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Books of special value and gift books, when the giver wishes it, are not allowed to circulate. Readers are asked to re- port all cases of books marked or mutilated. Do not deface books by marks and writing. Cornell University Library HJ4653.E8 M781 1921 Excess profits tax,,RroSSflV,'',Biiii;i?™iiiir olin 3 1924 030 220 952 Cornell University Library The original of tiiis book is in tine Cornell University Library. There are no known copyright restrictions in the United States on the use of the text. http://www.archive.org/details/cu3l924030220952 EXCESS PROFITS TAX PROCEDURE 1921 Including Federal Capital Stock (Excise) Tax BY ROBERT H. MONTGOMERY, C. P. A. of Lybrand, Ross Brothers and Montgomery ; Attomey- at-Law; Former President, American Association of Public Accountants; Professor of Accounting, Columbia University New York THE RONALD PRESS COMPANY 1921 > Copyright, 1921, by Robert H. Montgomery ^-J? PREFACE In the 1920 edition of Excess Profits Tax Procedure I was optimistic enough to prophesy that the excess profits law might be abandoned in 1920, but Congress has had two good chances to repeal it without taking action, so that the situation in Jan- uary, 1 92 1, is much the same as in January, 1920. I do think, however, that taxpayers who, for other than tax reasons, find it desirable to make changes in their organization can count with some confidence on the repeal of the law as of January I, 192 1. In any event, the chances in favor of repeal are greater than the chances of its continuance. This book contains much new material. All published rulings and decisions of the Treasury during 1920 have been considered and are quoted in full or commented upon when- ever the points involved were of interest. In addition I have dealt with the principles at issue in many cases which have not been made public. Some progress (but not much rela- tively) has been made in the interpretation of the 191 7 and 1918 laws. The Supreme Court will have to decide some important cases dealing with invested capital. With no de- cisions as yet to guide us and with a vast number of disputed returns to be adjusted, it is safe to say that our real troubles with the excess profits tax are just beginning. I am inclined to think that there will be a 1922 edition of this book and that it will contain much new material. In addition to those who assisted me in the preparation of Income Tax Procedure, 1921, I wish to acknowledge my thanks to two of my assistants in the preparation of this book : to Hamilton Howard, who prepared (but who is not solely responsible for) the chapters on "Consolidated Returns," and to S. L. Heacock, who prepared the chapter on the "Capital Stock (Excise) Tax." Robert H. Montgomery. 55 Liberty St., New York, February 10, 1921. iii CONTENTS Chapter Page I Introductory 3 II Administration and Application of the Law . 12 III Exemptions 18 IV Returns 29 V .Computation and Rates of the Tax ... 41 VI Credits and Specific Exemptions . . . . 109 VII Invested Capital Described — Borrowed Money 122 VIII Invested Capital — Adjustment of Asset Values 142 IX Inadmissible Assets 190 X Adjustment of Capital, Surplus, Reserves and Liabilities 225 XI Changes in Invested Capital During the Tax- able Year 252 XII Pre-War Invested Capital 276 XIII General Principles of Consolidated Returns . 282 XIV Consolidated Returns of Affiliated Corpora- tions 304 XV Invested Capital in Special Cases — "The Relief Sections" 331 XVI Adjustment of Net Income for Taxable and Pre-War Years 362 XVII Reorganizations 382 XVIII Income from Government Contracts . . . 404 XIX Nominal Capital — The 191 7 Tax (Former Procedure) 414 XX Federal Capital Stock (Excise) Tax . . . 433 Appendices A — Illustrations of Returns 473 V vi CONTENTS Chapter Page B — Forms 483 C — War Profits and Excess Profits Tax Law — 1918 537 Indexes Index to Sections of Excess Profits Tax Law 551 Index to Articles of Regulations 45 and Regu- lations 50 553 General Index 557 EXCESS PROFITS TAX PROCEDURE 1921 CHAPTER I INTRODUCTORY The excess profits tax law of 191 7 applied to individuals, partnerships and corporations for the year 19 17. The excess and war profits tax law of 1918 applies only to corporations. The war profits tax imposed by the 1918 law did not apply after January i, 1919 (except to unfinished government con- tracts), and the excess profits tax rates imposed by the 19 18 law are considerably reduced for 19 19 and 1920. The pro- cedure under the 1917 and 1918 laws was fully discussed in the author's Income Tax Procedure, 1918 and 1919 editions. Beginning with 1919 practice several factors combine to make desirable separate volumes on excess profits tax procedure. In the first place, the statute now applies to corporations only and, consequently, the procedure is of interest only to this limited class. Next, the body of interpretive material relating to in- come and profits taxes has grown to such proportions that a single volume which attempts an adequate treatment of both taxes is inconveniently large. Finally, great uncertainty sur- rounds the future of the profits tax and the possibility that it may be abandoned during the next few months makes it advantageous to have the procedure relating to it in a separate volume. Plan of the book. — This volume should be used in conjunc- tion with the latest edition of the author's Income Tax Pro- cedure. The aim has been to avoid duplicating here material presented in that volume. The excess profits tax is, of course, a variant of the income tax. It takes the profits of a corpora- tion as determined for income tax purposes, subjects them to definite tests to determine their reasonableness and applies rates which vary with the so-called excessiveness of the profits 3 4 EXCES:^ PROFITS TAX PROCEDURE SO ascertained. Consequently it is inevitable that the pro- cedure under a tax such as this should be to a considerable extent interlocked with that under the income tax. The solu- tion adopted here is to make this book practically a supple- ment to the other. Frequent cross-references are made to Income Tax Procedure, 1921, in the expectation that the user of this book will have access to that treatise. Procedure relating to the federal capital stock (excise) tax appears this year for the first time in this volume. The tax, like the profits tax, is imposed on corporations only and space no longer permits its inclusion in Income Tax Procedure. The general plan is the same as that used in the income tax volume. The law and the regulations bearing on a par- ticular point are first quoted verbatim, followed by the author's explanations, criticisms and suggestions. The wide differ- ences between the procedure under the 1917 law and the 1918 law make former procedure an important feature of the treat- ment. Treasury Regulations 45 as revised from time to time con- stitute the ofificial interpretation of the law. All regulations bearing on the excess profits tax are reproduced and discussed herein. For convenience Regulations 45 are quoted by article numbers. Other regulations and decisions are cited in detail. The rulings of the Treasury which are issued weekly as bulletins contain the official interpretations of the law and regulations. The following illustrates the method and mean- ing of bulletin citation: B. 2-20-679; A. R. M. 12, refers to the second bulletin issued in 1920, serial number 679, quoting memorandum No. 12 of the Committee on Appeals and Re- view. The following abbreviations are used : T. D Treasury decision. Op. A. G Opinions of Attorney General. O Solicitor's law opinion. S Solicitor's memorandum. T. B. R Advisory Tax Board recommendation. T. B. M Advisory Tax Board memorandum. A. R. R .Committee on Appeals and Review recommendation. INTRODUCTORY 5 A. R. M Committee on Appeals and Review memorandum. O. D Office decision. ABC, etc Represent the names of individuals. M N X Y Z, etc. . Represent the names of corporations, places, or bus- inesses according to context. X Is used to represent a certain number. X dollars or $.r. . . Is used to represent a sum of money, x preceded by a number (15^) represents an amount equal to the amount represented by x multiplied by the number preceding x. Origin and development of profits taxation. — Excess profits taxation found its origin in tlie exigencies of the great war. It was first introduced in England, in September, 1915, largely as a concession to the labor element which agreed to co-operate in a program of war production on condition that steps were taken to recapture profits. Much support was found for the measure, moreover, in the feeling which existed in the com- munity generally that no one should be permitted to grow rich from the war. The English plan called for a 50 per cent levy (later increased to 80 per cent, in 19 19 reduced to 40 per cent and in 1920 raised to 60 per cent) upon the increase in the profits of business enterprises over the standard achieved in the years of a pre-war period.^ Almost simultaneously with England, Germany established a war profits tax as a part of her program of 1915. Other nations followed, until practically all the belligerents and many of the neutrals applied such a tax in some form or other. The excess profits tax of March 3, 1917. — The first excess profits tax in this country was passed while the United States was still neutral. On March 3, 19 17, Congress passed a law imposing a tax of 8 per cent upon the profits of corporations 'Parliamentary Debates, House of Commons, September 21, 191S, Vol. 74, No. 94, page 349. The British statute, however, has always con- tained a provision permitting at the option of the taxpayer the use of a standard of invested capital. For details see Robert Murray Haig, "The Taxation of Excess Profits in Great Britain," Special Supplement to Amer- ican Economic Review, December, 1929. 6 EXCESS PROFITS TAX PROCEDURE and partnerships in excess of $5,000 plus 8 per cent of the "actual capital invested." This phrase was defined as "(i) actual cash paid in, (2) actual cash value at the time of pay- ment of assets other than cash paid in, and (3) paid-in or earned surplus and undivided profits used or employed in the business but does not include money or other property bor- rowed by the corporation or partnership" (section 202). Before this act became generally applicable, war was de- clared and this simple rudimentary profits tax was replaced by the Act of October 3, 191 7. The first excess profits tax was therefore of no significance even to the few concerns which chanced to go out of business during the seven-month period when it was in force. Such concerns, it was held, were subject to the Act of October 3, 1917.^ The 191 7 excess profits tax. — American business men con- sequently received their first real contact with excess profits taxation through the Act of October 3, 191 7, which taxed cor- porations, partnerships and individuals on the excess profits arising after January i, 191 7. Like its short-lived prede- cessor, this law determined the so-called excessiveness of profits by reference to a standard of invested capital. How- ever, the rates were not only made very heavy but were also made progressive, the more "excessive" profits paying larger taxes. The rates varied from 20 per cent to 60 per cent, the highest rate applying to profits in excess of 33 per cent return on invested capital.^ The line above which profits were deemed excessive was established by adding together the specific exemption ($3,000 for corporations and $6,000 for individuals and partnerships) and a percentage upon the capi- tal invested varying from 7 to 9 per cent, depending on how prosperous the concern had been in the pre-war period. In the case of businesses with "no invested capital or not more "Letter to Joseph and Alvin T. Sapinsky, New York, N. Y., signed by Deputy Commissioner L. F. Speer, and dated November 17, 1917; see also Bulletin 12-20-794; A. R. R. 43. 'For a full stalemenl of the rates, see page 96. INTRO.DUCTORY 7 than a nominal capital"* a rate of 8 per cent was applied to the net income in excess of the specific exemption. Consequently this rate applied to most professional and other "earned" incomes. This law was a brilliant fiscal success but was open to severe criticism from many other points of view. It was un- fair in its scope, operating as a differential against earned incomes. It was uneven in its application, taxing concerns of substantially the same strength at widely different rates, de- pending upon accidents in their financial history. It was so poorly drafted that only by the most heroic administrative measures was it made workable at all. Complicated as this tax appeared to be, it was not suffi- ciently refined and flexible to secure that approximate equality in the distribution of the burden without which a tax becomes unendurable. Some relief was obtained through the Treas- ury's liberal interpretation of section 210, which permitted the deduction — in cases in which invested capital could not be satisfactorily determined — to be fixed with reference to that of representative concerns engaged in a similar trade or busi- ness. Through the exercise of administrative discretion to an extent which can be justified only when one considers the seriousness of the issues involved, this section was apphed when invested capital, even though definitely known, was "seriously disproportionate" to the taxable income. In a number of other particulars the Treasury found it necessary practically to amend the law by interpretation in order to avoid glaring injustices. Thus in the determination of invested capital, tax-exempt securities, declared by the law to be inadmissible, were under certain conditions admitted as assets. Money borrowed by corporations was also admitted, in spite of the law, to an extent determined by the amount upon which they were not permitted to deduct interest under the income tax. Again, in determining income, the Treasury per- mitted the deduction of salaries for proprietors of concerns, '1917 law, section 209. 8 EXCESS PROFITS TAX PROCEDURE whether actually paid in 191 7 or not, although the law con- tained no specific provisions therefor. Finally, the Treasury apparently found it necessary to do violence to the law in order to give to small concerns the full benefit of the stated deduction in cases in which it was greater in amount than 15 per cent of the invested capital. That such a faulty, poorly framed law should have achieved the measure of success it did was due largely to the courageous and intelligent administration of it by the Treas- ury. The 1918 law. — Eagerness on the part of the Treasury to be relieved of some of the responsibility it had assumed by its liberal interpretation of the 19 17 law was largely responsible for the Revenue Act of 1918, which made radical changes in the excess profits tax law. The most striking feature was the addition to the statute of a new test of the so-called ex- cessiveness of profits, coupled with a differeYit rate, which was to apply as an alternative to the old invested capital test in cases where it would yield a higher tax. This alternative fea- ture of the tax was a novel one. Little can be said for it ex- cept that it imposed a tax on a number of concerns which would have been less heavily taxed had the invested capital plan been used alone. The new test of excessiveness of profits introduced at this time was copied from the English system. Profits in the tax- able year were compared with those in a pre-war period and a rate of 80 per cent was imposed on the excess. An allowance of 10 per cent was made for new capital or surplus accumulated since 1913, except in the case of new concerns when the allowance for new capital in some cases is more than 10 per cent. It is interesting that resort to the English plan did not take place until five years after the expiration of the pre-war period and not until the English themselves were on the point of abandoning it because it had grown unfair and anomalous with the passage of time. The alternative arrangement under INTRODUCTORY 9 the 1918 law was made to apply for one year only, except as to profits from government contracts. At the same time when this new test of pre-war earnings was introduced, the rates imposed under the old invested capital standard were changed and made 30 and 65 per cent. The 30 per cent rate applied to the pirofits in excess of the credit, consisting of 8 per cent of invested capital plus the specific exemption of $3,000, but not in excess of 20 per cent of the invested capital. The 65 per cent rate applied to profits above 20 per cent of capital. Congress wrote into the new law the more important rulings which the Treasury had evolved in its effort to make the 1917 law reasonable and equitable. Non-taxable securities are not invariably to be deemed inad- missible assets. The allowance to corporations of full deduc- tion® under the amended income tax law for interest paid eliminated the necessity of admitting as assets the portion of borrowed money corresponding to the interest which could not be deducted. Full deduction was allowed of the "credits" even though the sum exhausted the amount in the "first bracket" and carried over into the second. The tax became efifective January i, 1918, although it did not become a law until February 24, 1919. It is impossible adequately to express one's views of lawmakers who impose enormous tax burdens as of a date fourfeen months prior to the enactment of the laW. The taxpayers of the country should remember the inconvenience caused by this tardy legislation and see to it that Congress completes in seasonable time the revision of the revenue act contemplated in 1921. The statute for 1919 and 1920. — The law as it applies to 1919 and 1920 profits is radically different from the 1918 schedule, the changes having been embodied in the statute itself at the time it was passed. In the first place the alterna- 'Except in so far as the interest on money borrowed for the pur- chase of tax-exempt securities is concerned. In this case the 1918 law makes provision for the admission, of a proportionate amount of assets. [Section 325 (a).] lO EXCESS PROFITS TAX PROCEDURE tive plan with its English test of pre-war earnings disappears and the tax is once more on the single standard of invested capital, except when profits in excess of $10,000 have been realized from government contracts made after April 5, 191 7, and prior to November 12, 1918. In the second place, the rates are considerably reduced, being 20 and 40 per cent instead of 30 and 65 per cent. Future of the excess profits tax. — In December, 19 19, the Secretary of the Treasury, in his annual report," recommended the elimination or reduction of the excess profits tax on the grounds, among others, that it "encourages wasteful expendi- ture, puts a premium on overcapitalization and a penalty on brains, energy and enterprise, discourages new ventures and confirms old ventures in their monopolies." This recommen- dation has been reiterated in subsequent Treasury pronounce- ments and has been recorded by trade organizations too numerous to be mentioned. What effect these recommenda- tions will have upon Congress cannot be foretold. Such great pressure is being brought to bear by business men that the tax will probably be entirely swept away in the near future. It is the author's prophecy that 1920 incomes will be the last to be subject to excess profits taxation.' This volume deals solely with procedure under the 191 7 and 1918 laws. Those who are interested in the general as- pects of excess profits taxation are urged to read "The Taxa- tion of Excess Profits in Great Britain — A Study of the British Excess Profits Duty in Relation to the Problem of Excess Profits Taxation in the United States," by Professor Robert Murray Haig, Ph. D., which appears as a special sup- plement to the American Economic Review, December, 1920. Is incorporation desirable? — It is hardly worth while to 'Page 23. 'This paragraph appeared in the 1920 edition of this book. The situa- tion in January, 1921, justifies its quotation without any change. INTRODUCTORY II estimate the relative advantages of partnerships and corpora- tions in the future. If corporate taxation is substantially reduced it is probable that another attempt will be made to tax the individual stockholders of a corporation upon undis- tributed profits. If some practicable method of taxing undis- tributed profits is not enacted the corporate form of organiza- tion w^ill be preferable, unless it is found to be lawiul to tax a partnership as such upon the same basis as a corporation. CHAPTER II ADMINISTRATION AND APPLICATION OF THE LAW Administration Administration of the excess profits tax sections of the 1918 law is in the hands of the Commissioner of Internal Revenue, referred to hereafter as the "Commissioner," sub- ject in some respects to the general supervision and control of the Secretary of the Treasury. The organization and procedure of the Bureau of Internal Revenue are fully described in Income Tax Procedure, 192 1. Committee on Appeals and Review. — The 19 18 law [sec- tion 3101 (d-ii)] provides for a board called the "Advisory Tax Board" to which the Commissioner of his own motion may and, on request of a taxpayer, must submit questions re- lating to the interpretation or administration of the income and excess profits tax laws. The Board was appointed in ■ March, 19 19. After about six months' service it was dis- solved on October i, 1919, under statutory power of the Com- missioner. It had a large influence in the interpretation of and procedure under the new law. It is now succeeded by the "Committee on Appeals and Review," appointed by the Com- missioner from the official personnel of the Treasury.