Section 41 provides for a research tax credit equal to 20 percent of the amount by which a taxpayer's qualified research expenditures for a taxable year exceeded its base amount for that year. The research tax credit expired and generally does not apply to amounts paid or incurred after June 30, 1998.

A 20-percent research tax credit also applied to the excess of (1) 100 percent of corporate cash expenditures (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation. This separate credit computation is commonly referred to as the "university basic research credit" (see sec. 41(e)).

Except for certain university basic research payments made by corporations, the research tax credit applies only to the extent that the taxpayer's qualified research expenditures for the current taxable year exceed its base amount. The base amount for the current year generally is computed by multiplying the taxpayer's "fixed-base percentage" by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenditures and had gross receipts during each of at least three years from 1984 through 1988, then its "fixed-base percentage" is the ratio that its total qualified research expenditures for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum ratio of .16). All other taxpayers (so-called "start-up firms") are assigned a fixed-base percentage of 3 percent. (A special rule is designed to gradually recompute a start-up firm's fixed-base percentage based on its actual research experience. Under this special rule, a start-up firm will be assigned a fixed-base percentage of 3 percent for each of its first five taxable years after 1993 in which it incurs qualified research expenditures. In the event that the research credit is extended beyond the scheduled expiration date, a start-up firm's fixed-based percentage for its sixth through tenth taxable years after 1993 in which it incurs qualified research expenditures will be a phased-in ratio based on its actual research experience. For all subsequent taxable years, the taxpayer's fixed-based percentage will be its actual ratio of qualified research expenditures to gross receipts for any five years selected by the taxpayer from its fifth through tenth taxable years after 1993 (sec. 41(c)(3)(B)).

In computing the credit, a taxpayer's base amount may not be less than 50 percent of its current-year qualified research expenditures.

Taxpayers are allowed to elect an alternative incremental research credit regime. If a taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under present law) and the credit rate likewise is reduced. Under the alternative credit regime, a credit rate of 1.65 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1 percent (i.e., the base amount equals 1 percent of the taxpayer's average gross receipts for the four preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit rate of 2.2 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a fixed-base percentage of 2 percent. A credit rate of 2.75 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 2 percent. An election to be subject to this alternative incremental credit regime may be made only for a taxpayer's first taxable year beginning after June 30, 1996, and such an election applies to that taxable year and all subsequent years (in the event that the credit subsequently is extended by Congress) unless revoked with the consent of the Secretary of the Treasury.

Qualified research expenditures eligible for the research tax credit consist of: (1) "in-house" expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid by the taxpayer for qualified research conducted on the taxpayer's behalf (so-called "contract research expenses"). (Under a special rule, 75 percent of amounts paid to a research consortium for qualified research is treated as qualified research expenses eligible for the research credit (rather than 65 percent under the general rule under sec. 41(b)(3) governing contract research expenses) if (1) such research consortium is a tax-exempt organization that is described in section 501(c)(3) (other than a private foundation) or section 501(c)(6) and is organized and operated primarily to conduct scientific research, and (2) such qualified research is conducted by the consortium on behalf of the taxpayer and one or more persons not related to the taxpayer).

To be eligible for the credit, the research must not only satisfy the requirements of present-law section 174 but must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and must pertain to functional aspects, performance, reliability, or quality of a business component.

Expenditures attributable to research that is conducted outside the United States do not enter into the credit computation. In addition, the credit is not available for research in the social sciences, arts, or humanities, nor is it available for research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).

The research tax credit would be extended for the period July 1, 1998, through February 29, 2000.

In addition, the credit rate applicable under the alternative incremental credit would be increased by one percentage point per step, that is from 1.65 percent to 2.65 percent when a taxpayer's current-year research expenses exceed a base amount of 1 percent but do not exceed a base amount of 1.5 percent; from 2.2 percent to 3.2 percent when a taxpayer's current-year research expenses exceed a base amount of 1.5 percent but do not exceed a base amount of 2 percent; and from 2.75 percent to 3.75 percent when a taxpayer's current-year research expenses exceed a base amount of 2 percent.

The work opportunity tax credit is available on an elective basis for employers hiring individuals from one or more of eight targeted groups. The eight targeted groups are: (1) families eligible to receive benefits under the Title IV-A Temporary Assistance for Needy Families Program (the successor to the Aid to Families with Dependent Children Program); (2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation referrals; (5) qualified summer youth employees; (6) qualified veterans; (7) families receiving food stamps; and (8) persons receiving certain Supplemental Security Income (SSI) benefits.

The credit generally is equal to 40 percent (25 percent for employment of 400 hours or less) of qualified wages. Qualified wages consist of wages attributable to service rendered by a member of a targeted group during the 1-year period beginning with the day the individual begins work for the employer. For a vocational rehabilitation referral, however, the period begins on the day the individual begins work for the employer on or after the beginning of the individual's vocational rehabilitation plan.

Generally, no more than $6,000 of wages during the first year of employment is permitted to be taken into account with respect to any individual. Thus, the maximum credit per individual is $2,400. With respect to qualified summer youth employees, the maximum credit is 40 percent of up to $3,000 of qualified first-year wages, for a maximum credit of $1,200.

In general, an individual is not to be treated as a member of a targeted group unless: (1)on or before the day the individual begins work for the employer, the employer received in writing a certification from the designated local agency that the individual is a member of a specific targeted group; or (2) on or before the day the individual is offered work with the employer, a prescreening notice is completed with respect to that individual by the employer and within 21 days after the individual begins work for the employer, the employer submits such notice, signed by the employer and the individual under penalties of perjury, to the designated local agency as part of a written request for certification. The prescreening notice will contain the information provided to the employer by the individual that forms the basis of the employer's belief that the individual is a member of a targeted group.

No credit is allowed for wages paid unless the eligible individual is employed by the employer for at least 120 hours. The credit percentage is 25 percent for employment of 400 hours or less, assuming that the minimum employment period is satisfied with respect to that employee. For employment of more than 400 hours, the credit percentage is 40 percent.

