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Treas . 

HJ 

4651 

.A22 

P94 



General Explanations 

of the 

Administration's Revenue Proposals 




Department of the Treasury 
February 1995 



r.*-, 



M3 
^2,a Table of Contents 

Tax Credit for Dependent Children 1 

Education and Job Training Tax Deduction 3 

Expanded Individual Retirement Accounts 6 

Increase in Number of Empowerment Zones 10 

Reduce Vaccine Excise Taxes 11 

Earned Income Tax Credit Compliance Proposals 13 

Interest and Dividend Test for Earned Income Tax Credit 15 

Tax Responsibilities of Americans Who Renounce Citizenship 16 

Revise Taxation of Income from Foreign Trusts 18 

I. Information Reporting and Foreign Trusts 18 

n. Outbound Foreign Grantor Trusts 19 

m. Inbound Foreign Grantor Trusts 22 

IV. Foreign Nongrantor Trusts 23 

V. Residence of Trusts 24 

Proposals to Improve Tax Administration and Compliance 27 

I- 



iP'^^iW; :.1?:~.::.:-i 



TAX CREDIT FOR DEPENDENT CHILDREN 



Current Law 

A tax exemption, in the form of a deduction, is allowed for each taxpayer and for 
each dependent of a taxpayer. A dependent includes a child of the taxpayer who is supported 
by the taxpayer and is under age 19 at the close of the calendar year or is a student under 
age 24. The deduction amount is $2,500 for tax year 1995. This amount is indexed 
annually for inflation. 

In addition to an exemption for each child, tiiree other tax benefits may accrue to 
taxpayers with dependent or otherwise qualifying children: 

• the credit for child and dependent care expenses, 

• the exclusion for employer-provided child and dependent care benefits, and 

• the earned income tax credit (EITC). 

The EITC is a refundable tax credit based on the earnings of the taxpayer. The EITC 
is restricted to lower-income taxpayers and is phased out when earnings exceed specified 
levels. Although the EITC is available for taxpayers without dependents or otherwise 
qualifying children, the credit rate and income range of the credit are far greater when the 
taxpayer has one or more qualifying children. In addition, the rate and income range are 
higher for taxpayers with two or more qualifying children than for taxpayers with only one 
qualifying child. 

Reasons for Change 

Tax relief for middle-class families has been and continues to be an important goal of 
this Administration. In 1993, the Administration faced a projection of ever-increasing 
deficits. Bringing the deficit under control and providing tax relief for the working poor 
through an expansion of the EITC were the first priorities. Having achieved more favorable 
than projected results from the deficit reduction program introduced in 1993, the 
Administration can now turn to providing tax relief to middle-income famiUes. 

Tax relief to taxpayers with children is needed to adjust the relative tax burdens of 
smaller and larger families to reflect more accurately their relative abilities to pay taxes. 
Available resources should be targeted to those in greatest need and at greatest risk. 

Proposal 

A nonrefundable tax credit, which would be applied after the EITC, would be allowed 
for each dependent child under age 13. It would be phased in, at $300 per child for tax 
years 1996, 1997, and 1998, and $500 per child for 1999 and thereafter. The credit would 
not reduce any alternative minimum tax liability. The credit would be phased out for 



taxpayers with adjusted gross income between $60,000 and $75,000. Beginning in the year 
2000, both the amount of the credit and the phase-out range would be indexed for the effects 
of inflation. 

Taxpayers claiming the dependent child credit would be required to provide valid 
social security numbers for themselves, their spouses, and their children who qualify for the 
credit. The procedures that would apply for determining the validity of social security 
numbers under the EITC, discussed below, would apply for purposes of the dependent child 
credit. 

Revenue Estimate (in billions of dollars) 









Fiscal Years 










1995 


1996 


1997 1998 


1999 


2000 


Total 


Tax credit for dependent 





-3.5 


-6.8 -6.6 


-8.3 


-10.1 


-35.4 


children 















-2- 



EDUCATION AND JOB TRAINING TAX DEDUCTION 



Current Law 

Taxpayers generally may not deduct the expenses of higher education and training. 
There are, however, special circumstances in which deductions for educational expenses are 
allowed, or in which the payment of educational expenses by others is excluded from 
income. 

Educational expenses may be deductible, but only if the taxpayer itemizes, and only 
to the extent that the expenses, along with other miscellaneous itemized deductions, exceed 
two percent of adjusted gross income (AGI) . A deduction for educational purposes is 
allowed only if the education maintains or improves a skill required in the individual's 
employment or other trade or business, or is required by the individual's employer, or by 
law or regulation for the individual to retain his or her current job. 

The interest from qualified U.S. savings bonds is excluded from a taxpayer's gross 
income to the extent the interest is used to pay qualified educational expenses. To be 
qualified, the savings bonds must be purchased after December 31, 1989, by a person who 
has attained the age of 24. Qualified educational expenses consist of tuition and fees for 
enrollment of the taxpayer, the taxpayer's spouse, or the taxpayer's dependent at a public or 
non-profit institution of higher education, including two-year colleges and vocational schools. 



Reasons for Change 

Deductions for educational expenses combine needed tax relief with preparation for 
new economic imperatives. The expenses of higher education place a significant burden on 
many middle-class families. Grants and subsidized loans are available to students from low- 
and moderate-income families; high-income families can afford the costs of higher education. 

Well-educated workers are essential to an economy experiencing technological change 
and facing global competition. The Administration believes that reducing the after-tax cost 
of education for individuals and families encourages investment in education and training 
while lowering tax burdens for middle-income taxpayers. 

Proposal 

A taxpayer would be allowed to deduct qualified educational expenses paid during the 
taxable year for the education or training of the taxpayer, the taxpayer's spouse, or the 
taxpayer's dependent. The deduction would be allowed in determining AGI. Therefore, 
taxpayers could claim the deduction even if they do not itemize and even if they do not meet 
the two-percent AGI floor on itemized deductions. 



Qualified educational expenses would be defined as tuition and fees charged by 
educational institutions that are directiy related to an eligible student's course of study (e.g., 
registration fees, laboratory fees, and extra charges for particular courses). Charges and 
expenses associated with meals, lodging, student activities, athletics, health care, 
transportation, books and similar personal, living or family expenses would not be included. 
The expenses of education involving sports, games, or hobbies would not be qualified 
educational expenses unless the education is required as part of a degree program or related 
to the student's current profession. 

