81

duction. Extension of the recapture rule to all exploratilon expenses now, in effect, makes small mining companies pay for the benefit extended to the large companies in 1966.

(2) Since some companies are willing to limit exploration expenditure deductions to $400,000, they should not be subjected to the recapture rules.

4. Treatment Processes in the Case of Oil Shale

Present law. The depletion allowance for oil shale under present law is applicable only to the value of the rock itself-which has little if any value. Liquid oil from wells, on the other hand have considerable value.

Problem. The industry will never develop in its use of oil shale until oil from shale receives more nearly the same percentage depletion allowance as oil produced from a well.

House solution. The bill extends the point at which percentage depletion is computed in the case of oil shale to after extraction from the ground, through crushing, loading into the retort, and retorting, but not to hydrogenation, or any refining process or any other process subsequent to retorting.

Argument For.-Oil from shale should receive similar treatment to that given to oil produced from a well, that is on the value of liquid oil. Argument Against.-This provision will allow percentage depletion to be taken on certain manufacturing processes performed in reducing oil shale to oil. The cut-off point should be at the completion of the mining from the ground.

U. CAPITAL GAINS AND LOSSES

1. Alternative Tax

Present law. One-half of an individual's net long-term capital gains are included in taxable income and, accordingly, are taxed at regular tax rates. The alternative tax-a maximum of 25 percent on net long-term capital gains is applied when an individual's marginal tax rate exceeds 50 percent. For married couples filing a joint return, the alternative tax is applied when other taxable income is greater than $52,000. For single persons, the alternative tax is applied when other taxable income exceeds $26,000.

Problem.-The incentive for many high income taxpayers to convert their income into capital gain is greater than for taxpayers subject to lesser rates because to the extent they do so the alternative tax rate for capital gains decreases their effective tax rate by more than one-half. This effect is associated with the extent that the taxpayer's income is greater than the level where the 50 percent marginal tax rate is effective.

House solution.-The bill eliminates the alternative tax rate for net long-term capital gains for individuals. The provision applies to sales and other dispositions made after July 25, 1969.

Arguments For.-(1) It is appropriate to remove the alternative capital gains rate to lessen the incentive for individuals to plan the conversion or ordinary income into capital gains.

(2) The alternative tax on capital gains benefits only the superrich-those whose marginal income tax rate exceeds 50 percent-by

90

control over the subfranchise will constitute the franchisor's retention of a significant power, right, or continuing interest. Moreover, if the franchisor's conduct constitutes participation in the commercial or economic activities of the subfranchise then this conduct will be regarded as a retention of a significant power, right, or continuing interest. The rule provided by the bill, however, does not apply with respect to amounts received or accrued in connection with a transfer of a franchise which is attributable to the transfer of all substantial rights to a patent, trademark, or trade name, to the extent the amounts are separately identified and are reasonable in amount. These rules will apply to transfers made after July 25, 1969.

Argument For-The substantial growth of franchising throughout the United States in recent years, and the split of authority among the courts with respect to the proper tax treatment to be accorded the transfer of a franchise, necessitates the adoption of more definite guidelines in this area so that where a franchisor does not part with all his interest in a franchise then the transfer will not be entitled to capital gains treatment.

Argument Against.-On the other hand, it is argued that most transfers of franchises are more like sales than licenses and, accordingly should continue to receive capital gains treatment.

V. REAL ESTATE DEPRECIATION

Present law. Under present law, the first owner may take depreciation allowances for real property under the double declining balance method or the sum-of-the-years-digits method. These rapid depreciation methods generally permit large portions of an asset's total basis to be deducted in the early years of the asset's useful life. A subsequent owner is permitted to use the 150 percent declining balance method which also provides more rapid depreciation than straight line in the early years.

Depreciation is allowed on the total cost basis of the property (minus a reasonable salvage value), even though the property was acquired with little equity and a large mortgage.