The Code provides to employers a tax credit on the first $20,000 of eligible wages paid to qualified long-term family assistance (AFDC or its successor program) recipients during the first two years of employment. The credit is 35 percent of the first $10,000 of eligible wages in the first year of employment and 50 percent of the first $10,000 of eligible wages in the second year of employment. The maximum credit is $8,500 per qualified employee.

Qualified long-term family assistance recipients are: (1) members of a family that has received family assistance for at least 18 consecutive months ending on the hiring date; (2) members of a family that has received family assistance for a total of at least 18 months (whether or not consecutive) after the date of enactment of this credit if they are hired within 2 years after the date that the 18-month total is reached; and (3) members of a family who are no longer eligible for family assistance because of either Federal or State time limits, if they are hired within 2 years after the Federal or State time limits made the family ineligible for family assistance.

Eligible wages include cash wages paid to an employee plus amounts paid by the employer for the following: (1) educational assistance excludable under a section 127 program (or that would be excludable but for the expiration of sec. 127); (2) health plan coverage for the employee, but not more than the applicable premium defined under section 4980B(f)(4); and (3) dependent care assistance excludable under section 129.

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to deduct the fair market value of property contributed to a charitable organization. (The amount of the deduction allowable for a taxable year with respect to a charitable contribution may be reduced depending on the type of property contributed, the type of charitable organization to which the property is contributed, and the income of the taxpayer (secs. 170(b) and 170(e)). However, in the case of a charitable contribution of short-term gain, inventory, or other ordinary income property, the amount of the deduction generally is limited to the taxpayer's basis in the property. In the case of a charitable contribution of tangible personal property, the deduction is limited to the taxpayer's basis in such property if the use by the recipient charitable organization is unrelated to the organization's tax-exempt purpose.

Tax-exempt organizations (other than churches and certain small organizations) are required to file an annual information return (Form 990) with the Internal Revenue Service ("IRS"), setting forth the organization's items of gross income and expenses attributable to such income, disbursements for tax-exempt purposes, plus certain other information for the taxable year.

Private foundations are required to make the current year's annual information return available for public inspection at the foundation's principal office during regular business hours (sec. 6104(d)). Such return must be made available for inspection by any citizen on request made within 180 days after the date of publication of notice of its availability. Notices must be published not later than the day the return is required to be filed in a newspaper having general circulation in the county in which the principal office of the foundation is located. The notice must state that the annual return is available for public inspection by any citizen who requests it, and must state the address and telephone number of the private foundation's principal office and the name of its principal manager.

Other tax-exempt organizations that are required to file a Form 990, including public charities, are required to allow public inspection at the organization's principal office (and certain regional or district offices) of their annual information returns for the three most recent taxable years (sec. 6104(e)). In addition, upon written request to the IRS, members of the general public are permitted to inspect annual information returns of tax-exempt organizations and applications for recognition of tax-exempt status (and related documents) at the National Office of the IRS in Washington, D.C. A person making such a written request is notified by the IRS when the material is available for inspection at the National Office, where notes may be taken of the material open for inspection, photographs taken with the person's own equipment, or copies of such material obtained from the IRS for a fee (Treas. Reg. secs. 301.6104(a)-6 and 301.6104(b)-1).

Under the subpart F rules, certain U.S. shareholders of a controlled foreign corporation ("CFC") are subject to U.S. tax currently on certain income earned by the CFC, whether or not such income is distributed to the shareholders. The income subject to current inclusion under the subpart F rules includes, among other things, "foreign personal holding company income" and insurance income. The U.S. 10-percent shareholders of a CFC also are subject to current inclusion with respect to their shares of the CFC's foreign base company services income (i.e., income derived from services performed for a related person outside the country in which the CFC is organized).

Foreign personal holding company income generally consists of the following: dividends, interest, royalties, rents and annuities; net gains from the sale or exchange of (1) property that gives rise to the preceding types of income, (2) property that does not give rise to income, and (3) interests in trusts, partnerships, and REMICs; net gains from commodities transactions; net gains from foreign currency transactions; income that is equivalent to interest; income from notional principal contracts; and payments in lieu of dividends.

Insurance income subject to current inclusion under the subpart F rules includes any income of a CFC attributable to the issuing or reinsuring of any insurance or annuity contract in connection with risks located in a country other than the CFC's country of organization. Subpart F insurance income also includes income attributable to an insurance contract in connection with risks located with the CFC's country of organization, as the result of an arrangement under which another corporation receives a substantially equal amount of consideration for insurance of other-country risks. Investment income of a CFC that is allocable to any insurance or annuity contract related to risks located outside the CFC's country of organization is taxable as subpart F insurance income (Prop. Treas. Reg. sec. 1.953-1(a)).

Temporary exceptions from foreign personal holding company income and foreign base company services income apply for subpart F purposes for certain income that is derived in the active conduct of a banking, financing, insurance, or similar business. These exceptions (described below) are applicable only for taxable years beginning in 1998.

A temporary exception from foreign personal holding company income applies to income that is derived in the active conduct of a banking, financing or similar business by a CFC that is predominantly engaged in the active conduct of such business. For this purpose, income derived in the active conduct of a banking, financing or similar business generally is determined under the principles applicable in determining financial services income for foreign tax credit limitation purposes. However, in the case of a corporation that is engaged in the active conduct of a banking or securities business, the income that is eligible for this exception is determined under the principles applicable in determining the income which is treated as nonpassive income for purposes of the passive foreign investment company provisions. In this regard, the income of a corporation engaged in the active conduct of a banking or securities business that is eligible for this exception is the income that is treated as nonpassive under the regulations proposed under section 1296(b) (as in effect prior to the enactment of the Taxpayer Relief Act of 1997). See Prop. Treas. Reg. secs. 1.1296-4 and 1.1296-6. The Secretary of the Treasury is directed to prescribe regulations applying look-through treatment in characterizing for this purpose dividends, interest, income equivalent to interest, rents and royalties from related persons.

