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House solution.-The bill provides that a stock dividend is to be taxable if one group of shareholders receives a distribution in cash and there is an increase in the proportionate interest of other shareholders in the corporation. In addition, the distribution of convertible preferred stock is to be taxable unless it does not cause such a disproportionate distribution.

To counter the various devices by which the effect of a distribution of stock can be disguised, the bill gives the Treasury Department regulatory authority to treat as distributions changes in conversion ratios, redemptions, and other transactions that have the effect of disproportionate distributions.

The bill also deals with the related problem of stock dividends on preferred stock. Since preferred stock characteristically pays specified cash dividends, all stock dividends on preferred stock (except antidilution distributions on convertible preferred stock) are a substitute for cash dividends, and all stock distributions on preferred stock (except for antidilution purposes) are taxable under the bill.

These provisions, apply (subject to certain transitional rules) to distributions after January 10, 1969.

Arguments For.-(1) This provision is supported on the basis that if a corporation in effect were permitted to offer both growth stock and current income stock to investors, the taxation of dividends at ordinary income rates would be seriously undermined, and there would be a substantial loss of revenue, exceeding $1.5 billion a year. If this option were clearly permitted by statute, it is argued that most publicly held corporations would establish two classes of stock, one cash-dividendpaying stock and the other growth stock. The cash paying stock would tend to be held by exempt organizations and taxpayers in low tax brackets, and the growth stock would tend to be held by taxpayers in high brackets. The holders of the growth stock would normally realize their gains as capital gains (or without tax, if held until death).

(2) Giving investors the option to take taxable cash dividends or to permit earnings to accumulate without tax payment (but with a relative increase in the investor's equity interest) would provide them an option not available to those receiving earned income.

(3) By permitting corporations unlimited discretion to pattern their securities to fit various special situations, the present law facilitates the takeover of businesses and the growth of conglomerate enterprises. (4) Existing regulations (promulgated January 10, 1969) fail to prevent all arrangements by which taxable cash dividends can be paid to some shareholders while others enjoy a tax-free increase in their proportionate ownership interest in the corporation.

Arguments Against.—(1) Stockholders should be allowed the choice of taking down taxable dividends or leaving the corporation's earnings to accumulate and thereby increasing their equity in the corporation. A corporation that gave investors this choice would find it easier to raise capital, both by broadening its appeal to investors and by decreasing the amount it pays out in dividends. Under present law, investors have the option to delay tax on investment earnings by investing in growth stocks that pay little or no dividends, although this choice is limited insofar as the corporation is concerned, since it must generally choose to offer its investors either growth on orrent income.

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(4) These changes will adversely affect home mortgage financing, contrary to the intent of Congress, because increased taxes will mean less funds for loans, a lower return, and less protection for depositors. This will further retard an industry already hard hit by high interest rates.

(5) With the growth in the deposits of mutual savings banks, they need additional reserves to provide necessary protection for their depositors.

(6) The more generous investment standard will lead to heavier involvement in fewer properties, thereby exposing depositors to greater risks.

3. Treatment of Bonds Held by Financial Institutions

Present law. Commercial banks and mutual savings institutions receive special tax treatment in regard to their transactions in bonds and other corporate and governmental evidences of indebtedness. Like other taxpayers, they can treat long-term gains from such transactions as long-term capital gains for tax purposes. However, unlike other taxpayers, they can treat capital losses from such transactions as or dinary losses and may deduct such losses without limit from ordinary income.

Problem. The present nonparallel treatment of gains and losses on bond transactions by financial institutions appears to have inequitable results.

Transactions of financial institutions in corporate and government bonds and other evidences of indebtedness do not appear to be true capital transactions; they are more akin to transactions in inventory or stock in view of the size of the bank holdings of these items and the extent of their transactions in them. Moreover, financial institutions now maximize their tax advantages by arranging their transactions in bonds in the light of existing market conditions in order to realize gains in selected years and losses in other years. This enables them to report their gains as capital gains for tax purposes and their losses as ordinary losses chargeable against regular income. The result is to permit financial institutions to reduce their taxable liability and to receive preferential treatment over other taxpayers.