^ The Committee is composed of experienced men who give careful consideration to all questions referred to them. Upon request, hearings are granted whenever taxpayers appeal from the findings of one of the subordinate sections of the Bureau. Mr. P S. Talbert, formerly the chairman of this commit- tee, recently made the following statement in the course of a lecture at Columbia University: 'For a full discussion of the Advisory Tax Board and the Com- mittee on Appeals and Review, see Income Tax Procedure, 1921, page 160 et seq. 12 ADMINISTRATION AND APPLICATION 13 Shortly before leaving the service, being curious as to exactly what extent the committee had afforded relief to the taxpayer in actual practice, I had an examination made of all of its recommenda- tions, and found that in 40 per cent of all cases handled, it had re- versed the Unit and allowed the taxpayer's claims in full; in 37 per cent it had supported the Unit and rejected the taxpayer's conten- tions, and in 23 per cent it had in part supported the taxpayer's claims and in part the views of the Unit.^ The author is convinced of the sincerity and abiHty of the members of the Committee. He is convinced, however, that because of a grave defect in its fundamental character as an administrative body officially connected with the Treasury it cannot function as a satisfactory adjustment agency. As the author has been charged with undue criticism of the administration of the income and excess profits tax laws he is eager to make it clear that in his opinion the apparent disposition of the Committee to decide doubtful points in favor of the government is due to a weakness inherent in its form of organization as a Treasury body. The author was a member of the War Department Board of Appraisers. Theo- rectically, the Board acted impartially. Practically, the Board was compelled to present the government's side of a case and also to attempt to weigh the testimony of each side with an open mind. This cannot be done. We are all too human to shift quickly and in the same case from prosecuting attorney to judge and jury. The law should provide for an appeal board entirely separate from the Treasury. The Board should sit as a court and give equal attention to the taxpayer and the Bureau. Its decisions should be on the facts and not on the theory that all doubtful cases should be against the taxpayer, on the old principle that he can get relief in the courts. The only relief (?) many taxpayers will get in such cases will be in the bankruptcy courts! Manner of assessment and payment. — The law provides that the taxes imposed by the provisions of the excess profits ^Columbia University Lectures, The Federal Income Tax, page 257. 14 EXCESS PROFITS TAX PROCEDURE sections shall be paid at the same times and places, in the same manner and subject to the same conditions, including penalties, as are provided in the case of corporation income taxes.' Law. Section 336. That every corporation, not exempt under section 304, shall make a return for the purposes of this title. Such returns shall be made, and the taxes imposed by this title shall be paid, at the same times and places, in the same manner, and subject to the same conditions, as is provided in the case of returns and pay- ment of income tax by corporations for the purposes of Title II, and all the provisions of that title not inapplicable, including pen- alties, are hereby made applicable to the taxes imposed by this title. Regulations and rulings. — The administration of the ex- cess profits tax law is governed by Regulations 45 and by other rulings issued from time to time by the Treasury.* Types of Corporations Liable to the Tax The igiiS law imposes the excess profits and war profits taxes only on corporations. However, several forms of busi- ness organizations besides actual corporations are included by the act in the term "corporation" and consequently are taxable as corporations. Law. Section i The term "corporation" includes asso- ciations, joint-stock companies, and insurance companies ; Foreign corporations are taxable upon net income derived from sources within the United States and are not entitled to the $3,000 exemption. Personal service corporations are subject to the full gradu- ated rates of the excess profits tax if 50 per cent or more of their net income is derived from government contracts. The following classes of organizations are treated as cor- porations for the purposes of the excess profits tax: Penn- sylvania limited partnerships, Michigan partnership associa- 'See Income Tax Procedure, 1921, Chapter VII. 'For full discussion, see Chapter I. ADMINISTRATION AND APPLICATION 15 tions, Ohio partnerships, when organized under sections 8059- 8078 of the Ohio code, Virginia partnerships formed under the Viriginia code of 1904, but not in some cases if formed under the March 4, 1918, law, Massachusetts trusts" and all other limited partnerships whose status is doubtful unless they submit satisfactory evidence that they should not be so treated. The following organizations are not treated as corporations: New York, Michigan and Illinois limited partnerships; Cali- fornia special partnerships; and joint ventures. Limited partnerships as corporations. — Regulations If, however, the cestuis que trust have a voice in the conduct of the business of the trust, whether through the right periodically to elect trustees or otherwise, the trust is an association within the meaning of the statute. (Art. 1504.) .... limited partnerships of the type of partnerships with lim- ited liability or partnership associations authorized by the statutes of Pennsylvania and of a few other States are only nominally part- nerships. Such so-called limited partnerships, offering opportunity for limiting the liability of all the members, providing for the trans- ferability of partnership shares, and capable of holding real estate and bringing suit in the common name, are more truly corporations than partnerships and must make returns of income and pay the tax as corporations. The income received by the members out of the earnings of such limited partnerships will be treated in their personal returns in the same manner as distributions on the stock of corporations. In all doubtful cases limited partnerships will be treated as corporations unless they submit satisfactory proof that they are not in effect so organized. A Michigan partnership associa- tion is a corporation. Such a corporation may or may not be a per- sonal service corporation. (Art. 1506, as amended by T. D. 2943, signed by Commissioner Daniel C. Roper, and dated November 6, 1919.) °See Crocker v. Malley, Collector, 249 U. S. 223. In this case the question was whether distributions to the shareholders of a certain "Massachusetts trust" were taxable as dividends. The Supreme Court held that the trust was not to be classed as a corporation but as a trust in the ordinary sense. The trust in question, however, existed for the purpose of liquidating certain property and only incidentally for carrying on business, and the shareholders had no direct control of the choice of trustees. See also Income Tax Procedure. 1921, Chapter IV. l6 EXCESS PROFITS TAX PROCEDURE Joint ownership and venture associations as corpora- tions. — Regulation. Joint ■ investment in and ownership of real and personal property not used in the operation of any trade or business and not covered by any partnership agreement does not constitute a partnership. Co-owners of oil lands engaged in the joint enter- prise of developing the property through a common agent are not necessarily partners. In the absence of special facts affirmatively showing an association or partnership, where a vessel is owned by several individuals and operated by a managing owner or agent for the account of all, the relation does not constitute either a joint- stock association or a partnership. The participation of two United States corporations in a joint enterprise or adventure does not con- stitute them partners. (Art. 1507.) Transportation systems subject to the tax. — Law. Section 301. (e) For the purposes of the Act approved March 21, 1918, entitled "An Act to provide for the operation of transportation systems while under Federal control, for the just compensation of their owners, and for other purposes," the tax im- posed by this title shall be treated as levied by an Act in amendment of Title II of the Revenue Act of 1917. Regulation. The Act to provide for the operation of trans- portation systems while under federal control, for the just compen- sation of their owners, and for other purposes, of March 21, 1918, authorizes the President to agree with carriers for their just com- pensation and provides: "Every such agreement shall provide that any federal taxes under the Act of October third, nineteen hundred and seventeen, or Acts in addition thereto or in amendment thereof, commonly called war taxes, assessed for the period of federal control beginning January first, nineteen hundred and eighteen, or any part of such period, shall be paid by the carrier out of its own funds, or shall be charged against or deducted from the just compensation; that other taxes assessed under federal or any other governmental authority for the period of federal control or any part thereof, either on the property used under such federal control or on the right to operate as a carrier, or on the revenues or any part thereof derived from operation (not including, however, assessments for public improve- ments or taxes assessed on property under construction, and charge- able under the classification of the Interstate Commerce Commis- sion to investment in road and equipment), shall be paid out of reve- nues derived from railway operations while under federal control; that all taxes assessed under federal or any other governmental au- ADMINISTRATION AND APPLICATION 17 thority for the period prior to January first, nineteen hundred and eighteen, whenever levied or payable, shall be paid by the carrier out of its own funds, or shall be charged against or deducted from the just compensation." (Art. 504.) [Former Procedure] Individuals and partnerships. — The 191 7 law imposed the excess profits tax vipon individuals and partnerships as well as upon corpora- tions. The procedure under the 1917 law was greatly modified by the 1918 law which affects corporations only. Individuals in "trade or business" were subject to the graduated rates of tax. Individuals deriving their income from professions, salaries and other personal services were subject to a rate of 8 per cent (section 209). Regulation. "In the case of an individual, the terms 'trade,' "busi- ness," and 'trade or business' comprehend all his activities for gain, profit, or livelihood, entered into with sufficient frequency, or occupying such portion of his time or attention as to constitute a vocation, including occupations and professions. When such activities constitute a vocation they shall be construed to be a trade or business whether continuously carried on during the taxable year or not, and all the income arising therefrom shall be included in his return for excess profits tax. "In the following cases the gain or income is not subject to excess profits tax, and the capital from which such gain or income is derived shall not be included in 'invested capital' : (a) gains or profits from transactions entered into for profit, but which are isolated, incidental, or so infrequent as not to constitute an occupation, and (b) the income from property arising merely from its ownership, including interest, rent, and similar income from investments except in those cases in which the management of such investments really constitutes a trade or business." (Reg. 41. 1918. Art. 8.) There have been many rulings defining "trade or business." Trans- actions which were obviously isolated were held not to be subject to the tax. On the other hand the tax has been imposed in cases which the law was not intended to cover. The author has been informed that in many cases the 8 per cent tax has been improperly imposed upon individuals on account of isolated profits from underwritings and similar investment transactions. Taxpayers should bear in mind that when an assessment has been made which does not appear to conform to the regulations, an appeal to the Commissioner is always permissible. CHAPTER III EXEMPTIONS All individuals and partnerships are exempt under the 1 918 excess profits tax law; also the following corporations: 1. Corporations generally which are not organized for profit.' 2. Personal service corporations.'' 3. Corporations whose net annual income is less than $3,000.' 4. Corporations engaged in gold mining so far as their income accrues from this source.* 5. Corporations owning vessels operated in foreign trade to the extent of earnings from such vessels." 6. Corporations deriving profits from sale of vessels, under certain conditions." The exclusion of individuals and partnerships from the imposition of the tax marks the most radical departure from the 1917 law.' It might seem to be apparent that this entire exemption from any excess profits tax would in every case be 'Section 231. 'Section 200. 'Section 304 (b). 'Section 304 (c). "See page 24. "See page 26. '[Former Procedure] Under the 191 7 law the only exemptions were: corporations not organized for profit; "weekly-payment" insur- ance companies; officers of the state and federal governments (except congressmen) ; individuals and partnerships with net income of less than $6,000 and domestic corporations with net income of less than $3,000. Foreign corporations and partnerships and non-resident alien individuals were not entitled to the specific exemption of $3,000 and $6,000, nor to any exemption whatever except that the tax was not imposed at all unless the net income from sources within the United States exceeded $3,000. (Sections 202 and 203.) If the net income exceeded $3,000, the tax was imposed on the entire net income and at the 8 per cent rate or the graduated rates, depending on the status of the taxpayer. 18 EXEMPTIONS 19 an advantage great enough to throw the balance in favor of the individual or partnership form of organization, but this does not take into account the advantage possessed by the cor- poration in that profits are not subject to individual surtaxes until distributed. Partnerships are exempt from the excess profits tax, but the members of the partnership are subject to the income tax on their distributive shares of the partnership earnings whether distributed or not. When the earnings are large the surtaxes are correspondingly large. Corporations are subject to excess profits taxes but only to 10 per cent income tax on the net income remaining after excess profits taxes are deducted. The inference sometimes drawn that only 10 per cent in- come tax (because that is the 1920 rate) will be paid on cor- poration earnings is erroneous. At least part of 1920 cor- porate earnings will hereafter be distributed in cash dividends, and in the case of some corporations a large proportion will be distributed. If so, stockholders will be compelled to pay the high rates of surtax which will be in force for many years. The advantage of the corporation over the partnership rests upon its ability to hold its surplus undistributed.* Corporations not organized for profit are exempt.* — Law. Section 304. (a) That the corporations enumerated in section 231 shall, to the extent that they are exempt from income tax under Title II, be exempt from taxation under this title. Section 231. That the following organizations shall be exempt from taxation under this title — 'Very recently (March, 1920) it was pointed out by the Secretary of the Treasury in a letter to the Ways and Means Committee of the House of Representatives that, "in 1918 the members of a well-known partner- ship paid nearly $1,125,000 more taxes than they would have paid had their business been organized as a corporation." The letter failed to state what would have been the result if the con- cern, assuming the corporate form, had distributed any considerable part of its earnings. Many of the illustrations appearing in the public press and elsewhere have been misleading in recommending the formation of corporations because of the assumption that very limited dividends would be paid. "See Income Tax Procedure, -1^21, Chapter II. 20 EXCESS PROFITS TAX PROCEDURE (i) Labor, agricultural, or horticultural organizations; (2) Mutual savings banks not having a capital stock represented by shares; (3) Fraternal beneficiary societies, orders, or associations, (a) operating under the lodge system or for the exclusive benefit of the members of a fraternity itself operating under the lodge system, and (b) providing for the payment of life, sick, accident, or other ben- efits to the members of such society, order, or association or their dependents ; (4) Domestic building and loan associations and cooperative banks without capital stock organized and operated for mutual pur- poses and without profit; (5) Cemetery companies owned and operated exclusively for the benefit of their members; (6) Corporations organized and operated exclusively for relig- ious, charitable, scientific, or educational purposes, or for the pre- vention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private stockholder or indi- vidual; (7) Business leagues, chambers of commerce, or boards of trade, not organized for profit and no part of the net earnings of which inures to the benefit of any private stockholder or individual; (8) Civic leagues or organizations not organized for profit but operated exclusively for the promotion of social welfare; (9) Clubs organized and operated exclusively for pleasure, recreation, and other nonprofitable purposes, no part of the net earn- ings of which inures to the benefit of any private stockholder or member ; (10) Farmers' or other mutual hail, cyclone, or fire insurance companies, mutual ditch or irrigation companies, mutual or coopera- tive telephone companies, or like organizations of a purely local character, the income of which consists solely of assessments, dues, and fees collected from members for the sole purpose of meeting expenses ; (11) Farmers', fruit growers', or like associations, organized and operated as sales agents for the purpose of marketing the products of members and turning back to them the proceeds of sales, less the necessary selling expenses, on the basis of the quantity of produce furnished by them ; (12) Corporations organized for the exclusive purpose of hold- ing title to property, collecting income therefrom, and turning over the entire amount thereof, less expenses, -to an organization which itself is exempt from the tax imposed by this title; (13) Federal land banks and national farm-loan associations as provided in section 26 of the Act approved July 17, 1916, entitled "An Act to provide capital for agricultural development, to create EXEMPTIONS 21 standard forms of investinent based upon farm mortgage, to equalize rates' of interest upon farm loans, to furnish a market for United States bonds, to create Government depositaries and financial agent* for the United States, and for other purposes"; Personal service corporations. — Corporations described as "personal service corporations," that is, those "whose income is to be ascribed primarily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the afifairs of the corporation and in which capital (whether invested or borrowed) is not a ma- terial income-producing factor," are not subject to any excess profits tax, unless such corporations also engage to some ex- tent in business which requires the employment of capital.^" As the constitutionality of the provision of the law taxing the stockholders of personal service corporations is doubtful, there is a possibility that personal service corporations may escape both profits and income taxes. If the doubt is decided against the government there is no provision in the law for taxing a personal service corporation as an entity nor for tax- ing its stockholders as individuals. Because of this contingency or for other reasons the Treasury is making severe require- ments of corporations which claim to be personal service £or- porations.