For purposes of the temporary exception, a corporation is considered to be predominantly engaged in the active conduct of a banking, financing or similar business if it is engaged in the active conduct of a banking or securities business or is a qualified bank affiliate or qualified securities affiliate. In this regard, a corporation is considered to be engaged in the active conduct of a banking or securities business if the corporation would be treated as so engaged under the regulations proposed under prior law section 1296(b) (as in effect prior to the enactment of the Taxpayer Relief Act of 1997); qualified bank affiliates and qualified securities affiliates are as determined under such proposed regulations. See Prop. Treas. Reg. secs. 1.1296-4 and 1.1296-6.

Alternatively, a corporation is considered to be engaged in the active conduct of a banking, financing, or similar business if more than 70 percent of its gross income is derived from such business from transactions with unrelated persons located within the country under the laws of which the corporation is created or organized. For this purpose, income derived by a qualified business unit ("QBU") of a corporation from transactions with unrelated persons located in the country in which the QBU maintains its principal office and conducts substantial business activity is treated as derived by the corporation from transactions with unrelated persons located within the country in which the corporation is created or organized. A person other than a natural person is considered to be located within the country in which it maintains an office through which it engages in a trade or business and by which the transaction is effected. A natural person is treated as located within the country in which such person is physically located when such person enters into the transaction.

A temporary exception from foreign personal holding company income applies for certain investment income of a qualifying insurance company with respect to risks located within the CFC's country of creation or organization. These rules differ from the rules of section 953 of the Code, which determines the subpart F inclusions of a U.S. shareholder relating to insurance income of a CFC. Such insurance income under section 953 generally is computed in accordance with the rules of subchapter L of the Code.

A temporary exception applies for income (received from a person other than a related person) from investments made by a qualifying insurance company of its reserves or 80 percent of its unearned premiums. For this purpose, in the case of contracts regulated in the country in which sold as property, casualty or health insurance contracts, unearned premiums and reserves are defined as unearned premiums and reserves for losses incurred determined using the methods and interest rates that would be used if the qualifying insurance company were subject to tax under subchapter L of the Code. Thus, for this purpose, unearned premiums are determined in accordance with section 832(b)(4), and reserves for losses incurred are determined in accordance with section 832(b)(5) and 846 of the Code (as well as any other rules applicable to a U.S. property and casualty insurance company with respect to such amounts).

In the case of a contract regulated in the country in which sold as a life insurance or annuity contract, the following three alternative rules for determining reserves apply. Any one of the three rules can be elected with respect to a particular line of business.

First, reserves for such contracts can be determined generally under the rules applicable to domestic life insurance companies under subchapter L of the Code, using the methods there specified, but substituting for the interest rates in Code section 807(d)(2)(B) an interest rate determined for the country in which the qualifying insurance company was created or organized, calculated in the same manner as the mid-term applicable Federal interest rate ("AFR") (within the meaning of section 1274(d)).

Second, the reserves for such contracts can be determined using a preliminary term foreign reserve method, except that the interest rate to be used is the interest rate determined for the country in which the qualifying insurance company was created or organized, calculated in the same manner as the mid-term AFR. If a qualifying insurance company uses such a preliminary term method with respect to contracts insuring risks located in the country in which the company is created or organized, then such method is the method that applies for purposes of this election.

Third, reserves for such contracts can be determined to be equal to the net surrender value of the contract (as defined in section 807(e)(1)(A)).

In no event can the reserve for any contract at any time exceed the foreign statement reserve for the contract, reduced by any catastrophe or deficiency reserve. This rule applies whether the contract is regulated as a property, casualty, health, life insurance, annuity or any other type of contract.

A temporary exception from foreign personal holding company income also applies for income from investment of assets equal to: (1) one-third of premiums earned during the taxable year on insurance contracts regulated in the country in which sold as property, casualty, or health insurance contracts; and (2) the greater of 10 percent of reserves, or, in the case of a qualifying insurance company that is a startup company, $10 million. For this purpose, a startup company is a company (including any predecessor) that has not been engaged in the active conduct of an insurance business for more than 5 years. In general, the 5-year period commences when the foreign company first is engaged in the active conduct of an insurance business. If the foreign company was formed before being acquired by the U.S. shareholder, the 5-year period commences when the acquired company first was engaged in the active conduct of an insurance business. In the event of the acquisition of a book of business from another company through an assumption or indemnity reinsurance transaction, the 5-year period commences when the acquiring company first engaged in the active conduct of an insurance business, except that if more than a substantial part (e.g., 80 percent) of the business of the ceding company is acquired, then the 5-year period commences when the ceding company first engaged in the active conduct of an insurance business. Reinsurance transactions among related persons may not be used to multiply the number of 5-year periods.

Under rules prescribed by the Secretary, income is allocated to contracts as follows. In the case of contracts that are separate-account-type contracts (including variable contracts not meeting the requirements of sec. 817), only the income specifically allocable to such contracts are taken into account. In the case of other contracts, income not specifically allocable is allocated ratably among such contracts.

A qualifying insurance company is defined as any entity which: (1) is regulated as an insurance company under the laws of the country in which it is incorporated; (2) derives at least 50 percent of its net written premiums from the insurance or reinsurance of risks situated within its country of incorporation; and (3) is engaged in the active conduct of an insurance business and would be subject to tax under subchapter L if it were a domestic corporation.

The temporary exceptions do not apply to investment income (includable in the income of a U.S. shareholder of a CFC pursuant to sec. 953) allocable to contracts that insure related party risks or risks located in a country other than the country in which the qualifying insurance company is created or organized.

An anti-abuse rule applies for purposes of these temporary exceptions. For purposes of applying these exceptions, items with respect to a transaction or series of transactions are disregarded if one of the principal purposes of the transaction or transactions is to qualify income or gain for these exceptions, including any change in the method of computing reserves or any other transaction or transactions one of the principal purposes of which is the acceleration or deferral of any item in order to claim the benefits of these exceptions.

The proposal would modify the present-law temporary exceptions from subpart F for income that is derived in the active conduct of a banking, financing, insurance or similar business. These exceptions (as modified) would be applicable only for taxable years beginning in 1999.

