debt announced activity figures for the month of April 1990, of
securities within the Separate Trading of Registered Interest and Principal of Securities program,
(STRIPS).
Dollar Amounts in Thousands
Principal Outstanding
(Eligible Securities)
$408,865,583
Held in Unstripped Form
$310,745,253
Held in Stripped Form
$98,120,330
Reconstituted in April
$2,074,720
The accompanying table gives a breakdown of STRIPS activity by individual loan description.
The balances in this table are subject to audit and subsequent revision. These monthly figures are
included in Table VI of the Monthly Statement of the Public Debt, entitled "Holdings of Treasury
Securities in Stripped Form." These can also be obtained through a recorded message on
(202) 447-9873.
000
PA-6
26
TABLE VI-HOLDINGS OF TREASURY SECURITIES IN STRIPPED FORM, APRIL 30, 1990
(In thousands)
PrinCipal Amount Outstanellng
Loan DescriPtion
Maturity Date
, 1-5/8% Note C-I994
: 111519.
. , 114% No/e A-I995
2'15/95
Reconstrtutec:l
This Month I
Pon,on Helel In
Stripped Form
Ponlon Hekl In
Unstnpped Form
Total
S6.658.554
$5.264,954
$1,393,600
-0-
6.933_861
6.413.381
520,480
$12.000
, 1/4% NOle 8-1995
0/15/95
' 127.086
5,666.286
1460.800
-0-
, 0. I 12% Note C-I995
8115/95
7.955.901
7.321, /01
634.800
10,000
"- 112% Nole (}-1995
11115195
7.318.550
6.4al ,350
837.200
10.000
8·7/8% Note A·I996
2115/96
8.575.199
8.322,399
252,800
-0-
, 3/8% Note C-1996
5/15/96
20.085.643
19,8&4,843
220.800
-0-
300,000
-0-
:1/4% Note 0-1996
I 1115/96
20.258.810
19.958,810
'>- I 12% NOle A· I 997
5/15197
9.921.237
9.852,037
69.200
-0-
8·5/8% Note B-1997
8/15197
9.362.636
i
9.362.836
-0-
-O-
I
9.792.329
R 7IS% Note C· I 997
11/15197
9.808,329
8·1/8% Note A·I998
2115/98
9.159,068
9% Note 8- 1998
5/15198
9.165.387
9,135,387
9-1/4% Nole C·I998
8/15/98
11.342.646
I I .214,646
I
16.000
-0-
640
-0-
I
30,000
-0-
I
128.000
-0-
I
9,158 .• 26
,
8-7/8% Note (}-1998
11/15/98
9.902.875
8-718% Note A·I999
2/15199
9.719.628
<t-1/8% Note 8-1999
5/15199
10,047,103
8% Note C-1999
8/15199
10,163.644
• 718% Note (}- I 999
11/15199
10na.960
,
10.769,160
4,800
8- 1/2% NOle A-2000
2/15/00
10,673,033
!
10.673.033
-0-
-0-
,
75,200
·518% Bond 20Q.4
I
9.896.475
6,400
-0-
9.716.428
3,200
-0-
868,800
-0-
9,178.303
10,081.644
i
-0-
82.000
,I
-0-
11115104
8.301,806
3,804,206
4.497,600
I 2% Bond 2005
5/15105
4,260,758
1,882,708
2,378,050
-0-
10-314% Bond 2005
8/15105
9.269,713
8,295,313
i
974,400
26.400
9-.318% BonO 2006
2/15106
4.755.916
4.755.916
I
11115114
6.005.5804
I I
11-314% Bond
~14
-0-
-0-
1,861.584
4.144.000
48,800
11-114% Bond 2015
2115115
12.667.799
2.631.159
10.036.640
397.280
10-518% Bond 2015
6115115
7.149.916
1.735.516
5.41".400
l00.1eo
9-7/8'11> Bond 2015
11/15115
6.899.859
2.m.059
4,676.800
-0-
9-1/4'11> Bond 2016
2115116
7.266.as.
