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84-62 Effect of the Tax Reform Act of 1984 and Amendments to Various NASD and SEC Rules on NASD Qualification Examinations

TO: All NASD Members and Interested Persons

ATTN: Registration, Training and Compliance Personnel

The subject matter of various NASD qualification examinations has been affected by the passage of the Tax Reform Act of 1984 (the "Act") as well as by recently adopted amendments to certain SEC and NASD rules. The test items affected by these changes have been deleted from the current test question banks. Updated questions will be instated in the appropriate examinations effective January 1, 1985. In addition, new recordkeeping and IRS reporting requirements for broker-dealers and promoters of tax sheltered investments were adopted under the Act. Because of their relevance to the securities industry, test questions on these rules will also be incorporated in the appropriate examination banks on January 1, 1985. The following is a brief explanation of the new compliance requirements under the Tax Reform Act of 1984.

  • Promoter's Investor List - The Act requires organizers and sellers of "tax shelter" investments sold after August 31, 1984, to maintain investor lists and provide them to the IRS on request. The list must be maintained for seven years for any tax shelter program required to be registered.
  • Promoter's Penalty - Effective July 18, 1984, the Act provides for a penalty on promoters of abusive tax shelters equal to the greater of $1,000 or 20% of shelter income to be derived from the organization or sale of the program.
  • Registration of Tax Shelters - The Act requires tax shelter promoters to register their tax shelter programs sold after August 31, 1984, with the IRS or before the day it is first offered for sale. The IRS will assign a registration number to each program and the promoters will have to notify the investors of this number so that it can be included on their tax returns.
  • Disposition of Partnership Interests - Beginning in 1985, when partnership interests are exchanged or sold, the Act requires a partnership after it is notified by the selling partner, to inform the IRS, the seller and the buyer of the fair market value of the partner's allocable share of unrealized receivables and appreciated inventory. This provision applies to all partnerships.
  • Original Issue Discount Reporting - The Act provides that issuers of publicly traded original issue discount instruments issued after July 18, 1984, must furnish information to the IRS including issue date and the amount of original issue discount.

* * * * *

On April 3, 1984, the NASD adopted a new rule under Article III, Section 38, of the Rules of Fair Practice. As approved by the SEC, Section 38 addresses two levels of possible financial or operational difficulties of member firms. First, it restricts a member from expanding its business whenever certain early warning criteria relating to minimum capital, ratios or scheduled capital withdrawals are exceeded. Secondly, it covers a deteriorating situation in which another set of warning criteria with lower tolerance are exceeded. In such situations, the rule requires a member to reduce or eliminate certain facets of its business. The rule is intended to address such problems in a timely fashion to protect the member, the investing public and other members. For more information on this new rule, refer to NASD Notice to Members 84-21, dated April 3, 1984.

* * * * *

Recently adopted amendments to certain SEC and NASD rules which will be reflected in the qualification examinations on January 1, 1985, include the following:

A. Rule 144 Under the Securities Act of 1933 - Paragraph (k) under Rule 144: Termination of certain restrictions on sales of restricted securities by persons other than affiliates.
B. NASD Rules of Fair Practice
Section 1 - Amendments to the Free-Riding and Withholding Interpretation: The purpose of this amendment is to explain in more detail provisions already in the Interpretation. Refer to NASD Notice to Members 83-68, dated December 12, 1983, for further details.
Section 10 - Influencing or rewarding employees of others: The limit on gifts and gratuities to any person, principal, proprietor, employee, agent or representative is $50 per year.
Section 34 - Direct Participation Programs: The provisions of Appendix F have been amended to require disclosure to public investors of the use of sales incentive programs. The amendments are also designed to permit members participating in public offerings of programs utilizing such arrangements to appropriately supervise their salesmen and maintain required books and records. The amendments also require that all sales incentives be paid to a member and that such incentives be paid only in the form of cash. Refer to NASD Notice to Members 84-28, dated May 22, 1984, for further details.
C. Article V—Penalties
Section 1 - Penalties for violations of the rules: This amendment increases from $5,000 to $15,000 the maximum fine which may be assessed upon any member or person associated with a member.
D. Code of Procedure for Handling Complaints
Section 12 - Summary Complaint Procedure: This amendment increases from $1,000 to $2,500 the penalty which may be imposed by summary complaint procedure for all violations of the Rules of Fair Practice as to each respondent.
E Code of Arbitration Procedure
Amendments to various sections of the Code are intended to conform the provisions of the Association's Code of Arbitration Procedure to recent amendments to the Uniform Arbitration Code which has been developed by the Securities Industry Conference on Arbitration. The Uniform Code, as implemented by the various self-regulatory organizations, has established throughout the securities industry a uniform system of arbitration procedures. Refer to NASD Notice to Members 84-51, dated September 28, 1984, for further details.

