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(2) The bill imposes a tax on common stockholders even in situations where their proportionate interests decline (or at least do not increase) because of the changing redemption or conversion rates attached to preferred stock.

P. FOREIGN TAX CREDIT

Present law. Under present law a U.S. taxpayer is allowed a foreign tax credit against his U.S. tax liability on foreign income. Generally, the amount of the credit is limited to the amount of U.S. tax on the foreign income.

There are two alternative formulations of the limitation on the foreign tax credit: the "per country" limitation and the "overall" limitation. Under the per country limitation, foreign taxes and income are considered on a country by country basis. Under the overall limitation, on the other hand, all foreign taxes and foreign income are aggregated.

Thus, under this limitation, foreign taxes in one country, in effect, can be averaged with lower foreign taxes in another foreign country. Problem.-A. Foreign Losses :

The per country limitation allows a U.S. taxpayer with losses in a foreign country to, in effect, obtain a double tax benefit. Since the limitation is computed separately for each foreign country, the losses reduce U.S. tax on domestic income, rather than reducing the credit for taxes paid to other foreign countries (as would occur under the overall limitation). When the business operation in the loss country becomes profitable, the income, in effect, is likely not to be taxed by the United States because a foreign tax credit is allowed with respect to that income.

Problem-B. Foreign Tax-Royalties:

Another problem which may arise under either limitation (but which primarily arises under the overall limitation) is the difficulty of distinguishing royalty payments from tax payments. This problem especially arises in cases where the taxing authority in a foreign country is also the owner of mineral rights in that country. Since royalty payments may not be credited against U.S. taxes, the allowance of a foreign tax credit for a payment which, although called a tax, is in fact a royalty, allows a taxpayer a larger credit than he should receive. Where the credit exceeds the U.S. tax on the income from the mineral production in the foreign country, the excess credit may be used to offset U.S. tax on income from other operations in that country, or on income from other foreign countries.

House solution.-The bill provides two additional limitations on the foreign tax credit.

A. Foreign Losses:

First, a taxpayer who uses the per country limitation, and who reduces his U.S. tax on U.S. income by reason of a loss from a foreign country, is to have the resulting tax benefit recaptured when income is subsequently derived from the country. This is accomplished by taxing subsequent income from that country until, in effect, the previous tax benefit is recaptured (i.e., until tax has been imposed on an amount of income equal to the amount of the loss previously deducted from

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U.S. income). Generally, the amount of the benefit recaptured in any one year is limited to one-half the U.S. tax which would have been imposed on the income from the foreign country for that year, in the absence of the foreign tax credit. The amount of the tax benefit not recaptured in a year because of this limitation would be recaptured in subsequent years. The bill also applies the recapture rule where the taxpayer disposes of property which was used in the trade or business from which the loss arose. In this case, the amount of the loss not previously recaptured is included in income when the property is disposed of.

B. Foreign Tax-Royalties:

The bill also provides a separate foreign tax credit limitation in the case of foreign mineral income so that excess credits from this source cannot be used to reduce U.S. tax on other foreign income. In other words, the foreign tax credit allowed on mineral income from a foreign country will be limited to the amount of U.S. tax on that income. Excess credits may be carried over under the normal foreign tax credit carryover rules and credited against U.S. tax in other years on foreign mineral income. This separate limitation applies (1) where the foreign country from which the mineral income is derived requires the payment of a royalty with respect to the income producing property, (2) where that country has substantial mineral rights in the income producing property, or (3) where that country imposes higher taxes on mineral income than on other income. The purpose of these criteria is to isolate these cases in which it is likely that the taxes, at least in part, represent royalties. This separate limitation does not apply where a taxpayer's foreign mineral income for a year is less than $10,000.

The loss recapture rule applies to losses in years after 1969 and the separate foreign tax credit limitation on foreign mineral income applies to years beginning after the enactment of the bill.

A. Foreign Losses:

Argument For.-The foreign tax credit was designed to prevent the same income from being subjected to a double tax-once by the foreign country where the income was earned and a second time by this country; it was not intended to allow a double tax benefit, for example, where a foreign loss prevents the application of both foreign and domestic taxes on other domestic income. The amendment is needed to correct this loophole.