6.330.054
936.800
204.000
7·1/''% Bond 2016
5/15116
16.823,551
16.766.751
2,056.800
7<4.400
71/2% Bond 2016
11115116
18.860'.448
10.929.&48
7.934.800
267,440
8-31"'11> Bond 2017
5/15117
lB.1901.169
7.241.369
10.952.800
-0-
8-718% Bond 2017
6115117
14.016.658
9.168.858
4.&48.000
59.200
9- 1/8% Bond 2018
5115118
8.708,639
3.687.839
5.020.800
-0-
9% Bond 2018
11/15118
9.032,870
2.019.<470
7,013.400
29.200
8-718% Bond 2019
2/15119
19.250,793
7.287,593
11.963.200
389,800
8- 1/8'\\1 Bond 2019
8/15119
20.213.832
13.664,712
6.549.120
391.0<10
8-1/2% Bond 2020
211sno
10.228.868
8,335.668
1.893.200
-0-
408.865.583
310.745.253
98.120.330
2.07<4.720
To/al
, E "ectrve May '. 1981. secunll8s hekl In SInpped lorm ..ere eligible lor reconslltuhon 10 Ihelr unstrlpped lorm.
Note On Itle 41" worl<day 01 eaCh monlh a recording of Table VI WIll b<! available afler 3:00 pm. The telephOne number IS (2021 441·9873.
The balances In thiS table are SUbJect to audit and subSeQuenl ad,ustmenlS.
May 6, 1990
STATEMENT OF THE GROUP OF SEVEN
The Finance Ministers and Central Bank Governors of
Canada, Franc 7 , the,Federal Republic of Germany, Italy,
Japan, the Unlted Klngdom and the United States met on
May 6, 1990, in Washington, for an exchange of views on
c~rrent global economic and financial issues.
The Managing
Dlrector of the IMF participated in the discussions on recent
economic developments in the Group of Seven.
The Ministers and Governors reviewed developments in
their economies and in global financial markets since their
meeting of April 7. They noted with satisfaction the recent
stability in exchange markets and continued growth in
industrial countries. However, they agreed that price
pressures warrant continued vigilance. They also noted the
yen had stabilized since their meeting in Paris, but remained
of the view that the present level may have undesirable
consequences for the global adjustment process. They
discussed recent developments towards German economic and
monetary union.
They agreed that this process would
contribute to improved non-inflationary global growth and to
a reduction of external imbalances. This process would also
contribute to positive economic developments in Eastern
Europe which at the same time are supported by the
international community.
They agreed to keep economic and monetary developments
under review and reaffirmed their commitment to economic
policy coordination, including cooperation on exchange
markets.
The Ministers and Governors underscored their
determination to resist protectionism. They emphasized that
a successful conclusion of the Uruguay Round is essential for
promoting an open and growing world economy.
The Ministers and Governors expressed their continued
strong support for the strengthened debt strategy, and were
encouraged by the SUbstantial progress which has been
achieved, including the commercial bank accords with six
heavily indebted countries. They reaffirmed their support
for the case-by-case approach and for the guidelines
governing Fund and Bank financial support for debt and debt
service reduction.
They reemphasized the central importance
of sustained debtor reforms and urged a stronger emphasis in
Fund and Bank programs on measures to attract new investment
and a return of flight capital as new sources of finance for
debtor nations.
The Ministers and Governors also discussed the Ninth
General Review of Quotas of the International Monetary Fund.
They agreed that a 50 percent increase in IMF quotas would
provide the Fund with the resources to fulfill its central
responsibilities in the world economy. They also agreed on
the need for strengthening the IMF arrears strategy as an
integral part of the quota review.
TREASURY N
~.partm.nt
of the Treasurv • Washington, D.C ••
~~~~~~e,58 •• 204t
TEXT AS PREPARED
FOR IMMEDLATE RELEASE
I_arks by
Secreury of the Treuury
Nicholas F. Brady
at the Morning Session of
The Interim Committee
Vuhington, D.C.
May 7,1990
Ihe World Eeonomic Outlook, the Ninth General R~vi~w
pf Quotas and the Strep'thenin& of the IMF Arrears Strategy
The global economic expansion, now into its eighth year, continues at a
and sustainable pace, The industrial countries are expeeted to
maintain average irowth of about 3 percent per year through 1991,
supporting improved developing country growth and eontinued healthy
expansion of world trade, Substantial progress has been made in reducing
some of the largest industrial country external imbalances, Price
pressures warrant continued vigilance. With the passing of some temporary
faetor;, however, they should remain under control.
~oderate
The generally favorable global economic picture owes much to sound
economic policie5 and the effective international coordination of these
policies. We have built our strategy around the goals of a prudent and
coordinated approach to fiscal and monetary policy, and measures to
increase economic efficiency and maintain financial market atability.