^^ Exemption depends on "personal activities." — In order to secure exemption from the excess profits tax as a per- sonal service corporation it must be shown affirmatively that a corporation's earnings are primarily due to the activities of the principal stockholders. If the corporation has in fact sub- stantial capital it cannot qualify as a personal service corpora- tion even though its prosperity would appear to be due to the personal activities of the owners (stockholders) of the busi- ness. If there is substantial invested capital the credits or "See section 231 (14). "For a complete definition of a personal service corporation, and the arguments for non-taxability, etc., see Income Tax Procedure, 1921, page 629 et seq. 22 EXCESS PROFITS TAX PROCEDURE exemptions are supposed to provide equitable relief. As Sena- tor Simmons has said :" Where the income is not derived from capital, but is derived from the personal exertions of the principal owners of the corpora- tion, there can be no exemption based upon invested capital. Part exemption when services from personal ac- tivities CAN BE segregated. — The law provides that when part of the earnings of a corporation is derived from trans- actions in which the use of capital is necessary and part (at least 30 per cent) of the earnings of the same corporation is derived from transactions carried on by another branch of the corporation in which the use of capital is not necessary, the earnings from the latter or "personal activity" part of the business may be deducted from the earnings as a whole and a calculation may be made which will result in a tax lower than if the segregation were not made.^' Net income less than $3,000 for a full year not taxable. — Law. Section 304. (b) Any corporation whose net income for the taxable year is less than $3,000 shall be exempt from taxation under this title. In calculating the tax there is a specific exemption of $3,000. Section 336 provides that every corporation unless exempt under section 304 shall make a return. This section states that a corporation whose net income is less than $3,000 is not subject to the excess profits tax. Consequently it need compile only that part which refers to the income tax. Regulation. A corporation whose net income for a full taxable year of twelve mimths is less than $3,000 is exempt from the tax. If the taxable peri(;d is less than twelve months the corporation is exempt from the lux if its net income for the period is less than the same proportion of $3,000 as the number of months in the period is of twelve months, any fractional part of a month being counted as the number of days in such part of a month divided by 30 (Art. 751.) "February 11, 1919, Congressional Record, page 3777. "See page 78, EXEMPTIONS 23 Limited partnerships which are not subject to the tax. — Regulation. So-called limited partnerships of the type author- ized by the statutes of New York and most of the States are partner- ships and not corporations within the meaning of the statute. Such limited partnerships, which can not limit the liability of the general partners, although the special partners enjoy limited liability so long as they observe the statutory conditions, which are dissolved by the death or attempted transfer of the interest of a general partner, and which can not take real estate or sue in the partnership name, are so like common law partnerships as to render impracticable any dif- ferentiation in their treatment for tax purposes. Michigan and Illi- nois limited partnerships are partnerships. A California special partnership is a partnership. (Art. 1505.) "Trusts" which are not subject to the tax. — Regulation. Where trustees hold real estate subject to a lease and collect the rents, doing no business other than distributing the income less taxes and similar expenses to the holders of their re- ceipt certificates, who have no control except the right of filling a vacancy among the trustees and of consenting to a modification of the terms of the trust, no association exists and the cestuis que trust are liable to tax as beneficiaries of a trust the income of which is to be distributed periodically, whether or not at regular intervals. But in such a trust if the trustees pursuant to the terms thereof have the right to hold the income for future distribution, the net income is taxed to the trustees instead of to the beneficiaries (Art. 1504-). Gold mining income is exempt. — Law. Section 304. (c) In the case of any corporation engaged in the mining of gold, the portion of the net income derived from the mining of gold shall be exempt from the tax imposed by this title, and the tax on the remaining portion of the net income shall be the proportion of a tax computed without the benefit of this subdivision which such remaining portion of the net income bears to the entire net income. This provision was inserted in the law to stimulate the pro- duction of gold. Because of high labor and other costs the gold mining industry was greatly depressed during the war. It was believed that the industry would be encouraged if net income derived from the mining of gold were exempt from the excess profits tax. If the net income of a gold mining company arises partly W «. <: w CJ >H ;? ■H rt 5 < o ^ 1 § s Pi< o o p< fa fa ^ < W :s W3 o H fa u o HH fa S Ui Z Ui M fa U O >^ W fa o :z; o hH H <; P Ph s o u « w o « w p o o o o d d o o o o do O -i- •-I B > > > o O O o o o o o O O o o o o d d d d d d >A o o o o o c^ 00 o o o_ o_ o l-l •On LO o LO l-O d" yD CO CI M C^ -+ 66- ea «& «© ee- o O o O d d o o o o ON o «6 «& w a 3- o ™ «_r 'B, o 3 P. B o H PL, X o bo a |m B a •a.S "o B o2 ■u o 0) Wl 15 11 aj h B^ o to tH g ^ flj 2& M 13 .a +-> O II O S SB o o o d o o o LO o H _o j:3 7 1/3 '-' W Pi fa u o o H <: Oh O u in H fa o fa O S otn fc o o o o d d o 9 o o d'l^ UO o o o OO QQ o o o O O O Q Q Q o o o o o 2 ° 9 J4 M s ■Si oo OnOv ft a O-g mm ^^ o o o o o o d d d o o o ovo VO ■f -f SD- T m M :--g C4 t-i .tio _, o li o o 8 § 8 pq ••a • ci ■ 3 > :5 'ft+j o! O " m o o X o o a it; o u ^ i-i W o o U o o o o d o \o o «e^ ^ -M CO . O M . n o • — j X ■ •ri" : ja.g . g'-g If ©■+-«& CO "1 " 53 en o "^ g o X a o rt 8° ■^^ o o aJ w o « o ■^•sg •d ■3 ft •§ ,a 5 .m o o 00 I 44 COMPUTATION AND RATES OF THE TAX 45 vested capital and taxable net income of the corporation have been determined. It will be noted that the illustration fol- lows form 1 1 20 which has been issued for the year 1920, and, by using the schedules and item numbers indicated, the figures of this illustration, or of an actual case, may be entered on the official form without any difficulty. The provisions of this article are concretely set forth in the following illustration. The formulas given below are useful in proving the total tax, both income and excess profits: Taking the items given in the illustration on page 43, we have — I. When there is income in 40 per cent bracket: Earnings , $30,000.00 Less: Excess profits tax $S,8oo.oo Specific exemption 2,000.00 7,800.00 Taxable at 10% $22,200.00 Income tax at 10% $ 2,220.00 Excess profits tax as above S,8oo.oo Total tax $ 8,020.00 2. When there is income in 20 per cent bracket only : Earnings $20,000.00 Less: Excess profits tax $1,800.00 Specific exemption 2,000.00 3,800.00 Taxable at 10% $16,200.00 Income tax at 10% $ 1,620.00 Excess profits tax as above 1,800.00 Total tax $ 3,420.00 The proof showing the working out of the formulas ap- pears on the following page. 46 EXCESS PkOFITS TAX PROCEDURE Formulas for Proof of Tax Calculations A. For return showing that company has income in 40 per cent excess profits tax bracket : 4.16% of invested capital (Schedule B, line 9)* $4,160.00 46% of excess of taxable net income (Schedule A, line 27) over 20% of invested capital* 4,600.00 $8,760.00 Less: Account of specific exemptions . ; $740.00** 10% of non-exempt United States interest ( Schedule A, line 4) None 740.00 Total income and profits taxes $8,020.00 B. For return showing that company has income only in 20 per cent excess profits tax bracket : .8% of invested capital (Schedule B, line 9)* $ 800.00 28% of excess of taxable income (Schedule A, line 27) over 8% of invested capital* 3,360.00 $4,160.00 Less: Account of specific exemptions $740.00** 10% of non-exempt United States interest (Schedule A, line 4) None 740.00 Total income and profits taxes $3,420.00 *If return is for less than a full year use in the above calculation as many twelfths of invested capital as there are months in the period for which return is made. **Omit this item if return is for foreign corporation. The accompanying table shows the combined excess profits and income taxes payable by corporations with varying amounts of invested capital and net income, and will prove useful for approximating taxes. As net income and invested capital rarely appear in even thousands of dollars the table may not show the tax of any corporation exactly, but the gradations are close enough together to check most errors in calculation. The table will be most useful in making estimates before final results are available. COMPUTATION AND RATES OF THE TAX 47 2 E 3 lO lO to (O lO » « 1 » » I K_ K S S. S * " -H « o ♦ » * o_ w w. PJ. N ototo>otoi9>9io>a 1 N N lO O «- 00 ¥S¥ooionQsto , . SJ K S S; S * S i = 5 * 5 5. S « N N c N n S ov S *-, ". -. « O * w * o_ w_ r^ N OofoTrCojnVojV'j SS ? Slo SSJ Ni<-N tnS*S-l-^. o^co^o'ow- i-eoooeoooooooe . o ^ no «*■ o ■» W o o, no r* 2 seooeoeooeoeooooeooooc ""•or S -3 48 EXCESS PROFITS TAX PROCEDURE Rates for calendar year 19 18. — The application of the 19 18 rates is given in the following pages. These rates involve the calculation of the war profits tax, which is not in effect for the calendar year 1920. Computations at 1918 rates, however, must be made in certain cases if income has been received from government contracts." Law. Section 301. (a) . . . First Bracket 30 per centum of the amount of the net income in excess of the excess-profits credit (determined under section 312) and not in ex- cess of 20 per centum of the invested capital; Second Bracket 65 per centum of the amount of the net income in excess of 20 per centum of the invested capital; Third Bracket The sum, if any, by which 80 per centum of the amount of the net income in excess of the war-profits credit (determined under section 311) exceeds the amount of the tax computed under the first and second brackets. The excess profits tax. — First bracket: The tax is 30 per cent of the amount of net income in excess of the credit ($3,000 plus 8 per cent of the invested capital)' not in excess of 20 per cent of the invested capital. Illustration : Invested capital $100,000.00 Earnings $ 20,000.00 Specific credit $3,000.00 Credit 8% on $100,000 8,000.00 11,000.00 Net taxable income $ 9,000.00 Tax 30% $ 2,700.00 Second bracket: The tax is 65 per cent of the amount of the net income in excess of 20 per cent of the invested capital. "See page 55 for calculation of net income from government con- tracts. 'See Chapter XVI for method of determining net income. COMPUTATION AND RATES OF THE TAX 49 Illustration : Invested capital $100,000.00 Earnings $ 30,000.00 On first $20,000 as above $ 2,700.00 On excess above $20,000 ; $10,000 at 65% 6,500.00 Total tax $ Q,20o.oo This calculation is according to the excess profits tax method. The computation of the tax is not complete until the calculation under the war profits tax is also made. War profits tax. — Third bracket: In the third bracket something is added to the tax as determined in the preceding two brackets only when the calculation under the war profits method yields a larger result than that shown in the first two brackets. As shown above, the excess profits tax is established in the first two brackets by applying the rates of 30 per cent and 65 per cent on net income over and above the credits allowed.* The war profits calculation consists of applying the rate of 80 per cent to net income in excess of the war profits credits." The third bracket, then, is to contain "the sum, if any, by which 80 per centum of the amount of the net income in excess of the war profits credit .... exceeds the amount of tax com- puted under the first and second brackets." Illustration : Invested capital pre-war" period $100,000.00 Earnings pre-war period $20,000.00 Invested capital taxable year $100,000.00 Earnings taxable year $ 20,000.00 Specific credit $3,000.00 Pre-war profit 20,000.00 23,000.00 Net taxable income none •8 per cent plus $3,000. "Pre-war profits plus 10 per cent on additional invested capital or minus 10 per cent on decrease in invested capital plus $3,000. (See page no.) "For definition of "pre-war period," see Chapter XII. 50 EXCESS PROFITS TAX PROCEDURE Therefore the tax as determined under the excess profits tax method must stand. Illustration : Invested capital pre-war period $80,000.00 Earnings pre-war period $10,000.00 Invested capital taxable year $100,000.00 Earnings $30,000.00 Specific credit $3,000.00 Pre-war earnings 10,000.00 10% on additional capital 2,000.00 1 5,000.00 Net taxable income $15,000.00 80% = $12,000.00 Tax on same invested capital of $100,000 and earnings of $30,000 under excess profits tax method $9,200.00 As the war profits method produces a higher tax the amount to be paid is thus determined to be $12,000. The ac- tual computation is made by completing the calculation under the third bracket, which requires the determination of the amount, if any, by which 80 per cent exceeds the tax computed under the first two brackets. 80% = $12,000.00 Tax under the first two brackets was 9,200.00 The third bracket therefore exceeds the total of the first and second by $ 2,800.00 The amount of the third bracket must now be added to the first and second which amounted to 9,200.00 Making the total tax payable $12,000.00 In Other and simpler words, two calculations must be made, one under the excess profits and one under the war profits method. Whichever calculation gives the higher result is the tax payable. The following set forth the illustrations given in article 716 and 717 of the regulations. w w < w p^ Q W < Pi o < H c« H o p^ Ph tn W u XI w S(/2l-l I-HIH l-H o w w u p^ m p K H Pi W Q <; o a w Pi o o l-H H < H o o o o g o o q o dodo o o o o o o o o_ o o d d »ri rt O '^ ■ «& " 1 M tJ ■<*■ bis Pi tS ft . ua . -3 O^ 1-1 '^^ o ii fi ^^ 05 hH f> ^ <& > > > ^^ ^ m en B " O > ^. C 00 o o o o d d o o o o_ o" " O O P5 -!-> (A CO +J u«a >■ o 1-1 Ph pq ca w « m o O o o O O O o W ^ tn 1-1 -t; CO u M CO ^ oi ft!^ a u oja ^ Pi < Q W u o H- xn H o Pi a. t/3 (/) w u X w Q < Pi < o ^; o H < P O o a p or i-i\0 OM^OvM O 0\ Pi < < Q W o X < H I— I O Ui Ui W U ><; w o o o o o o o o o o o o d d d d d d o o o o o o o o o o o o o o o o d" o P^ 00 M o M H p O U p. "a . «J O « 'T'T >-B >^ 5^ JJ.a-? ct PnflH ^g^^ ^ CO 00 O O OJ lU M *H tS C4 fcuO bfl ON 0^ 0> CK rt rt i-t M *-" HH Eh M Q O a 1.3^11 o a o w lu S o Sag " S "> " o S 0) S 3 >"-'«& WPhPh W a w tH M N o S o o o 9 o 9 q o 00 <^ ?> p< B rt w fe o O •« Pk C/1 tfl OJ en > H a u w >> > 6?^ =22 o fe5 o o (J o O > > o o o o o d o o cS 6 «» «& 5h ■ ia • o.-S Mo o 52 o On " O O Q U U O (3 o U >> > > > > j_| HH t-H M ■Q Q Q o o o o d d o o <> vo hH « o O o CO 3 ;:3 -I-) 3 :!« < 1^ i CO I; X M *0 ^ ?^ 3 O S < Id o u Ph ci! •d o o M o O H < D O U J s « w ti o "8 o -I cj PM -o W d ".tl Woo O o u a o 53 54 EXCESS PROFITS TAX PROCEDURE War profits credit where a corporation did not exist for at least one calendar year of pre-war period. if the corporation in the preceding illustration did not exist dur- ing the whole of one calendar year during the pre-war period, the war profits credit consists of the specific exemption of $3,000 plus what is termed the "median" or average per- centage of the invested capital of "business of the same gen- eral class" for taxable year but in no event less than 10 per cent. [Section 311 (c).j For a full explanation of the method of determining the war profits credit in such cases and a list of corporations per- mitting a credit of more than 10 per cent, see Chapter VI. Income from government contracts. — Section 301 (c) re- quires that where income derived from government contracts made between April 6, 1917, and November 11, 1918, amounts to $10,000, during the taxable period, such income must be taxed at the 1918 rates. The computation is somewhat difiS- cult in that the income and expenses applicable to government contracts must be segregated from the other income and ex- penses of the corporation. The method of computation is set forth in the following illustration. The mstructions which appear on form 1120S require sup- porting schedules as follows: A schedule should be submitted .... In the case of affiliated companies, this information should be shown separately for each company. This schedule should be in columnar form and should con- tain the following information as respects each contract : (a) Amount of contract. (&) Gross income from contract during period. (c) Expenses directly applicable to each contract. Total of each column should be shown. There should also be shown in the most practicable form: (d) Total gross income of corporation. (e) Percentage which total of column (6) is of (rf). (/) Total general expenses, losses, and deductions of corpora- tion. (g) Amount of (/) allocated to Government contracts (total). (h) Percentage which {g) is of (/). w o M W ■ < 2 U w o < H en H o c« P U < Ph ^ & 'z w > o en Pj fh W P^ " U O 15! X ^ O O fe <: ^5 o o I— ( H H Pli o u w 888 o o odd d 8 8 8 o o o" o" o" o Ul M M i^ . •i-H o :-S8 gdj (u d' O oj I -I 8 ■M O (^ O O 'o'T ""cS o o o o d d o o oo o oo C^ M se- tt W Bi 1 . . o-a m rt K" s-s Pi -^ Pm S in l> S^ N8 W 0^ •-* O «3 5^1 00 W O o o o o o d d d VO o ^ o C4 « o o o o d d o o O 00 cT ^ Ph o! &'-3 CO rt> %^ wtcl oj o > u .rtP^ o o » o o o o d d o o M o o oo t-« C4 ee e» 6^ H M i a o p cS CJ +J o o o a a o " J. -^ CO is 55 < o o o o d d o « 00 o ^ S N «& e& o o o o o 9 o o O 00 o o d o o o o -*■ 4 ■J- >o O; 00 o o o o o o d" ON in w M •CJ 6? o i p^ 3 gS 11"^ O OJ o o o " o oa ae ^ ° o 01 .O o! op. o 9 o o O 00 OS O o Pi <; o >^ H <; D ft, o u H OS Id o (d a K U OS ^; o o S « £ fa o w 8 BS H (4 O o a o W s o !z; M o K M o o&i O O ON o o ■ * - o « o tfl .. tfi ^ tn d w ' 4J H O ( In J3 W 1 -4-) +J g'o'ri dW " O (4-1 ^^— ^ CO jj*^^ u to fe5 o o o o o o o o o o o o o o o o o q 6 6 6 6 6 6 n o o o o o O Ln O ^^ o o o o o o o o O Lo O O ' x^ tS C\ lO^" o CJ O 'O - O O o JJes- > o O E o O to b p. f^ IMS' J3 S d -fc' o u P- o .g rt t! S p i^*^' — ^w] . f^ V ^ ^ gl3|uSHO>SE-im«h-t g & a. 57 00 N o Ov W OO * o O; 00 m 00 « t^ ^ w- d c o o o o o o d d o o O iJ^ d' d' o n CM- 88 o 2 2 O o o o O d d Q d d d o o 2 2 o_ o_ Q o_ q^ o w" t^ iri O CO ^ t^ 1^ CN OS'; _2 d' o o o o o d o ' m • o u m m gs go- CO o a o. .."3 o" "^ d 2 *a 11.2 °t o 5 ° ft o P. ^ (U '.in OJ n , — . o O irt5-i o o •^ : ts c^ ^ OO 7o;o 2 = 8 tnO 1) m So (1) 5 '-' S R sal O aJ ,»-* 0) > "*-< ,-H O • o u o . o so • o S '.■¥. o Pi l-H u O ^ Y, (U o ■ a " o o H ; o ^ II- O O o) o ' 1) o o o a N W CIS 59 < ^J^ u^ )-l t-t 4 oo C*^ oo ^ o < m 0\ f^ ON W u o S W 25 O :s M fe E3 O U o ■a O H 05\ Ph t4-i d to II p." o 1-4 Ph o H 6o o o O O o o q O d d (>i CT> o o en Tj- ^ i^ ^ ■+ vo oo ci 0^ «& «» o ■^ o o 0^ *^ M- * m o o " C^ r^ m5 4 CT. tn ^ K. ^ Ln " ^ VO 00 -t l^ O mvo I-. 