House solution.-The House bill provides parallel treatment for gains and losses derived by financial institutions on transactions in corporate and governmental bonds and other evidences of indebtedness. Under the bill, financial institutions are to treat net gains from these transactions as ordinary income instead of as capital gains but they will continue to treat net losses from such transactions as ordinary losses as under present law. This provision applies to taxable years beginning after July 11, 1969.

Arguments For.-(1) This provision removes the preferential treatment accorded to financial institutions over other taxpayers in regard to transactions in corporate and government bonds. It would have been possible to treat financial institutions exactly like other taxpayer with regard to such transactions that is, treat the gains as capital gains and the losses as capital losses. However, it is understood that the financial institutions preferred the ordinary income tax treatment provided by the House bill to consistent capital gains treatment for their bond gains and losses, because they want to continue to have the protection offered by ordinary loss treatment on their bond losses.

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(2) The bill prevents banks from so arranging their affairs as to realize gains from their securities when they have no other income, and to preserve losses on these securities until years in which they are = profitable.

Arguments Against.—(1) The bill will further depress an already weak securities market by discouraging banks from buying and selling securities and this will have an adverse impact on Treasury revenues. (2) The existing law reflects a wise policy of treating losses realized by financial institutions on governmental and corporate securities as ordinary losses while encouraging banks to invest in such securities (and thus create a market for government bonds) by offering capital gains treatment on potential profits; changing the existing law can only serve to narrow the market for governmental securities, making Federal debt management more difficult.

4. Foreign Deposits in U.S. Banks

Present law. Present law provides special rules, for purposes of the income tax and the estate tax, for the treatment of U.S. bank deposits, and the interest thereon, of foreign persons.

In general the effect of these special rules is to exempt this type of interest income received by foreign persons from U.S. tax and to exempt the deposits from the estate tax. Under present law the special bank deposit rules are to cease to apply at the end of 1972. In other words, after 1972 the interest on these bank deposits otherwise would be subject to income tax and the bank deposits themselves would be subject to the estate tax.

Problem. Congress provided, in 1966, that the special treatment accorded U.S. bank deposits of foreign persons should be terminated. It was believed, however, that an immediate elimination of the special rules might have a substantial adverse effect on the balance of payments. Accordingly, it was decided to postpone the elimination of the special rules until the end of 1972. In view of the continuing deficit in the balance of payments, it appears that our balance of payments situation might be adversey affected to a substantial degree if the special treatment were removed at the end of 1972.

House solution.-The bill provides that the special income tax and estate tax rules regarding U.S. bank deposits (including deposits with savings and loan associations and certain amounts held by insurance companies) of foreign persons are to continue to apply until the end of 1975.

Arguments For.-(1) Postponement of the termination date for the special bank deposits rule will forestall the possibility of an outflow of funds from the United States (in anticipation of the termination of the special status) and the resulting harmful effect on our balance of payments.

(2) The bill retains the long-term goal set by Congress in 1966 of eventually treating foreigners who deposit their money in U.S. banks in the same manner as U.S. citizens are treated with respect to their bank deposits, both under the income tax and the estate tax.

(3) The bill recognizes the desirability of continuing the present U.S. income tax exemption for interest paid on foreign-owned bank deposits and the estate tax exemption with respect to the depositsin order to encourage an inflow of foreign capital and thus help adjust our unfavorable balance of payments.

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Arguments Against.-(1) The tax reform bill is designed to elimi nate preferences in the tax law and make the tax burden more equal on all persons who have U.S. income and property; this feature of the bill runs counter to the objectives of tax reform and tax equity by continuing a pronounced preference in the tax law beyond the date when it would ordinarily end.

(2) Questions can be raised as to whether the termination of this special treatment, in fact, will have an appreciable adverse effect on the balance of payments.