We have ~de significant progress toward these goal;. Nevertheless, Vt
have .ome important unfinished business. External imbalances still remain
too high. We are committed to achieving substantial further reductions,
and to implementing the domestic policies neee •• ary to help bring this
about. For the United St~t.St this mean, maintaining export-led growth and
boostina national aavinls. 1 recognize there are concerns about the need
for continued reduction; in the U.S. ftderal budget deficit. Let me assure
you that the Pre,ident remains fully committed to deficit reduction, and we
will work closely with the Congress to make further progres8. In addition,
we have proposed mealures to strengthen our private saving and investment
performance.
NB-791
2
Of course, in an interdependent global economy, sustained global growth
and a reduction of external tmbalances require appropriate policies in
other countries. In the aurplus countries, economic growth needs to be led
by dome;tic investment and consumption to address their own
saving/investment imbalances ano to encourage continued import growth. In
many countries, there is ample scope for additional measures to remove
structural impediments to growth and adjustment.
Recent developments in Eastern Europe pose great new challenges and
opportunities for the 1990s. Unificetion of the Federal Republic of
Germany and the German Democratic Republic, for example, will ha~
fundamental economic consequences of great interest both within and outside
Europe. ~e believe that reunification would contribute to improved noninflationary global growth and to a reduction in external imbalances.
The Ninth General Revlgw pf Quotas
Let me turn now to the Ninth General Review of Quotas.
The United States is a strong supporter of the IMF and its central role
as a monetary institution in the world economy. The Fund remains pivotal
to the international debt strategy and it will be at the center of
international efforts to help Ea;tern European countries restructure their
economies toward free markets. We firmly believe that the IMF mu$t have
adequate resources and that it must safeguard its financial integrity in
order to continue to fulfill its eritieal responsibilities in the world
economy.
At our last meetIng in September, we pledged to work to complete the
Ninth General Review as a matter of priority. The United States has worked
aetively since that time to bring the quota review to conclusion, and
significant progress has been made in resolving and narrowing difference~
on a broad range of issues. Today, we are on the verge of auccessfully
completing the quota review. Against this background, let me turn to the
handful of issues that remain outstanding.
A eentral Issue in the negotiation. has been the overall size of the
quota inerease. In recent weeks, a consensus has appeared to emerge for up
to a 50 percent increase in the size of the Fund. Though the United States
has supported a smaller increase, this is a compromise that can command the
support of the United States in the context of a satisfactory resolution of
other issues. A 50 percent inereas., coupled with the Fund's existing
uncommitted liquid resources .- presently $35 billion--vill allow the IMF
to discharge its systemic responsibilities over the coming years.
The IMF's Articles of Agreement provide for a fi~e-year quota review
period to ensure that the Fund's resources are adequate. Given the
historically high level of resourc@s at this time in the quota reView, as
well as the prospective quota increase, the IMF's resources should suffice
to meet ~he challenges of the first half of this decade. Furthermore, the
United States has .hown in the past that if a demonstrated need for an
increase in 1MF resourees emerges sooner than antiCipated, we stand ready
3
to consider the need for earlier action. In these circumstances, we
believe that the next quota review should run through 1995.
Strenith,nini the IMF Arrears Strategy
Let me now turn to the need for strengthening the IMF arrears strategy
in the context of the quota review.
Arrears to the IMF have grown significantly in recent years, despite the
adoption of numerous measures. They now total $4 billion from 11 members,
an amount roughly twice the level of the IMr's reserves. These arrears
po~e a fundamental challenge to the !MF's financial integrity and its
central role in the world economy. The IMP must strengthen its policies on
arrears, as an integral part of the quota review, in order to preserve its
role as an anchor for the international monetary system and ensure that
increased capital is used effectively.
Over the past months, the E~ecutive Board has worked hard to develop a
comprehensive approach to arrears. This effort has borne fruit. I am
pleased that broad support has emerged for the key alements of a
strengthened approach. These elements should combine a mix of incentives
to reward sound economic performance and disincentives to the accumulation
of arrears. We must implement both aspects in full.
In this regard, I support the proposal to use the IMF's Enhanced
Structural Adju~tment Facility (ESAF) to provide financing to low~income
arrears countries, performing UDder extended Fund-monitored arraniements,
to eliminate their overdue obligations. Also, the proposal for a
contingent and limited mobilization of 3 million ounces of LMF gold, to
provide additional 5ecurity to ESAF creditors for such lendini, is fair
and reasonable.
