Effective date. The amendment relating to the 30-percent withholding rule applies with respect to payments made in taxable years beginning after December 31, 1966. The amendment relating to domestic wage withholding applies with respect to remuneration paid. after December 31, 1966.

f. Withheld taxes and declarations of estimated income tax (secs. 103 (i) and (j) of the bill and secs. 1461 and 6015 of the code)

Under present law, persons who are required to withold on amounts paid to nonresident aliens and foreign corporations are required to file a return and remit the taxes withheld during any calendar year by March 15 of the following year. This procedure is unusual since all other withheld taxes, such as the employees' social security taxes and domestic wage withholding, are required to be remitted (together with the return) at least quarterly. As a result of the delay in the remittance of these 30-percent-withholding taxes, the witholding agents are given the use of these revenues for periods of time which are, in some cases, more than 1 year.

Your committee agrees with the House that there is no reason for not requiring the remittance of these tax revenues at a time period approximating that applicable in the case of domestic withholding. Therefore, your committee's bill amends present law to provide the Treasury Department with the authority to require more current remittance of the taxes withheld on nonresident aliens and foreign corporations. This amendment is effective with respect to payments made after December 31, 1966.

The bill also amends the provisions of present law which require individuals to file declarations of estimated tax. The amendment continues present law which includes nonresident aliens within the category of individuals required to file these declarations. However, the application of this provision to nonresident aliens is limited to those who receive income which is effectively connected with the conduct of a trade or business within the United States.

These amendments are effective with respect to taxable years beginning after December 31, 1966.

g. Foreign estates or trusts (sec. 103 (e) and (l) of the bill and secs. 875 and 7701a (a) (31) of the code)

Present law defines the terms "foreign trust" and "foreign estate" to mean a trust or estate, whose income from sources without the United States is not included in gross income for U.S. income tax purposes. Your committee's and the House bill amends this definition to conform it to the effectively connected concept. As amended, the terms mean an estate or trust the income from 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 included in gross income for U.S. income tax purposes. This amendment applies for taxable years beginning after December 31, 1966.

Your committee added an amendment which imputes the business activities of a trust or estates to its beneficiaries. In other words, if a trust, whether a foreign or a domestic trust, is engaged in a trade or business in the United States, its beneficiaries are deemed to also be engaged in that trade or business.

h. Citizens of possessions of the United States (sec. 103(m) of the bill and sec. 932 (a) of the code)

Under present law, individuals who are citizens of possessions of the United States but not otherwise citizens of the United States, are taxed as nonresident aliens on their U.S. source income. This provision is amended by your committee's and the House bill, effective for taxable years beginning after December 31, 1966, to conform to the changes made to the taxation of nonresident aliens generally.

i. Gain from disposition of certain depreciable realty (sec. 3(j) of the House bill and sec. 1250 (d) of the code)

Your committee's bill strikes the House provision which provides that the recapture rule applicable to depreciable realty is to apply to the transfer of depreciable real estate by a foreigner to a domestic corporation in a tax-free exchange for stock or securities of a domestic corporation. Your committee took this action after being advised that the relationship between the House provision and the corresponding provisions of present law affecting U.S. persons make the provision discriminatory.

4. TAXATION OF FOREIGN CORPORATIONS

a. Income tax on foreign corporations (secs. 104 (a) and (b) of the bill and secs. 881 and 882 of the code)

Present law.-Present law taxes foreign corporations not engaged in a trade or business in the United States at a flat rate of 30 percent on fixed or determinable income from sources within the United States. These items are (with a few exceptions) the same as those presently taxed at the 30-percent rate to nonresident alien individuals. not engaged in a trade or business in the United States. They are interest, dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments or other fixed or determinable annual or periodical gains, profits, and income (including certain timber, coal, and iron ore royalties).

The U.S. source income of a foreign corporation engaged in business in the United States is taxed, under present law, at the regular corporate rates. In computing the tax, deductions generally are allowed to the extent that they are properly allocable to the U.S. source income if a true and accurate return is filed by the corporation.