Argument Against. This provision will tend to discourage new ventures by United States corporations in foreign countries.

B. Foreign Tax-Royalties:

Arguments For.-(1) Where a foreign government owns mineral deposits it makes little difference to the foreign government whether it demands royalties from the companies developing the deposits or assesses high taxes on the income they earn from those mineral deposits. For U.S. tax purposes, however, it is important that payments to a foreign government with respect to mineral deposits owned by that government be designated as a "tax" since foreign taxes are creditable against U.S. taxes while "royalties" are not. This amendment is needed to prevent these payments which may largely represent a "royalty" from being designated as "foreign taxes" in order to gain a U.S. tax advantage.

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(2) The bill is desirable in that it recognizes the significant difficulties of ascertaining whether a payment labeled as a tax payment is, in fact, a tax or a royalty by limiting the major abuse which arises in this area, namely the use of excess foreign tax credits on mineral income to offset U.S. tax on other foreign income.

Arguments Against.—(1) A United States taxpayer with foreign mineral operations should not be penalized as compared to other U.S. taxpayers with other types of operations; if a foreign government imposes an income tax it should uniformly be treated as income tax for foreign tax credit purposes.

(2) Just because it is "difficult" to distinguish a true rovalty and a tax is no reason to treat that portion of a "tax payment" made to a foreign government with respect to a mineral deposit it owns which is a true "tax" any less favorably than any other tax; by subjecting the entire payment to a separate limitation mineral taxes paid to a foreign government are discriminated against.

(3) The bill places further obstacles before U.S. companies competing with companies of other nations for the right to develop and control mineral production abroad; this hurts our balance of payments and can affect the share of worldwide oil reserves available to the free world.

(4) The general nature of the separate limitation on foreign mineral income may have the effect of denying a foreign tax credit for part of a tax payment even where no amount of the tax payment is, in fact, a royalty.

Q. FINANCIAL INSTITUTIONS

1. Commercial Banks-Reserves for Losses on Loans

Present law.-Commercial banks, as a result of Revenue Ruling 65-92 (C.B. 1965-1, 112), now have the privilege of building up a bad debt reserve equal to 2.4 percent of outstanding loans not insured by the Federal Government. The 2.4-percent figure used for this purpose is roughly three times the annual bad-debt loss of commercial banks during the period 1928-47. In 1968, Revenue Ruling 68-630 (C.B. 1968-2, 84) clarified the loan base used for computing the allowable bad-debt reserve to include only those loans on which banks can suffer an economic loss.

Problem. By allowing commercial banks to build up bad-debt reserves equal to 2.4 percent of uninsured outstanding loans, present law gives them much more favorable treatment than most other taxpayers. Section 166 (c) of the Internal Revenue Code permits business taxpayers to take a deduction for a reasonable addition to a reserve for bad debts. Most taxpayers accumulate a bad-debt reserve equal to the ratio of the average year's losses to accounts receivable. The average loss is computed on the basis of losses for the current year and the 5 preceding years.

Commercial banks have the option of establishing their bad-debt reserves on the basis of their actual experience like other taxpayers. However, they generally elect to build up these reserves on the basis of the industrywide 2.4-percent figure permitted by Revenue Ruling 65-92. The extent of the favored tax treatment granted to commercial banks by this ruling is shown by the fact that if banks were subject to the same bad-debt reserve rules applying to taxpayers generally, they

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would on the average be allowed to build up a bad-debt reserve of less than 0.2 percent of outstanding noninsured loans.

House solution.-The House bill provides that in the future the deduction allowed commercial banks for additions to bad debt reserves is to be limited to the amount called for on the basis of their own experience as indicated by losses for the current year and the 5 preceding years. Banks with bad debt reserves in excess of the amount allowable on the basis of their own experience (as of the close of the last taxable year beginning before July 11, 1969) will not be required to reduce these reserves. However, these banks will not be permitted to add to reserves until additions are justified on the basis of their own experience; and if such additions to reserves are not so justified they will be allowed in effect to deduct only actual bad-debt losses.

To provide an extra margin of safety to protect against the possibility of unusually large bad-debt losses, banks will be permitted to carry back net operating losses for 10 years instead of 3 years as under present law. In addition, commercial banks will be permitted, as under present law, to carry forward net operating losses for 5 years.