Qualified educational expenses would be deductible in the year the expenses are paid, 
subject to the requirement that the education commences or continues during that year or 
during the first three months of the next year. Qualified educational expenses paid with the 
proceeds of a loan generally will be deductible (rather than repayment of the loan itself). 
Normal tax benefit rules would apply to refunds (and reimbursements through insurance) of 
previously deducted tuition and fees. 

In 1996, 1997, and 1998, the maximum deduction would be $5,(X)0. In 1999 and 
thereafter, this maximum would increase to $10,000. The deduction would be phased out 
ratably for taxpayers with modified AGI between $70,000 and $90,000 ($100,000 and 
$120,000 for joint returns). Modified AGI would include taxable Social Security benefits 
and amounts otherwise excluded with respect to income earned abroad (or income from 
Puerto Rico or U.S. possessions). Beginning in 2000, the income phase-out range would be 
indexed for inflation. 

Any amount taken into account as a qualified educational expense would be reduced 
by educational assistance that is not required to be included in the gross income of either the 
student or the taxpayer claiming the deduction. Thus, qualified educational expenses would 
be reduced by scholarship or fellowship grants excludable from gross income under section 
117 of die Internal Revenue Code (even if die grants are used to pay expenses other than 
qualified educational expenses) and any educational assistance received as veterans' benefits. 
However, no reduction would be required for a gift, bequest, devise or inheritance within the 
meaning of section 102(a). 

An eligible student would be one who is enrolled or accepted for enrollment in a 
degree, certificate, or other program (including a program of study abroad approved for 
credit by the institution at which such student is enrolled) leading to a recognized educational 
credential at an eligible institution. The student must pursue a course of study on at least a 
half-time basis, cannot be enrolled in an elementary or secondary school, and cannot be a 
nonresident alien. Educational institutions would determine what constitutes a half-time basis 
for individual programs. 

"Eligible institution" is defined by reference to section 481 of the Higher Education 
Act. Such institutions must have entered into an agreement with the Department of Education 
to participate in the student loan program. This definition includes certain proprietary 
institutions. 



This proposal would not affect deductions claimed under any other section of the 
Code, except that any amount deducted under another section of the Code could not also be 
deducted under this provision. An eligible student would not be eligible to claim a deduction 
under this provision if that student could be claimed as a dependent of another taxpayer. 

Revenue F.«>f imate (in hillions of dollars) 



Education and job training 
tax deduction 







Fiscal Years 








1995 


1996 


1997 1998 


1999 


2000 


Total 





-0.7 


-4.7 -4.9 


-5.7 


-7.5 


-23.5 



-5- 



EXPANDED INDIVIDUAL RETIREMENT ACCOUNTS 



Current Law 



Under current law, an individual may make deductible contributions to an individual 
retirement account or individual retirement annuity (IRA) up to the lesser of $2,000 or 
compensation (wages and self-employment income). If the individual (or the individual's 
spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 limit on 
deductible contributions is phased out for couples filing a joint return with adjusted gross 
income (AGI) between $40,000 and $50,0(X), and for single taxpayers with AGI between 
$25,000 and $35,000. To the extent that an individual is not eligible for deductible IRA 
contributions, he or she may make nondeductible IRA contributions (up to the contribution 
limit). 

The earnings on IRA account balances are not included in income until they are 
withdrawn. Withdrawals from an IRA (other than withdrawals of nondeductible contribu- 
tions) are includable in income, and must begin by age 70 V2. Amounts withdrawn before 
age 59V2 are generally subject to an additional 10 percent penalty tax. The penalty tax does 
not apply to distributions upon the death or disability of the taxpayer or withdrawals in the 
form of substantially equal periodic payments over the life (or life expectancy) of the IRA 
owner or over the joint lives (or life expectancies) of the IRA owner and his or her 
beneficiary. 

Reasons for Change 

The nation's savings rate has declined dramatically since the 1970s. The 
Administration believes that increasing the savings rate is essential if the United States is to 
sustain a sufficient level of private investment into the next century. Without adequate 
investment, the continued healthy growth of the economy is at risk. The Administration is 
also concerned that many households are not saving enough to provide for long-term needs 
such as retirement and education. 

The Administration believes that individuals should be encouraged to save, and that 
tax policies can provide a significant incentive. Under current law, however, savings 
incentives in the form of deductible IRAs are not available to all middle-income taxpayers. 
Furthermore, the present-law income thresholds for deductible IRAs and the maximum 
contribution amount are not indexed for inflation, so that fewer Americans are eligible to 
make a deductible IRA contribution each year, and the amount of the maximum contribution 
is declining in real terms over time. The Administration also believes that providing 
taxpayers with the option of making IRA contributions that are nondeductible but can be 
withdrawn tax free will provide an alternative savings vehicle that some middle-income 
taxpayers may find more suitable for their savings needs. 



Individuals save for many purposes besides retirement. Broadening the tax incentives 
for non-retirement saving can be an important element in any proposal to increase the 
nation's savings rate. Expanding the flexibility of IRAs to meet a wider variety of savings 
needs, such as first-time home purchases, higher education expenditures, unemployment and 
catastrophic medical and nursing home expenses, should prove to be more attractive to many 
taxpayers than accounts limited to retirement savings. 

Proposal 

Expand Deductible IRAs. Under the proposal the income thresholds and phase-out 
ranges for deductible IRAs would be doubled; therefore, eligibility would be phased out for 
couples filing joint returns with AGI between $80,000 and $100,000 and for single 
individuals with AGI between $50,000 and $70,000. The income thresholds and the present- 
law annual contribution limit of $2,000 would be indexed for inflation. As under current 
law, any individual who is not an active participant in an employer-sponsored plan and 
whose spouse is also not an active participant would be eligible for deductible IRAs 
regardless of income. 

Under the proposal, the IRA contribution limit would be coordinated with the current 
law limits on elective deferrals under qualified cash or deferred arrangements (sec. 401(k) 
plans), tax-sheltered annuities (sec. 403(b) annuities), and similar plans. The proposal also 
would provide that the present-law rule permitting penalty-free IRA withdrawals after an 
individual reaches age 59V2 does not apply in the case of amounts attributable to contribu- 
tions made during the previous five years. This provision does not apply to amounts rolled 
over from tax-qualified plans or tax-sheltered annuities. 