00 O O 01 00 1-1 I>^ O 66 M M r*^ » «& m- «& 000 000 odd 000 o o o do' o ■n o -it- 10 o w < O u ^1 0) t! (flOO -tJ »-• OT OS M ■^ , 4) U ■U.O P di to 4-> o o o o d ^ ^ m H < 00 X CTv < d H .1-1 H S +J S U ^ B t—i ■1 . ;h u ^ a ;3 c ja IS & o a o -ii Ph in m Si tj OS 2° tn S P t^ O 1- o 4j Ph 'J . S « ti a aj s B 13 O 6^ o na o o 61-1 p. CO O M "Ph 5 aJ >< Id 6^ ^ O 01 O H 61 62 EXCESS PROFITS TAX PROCEDURE Applying to the preceding illustration the test outlined in the instructions on form 1120S (see page 54), the ratio of gross income from government contracts to total gross income is 65.4 per cent. The ratio of expenses attributable to govern- ment contracts to total expenses is 65.4 per cent. If, instead of being exactly the same, there is variation in these percentages, it is to be expected that the Treasury will recjuire a more definite allocation of expenses. In other words, the ratio of unallocated expenses assignable to government contracts to total expenses of that kind should be about the same as the ratio of government contract income to total in- come. Amendicu returns may be necessary. — Claims against the government are often long delayed in settlement, and when finally settled an amount less than the face of the claim is often accepted by the taxpayer. If this occurs in 1920, and a sub- stantial amount is involved, the difference between the face of the claim and the amount received should not be charged as a bad debt. The amount already returned and taxed at the high rates should be adjusted by filing an amended return. Lower rates applicable in certain cases. — Because of numerous complaints that the 19 17 law bore more heavily relatively on small concerns than on large ones the 19 18 law contains a provision which is intended to ameliorate the con- dition of small corporations. Law. Section 302. That the tax imposed by subdivision (a) [1918 rates] of section 301 shall in no case be more than 30 per centum of the amount of the net income in excess of $3,000 and not in excess of $20,000, plus 80 per centum of the amount of the net income in excess of $20,000; the tax imposed by subdivision (b) [1919 rates] of section 301 shall in no case be more than 20 per centum of the amount of the net income in excess of $3,000 and not in excess of $20,000, plus 40 per centum of the amount of the net income in excess of $20,000; and the above limitations shall apply to the taxes com- puted under subdivisions (a) and (b) of section 301, respectively, COMPUTATION AND RATES OF THE TAX 63 when used in subdivision (c) of that section. Nothing in this sec- tion shall be construed in such manner as to increase the tax imposed by section 301. A condensed statement of the limitation of the tax is found in the following regulation : Regulation. In any case where the net income is at least $20,000 the computation under section 302 of the statute may be shortened as follows: (i) The tax imposed by subdivision (a) of section 301 shall not exceed $5,100, plus 80 per cent of the amount of the net income in excess of $20,000; and (2) The tax imposed by subdivision (b) of section 301 shall not exceed $3,400, plus 40 per cent of the amount of the net income in excess of $20,000. Where the net income is less than $20,000 the tax shall not exceed 30 per cent or 20 per cent, as the case may be, of the amount of the net income in excess of $3,000. (Art. 731.) By using this short form, the calculation can be made more rapidly than by following the formal wording of the law. For instance, $3,400 equals the tax on the net income m excess of $3,000 and not in excess of $20,000 ($17,000) at 20 per cent. It will be noted that commencing January i, 1919, the tax is limited to 20 per cent of the amount in excess of $3,000 and not in excess of $20,000, plus 40 per cent of the amount of the net income in excess of $20,000. The section applies primarily to corporations whose net income for the taxable year is less than $20,000. In such cases for the year 1919 and following years the excess profits tax will not exceed 20 per cent of $17,000. If the calcula- tion under brackets one and two produces a larger sum it is disregarded and the 20 per cent tax is substituted in its stead. When the income is more than $20,000, section 302 may still apply but chiefly in cases where invested capital is very small in proportion to earnings and the earnings are not sub- stantially in excess of $20,000. 64 EXCESS PROFITS TAX PROCEDURE An illustrative case is: Invested capital $25,000.00 Earnings $75,ooo-00 Tax under excess profits brackets: 20% of $25,000 $ 5,000.00 Credits : Specific exemption $3,000.00 8% of $25,000 2,000.00 5,000.00 no tax at 20% 40% of $70,000 = $28,000.00 Tax computed under section 302 : 20% of $17,000 ($20,000— $3,000) $ 3,400.00 40% of $55,000 ($75,000— $20,000) 22,000.00 Maximum tax $25,400.00 It is obvious from the above that in every case where excess profits taxes are calculated the limitation of tax should be borne in mind and this limitation applied to see that it is not exceeded by the amount of tax calculated in the ordinary manner under section 301. While the income from government contracts received in 1919 is subjected to the higher rates of 1918, it is well to note that the limitation of tax under section 302 also applies to tax on income of this character, and if the higher taxes computed on such income exceed the limitation, of course the lower figure will apply. If net income from government contracts' in excess of $10,000 was also received during 1920 and the 1918 rates are applicable thereto, the same precautions should be observed. The following statement illustrates the method of applying the limitation, when there is income from government con- tracts. COMPUTATION AND RATES OF THE TAX 65 Net income: From government contracts $20,000.00 From other sources 30,000.00 Total \ $50,000.00 Assumed tax: Total tax at 1918 rates $32,400.00 Applicable to income from government contracts 2/5.. $12,960.00 Total tax 1919 rates $16,200.00 Applicable to income for other sources 3/S 9,720.00 Total tax payable $22,680.00 Limitation of tax: 1918 rates: 30% of $17,000 ($20,000 — $3,000) = $ 5,100.00 80% of 30,000 = 24,000.00 Total $29,100.00 Applicable to government contract income, 2/5 of $29,100 ^= $11,640.00 1919 rates : 20% of $17,000 ($20,000 — $3,000) =^ $ 3,400.00 40% of $.^0,000 = 12,000.00 Total $15,400.00 Applicable to non-government income, 3/5 of $15,400.... 9,240.00 Total tax payable $20,880.00 Since the tax under the hmitation is smaller than that com- puted in the ordinary way, the amount to be paid is $20,880. Formula for calculation under section 302. — A short form to be used when net income is at least $20,000 (suggested by article 731) is shown on the following page. o o d 8 o u^ Q «& g <; 88 o o o d d d w o o o ON "t °. tJ- l-H t-4 p!, €6- «» < CO 1 :-S : : •o Pi "3 • d • • ^ • o ■ • § < m : O ■ • •o Q ta • t^ . . ii 1^ "■■?■■ 3 W ^ : II : : a <; ft "o ■ • a :o : : 8 u o • 9. • • (A .2 :? :65 4-> 5 M H :8. --tS to ^>; K V, ■° -o JJ in 1=1 .«©■ o profit: EQUENT 4-! 2 --^ • ° ^ •§ ■- to • O -ffi- 8 : 8 : 11 « :- --o 1 • !8 : °- -»-• ■ OJ . O "■a O o t/3 CQ « 2 =3 ■a ., WP- g^ Ut/) (A ^ >< . S.2 : §1 " : d ■ o > «8 g o O u a-3 8-3 70 o o q o 1^ d N o 00 O 3 ■•o O • a> * u :o pj ■ m H !u3 xn • P 4_) . u U3 (UCL, 2 O d s ^ ^S ^ ^4 H o o o o d d o o ° °- c^ O o o 2 :.^ o O o O d d o iri o_ t-~ c^ O 6& €3- a Pi O a. ni , •u do If) " 3 Pi o a « o ■a " d d rt u 8-". o-d m tu «& o o . 3 o ^"2 6 tn u o S OJ o O.Q LO X m •"* (U -^ €©■ .s§ o O "! 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Sag rt o o .. ,2 i! ^ .t. ^ ais^s o u O-jJ, 5^ o P » .Q 8? at m js a S o tS w 3 '^ W a u w Q I'l tl ., ■^ ON S't^ c^ < o « » o ^ to 2 V, WdnO u ON o O p< : o t! OM Q Q vo 00 lA oo c^ ^f ON Ti- « •^ «©■ CI ' m !i3| 8-3(3 o ON 00 00 o d o o_ VO cT a\ ■* CO M «& .a ^ On ja Sa « •3 -3 a II o '3' m o U •> s o (U P.NO i. On g CO o h o «& ^ a o OJ "3 a 1-4 "3 6? tn c4 n "J d n "J 1 O w fl Ooo rl " d«& g -•nJ> O o d S S o ° a X s 8 ■'-'H.H -Sis: O CO 1-31 H.2§ d o K 01 d tu u,t^ NO On ON no' o o d .tl ■t-» d (U d o ta h ■ X to t3 u d X O (U S 0) o d P" M 05 f-1 H Ph « d a a o a! l-l a 13 o Go o as 5-a QQ QQ Q Q o 1^ « a" « CO C'l d c4 lA CO -^ M o O rt vS" ^ja ■* 1^ sTm o c^ o 11 i-T 3 vo „ a -■± S-. a " ■■Sg •g a a" $ o O o Fd e=< plH fe fc !^ Q O ^ 5 iz; P O 0) On ON bjO bo d a ■• 5 S I— I o ^^ oo. •"f t^ tf HI w «» te- o o o o o o d d 6 O 00 C4 « Th r^ vd"tC op ee- «e o o o o •<»■ o VO « tC 6 «& » W m M ft a n! d o 0. "-« CS T3 O )~l T3 o a J3 a 1 Ov ES (U Ov O 1^ >4 «w M o ^ 8 Q ^ o M CO o S § " CO O 0) « «^" §d- O bo a " 22 Si is a u -4-» ra a) -t-> u J3 d o u u o a o d h-( d o X H o o o d o u u d S " CLi bo d o -0 ■5 2 ca *^ Pi o d-g — ' w _ " 6§ S5 'S d d +J ° u i"sa 9 ■" o ■^|§ d (u ja _, (Um-i d o o O ' SB'S 2-2 8 I> IH OJ O CO o„ o rt . °g u ^§ ^ d " d 'i o OS H o W o H OJ ' 01 88 COMPUTATION AND RATES OF THE TAX 89 Profits on sales of mines, oil or gas wells may be subject to reduced tax. — It was urged that the excess profits tax law of 191 7 worked undue hardship on prospectors and others who by their own efforts discovered valuable deposits of minerals, oil, etc. In case of sale the tax took a considerable part of the sale price. In response to these complaints the following provision was inserted in the 19 18 law. •Law. Section 337. That in the case of a bona fide sale of mines, oil or gas wells, or any interest therein, where the principal value of the property has been demonstrated by prospecting or exploration and discovery work done by the taxpayer, the portion of the tax im- posed by this title attributable to such sale shall not exceed 20 per centum of the selling price of such prpperty or interest. The relief afforded by the foregoing is greatly restricted. It applies only to bona fide sales. The principal value of the property must have been demonstrated by prospecting or ex- ploration, and discovery work must have been done by the tax- payer. The 20 per cent tax applies to the gross sales price, and not to the net profit thereon. It was the intention to ex- tend relief in meritorious and isolated cases and it cannot be extended to any others. Regulation. In the case of a sale of mines, oil or gas wells, or any interest therein, as described in article 13, the portion of the war profits and excess profits tax attributable to such a sale shall not exceed 20 per cent of the selling price. To determine the application of this provision to a particular case the corporation should com- pute the war profits and excess profits tax in the ordinary way upon its net income, including its net income from any such sale. The proportion of the total tax indicated by the ratio which the taxpayer's net income from the sale of the property, computed as prescribed in article 715^^ bears to its total net income is the portion of the tax attributjible to such sale, and if it exceeds 20 per cent of the selling price of the property such portion of the tax shall be reduced to that amount (Art. 971.) The first illustration following ( official) is believed to be incorrect. The second illustration shows the correct method of computation. "See page 79. i 8 ON w I « CO VO in H o o C4 i t-. CO •3-3 1 1 1 •3 •3 o ^ S 1 1 1 1 uu 1 QQ Q 1 Q iz; o o o o o 1 ° o o o o o c o o o o o Q d o d g d d o o o o o o o 0^ o o o X 00 ° 00 ON c ' Cj" II 00 c^ 1 w" k- oo On •—1 o i^ hi H P^ «& «» m 66- <; w o o o O >• o o o O d o c d f^ o o o c ^ 8 < d' M ^ d;ll d-i p r4 M c^ «& €9-11 es- 1 ^ 1-1 ^ s ^ Q . , 1 u p^ o 1— 1 o i Ph s M CI 11 1 <; o w h4 be P4 M Crt < « O H m w Id 1 — 1 "^ fe tS O s; rt fl F^ t/2 o cn 65 S H W u o X *c3 +J + *o CO w 4J ■ft (J3 2 o O •r) feS Oh ^ *C . 1 s"? c X o hH 1 %^ < a W -<- I 1- 8 o o M o H CM > 1 " c "o o c c c ^ C >< 6?b O . n Cj C3 C -4-J o o ■3 a o o d VH o s •»■ o ^ r o , « ife? 1^^ a " o o ^ Q y a ^S, .2^5 i;,j2 ti ° =« COUP'S S ■"^.2 S5-1 m o « "" a J) 2 -t-» "^ J2 ca p< Cli p^ o ja •o o C4 OS OJ bo P. o 5 s§ ^ "o d 'A ■d 1 S^ ^ d Jd

t) 5 o o o p^fe "o 00 m P. O O O &^ ra flj in Wl cotp O VI o o «Ph < d d d H c* CO cT c*^ ■6? o W3 8° M O u d d 00 B Is? - o b: O cd o . 0) ft !5r1 T3 § a o o a) oj o ^ OJ Ln •5 ->-'» X o m B.gl O M tea o ii o m 5 1«1 9 ** a -e * a - •" t; j2 £ p > mTa g £ S S * S S 9 .9 PI Sm ;, "■§ •i->-° b-s a 6 s to O > o 01 J3 Q3-tij"*-'PCrt+'. gSg-Sag-s-a § ft^-i->2"m 0) ?9SlSli1 rH dJ CO n i-« ■'^ il o-S^ ■1-' .-d ti 9 y 2 u ^ « <" " S.9|o-s-S^3 ^^5t^2 p en bo □ O fl O ^ O .-tt ft 0. ^- — +^ fa S.aS^s .. cu3 a^ B 5 '^ Odd) o^:;^„g.9:g^ zc.tjaojiu'^a ■^ori^^al a) .in ej ir! *^ o oi 92 COMPUTATION AND RATES OF THE TAX 93 Fiscal years ending in 1920. — Since the rates for 1919 and 1920 are exactly the same, no adjustment is necessary in making returns for a fiscal year which ended in 1920. Computation of tax for fiscal year ending in igig. — Law. Section 335. (b) If a corporation makes return for a fiscal year beginning in 1918 and ending in 1919, the tax for such fiscal year under this title shall be the sum of: (i) the same pro- portion of a tax for the entire period computed under subdivision (a) of section 301 which the portion of such period falling within the calendar year 1918 is of the entire period, and (2) the same pro- portion of a tax for the entire period computed under subdivision (b) or (c) of section 301 which the portion of such period falling within the calendar year 1919 is of the entire period. The following regulation states in detail the method of computation covered by the section of the law quoted above : Regulation. The method provided for computing the tax for a fiscal year beginning in 1918 and ending in 1919 is as follows: (a) the tax attributable to the calendar year 1918 is found by computing the income of the taxpayer and the tax thereon in accordance with the statute as if the fiscal year was the calendar year 1918, and determining the proportion of such tax which the number of months falling within the calendar year 1918 is of the number of months in the entire period; (fe) the tax attributable to the calendar year 1919 is found by computing the income of the taxpayer and the tax there- on in accordance with the statute as if the fiscal year was the calendar year 1919, and determining the proportion of such tax which the number of months falling within the calendar year 19 19 is of the number of months in the entire period; and (c) the tax for the fiscal year is found by adding the tax attributable to the calendar year 1918 and the tax attributable to the calendar year 1919. . . . (Art. 954.) When a fiscal year ended in 1919 prior to December 31 it was necessary to compute the tax under both 19 18 and 19 19 rates, for the reason that the rates of tax and credits were not the same during the two calendar years. The war profits tax was in effect only in the year 1918. The following illustra- tion shows in detail the necessary adjustments. M u o I— I Q 'A W < o o o o o o o q 6 6 6 6 o o o o O "1 o o d* en lo O OS p. o o ■a 01 ■5 PiS o iz; p^ o I— I o t o o Q ti < in u P^ « en 00 O O ou tt p o o X d < o t-l ^o ,1-1^ VO t^ 00 l-H l-H i-Hl— I t-* t-( '-' t-H (-1 M o O o o 6 d o o VO_ t^ 1^ vo" «n « €& ea ^ rt §1 ft m CO '^ M.tl . I ft .„ a> J- rt > c« d 00 to ft 8.a_ _ n (4-1 I toP< 5 94 "cS -l-> ■ft f1 : -2 \J +j •d ! "d "T • t to 3- : > c tn 0^ a 1 CJ u O^ 'ii Ph M C c ) 1) Gt ^ 1- SW ^ ^- J3 5 09 3-S^ +* 'P< m ■M 3 3 j:3 n fi •a n! ^ ,^ •d en ^ II H •d a vo_ 3 Ifl en .<& to .3 2 1 ?2 OS is ^ m d >, (U >, "3 CJ I/l i"^ ta a m j:) -tj ^J fH rt ft a 00 4^ ■s Ov 4-1 s b .2 .2 X s 5 !z;h >> > MM l-l to - . f >^ ^ ° 9 o o o g" 4^" o o O o o o d d o o o o_o o lO t^ « r4 M «e- u t "3 ■ n ■M • i^ 'S..-ti I o| fe 1^^ $; >■ o feS o fl t< O^ f! MfL, O ^ < h « 1^ •gw 6 o » o\ «M Q W O) & tB o a^ « >-* PM g tn ^-< tn w o 4-" tt a. 1 > i c il 1 5 < 1 ^ S > « 8^1 o .2 o ^<^ " o „ s « ^ M-l O - _ "^H CO On a> ^ •H n g u ga -I S ca ja m Si to ^^ , ■<- y S S c P. 01 a ts m "3 ■»-» o ?S ^ ^ 7i K 95 96 EXCESS PROFITS TAX PROCEDURE [Former Procedure] Rates and Computation of the Tax The graduated rates for the calendar year 1917 were as follows (section 201) : Percentage of Rate of profits to capital tax 15% less the deductions 20% iS-20 2S 20-25 35 25-33 45 Above 33 60 Fiscal year rates. — In all cases if a partnership or corporation had established a fiscal year ending on November 30, 1917, or in an earlier month in 1917, the tax was computed at full rates for the entire twelve months of the fiscal year, but no excess profits tax was assessed on the proportion of the period falling in 1916. If a corporation's fiscal year ended June 30, 1917, it rendered a return for twelve months to that date and the tax was calculated for an entire year. After the calculation was made, one-half thereof, as representing the 1916 period, was deducted and the balance was assessed. Ruling. "... It was apparently the consistent practice of this part- nership to close its books in the past on April 15, and in doing so it estab- lished, so far as it might, a fiscal period ending April 15. The Committee is, therefore, of the opinion that the subsequent provision in the regulations under the act of October 3, 1917, providing that the fiscal year of a partner- ship should end on the last day of a month, is not to be regarded as effec- tive against a fiscal year ending on some day other than the close of a month in 1917 prior to the passage of the law and the promulgation of the regula- tions. . . ." (B. 8-20-760; A. R. R. 26.) The 8 per cent rate. — When net income was derived from a trade or business having no invested capital or not more than a nominal capital, the rate was 8 per cent. For procedure thereunder, see Chapter XVIII. Fiscal year rates 1917-1918. — The method of computation for fiscal year beginning in 1917 and ending in 1918 is detailed in the following regulation : Regulation. "The method provided for computing the tax for a fiscal year beginning in 1917 and ending in 1918 is as follows: (o) the tax attributable to the calendar year 1917 is found by computing the income of the taxpayer and the tax thereon in accordance with Title II of the Revenue Act of 1917 as if the fiscal year was the calendar year 1917, and determining the proportion of such tax which the number of months falling within the calendar year 1917 is of the number of months in the entire period; (&) the tax attributable to the calendar year 1918 is found by computing the income of the taxpayer and the tax thereon in accordance with the present statute as if the fiscal year was the calendar year 1918, and determining the proportion of such tax which the number of months falling within the calendar year is of the number of months in the entire period ; and (c) the tax for the fiscal year is found by adding the tax attributable to the calendar year 1917 and the tax attributable to the calendar year 1918." (Art. 952.) COMPUTATION AND RATES OF THE TAX 97 [Former Procedure — Continued] In the first illustration following, showing the computation of tax for fiscal year beginning in 1917 and ending in 1918, adjustments of invested capital under the 1917 law are shown, as are also adjustments of invested capital under the 1918 law, because under these two laws invested capital was defined differently and the adjustments accordingly had to be made on different bases. No such differences arise for fiscal years beginning in 1918 and ending in 1919, because the 1918 law with its definition of invested capital applies to both of those years, as well as subsequent years. < Q < H o I— I H O o B, Hi « o o P4 o u 1—1 M . . 00 [l] H w w m <1 P^ XI w Q W Q < H CM U Q W H t/3 w > iz; P w n t/3 w <: w pq u o o :z; o H <: o u M 2 o to W pq o o o o o q - >fy, odd fr 0^ ° ° ° ,^ « fe o (In :z; I— 1 H p^ Pti o Ph Ph en W u W W P^ o w o o o o o o Q d d o o o lo o irl K -* ■* c^ t/) w : ii ^ C . 3 fl M -S >■ O lU o S O o o Iz; . 6 6 6 ^- " o o o ^ O u-i O O Ph HI - - - \H ly^ lo N W «6 ° "" H, .;; TS -^ ^ g " o CJ ■•-* ^ 01 T3 K O' -t-* >-H ■•-■ HI o ov a 3 m o o o o o o o o O ^ O Q 1^ HI M O O o o O»oc*00ooinio ITi t^ "* U^ lO HI ^» J3 o : XI S3.§ a S S •- '^ S o '^ t> flj « 1 P^ a « H^ .2 y O & !? 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P. ►< ►< <" >" " » be M w "J > > •3 y " K SI ^^ :3 3 « +j +^ ^ (U o Ih ^ -^ -^ 2 S "" 13 m jq -O +j oj t, ■^ d o ii 1- 3 d ">£ •S-^ 2 "■ f^ •^:d-" o p, 3 m cj US >. ft'ri Id ™ ti d H fe •" d O P +j p. 0-J3 .— o " « d hT fe cil ° u cS J, d u g " M a) d o L^ »t; w "> S d Vi ° o^ (U S d « „ d8-S='§'3 - -2 « u o *■ (u - si vh y 1-t o o o S t>^ en 'o o o t. «& o H "3 4-) ^ '£■ s o s •d o ii U M d o\ >-t d w fM ■^ o in o :z;a ^ d ^ '- o .2-S^ 104 o o o o o o o o o o ?< 6 6 6 6 6 << O >-n iJ-i O O i-T i-T .-T t^ »J^ o o o o d d o o 00 VO cT H- t^ (^ ^ «©■ z o M H D o U o\ J O ir^ i-O >^ O fq H c^ CO -^^ < -fj +J -(_> +J -(-' X ca a ai ca ca 9 ,"^ o o o o o OJ P,„^i S - M Q (S W 4-) ai 'E O C3 en o H-d 0) ll4 +J o tn OJ X M y ^ o ■ O o o o o d d o o u^ o 1-^ 4 o o o o o o d d d o o o u^ o ir, c^ c*^ 1^ «e «& CO J&d- ■1:: T-l ^®" °^ I j>5 M 6 o^ o 00 «©• W ri QJ O P- o 6§u o-d.S 1-4 lU s-^S p- ^ m O OT pq ^°S 5 o 1) m j5" los o O o O t I I >> > O OS M f-ll-l M H o o o o d d 1^ o (^ SO^ o" c*^ o o o o o o o o o o d d d o o °- °. i^ CI M N M M <» €©■ pq n! W O M o o o S5 6S o 00 m ON o < M « o ^5 (U o •^ IT] OJSO s^ O TO f^ s I— I o 00 o o o o O uo o O O o o o d d d o O lJ^ in 'O GO ■4- c^ p» LO T^^n «&• «e- P5 M a ^ o h Ph J-H t-( •4-> ^ 00 (^ HI to o^ 1J M H-^ u ■t3 ^§ O -Tj 00 (U >*r3 u ™ cd "3 m S; Oto !