includes "only gains and losses from the sale or other disposition of property used for the production of interest, dividends, rents, and royalties,” and certain other property involved in the tax on unrelated business income.

This is a case of first impression. Before analyzing the regulation here at issue, it may be appropriate to briefly describe some of the context within which this private foundation excise tax operates.

The matrix.-Section 4942 requires each private foundation (if it is not a private operating foundation) to spend for charitable purposes the greater of its adjusted net income or a percentage of the fair market value of the foundation's noncharitable assets. The noncharitable assets are described in section 4942(e)(1)(A)(i) as “all assets of the foundation other than those being used (or held for use) directly in carrying out the foundation's exempt purpose."

Section 4944 (successor to sec. 504(a)(3), see n. 8 supra) prohibits investments which jeopardize the carrying out of the foundation's exempt purposes. Section 4944(c)1o exempts from this prohibition any investment which is made to accomplish charitable purposes, but only if "no significant purpose of [the investment] is the production of income or the appreciation of property."

Section 4943 requires private foundations to divest themselves of "excess business holdings." In determining whether an activity is a business enterprise (and, therefore, whether an investment in it might be an excess business holding), section 4943(d)(4) provides that a trade or business which derives at

*In this respect, sec. 4942 may be viewed as the successor to sec. 504(a)(1). Sec. 504 was repealed by sec. 101(j)(15), Tax Reform Act of 1969, 83 Stat. 527.

"The subsequent amendment of this provision by sec. 1303, Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1715, affects neither the issue nor the taxable year before us. The quoted language now appears as subpar. (A) of sec. 4942(e)(1).

10SEC. 4944. TAXES ON INVESTMENTS WHICH JEOPARDIZE CHARITABLE PURPOSE. (c) EXCEPTION for Program-Related InvestmENTS.-For purposes of this section, investments, the primary purpose of which is to accomplish one or more of the purposes described in section 170(c)(2)(B), and no significant purpose of which is the production of income or the appreciation of property, shall not be considered as investments which jeopardize the carrying out of exempt purposes.

"SEC. 4943. TAXES ON EXCESS BUSINESS HOLDINGS.

(d) DEFINITIONS; SPECIAL RULES.-For purposes of this section

(4) BUSINESS ENTERPRISE.—The term "business enterprise" does not include(A) a functionally related business (as defined in section 4942(j)(5)), or

least 95 percent of its gross income from passive sources is not a business enterprise. "Passive sources" is defined to include certain types of income exempt from the tax on unrelated business income. The particular types of passive income referred to are those that are excluded from the tax on unrelated business income by paragraphs (1), (2), (3), and (5) of section 512(b).12 These provisions exclude dividends, interest, annuities, royalties, rents under certain circumstances, and capital gains. Section 509(a) defines the term "private foundation." Certain

(B) a trade or business at least 95 percent of the gross income of which is derived from passive

sources.

For purposes of subparagraph (B), gross income from passive sources includes the items excluded by section 512(b)(1), (2), (3), and (5), and income from the sale of goods (including charges or costs passed on at cost to purchasers of such goods or income received in settlement of a dispute concerning or in lieu of the exercise of the right to sell such goods) if the seller does not manufacture, produce, physically receive or deliver, negotiate sales of, or maintain inventories in such goods.

12SEC. 512. UNRELATED BUSINESS TAXABLE INCOME.

(1) There shall be excluded all dividends, interest, and annuities, and all deductions directly connected with such income.

(2) There shall be excluded all royalties (including overriding royalties) whether measured by production or by gross or taxable income from the property, and all deductions directly connected with such income.

(3) In the case of rents

(A) Except as provided in subparagraph (B), there shall be excluded—

(i) all rents from real property (including property described in section 1245(a)(3)(C)), and (ii) all rents from personal property (inlcuding for purposes of this paragraph as personal property any property described in section 1245(a)(3)(B)) leased with such real property, if the rents attributable to such personal property are an incidental amount of the total rents received or accrued under the lease, determined at the time the personal property is placed in service.

(B) Subparagraph (A) shall not apply

(i) if more than 50 percent of the total rent received or accrued under the lease is attributable to personal property described in subparagraph (A)(ii), or

(ii) if the determination of the amount of such rent depends in whole or in part on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages of receipts or sales).

(C) There shall be excluded all deductions directly connected with rents excluded under subparagraph (A).