R. DEPRECIATION ALLOWED REGULATED INDUSTRIES 1. Accelerated Depreciation

Present law.-Regulated industries may make the same elections as other taxpayers regarding depreciation of their business property. About half the regulatory agencies require utilities that use accelerated depreciation to "flow through" the resulting reduction in Federal income taxes currently to income. (Where the utility is earning the maximum allowed by law or regulations, this results in flowing through the tax reduction to the utility's current customers.) Other agencies permit the utilities they regulate to "normalize" the deferred tax liabilities resulting from accelerated depreciation. (This involves the utility retaining the current tax reduction and using this money in lieu of capital that would otherwise have to be obtained from equity investments or borrowing.) Some agencies insist that utilities subject to their jurisdiction use accelerated depreciation for tax purposes and, in a few rate cases, such agencies have treated the utilities they regulate as though they used accelerated depreciation (and flowed through the resulting tax reduction), even though the utilities may have in fact used straight-line depreciation.

Problem. The trends of recent years are shifts from straight line to acclerated depreciation and shifts from normalization to flowthrough, often against the will of the taxpayer utilities. In general, flow through to customers doubles the revenue loss involved in shifting from straight-line to accelerated depreciation. It is understood that continuation of these trends would shortly lead to revenue losses of approximately $1.5 billion. Consideration of legislative action in this area is complicated by the fact that many utilities do not have effective monopolies while others do; many utilities are in growing industries while others are losing ground; many utilities compete (to the extent they face any competition) only with other regulated utilities while others compete with businesses not subject to governmental rate regulation.

House solution.-The bill provides that, in general, utilities brought under these provisions will be "frozen" as to their depreciation prac tices. As to existing property: if straight-line depreciation is presently being taken, then no faster depreciation may be used; if the taxpayer is taking accelerated depreciation and is normalizing, then accelerated depreciation can continue to be taken only if the taxpayer continues to normalize; no change is required if the taxpayer is now on flowthrough. As to new property: a taxpayer presently on straight line or presently on accelerated depreciation with normalization will be per

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mitted to take accelerated depreciation only if the tax benefits are normalized in the manner described above (otherwise such taxpayers must take only straight line depreciation); no change is made if the taxpayer is now on flow-through insofar as the same kind of property is involved. The bill also does not change the power of the agency, in the case of normalization, to exclude the normalized tax reduction from the base upon which the company's maximum permitted profits are computed. These rules apply to property used predominantly in the trade or business of the furnishing or sale of: electrical energy, water, sewage disposal services, gas through a local distribution system, telephone services (other than those provided by COMSAT), or transportation of gas, oil (including shale oil), or petroleum products by pipeline, if the rates are regulated by a utilities commission or similar

agency.

The changes apply to taxable years ending after July 22, 1969.

Arguments For.-(1) The bill substantially forestalls the entire revenue loss that continuation of existing trends would have made almost inevitable. It does so in a way that (with very few exceptions) will require no increase in utility rates because of the tax laws, since by and large, it merely takes the various regulatory situations as it finds them and freezes those situations.

(2) Although regulatory commissions have adopted widely varying rules relating to the depreciation policies, this change will assure uniform tax rules for all affected utilities in the future.

Arguments Against.—(1) The change will deny to some utility taxpayers the tax benefits of accelerated depreciation which are available to other taxpayers. The denial would be inconsistent and discriminatory.

(2) The bill is discriminatory against rate-payers to the extent that utilities under present law may adopt accelerated depreciation on their investments and "flow-through" the tax deferral to these ratepayers. (3) This change infringes upon the authority of the various Federal and State commissions to regulate the accounts, financial reports, and rates of the various utilities which they are charged to supervise.

(4) Regulated utilities should be limited to straight line depreciation since they must expand services in accordance with their customers' needs and are protected from competition.

(5) All utilities should be permitted to elect accelerated depreciation with normalization, as a method for meeting competition by means that accord with generally preferred accounting standards.

2. Earnings and Profits

Present law.-A dividend is defined as a distribution of property by a corporation to its shareholders out of earnings and profits. If a distribution exceeds the corporation's earnings and profits, then the excess is a "tax-free dividend" (not currently taxable to the shareholder) which reduces his cost basis in the stock (increasing capital gain or reducing capital loss if the stock is sold by him). Earnings and profits in general are computed by reference to the method of depreciation used in computing the corporation's taxable income and so are reduced by the amount of depreciation deducted by the corporation on its return.