The United States also supports the proposed amendment to the IMF
Articles of Agreement authorizing the possible suspension of the voting
rights and representation privileges of certain members with arrears. The
quota increase should only become effective when this amendment has been
ratified and adopted by the necessary majority.
TREA5UR¥NEW5
a.llartment Of the T,.a.ury •
wa~~I~~""fJD.C~.
Telellhone S88.2a41
CONTACT: 25~~~76~~35~nancing
FOR IMMEDIATE RELEASE
May 7, 1990
RESULTS OF TREASURY'S WEEKLY BILL AUCTIONS
Tenders for $8,408 million of 13-week bills and for $8,405 million
of 26-week bills, both to be issued on
May 10, 1990,
were accepted today.
RANGE OF ACCEPTED
COMPETITIVE BIDS:
Low
High
Average
13-week bills
maturins August 9, 1990
Discount Investment
Rate 1/
Rate
Price
7.77%
7.80%
7.79%
8.04%
8.07%
8.06%
26-week bills
maturins November 8, 1990
Discount Investment
Rate
Rate 1/
Price
98.036
98.028
98.031
7.81%
7.84%
7.84%
8.24%
8.28%
8.28%
96.052
96.036
96.036
Tenders at the high discount rate for the 13-week bills were allotted 11 %.
Tenders at the high discount rate for the 26-week bills were allotted 76%.
TENDERS RECEIVED AND ACCEPTED
(In Thousands)
Received
Received
AcceEted
Location
Boston
New York
Philadelphia
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
Kansas City
Dallas
San Francisco
Treasury
TOTALS
~
Competitive
Noncompetitive
Subtotal, Public
Federal Reserve
Foreign Official
Institutions
TOTALS
$
57,345
20,913,365
17,265
53,850
57,370
32,610
1,867,155
36,010
21,310
38,850
37,225
789,050
694,475
57,345
6,965,390
17,265
53,850
57,370
30,800
236,145
17,110
12,410
38,850
27,775
198,800
694,475
$
51,320
22,641,890
15,285
54,720
58,850
33,800
1,654,315
26,535
17,920
64,590
39,940
938,925
557,725
$
51,320
7,207,535
15,285
54, 720
48,350
32,790
192,035
18,535
12,680
61,250
29,940
122,925
557,725
$24,615,880
$8,407,585
$26,155,815
$8,405,090
$20,875,060
1,543,205
$22,418,265
$4,666,765
1,543,205
$6,209,970
$21,674,670
1,302,345
$22,977,015
$3,923,945
1,302,345
$5,226,290
2,073,815
2,073,815
2,100,000
2,100,000
123 2 800
123,800
1,078,800
1,078,800
$24,615,880
$8,407,585
$26,155,815
$8,405,090
1/ Equivalent coupon-issue yield.
NB-792
$
AcceEted
TREASURY N"ErWS
aepartment of the Treasury • washlnll~WI,uDlC.U. ~~Phone 588-20."
STATEMENT BY
JOHN M. NIEHUSS
SENIOR DEPUTY ASSISTANT SECRETARY
FOR INTERNATIONAL ECONOMIC POLICY
DEPARTMENT OF THE TREASURY
BEFORE THE
SUBCOMMITTEE ON INTERNATIONAL DEVELOPMENT,
FINANCE, TRADE AND MONETARY POLICY
COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS
HOUSE OF REPRESENTATIVES
MAY 8, 1990
Mr. Chairman and Members of the Committee:
I am here at your invitation to testify on World Bank
lending to China.
In March, Assistant Secretary Dallara testified before
this Committee on the Administration's request for
authorization to participate in the ninth replenishment of
the resources of the International Development Association
(IDA). In response to statements and questions from you, Mr.
Chairman, and Congresswoman Pelosi, Assistant Secretary
Dallara presented the Administration's position on World Bank
lending to China. My testimony today elaborates on that
position.
Basic Objectives of U.S. Policy
The U.S. policy toward World Bank lending to China
should be seen in the context of the Administration's broader
policy toward China. The elements of this policy were set
forth in the February 7, 1990, testimony of Acting Secretary
of State Eagleburger before the Senate Foreign Relations
Committee. In that testimony, Acting Secretary of State
Eagleburger stated:
NB-793
- 2 -
The challenge was to make clear American revulsion at
and condemnation of the bloodshed at Tiananmen, yet
express it in a way that would maintain, to the extent
possible, our ability to influence events within China
and encourage a return to reforms of the economy and
society. The Administration has, therefore, sought to
demonstrate its repugnance for the actions taken by the
Beijing government while preserving the framework of
our relationship with the Chinese people -- links
wisely forged in a spirit of bipartisan consensus in
the 1970s and 1980s.