(5) There shall be excluded all gains or losses from the sale, exchange, or other disposition of property other than

(A) stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or

(B) property held primarily for sale to customers in the ordinary course of the trade or business.

This paragraph shall not apply with respect to the cutting of timber which is considered, on the application of section 631, as a sale or exchange of such timber.

The subsequent amendments of pars. (1) and (5) by sec. 2(a)(2), Pub. L. 95-345 (Aug. 15, 1978, 92 Stat. 481) and subsec. (a) of sec. 1, Pub. L. 94-396 (Sept. 3, 1976, 90 Stat. 1201), respectively, do not affect the taxable year before us (see sec. 2(e) of the 1978 Act, 92 Stat. 483 and subsec. (b) of sec. 1 of the 1976 Act, 90 Stat. 1201, respectively).

types of publicly-supported organizations are not treated as private foundations. However, under section 509(a)(2)(B), in order to be excluded from the category of private foundation, the organization must not normally receive more than one-third of its support from "gross investment income." Section 509(e)13 defines gross investment income to mean "income from interest, dividends, rents, and royalties."

All of the provisions described above, except for paragraphs (1) and (5) of section 512(b), were initially enacted or substantially revised by the Tax Reform Act of 1969 (Pub. L. 91-172, 83 Stat. 487). Most of these provisions were enacted by section 101 of that Act, the same section that enacted the investment income tax sought to be applied in the instant case. The remaining provisions, paragraphs (1) and (5) of section 512(b), were part of the matrix within which the Congress enacted the other provisions.

Evolution of the tax in 1969.-The excise tax on investment income of private foundations was enacted as part of section 101(b) of the Tax Reform Act of 1969 (Pub. L. 91-172, 83 Stat. 498).

Section 101(a) of H.R. 13270 (the Tax Reform Act of 1969), as passed by the House of Representatives on August 7, 1969 (hereinafter sometimes referred to as the House bill), would have imposed a tax at the rate of 72 percent of net investment income.14 Subsection (a) and paragraphs (1), (2), and (4)(A) of subsection (c) of section 4940 as enacted (set forth in the margin supra at notes 3, 4, 6, and 7, respectively) follow closely the

13SEC. 509. PRIVATE FOUNDATION DEFINED.

(e) DEFINITION OF GROSS INVESTMENT INCOME.-For purposes of subsection (d), the term "gross investment income" means the gross amount of income from interest, dividends, rents, and royalties, but not including any such income to the extent included in computing the tax imposed by section 511. The subsequent amendment of this provision by sec. 2(a)(1), Pub. L. 95-345 (Aug. 15, 1978, 92 Stat. 481) does not affect the taxable year before us (see sec. 2(e) of the 1978 Act, 92 Stat. 483).

14 The House Ways and Means Committee Report gave the following reasons for seeking to impose this tax:

"General reasons for change.-Your committee believes that since the benefits of government are available to all, the costs should be borne, at least to some extent, by all of those able to pay. Your committee believes that this is as true for private foundations as it is for taxpayers generally. Also, it is clear that vigorous and extensive administration is needed in order to provide appropriate assurances that private foundations will promptly and properly use their funds for charitable purposes. This tax, then, may be viewed as being in part a user fee.

"Accordingly, your committee has determined that a minimal tax should be imposed upon the investment income of private foundations. [H. Rept. 91-413 (Part 1), p. 19, 1969-3 C.B. 213.]"

language in the House bill at subsection (a) and paragraphs (1), (2), and (4)(B) of subsection (b) of section 506, respectively.15 In the House bill, this was an income tax, in chapter 1 of the Internal Revenue Code of 1954.

The House Ways and Means Committee Report explained this provision as follows:

the capital gains and losses to be taken into account are only those on capital assets used to produce income subject to this tax or used to produce unrelated business income (except to the extent such gains and losses are used to compute the tax on unrelated business income). [H. Rept. 91-413 (Part 1) p. 20, 1969-3 C.B. 214.]

Paragraph (4) of section 506(b) provides under subparagraph (A) that in determining net capital gain or loss the basis of property held by the private foundation on December 31, 1969, and continuously thereafter to date of disposition is to be not less than the fair market value on December 31, 1969. Subparagraph (B) provides that the sale or other disposition of property used for the production of investment income or income included in computing the tax imposed by section 511 shall be taken into account, except to the extent that such gain or loss is taken into account for purposes of the tax imposed by section 511 (relating to tax on related [sic] business income). [H. Rept. 91-413 (Part 2) pp. 2-3, 1969-3 C.B. at 341.]