With respect to income derived in the active conduct of a banking, financing, or similar business, the proposal differs from the present-law temporary exceptions in the following significant respects. First, the proposal would require a CFC to conduct substantial activity with respect to its business in order to qualify for the exceptions. Second, the proposal would add certain nexus requirements which would require that income which is derived by a CFC or QBU from transactions with customers would be eligible for the exceptions if, among other things, substantially all of the activities in connection with such transactions are conducted directly by the CFC or QBU in its home country, and such income is treated as earned by the CFC or QBU in its home country for purposes of such country's tax laws. Third, the proposal would modify the tests for determining whether a CFC is predominantly engaged in the active conduct of a banking, financing, or similar business, including modifications for income derived from a lending or finance business. Fourth, the proposal would extend the exceptions to income derived from certain cross-border transactions, provided that certain requirements are met. Fifth, the determination of where a customer is treated as located would be made under rules prescribed by the Secretary of the Treasury. Finally, the look-through rule that was included in the present-law provision for purposes of determining the income eligible for the exceptions would be eliminated.

In the case of insurance, the proposal differs from present law in the following significant respects. In addition to the exception for certain income of a qualifying insurance company with respect to risks located within the CFC's country of creation or organization that is provided under present law, the proposal would provide additional exceptions. First, the proposal would provide temporary exceptions from insurance income and from foreign personal holding company income for certain income of a qualifying branch of a qualifying insurance company with respect to risks located within the home country of the branch, provided certain requirements are met under each of the exceptions. Further, the proposal would add additional temporary exceptions from insurance income and from foreign personal holding company income for certain income of certain CFCs or branches with respect to risks located in any country other than the U.S., provided that requirements for these exceptions are met.

The proposal would modify the exceptions from subpart F for income derived in the active conduct of a banking, financing, or similar business by, among other things, incorporating a substantial activity requirement. Under the proposed modifications, the subpart F exceptions would apply to a CFC that is an eligible controlled foreign corporation (an "eligible CFC"). An eligible CFC would be defined as a CFC which is predominantly engaged in the active conduct of a banking, financing, or similar business, but only if it conducts substantial activity with respect to such business.

Whether a CFC would be considered to conduct substantial activity with respect to a banking, financing, or similar business would be determined under all the facts and circumstances. It would be intended that as part of this facts and circumstances analysis in determining whether the activities conducted by the CFC are substantial, all relevant factors would be taken into account, including the overall size of the CFC, the amount of its revenues and expenses, the number of its employees, the ratio of its revenues per employee, the amount of property it owns, and the nature, size, and relevant significance of the applicable activities conducted by the CFC. Under the proposal, the Secretary would be granted the authority to prescribe regulations to carry out the purposes of these exceptions. It would be intended that such authority would include the authority to prescribe regulations relating to whether a CFC (or, as relevant, a QBU) would be considered to conduct substantial activity.

It also would be intended that as part of this facts and circumstances analysis, a CFC would be required to conduct substantially all of the activities necessary for the generation of income with respect to the business, which generally would include the following:

• initial solicitation of customers (including vendors);
• advising customers on financial needs, including funding and financial products;
• providing financial and technical advice to customers;
• designing or tailoring financial products to customers' needs;
• negotiating terms with customers;
• performing credit analysis on customers and evaluating noncredit risks;
• providing related services to customers;
• making loans, entering into leases, extending credit or entering into other transactions with customers that generate income that would be considered derived in the active conduct of a banking, financing, or similar business;
• collecting from customers;
• performing remarketing activities (including sales) following termination of transactions with customers;
• responding to customers' failure to satisfy their obligations under transactions, including enforcement or renegotiation of terms, liquidation of collateral, foreclosure, and/or institution of litigation; and
• holding collateral for transactions with customers.

It would be intended that the performance of back-office functions (including accounting for income or loss, recordkeeping, and communicating with customers) not be taken into account in determining whether the substantial activity requirement is satisfied. It also would be intended that the 5 relevant activities of the business may be modified by Treasury regulation to take into account future changes in the operations of these businesses.

In general, the substantial activity requirement would be applied based on the activities of the CFC as a whole, including the activities of any QBUs of the CFC. In determining whether the substantial activity requirement would be satisfied, activities performed in the country in which the CFC is incorporated (or in the country in which the QBU has its principal office) by employees of a related person of the CFC would be taken into account, to the extent that the related person is compensated on an arm's-length basis for the services of such employees and such compensation is includible in the related person's income in such country for purposes of such country's income tax laws. For this purpose, a related person would have the meaning provided in section 954(d)(3), substituting "at least 80 percent" for "more than 50 percent." It would be intended that the activities of such a related person would not again be taken into account in determining whether another CFC or QBU (e.g., the related person) satisfies the substantial activity requirement.

The proposal also would modify the rules for determining whether a CFC is predominantly engaged in the active conduct of a banking, financing, or similar business. Different rules would apply to banks and financing or similar businesses for this purpose.

Under the present-law provision, a CFC is considered to be predominantly engaged in the active conduct of banking, financing, or similar business if the CFC is engaged in the active conduct of a banking business within the meaning of section 1296(b) (as in effect prior to the enactment of the Taxpayer Relief Act of 1997), or is a qualified bank affiliate within the meaning of the proposed regulations under former section 1296(b). See Prop. Treas. Reg. sec. 1.1296-4. The proposal would modify the application of the banking business test for determining whether a CFC is predominantly engaged in the active conduct of a banking, financing or similar business. Under the proposal, a CFC would be considered to be predominantly engaged in the active conduct of a banking, financing, or similar business if it is engaged in the active conduct of a banking business and is an institution licensed to do business as a bank in the United States (or is any other corporation not so licensed which is specified in regulations). In this regard, it generally would be intended that these requirements for the active conduct of a banking business would be interpreted in the manner provided in the regulations proposed under former section 1296(b). See Prop. Treas. Reg. sec. 1.1296-4. However, it would not be intended that this requirement be considered to be satisfied by a CFC merely because it is a qualified bank affiliate within the meaning of the proposed regulations under former section 1296(b).

Under the present-law provision, a CFC is considered to be predominantly engaged in the active conduct of a banking, financing, or similar business if more than 70 percent of its gross income is derived from such business from transactions with unrelated persons located within the CFC's country of creation or organization. For this purpose, income derived by a QBU of the CFC from transactions with unrelated persons located within the country in which the QBU maintains its principal office are taken into account in satisfying this test if the QBU conducts substantial business activity.

