bled. No loans have been made to date by Puerto Rican's Government Development Bank. Also, questions have been raised about whether the projects financed with 936 funds are the type of projects that Congress intended.

Let me reemphasize two important facts. There are currently $13 billion in tax-free 936 funds on deposit or invested in Puerto Rico. Investment of $100 million annually, is less than 1 percent-0.8 percent to be exact-of the $13 billion of 936 funds available. Investments of $100 million in CBI countries would leave plenty of 936 funds available for productive use in Puerto Rico. It is hard for some of us to understand why loans of 936 funds have only trickled out of Puerto Rico.

This will be the first subcommittee hearing on this matter. Our intent today is to get the facts. I believe that the facts will speak for themselves. Among other things, I expect to clarify exactly what Puerto Rico understands its commitment to be and exactly what the Congress is to expect in the future. I hope to schedule additional testimony at a later date on this subject.

Now, the Chair will recognize Mr. Schulze for an opening statement.

Mr. SCHULZE. Thank you, Mr. Chairman.

I am pleased to join you in opening our hearing on the use of section 936 funds in the Caribbean region. The original motivation behind section 936 was to provide a tax incentive for corporations to establish business operations in the possessions and territories of the United States.

Such business activity can be helpful in supporting the local economy and creating jobs. This is a praiseworthy objective. As a matter of fact, it is an objective shared by every State and local government in the United States. However, the State and local governments cannot offer the benefits of section 936 to corporations which locate in their jurisdictions.

There are provisions in the Internal Revenue Code which provide a tax incentive to foster some economic objective. Section 936 pushes this general feature to the extreme. The revenue loss associated with section 936 thus far has been out of line with the jobs that it helps create.

Reports show that the revenue loss from section 936 is greater than the wages paid to the persons employed by section 936 corporations. Section 936 was sold to us as an instrument of foreign policy in the Caribbean region, not as sound tax policy. In particular, the government of Puerto Rico urged the retention of section 936 in return for a commitment to invest at least $100 million each year in economic development in the Caribbean region.

Today the subcommittee will review the operation of 936, after the Tax Reform Act of 1986. The tax benefits of 936 to corporations doing business in Puerto Rico are very tangible. They total $1.9 billion in 1989. However, the Caribbean economic development which was supposed to accompany the new section 936 has been much less tangible. We truly want Puerto Rico to become the anchor of economic leadership in the Caribbean. However, so far the trickle down of section 936 benefits to Caribbean development has been extremely slow.

What are the reasons for the slow pace of the Caribbean development activity under 936? What can be done to promote the vigorous use of section 936 to serve as an anchor of development in the region? If section 936 proves to be unworkable, or ineffective in Caribbean development, then we might question the justification for retaining it. The United States might be better off to trim back 936 benefits and let the State Department and the Appropriations Committees use the revenue savings to fund direct foreign aid projects in the region.

Mr. Chairman, the future of section 936 will be strongly influenced by its current track record. The subcommittee should prepare a report card on section 936. Today's witnesses can help us evaluate what grade should be presented.

I look forward to hearing today's witnesses.
Chairman PICKLE. Thank you, Mr. Schulze.

Any other Member have any opening statement?

[No response.]

If not, then Mr. Gideon we are pleased to have you here and we are looking forward to your testimony.

If you will proceed, sir?

STATEMENT OF HON. KENNETH W. GIDEON, ASSISTANT SECRETARY FOR TAX POLICY, U.S. DEPARTMENT OF THE TREASURY Mr. GIDEON. Thank you, Mr. Chairman.

Mr. Chairman and members of the subcommittee, I am pleased to be here today to address this subcommittee on the status of the section 936 program in the Caribbean Basin Initiative countries.

Section 936 of the Internal Revenue Code effectively grants an exemption from Federal income taxes on certain income earned by electing U.S. corporations doing business in Puerto Rico. The exemption applies to the corporation's active business income from Puerto Rico and a certain passive income from Puerto_Rican sources called QPSII, or 936 funds. It is estimated that the Puerto Rican banking system currently holds almost $10 billion in section 936 funds.

The Tax Reform Act of 1986 added income derived from certain investments in qualified CBI countries to the definition of QPSII. Prior to that time, QPSII funds could only be invested in Puerto Rico. This change was perceived to be a means by which Puerto Rico could share its benefits under section 936 while the United States furthered CBI objectives. In the course of developing the legislation the Puerto Rican government pledged to make a good faith effort to make $100 million in these section 936 funds available for CBI purposes each year. Since enactment of the 1986 act, approximately $167 million has been lent to projects in CBI countries under the program.

Congress placed clear limits on which CBI countries and what projects in those countries would qualify. Thus, only CBI countries having effective tax information exchange agreements with the United States are eligible to use 936 funds. The tradeoff required is quite explicit. CBI tax benefits are not available for economic development where the economy is being aided or relies on tax haven activities. The administration supports this fundamental policy.

The last few months have seen an encouraging trend in tax information exchange agreement activity. Until September of 1989, we had effective TIEA's with only four CBI countries: Barbados, Dominica, Grenada, and Jamaica. In October of 1989, a TIEA with the Dominican Republic went into effect and in February of this year, an agreement with Trinidad and Tobago became effective. In addition, our TIEA with Costa Rica is in the ratification stage in Costa Rica and we anticipate having a TIEA with Guyana shortly. Congress also provided that 936 funds may be used only for investments in active business assets and development projects and that the funds be used promptly for authorized purposes only. Last September, the Internal Revenue Service issued temporary and proposed regulations under section 936 (d)(4). Before that, the Treasury Department and the IRS reviewed potential CBI investments submitted to us on a case-by-case basis. This was done in order to assist potential investors in the absence of published regulations, but such approval was not required.