* * * * *

The remainder of this notice summarizes changes in the Tax Reform Act of 1984 which affect various qualification examinations. This is followed by a chart identifying the specific examinations and relevant study outline sections affected by all the material of this notice.

All questions in the item banks affected by these changes will be updated to reflect the new rule provisions beginning January 1, 1985.

Questions regarding this notice should be directed to Carole Hartzog at (202)728-8141.

Sincerely,

Frank J. McAuliffe
Vice President
Qualifications Department

Attachments

Tax Reform Act of 1984

A. Individual Income Taxes
Capital gain holding period - The Act reduces to six months the long-term capital gain or loss holding period for assets acquired after June 22, 1984. This one year holding period will be reinstated for assets acquired after 1987.
Alternative minimum tax - For tax years beginning after 1982, the Act clarifies that:
  • When calculating the regular tax for alternative minimum tax purposes, the amount of any recaptured investment credit due is in addition to the alternative minimum tax and regular tax liability. The credit must be recaptured and added to the amount of tax for the year of disposition.
  • Intangible drilling costs are tax preference items for purposes of the alternative minimum tax, unless they are capitalized (in which case they are eligible for the investment credit and ACRS deductions). The new law makes clear that the election to the ACRS deductions and the investment credit in lieu of expensing intangible drilling costs is only available for oil, gas and geothermal wells located in the U.S.
  • Rapid writeoffs of circulation expenses are a tax preference item to the extent they exceed the amount allowable had the expenditures been capitalized and deducted ratably over a 10-year period. The new law substitutes a 3-year amortization period for the 10-year period.

Investment income from S corporations - Effective for tax years beginning 1982, income from an S corporation will be treated as investment income if the individual so elects. However, income attributable to personal services is not eligible for treatment as investment income.
B. Tax-Oriented Investment Transactions
Prepayment of expenses - For prepayments made after March 31, 1984, the Act provides that "tax shelters" (other than farming syndicates), whether on the cash or accrual method will not be permitted to deduct prepaid expenses until both economic performance occurs and the expense is actually paid or incurred. Economic performance will generally occur when services are performed, property is provided, use of property occurs or when the obligation to perform is otherwise satisfied. These provisions will apply to individuals engaged in farming activities with the principal purpose of tax avoidance.
C. Business Income Taxes—Real Estate
Real property recovery period - Effective for property placed in service after March 15, 1984, the recovery period of real property (other than low-income housing) is lengthened to 18 years based on 175% declining balance, or straight line over a period of 18, 35 or 45 years. The 15 year recovery period at accelerated rates based on 200% declining balance for low income housing remains unchanged.
Rehabilitation Credit - For rehabilitation expenditures incurred after 1983, the Act provides an alternative test to determine whether a project qualifies for the rehabilitation credit and allows the credit where:
  • at least 50% of the external walls are retained as external walls.
  • at least 75% of the external walls are retained as either external or internal walls.
  • at least 75% of the internal structural framework is retained in place.

Rehabilitation of low-income housing - The Act extends retroactively for three years the prior law provisions permitting the amortization over 60 months of certain rehabilitation expenditures on low-income housing.
D. Business Income Taxes — General
Investment tax credit for used property — The scheduled increase in the amount of used property eligible for the investment tax credit from $125,000 to $150,000 has been deferred to 1988.
Depreciation recapture on installment sales - All depreciation recapture on installment sales of both real and personal property occurring after June 6, 1984, is recognized as income in the year of sale. The remaining gain on the sale will continue to be reported proportionately as the installments are received.
Non-simultaneous, like-kind exchanges - Property received in an exchange after July 18, 1984, will not qualify for like-kind, non-recognition treatment unless it is received within 180 days of the taxpayer's transfer. The substitute like-kind property must be identified within 45 days.
At-risk rules - For property placed in service after July 18, 1984, the Act reduces the base for the investment tax credit by the amount of nonrecourse indebtedness. However, non-recourse financing that is qualified commercial financing will not reduce the credit base. Qualified commercial financing includes any financing, other than convertible debt for property that:
  • does not exceed 80% of the credit base of the property;
  • is borrowed generally from an unrelated person regularly engaged in the business of lending money;
  • is not acquired from a related party.