*> c^ _ ° S<3 m 2 a o i- O oo +j i-i . . aj v-< t-t ^ O O S ^ H ►< M S ci 13! o u d w o M o io6 COMPUTATION AND RATES OF THE TAX 107 [Former Procedure — Continued] Certain corporations denied full benefit of 1917 excess profits tax credit. — When a corporation's fiscal year did not end December 31, 1917, it was overtaxed in 1918 (when assessed tax on 1916-1917 in- come) in using form 1031 by an amount equal to 4 per cent of the proportion of the excess profits tax which the Treasury erroneously apportioned (in effect) to the period prior to January i, 1917. (For full explanation, see Income Tax Procedure, 1919, page 125.) The Treasury's position may have grown out of the faulty con- struction of form 1031. Line II on which the erroneous calculation is based reads : "Amount taxable at 4 per cent." This is inaccurate because the amount shown as taxable at 4 per cent includes the proportion of net income applicable to 1916, which it was never intended should be subject to the 4 per cent rate. Special rulings for small concerns under 1917 law. — In calculating the tax to be paid by a corporation with an invested capital of less than $50,000, and by an individual or a partnership with capital of less than $100,000, the strict application of the 1917 law would have deprived such concerns of the full deductions to which they were equitably entitled. To remedy this injustice in the law, T. D. ^602 was issued, under which the smallest concerns received the benefit of the full deduction to which they were entitled. Regulation. "The method of allowing the deduction authorized by sections 203, 204, 205 or 210 of the Act of October 3, 1917, will be as follows : "In any case in which the deduction provided for in section 203, 204, 205 or 210 is greater than 15 per cent of the invested capital and there- fore cannot be fully allowed under the first rate or bracket of section 201, then in that event any remaining portion of the deduction will be allowed under the second bracket, and continued if necessary into the succeeding bracket or brackets until the entire amount of the deduction is allowed. "Illustrations: — An individual or partnership engaged in the manufacturing business with a capital of $30,000 and a net income of $12,000 for the taxable year, an average pre-war net income of 9 per cent, or $2,700, and a total deduction of $8,700; Amount taxable Rate under each Bracket (Per cent) bracket Tax 1st 20 2nd 25 3rd 35 ■•■•■ ^•••• 4th 45 $1,200 $ 540 5th 60 2,100 1,260 Total ...,,,,.,. $1,800 lo8 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] "A corporation engaged in the manufacturing business with a capital of $30,000 and a net income of $12,000 for the taxable year, an average pre-war net income of 9 per cent, or $2,700, and a total deduction of $5,700 : Amount taxable Rate under each Bracket (Per cent) bracket Tax 1st 20 2nd 25 $ 300 $ 75 3rd 35 1,500 525 4th 45 2,400 1,080 Sth 60 2,100 1,260 Total $2,940" (T. D. 2602, December 3, 1917.) CHAPTER VI CREDITS AND SPECIFIC EXEMPTIONS The expressed intention of the framers of the law was that no excess or war profits tax should be imposed until the tax- payer had realized a fair or normal return upon his entire invested capital. This normal return is presumably vouch- safed to the taxpayer by a specific exemption of $3,000 plus a so-called "credit" consisting of 8 per cent of the capital in- vested in the undertaking. This is not the place to discuss whether or not these allow- ances provide a fair return. In the author's opinion a specific exemption of $3,000 plus 8 per cent upon invested capital is not a fair or normal return upon capital which is subject to the hazards of competitive business. As has been pointed out, the 1918 law made temporary provision for both an excess profits tax, with the invested capi- tal standard just described and a war profits tax with a stand- ard of pre-war profits.^ Both taxes were to be calculated and the higher paid. This alternative arrangement held for one year only, viz., for the taxable year 1918, so that the war profits tax, with its pre-war profits "credit," is now obsolete except with respect to corporations having net income of more than $10,000 from government "contracts made between April 6, 1917, and November 11, 1918, both dates inclusive." Corporations with fiscal years ending in 1919 were subject to '[British Practice] An attempt was made in England to extend to the taxpayer an opportunity to select a pre-war period which would be fair to him. The three years selected were generally prosperous ones in England, and to allow for one of such years being unprofitable the taxpayer is given a choice of two years out of three. When the three years were not prosperous ones two alternatives are given, either a choice could be made of four years out of six (if during the three years' period the profits of the business were 25 per cent below normal) or a reasonable rate of return on capital could be claimed as the pre-war standard. A specially constituted board of referees has power to increase the statutory rate. 109 no EXCESS PROFITS TAX PROCEDURE the war profits tax for that part of the taxable year which fell in 1918. Excess Profits Credits For the purpose of calculating the excess profits tax the credits are: 1. A specific exemption of $3,000- 2. 8 per cent of the invested capital for the taxable year. Law. Section 312 the excess-profits credit shall consist of a specific exemption of $3,000 plus an amount equal to 8 per centum of the invested capital for the taxable year. Exemption reduced if return is less than 12 months. — Law. Section 305. That if a tax is computed under this title for a period of less than twelve months, the specific exemption of $3,000, wherever referred to in this title, shall be reduced to an amount which is the same proportion of $3,000 as the number of months in the period is of twelve months. The specific income tax credit of $2,000 is also re- duced. — Ruling. Where, for any cause, a corporation files a return for a period of less than twelve months, the credit of $2,000 provided in section 236 (c) of the Revenue Act of 1918 shall be such proportion of the full amount as the number of months in the period bears to twelve months. If the period for which the first or final return is made includes a fraction of a month there shall be added to the number of complete months as many thirtieths of a month as there are days in the fractional part of the month. (B. 51-20-1356; O. D. 756.) Full amount of credits deductible. — Under the 191 7 law, because of its faulty construction, many small concerns, by the limitation of the credits to the first bracket, would have been deprived of the full amount of the excess profits tax credit to which they were entitled. The regulations arbitrarily ex- tended the right so that if advantage could not be taken of all the credits in the first bracket the balance could be credited in subsequent brackets. CREDITS AND SPECIFIC EXEMPTIONS m The 19 1 8 law specifically permits the full amount of credits to be taken. Law. Section 301 (d) In any case where the full amount of the excess-profit credit is not allowed under the first bracket of sub- division (a) or (b), by reason of the fact that such credit is in excess of 20 per centum of the invested capital, the part not so allowed shall be deducted from the amount in the second bracket. War Profits Credits Summary of credits. — The war profits credits may be sum- marized as follows : (i) A specific exemption of $3,000,- plus one of the fol- lowing : (2) The average net income of the pre-w^r period, unless the invested capital for the taxable year is more or less than it was for the pre-war period. (3) If the invested capital for the taxable year is more than the average invested capital during the pre-war period, the credit is : (a) The average net income of the pre-war period to which shall be added (b) 10 per cent of such in- crease in invested capital. (4) If the invested capital for the taxable year is less than the average invested capital during the pre-war period, the credit is: (a) The average net income of the pre-war period, from which must be deducted (b) 10 per cent of such decrease in invested capital. (5) When the corporation was in existence during the pre-war period and had no income, or earned less than 10 per cent upon its invested capital, the war profits credit is 10 per cent^ of the invested capital of the taxable year. (6) If the corporation was not in existence during the whole of at least one calendar year during the pre-war period and if a majority of its stock was not controlled during the taxable year by a then existing corporation, and if 50 per cent of its gross income is not from government contracts, the ^Section 311 (b). 112 EXCESS PROFITS TAX PROCEDURE credit is the same percentage as that of corporations engaged in the same "general class" of business as the taxpayer, but in no case will the rate be less than lo per cent of the invested capital for the taxable year.^ (7) When the corporation was not in existence during the whole of at least one calendar year during the pre-war period and (a) if a majority of its stock was controlled by a then existing corporation or (b) if 50 per cent of its gross income for the taxable year is from government war con- tracts, the war profits credit is 10 per cent of the invested capital for the taxable year.* The sections of the law and regulations dealing with this subject follow. "Pre-war period" defined. — Law. Section 310. That as used in this title the term "prewar period" means the calendar years 1911, 1912, and 1913, or, if a cor- poration was not in existence during the whole of such period, then as many of such years during the whole of which the corporation was in existence. Credit for corporations with pre-war earnings of more than 10 per cent of the invested capital for the pre-war period. — Law. Section 311. (a) That the war-profits credit shall consist of the sum of: (i) A specific exemption of $3,000; and (2) An amount equal to the average net income of the corpora- tion for the prewar period, plus or minus, as the case may be, 10 per centum of the difference between the average invested capital for the prewar period and the invested capital for the taxable year Credit when pre-war net income is meager. — Law. Section 311. (b) If the corporation had no net income for the prewar period, or if the amount computed under paragraph (2) of subdivision (a) is less than 10 per centum of its invested capital for the taxable year, then the war-profits credit shall be the sum of: (i) A specific exemption of $3,000; and "Section 311 (c-2). For credit to be used, see page 113. 'Section 311 (d). CREDITS AND SPECIFIC EXEMPTIONS 113 (2) An amount equal to 10 per centum of the invested capital for the taxable year. Credit when stock was owned by another corporation. — The privilege of securing a credit of more than 10 per cent was not extended : Law. Section 311. (d) .... in the case of any corporation which was not in existence during the whole of at least one calendar year during the prewar period, if (i) a majority of its stock at any time during the taxable year is owned or controlled, directly or indi- rectly, by a corporation which was in existence during the whole of at least one calendar year during the prewar period, .... The object of this limitation was to prevent new subsid- iaries, possibly formed to secure government contracts, from getting a credit greater than 10 per cent. Credit when income is from government contracts. — The privilege of securing a credit of more than 10 per cent was likewise not extended : Law. Section 311. (d) .... if (2) 50 per centum or more of its gross income (as computed under section 233 for income tax purposes) consists of gains, profits, commissions, or other income, derived from a government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. The object of this limitation was to increase the tax on profits from government contracts, but as the government's published pre-war ratios of profits of other concerns in the same line of business in few cases reached 10 per cent, the penalty was slight. Credit when corporations were not in existence during pre- war period. — Law. Section 311. (c) If the corporation was not in existence during the whole of at least one calendar year during the prewar period, then, except as provided in subdivision (d), the war-profits credit shall be the sum of: (i) A specific exemption of $3,000; and (2) An amount equal to the same percentage of the invested capital of the taxpayer for the taxable year as the average percentage 114 EXCESS PROFITS TAX PROCEDURE of net income to invested capital, for the prewar period, of corpora- tions engaged in a trade or business of the same general class as that conducted by the taxpayer; but such amount shall in no case be less than 10 per centum of the invested capital of the taxpayer for the taxable year. Such average percentage shall be determined by the Commissioner on the basis of data contained in returns made under Title II of the Revenue Act of 191 7, and the average known as the median shall be used. If such average percentage has not been de- termined and published at least 30 days prior to the time when the return of the taxpayer is due, then for purposes of such return 10 per centum shall be used in lieu thereof; but such average per- centage when determined shall be used for the purposes of section 250 in determining the correct amount of the tax. The regulations of the Treasury provide that : Regulation The war profits credit shall be computed in the first instance on the basis of 10 per cent of the invested capital, and when the average percentage of corporations engaged in the same general class of trade or business has been determined the amount of the tax will if necessary be recomputed. . . . (Art. 783.) When a corporation was in existence during the whole of one pre-war year and its net income exceeded 10 per cent, the full pre-war net income could be used as a credit in computing the 191 8 war profits tax. Many corporations earned much more than 10 per cent during the pre-war period and thus greatly reduced their 1918 taxes. It was expected that when the Treasury ascertained the earnings of corporations as re- quired by section 311 (c-2) a great many corporations, which had temporarily received a credit of only 10 per cent, would be entitled to receive a much greater percentage of credit and thus reduce their 1918 taxes. The new corporations entitled to claim more than 10 per cent credit reap an advantage over corporations which were in business during the pre-war period. The full increased credit applies to the entire invested capital at the beginning of the taxable year, whereas corporations in business during the pre- war period are limited to 10 per cent on all additions to in- vested capital since December 31, 1913. Most of the cor- porations affected by the adjustment made large additions CREDITS AND SPECIFIC EXEMPTIONS 115 to capital and surplus between dates of organization and Janu- ary I, 1918, so that the increased credit may result in a sub- stantial saving in tax, even though the percentage of credit is little more than 10 per cent. The compilation referred to v/as issued by the Treasury late in November, 1919 (undated), as Bulletin "D" Income Tax, "Average percentages of pre-war income to pre-war in- vested capital of general classes of corporations, grouped as to trades or businesses, as provided for in section 311 (c-2) rev- enue act of 1918." The compilation is most remarkable as it shows that very few business enterprises in the United States earned as much as 10 per cent on their invested capital during the years 191 1, 1912 and 1913. In view of repeated statements that corporations as a whole have reaped enormous profits for many years past, the official evidence of low profits is most interesting. The chart in the bulletin shows that out of 277 subdivisions of industries 229 earned less than 10 per cent and only 8 earned 15 per cent or more. It is not deemed necessary to reproduce a list of the in- dustries which earned less than 10 per cent. Those which earned more than 10 per cent follow: Abrasive products, including emery wheels, sand- paper and corundum , . 12.72% Ammunition, explosives and fireworks 11.28 Asbestos wares, magnesia, material for insulation. . 16.88 Awnings, tents, tarpaulins, etc 11.88 Bags and bagging — cotton and burlap 17-34 Baking powder, yeast i4-i4 Blacking, bluing, whiting, stains and dressing, dye- stuffs, extracts and coloring materials, inks (printing and writing), paints and varnishes 11.44 Boots and shoes 10.94 Bread and other bakery products, not including con- fectionery 11.26 Canning, preserving and evaporating fruits, vege- tables, fish, oysters and shrimps 10.67 Il6 EXCESS PROFITS TAX PROCEDURE Cardboard, box materials and box manufacturer 10.48 Cleansing and polishing preparations, soaps and washing compounds 10.56 Coffee roasting, grinding spices, and coffee substi- tutes 10.87 Corsets and brassieres 19-90 Cotton duck 11.90 Cotton ginning 1 1-73 Cotton spinning — fine yarns 10.17 Druggists' preparations, including perfumery, cos- metics, and patent medicine compounds 10.98 . Dyers of fur ii-97 Envelopes 10.28 Food preparations, not elsewhere specified 10.83 Forestry and forestal pursuits, naval stores, char- coal burning and grinding 13.00 Gypsum 1 1.81 Leather manufacture 10.69 Leather substitutes 11.82 Machinery — ^textile, also parts 10.42 Merchant tailoring, needlework, etc I7-I4 Merchants — wholesale 10.45 Mucilage and paste 1 1.23 Needles, pins, metal hairpins, and pen points IS-S4 Oleomargarine and other butter and lard substitutes, including both animal and vegetable 12.45 Petroleum refining, products and by-products 11.27 Phonographs and all other musical instruments and parts (not including pianos, organs and parts) . . . 11.53 Photographs and art portraits 19.66 Pipe lines 17-24 Professional and scientific instruments, including dental supplies, and optical goods, surgical and hospital appliances, photographic apparatus and materials 10.50 Railway express companies 13-89 Shipbuilding — wooden craft of all kinds 10.15 Signs and advertising novelties 14-45 Silk dyeing and finishing 12.10 Soda fountain apparatus, siphons 15.20 Special package foods, such as cornstarch, macaroni, tapioca, etc., breakfast foods and other cereal products 10.79 Stationery goods, school supplies, office system sup- plies 10.36 Tobacco 12.87 CREDITS AND SPECIFIC EXEMPTIONS 117 Typefounding, stereotyping and electrotyping I3-I7 Washing machines and clothes wringers 12.22 Waste — cotton and wool, linters and oakum n.89 Wire cables, fences, springs, nails and spikes 10.24 When use of median affords no adequate relief. — Ruling The M Co. claims that inequity and hardship are imposed upon it through the apphcation of the "median" in determin- ing its war profits credit under the revenue act of 1918 and requests the commissioner to determine its tax liability under the provisions of section 328 for the reason that the median as determined allows the taxpayer a war profits credit of slightly in excess of 10 per cent. It is contended that this percentage is not a representative per- centage earned by corporations in the same general class of business during the prewar period. The taxpayer has made an independent investigation and apparently has taken into consideration only a few concerns similarly situated and claims that these concerns earned over 20 per cent during the prewar period. The bureau has com- puted the median by using the returns of all corporations in same general class of business as that conducted by the M Co After analyzing the situation presented in the instant case the committee is of the opinion and recommends (i) that the median established as provided by law and pubhshed by the bureau be considered final and that the taxpayer is not entitled to considera- tion under the provisions of section 328 of the statute; (2) that there is no warrant in law or the regulations which authorizes the com- missioner to allow a larger percentage in this class of cases than that established by the median for the purposes of computing the war profits credit; and (3) that the instant case does not fall within any class of cases enumerated in section 327, therefore, relief can not be granted under section 328. (B. 10-20-783; A. R. R. 36.) Taxpayers whose credit is more than 10 per cent should file claim for abatement or refund. — Ruling. Inasmuch as the examination of all returns filed will not be completed by the due date of the last instalment of 1918 taxes, it is suggested that the taxpayers entitled to credit based on the appro- priate median shown in the accompanying tables, may recompute their tax using a war profits credit based on such rriedian, and file claim for abatement for as much of the last instalment of the out- standing assessment as the total tax assessed exceeds the tax so recomputed. In any case where the amount already paid exceeds the amount due, with the benefit of the median, claim for refund ghoHld also be filed on form 46. (Extract from Bulletin D.) Ii8 EXCESS PROFITS TAX PROCEDURE Exemptions reduced when return is for less than 12 months. — Law. Section 311. (a) .... (2) .... If the tax [war profits tax] is computed for a period of less than twelve months such amount shall be reduced to the same proportion thereof as the num- ber of months in the period is of twelve months. Regulation If a return is made for a period of less than twelve months, the amount equal to the average net income for the prewar period plus or minus 10 per cent of the difference between the average invested capital for the prewar period and the invested capital for the taxable year shall be reduced to the same proportion thereof as the number of months in the period is of twelve months The same result is reached in schedule IV of return form 1120 by computing the war profits credit for a full year and taking a fractional part of the result (Art. 781.) Foreign corporations — No specific exemption. — Law. Section 311. (e) A foreign corporation shall not be. en- titled to a specific exemption of $3,000. [Former Procedure] Deductions. — Under the 191 7 law domestic corporations were entitled to a specific deduction of $3,000 plus 7 to 9 per cent on