Statement of Dan Kostenbauder, General Tax Counsel, Hewlett-Packard Company, Palo Alto, California

Hewlett-Packard Company commends Chairman Herger and Chairman McCrery for holding hearings on a bill that would encourage charitable contributions by businesses and individuals.

HP submits this testimony to urge the repeal of section 170(e)(4)(C) of the Internal Revenue Code. Section 170(e)(4)(C) limits the incentives of sections 170(e)(4) and (e)(6) to products "constructed" by the taxpayer. Section 170(e)(4)(C) should be repealed because:

          *Section 170(e)(4)(C) serves no policy objective and is inconsistent with the Congressional goal of encouraging taxpayers to donate computers and other scientific equipment to schools and universities;
          *The "constructed by the taxpayer" requirement imposes significant administrative burdens of taxpayers without any useful purpose;
          *Section 170(e)(4)(C), when applied to 170(e)(6), places greater limits on new equipment than on used equipment; and
          * Section 170(e)(4)(C), when applied to 170(e)(6), imposes unfair burdens on donations to public schools.

HP is a leading global provider of computing and imaging solutions and services for business and home, and is focused on capitalizing on the opportunities of the Internet and the emergence of next-generation appliances, e-services and infrastructure. During its fiscal year ending in October 2000, HP had net revenue of almost $ 49 billion.

Good citizenship is one of HP’s seven corporate objectives. One avenue for achieving this objective is corporate philanthropy. Following in the footsteps of our founders, Dave Packard and Bill Hewlett, HP has given significantly to philanthropic causes, particularly U.S. universities. For example, last year HP made charitable contributions of almost $52 million worldwide, with over $ 29 million in the United States.

Congress has encouraged philanthropy by allowing charitable contribution deductions against income and other taxes. Over the years, Congress has identified three particular areas where it provides certain donors an enhanced tax deduction (cost plus one-half of gross profit, limited to two times cost). The three areas relate to care of the ill, needy and infants (section 170(e)(3) adopted in 1976), scientific equipment for US universities (section 170(e)(4) adopted in 1981), and PC’s for K-12 (section 170(e)(6) adopted in 1997).

To be eligible for the incentives under sections 170(e)(4) relating to contributions of scientific equipment to US universities, subparagraph 170(e)(4)(B)(ii) requires that scientific equipment or apparatus donated by a corporation must be "constructed" by the taxpayer. To be eligible for the incentives under sections 170(e)(6) relating to the special rule for contributions of computer technology for elementary or secondary school purposes, section 170(e)(6)(D) provides that the "constructed by the taxpayer" requirement of 170(e)(4)(C) must be satisfied.

Section 170(e)(4)(C) provides as follows:

(C) CONSTRUCTION OF PROPERTY BY TAXPAYER --For purposes of this paragraph, property shall be treated as constructed by the taxpayer only if the cost of the parts used in the construction of such property (other than parts manufactured by the taxpayer or a related person) do not exceed 50 percent of the taxpayer's basis in such property.

Section 170(e)(4)(C) should be repealed because it serves no useful policy objective while imposing tremendous administrative and compliance burdens on taxpayers that respond to the incentives under section 170(e)(4) and 170(e)(6).

Section 170(e)(4)(C) serves no useful policy objective. The objective of both section 170(e)(4) and 170(e)(6) is to encourage modern scientific and computer equipment to be donated to U.S. schools. There is no need to limit such incentives to companies that "construct" equipment within this peculiar definition. Sections 170(e)(4) and (6) have other provisions that ensure that the only eligible property is new inventory used first by the donee.

Furthermore, an overly restrictive reading of the requirements of section 170(e)(4)(C) could lead to the conclusion that almost no scientific or computer equipment is "constructed" by anyone. This is because today’s sophisticated equipment and computers are full of integrated circuits, circuit boards, and other components that are purchased from a wide variety of suppliers. If these were all considered "parts" for purposes of section 170(e)(4)(C), it is possible that their value would exceed 50% of the taxpayer’s basis (manufacturing cost) of the product. Since most manufacturers of computers, in particular, buy their computer chips and other components (hard drives, monitors, keyboards, memory, floppy drives, CD-drives, etc.) from the same group of unrelated suppliers, it is conceivable that no manufacturer of computers would qualify as constructing computers under the definition set forth in 170(e)(4)(C).

The legislative history of sections 170(e)(4) and 170(e)(6) provides no explanation whatsoever for the inclusion of the "constructed by the taxpayer" requirement. See Ways and Means Committee Report, p.120, and Senate Finance Committee Report, p. 140, on the Economic Recovery Tax Act of 1981, and Ways and Means Committee Report, p. 38, Conference Committee Report, pp. pp373-374 on H.R.2014 (1997).

In addition to having no identifiable policy objective, section 170(e)(4)(C) imposes inordinate administrative and compliance burdens on taxpayers. These burdens can be demonstrated by reference to HP’s procedures for complying with section 170(e)(4)(C).