Reasons for provision.-Your committee's and the House bill, both in the case of nonresident aliens and in the case of foreign corporations, provides a consistent pattern of taxation. Nonresident aliens and foreign corporations will be taxed at the regular income tax rates in the case of income which is effectively connected with a U.S. trade or business. In the case of nonresident alien individuals and foreign corporations with U.S. source fixed or determinable income which is not effectively connected with a U.S. trade or business a flat 30-percent rate is applied. The reasons for differentiating the tax treatment on this basis have already been explained to a substantial extent in connection with the definition of effectively connected (No. 2(b), above) and in connection with the explanation of the taxation of nonresident aliens (No. 3 (a), above).

One of the principal changes resulting from this new classification in the case of foreign corporations is that investment income which is not related to a trade or business carried on in the United States will be taxed at the flat 30-percent rate (or lower treaty rate) rather than at the regular corporate rate. This does away with the arbitrary distinction which exists under present law which makes the rate of tax, a flat 30 percent or regular rate, turn on the presence or absence of a trade or business in the United States which may be wholly unrelated to the investment income.

Under the bill all U.S. source investment income (fixed or determinable income) of foreign corporations which is not effectively connected with a trade or business in the United States will be taxed at a flat rate. However, all investment income effectively connected with a U.S. trade or business will be taxed in the same manner as other income of that trade or business, and in the same manner as similar income of a domestic corporation.

As indicated in connection with the definition of effectively connected the new rule for the taxation for foreign corporations will also prevent the use of the United States as a "tax haven" in the case of limited categories of foreign source income. However, these limited types of income do not, in any event, include "subpart F income" or, generally, income received from a foreign subsidiary.

This new rule for the taxation for foreign corporations should also tend to encourage foreign investment in the United States and thus is likely to have a favorable effect on the U.S. balance of payments.

Explanation of provision.-The bill substantially revises the income. tax treatment of foreign corporations. Under the bill the income of a foreign corporation is divided into two classifications.

(A) Income not effectively connected.-Fixed or determinable income of a foreign corporation from sources within the United States. which is not effectively connected with the conduct of a trade or business within the United States, under your committee's and the House bill, is taxable at a flat 30-percent rate (or lower treaty rate). Under your committee's bill, the types of fixed or determinable income specified are the same as under present law with the same two additions provided in the case of nonresident aliens: (1) contingent income received from the sale of patents and other intangibles, and (2) amounts of original issue discount which are treated as ordinary income received on retirement or sale or exchange of bonds or other evidences of indebtedness issued after September 28, 1965. A corresponding amendment to the House bill deleting the tax on income realized with respect to stock of a collapsible corporation was made in this provision. As indicated in the case of the taxation of nonresident aliens, the source of this original issue discount is to be determined by the same rules as those applicable to interest income. As a result, if the corporation with respect to whose bonds the original issue discount arises is a domestic corporation which for the 3-year period preceding the year of redemption derives 80 percent or more of its income from foreign sources, then the original issue discount (interest), at the time of the retirement or sale or exchange of the bonds also, will be considered as foreign source income. Moreover, the language in the nonresident alien section of this report clarifying the scope of the references in the bill to section 1232 is equally applicable with respect to this provision.

The bill has also clarified the language of present law which includes certain timber, coal, and iron ore royalties in the 30-percent list.

(B) Income effectively connected.-Income of a foreign corporation which is effectively connected with the conduct of a trade or business within the United States is taxable, under the bill, at the regular corporate income tax rates. In determining "taxable income" for this purpose, gross income includes only gross income which is "effectively connected" with the conduct of the trade or business within the United States.

(C) Income from real property.-Under present law (as explained with respect to nonresident alien individuals) it is not clear as to what situations or arrangements for the ownership by a foreign corporation of real property located in the United States will cause the foreign corporation to be considered as engaging in a trade or business within the United States. This is important to know because if a foreign corporation not engaged in a trade or business in the United States receives rents from U.S. real property, this rental income is taxable at the flat 30-percent rate (or applicable treaty rate) on the gross amount of such rents, without the allowance of any deductions attributable to the rental income. Consequently, the tax liability generated by this rental income may exceed the net rental income the corporation receives. Your committee agrees with the House that the law in this area should be clarified and doubts whether it is appropriate to tax the gross amount of this type of income.