in- vested capital. If not in existence for the whole of one year during the pre-war period the rate was 8 per cent. Individuals and partner- ships (except non-resident aliens) were entitled to a specific deduction of $6,000, plus the 7 to 9 per cent deduction, and if an individual was subject to both the 8 per cent and the graduated rate, two deductions of $6,000 could be taken. (Reg. 41, Art. 36.) (For regulations and procedure under 1917 law, see Income Tax Procedure, 1919, pages 807-812.) Ruling. "In computing the invested capital of an individual engaged in business for a period less than the 'full calendar year 1917, the invested capital should be averaged monthly for the entire year; the percentage de- duction allowable in the computation of the tax should be computed on the capital so averaged; and the full specific deduction of $6,000 should be allowed." (B. Digest 37-20-1197; A. R. M. 81.) Percentage deduction when business is substantially a continua- tion. — 1917 Law. Section 204. "A trade or business carried on by a corpora- tion, partnership, or individual, although formally organized or reorganized on or after January second, nineteen hundred and thirteen, which is sub- stantially a continuation of a trade or business carried on prior to that date, shall, for the purposes of this title, be deemed to have been in existence prior to that date, and the net income and invested capital of its prdecessor prior to that date shall be deemed to have been its net income and invested capital." CREDITS AND SPECIFIC EXEMPTIONS 119 [Former Procedure — Continued] The 1917 and 1918 laws arc in many respects arbitrary; but the com- putation of invested capital requires more or less arbitrary rules. Through- out both laws there is a clear intention to use cash as a basis for invested capital, ignoring, whenever possible, appreciation in values and changes of corporate form or organization which would defeat the purpose of the law. Section 204, in effect, ignores the so-called separate entity theory and restricts the percentage deduction of a new corporation to the percentage allowance of the old corporation. The rule works both ways. If as separate entities the old corporation was entitled to 9 per cent and the new corpora- tion to 7 per cent, the new corporation nevertheless may claim the 9 per cent deduction. The position of the Treasury in the following ruling is sound, if the application of the principle is not confined to taxpayers who are unfavor- ably affected. Ruling. " . . The attorney for this corporation contends in a memorandum brief submitted that it would not be fair and equitable to say that the trade or business carried on by the new corporation was substan- tially a continuation of the trade or business carried on by the N Company and that the N Company had no good will to continue for the reason that it became bankrupt in 1914, and was closed for a period of approximately one year before the new corporation came into existence. The attorney submits that the Income Tax Unit was in error in fixing the deduction at 7 per cent for the purpose of computing the tax, rather than at 8 per cent claimed by the corporation, for the reason that the new corporation did not succeed to the trade or business of the N Company since it had become bankrupt and had not been in operation since the early part of 1914. In this connection it is contended that since the N Company had not been opetating for a period of over one year there was no trade or business in existence at the time the new corporation was organized for the purpose of acquiring the assets formerly owned by the N Company ; therefore, since no business was in existence it was impossible for the business of the new corporation to be considered a continuation of the business of the bankrupt corpora- tion "The Income Tax XJnit has held in a specific case where an individual was engaged in the hardware business during the prewar period and made more than 9 per cent on his invested capital, but subsequent to the prewar period the hardware business was sold and the individual established a furni- ture store and made over 9 per cent on his invested capital in that business, that the deduction should be 8 per cent since he is now carrying on a busi- ness in which he was not engaged during the prewar period. The Unit has also held in the case of an individual buying a hotel business in 1914, which had been in existence during the prewar period that the deduction should be computed at 7 per cent, but since no records were available so that the average invested capital for that period could be ascertained a claim for final assessment under the provisions of section 210 and articles 18, 24 and 52 of Regulations 41 would be in order provided the Secretary of the Treasury is unable to satisfactorily determine the invested capital for the prewar period. "In the instant case, the M Company came into existence in 1915, after its predecessor, the N Company, had ceased to operate as a going concern and had not operated for a period of one year or more prior to the organ- I20 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] ization of the new company. However, it appears that this corporation ac- quired the assets of the bankrupt corporation and that even though a con- siderable amount was invested in new machinery, etc., the plant of the new corporation is located in the same place as the old corporation and that the product of the new corporation is sold under the same trade name as the product of the predecessor corporation was sold. "The facts presented in this case clearly indicate to the Committee that the business now carried on by the M Company is substantially a continua- tion of the trade or business carried on by its predecessor, the N Company, and that this view is substantiated by the fact that the new corporation is operating on the same location as its predecessor and the product of the new corporation is sold under the same trade name. "In view of the foregoing the Committee is clearly of the opinion that the action of the Income Tax Unit in holding that the new business is sub- stantially a continuation of the trade or business carried on by the N Com- pany is correct, and, therefore, recommends that its action in fixing the deduction for the purpose of computing the tax at 7 per cent, rather than 8 per cent claimed by the corporation, was proper." (B. 32-20-1124; A. R. R. 221.) Deductions permitted when, for pre-war period, there either was no income or percentage of net income on invested capital was low, by comparison. — 1917 Law. Section 205. "(a) That if the Secretary of the Treas- ury, upon complaint tinds either (i) that during the prewar period a domestic corporation or partnership, or a citizen or resident of the United States, had no net income trom the trade or business, or (2) that during the prewar period the percentage, which the net income was of the invested capital, was low as compared with the percentage, which the net income during such period of representa- tive corporations, partnerships, and individuals, engaged in a like or similar trade or business, was of their invested capital, then the deduction shall be the sum of (i) an amount equal to the same per- centage of its invested capital for the taxable year which the average deduction (.determined in the same manner as provided in section two hundred and three, without including the $3,000 or $6,000 therein referred to) for such year of representative corporations, partner- ships, or individuals, engaged in a like or similar trade or business, is of their average invested capital for such year, plus (2) in the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000. "The percentage which the net income was of the invested capital in each trade or business shall be determined by the Commissioner of Internal Revenue, in accordance with regulations prescribed by him, with the approval of the Secretary of the Treasury. In the case of a corporation or partnership which has fixed its own fiscal year, the percentage determined by the calendar year ending during such fiscal year shall be .used." It could not be expected that the Treasury would be able to determine the earnings of representative concerns until a considerable period of time had elapsed after the 1917 returns were due. The 1917 law presented so many new problems that it required all of the year 1918 to become familiar with it. By this time, however, full informa- tion is available and all taxpayers whose pre-war earnings were CREDITS AND SPECIFIC EXEMPTIONS 121 [Former Procedure — Continued] abnormally low as compared with representative concerns in similar lines of business should apply for an increased deduction. In many instances this will make a substantial difference in the tax. (Bulletin D, referred to on page 115, shows the corporations which earned oyer 10 per cent during the pre-war period. Probably many of those which failed to earn lo per cent did earn g per cent. The Treasury can now fur- nish the details. But it must be remembered that Bulletin D does not indi- cate earnings of "representative" concerns because it includes all corpora- tions in each class.) Ruling. "Smith bought a hotel business in 1914 which had been in existence during the pre-war period, but he is unable to ascertain what was its average invested capital for that period. What is his percentage deduction? "He should compute the tax in the first instance on the basis of a seven per cent deduction, but may file a claim (with explanation) for final assessment under the provisions of section 210 (articles 24 and 52), and if the Secretary of the Treasury is unable satisfactorily to determine the invested capital, the percentage deduction will be computed at the same rate per cent as in the case of representative individuals engaged in a like or similar business." {Excess Profits Tax Primer, 1918, question 18.) CHAPTER VII INVESTED CAPITAL DESCRIBED— BORROWED MONEY It has been pointed out that the excess profits tax is a vari- ant of the income tax. Net income as determined for income tax purposes is, with certain modifications (see Chapter XVI), the base upon which the rates of the excess profits tax are im- posed. The pecuHar characteristic of the tax is that the rates are not imposed at all until a certain return has first been earned upon the capital invested in the enterprise and that the rates are higher upon that portion of the profits which are found to be very rich or "excessive" than they are on the more moderate profits. There is opposition to the excess profits tax which proceeds from the conviction that the whole theory of the tax is wrong; that it is a mistake to tax business profits as such and to tax rich profits more heavily than moderate ones. But in addition to such opposition there is the even more damn- ing criticism that in actual operation the .standard of invested capital does not perform the function of determining the rich- ness of profits even reasonably well; that the results of its application are eccentric and unfair and that the task of cal- culating the standard is an impossibly burdensome one on both administrator and taxpayer. Now that the community is in the midst of a depression the productivity of the excess profits tax is decreasing and with the country fast approaching a peace basis it is expected that demand for its repeal will soon be too strong to be denied. The sixteenth amendment relieves Congress from the necessity of apportioning an income tax according to popula- tion. Direct taxes generally must be apportioned. Although the excess profits tax uses capital values as a foundation for the process of determining the rates, the Supreme Court would 122 INVESTED CAPITAl^-BORROWED MONEY 123 almost certainly classify it as an income tax within the meaning of the sixteenth amendment.^ There is no constitutional in- hibition upon Congress with respect to the method of calcula- tion except that the rules of due process of law and of uni- formity must be observed. Then the excess profits tax carries a series of credits or exemptions somewhat similar to the ex- emptions in the income tax. If these credits were not uniform as applied to each member of a class of taxpayers, the law could not be enforced. The profits tax rates are influenced by one's "invested capital" and the law attempts to impose the tax so that every member of a particular class will pay the same rate of tax and have the benefit of the same exemptions or credits. Since invested capital affects the rate in a funda- mental fashion, it would be illegal to allow one taxpayer to compute his capital one way and another taxpayer (owning similar property) another way. This principle is the basis of the right which taxpayers have to adjust and revise their book records when such records do not reflect actual conditions. Definition of "invested capital." — Both the 1917 law and the 191 8 law use the term "invested capital" and purport to define it but neither really attempts a definition at once precise and comprehensive. Both laws merely state that the item shall include certain items and exclude certain other items, leaving in doubt the status of some items not specified. Certain gen- eral statements, however, may be made regarding the content of invested capital which results from the law and the Treas- ury interpretation. Thus it is clear that "proprietor's capital" is the fundamental concept. Borrowed money and unrealized appreciations in property values are both excluded. "What are the proprietors' interests in the business?" is the question asked, but the answer must be in terms of the value of the 'Even though it were not so classified it would be possible to construct a constitutional defense for the tax on the ground that it is a type of busi- ness .tax. For a discussion of the constitutional aspects of this tax, see Arthur A. Ballentine, "Some Constitutional Aspects of the Excess Profits Tax," Yale Law Journal, Volume 29, page 632. 124 EXCESS PROFITS TAX PROCEDURE capital when invested by the present proprietors and not its worth on the market at present or any other arbitrary date. The sum originally invested constitutes on the other hand an irreducible minimum, which makes it convenient to work from the liability rather than the asset side of the balance sheet in making the computation. In general one takes the value of the original investment and makes whatever modifications are necessary to meet the limiting conditions laid down in the law. Earnings reinvested in the business are added. Certain assets, the income from which is not subject to tax, are deducted. The various modifications are treated in detail in the chapters which follow. The most difficult question which arose in determining the content of invested capital was the treatment of unrealized appreciation. Were assets to be included at cost or at a valua- tion? There were proponents of revaluation at January i, 1914 (the "pre-war date"), for March i, 1913 (the income tax date), and, most active of all, for January i, 1917 (the date at which the excess profits tax became effective). All dates were considered and all were abandoned. If practicable, March i, 19 13, would have been selected, but it would have involved an impossible task as it meant the revaluation of all business property in the United States as of a single date. The only alternative was cost. It is admitted that the cost basis works unequally because certain taxpayers realized on appreciation prior to 1917 while others did not. It is obvious, however, that those who sold or incorporated placed them- selves in a different class from those who did neither. Those who incorporated have been compelled to pay the federal capi- tal stock tax, while those who did not have paid no such tax. Since 191 7 partnerships have paid no profits taxes, as such, only corporations being subject thereto. There is little to support the contention that the cost basis for the valuation of assets is unconstitutional. If the law were imposed on capital every taxpayer would be permitted to- com- pute his capital in the same way and as of the same time. But INVESTED CAPITAI^BORROWED MONEY 125 capital is not taxed under the profits tax laws. In order to determine credits, deductions and rates, certain assets are in- cluded at cost. There have been far greater discriminations in other tax laws. The limitation on interest deductions, the double taxation of dividends, the variance in depletion allow- ances (from nothing in the 1909 law to full allowance in the 191 6 law) are only a few of many inequalities. A greater in- equality lies in the restriction on the inclusion of patents as invested capital. On the whole, cost is probably as fair a basis as can be expected in a law which otherwise is full of inequities. No excess profits tax depending on "invested capital" will ever work equitably unless someone is able to define capital and then require all taxpayers to apply the definition simultane- ously and uniformly. It must not be forgotten that goodwill is property, and if there were a general revaluation of goodwill the amount col- lected under an excess profits tax would be small. Effect of additional invested capital. — Exaggerated notions prevail regarding the effect of additional amounts of invested capital upon the taxes payable by the corporation. The fol- lowing table shows that the saving in taxes by the introduc- tion of additional invested capital is not as large as many imagine. On each $100 of capital the saving in tax is: In 1919 and 1920 $5.04 In 1918 7.04 In 1917 (8% deduction) 11.09 In 1917 (7% deduction) 10.90 In 1917 (9% deduction) 11.28 This saving is in addition to the net earnings (after taxes) from such additional capital. The calculation assumes that the taxpayer reports income in each bracket, and that in 19 19 and 1920 there are no profits from government contracts. The saving as stated is net. In each case the profits tax is decreased and the income tax is increased. 