He went on to note that:
In short, we seek to soften the blow to the Chinese
people brought about by the crisis in China ••• Indeed,
the forces favoring reform have not disappeared. We owe
them an approach that strengthens their hand, not the
hand of those who would welcome isolation.
Evolution of u.s. Policy
with these basic policy objectives in mind, I would like
to begin my testimony with a brief chronology summarizing the
evolution of the Administration's policy toward World Bank
lending to China. The key events are as follows:
June 3-4, 1989 - Tiananmen Square
June 20. 1989 - President Bush announced that the
Administration would seek to postpone consideration of all
new loans to China by international financial institutions.
July 14. 1989 - The heads of state and government of the G-7
(the U.S., Japan, Federal Republic of Germany, Britain,
France, Canada, and Italy) met in Paris for the annual
Economic summit and agreed that "in view of current economic
uncertainties, the examination of new loans by the World Bank
be postponed."
December, 19, 1989 - section 604 (b) of the International
Development and Finance Act of 1989 expressed the sense of
Congress that the u.s. should oppose loans to China in
accordance with section 701 (f) of the International
Financial Institutions Act. (This provision instructs the
u.s. to oppose loans to countries engaging in a pattern of
human rights violations unless the loans are directed to
programs which serve the basic human needs of citizens of the
country.)
- 3 -
January 10. 1990 - The state Department announced that the
u.s. was considerinq supportinq a limited resumption of
1endinq to China for humanitarian reasons.
February 7. 1990 - Actinq Secretary of State Eaq1eburqer
testified before the Conqress that "in 1iqht of our belief
that we should avoid actions which harm the Chinese people .•.
the united states would be prepared, on a case-by-case
basis, to have the World Bank consider earthquake aid and
other basic human needs loans to China."
February 8. 1990 - The u.s. supported a $30 million IDA
credit for an earthquake reconstruction project.
February 27,1990 - The u.s. supported a $60 million IDA
credit, the Jianqxi Aqricu1tura1 Development Project.
March 27, 1990 - The u.s. supported a $50 million IDA
vocational and Technical Education credit.
World Bank Loans Pending as of June 1989
Prior to June 1989, the World Bank and IDA had approved
loans and credits tota11inq $8.6 billion to China.
The Bank
and IDA have approved commitments of sliqht1y less than an
annual averaqe of $1.5 billion in the last three World Bank
fiscal years (July 1 - June 30). At the time of the June 4,
1989, events of Tiananmen square, there were seven loans and
credits totallinq $786 million scheduled for World Bank Board
consideration by June 30, 1989, the end of World Bank fiscal
year 1989. At that time, the World Bank had over 40
projects totallinq about $7 billion dollars in the pipeline.
Administration Policy
since June, 1989, the Administration has kept the issue
of World Bank lendinq to China under constant review. With
its support of the earthquake reconstruction credit in early
February, 1990, the Administration formally modified its
position on lendinq to China for humanitarian reasons,
consistent with the sense of Conqress expressed in the
International Finance and Development Act of 1989. At the
time, the Administration decided that the united states
should continue to oppose a qeneral resumption of World Bank
1endinq to China. However, it also concluded that, on a
case-by-case basis, it would not oppose lendinq which clearly
meets basic human needs (BRN).
- 4 -
Two important considerations were involved in the u.s.
position to support a limited resumption of lending to China.
First, Congress had expressed its sense that the united
states should use its voice and vote in the World Bank on
loans to China, in accordance with section 701 (f) of the
International Financial Institutions Act.
Support for
loans which meet basic human needs is consistent with section
701 (f), the human rights legislation. We concluded that it
was justified on humanitarian grounds to support lending to
China which would help the poorest segments of the
population in such areas as housing, education, health, and
rural development.
The second consideration was the position of our G-7
allies with whom we developed the July 1989 consensus in
Paris. within the G-7, there has been a broad consensus on
limiting World Bank lending to China. However, with the
passage of time, there has been increasingly strong pressure
on World Bank members and management to resume lending to
China. There also has been growing pressure from some of our
major allies to resume some lending to China.