These provisions would be effective January 1 , 1996. 

Special IRAs. Each individual eligible for a traditional deductible IRA would have the 
option of contributing an amount up to the contribution limit to either a deductible IRA or to 
a new "Special IRA." Contributions to a Special IRA would not be deductible, but if the 
contributions remained in the account for at least five years, distributions of the contributions 
and the earnings thereon would be tax-free. Withdrawals of earnings from Special IRAs 
during the five-year period after contribution would be subject to ordinary income tax. In 
addition, such withdrawals would be subject to the 10-percent penalty tax on early 
withdrawals unless used for one of the four purposes described below. 

The proposal would permit individuals whose AGI for a taxable year did not exceed 
the upper end of the new income eligibility limits to convert balances in deductible IRAs into 
Special IRAs without being subject to the 10-percent tax on early withdrawals. The amount 
transferred from the deductible IRA to the Special IRA generally would be includable in the 
individual's income in the year of the transfer. However, if a transfer was made before 
January 1, 1997, the transferred amount included in the individual's income would be spread 
evenly over four taxable years. 



-7- 



The Special ERA provisions would be effective January 1, 1996. 

Penalty-Free Distributions. Amounts could be withdrawn penalty-free from deductible 
IRAs and Special IRAs within the five-year period after contribution, if the taxpayer used tiie 
amounts to pay post-secondary education costs, to buy or build a first home, to cover living 
costs if unemployed, or to pay catastrophic medical expenses (including certain nursing home 
costs). 

a. Education expenses 

Penalty-free withdrawals would be allowed to the extent the amount withdrawn is 
used to pay qualified higher education expenses of the taxpayer, the taxpayer's spouse, the 
taxpayer's dependent, or the taxpayer's child or grandchild (even if not a dependent). In 
general, a withdrawal for qualified higher education expenses would be subject to the same 
requirements as the deduction for qualified educational expenses (e.g., the expenses are 
tuition and fees that are charged by educational institutions and are directiy related to an 
eligible student's course of study). 

b. First- time home purchasers 

Penalty-free withdrawals would be allowed to the extent the amount withdrawn is 
used to pay qualified acquisition, construction, or reconstruction costs with respect to a 
principal residence of a first-time home buyer who is the taxpayer, the taxpayer's spouse, or 
the taxpayer's child or grandchild. A first-time home buyer would be any individual (and if 
married, the individual's spouse) who (1) did not own an interest in a principal residence 
during the three years prior to the purchase of a home and (2) was not in an extended period 
for rolling over gain from the sale of a principal residence. 

c. Unemployment 

Penalty-free withdrawals could be made by an individual after the individual is 
separated from employment if (1) the individual has received unemployment compensation 
for 12 consecutive weeks and (2) tiie withdrawal is made in the taxable year in which the 
unemployment compensation is received or the succeeding taxable year. 

d. Medical care expenses and nursing home costs 

The proposal would extend to IRAs the present-law exception to tiie early withdrawal 
tax for distributions from tax-qualified plans and tax-sheltered annuities for certain medical 
care expenses (deductible medical expenses that are subject to a floor of 7.5 percent of AGI) 
and expand the exception for IRAs to allow witiidrawal for medical care expenses of tiie 
taxpayer's child, grandchild, parent or grandparent, whether or not such person otherwise 
qualifies as the taxpayer's dependent. 



In addition, for purposes of the exemption from the 10 percent tax on early 
withdrawals for distributions from IRAs, the definition of medical care would include 
expenses for qualified long-term care services for incapacitated individuals. Qualified long- 
term care services generally would be services that are required by an incapacitated 
individual, where the primary purpose of the services is to provide needed assistance with 
any activity of daily living or protection from threats to health and safety due to severe 
cognitive impairment. An incapacitated individual generally would be a person who is 
certified by a licensed professional within the preceding 12-month period as being unable to 
perform without substantial assistance at least two activities of daily living, or as having 
severe cognitive impairment. 



These provisions would be effective January 1, 1996. 



Revenue Estimate (in billions of dollars) 









Fiscal Years 










1995 


1996 


1997 1998 


1999 


2000 


Total 


Expanded individual 





0.4 


-0.3 -0.8 


-1.0 


-2.0 


-3.8 


retirement accounts 















-9- 



INCREASE IN NUMBER OF EMPOWERMENT ZONES 



Current Law 

The Omnibus Budget Reconciliation Act of 1993 (OBRA '93) authorized a federal 
demonstration project in which nine empowerment zones and 95 enteq)rise communities 
would be designated in a competitive application process. Of the nine empowerment zones, 
six were to be located in urban areas and three were to be located in rural areas. State and 
local governments jointly nominated distressed areas and proposed strategic plans to stimulate 
economic and social revitalization. By the June 30, 1994 application deadline, over 500 
communities had submitted applications. 

On December 21, 1994, the Secretaries of the Department of Housing and Urban 
Development and the Department of Agriculture designated the empowerment zones and 
enterprise communities authorized by Congress in OBRA '93. 

Among other benefits, businesses located in empowerment zones are eligible for three 
federal tax incentives: an employment and training credit; an additional $20,000 per year of 
section 179 expensing; and a new category of tax-exempt private activity bonds. Businesses 
located in enterprise communities are eligible for the new category of tax-exempt bonds. 
OBRA '93 also provided that federal grants would be made to designated areas. 

Reasons for Change 

Because of the vast number of distressed urban areas and the need to revitalize these 
areas, the Administration believes that the number of authorized empowerment zones should 
be expanded, subject to budgetary constraints. Extending the tax incentives to economically 
distressed areas will help stimulate revitalization of these areas. 

Proposal 

The proposal would authorize the designation of two additional urban empowerment 
zones and would be effective on the date of enactment. No additional federal grants would 
be authorized. The sole effect of the proposal would be to extend the empowerment zone tax 
incentives to two additional areas. 