Net gains on sales of real property used in a trade or business are, with certain exceptions, taxed as capital gains and losses are treated as ordinary losses. Gain on the sale of buildings is taxed as ordinary income to the extent of depreciation taken on that property after December 31, 1963, if the property has been held not more than 12 months. If the property has been held over 12 months, only the excess over straight-line depreciation is "recaptured" and even that amount is reduced after 20 months, at the rate of 1 percent per month, until 120 months, after which nothing is recaptured.

Problem. The present tax treatment of real estate has been used by some high income individuals as a tax shelter to escape payment of tax on substantial portions of their economic income. The rapid depreciation methods now allowed make it possible for taxpayers to deduct amounts in excess of those required to service the mortgage during the early life of the property. Moreover, because accelerated depreciation usually produces a deduction in excess of the actual decline in the usefulness of property, economically profitable real estate operations are normally converted into substantial tax losses, sheltering from

91

income tax such economic profits and permitting avoidance of income tax on the owner's other ordinary income, such as salary and dividends. Later the property can be sold and the excess of the sale price over the remaining basis can be treated as a capital gain to the extent that the recapture provisions do not apply. By holding the property for 10 years before sale, moreover, the taxpayer can arrange to have all the gain resulting from excess depreciation (which was offset against ordinary income) taxed as a capital gain without the recapture provisions coming into play. The tax advantages from such operations increase as a taxpayer's income moves into the higher tax brackets.

Because of the present tax situation, when investment is solicited in a real estate venture it has become the practice to promise a prospective investor substantial tax losses which can be used to diminish the tax on his income from other sources. Thus, there is, in effect, substantial dealing in "tax losses" produced by depreciable real property.

House solution.-The House bill revises real estate depreciation allowances to limit the opportunities to use the present treatment as a tax shelter and yet, at the same time, to maintain tax incentives to build low income housing where the need is great.

Under the bill the most accelerated methods of real estate depreciation (the 200 percent declining balance and the sum-of-the-years-digits methods) are limited to new residential housing. To qualify for such accelerated depreciation at least 80 percent of the income from the building must be derived from rentals of residential units. Other new real estate, including commercial and industrial buildings, is to be limited to the 150 percent declining balance depreciation method. In general the new rules will not apply to property if its construction began before July 25, 1969, or if there was a written binding contract to construct the building before July 25, 1969.

Only straight line depreciation is to be allowed for used buildings acquired after July 25, 1969. A special 5-year amortization deduction is provided in the case of expenditures after July 24, 1969, however, for the rehabilitation of buildings for low-cost rental housing.

Finally, the bill provides for the recapture of the excess of accelerated depreciation over straight line depreciation on the disposition after July 24, 1969, of depreciable real property (but only to the extent of depreciation taken after that date). Thus, to the extent of this excess depreciation, the gain on the sale of the real property will be treated as ordinary income rather than as capital gain.

Arguments For.-(1) This provision strikes a good balance between the need to curtail the availability of the real estate provisions as a tax shelter and the need to provide adequate incentives for the building of low income housing. Since the provision allows the most accelerated methods of real estate depreciation to be used for new residential housing, it continues the encouragement to build the residential housing needed to meet present housing shortages. On the other hand, by limiting new real estate other than residential housing to the 150-percent declining balance method, by limiting used buildings to straight line depreciation, and by strengthening the recapture provisions, the bill reduces the potential base of real estate as a tax shelter.

(2) Many economically profitable real estate operations produce substantial "tax losses" because of accelerated depreciation deductions

92

which are used to avoid income tax on the taxpayer's other income, such as salary and dividends, and in many cases result in the conversion of ordinary income into capital gain.

(3) Reducing depreciation deductions for slum and ghetto housing while continuing accelerated depreciation for new housing will make investments in slum housing less attractive and lead to its earlier demolition and replacement with modern housing, thus achieving a socially desirable goal.

(4) Recapturing real estate depreciation taken in excess of straight line depreciation at ordinary income tax rates not only simplifies this area of the tax law, but also it more closely recognizes that the larger deductions taken for depreciation reduced ordinary income (even though the property itself actually did not decrease in value) and should not now be allowed as a capital gain.