We believe that it is essential that the G-7 consensus
remain intact in order to effectively limit future actions of
the Bank with respect to lending for China. This consensus
was, and is, important since the united states does not have
sufficient voting power alone to block World Bank loans. We
want to be sure that there is not a return to "business as
usual" at this time. Thus, we worked closely with our G-7
allies, to develop a new consensus to support a gradual
resumption of lending which meets basic human needs, but
which stopped far short of a complete resumption of lending
to China. While our G-7 allies have been willing to restrict
a resumption of lending to basic human needs loans, they
have pointed out that they do not have legislation similar to
u.s. laws on human rights which limit lending to projects
which meet the BRN criterion.
Approved Loans
since early February three loans have come to the Board
for consideration. The u.s. supported all three because they
clearly met the basic human needs criteria. These three
loans are the only IDA commitments approved for China since
last May and total $140 million.
- 5 -
On February 8, 1990, we supported a $30 million IDA
credit, the North China Earthquake Reconstruction Project. A
serious earthquake hit two northern provinces on October 18,
1989, causing widespread damage. The credit provides
assistance to rebuild housing, schools, clinics, community
facilities and some basic infrastructure -- bridges, power
and telecommunications.
On February 27, we supported a $60 million IDA credit,
the Jiangxi Agricultural Development Project. This project
will support small farmers' efforts to diversify their
agricUltural activities. On March 27, we supported a $50
million IDA vocational and Technical Education credit. The
credit will help the State Education Commission and
provincial and municipal governments to improve vocational
and technical education. These two loans had been scheduled
for Board consideration in June 1989, but were postponed.
World Bank Country Review
Any time that there is a significant interruption in
Bank lending to a country or potentially significant changes
in economic policy, we believe that there should be a
thorough review of the country's economic situation and
policies. There was no lending from June 1989 to February
1990. The Bank is preparing a Country Economic Memorandum,
which will be distributed shortly. It will serve as the
basis for a full review on May 29, by the Executive Board of:
the current economic situation, policies, and prospects in
China; China's commitment to economic reform; its
creditworthiness; China's ability to implement projects
effectively; and the Bank's lending strategy. We expect the
discussion to include an assessment of the adequacy of
macroeconomic and sectoral policies as a basis for effective
use of Bank and IDA funds, identification of the economic
policies that have changed since last June, and the areas in
need of reform.
We have some questions as to whether significant lending
to China is appropriate based on the current economic
situation and policies. We have concerns about China's
creditworthiness, its commitment to economic reform, and its
ability to effectively implement projects. Accordingly, we
will be analyzing very carefully the Bank report, as well as
information from our Embassy in China and other sources.
- 6 -
G-7 Coordination
It has taken a great deal of time and effort on the part
of the u.s. Government working closely with our allies to
arrive at a consensus to limit World Bank lending to China.
This has involved communications and meetings with
representatives from national capitals as well as intensive
coordination with their Executive Directors based at the Bank
in Washington. As Assistant Secretary Dallara mentioned to
you on March 28, we have made very clear to the Bank that the
"lending program should be one that is modest, moderately
paced, and limited in the foreseeable future strictly to
basic human needs". To date, we have worked successfully
with other countries to ensure that World Bank lending to
China conforms to this program. We will continue to work
with our allies to sustain the consensus on lending to China.
Conclusion
We fully share Congressional concerns regarding China's
human rights situation. We continue to oppose a general
resumption of World Bank lending to China. On a case-by-case
basis, we will support lending which, after careful analysis,
clearly meets the basic human needs criteria in order to
avoid penalizing the Chinese people just because their
government follows repressive practices. We believe that
this policy is consistent with the basic objectives set forth
by Acting Secretary Eagleburger in his February testimony.
It expresses our condemnation of the policies of the Chinese
government, but does so in a way that helps soften the blow
to the Chinese people brought about by the crisis in China.
supporting BHN projects is an expression of humanitarian
concern for the welfare of the poorest and most vulnerable
people in China. This approach is consistent with existing
human rights legislation and past u.s. Government practices
in other human rights problem countries.
TREASURY NEWS
Department of the TN.SU., • W.Shlngton, D.C•• T.lallhone S ••-IO.'
FOR REI~ASE ON DELIVERY
EXPECTED AT 2:30 P.M.