Revenue Estimate (in billions of dollars) 



Increase in number of 
Empowerment Zones 







Fiscal Years 








1995 


1996 


1997 1998 


1999 


2000 


Total 


-0.1 


-0.1 


-0.1 -0.1 


-0.1 


-0.1 


-0.7 



-10- 



REDUCE VACCINE EXCISE TAXES 



Current Law 

The Vaccine Injury Compensation Program provides compensation for individuals 
who suffer certain injuries following the administration of the following vaccines: 
diphtheria, pertussis, and tetanus (DPT); diphtheria and tetanus (DT); measles, mumps, and 
rubella (MMR); and polio. Compensation is paid from the Vaccine Injury Compensation 
Trust Fund (Vaccine Trust Fund), which is funded by net revenues from a manufacturer's 
excise tax on DPT, DT, MMR, and polio vaccines. The excise tax per dose is $4.56 for 
DPT, $0.06 for DT, $4.44 for MMR, and $0.29 for polio vaccines. A vaccine for measles 
only, mumps only, or rubella only is taxed at the full MMR rate. 

The Vaccine Injury Compensation Program provides compensation for adverse 
reactions to a vaccine only if the vaccine is included in the Vaccine Injury Table prescribed 
by the Department of Health and Human Services and is subject to the vaccine excise tax. 

Reasons for Change 

The Vaccine Trust Fund is overfunded. At the end of FY 1994 the trust fund balance 
was $809 million and, at current tax rates, transfers to the trust fund will continue to exceed 
ouUays by over $50 million per year. While the current trust fund balance is an appropriate 
reserve against any unexpected increase in awards, future transfers to the trust fund should 
be brought in line with expected outiays by a reduction in the tax. 

It is expected that haemophilis influenzae type b (Hib) and hepatitis type B (Hep B) 
vaccines, which are now routinely recommended for administiation to children, will be added 
to the Vaccine Injury Table before the end of 1995. Those vaccines should also be added to 
the list of taxed vaccines. 

Proposal 

The Administration will submit a proposal to restructure the vaccine excise taxes. 
Revenues from these taxes wiU be reduced to approximately half the amounts expected under 
current law. 



-11- 



Revenue Estimate (In billions of dollars)^ 









Fiscal Years 










1995 


1996 


1997 1998 


1999 


2000 


Total 


Reduce vaccine excise 





-0.1 


-0.1 -0.1 


-0.1 


-0.1 


-0.3 


taxes 















Net of income tax offset. 

-12- 



EARNED INCOME TAX CREDIT COMPLIANCE PROPOSALS 



Current Law 

To be eligible for the Earned Income Tax Credit (EITC), a taxpayer must reside in 
the United States for over six months. Nonresident aliens are not entitled to the EITC 
beginning in 1995. Other non-U.S. citizens are eligible for the EITC if, among other things, 
they meet a six-month residency requirement and do not file an income tax return as a non- 
resident alien. 

To claim the higher EITC amounts available to taxpayers with qualifying children, 
those taxpayers are required to provide taxpayer identification numbers (TINs) for each 
qualifying child. Unless otherwise proscribed by regulation, social security numbers serve as 
TINs. Some taxpayers are unable to obtain social security numbers. Under section 205(c) 
of the Social Security Act, social security numbers are generally issued only to individuals 
who are citizens or who are authorized to work in the U.S. Undocumented workers may not 
be able to obtain social security numbers. 

The IRS must follow deficiency procedures when investigating questionable EITC 
claims. First, contact letters are sent to the taxpayer. If the necessary information is not 
provided by the taxpayer, a statutory notice of deficiency is sent by certified mail, notifying 
the taxpayer that the adjustment will be assessed unless the taxpayer files a petition in Tax 
Court within 90 days. If a petition is not filed within that time and there is no other 
response to the statutory notice, the assessment is made and the EITC is denied. 

Reasons for Change 

The Administration believes that the EITC should not be available to individuals who 
are not authorized to work in the United States. During the past year, the Administration 
and Congress have taken steps to improve the administration of the EITC. Further steps are 
desirable to ensure that only the intended beneficiaries receive the EITC. 

Proposal 

Only individuals who are authorized to work in the United States would be eligible 
for the EITC. Taxpayers claiming the EITC would be required to provide a valid social 
security number for themselves, their spouses, and qualifying children. Social security 
numbers would have to be valid for employment purposes in the United States. Thus, 
eligible individuals would include U.S. citizens and lawful permanent residents. Taxpayers 
residing in the United States illegally would not be eligible for the credit. 

In addition, the IRS would be authorized to use the math-error procedures, which are 
simpler than deficiency procedures, to resolve questions about the validity of a social security 
number. Under this approach, the failure to provide a correct social security number would 



-13- 



be treated as a math error. Taxpayers would have 60 days in which they could either 
provide a correct social security number or request that the IRS follow the current-law 
deficiency procedures. If a taxpayer failed to respond within this period, he or she would be 
required to refile with correct social security numbers in order to obtain the EITC. 

These provisions would be effective for tax years beginning after December 31, 1995. 
Revenue Estimate Hn hillions of dollars)^ 



EITC compliance 
proposals 







Fiscal Years 








1995 


1996 


1997 1998 


1999 


2000 


Total 








0.4 0.5 


0.5 


0.5 


1.9 



Includes reduction in outlays. 

-14- 



INTEREST AND DIVIDEND TEST 
FOR EARNED INCOME TAX CREDIT 



Current Law 

To be eligible to receive the Earned Income Tax Credit (EITC), an individual must 
have earned income. To target the EITC to low-income workers, the amount of the credit to 
which a taxpayer is entitled decreases when the taxpayer's earned income (or, if greater, 
adjusted gross income (AGI)) exceeds certain thresholds. The earned income and AGI 
thresholds are indexed for inflation and are also adjusted to take into account qualifying 
children. In 1995, a taxpayer with two or more qualifying children will not be eligible for 
the EITC if his or her income exceeds $26,673. The income cut-offs decline to $24,396 for 
a taxpayer with one qualifying child and $9,230 for a taxpayer with no qualifying children. 

Reason for Change 

Under current law a taxpayer may have relatively low earned income, and therefore 
may be eligible for the EITC, even though he or she has significant interest and dividend 
income. The EITC should be targeted to families with the greatest need. Most EITC 
recipients do not have significant resources and must rely on earnings to meet their day-to- 
day living expenses, but taxpayers with high levels of interest and dividend income can draw 
upon the resources that produce this income to meet family needs. 