The Senate adopted a different concept for the tax on private foundations. H.R. 13270, as reported by the Senate Finance Committee provided for a tax16 equal to the greater of $100 or

15SEC. 506. TAX ON PRIVATE FOUNDATION INVESTMENT INCOME.

(a) IMPOSITION OF TAX.-There is hereby imposed for each taxable year on the net investment income of every private foundation (as defined in section 509) a tax equal to 71⁄2 percent of such income.

(b) NET INVEStment Income Defined.—

(1) IN GENERAL.-For purposes of subsection (a), the net investment income is the amount by which (A) the gross investment income and the net capital gain, exceed (B) the deductions allowed by paragraph (3) and the net capital loss.

(2) GROSS INVESTMENT INCOME.-For purposes of paragraph (1), the term "gross investment income" means the gross amount of income from interest, dividends, rents, and royalties, but not including any such income to the extent included in computing the tax imposed by section 511. (3) DEDUCTIONS.-For purposes of paragraph (1), there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred for the production or collection of gross investment income or for the management, conservation, or maintenance of property held for the production of such income.

(4) CAPITAL GAINS and losses.-For purposes of paragraph (1), in determining net capital gain or loss

(B) There shall be taken into account only the sale or other disposition of property used for the production of interest, dividends, rents, and royalties, and property used for the production of income included in computing the tax imposed by section 511 (except to the extent gain or loss from the sale or other disposition of such property is taken into account for purposes of such tax). 16SEC. 4940. AUDIT-FEE TAX.

(a) TAX EXEMPT FOUNDATIONS.-There is hereby imposed on a private foundation which is exempt

one-fifth of 1 percent of the fair market value of all assets other than those being used (or held for use) directly in carrying out the foundation's exempt purpose.17 The Senate Finance Committee explained this provision as follows:

The tax base is in general to be the same as the base used for determining the minimum amount such a foundation must distribute currently, as described below in Distributions of Income. The base does not include assets used (or held for use) directly in the active conduct of the foundation's charitable activities. In the case of operating foundations (described below) meeting the usual "assets test,” substantially more than half of their assets would not be subject to this tax.

Where the assets include all the stock of a corporation performing a functionally related activity (such as Colonial Williamsburg's Lodge and Inn), then the tax base is not to include those underlying assets which, if held by the foundation directly, would be assets used in the active conduct of the foundation's charitable activities. However, any endowment or other noncharitable assets of the subsidiary corporation, to the extent they are reflected in the value of the stock of the subsidiary, would be included in the base for the private foundation's audit-fee tax. [S. Rept. 91-552, pp. 27-28, 1969-3 C.B. 442.]

The Senate agreed with the approach of the Senate Finance Committee, except that (1) the tax rate was reduced to the greater of $100 or one-tenth of 1 percent18 for years after 1970, and (2) the Treasury Department was directed to report

from taxation under section 501(a) for the taxable year, to compensate for the cost of administering the provisions of this chapter, a tax equal to the greater of $100 or one-fifth of 1 percent of the excess of

(1) the aggregate fair market value of all assets of the foundation other than those being used (or held for use) directly in carrying out the foundation's exempt purpose, over

(2) the acquisition indebtedness (determined under section 514(c)(1), but without regard to the taxable year in which the indebtedness was incurred) with respect to such assets.

This was the revenue equivalent of a tax of somewhat more than 4 percent of net investment income as defined in the House bill.

The Senate Finance Committee Report gave the following reasons for seeking to impose this tax: “General reasons for change.—The committee agrees with the House that private foundations should be subject to substantial supervision, of the type appropriate to their receipt of tax benefits under the Internal Revenue Code. It also agrees that the costs of this supervision should not be borne by the general taxpayer, but rather should be imposed upon those exempt organizations whose activities have given rise to much of the need for supervision. Accordingly, the committee agrees that an annual tax should be imposed upon private foundations."

"The committee views this tax as a supervisory fee and as an indication of the amount of funds needed by the Internal Revenue Service for proper administration of the Internal Revenue Code provisions relating to private foundations and other exempt organizations. [S. Rept. 91-552, p. 27, 1969-3 C.B 441-442.]"

18This was the revenue equivalent of a tax of somewhat more than 2 percent of net investment income as defined in the House bill.