May 8, 1990
statement of
The Honorable Robert R. Glauber
Under Secretary of the Treasury for Finance
Before the
U.s. Senate committee on
Agriculture, Nutrition, and Forestry
May 8, 1990
Chairman Leahy, Senator Lugar, and Members of the Committee:
Thank you for this opportunity to discuss the
Administration's views on requlatory fraqmentation and related
issues in the securities and futures markets. We believe the
time has come to reform the disjointed requlation of the markets
governing stocks, stock options, and stock index futures.
We also believe that if steps are not taken to correct the
problem now, we are more likely to see minor events trigger
major market disruptions like the breaks in october of 1987 and
October of 1989 -- and the appropriate requlatory tools will not
be in place to help contain the risk to this country's financial
system. Finally, a failure to act will impede innovation; drive
new financial instruments to overseas markets; and thwart
enforcement of intermarket abuses.
As Secretary Brady has said many times, any reform must be
based upon the fact that the markets for stocks, stock options,
and stock index futures are really "one market." The financial
community already recognizes this fact, as do requlators in other
countries. The question is whether our regulatory structure
needs change in order to recognize this fact as well -- whether
one market requires one requlator, and whether this will result
in progress on key intermarket issues that will reduce the
likelihood and risk of major market disruptions.
NB-794
2
We believe the answer to all these questions is yes. As a
result, the Administration will submit proposed legislation this
week. Before outlining this proposal, however, let me explain
why the Administration has come to this position.
'l'he
onset
of 1Io1or _rut Disruptions
As this committee knows, stock index futures began trading
on futures exchanges less than ten years ago. These instruments
have proved to be one of our financial system's most innovative
new developments, and we believe their use has helped keep our
cost of capital lower than it otherwise would be. They have
also permitted institutional traders to engage in more effective
asset allocation techniques and have provided a more flexible
mechanism to enter and exit the stock market.
Nevertheless, the interaction of these new instruments with
stocks and stock options has been an important contributor to
major market disruptions -- periods when the markets disconnect
with prices spiraling down. These major market disruptions are
not episodes of markets adjusting to fundamental changes in value
or responding to major news events. They are periods when the
markets break down, as history has shown us.
In the 52 years between 1930 and 1982 (the year stock index
futures began trading) the Dow Jones Industrial Average declined
by more than 6 percent on only three occasions: when the Germans
took the Netherlands in May of 1940 (6.8 percent); when they
encircled the Allied forces at Dunkirk just days later in the
same month (6.8 percent); and when President Eisenhower suffered
a heart attack in September of 1955 (6.5 percent). As the
futures markets have grown, such massive one-day selloffs have
occurred four times in the last three years:
october 19, 1987
October 26, 1987
January 8, 1988
October 13, 1989
22.6
8.0
6.9
6.9
percent
percent
percent
percent
Not one of these days corresponded with any major news
events like the ones before 1982. But they all shared the
characteristic of enormous selling pressure from the stock index
futures markets.
Again, these were not merely days of "excessive price
fluctuations" or "increased volatility." Beginning with the
Report of the Presiden~ial Task Force on Market Mechanisms,
chaired by Secretary Brady, we have consistently recognized that
there is no compelling evidence that average stock market
volatility has increased over the past 25 years. But that is
completely beside the point.
3
The problem is not an increase in average price volatility,
but the infrequent episodes of violent disruptions when the
aarkets cease to function correctly. During these episodes,
pricing relationships between .tocks and futures break down;
markets in particular instruments experience difficulties in
staying open; serious supply-demand imbalances develop; and very
large market moves occur in the absence of underlying
fundamental information.
It is the increased potential for and consequences of these
major market disruptions that lead us to urge prompt requlatory
reform.
Systemic Risk and Erosion of Investor Confidence
The most disturbing consequence is the risk these major
market disruptions pose to the entire financial system,
especially through the clearance and settlement process. For
example, after the October 1987 break, the clearance and
settlement system fell over 6 hours behind its normal payment
times, with futures clearinghouses owing over $1.5 billion to
investment houses. Had these funds been missing for any
significantly longer time, it would have unleashed a chain
reaction of events where other payments to other creditors would
not have been made. The Presidential Task Force concluded that
the prospect of clearinghouse failures reduced the willingness of
lenders to finance market participants, leading to "a crisis of
confidence [that] raised the spectre of a full-scale financial
system breakdown."