During any year, HP donates at least one unit of hundreds of different models of scientific equipment or computers that would otherwise be eligible for the enhanced deductions under sections 170(e)(4) or (6). This means that for each of these hundreds of models, HP needs to determine whether it has "constructed" the model for purposes of 170(e)(4)(C) before it can claim the enhanced deduction under sections 170(e)(4) or (e)(6). To do this, HP must create a list of each of these different models that has been donated during the year, separated by the division that supplies each of these products (PC’s, printers, scanners, servers, etc.). This list is then distributed by the HP tax department to the controllers of each of those divisions. This request is distributed so broadly because the detailed cost data required to perform the analysis for purposes of 170(e)(4)(C) is not available centrally. The request for this information is accompanied by instructions about how to determine whether or not a product is "constructed" within the meaning of 170(e)(4)(C). The controllers then forward this request to the appropriate financial staff, usually cost accountants, who then do a detailed analysis of each product. Since the rules for doing this computation are unfamiliar to the individuals doing this analysis, there are often questions to be answered by HP’s tax department. There is always a need for regular follow-up to ensure that all product divisions complete their responses in a timely way. When the analysis is complete, it is transferred to the HP Corporate Philanthropy department, which enters all models that do not qualify in a table located within a computer program for computing the enhanced tax deductions under section 170(e)(3), (4), and (6). As the enhanced deduction is computed for each product, there is a query from the system to the table to determine whether or not a product is disqualified from the enhanced deduction because it fails to satisfy the requirements of 170(e)(4)(C). In addition, the background material developed for this effort must be retained in a special fashion. This is because there is no routine business need to keep the detailed cost data needed to make the section 170(e)(4)(C) analysis as long as could be necessary in the event that the Internal Revenue Service requires it for purposes of their audit of HP, which covers every year. This process is extremely time-consuming and complex. Corresponding audit burdens are also placed on the IRS by section 170(e)(4)(C).

In addition to its extremely factual nature, making a valid assessment of whether a product qualifies under section 170(e)(4)(C) is made more difficult because no regulations have ever been issued with regard to this provision, even though it was enacted in 1981. Some of the inherent difficulties of applying section 170(e)(4)(C) relate to the fact that a number of its terms are not widely used elsewhere in the Internal Revenue Code.

Of critical importance is the meaning of the word "parts." In the context of high-tech electronic equipment and computers, however, it is not nearly as clear as one might think. For example, many of the purchases that a computer manufacturer makes in order to build a computer might be called: components, assemblies, sub-assemblies, boards, integrated circuits, motherboards, memory boards, memory modules, floppy disk drives, hard drives, CD-drives, CD-writers, keyboards, monitors, batteries, cables, etc. In common parlance, these might all be called "parts." If they were all treated as "parts" for purposes of section 170(e)(4)(C), however, then it might be argued that there in no company on the planet that "constructs" computers within the meaning of that section. Such a result would clearly be inconsistent with the intent of Congress to provide an incentive for donations of high-tech equipment and PC’s to the US educational system, from kindergarten through universities. This lack of clarity as to the meaning of "parts" adds to the administrative and compliance burden on taxpayers in their effort to ensure that they satisfy the requirements of section 170(e)(4)(C).

There are several other challenges in interpreting section 170(e)(4)(C). It treats parts purchased from "related parties" in a favorable way. It is not clear exactly which suppliers would be considered "related parties" for this purpose. Also, it is not clear whether a finished product purchased from a related party would qualify as "constructed" by the taxpayer. If all of the parts were purchased from the related party by the taxpayer and assembled, they would meet the test. Why should the test not be satisfied if the finished product is purchased from the taxpayer? The other question inherent in any effort to apply the "constructed by the taxpayer" test under section 170(e)(4)(C) is the degree to which "parts" purchased by one operation of a taxpayer and processed further and then passed on to still another operation of the taxpayer must be traced back to the original purchase from an unrelated party. An expansive tracing requirement would magnify the administrative effort described above immensely.

Section 170(e)(6)(D) provides that the rules of section 170(e)(4)(C) apply to section 170(e)(6). This requirement should be eliminated from Section 170(e)(6) because it both limits and complicates the incentive. Section 170(e)(6) applies not only to property constructed by the donor, but also to inventory acquired for resale and property used in a donor's business. However, the requirements of section 170(e)(4)(C) apply only in the case of new inventory supplied by the manufacturer, and not to used computers purchased from a manufacturer. There is no policy rationale that would justify imposing a more onerous substantive and administrative requirement on donations of new, as opposed to used, computers.

Section 170(e)(6)(D) provides that the rules of section 170(e)(4)(C) apply to section 170(e)(6). Therefore, the burden of complying with section 170(e)(4)(C) clearly applies to the incentives under for section 170(e)(6). The burden, however, would only apply to donations to public schools at the K-12 level. This is because donations to private schools could be eligible for an equivalent enhanced deduction under section 170(e)(3), relating to the care of the ill, needy and infants, which does not have the "constructed by the taxpayer" requirement. See, for example, LTR 9528022.

If section 170(e)(4)(C) is repealed, then sections 170(e)(4)(B)(ii) and 170(e)(6)(D) should also be repealed, since they are the two provisions that impose the requirements of section 170(e)(4)(C) on 170(e)(4) and (6) contributions, respectively.

Hewlett-Packard Company greatly appreciates the opportunity to offer its views on this matter and is available to provide further information or to answer such questions as Members of the Committee may have.