It might be appropriate to provide for determination of the holding period of a partner's interest in the partnership; the bill contains no provision with respect thereto.

VII.

EFFECTIVE DATE

Because of the extensive changes which Subchapter K will make in the taxation of partners and partnerships, our Committee recommends that the effective date with respect to certain transfers and distributions, presently stated in Section 771 (b) to be March 1, 1954, be extended to the date of enactment of the bill or to a later date.

PART SIX

FOREIGN INCOME

The bill makes three substantial changes in the treatment of foreign income:

(1) it grants domestic corporations a credit of 14% of certain business income from foreign sources (Sections 37 and 923);

(2) it permits certain income of domestic corporations from foreign branches to be deferred (Subchapter N, Part IV, Sections 951-958); and

(3) it revises the foreign tax credit to eliminate the "over-all" credit limitation and to introduce a new concept of a "principal tax" (Sections 901-905).

A. Credit of 14% of Certain Business Income

Section 37 allows a tax credit of 14% of a domestic corporation's taxable income which meets the requirements of Section 923. Income meeting the requirements of Section 923 consists of branch income

as computed in Part IV; compensation for the rendition of technical, engineering, scientific or like services; and dividends and interest from a foreign corporation; all subject to strict limitations set forth in Section 923. Generally speaking, the branch income or the income from dividends and interest must be income of a year the gross income of which (1) has been derived, to the extent of at least 95%, from sources without the United States, and, to the extent of at least 90%, from the "active conduct of a trade or business through a factory, mine, oil or gas well, public utility facility, retail establishment, or other like place of business situated within a foreign country," and (2) does not consist of more than 25% of gross income derived from the sale of articles or products manufactured in the foreign country and "intended for use, consumption or sale in the United States". Under Section 923 (b) (1) the term "trade or business" excludes "the operation of an establishment engaged principally in the purchase or sale (other than at retail) of goods or merchandise" and the maintenance of an office or agent in connection with the importing of goods.

A further limitation applicable to the credit with respect to dividends and interest from a foreign corporation is that the domestic corporation is allowed such credit only if it owns (1) either alone or "in association with" no more than three other domestic corporations, more than 50% of the voting stock of such foreign corporation, or (2) at least 10% of the voting stock of such foreign corporation and the trade or business of the two corporations are related by reason of the rendition of technical, engineering, scientific or like services incidental to the operation of the trade or business of such foreign corporation. See Section 923 (a) (3) (B), (4).

The highly restricted nature of the provisions of Section 923 suggests the question whether they may exclude businesses and activities from the benefits of the section which would seem to be within its policy. The fixed percentage rules governing the classes of income which are permissible for qualification purposes could operate erratically and cause qualification to depend upon the form of the business rather than its substance. The exclusion from the term "trade or business" of the operation of an establishment engaged principally in the purchase of goods and their sale, other than at retail, appears to disqualify types of business activities carried on

either independently or as part of manufacturing operations which should, it is believed, receive the benefit of the section. The definition in Section 923(a)(3)(A)(ii) setting forth the type of establishment or means through which the permitted business can be conducted, while described in the House Report, page A255, as not exhaustive, would appear to exclude from the benefits of the section, agricultural operations and perhaps other types of business which the bill may have been intended to cover.

Section 923 (a) (1) provides that the benefit of the section shall be allowed to "branch income includible in gross income under Part IV". Part IV deals with the deferment of branch income and requires definite accounting procedures to be complied with and lays down a rule for the determination of the income taxable to the domestic corporation based on the withdrawal of the domestic corporation's investment in the branch. Section 923(a)(1) as drawn is susceptible of the interpretation that branch income is not entitled to the benefits of Section 923 unless it is an "elected branch" under Part IV. This would mean that a domestic corporation would have to elect to defer foreign branch income if it wished to qualify under Section 923. It is questionable whether this was intended.