These provisions apply to years beginning after July 11, 1969. Arguments for.-(1) The present bad debt reserves of commercial banks based on the 2.4-percent industrywide figure are in excess of the reserves needed in anything other than a catastrophic depression such as occurred in the early 1930's.

(2) The more generous loss carrybacks provided by the House bill should provide substantial protection to banks in the event of unusual

losses.

(3) The administratively determined 2.4 percent formula is based generally on depression losses and ignores the many government policies since 1933, all designed to prevent a repetition of the financial chaos of that era. In light of these policies and in view of favorable banking experience since the depression, the present tax reduction for loss reserves is unreasonably generous.

Arguments Against.-(1) Banks should be encouraged to take every possible precaution, including the creation of adequate reserves, to assure depositors that their money is safe and that they will be able to protect against depression-scale losses. Without such assurance, confidence in the financial system could be threatened.

(2) Extension of the period for carrying bank losses back is no substitute for the strength and solvency which depression-related reserves convey, not only domestically, but in international financial circles as well.

2. Mutual Savings Banks, Savings and Loan Associations, etc. Present law. Mutual savings banks, savings and loan associations, and cooperative banks are permitted to compute additions to their bad-debt reserves on the basis of their actual experience or under one of two alternative formulas (specified by the 1962 Revenue Act), whichever produces the greatest addition to the reserve. The two alternative formulas provide for the deduction of (1) 60 percent of taxable income, or (2) 3 percent of qualifying real property loans. Under the 60-percent method, a mutual institution is permitted to deduct each year an amount equal to 60 percent of its taxable income (computed before any bad-debt deduction). Under the 3-percent

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method, an institution is permitted to deduct an amount sufficient to bring the balance of the reserve for losses on qualifying real property loans to 3 percent of such loans outstanding at the close of the taxable year, plus an amount sufficient to bring the balance of the reserve for losses on other loans to a "reasonable" amount.

A savings and loan association and a cooperative bank are entitled to use these special reserve methods only if they meet a comprehensive set of investment standards, which were established by Congress in the 1962 act to insure that the tax benefits are available only to those institution primarily engaged in the business of home mortgage financing. Mutual savings banks, however, are not subject to any investment standards under these tax provisions and may use the special reserve methods regardless of the amount of their investments in home mortgage financing.

Problem. In 1952 Congress repealed the exemption of these institutions from Federal income tax and subjected them to the regular corporate income tax. At that time, however, these institutions were allowed a special deduction for additions to bad-debt reserves which proved to be so large that they remained virtually tax exempt. In the Revenue Act of 1962, Congress sought to end this virtual tax exemption by providing the special alternative methods for these institutions in the computation of their bad-debt reserve. Although these methods are more restrictive than prior law, they still provide highly favorable treatment for the bad-debt reserves of these institutions.

It was expected that most of these institutions would compute their deduction under the 60-percent method, which requires the payment of some tax, while the 3-percent method would be an alternative primarily benefitting a limited number of new or rapidly growing institutions. In practice, about 90 percent of the savings and loan associations use the 60-percent method, but most mutual savings banks use the 3-percent method and as a result have been able to avoid substantially all Federal income taxes.

House solution.-The bill revises the treatment of mutual savings banks and savings and loan associations in a number of ways. It amends the special bad-debt reserve provisions by eliminating the 3 percent method and reducing the present 60 percent method to 30 percent gradually over a 10-year period.

The bill also revises the present investment standard applicable to savings and loan associations by liberalizing the composition of the qualifying assets and by applying the standard to mutual savings banks, as well as the other mutual institutions, as the basis on which the percentage for the special deduction method is determined. This new investment standard is a flexible one which reduces the percentage (applied against taxable income to compute the bad debt reserve deduction) depending on the percentage of the assets invested in the qualifying assets-residential real property loans, liquid reserves, and certain other assets. The full percentage (presently 60, to become 30) is to be allowed generally only if the institution has a prescribed percentage (82 percent for savings and loan associations and 72 percent for mutual savings banks) of its investments in qualifying assets. The percentage is proportionately reduced where an institution's qualifying assets are less than the prescribed percentage of total assets, but if less than 60 percent of its funds are in qualifying assets, the