Proposal 

Beginning in 1996, a taxpayer would not be entitled to the EITC if his or her 
aggregate interest and dividend income during a taxable year exceeds $2,500. This threshold 
would be indexed for inflation thereafter. 

Revenue Estimate (in billions of dollars) 









Fiscal Years 










1995 


1996 


1997 1998 


1999 


2000 


Total 


Interest and dividend test 





* 


0.3 0.3 


0.4 


0.4 


1.4 


for Earned Income Tax 














Credit 















* Revenue gain of less than $50 miUion 



Includes reduction in outlays. 

-15- 



TAX RESPONSIBILrnES OF AMERICANS WHO RENOUNCE CITIZENSHIP 



Current Law 

Under current law, worldwide gains realized by U.S. citizens and resident aliens are 
subject to U.S. tax. Existing rules recognize that the United States has a tax interest in 
preventing tax avoidance through renunciation of citizenship. These rules continue to tax 
former U.S. citizens on U.S. source income for ten years following renunciation of 
citizenship if one of the principal purposes of the renunciation was to avoid U.S. income tax. 
A similar rule applies to aliens who cease to be residents. 

Reasons for Change 

Wealthy U.S. citizens and long-term residents sometimes abandon their U.S. 
citizenship or status as residents. Existing rules to prevent tax avoidance through 
expatriation have proven largely ineffective because departing taxpayers have found ways to 
restructure their activities to avoid those rules, and compliance with the rules is difficult to 
monitor. Consequentiy, existing measures need to be enhanced to ensure that gains 
generally accruing during the time a taxpayer was a citizen or long-term permanent resident 
will be subject to U.S. tax at the time the taxpayer abandons citizenship or residency. 

Proposal 

Existing rules would be expanded to provide that if a U.S. person expatriates on or 
after February 6, 1995, the person would be tieated as having sold his or her assets at fair 
market value immediately prior to expatriation and gain or loss from such sale would be 
recognized and would be subject to U.S. income tax. A U.S. citizen would be considered to 
expatriate if the citizen renounces or abandons U.S. citizenship. A resident alien individual 
would be taxed under this proposal if the alien has been subject to U.S. tax as a lawful 
permanent resident of the United States in at least ten of the prior fifteen taxable years and 
then ceases to be subject to U.S. tax as a resident. 

For this purpose, a taxpayer would be treated as owning those assets that would be 
included in the taxpayer's gross estate (determined as if the taxpayer's estate had been 
created on the date of expatriation) as well as, in certain cases, the taxpayer's interest in 
assets held in certain trusts (defined below in Section 11 of the foreign trust discussion). 
Exceptions to the tax on expatriation would be made for most U.S. real property interests 
(because they remain subject to U.S. taxing jurisdiction) and interests in qualified retirement 
plans. An expatriating individual also would be entitied to exclude $600, (X)0 of gain as 
determined under the proposal. 

The ERS may allow a taxpayer to defer payment of the tax on expatriation with 
respect to interests in closely-held businesses. In those cases, the taxpayer would be required 



-16- 



to provide collateral satisfactory to the IRS. Payment of tax could not be deferred for more 
than five years, and an interest charge would be imposed on the deferred tax. 

Solely for purposes of determining gain or loss subject to the tax on expatriation, a 
resident alien individual would be permitted to elect to determine basis using the fair market 
value (instead of historical cost) of assets owned on the date when U.S. residence first began. 
If made, this election would apply to all of a taxpayer's property. 

This proposal would replace existing income tax rules with respect to expatriations on 
or after February 6, 1995. Existing rules that apply to taxes other than income taxes would 
continue to apply. 

Revenue Estimate ( in hilli ons of dollars) 









Fiscal Years 










1995 


1996 


1997 1998 


1999 


2000 


Total 


Tax responsibilities of 


0.1 


0.2 


0.3 0.4 


0.5 


0.7 


2.2 


Americans who renounce 














citizenship 















-17- 



REVISE TAXATION OF INCOME FROM FOREIGN TRUSTS 



U.S. tax rules applicable to foreign trusts have not been revised for nearly two 
decades. New rules are needed to accommodate changes in the use and incidence of foreign 
trusts and to limit the avoidance and evasion of U.S. taxes. The Administration proposals 
would reform the taxation of foreign trusts in five respects. 

I. INFORMATION REPORTING AND FOREIGN TRUSTS 

Current Law 

Under current law, most foreign trusts established by U.S. persons are grantor trusts, 
the income of which is taxed to the grantor. U.S. persons who create or transfer property to 
foreign trusts are required to report transactions with the foreign trust to the IRS. 

Reasons for Change 

The existing information reporting statute predates the significant expansion of the 
foreign grantor trust rules in 1976. In general, penalties for noncompliance with reporting 
requirements are minimal. U.S. grantors of foreign trusts often do not report the income 
earned by foreign trusts and often do not comply with required information reporting. These 
foreign trusts are frequently established in tax haven jurisdictions with stringent secrecy 
rules. Consequently, the IRS's attempts to verify income earned by foreign trusts are often 
unsuccessful. Existing penalties have not proven adequate to encourage some U.S. taxpayers 
to comply with existing rules. 

Proposal 

Notice of Transfer. Section 6048 would require U.S. persons transferring property to 
foreign trusts to notify the IRS. This notice would identify the trustee of the foreign trust, 
indicate the property transferred to the trust, and identify the trust beneficiaries. 

If a transferor did not file the required notice, a penalty would be imposed equal to 35 
percent of the gross value of the property transferred, valued as of the date of transfer. This 
penalty would not be less than $10,000, and could be further increased for continuing 
noncompliance. 

Trustee Statements. Section 6048 would require trustees of any foreign trust with a 
U.S. grantor or a U.S. beneficiary to file two types of statements: a "Section 6048 
Statement" and an annual information return. In the Section 6048 Statement, the trustee 
would be required to: 



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1) appoint a U.S. agent (whether or not a trustee) who has the ability to provide 
any information that reasonably should be available to the trust in response to 
requests by the IRS; and 

2) agree to file an annual information return for the foreign trust. 