126 EXCESS PROFITS TAX PROCEDURE Computation of Invested Capital In general, invested capital includes all assets acquired with capital stock, surplus or earnings, except that patents, goodwill etc., acquired for capital stock must not exceed 25 per cent of the total capital stock outstanding. Borrowed money is in theory excluded from capital, which means that in effect such assets as stocks of other corporations or municipal bonds, if acquired with the proceeds of borrowed money, would be de- ducted from capital and surplus, were it not for section 326 (c) which provides that a certain proportion of "inadmissible" assets may be included. Irrespective of borrowed money, inad- missible assets to some extent may be included [section 325 (a)] if profits have been realized from the sale thereof, or if interest paid on indebtedness incurred to carry or to pur- chase tax-exempt securities has not been allowed as a de- duction. The proper starting point for the calculation of invested capital at the beginning of the taxable year is the aggregate of all capital stock, surplus and undivided profits accounts, as shown by the books of account. Reserve accounts which rep- resent appropriated surplus, reserves for contingencies and, in general, reserves which have been disallowed as income tax deductions should be added. Corporations are entitled to in- crease their book figures if certain assets have been carried below cost, and other adjustments may favorably affect the amount of the book value of invested capital. To try to ascertain the invested capital by adding together certain asset and liability accounts is almost sure to give an incorrect result and to cause endless confusion. The author therefore has adopted the method of using the aggregate of the book totals of capital stock and surplus as a base for deter- mining invested capital as defined by the excess profits tax law, adding thereto all permissible adjustments and deducting therefrom such items as are expressly deductible under the law. INVESTED CAPITAI^BORROWED MONEY 127 Formula for ascertaining invested capital. — The adjust- ments mentioned in the regulations and in this book may be summarized as follows : To aggregate of capital stock, sur- plus and undivided profits accounts as shown by the books at the beginning of the year: Page ADD References 1 . Additional capital paid in during the year 225 2. Premiums received on capital stock, if not included above in surplus 23 7 3. Reserves for inventory fluctuations, losses, contingencies 238 4. Reserves for bad debts, federal income and profits taxes, excessive depreciation and other purposes, disallowed under income tax practice 238, 239 ,242 5 . Reserves for sinking funds 242 6. Increase of value of assets due to restoration of tangible property such as plant, when amount paid has been charged to expense 156, 173-180 7. Appreciation of property values accrued before March i, 191 3, realized in taxable year 233 8 . Appreciation of property values realized through depletion and depreciation charges prior to taxable year 233-234 9 . Excess of property values so far as allowable as paid-in sur- plus 152-156 10. Discounts on bonds sold 177 DEDUCT I . Book value of intangible property in excess of value allowed by law 165 Treasury stock 167, 227-223 Depreciation, depletion and obsolescence not provided for on books or by foregoing adjustments 161-164 Dividends paid out of earnings of prior years and other re- ductions of capital during the year 263-271 Federal income and excess profits taxes from date payable 271-272, 242-250 Any part of surplus representing valuation, revaluation or appreciation of assets not permitted by the law 146-150, 233 Percentage of invested capital equal to percentage of in- admissible assets to total admissible and inadmissible assets 128, 190 For detailed list of adjustments see Chapter VIII. Meaning of invested capital. — Regulation. Invested capital within the meaning of the statute is the capital actually paid in to the corporation by the stockholders, including the surplus and undivided profits, and is not based upon the present net worth of the assets, as shown by an appraisal or in any other manner. The basis or starting point in the computation 128 EXCESS PROFITS TAX PROCEDURE of invested capital is found in the amount of cash and other prop- erty paid in, the valuation at which such other property may be in- cluded being determined in accordance with the statute and the reg- ulations. The computation does not stop, however, with such origi- nal entries or amounts, but also takes into account the surplus and undivided profits of prior years left in the business. The invested capital of a corporation includes, generally speaking, (o) the cash paid in for stock, (&) the tangible property paid in for stock, (c) the surplus and undivided profits, and (d) the intangible property paid in for stock (to a limited amount), less, however, the same pro- portion of such aggregate sum as the amount of inadmissible assets bears to the total assets. Invested capital does not include borrowed capital The fair market value of the assets as of March i, 1913, has no bearing on invested capital (Art. 831.) Computation of average invested capital. — Regulation. For the purpose of computing invested capital for any period of one year or less each corporation shall add to- gether its paid-in capital and its paid-in or earned surplus and undi- vided profits (under whatever name it may be called) as shown by its books at the beginning of the period. The total so obtained shall be adjusted (a) for any property paid in, or for any asset reflected in surplus and undivided profits, which is not carried on the books at the valuation prescribed by the statute or by the regu- lations, and (&) for any changes in paid-in capital or in paid-in or earned surplus and undivided profits (not including surplus and undi- vided profits earned during the period) occurring during the period, averaged for the time for which such changes are effective The total so obtained and adjusted is the average invested capital for the period, unless the corporation at any time during the period held any inadmissible assets, in which case such total must be reduced by a percentage thereof equal to the percentage which the amount of inadmissible assets held during the period is of the total amount of admissible and inadmissible assets held during the period The invested capital for any year during the prewar period is de- termined in the same manner as for the taxable year. The invested capital can not be determined by adding the amounts of the assets of a corporation. (Art. 854.) Borrowed capital. — Law. Section 326. (b) As used in this title the term "in- vested capital" does not include borrowed capital.^ ^[Former Procedure] The 1917 law (section 207) provided that there should not be included as invested capital "money or other property borrowed." ' INVESTED CAPITAI^BORROWED MONEY 129 The proceeds or cash equivalents of borrowed money are economic capital, just as any assets form part of one's economic capital. But the liability incurred is a debt as distinguished from capital. Capital in a commercial sense is what remains after provision is made for debts. The inclusion of borrowed money as invested capital would involve very serious difficul- ties of computation. What the law calls for is the proprietor's investment in the undertaking. Amounts left in business. — Regulation. Whether a given amount paid into or left in the business of a corporation constitutes borrowed capital or paid-in sur- plus is largely a question of fact. Thus, indebtedness to stockholders actually cancelled and left in the business would ordinarily constitute paid-in surplus, while amounts left in the business representing sala- ries of officers in excess of their actual withdrawals, or deposit accounts in favor of partners in a partnership succeeded by the cor- poration, will be considered paid-in surplus or borrowed capital ac- cording to the facts of the particular case. The general principle is that if interest is paid or is to be paid on any such amount, or if the stockholder's or officer's right to repayment of such amount ranks with or before that of the general creditors, the amount so left with the corporation must be considered as borrowed capital and be so treated in computing invested capital. (Art. 813.) In the following case amounts due to stockholders, on which no interest was paid or credited, were held to be bor- rowed money, because no evidence was submitted showing When borrowed money was included as invested capital. — The gross injustice of restricting the amount of interest on borrowed money which corporations might deduct under the 1917 and previous laws was happily cured in the regulations (only so far as the excess profits tax law was concerned) by including as invested capital that part of the indebtedness the interest on which could not be claimed as an income tax deduction. The provision proved the versatility of the one who so interpreted the law. As it worked out, the cor- poration which was limited in its deduction was fortunate, as the larger invested capital permitted by the regulations more than offset the reduced deduction for interest paid on indebtedness. Regulation. "The term 'money or other property borrowed' as used in section 207 and these regulations includes not only cash or other I30 EXCESS PROFITS TAX PROCEDURE that the amounts were subordinate tg amounts due to other creditors. Ruling. The M Company is a close corporation. The earnings and profits which were allowed to accumulate from year to year were finally divided and placed to the credit of the three, principal stock- holders, but substantially all the amount has been left in the business. It is contended that the sums in question constitute an addition to invested capital and should be so treated in the audit of the cor- poration's return for 19 17. The Committee holds that the sums so accumulated and allowed to remain in the business are borrowed capital and not surplus and undivided profits ; and that the action of the Unit in refusing to con- sider them as an addition to invested capital is correct and should be sustained. (B. Digest 21-20-963; A. R. R. 102.) The following case was decided under the principles set forth in A. R. R. 102 (cited above). Ruling This company was incorporated July, 191-, with an authorized capital stock of 4jf dollars of which only 3.^ dollars has been paid in. Its business is conducted on the same general plan and by practically the same individuals who were copartners in the predecessor company. Prior to the incorporation, the partners had allowed a portion of their earnings to remain in the business, such amounts being credited as "Special Accounts" of partners. When the partnership was liquidated certain partners returned their pro rata share in distribution to the corporation and on the books of the cor- poration amounts so paid in were again credited to certain "Special Accounts." Since the incorporation certain other amounts, acquired borrowed property which can be identified as such, but current lia- bilities and temporary indebtedness of all kinds, and any permanent indebtedness upon which the taxpayer is entitled to an interest de- duction in computing net income. A corporation which under the income tax law is allowed to deduct only a part of the entire interest paid upon its indebtedness, may include in its invested capital such a proportion of its permanent indebtedness as the amount of interest upon such indebtedness which the corporation is not allowed to deduct is of the total amount of interest paid upon such indebtedness during the taxable year." (Reg. 41, 1918, Art. 44.) Rulings. "Amounts added to invested capital in accordance with article 44 of Regulations No. 41 must be based on the amount of interest for the taxable year which is not allowed as a deduction, and not on amounts disallowed representing accrued interest for prior years." (B. 14-20-838; A. R. R. 48.) "The amount of permanent interest-bearing indebtedness of a corpora- tion allowable as an addition to invested capital under the provisions of article 44 of Regulations 41 need not be reduced by the amount of any operating deficit." (B. 43-20-1271; A. R. R. 295.) INVESTED CAPITAl^-BORROWED MONEY 131 by declaration of dividend, have been credited to these accounts. It is stated that it was the intention of the stockholders, as it had been the custom of the partners, to allow this fund to be used in the busi- ness of the company so long as it was necessary, subject to all the debts of the corporation as fully as though it had been paid in for capital stock. It is accordingly contended by the corporation that the entire amount so credited to the special accounts is "Surplus accumulated during the existence of the partnership and the existence of the corporation — while technically the amount received from the part- nership cannot be treated as a surplus of the corporation, still so far as the individual interest of the stockholder is concerned, it is the same thing as though the entire amount was an accumulated sur- plus of the corporation." These special accounts of the corporation are now covered by notes, the pertinent part of which reads as follows: By mutual agreement and consent, demand for payment of this note is not to be made by , his heirs or assigns, until all of the indebtedness of the M Company, for money borrowed, merchan- dise bought and delivered, together with unfilled contracts for mer- chandise bought which may be outstanding when notice is given that payment is desired, has been fully paid and satisfied. This note is nonnegotiable. The Income Tax Unit has denied the inclusion of these special accounts for invested capital for the following reasons : 1. They represent advances made by the stockholders from time to time but not in proportion to stockholdings and, therefore, do not represent paid-in surplus. 2. They were secured by notes which were payable on demand provided all obligations outstanding at the time demand was made were satisfied, and accordingly the obligation of the notes is inferior to claims of general creditors only until the date when notice is given that payment is desired. 3. The notes contain an absolute and unconditional promise to pay interest every six months, which promise is not modified by the pro- vision subrogating the principal of the notes to the general creditors, and accordingly the notes could not be considered in the light of pre- ferred stock. The Committee finds this case quite analogous to that covered by its recommendation No. 102 The following exceptions of im- portance, however, are noted : 1. The special accounts, as indicated, represent loans only by special stockholders. 2. Interest is paid on such loans. 3. An agreement in the notes to the effect that demand for pay- 132 EXCESS PROFITS TAX PROCEDURE nient is not to be made until all indebtedness of the corporation is liquidated The stockholders are ten in number. Of this ten, five are owners of the so-called "Special Accounts" for which the above-mentioned notes were given. The liability, therefore, is not to all of the stock- holders, pro rata according to the shareholdings. It is not an undi- vided amount which may be distributed pro rata in liquidation. The amounts so retained in the business are subject to interest charges and interest is actually accrued but it is apparently credited to the special accounts in part or in whole. There is an obligation on the part of the stockholders directly interested in the special accounts, not to demand payment of the notes supporting these special ac- counts until the indebtedness of the corporation is fully paid and satisfied but this agreement does not preclude the corporation as a distinct entity from liquidating these liabilities at such time as it may be deemed proper and in accordance with the tenor of the notes — not pro rata accordng to shareholders in the corporation. Fur- thermore, as stated by the Income Tax Unit: "The notes contained an absolute and unconditional promise to pay interest every six months, which promise is not modified by the provisions subrogating the principal of the notes to the general creditors and accordingly the notes could not be considered in the light of preferred stock." It is further stated in affidavit submitted by the five stockholders, who financially give independent support to the corporation, that they are "guarantors of the debts of the corporation on guarantees given by the corporation to our banks and brokers and each and every one of us is individually liable on these guarantees for the en- tire debts of the corporation up to the extent of our private means as fully as though we were members of a partnership." This obliga- tion establishes a right of action against the stockholders individu- ally and not against the corporation. As against the corporation it would not be enforceable at law, which limits the liability of the stockholder to his share of paid-in capital. Briefly, it may be stated that capital in a corporate enterprise is : 1. Cash or property paid in by subscription to capital stock or as paid-in surplus. 2. Borrowed money for which obligations of the corporation may be issued. 3. Undivided increment of income resting in the surplus of the corporation. Manifestly these "Special Accounts" do not represent either stock subscriptions or undivided increment of income. In the latter the shareholder's interest is measured by his pro rata share interest in the corporation. This undivided increment of income is not a vested right. Borrowed capital is not invested capital under section 207 of the Revenue Act of 1917 (B. 53-20-1366; A. R. R. 356.) INVESTED CAPITAL— BORROWED MONEY 133 In the following case claim was made to the banks and mercantile agencies by the corporation, with the assent of the stockholders, that the latters' credit balances were in fact sur- plus subordinate to debts due to general creditors. Rulings. Advice is requested as to the proper treatment of credit balances of stockholders' accounts in the case of the M Company. The facts appear to be that no formal declaration of dividends has been made by this company, but a book entry has been made noting and crediting to each stockholder the share of each year's earnings to which he would be entitled under a dividend declaration, the individual shareholders having returned their shares of such earnings in their personal returns and paid the income tax thereon. Reference is made to Appeals and Review Recommendation 102 as supporting the view that balances to the credit of individual stock- holders are not invested capital. In that case, however, the balances standing to the credit of individual stockholders were not in propor- tion to their stockholdings, whereas it appears in the present case each stockholder has been credited with the amount of the earnings attributable to his stock. No interest has been or is to be paid upon the amounts standing to the credit of these stockholders, no formal declaration of a dividend has been made by the board of directors, and it appears that under the State law the stockholders do not rank with general creditors with respect to such credits. Under these circumstances the case is clearly distinguishable from the one covered by Recommendation 102, and in the judgment of the Committee the amounts so credited should be regarded as being a part of the earned surplus of the corporation to be included in in- vested capital. (B. 29-20-1081; A. R. M. 71.) National banks at times declare dividends which instead of being paid to stockholders are carried with the consent of the stock- holders to a stockholders' Hability account in the name of a trustee and the amount invested in deals not countenanced by the Comptroller of the Currency. Such stockholders' trustee account, however, is a lia- bility to the individual stockholders, and the assets in which the reserve is invested are the property of the trustee for the stockholders. There- fore, from a technical viewpoint, no part thereof should be included in the invested capital of the bank even though it includes the income from the reserve in its gross income. Since shares in the bank and in this reserve are on the same pro rata basis, and the stockholders are in fact an association, a consol- idated return could be required of the bank and the association, the practical effect of which would be to include the amount of the reserve in the consolidated invested capital and the income from the reserve in the consolidated income. The committee therefore recommends that 134 EXCESS PROFITS TAX PROCEDURE the returns as made, including the stockholders' reserve accounts in the capital of the banks, and the income therefrom in the income of the banks, be allowed to stand. ( Note : This memorandum overrules rul- ing 16-19-466.) . . . . (B. 17-20-881 ; A. R. M. 43.) Interest-bearing debenture bonds, which were issued by a corpora- tion in payment for assets transferred to it and which were secured by a lien on the corporate assets subordinate to the claims of general creditors, are not considered to be equivalent to preferred stock of the corporation and may not be included in the computation of its in- vested capital for the year 1917. In computing its net income for 1917 a corporation will, however, be entitled to deduct the interest paid on these bonds within the statutory limitations with respect to interest paid in 1917. (B. Digest 21-20-962; A. R. R. 116.) Other illustrations. — Regulation. Items such as deposits or amounts due to other banks shown in the balance sheet of a bank, unexpired subscriptions shown in the balance sheet of a publishing concern, etc., are deemed liabilities and can not be included in computing invested capital. (Art. 814.) Ruling. Principal stockholder of X corporation loans $35,000 to corporation for one year. In order to protect credit of corpora- tion, agreement is signed that lender shall be deferred to all other creditors, lender to receive i per cent additional interest in consid- eration. Can this $35,000 be included in "invested capital" in nature of preferred stock, the interest not being deducted as expense? (Answer.) Your telegram April second. Question answered in negative. (Telegram of inquiry from Bernhard Knollenberg, Rich- mond, Ind., and the reply thereto signed by Commissioner Daniel C. Roper, and dated April 4, 1919.) In the foregoing case it will be noted that the stockholder received "additional" interest on the loan. If no interest had been paid and loan was subordinated to the claims of other creditors it would seem that under Art. 813 the amount could have been treated as invested capital. Preferred stock is capital. — Regulation. Any interest in a corporation represented by bonds, debentures or other securities, by whatever name called, including so- called preferred stock, if with respect to the payment of either in- terest or principal it ranks with or prior to the interest of the general creditors, is borrowed capital and cannot be included in computing INVESTED CAPITAI^BORROWED MONEY 135 invested capital. Any such preferred stock may, however, be so in- cluded if it is deferred with respect to the payment of both in- terest and principal to the interest of the general creditors. (Art. 812.) The provision of the foregoing regulation that so-called preferred stock must be excluded from invested capital refers only to what in reality is a liability of a corporation. Pre- ferred stock which ranks with creditors is a debt and not capital. It has been stated that the Treasury has under considera- tion a ruling to the effect that any preferred stock which is to be retired through a sinking fund is to be classed as borrowed money. Such a ruling would not be a correct interpretation of the law. Many preferred stocks now outstanding contain similar provisions which corporations have not observed. The test of invested capital consists in whether or not it is at the risk of the business. Ruling. Preferred stock, if in the records