During that period 12 cases were submitted to us for review. And of these, seven cases were approved. We believe that the 936/CBI program benefited from our review of specific transactions. And from the review process we were able to identify many problems associated with CBI investments and, as a result, we were able to provide more relevant and practical guidance in the regulations.

Some of the major issues that we faced included the use of 936 funds for refinancing existing facilities; the use of 936 funds for privatizing nationally owned businesses; the use of Federal guarantees for 936 funds; the arbitrage of 936 funds; the use of multiple financial intermediaries to make 936 loans; and the use of conduit investments.

The regulations generally allow the use of Federal guarantees for 936 loans, and if the obligor is located in a qualified CBI country, conduit investments. The regulations, however, provide that 936 funds may not be used to refinance existing facilities because refinancing does not generate appreciable new assets in a CBI country. In addition, the regulations limit the number of non-Puerto Rican financial intermediaries to one, so that the benefit of a reduced 936 interest rate accrues to the ultimate borrower and not to a series of intermediary institutions. Also, the regulations generally require that a borrower of 936 funds use the funds for authorized purposes within 6 months after obtaining the funds. This requirement was added in order to prevent arbitraging 936 funds; that is, investing the funds in obligations that yield higher interest than the interest the borrower owes on 936 funds. The regulations currently reserve on the issue of privatization, and we are working with the State Department, the Agency for International Development, and the Overseas Private Investment Corporation to develop appropriate definitions and procedures to cover privatization cases. We expect to complete this work in the near future.

You asked the Treasury to address whether the 936 program has been effective in promoting investment and employment in the CBI region and how the program could be improved to better achieve these goals.

Because 936 funds available for lending are private deposits in financial institutions and not public funds, the success of the 936/

CBI program must be evaluated in light of the commercial reality of the CBI market. Financial institutions have been reluctant to make section 936 loans for CBI projects due to the perceived risk involved in investments in the region, except when the institution can obtain a comprehensive guarantee providing commercial and political risk coverage. OPIC may provide such a guarantee. However, OPIC involvement is generally limited to transactions which do not have an adverse impact on the U. S. economy or jobs. Also the problem of a mismatch between potential lenders and borrowers' needs is more pronounced in the 936/CBI market than in the non-936 market. In particular, there is substantial volatility in the short-term corporate deposits on which section 936 lending is based. Therefore, while development projects require long-term financing, financial institutions have generally been reluctant to lend on such terms where they are not assured of a long-term deposit base.

These unavoidable commercial restraints have affected the 936/ CBI program. And the program could be improved if a comprehensive guarantee mechanism existed for CBI investments. The legislative history of the 1986 act makes it clear that the 936/CBI program should operate without additional cost to the United States. It provides that funds for such programs should be made available from possessions corporations, the Government Development Bank funds, and grants by the government of Puerto Rico. We have been informed by Puerto Rican authorities that they recently created a public corporation called the Caribbean Basin Financing Authority which will make 936/CBI loans and provide guarantees for such loans. The future success of the 936/CBI program may depend on the Caribbean Basin Financing Authority's ability and willingness to provide appropriate guarantees.

The efforts of the last few years are just beginning to bear fruit. We now have more TIEA's in place now, and several projects are in development. In the next 2 years we will see whether the program will work as intended. I am hopeful that the economic circumstances in the CBI countries permitting, we will see positive results.

I thank you, Mr. Chairman and members of the subcommittee for the opportunity to testify on this issue, and I will be pleased to answer any questions that you may have at this time.

Chairman PICKLE. Thank you, Mr. Gideon.

We do have questions.

I am going to proceed first and yield to other members. I hope that during this first foray we will try to limit ourselves to the 5 minutes, but we will be able to come back if anybody wanted to ask additional questions. We will have a lot of questions of Mr. Gideon. But thank you for your testimony.

Now, let me ask you first an overall kind of a question.

What commitment did Puerto Rico have with the United States regarding section 936 funds to CBI countries?

Mr. GIDEON. Basically to provide $100 million of those funds a year in CBI loans to other CBI countries.

Chairman PICKLE. More specifically, was there a commitment to make available and to actually loan out $100 million of these moneys?

Mr. GIDEON. I think to use, certainly to use their best efforts and good faith efforts to try. I think that they thought they could do that and I think you should ask the Puerto Rican witnesses

Chairman PICKLE. Well, there is a general feeling, Mr. Secretary, that there was a definite commitment made on the part of Puerto Rico to make these funds available and to actually make it. Do you agree with that?

Mr. GIDEON. Well, I think that there has been an effort to meet that commitment, Mr. Chairman, and I think that, yes. It is true that at the time the companies involved and the Puerto Rican government made a commitment.

Chairman PICKLE. Well, there are a lot of rumors and a lot of data that we have studied that indicate that there was no question about the commitment being made. I wonder, in view of your statement that it was generally agreed that there was a commitment. I wonder if my committee would have your agreement and cooperation for subcommittee staff to review the files down in Treasury regarding this agreement?

[The following correspondence was provided to the subcommittee:]