The annual information return would be required to include a full accounting of trust 
activities, including separate schedules (K-ls) for income attributable to U.S. grantors or 
U.S. beneficiaries, as appropriate. The foreign trust would not be considered to have an 
office or permanent establishment in the United States merely because of the section 6048 
activities of its U.S. agent. 

There would be two consequences if the trustee of the foreign trust did not file a 
Section 6048 Statement or the required annual information return. First, the U.S. settlor of a 
foreign trust would be subject to a $10,000 penalty for each failure to file a Section 6048 
Statement or annual information return. This penalty would be increased for continuing 
noncompliance. Second, the IRS would be authorized to determine, in its discretion, the tax 
consequences of any trust transactions or operations to a U.S. grantor or U.S. beneficiary. 
Thus, for example, the IRS could impose a gift tax on property transferred to the foreign 
trust. In appropriate circumstances, the IRS could also impute taxable income to the U.S. 
settlor based on the value of assets transferred to or held in the foreign trust. A distribution 
to a U.S. beneficiary could be deemed to come from income accumulated in the year the 
trust was organized (or an alien beneficiary's first year of U.S. residence, if later). Although 
the trustee would have an incentive to file the trustee statements to avoid adverse U.S. tax 
consequences to U.S. grantors and U.S. beneficiaries, there would be no penalties directly 
imposed on a trustee for the failure to file those statements. 

The Secretary would be authorized to waive any information reporting requirements 
when there was no significant U.S. tax interest in obtaining the information. Penalties would 
not be imposed if the taxpayer acted with reasonable cause and not willful neglect. 

These proposals generally would be effective for trust taxable years beginning after 
the date of enactment. 



n. OUTBOUND FOREIGN GRANTOR TRUSTS 

Current Law 

Under section 679, a foreign trust established by a U.S. person for the benefit of U.S. 
persons generally is a "grantor trust", and the grantor is treated as owner of property 
transferred to the trust. There are, however, some transfers that are not covered by this 
general rule. First, transfers by reason of death are not subject to section 679. Second, 
sales of property to a foreign trust at fair market value are not subject to section 679. Third, 
if a foreign person transfers property to a foreign trust for the benefit of a U.S. person and 



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then becomes a resident of the United States, section 679 does not apply to the transfer. 
Finally, current rules do not clearly address the tax consequences for a domestic trust that 
becomes a foreign trust. 

Reasons for Change 

Tax planning to avoid or defer recognition of income from foreign trusts often utilizes 
the exceptions to section 679. For example, a foreign trust may be established by will upon 
the death of a U.S. person for the benefit of U.S. persons. Because the trust is not a grantor 
trust, the income of the trust is not subject to U.S. tax until distributed to a U.S. person, 
even though the trust was created by a U.S. person for the benefit of a U.S. person. 

U.S persons also sometimes attempt to avoid section 679 by selling property to a 
foreign trust in exchange for a note from the trust. Often, the U.S. transferor does not 
intend to collect on the note. In such a case, the purported seller of the assets should be 
treated as owning the assets transferred to the trust. (If there is no bona fide debt, these 
transactions are subject to challenge under current law, because the exchange would not be at 
fair market value.) 

Prior to becoming residents of the United States, foreign persons often put their assets 
into irrevocable trusts in tax haven jurisdictions for the benefit of U.S. persons. As a result, 
the trust income escapes U.S. tax until distribution. 

Further, as tax haven jurisdictions enact legislation to enable U.S. trusts to move to 
those jurisdictions, trust migrations are becoming more common. Taxpayers should not be 
able to achieve tax results through migration of a domestic trust that they could not achieve 
directly by creating a foreign trust. 

Finally, the inadequacy of the existing attribution rules as they apply to discretionary 
beneficiaries encourages taxpayers to avoid the appropriate tax consequences of their 
transactions by disguising true economic ownership of assets through the use of foreign 
discretionary trusts. 

Proposal 

The Administration proposes several changes to section 679, described below. 

Transfers at Death. Property transferred to a foreign trust at the death of a trust 
grantor (including property in a foreign grantor trust at the grantor's death) would be treated 
as having been transferred to the trust by the beneficiaries in accordance with their respective 
interests in the trust (described below) in a transaction in which no gain or loss would be 
recognized. U.S. beneficiaries therefore would become grantors for purposes of section 679. 
These proposals would be effective for assets transferred to foreign trusts after the date of 
enactment. 



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Sales to Foreign Trusts. The sale of property to a foreign trust by a U.S. person 
would be considered a transfer to a grantor trust under section 679 unless the trust pays the 
grantor full fair market value for the property without regard to any debt obligation received 
by the transferor issued by the trust, the grantor, a beneficiary, or a person related to the 
grantor or beneficiary or guaranteed by any such person. Exceptions would be provided for 
legitimate commercial transactions, such as credit extended by unrelated persons. A 
transferor would not be treated as receiving fair market value for property transferred in a 
deemed sale (pursuant to an election under section 1057 or otherwise). These proposals 
would be effective for assets transferred to foreign trusts on or after February 6, 1995. 

Pre-immigration Trusts. If a foreign person transfers property to a foreign trust and 
becomes a U.S. person within five years of the transfer, the trust would be considered a 
grantor trust under section 679 with respect to such transferred assets if the trust has U.S. 
beneficiaries after the grantor becomes a U.S. person. This proposal would be effective for 
assets transferred to foreign trusts on or after February 6, 1995. 

Outbound Trust Migrations. For purposes of section 679, if a domestic trust becomes 
a foreign trust, the trust assets would be deemed to have been transferred to the trust by the 
beneficiaries in accordance with their respective interests in the trust (defined below) in a 
transaction in which no gain or loss is recognized. Thus, any U.S. beneficiaries would be 
considered to be grantors of their respective interests in the foreign trust for purposes of 
section 679. However, if the IRS determines that the domestic trust was established pursuant 
to a plan to retransfer assets to a foreign trust, the IRS would be permitted to treat the U.S. 
settlor of the domestic trust as grantor of the foreign trust for purposes of section 679. The 
proposal would be effective for assets transferred to foreign trusts on or after February 6, 
1995. 