Since the provisions of this amendment parallell the amendment provided in the case of real estate income of nonresident alien individuals, the explanation is not repeated here (see No. 3(a) (C) (ii)).

(D) Certain interest received by banks in U.S. possessions.-The application of the flat 30-percent rate to U.S. source income which is not effectively connected with a U.S. trade or business results in a high ef fective rate of tax on interest received by banks located in U.S. possessions with respect to U.S. Government obligations which they must necessarily hold to meet reserve requirements. This result is due to the fact that these banks must pay interest on the amounts invested in the U.S. Government obligations. Therefore, the net profit margin on the interest received from these U.S. Government obligations is small relative to the gross amount of interest received. It was also brought to the attention of your committee that the usual method of effecting a mitigation of the flat 30-percent rate in the case of interest-an income tax treaty providing a lower rate (0, 5, or 15)-is, of course, not possible in the case of a possession.

In view of the facts set forth above your committee has added an amendment to the House bill which provides that interest received by banks located in a U.S. possession from U.S. government obligations will be treated as effectively connected with a U.S. trade or business whether or not the bank has such a business. Consequently, the interest received by a bank in a possession from U.S. Government obligations will be taxed on a net basis-gross interest income less allocable

expenses.

(E) Deductions.-Under the bill, deductions are allowed in computing the tax imposed at the regular corporate rates only to the extent that they are properly attributable to income which is effectively connected with the conduct of a trade or business within the United

States. The deduction for charitable contributions, however, is allowed whether or not attributable to income which is effectively connected. Generally, as under present law, deductions are permitted only if a true and accurate income tax return is filed.

Effective date. These amendments apply with respect to taxable years beginning after December 31, 1966.

b. Withholding of tax on foreign corporations (sec. 104(c) of the bill and sec. 1442 of the code)

Under present law, the fixed or determinable U.S. source income of a foreign corporation not engaged in trade or business in the United States, like that of a nonresident alien not engaged in a trade or business in the United States, is subject to a withholding tax of 30 percent. However, foreign corporations engaged in trade or business in the United States are not subject to the withholding tax.

The bill amends the withholding provisions of present law to conform to the effectively connected concept in the bill. Thus, under the bill a withholding tax at the 30-percent rate will apply in the case of a foreign corporation to items of fixed or determinable U.S. source income which are not effectively connected with the conduct of a trade or business in the United States. It is the understanding of your committee that the person required to withhold will be relieved of any liability for failure to withhold if the failure was in reliance upon information (as to whether or not the income was effectively connected) furnished (in accordance with regulations to be issued) by the foreign corporation entitled to the receipt of the income. The House bill provides that this 30-percent withholding provision is not applied if the Secretary of the Treasury determines that the withholding requirements impose an undue administrative burden and that the collection of the tax will not be jeopardized by an exemption. In cases like this, if the Treasury concludes that revenue will not be jeopardized (or delayed) by foregoing withholding, your_committee concluded it would be desirable to do so. This amendment is applicable to taxable years beginning after December 31, 1966. c. Deduction for dividends received from foreign corporations (sec. 104 (d) and (e) of the bill and sec. 245 (a) and (b) of the code) Present law. In general, present law allows corporations an 85-percent dividend-received deduction for dividends received from domestic corporations. In order for this deduction to be available in the case of dividends from a foreign corporation, it must be engaged in a trade or business in the United States for an uninterrupted period of at least 3 years and 50 percent of its gross income must be from U.S. sources during that period. Where these conditions exist, an 85-percent dividend-received deduction is available for the same proportion of the dividend as the corporation's gross income, which is from U.S. sources, is of its total gross income.

Explanation of the provision.-The House bill substantially conforms the dividends-received deduction to the effectively connected concept appearing elsewhere in the bill. Under the House bill 50 percent or more of the foreign corporation's gross income for the uninterrupted period must be from income effectively connected with the conduct of a trade or business within the United States for the deduc

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