The proposal would modify this test for determining whether a CFC is predominantly engaged in the active conduct of a banking, financing, or similar business. Under the proposal, a CFC would be considered to be predominantly engaged in the active conduct of such business if more than 70 percent of its gross income is derived directly from the active and regular conduct of a lending or finance business from transactions with customers which are unrelated persons. For this purpose, a CFC would be considered to be engaged in a lending or finance business if it is engaged in the business of:

1. making loans;
2. purchasing or discounting accounts receivable, notes, or installment obligations;
3. engaging in leasing (including entering into leases and purchasing, servicing and disposing of leases and leased assets);
4. issuing letters of credit and providing guarantees;
5. providing charge and credit card services;
6. rendering services or making facilities available in connection with the foregoing activities carried on by the corporation rendering such services or facilities, or by another corporation which is a member of the same affiliated group.

For this purpose, whether two corporations are affiliated would be determined by reference to section 1504 with one modification: the exclusion for foreign corporations would be disregarded.

If the CFC would be treated as an eligible CFC (i.e., it satisfies the substantial activity and predominantly engaged requirements), the subpart F exceptions would apply to so-called qualified banking or financing income of such corporation. In general, qualified banking or financing income would be defined as income which is derived in the active conduct of a banking, financing, or similar business by an eligible CFC or a QBU of such CFC if: (1) the income is derived from transactions with customers not located in the United States, (2) substantially all of the activities in connection with such transactions are conducted directly by the corporation or unit in its home country, and (3) the income is treated as earned by such corporation or unit in its home country for purposes of such country's tax laws. For this purpose, income would be considered to be earned by a CFC or a QBU in its home country if such income is sourced and allocable to such CFC or QBU in its home country for purposes of such country's tax laws. In addition, for this purpose, activities would be considered to be conducted by a CFC or QBU if such activities are performed by employees of the CFC or QBU. Except as provided by regulations, a CFC's home country would be defined as its country of creation or organization, and a QBU's home country would be defined as the country in which the unit maintains its principal office. It would be intended that income derived from transactions with customers would apply only to transactions with customers acting in their capacity as such.

In general, qualified banking or financing income of an eligible CFC or QBU of such CFC would be determined separately for the CFC and each QBU, taking into account, in the case of an eligible CFC, only items of income, gain, deduction, loss or other items, as well as activities, of such CFC that is not properly allocable to any QBUs. Similarly, in the case of a QBU, qualified banking or financing income would be determined by taking into account such applicable items (e.g., income and activities) that are properly allocable to such QBU. Under the proposal, the Secretary would be granted the authority to prescribe regulations to carry out the purposes of these exceptions. It would be intended that such authority would include the authority to prescribe regulations for properly allocating such items among branches or units of a CFC, and between the CFC and its branches or units.

If the requirements above are satisfied, the exceptions would apply to income that is derived from transactions with customers located in the CFC's home country. In addition, the exceptions would apply to income that is derived by a QBU of an eligible CFC from transactions with customers located in the QBU's home country.

For example, assume that a CFC is incorporated in the United Kingdom and has operations in France that constitute a QBU. Also assume that the activities of the U.K. CFC's head office together with the activities of the French QBU satisfy the substantial activity requirement. Under the proposal, income derived by the U.K. CFC from transactions with customers in the United Kingdom would be eligible for the exceptions if substantially all of the activities in connection with the transaction were performed in the United Kingdom by employees of the U.K. CFC, and the income was treated as earned by the U.K. CFC in the United Kingdom for U.K. income tax purposes. In addition, income derived by the French QBU from transactions with customers in France would be eligible for the exceptions if substantially all of the activities in connection with the transactions were performed in France by employees of the French QBU, and the income was treated as earned by the French QBU in France for French income tax purposes.

If the requirements above are satisfied, the exceptions also would apply to income from certain cross border transactions, but only if a higher standard with respect to the substantial activity requirement is satisfied. Under the proposal, income derived by a CFC from transactions with customers not located in the CFC's home country or the United States would be eligible for the exceptions if the CFC conducts substantial activity with respect to a banking, financing, or similar business in its home country. In addition, income derived by a QBU of an eligible CFC from transactions with customers not located in the QBU's home country or the United States would be eligible for the exceptions, but only if the QBU conducts substantial activity with respect to such a business in its home country. For this purpose, the substantial activity requirement would be applied by looking only at the activities of the applicable CFC or QBU on a stand-alone basis. Thus, income derived by a QBU from transactions with customers not located in its home country (or in the United States) would be eligible for the exceptions if the activities of the QBU itself constitute substantial activities (provided that the other requirements are satisfied).

Consider again the U.K. CFC and the French QBU. If the head office of the U.K. CFC derives income from a transaction with a customer in Germany, the income would be eligible for the exceptions if the activities of the CFC itself (without regard to those of the French QBU) satisfy the substantial activity requirement. Alternatively, if the French QBU derives income from a transaction with a German customer, the income would be eligible for the exceptions if the activities of the French QBU itself satisfy the substantial activity requirement.

In the case of a lending or finance business, in addition to the requirements described above, the proposal would include an additional requirement to qualify for these income exceptions in the case of income earned by a CFC that is an eligible CFC which satisfies the predominantly engaged requirement for an active lending or finance business. For such an eligible CFC, income derived by such CFC would be eligible for the exceptions only if such CFC derives more than 30 percent of its gross income directly from the active and regular conduct of a lending or finance business from transactions with customers that are unrelated persons and that are located within the CFC's home country (the "home country" requirement). In addition, income derived by a QBU of such an eligible CFC would be eligible for the exceptions only if such QBU derives more than 30 percent of its gross income directly from the active and regular conduct of a lending or finance business from transactions with customers that are unrelated persons and that are located within the QBU's home country.