Determination of Respective Interests. For purposes of preventing abusive 
transactions designed to avoid section 679 and the tax on expatriation, a beneficiary's 
respective interest in a trust would be based on all relevant facts and circumstances, including 
the terms of the trust instrument. Other relevant factors may include letters of wishes or 
similar documents, patterns of historical trust distributions, and the existence of and functions 
performed by a trust protector or any similar advisor. If the respective interests of 
beneficiaries in a discretionary trust cannot otherwise be determined, those beneficiaries with 
the closest degree of family affiliation to the settlor could be presumed to have equal 
proportionate interests in the trust. 

The proposal would apply the attribution rules for discretionary beneficiaries only to 
the abusive situations under section 679 described above and to the tax on expatriation of 
U.S. citizens and residents, but would not directly apply the attribution rules for other 
purposes {e.g., to determine if a discretionary beneficiary is a U.S. shareholder of a 
controlled foreign corporation that is owned by the trust). The determination of respective 
interests for purposes of the tax on expatriation by U.S. citizens and residents would be 
effective for expatriations occurring on or after February 6, 1995. 



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m. INBOXJND FOREIGN GRANTOR TRUSTS 
Current Law 

The United States disregards certain "grantor" trusts for income tax purposes. This 
treatment is designed to prevent abuses arising from attempts to shift income to beneficiaries 
who are likely to be paying taxes at lower rates than the grantor of the trust. Consequently, 
under existing anti-abuse rules, the grantor of such a trust is taxed as if he owned the trust 
assets directly. Trusts generally are considered grantor trusts if (1) the grantor has a 
reversionary interest in trust income or corpus, (2) the grantor or a nonadverse party holds 
certain powers over the beneficial enjoyment of trust income or corpus, (3) certain 
administrative powers are exercisable for the grantor's benefit (e.g., the grantor can 
reacquire trust assets by substituting assets of equivalent value), (4) the grantor or a 
nonadverse party has the power to revest trust assets in the grantor, or (5) trust income may 
be paid or accumulated for the benefit of the grantor or the grantor's spouse in the discretion 
of the grantor or a nonadverse party. A person other than the grantor is treated as owning 
trust assets if that person has the power to withdraw trust income or corpus. 

The IRS has issued a revenue ruling in which a foreign person funded a foreign 
grantor trust for U.S. beneficiaries. The ruling holds that since the foreign person is treated 
as the owner of the grantor trust, a U.S. beneficiary is not taxable on trust distributions. 

Reasons for Change 

Existing law inappropriately permits foreign taxpayers to affirmatively use the 
domestic anti-abuse rules concerning grantor trusts. Although current law treats a foreign 
grantor as the owner of the trust assets, the foreign grantor generally is not subject to U.S. 
tax on income of the trust. These rules therefore permit U.S. beneficiaries, who enjoy the 
benefits of residing in the United States, to avoid U.S. tax on trust income. U.S. 
beneficiaries should be appropriately taxed in the United States. 

Proposal 

Under the proposal, a person would be treated as owning trust assets under the 
grantor trust rules only if that person is a U.S. citizen, U.S. resident, or domestic 
corporation. The IRS may prescribe rules for applying the grantor trust rules to settlors that 
are partnerships, trusts, and estates to the extent that the beneficial interests in such entities 
are owned by U.S. citizens, U.S. residents, or domestic corporations. A U.S. person 
receiving distributions of trust income as result of this provision would be allowed to claim a 
foreign tax credit for foreign taxes paid on trust income by the trust or the foreign grantor. 

Several related provisions are proposed to enforce these rules. First, enhanced 
authority would be granted to the IRS to prevent the use of nominees to evade these rules. 
For this purpose, a bona fide settlor of a trust with power to withdraw income or corpus 
from the trust would normally not be considered a nominee. Second, new rules would 



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harmonize the treatment of purported gifts by corporations and partnerships with the new 
foreign grantor trust rules. Third, U.S. persons would be required to report the receipt of 
what they claim to be large gifts from foreign persons in order to allow the IRS to verify that 
such purported gifts are not, in fact, disguised income to the U.S. recipients. 

If a trust that is a grantor trust under current law becomes a nongrantor trust pursuant 
to this rule, the trust would be treated as if it were resettled on the date the trust becomes a 
nongrantor trust. Neither the grantor nor the trust would recognize gain or loss. If a 
resettled domestic trust that has a foreign grantor became a foreign trust before December 
31, 1995, the section 1491 excise tax on outbound transfers of assets would not be applied to 
the transfer by the domestic trust to the new foreign trust. Otherwise, this proposal would 
be effective on the date of enactment of this provision. These rules would not apply to 
normal security arrangements involving a trustee (including the use of indenture trustees and 
similar arrangements). 



IV. FOREIGN NONGRANTOR TRUSTS 

Current Law 

Accumulation distributions. U.S. beneficiaries of foreign trusts are subject to a 
nondeductible interest charge on distributions of accumulated income earned by the trust in 
earlier taxable years. The charge is based on the length of time the tax was deferred by 
deferring distributions of accumulated income. Under existing law, the interest charge is 
equal to six percent simple interest per year multiplied by the tax imposed on the 
distribution. If adequate records are not available to determine the portion of a distribution 
that is accumulated income, the distribution is deemed to be an accumulation distribution 
from the year the trust was organized. 

Constructive Distributions. The tax consequences of the use of trust assets by 
beneficiaries is ambiguous under current law. Taxpayers may assert that a beneficiary's use 
of assets owned by a trust does not constitute a distribution to the beneficiary. 

Reasons for Change 

Accumulation distributions. Interest paid by U.S. beneficiaries of foreign trusts should 
reflect market rates of interest. 

Constructive distributions. If a corporation makes corporate assets available for a 
shareholder's personal use (e.g., a corporate apartment made available rent-free to a 
shareholder), the fair market value of the use of that property is treated as a constructive 
distribution. Further, if a controlled foreign corporation makes a loan to a U.S. person, the 
loan is treated as a deemed distribution by the foreign corporation to its U.S. shareholders. 
The use of foreign trust assets by trust beneficiaries should give rise to tax consequences that 
are similar to those associated with the use of corporate assets by corporate shareholders. 