Start-up expenses - For tax years beginning after June 30, 1984, the Act makes clear that certain start-up expenses incurred in maintaining property (prior to its use in any active trade or business) are not current deductions but must be capitalized with an election to amortize over not less than 60 months. The Act provides that, when a trade or business is disposed of completely before the end of the amortization period, the unamortized start-up expenses may be deducted in that year.
Sound recordings - Sound recordings placed in service after March 15, 1984, may be treated as three-year ACRS property and be eligible for a 6% investment tax credit or they may be depreciated under the income forecast method without ITC.
Movies and video tapes - Movies and video tapes placed in service after 1980 do not qualify for ACRS or the 10% investment credit.
Basis adjustment for investment credit - TEFRA required taxpayers to reduce the basis of property by 50% of the allowed investment credit. On dispositions that trigger recapture of the credit, basis is increased immediately before the disposition by 50% of the recaptured credit. Under the new law, partners and S corporation shareholders must adjust their basis in the partnership interest or S corporation stock to reflect the basis adjustment by the partnership or S corporation on the allowance or recapture of the investment credit.
Construction period interest and taxes - The 1982 tax act provided that corporations must capitalize construction period interest and taxes with respect to nonresidential real property. The Act clarifies that commencing after 1982, construction period interest and taxes with respect to dwelling units in a cooperative housing corporation are exempt from the capitalization requirements, since that property is residential property.
E. Partnership
Property contributed to a partnership - Under the Act, where property is contributed to a partnership after March 31, 1984:
  • Built-in losses on capital assets contributed to a partnership will retain their character as capital losses for five years.
  • Contributed inventory will retain its character as ordinary income property for five years of ownership by the partnership.
  • Depreciation, depletion and any built-in gain or loss from a sale of partnership property will generally have to be allocated to the contributing partner.

The Act also provides that, when a partner transfers money or other property to a partnership with a related direct or indirect transfer of money or other property to that partner or another partner, the transaction will be treated, where appropriate, as a sale of property between the partners, or as a partial sale and partial contribution of the property to the partnership. The selling partner will be required to recognize gain or loss on the amount of the deemed sales proceeds.
Retroactive allocations - For amounts attributable to periods before or after March 31, 1984, the Act prohibits allocations of items of income, gain, loss, deduction, or credit to partners entering the partnership either directly or through tiered arrangements, after the accrual of such items of taxable income or loss by cash basis partnerships. This provision is intended to prevent the practice of accrual of expenses by a cash basis partnership before the limited partners enter into the partnership, with those expenses later allocated to the limited partners and will significantly reduce the first year tax benefits allocable to limited partners entering a syndicated partnership.
Other partnership allocations - For transfers after February 29, 1984, the Act provides that persons who become partners after performing services for, or transferring property to the partnership, are to be treated retroactively as partners.
Treatment of certain partnership liabilities - Effective July 18, 1984, the Act gives the Treasury authority to issue regulations regarding the conditions under which recourse and non-recourse liabilities may be reflected in the basis of general and limited partners' interests. It is intended that regulations to be issued will allow an increase in a limited partner's basis when the limited partner provides a guarantee of partnership debt or otherwise assumes economic risk.
F. Securities Transactions
Market discount bonds - Under the Act, for bonds issued after date of enactment and interest on bonds acquired after July 18, 1984, accrued market discount is taxed as interest income to the bondholder and recognized upon disposition of the bond (including disposition by gifts). Bondholders can elect to compute the accrued market discount under the economic accrual formula used for original issue discount rather than using the linear (straight-line) method. Also, an election is available to individuals who desire to report the accrued market discount on a current basis.
The Act also defers deductions for net interest expense on debt incurred or continued to purchase or carry a market discount bond, including expenses relating to short sales used to generate funds.
Options transactions - For positions established after December 31, 1983, the Act required that, where an investor has certain offsetting positions, and loss realized from closing one position must be deferred for tax purposes to the extent of any unrecognized gain on an offsetting position. This provision applies, for example, to:
  • "Covered option" positions involving "deep-in-the-money" options. (Covered option writing is an investment strategy whereby an owner of stock "writes" or sells short an option on the same stock. Under present law, an investor who sells deep-in-the-money options to offset a stock ownership position can continue to hold the stock with very limited market risk. This technique was also used to extend a holding period until it became long-term.)
  • Offsetting positions involving two traded options.
  • Offsetting positions in a stock and related securities (such as convertible debentures of the same corporation).
  • Positions in stock index products, including options offset by a stock portfolio that follows the performance of the index.