The home country requirement would be applied on a stand-alone basis to the particular CFC or QBU; thus, the 30 percent gross income test would take into account only the gross income of a particular CFC (without regard to the income of its QBUs) from transactions with its home-country unrelated customers, or the gross income of a particular QBU (without regard to the income of the CFC or other QBUs) from transactions with its home country unrelated customers. Accordingly, if more than 70 percent of the CFC's gross income is derived directly from the active and regular conduct of a lending or finance business from transactions with unrelated customers, and one of the CFC's QBUs satisfies the home country requirement but another QBU does not satisfy such requirement, income derived by the QBU that satisfies the home country requirement would be eligible for the exceptions from subpart F (provided that the other requirements are satisfied), but income derived by the other QBU would not be eligible for the exceptions.

Under the present-law provision, a CFC is considered to be predominantly engaged in the active conduct of a banking, financing, or similar business if the CFC is engaged in the active conduct of a securities business within the meaning of section 1296(b) (as in effect prior to the enactment of the Taxpayer Relief Act of 1997), or is a qualified securities affiliate within the meaning of the regulations proposed under former section 1296(b). See Prop. Treas. Reg. sec. 1.1296-6.

Under the proposal, the securities business test for determining whether a CFC is predominantly engaged in the active conduct of a banking, financing, or similar business would be eliminated. In replacement of these rules, the proposal would provide an additional exception from the definition of foreign personal holding company income for certain income derived by a securities dealer within the meaning of section 475. This exception would apply to interest or dividends (or equivalent amounts described in sec. 954(c)(1)(E) or (G)) from any transaction (including a hedging transaction or a transaction consisting of a deposit of collateral or margin described in sec. 956(c)(2)(J)) entered into in the ordinary course of the dealer's trade or business as such a securities dealer, but only if the income is attributable to activities of the dealer in the country in which the dealer is created or organized (or, in the case of a QBU of the dealer, is attributable to activities of the QBU in the country in which the QBU both maintains its principal office and conducts substantial business activity). For this purpose, income would be considered to be attributable to activities of the dealer in its country of incorporation (or to a QBU in the country in which the QBU both maintains its principal office and conducts substantial business activity), if such income is attributable to activities performed in such country by employees of the dealer (or QBU), and such income is treated as earned in such country by the dealer (or QBU) for purposes of such country's tax laws. For this purpose, income would be considered to be earned in the country in which the dealer is created or organized (or, in the case of a QBU, in the country in which the QBU both maintains its principal office and conducts substantial business activity), if such income is sourced and allocable to such dealer (or QBU) in such country for purposes of such country's tax laws.

The proposal would provide a temporary exception to insurance income under section 953. The exception does not apply to related person insurance income to which section 953(c) applies. For purposes of the exception to insurance income, reserves for any insurance or annuity contract would be determined in the same manner as under the exception, described below, for foreign personal holding company income relating to insurance (sec. 954(i), as added by the proposal). For purposes of these provisions, reserves would be intended to include discounted unpaid losses or losses incurred, as appropriate, for property and casualty contracts.

The proposal would provide an exception from insurance income for income derived by a qualifying insurance company that is attributable to the issuing (or reinsuring) of an exempt contract by the qualifying insurance company or a qualifying insurance company branch of such a company, and that is treated as earned by the company or branch in its home country for purposes of that country's tax laws. The exception from insurance income would not apply to income attributable to the issuing (or reinsuring) of an exempt contract as the result of any arrangement whereby another corporation receives a substantially equal amount of premiums or other consideration in respect of issuing (or reinsuring a contract that is not an exempt contract). For this purpose, an exempt contract would be an insurance or annuity contract issued or reinsured by a qualifying insurance company or qualified insurance company branch in connection with property in, liability arising out of activity in, or the lives or health of residents of, a country other than the United States.

No contract would be treated as an exempt contract unless the qualifying insurance company or branch derives more than 30 percent of its net written premiums from exempt contracts (determined without regard to this sentence) covering applicable home country risks, and with respect to which no policyholder, insured, annuitant, or beneficiary is a related person (within the meaning sec. 954(d)(3)). Applicable home country risks are risks in connection with property in, liability arising out of activity in, or the lives or health of residents of, the home country of the qualifying insurance company or branch, as the case may be. In all cases, the 30 percent test is applied on a unit-by-unit basis. Accordingly, income derived by a qualifying insurance company branch of a CFC qualifies only if such branch alone satisfies the 30 percent test (without regard to the net written premiums of any other branch). Income derived by the CFC qualifies only if the CFC alone satisfies the 30 percent test without regard to the net written premiums of any other unit or branch of the CFC.

When the CFC and a branch are tested separately, then in the case of the CFC, only income and activities of the CFC not properly allocable to any QBU would be taken into account. In the case of a QBU, only income and activities of the QBU would be taken into account for this purpose. It would be intended that the Treasury Secretary prescribe rules for allocating items among QBUs and between a CFC and its QBUs.

The home country of a CFC would be the country in which the CFC is created or organized. The home country of a QBU that is a qualifying insurance company branch of a qualifying insurance company means the country in which the principal office of such unit is located and in which such unit is licensed, authorized, or regulated by the applicable insurance regulatory body to sell insurance, reinsurance or annuity contracts to persons other than related persons (within the meaning of sec. 954(d)(3)) in that country.

A qualifying insurance company would be a CFC that meets the following requirements. The first requirement is that the CFC be subject to regulation as an insurance (or reinsurance) company by its home country.

The second requirement is that the CFC derive more than 50 percent of its aggregate net written premiums from the insurance or reinsurance by the CFC (on an aggregate basis, including qualifying insurance company branches) covering applicable home country risks (as described above) of the CFC or branch, as the case may be, provided that no policyholder, insured, annuitant, or beneficiary is a related person. A related person would have the meaning set forth in section 954(d)(3). In the case of a qualifying insurance company branch, premiums are taken into account under this second requirement only to the extent the premiums are treated as earned by the branch in its home country for purposes of that country's tax laws.