Arguments Against.-(1) There should be no change in the present tax treatment of real estate because of the pressing need to encourage the construction of more housing to eliminate the present housing shortages. This situation tends to imply that tax incentives have been deficient rather than excessive.

(2) Accelerated depreciation is a particularly appropriate incentive to real estate development in that it provides greater capital recovery during the uncertain earlier years when real property has to prove itself as a good or bad investment.

(3) The present recapture rules were carefully tailored to the peculiar requirements of the real estate industry and no case of favoritism has been established.

W. COOPERATIVES1

Present law. In determining taxable income under present law, cooperatives are permitted a deduction (or exclusion) for patronage dividends paid in money or in qualified patronage allocations. They also are permitted a deduction (or exclusion) for qualified per-unit retain certificates (that is, certificates issued to patrons to reflect the retention by the cooperative of a portion of the proceeds of the marketing of products for the patrons).

A patronage allocation, or per-unit retain certificate, is qualified— and therefore not taken into account by the cooperative-only if the patron consents to take it into account currently as income (or as a reduction in price in the case of purchases from the cooperative). Thus, in general, a cooperative is not taxed on patronage allocations or per-unit retains only if they are taxable to patrons. In the case of qualified patronage dividends, present law requires that 20 percent must be paid in money so that the patron will have all or part of the money to pay the tax.

Problem.-Qualified patronage allocations and qualified per-unit retains may be considered as amounts distributed by the cooperative to its patrons and reinvested in the cooperative as capital. However, the patron often does not have an independent choice between investing them in the cooperative or retaining them for his own use. This

1 Witnesses did not testify to this change in the law during the Ways and Means Committee hearings

85

periods of time should not be taxed as ordinary income and that special treatment should be provided for investment, as opposed to speculative gains. The 6-month holding period does not appear to be an adequate implementation of either of these concepts. It affords special treatment to gains which accrue over a period of less than a year and it does not appear to adequately distinguish between speculative and investment gains.

House solution.-The House bill provides that a long-term capital gain is to be a gain from the sale or exchange of a capital asset held for more than 12 months. This provision applies to taxable years beginning after July 25, 1969.

Arguments For.-(1) Lengthening the holding period to one year is necessary to restore the original concept of the capital gains taxthat is, that these gains accruing over a period longer than one taxable year should not be "bunched" together and subjected to the graduated tax rates generally applicable to income normally received on an annual basis.

(2) A person who holds an investment for little more than six months is primarily interested in obtaining speculative gains from short-term market fluctuations which may be taxed at favorable rates. In contrast, the person who holds an investment for a long time probably is interested fundamentally in the income aspects of his investment, and in its long-term appreciation in value. The available evidence suggests that assets held for a period between six months and one year tend to be speculative. Further, a study made in 1962, of gains from corporate stock transactions revealed that almost 90 percent of all capital gains in that year arose from sales occurring after one year of possession. By fixing the holding period at one year the bill reflects all these considerations.

Arguments Against.—(1) Lengthening the holding period would cause investors in securities to postpone the sale of these securities. This, in turn, would seriously reduce the liquidity of the various securities markets and would reduce, as well, the Federal revenues from capital gains.

(2) Many persons believe that any lengthening of the holding period should be accompanied by a decrease in the maximum capital gain rate which would apply to such a gain.

5. Total Distributions From Qualified Pension, Etc., Plans

Present law. An employer who establishes a qualified employee pension, profit-sharing, stock-bonus, or annuity plan is allowed to deduct contributions to the trust, or if annuities are purchased, may deduct the premiums. The employer contributions to, and the earnings of, a tax-exempt trust generally are not taxed to the employee until the amount credited to his account are distributed or "made available" to him. Retirement benefits generally are taxed as ordinar income under the annuity rules when the amounts are distributed to the extent they exceed the amounts contributed by the employee Thus, employee contributions to a pension, etc. fund are not taxec