Short sales - Under the Act, for short sales after July 18, 1984, payments made by short sellers of stock in lieu of dividends cannot be deducted against ordinary income unless the short sale is held open for at least 46 days. In the case of extraordinary dividends, the short sale must be held open for at least one year. Payments disallowed will be added to the basis of the stock used to close the short sale.
Capital gain dividends of investment companies - Under present law, an individual may buy shares in a regulated investment company that is about to distribute a sizable long-term capital gain dividend, hold the shares for 31 days and then sell them probably at a short-term loss roughly equivalent to the value of the dividend. The result would be a long-term capital gain and a short-term capital loss in approximately equal amounts. Under the Act, if a shareholder of a regulated investment company or a real estate investment trust holds stock for less than six months, any loss recognized on the sale of such stock will be treated as a long-term capital loss to the extent of any distribution on the stock which was treated as long-term capital gain. An exception is provided for dispositions of stock pursuant to a periodic redemption plan. This provision is effective for losses incurred on shares acquired after July 18, 1984.
Original issue discount on tax-exempt bonds - Original issue discount on any tax-exempt obligation will accrue under an economic accrual formula based on yield to maturity and compound interest. The effect of this provision will be to increase the adjusted basis of the bond only by this accrued discount in connection with the holder's determination of taxable gain or loss upon disposition of the bond. This provision is effective for obligations issued after September 3, 1982, and acquired after March 1, 1984.

* * * * *

EXAMINATIONS AFFECTED BY VARIOUS TAX LAW AND INDUSTRY RULE CHANGES

(Numerical References Within Test Series Identify Study Outline Sections Affected By These Changes)

Description

Test Series Number

 

4

6

7

8

22

24

26

27

39

AMENDMENTS TO NASD/SEC RULES

                 

Securities Act of 1933: Rule 144 — Persons deemed not to be engaged in a distribution and therefore not underwriters

                 

Rule 144(k) — Termination of restrictions on sales of restricted securities

2.5

15.1

1.1.1

1.2

NASD Rules

                 

Article III — Rules of Fair Practice

                 

Section 1 — Business conduct of members — Free-Riding and Withholding Interpretation of the Board

4.6

16.3

1.1.3

4.3.3

 

1.4

3.2

Section 10 — Influencing or rewarding employees of others

4.6

16.3

3.1

4.3.3

4.2

3.2

3.2

Section 34 — Direct participation programs - Appendix F

16.3

1.1.3

4.3.3

1.4

2.3

Section 38 — Regulation of activities of members experiencing financial and/or operational difficulties

X

X

X

X

Article V — Penalties

                 

Section 1 — Penalties for violation of the rules

4.6

4.3.3

4.2

3.2

3.2

Code of Procedure

                 

Section 12 — Summary Complaint Procedure

4.6

4.3.4

4.2

3.2

3.2

Code of Arbitration Procedure

4.6

16.6

3.1

4.3.5

4.2

3.2

3.2

TAX REFORM ACT OF 1984

                 

Compliance

                 

Promoter's customer list

X

X

Promoter's penalty

X

X

Registration of tax shelters

X

X

Disposition of partnership interests

X

X

Original issue discount reporting

X

X

X

Individual Income Taxes

                 

Capital gain holding period

1.6

21.14

14.3

3.3

1.4

Alternative minimum tax changes

3.3

1.4

Investment income from S corporations

1.2

1.2

Tax-Oriented Investment Transactions

                 

Prepayment of expenses

3.2

Business Income Taxes — Real Estate

                 

ACRS write-off period

4.2

3.2

Rehabilitation credit

3.2

Rehabilitation of low-income housing

3.2

Business Income Taxes — General

                 

Investment credit — used property

3.2

Installment sales — depreciation recapture

4.2

3.3

Like-kind exchanges

3.3

At-risk rules

3.3

1.4

Start-up expenses

2.1

Sound recordings

2.6

Movies and video tapes

2.6

ITC basis adjustment

3.2

1.4

Construction period interest and taxes

3.2

Partnership

                 

Property contributed to a partnership

       

3.3

     

1.4

Retroactive allocations

       

3.3

     

1.4

Other partnership allocations

       

3.3

     

1.4

Certain partnership liabilities

       

3.3

     

1.4

Securities Transactions

                 

Market discount bonds

14.11

Options transactions

1.6

14.10

Short sales

1.6

14.9

Capital gain dividends of investment companies

2.1

2.2

Original issue discount on tax-exempt bonds

14.11

TEST SERIES KEY

Series Number

Examination Title

4

Registered Options Principal Examination

6

Investment Company Products/Variable Contracts Representative Examination

7

General Securities Representative Examination

8

General Securities Sales Supervisor Examination

22

Direct Participation Programs Representative Examination

24

General Securities Principal Examination

26

Investment Company Products/Variable Contracts Principal Examination

27

Financial and Operations Principal Examination

39

Direct Participation Programs Principal Examination


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