Moreover, by its reference to Part IV, Section 923(a)(1) may cause the benefits of the section to be lost in cases where relief was probably intended. Section 951(a)(2) prescribes as a condition to qualification for relief under Part IV that 90% of the gross income of the elected branch be from the active conduct of a trade or business. Section 923 (a) (2), however, permits the credit for income received as compensation for the rendition of technical and similar services. It might be that a branch would derive less than 90% of its income from the active conduct of "a trade or business," but the balance of its income from the rendition of technical services. Thus it could not qualify for the benefits of Part IV, an exclusion which is apparently intended, but it would also lose the benefits of Section 923, although all its income would be either from the active conduct of a trade or business as defined in Part IV or compensation for technical services, both of which types of income are permissible under Section 923. It is therefore recommended that Section 923 (a) (1) be clarified on this point.

It should be noted that under Section 923 dividends from a foreign corporation would apparently not qualify for the application of the credit if the foreign corporation derived more than 10% of its income from excluded sources, including the rendition of technical services. It is not clear why a different rule is applied in the case of a foreign corporation than in the case of a domestic corporation.

The alternative qualifying provision in Section 923(a) (3) (B) (i) may work a hardship in situations where American corporations would not be permitted to own as much as 50% of the stock of the foreign corporation. It is recommended that this provision be modified to require only that the stock ownership, if 50% or less, constitute the maximum percentage of stock (not less, perhaps, than 25%) which under the laws of the foreign country can be owned by the American corporations.

Section 923 (d) lists corporations which are ineligible for the benefits of Section 923. At least two of these exclusions may be questioned:

Insurance companies are excluded. This exclusion is presumably related to a similar denial of the individual and corporate dividends received credit in the case of insurance company dividends. Presumably the exclusion is based on the belief that insurance companies are taxed on a different and more favorable basis than other corporations and are therefore not entitled to the benefits of the relief provisions in question. However, stock companies taxable under Section 831 of the bill are taxed at the same rates as other corporations. Accordingly, it is recommended that the exclusion not apply to corporations taxable under Section 831 of the bill.

Personal holding companies are excluded. No reason appears for this exclusion. The exclusion would presumably operate only with respect to dividends and interest received by such companies. If the foreign corporations paying the dividends met the requirements of Section 923, it is believed that the credit should be available.

B. Deferment of Foreign Income

Sections 951-958 (Part IV of Subchapter N) permit income from foreign branches to be deferred under certain conditions. The type

of income which may be deferred is substantially the same as the type of income entitled to the benefits of Section 923, and the comments made with respect to the limitations as to the types of activities entitled to the benefits of Section 923 are equally applicable here.

Sections 952 and 953 contain elaborate provisions for the treatment of the branch whose income is to be deferred and for the determination of branch income. Section 953 is designed to place branch income on the same basis as income of foreign subsidiaries so that income subject to deferment will approximate the earnings and profits of the foreign subsidiary withdrawn by way of dividends. Section 953(d)(4), allowing a deduction for taxes, including income taxes paid by the elected branch, is criticized in the report of the minority of the Ways and Means Committee (House Report, page B23-24) as allowing a double credit, but this treatment would seem consistent with the purpose of the section to assimilate branch income to corporate earnings since foreign income taxes would reduce the income of a corporation available for dividends.

It should be noted, however, that no loss is allowed on the winding up of an elected branch. This is intentional (House Report, page A264). Such denial appears inconsistent with the assimilation of an elected branch to a foreign subsidiary since, on the liquidation of a foreign subsidiary, a capital loss would be allowed. Accordingly, it is recommended that a capital loss be allowed with respect to losses realized on the termination of a branch.

Section 954, providing for the determination of the extent to which branch income is withdrawn and therefore subject to tax, bases the determination on the excess of the taxpayer's investment in the elected branch at the beginning of the year over the taxpayer's investment in such branch at the close of the year, with appropriate adjustments for income or losses of the year. The minority of the Ways and Means Committee (House Report, page B23) contends that this would permit easy evasion by a temporary year-end reinvestment. This abuse appears to be a real possibility. However, Section 954 (a) gives the Secretary the power by regulation to determine the basis of the taxpayer's investment in the elected branch and it would seem that abuses could be prevented under this power.