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Proposal 

Accumulation distributions. For periods of accumulation after December 31, 1995, the 
rate of interest charged on accumulation distributions would correspond to the interest rate 
taxpayers pay on underpayments of tax. If a trust does not provide information required 
under section 6048, the distribution would be deemed to be from income accumulated in the 
year the trust was organized (or an alien beneficiary's first year of U.S. residence, if later). 
If a taxpayer is not able to demonstrate when the trust was created, the IRS may use any 
approximation based on available evidence. 

Taxpayers have used a variety of methods (e.g., tiered trusts, divisions of trusts, 
mergers of trusts, and similar transactions with corporations) to convert a distribution of 
accumulated income into a distribution of current income or corpus. The proposal would 
authorize the IRS to recharacterize such transactions, effective for transactions or 
arrangements entered into after the date of enactment. Transactions that may be entered into 
to avoid the interest charge on accumulation distributions (e.g., excessive "compensation" 
paid to trust beneficiaries who are directors of corporations owned by the foreign trust) may 
be subject to recharacterization. 

The proposal also clarifies existing law by providing that if an alien beneficiary of a 
foreign trust becomes a U.S. resident and thereafter receives an accumulation distribution, no 
interest would be charged for periods of accumulation that predate U.S. residency. 

Constructive distributions. If a beneficiary uses assets of a foreign trust, the value of 
that use would be a constructive distribution to the beneficiary. Thus, if a foreign trust made 
a residence available for use by a beneficiary (or a related person), the difference between 
the fair rental value of the residence and any rent actually paid would be treated as a 
constructive distribution to that beneficiary. If a foreign trust purported to loan cash (or cash 
equivalents) to a U.S. beneficiary, the loan would be treated as a constructive distribution by 
the foreign trust to the U.S. beneficiary. These provisions would not apply if constructive 
distributions did not exceed $2,5(X) during a taxable year. The provisions would be effective 
for taxable years of a trust that begin after the date of enactment. 

V. RESroENCE OF TRUSTS 

Current Law 

Under current law, a "foreign estate or trust" is an estate or trust the "income of 
which, from sources without the United States which is not effectively connected with the 
conduct of a trade or business within the United States, is not includable in gross income 
under subtitie A" of the Internal Revenue Code. This definition does not provide criteria for 
determining when an estate or trust is foreign. 

Court cases and rulings indicate that the residence of an estate or trust depends on 
various factors, such as the location of the assets, the country under whose laws the estate or 



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trust is created, the residence of the fiduciary, the nationality of the decedent or settlor, the 
nationality of the beneficiaries, and the location of the administration of the trust or estate. 
See e.g., B.W. Jones Trust v. Comm'r, 46 B.T.A. 531 (1942), aff'd, 132 F.2d 914 (4th Cir. 
1943). 

Reasons for Change 

Present rules provide insufficient guidance for determining the residence of estates 
and trusts. Because the tax treatment of an estate, trust, settlor, or beneficiary may depend 
on whether the estate or trust is foreign or domestic, it is important to have an objective 
definition of the residence of an estate or trust. Reducing the number of factors used in 
determining the residence of estates or trusts for tax purposes would increase the flexibility 
of settlors and trust administrators to decide where to locate and in what assets to invest. 
For example, if the location of the administration of the trust were no longer a relevant 
criterion, settlors of foreign trusts would be able to choose whether to administer the trusts in 
the United States or abroad based on non-tax considerations. 

Proposal 

An estate or trust would be considered a domestic estate or trust if two factors were 
present: (1) a court within the United States is able to exercise primary supervision over the 
administration of the estate or trust; and (2) a U.S. fiduciary (alone or in concert with other 
U.S. fiduciaries) has the authority to control all major decisions of the estate or trust. A 
foreign estate or trust would be any estate or trust that is not domestic. 

The first factor would be fulfilled only if a U.S. court had authority over the entire 
estate or trust, and not if it merely had jurisdiction over certain assets or a particular 
beneficiary. Normally, the first factor would be satisfied if the trust instrument is governed 
by the laws of a U.S. state. One way to satisfy this factor is to register the estate or trust in 
a state pursuant to a state law which is substantially similar to Article Vn of the Uniform 
Probate Code as published by the American Law Institute. The second factor would 
normally be satisfied if a majority of the fiduciaries are U.S. persons and a foreign fiduciary 
(including a "protector" or similar trust advisor) may not veto important decisions of the 
U.S. fiduciaries. In applying this factor, the IRS would allow an estate or trust a reasonable 
period of time to adjust for inadvertent changes in fiduciaries {e.g., a U.S. trustee dies or 
abruptly resigns where a trust has two U.S. fiduciaries and one foreign fiduciary). 

The new rules defining domestic estates and trusts would be effective for taxable 
years of an estate or trust that begin after December 31, 1996. The delayed effective date is 
intended to allow estates and trusts a period of time to modify their governing instruments or 
to change fiduciaries. Moreover, taxpayers would be allowed to elect to apply these rules to 
taxable years of an estate or trust beginning after the date of enactment. 



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Revenue Estimate (\n hiHin ns of dollars) 



Revise taxation of income 
from foreign trusts 
(sections I - V) 







Fiscal Years 








1995 


1996 


1997 1998 


1999 


2000 


Total 


0.1 


0.3 


0.5 0.5 


0.5 


0.6 


2.4 



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PROPOSALS TO IMPROVE TAX ADMINISTRATION AND COMPLIANCE 



The Administration continues to support revenue-neutral initiatives to promote 
sensible and equitable administration of the internal revenue laws. These include 
simplification, technical corrections, and taxpayer compliance measures, including the 
reinstatement of authority to share information on cash transaction reports within the law 
enforcement community and to fund undercover operations. In addition, we support and 
want to work with Congress on the following proposals: 

• intermediate sanctions and disclosure requirements to improve public charities' 
compliance with the requirements for tax-exempt status; 

• a package of compliance and administrative initiatives that would assist the 
IRS's efforts to modernize and streamline its operations, to alleviate taxpayer 
burdens by facilitating the payment of taxes and filing of tax returns, and to 
rationalize existing rules to treat taxpayers more fairly; and 

• modifications to improve compliance with diesel dyeing requirements and to 
facilitate refunds of the excise tax on the sale of certain fuels. 



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Department of the Treasury 

Washington, D.C. 20220 



Official Business 
Penalty for Private Use, S300 



U S TBEASUSV LIBBAPV 



1 0077006