Obviously, we must take appropriate steps to reduce this
very real risk of systemic breakdown.
Moreover, we need to address another consequence of these
major market disruptions -- their contribution to the erosion of
investor confidence and capital formation:
o
Initial Public Offerings elPOs) have plummeted since the
1987 market break. After peaking at $18 billion in 1986,
lPOs raised only about $6 billion a year in 1988 and 1989.
o
Equity offerings as a percentage of new funds raised
domestically has fallen off dramatically. In the early
1980s, equity accounted for about 30-50 percent of all
public new issues, but the share dwindled to only 10 percent
in 1989.
o
The percentage of stock outstanding held by individuals has
declined from 84 percent in 1965 to 55 percent in 1989.
4
o
Trading volume in options, futures, and stocks is off
substantially from levels that prevailed before the OCtober
1987 market break.
To bring investors back into our markets to stay, we must
renew their confidence that aarket mechanis.. are operating
efficiently and that they are still a safe place to invest.
Regulatory rragwentatiQD
The fundamental impediment to reducing the likelihood of
major market disruptions -- and its consequences to the system
and to investors -- is regulatory fragmentation. One regulator
for the "one market" would have much aore flexibility to
coordinate the key intermarket mechanisms that disconnect to
create or exacerbate major market disruptions. These include the
following.
Clearance and Settlement. I bave already described the
systemic risks posed by potential breakdowns in the clearance and
settlement systems. This continues to be what Secretary Brady
has described as the weakest link in the financial system. The
problem is the fragmentation of clearing systems among the
stock, stock options, and stock index futures markets. While
legislation is pending in both the Senate and House to help
address these systems, there is little doubt that a single
regulator could help accelerate the coordination process.
Unbarmonized Margins. While there is federal oversight of
margins in the stock and stock options markets, there is
virtually none in the stock index futures markets. The result is
a tremendous disparity among margin levels in the three markets,
with futures margins often dipping to dangerously low levels.
The fact is that futures traders can control so great an amount
of stock with so little of their own money that relatively small
amounts of capital can concentrate enormous selling pressure on
the stock market -- great enough to cause a major market
disruption that could punch a hole in the fabric of the financial
system.
For example, just prior to the october 13, 1989 break, a
professional trader in the futures market with $50,000 in cash
could control almost $2,000,000 in stock, which is nearly 10
times more than the $200,000 that a professional trader in the
stock market can control with the same amount of cash. Many
observers were astounded that, while stock index futures margins
were increased temporarily in the wake of the October 1987 break,
they were actually lower in october of 1989 than they were in
october of 1987.
5
The result is that durinq .arket downdrafts, when the system
is most in need of liquidity, futures exchanqes are forced to
restrict liquidity throuqh marqin calls because marqins have been
set so low. This is precisely the opposite of what should occur~
durinq emerqencies it is critical to pump liquidity into the
system.
Thus, low futures marqins create a direct prudential risk
not merely to the futures markets, but to the financial system as
a whole. However, since these marqins are set by the futures
industry, with no day-to-day requlatory oversiqht, there is no
way to harmonize marqins between futures and stocks to protect
the public. This exposure to systemic risk requires federal
oversiqht of marqin-settinq for stock index futures, and the
oversiqht should come from one requlator that can ensure
harmonized marqins amonq linked markets.
Eyasion of Short Selling Restrictions. For over 50 years
the securities laws have restricted bear raiders like the 1920s'
Jessie Livermore from sellinq short in declining markets. The
purpose of these restrictions is to prevent "qunning" the
market, which drives down the market and confuses the small
investor. However, a concerted selling effort in the futures
market can completely undermine the short selling restriction
and in fact, because of low futures marqins, can accelerate the
stock market downdraft. Again, it is critical to harmonize these
intermarket rules to prevent manipulators from using one market
to evade restrictions in another market.
Uncoordinated CirCYit Breakers. Some progress has been made
to coordinate circuit breakers in stock and stock index futures
markets, and discussions are continuing within the President's
Working Group on Financial Markets. Nevertheless, more can be
done, and fundamental disagreements continue to exist between
markets and their requlators over the appropriate kinds of
circuit breakers.
In short, fraqmented requlation has impeded progress on the
coordination of these fundamental intermarket mechanisms. We
believe one requlator with appropriate authority could
accelerate progress substantially towards the harmonized
requlation we nead to address the problem of major market
disruptions.
Barriers t
@FedFRASER