The third requirement is that the CFC be engaged in the insurance business and that it would be subject to tax under subchapter L if it were a domestic corporation. A CFC would be considered to be engaged in the insurance business, within the meaning of this provision, if it operates in a manner consistent with the operation of other bona fide commercial insurance companies that sell insurance products to unrelated parties in its home country, and conducts managerial activities in that country with respect to the major functions of the insurance business. For this purpose, activities performed in the home country of the CFC by employees of the CFC and of a related person would be taken into account, to the extent that the related person is compensated on a arm's length basis for the services of such employees and such compensation is includible in the related person's income in such country for purposes of that country's tax laws. For this purpose, a related person would have the meaning provided in section 954(d)(3), substituting "at least 80 percent" for "more than 50 percent." In determining whether a CFC is engaged in the insurance business, for example, an entity that is not engaged in regular and continuous transactions with persons that are not related persons (as described in the generally applicable anti-abuse rules) would not be considered as engaged in the insurance business.

The last requirement is that the CFC be licensed, authorized, or regulated by the applicable insurance regulatory body for its home country to sell insurance, reinsurance, or annuity contracts to persons other than related persons (within the meaning of section 954(d)(3)) in its home country.

A qualifying insurance company branch would be a qualified business unit of a CFC that meets two requirements. A qualified business unit would mean any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records (within the meaning of sec. 989(a)). The first requirement would be that the unit be licensed, authorized, or regulated by the applicable insurance regulatory body for its home country to sell insurance, reinsurance or annuity contracts to persons other than related persons (within the meaning of sec. 954(d)(3)) in that country. The second requirement would be that the CFC (of which the branch is a unit) be a qualifying insurance company, taking the unit into account as if it were a qualifying insurance company branch.

The proposal would impose additional requirements with respect to any contract that covers cross border risks (that is, risks other than applicable home country risks). A contract issued by a qualifying insurance company or qualifying insurance company branch that covers risks other than applicable home country risks would not be treated as an exempt contract unless such company or branch, as the case may be, (1) conducts substantial activity in its home country with respect to the insurance business, and (2) performs in its home country substantially all of the activities necessary to give rise to the income generated by the contract.

Whether a CFC or unit thereof would be considered to perform in its home country substantial activities with respect to the insurance business would be determined under all the facts and circumstances. It would be intended that as part of this facts and circumstances analysis in determining whether the activities conducted by the CFC or unit are substantial, all relevant factors would be taken into account, including the overall size of the CFC or unit, the amount of its revenues and expenses, the number of its employees, the ratio of its revenues per employee, the amount of property it owns, and the nature, size and significance of the applicable activities conducted by the CFC or unit. Under the proposal, the Secretary would be granted the authority to carry out the purposes of these exceptions. It would be intended that such authority would include the authority to prescribe regulations relating to whether a CFC or unit would be considered to conduct substantial activity.

It also would be intended that as part of this facts and circumstances analysis, a CFC or unit would be required to conduct substantially all of the activities necessary for the generation of income with respect to the insurance business. Such activities of an insurance business generally would depend on the line of business, and generally would include:

• designing or tailoring insurance products to meet market or customer requirements;
• performing actuarial analysis with respect to insurance products;
• performing underwriting functions with respect to insurance products;
• performing analysis for purposes of risk assessment;
• performing analysis for purposes of setting premium rates;
• performing analysis for purposes of calculating reserves;
• performing claims management and adjustment functions;
• developing marketing strategies, advertising and other public image activities;
• making (or arranging for) sales to customers;
• maintaining reserves and surplus (other than excess surplus);
• making (or arranging for) investments; and
• collecting from customers.

It would be intended that the performance of back-office functions (including accounting for income or loss, recordkeeping, and communicating with customers) not be taken into account in determining whether the substantial activity requirement is satisfied. It also would be intended that the relevant activities of the business may be modified by Treasury regulation to take into account the actual operation of lines of insurance business, and to take account of future changes in the operation of lines of insurance business.

It would be intended that activities performed in the CFC's or unit's home country by employees of a related person (within the meaning of sec. 954(d)(3), substituting "at least 80 percent" for "more than 50 percent") be taken into account, to the extent that the related person is compensated on an arm's length basis for the services of such employees and such compensation is includible in the related person's income in that country for purposes of such country's tax laws. It also would be intended that the activities of such a related person would not again be taken into account in determining whether another CFC or unit (e.g., the related person) satisfies the substantial activity requirement.

In addition, the qualifying insurance company or qualifying insurance company branch that covers risks other than applicable home country risks would be required to perform in its home country substantially all of the activities necessary to give rise to the income generated by the contract.

The proposal would provide an exception from foreign personal holding income for certain investment income derived by a qualifying insurance company and by certain qualifying insurance company branches. Income of a qualifying insurance company branch would come within this exception if the income were to satisfy the exception under the condition that such branch were treated as a qualifying insurance company whose home country is such branch's home country.

The exception applies to income (received from a person other than a related person) from investments made by a qualifying insurance company or qualifying insurance company branch of its reserves allocable to exempt contracts or 80 percent of its unearned premiums from exempt contracts. For this purpose, an exempt contract has the meaning provided under the proposal.

In the case of exempt contracts that are property, casualty, or health insurance contracts, unearned premiums and reserves would mean unearned premiums and reserves for losses incurred determined using the methods and interest rates that would be used if the qualifying insurance company or qualifying insurance company branch were subject to tax under subchapter L of the Code, with certain modifications. For this purpose, unearned premiums and losses incurred would be determined in accordance with section 832(b) and 846 of the Code (as well as any other rules applicable to a U.S. property and casualty insurance company with respect to such amounts). However, in applying these rules, there would be substituted for the applicable Federal interest rate the interest rate determined for the functional currency of the company's or branch's home country and which (except as provided by the Treasury Secretary) is calculated in the same manner as the Federal mid-term rate under section 1274(d). In addition, there would be substituted for the loss payment pattern under section 846 the foreign loss payment pattern determined by the Treasury Secretary for the line of business.

In the case of an exempt contract that is a life insurance or annuity contract, reserves for such contracts would be determined as follows. The reserves would equal the greater of: (1) the net surrender value of the contract (as defined in section 807(e)(1)(A)), including in the case of pension plan contracts; or (2) the amount determined by applying the tax reserve method that would apply if the qualifying insurance company were subject to tax under Subchapter L of the Code, with the following modifications. First, there would be substituted for the applicable Federal interest rate an interest rate determined for the functional currency of the qualifying insurance company's home country, calculated (except as provided by the Treasury Secretary in order to address insufficient data and similar problems) in the same manner as the mid-term applicable Federal interest rate ("AFR") (within the meaning of section 1274(d)). Second, there would be substituted for the prevailing State assumed rate the highest assumed interest rate permitted to be used for purposes of determining statement reserves in the foreign country for the contract. Third, in lieu of U.S. mortality and morbidity tables, there would be applied mortality and morbidity tables that reasonably reflect the current mortality and morbidity risks in the foreign country. Fourth, the Treasury Secretary may provide that the interest rate and mortality and morbidity tables of a qualifying insurance company may be used for one or more of its branches when appropriate.

In no event would the reserve for any contract at any time exceed the foreign statement reserve for the contract, reduced by any catastrophe, equalization, or deficiency reserve or any similar reserve. This rule would apply whether the contract is regulated as a property, casualty, health, life insurance, annuity, or any other type of contract.

The proposal would also provide an exception from foreign personal holding company income for income from investment of assets equal to (1) one-third of premiums earned during the taxable year on exempt contracts regulated in the country in which sold as property, casualty, or health insurance contracts, and (2) 10 percent of reserves (determined for purposes of the proposal) for contracts regulated in the country in which sold as life insurance or annuity contracts. In no event would the exception from foreign personal holding company income apply to investment income with respect to excess surplus.

To prevent the shifting of relatively high-yielding assets to generate investment income that qualifies under this temporary exception, the proposal would provide that, except as provided by the Treasury Secretary, income would be allocated to contracts as follows. In the case of a separate account-type contract (including a variable contract not meeting the requirements of section 817), the income credited under the contract would be allocable only to that contract. Income not so allocated would be allocated ratably among all contracts that are not separate account-type contracts.

The proposal would provide that the present-law statutory definition of a life insurance contract (under secs. 7702 or 101(f)), as well as the distribution on death requirement of section 72(s) and the diversification requirement of section 817(h), would not apply for purposes of determining reserves for a life insurance or annuity contract under sections 953 and 954 of the Code, provided that neither the policyholders, the insureds or annuitants, nor the beneficiaries with respect to the contract are U.S. persons. In addition, the proposal would provide Treasury regulatory authority to provide for the treatment of accident and health insurance contracts generally in the same manner as a life insurance contract, where appropriate.

The anti-abuse rules applicable under the subpart F exceptions provided in section 954(h) (as added by the proposal) would apply to these exceptions for insurance. In addition, the proposal would provide anti-abuse rules applicable under the exceptions from subpart F income relating to insurance. The proposal would provide that there shall be disregarded any change in the method of computing reserves or any other transaction or transactions one of the principal purposes of which is the acceleration or deferral of any item in order to claim the benefits of these exceptions.

The proposal would provide that a contract is not treated as an exempt contract (as described above), if any policyholder, insured or annuitant, or beneficiary is a resident of the United States, the contract was marketed to the U.S. resident, and was written to cover a risk outside the United States

The proposal would provide that a contract is not treated as an exempt contract, if the contract covers risks located both within and outside the United States, and the qualifying insurance company or branch does not maintain such records, and file such reports, with respect to the contract as the Treasury Secretary requires. It would be intended that documentation that is contemporaneous with the issuance of the contract be maintained by the qualifying insurance company or branch.

The proposal would provide that the Treasury Secretary may prescribe rules for the allocation of contracts (and income from contracts) among two or more qualifying insurance company branches of a qualifying insurance company in order to clearly reflect the income of such branches.

The proposal would provide that the Treasury Secretary may prescribe regulations similar to the regulations under section 842(d) to prevent the avoidance of the purposes of the exceptions for insurance income and foreign personal holding company income under the proposal.

The proposal would include the anti-abuse rules of the present-law provision, with certain further refinements reflected under the proposal. The proposal would add an anti-abuse rule which would, for purposes of these exceptions, disregard any item of income, gain, loss or deduction with respect to certain transactions, including utilizing or doing business with an entity which is not engaged in regular and continuous transactions with customers that are unrelated persons. In addition, to the extent provided in regulations, this anti-abuse rule would apply to other transactions, including utilizing or doing business with a special purpose vehicle, including securitization vehicles, intragroup financing arrangements, or any similar entity or arrangement. The proposal also would modify the anti-abuse rule of the present-law provision relating to organizing entities in order to satisfy any same country requirement under these exceptions. The proposal would provide that to the extent provided in regulations, the anti-abuse rule would apply to transactions involving utilizing or doing business with any entity in order to satisfy any home country requirement under these exceptions.

The proposal also would provide a rule which denies customer treatment in certain cases. The proposal would provide that a person who is a related person, an officer, a director, or an employee of a CFC or QBU and who otherwise would be treated as a customer, would not be treated as a customer with respect to any transaction if a principal purpose of the transaction is to satisfy any requirement for these exceptions.

Finally, the proposal includes a modification to address the treatment of sales of assets of an active financing business. In general, foreign personal holding company income includes net gains from the sale or exchange of property that gives rise to dividends, interest, royalties, rents, or annuities. The proposal would provide an exception from this rule for income that qualifies for the exception from subpart F for income derived in the active conduct of a banking, financing, or similar business. Under the proposal, foreign personal holding company income would not include net gains from the sale or exchange of property that gives rise to dividends, interest, royalties, rents, or annuities if such property gives rise to income not treated as foreign personal holding company income for the taxable year by reason of the exceptions for banking, financing, or similar income under proposed section 954(h). It would be intended that this exception would apply only to the extent that the property was held to generate or generated income from the active conduct of a banking, financing, or similar business prior to its disposition (and such property was not so held for a principal purpose of taking advantage of this exception).

The present-law provision includes a corresponding exception from foreign base company services income for income derived by a CFC from the performance of services that are directly related to a transaction entered into by the CFC that gives rise to income that is eligible for these exceptions from subpart F. Under the proposal, foreign base company services income would not include income that is not treated as foreign personal holding company income by reason of the exceptions under proposed section 954(h) or 954(i) or the securities dealer exception under proposed section 954(c)(2)(C)(ii), or is treated as exempt insurance income by reason of proposed section 953(e).