of the corporation it is declared to be part of its capital stock, though convertible -into first- mortgage bonds of even date therewith, is inferior, on a distribution of assets to pay debts, to the rights of general creditors, and is to be treated as invested capital so long as it is not converted. (B. Digest 27-19-609; S. 1200.) In the following case the Income Tax Unit held that the proceeds from the sale of debenture stock should be included in invested capital and interest thereon should be treated as dividends. The corporation appealed from the decision and the Unit was overruled. The opinion of the solicitor and the detailed decision of the Committee on Appeals and Review indicate that the case is a difficult one, and that it would require a very slight change in the facts to change the final decision. Ruling. Whether or not amounts received by a corporation upon the sale of so-called debenture stock constitute invested capital or borrowed capital depends upon the rights and powers enjoyed by the holders of such stock and the obligations with respect thereto under- taken by the corporation. Wher? so-called debenture stock i? issued 136 EXCESS PROFITS TAX PROCEDURE by a corporation for cash or property under a power given by the charter to borrow money, and the certificates of such stock contain an agreement on the part of the corporation to repay the face amount thereof upon dissolution, and to pay interest thereon from time to time at a certain rate per cent per annum; and where it appears that the claim of such debenture stockholders will, upon dissolution of the cor- poration, be subordinate to the claims of general creditors, but superior to the claims of the ordinary stockholders; and where it further appears that the holders of such certificates exercise no voice in the control or management of the corporation, the amounts received for the sale of such stock constitute borrowed capital, and the interest paid thereon, from time to time, by the corporation is properly de- ductible as a business expense. (B. Digest 33-20-1142; A. R. R. 237.) No connection with federal capital stock tax law. — Prior to the passage of the excess profits tax law of March 3, 1917, (repealed), it was considered likely that it would be feas- ible to base an excess profits tax law, to some extent at least and only in the case of corporations, upon the valuations of capital stock as shown by the returns made by corporations un- der the corporation excise tax law of September 8, 191 6, com- monly known as the federal capital stock tax law. The plan was so impracticable, however, that it was almost immediately abandoned. In the excess profits tax laws of 1917 and 1918, no such intention is indicated. It can be stated most positively that no corporation which has voluntarily reported a high valuation upon its capital stock under the capital stock tax law and no corporation whose capi- tal stock value has been illegally assessed at an excess rate based upon the former rules of the Treasury will receive the slightest benefit therefrom in the determination of its in- vested capital as called for by the excess profits tax law. And no corporation, which for sufficient or insufficient reasons has reported and been assessed upon a low valuation under the capital stock tax law, can be embarrassed thereby in filing a return showing the proper valuation of its invested capital as called for by the excess profits tax law. Form 1 120, for returns of corporations, calls for informa- tion as to the fair value of the capital stock as determined in INVESTED CAPITAL— BORROWED MONEY 137 the last assessment of the capital stock tax, but this is not to be understood as indicating that the Treasury regards such valuation as affecting invested capital. Regulation (fc) Section 1000 of the statute imposes a tax on the fair value of the capital stock of corporations. As in the case of the war profits and excess profits tax the invested capital is based upon the actual investment of the stockholders in the cor- poration, irrespective of the present value of its assets, and in the case of the capital stock tax the fair value looks to the present value of the corporation's assets, irrespective of the amount of the invest- ment of the stockholders therein, the amount determined as the fair value of the capital stock for the purpose of the capital stock tax can have no bearing upon the determination of invested capital. (Art. 863.) Nevertheless, form 1120 calls for the "last assessment, if any, of the capital stock tax" and the "date of that assess- ment." Of course the question should be answered; but it seems to be superfluous in view of article 863. If it has "no bearing" on invested capital, why should taxpapers be required to furnish such information? And what use can the audit section make of it? The "last assessment" is the latest return of the taxpayer in case no additional assessment has been made. Foreign corporations. — Regulation. Inasmuch as the war profits and excess profits tax in the case of a foreign corporation is not based on the invested capital of the corporation, but is computed in accordance with sec- tion 328 of the statute,^ the provisions of section 326 and of articles 831-870 have no application to foreign corporations. For the same reason, when rendering a return of income on form 1120 for a foreign corporation, no entry of invested capital should be made thereon (Art. 871.) "Relief section, see Chapter XV. [Former Procedure], Invested Capital — Individuals 1917 Law The invested capital of an individual was most easily ascertained by taking as a starting point the capital account of the proprietor as it stood on his books of account. Added to this were any credit 138 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] balances representing undivided profits, or reserves, which were not the equivalent of liabilities, less any debit balances representing bal- ances due from the proprietor, losses sustained but not yet charged off, etc. Thus the proprietor's net worth was ascertained by stating actual assets at their book value and deducting therefrom the actual liabiHties. After determining the amount of invested capital as it appeared on the books at the beginning of the taxable year, the next step was to see if the law sanctioned any increase. If any assets were carried below cost it was permissible to write up the book values, unless the difference represented normal depreciation allowances. It was also permissible to include, as invested capital, assets which were reported by the taxpayer to banks, mercantile agencies, etc., even though not on the individual's business books. Increases and decreases in capital. — The regulations held that profits earned by an individual during the taxable year could be included in his invested capital. Profits earned during taxable year may be included. — Regulation. "The restriction in respect of undivided profits earned during the taxable year which is imposed upon corporations and partnerships does not apply to individuals, and therefore, unless otherwise shown, the profits of the taxable year remaining in the trade or business will be deemed to have arisen ratably throughout the year, and the capital at the beginning of the year may be increased by the total amount of such profits remaining in the trade or business averaged monthly over the year." (Reg. 41, 1918, Art. 69.) Invested Capital — Partnerships 1917 Law The regulations held that the rules as to invested capital, etc., which applied to corporations also applied to partnerships. In general the same rules applied to individuals, except that the accruing profits during the taxable year could be added to the invested capital of individuals, but not to that of partnerships and corporations. In order to determine the invested capital of a partnership, as a starting point the aggregate of all accounts of general partners reflecting money (or the equivalent of money) at the risk of the business should be taken. Partners sometimes contribute marketable securities which form part of the firm's capital. The test is whether or not the securities are primarily at the risk of the business and whether or not the securities are or may be employed in the business. So-called loans from partners and any other credit balances of partners' accounts should be included. In many partnerships separate accounts are kept representing additional capital contributions, undrawn profits and salaries and INVESTED CAPITAI^BORROWED MONEY 139 [Former Procedure — Continued] other special matters. If such accounts do not represent liabilities to the public and are clearly at the risk of the business, they properly constitute part of the firm capital just as much as the regular capital accounts. The special or loan accounts merely indicate the order of priority of liquidation among the partners. All the accounts are grouped together when a balance sheet is prepared for the use of mercantile agencies, banks, etc. If debit balances exist representing amounts due from partners, the aggregate thereof should be deducted from the aggregate of the credit balances. The propriety of including borrowed money was seriously dis- cussed in Congress and was specifically rejected (section 207). In the opinion of the author the framers of the law considered that con- tributions of any kind from general partners to the partnership would form part of the aggregate capital of the partnership, and would not fall within the category "money or other property borrowed." Creditors are not concerned with mutual agreements among partners any more than they are with agreements among different classes of preferred stockholders. "What is the aggregate net worth of the partnership available for creditors?" is the question the govern- ment must ask. If bonds and other securities are contributed by partners as part of the invested capital of the firm, there must be no question about the availability thereof for the creditors of the firm. The securities could scarcely be counted as invested capital unless actually used in the business. The law provided that invested capital included the "actual cash value of tangible property paid in other than cash for .... shares in such partnership." It would appear that the securities used in the business must have been turned in for a share in the business. If made subject to the risks of the business it would seem that the requirements of the law were met. Cash paid in by general partners, even though it is merely credited to their accounts and interest is paid thereon, unquestionably forms part of the invested capital of the partnership. Securities or other tangible property paid in for the reasonable requirements of the business would also form part of the invested capital. Rulings. "Whether a given amount paid into or left in the business of a partnership constitutes borrowed capital or paid in surplus is largely a question of fact. Indebtedness to the partners actually cancelled and left in the business would ordinarily constitute paid in surplus. The gen- eral principle is that if interest is paid, or is to be paid on any such amount, or if the partners' or shareholders' right to repayment of such amount ranks with or before that of general creditors, the amount so left in the partnership should be considered borrowed capital and be so treated in computing invested capital. Any amount of money, therefore, that is borrowed by on? partner and contributed to the partnership, even I40 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] though such partner may have a right to withdraw such amount_ at, his discretion, and especially where the partnership does not pay interest on such amount and has not given its note for the repayment of such amount, the money so paid in would not rank prior to or with that of the general creditors and in the judgment of the committee it should be m- cluded in the computation of invested capital. "The committee is of the opinion that the framers of the law con- templated that contributions of any amount from joint partners to the partnership would form part of the aggregate capital of the partnership and would not fall within the category 'money or other property bor- rowed.' A distribution should, however, be made where the partnership having bills of lading in its name, takes such bills of lading to_ banks with a note attached, and borrows money which the partnership is primarily liable to pay and the partners are secondarily liable to pay in the event of failure of the partnership. This, in the judgment of the committee, would constitute borrowed capital used in the business of a partnership. . . . " (B. Digest 18-20-904; A. R. R. 78.) "The facts appear to be that the taxpayer [a partnership] has the selling agency for the goods of a number of different textile mills and that in order to secure such agency, financing and part ownership of the mills is necessary. In order to effect this the partnership has from time to time turned over to the individuals who composed it sums of money and they have purchased the stocks and bonds necessary on their personal account. "It does not appear from the papers that such purchase was made as agents of the company from funds specifically turned over for that pur- pose and it is presumed that the funds so turned over are merely a distribu- tion to all interests in the partnership in proportion to their interests of the profits of the company, although such distribution may have been made for the purpose of providing the funds with which the partners might make their purchases. Assuming that this is the case, the Com- mittee is of the opinion that the stocks so purchased are not in any sense assets of the partnership any more than any other assets privately owned by the individual members are assets of the partnership ; nor does it appear that they have been so treated in the past on the books of the partnership. The income from such securities has not gone into the income account of the partnership, nor has the amount of the invest- ment in them gone to increase the amount of capital credited to the part- ners on which interest is allowed before distributing the balance of profits in accordance with the partnership agreement. It is strongly urged by the taxpayer and may be conceded by the Department that the purchase of these stocks is not made for the investment yield, the average return upon the entire amount being approximately five per cent, and that the investments were in fact made for the purpose of securing the selling agencies or business of the mills whose stocks are owned, and that with- out this financial connection a large part of the profits of the business will be lost. "The fact remains, however, that the law expressly provides what may be regarded as the invested capital of a corporation or partnership, and that is, as affects the question now at issue, the amount of cash or tangible property paid in to the corporation or partnership for stock or shares, the share evidently referring to the member's interest in the paid- in capital of the partnership. "The committee is, therefore, unable to find any warrant of law for recognizing as capital of the partnership property individually owned by INVESTED CAPITAL— BORROWED MONEY 141 [Former Procedure — Continued] members of the partnership, even though such ownership may favorably affect the general partnership interest, and recommends that the action of the Unit in disallowing the amount in question be confirmed." (B. 3-20- 696; A. R. R. 17.) Theoretically the above stock was not invested in the business of the partnership, but as a matter of fact it was a part of the capital of the partnership. The author is of the opinion that the partnership and indi- viduals should have been permitted to readjust their accounts so as to make these stocks a part of the assets of the partnership. As to items relating to a partnership, there is very little difference between the part- nership's books and those of the individuals of the partnership. Part- ners, unlike stockholders, do not have to be so careful about keeping their accounts separate from those of the partnership, because they are not separate entities. In the case of the partnership, the question is : Is the asset actually invested in the business of the partnership? If it is, then it should be allowed as a part of invested capital. Reserve for federal taxes. — If withdrawals by partners during the taxable year 1917 exceeded accrued current earnings the excess reduced invested capital. The Treasury has held that a reserve first should be set aside for accrued income and profits taxes before profits could be distributed (Art. 1542), but it also holds that such reserves may be in- cluded in the computation of invested capital until such taxes become due and payable. (Art. 84S.) As income and profits taxes for 1917 did not become due and payable until some time in 1918 no deductions should have been made from invested capital on account of partners' withdrawals unless the current earnings (before providing for taxes) were exhausted. Cash value of insurance policies. — If life insurance has been carried by partners for the benefit of the firm, the cash value of the policies was held to constitute part of the invested capital. (But if the fair value of the policies exceeded the cash surrender value there would seem to be no good reason why such fair value should not be included in invested capital. For full discussion of this point, see page 175.) Procedure under 1917 law. — For details regarding procedure to be followed by individuals and partnerships under the 1917 law, see Income Tax Procedure, 1917 and 1918 editions and supplements thereto. CHAPTER VIII INVESTED CAPITAL— ADJUSTMENT OF ASSET VALUES The law prescribes what may and what may not be in- cluded in invested capital and the basis of valuation of such assets as are included. An important part of the preparation of corporation tax returns is the adjustment of book values. The adjustment of asset accounts correspondingly affects capi- tal stock and surplus accounts, which either decreases or in- creases the invested capital. Books need not reflect adjustments. — It is not necessary that the books should reflect the adjustments required for the tax return, but it is very essential that all the figures in the tax returns can be readily traced to the books and to do this, complete working paper used in preparing the returns should be preserved. Regulation, (a) The invested capital as here defined may dif- fer from the capital as shown on the books of the corporation. In such event no changes should be made in the books themselves. The corporation should, however, in all cases keep a permanent record of the adjustments which are made in computing invested capital. (Art. 863.) Reconciliation statement helpful. — Whenever it is impos- sible to prepare the excess profits and income tax returns di- rectly from the face of the books of account, it is most impor- tant to retain an accurate and detailed memorandum showing the relation between the items on the several records. If the two records are not reconciled it is very easy to make an error which may cause a loss to the taxpayer or to the govern- ment. A draft form of reconciliation of invested capital be- tween books and returns is given on the following page. 142 RECONCILEMENT OF BOOK CAPITAL WITH INVESTED CAPITAL AS DEFINED IN THE 1918 LAW* Fiscal Year Ended 1920 Invested Capital at Beginning of Fiscal Year According to the Books Page Item References loi . Capital Stock 225-23 1 102 . Premium realized on Capital Stock 237 103 . Earned Surplus (while Surplus is added, any Deficit should not be deducted) '. 231 104 . Paid-in Surplus .' 234 Adjustments to be Added: 105. Dividends Payable ** (see item 134) (Art. 858) 263-271 106. Reserve for Accrued Preferred Stock Dividends (see item 134) (Art. 858) 263-271 107. Reserve for Accrued Federal Income and Excess Profits Taxes ** (see item 135) (Art. 845) 242 108 . Reserve for Uncollectible Accounts or Bad Debts** 238 109. Reserve for Losses and Contingencies** 238 no. Reserve for Sinking Eund 242 111. Appreciation realized through depreciation or depletion prior to taxable year (Art. 844) 233 112. Appreciation accrued prior to March i, 1913, but realized in the taxable year** (Art. 844) 233 113. Cash surrender value of life insurance if not on the books (Art. 846) 175-176 114. Cost less accrued depreciation of plant assets charged to ■ Expense Account but still owned and in active use (Art. 840) 156, 173-180 115. Depreciation charged on the books in excess of deductions allowed on tax returns and excessive depreciation charged off before 1909 (Arts. 840 and 842) 239 116. Excess of cash value of tangible property at date acquired over book value at same date when not acquired with stock (Art. 837) 154 117. Excess of cash value of tangible property when acquired with stock at date acquired, over book value at same date (Art. 836) iS3, iS4 118. Excess of cash value of intangible property purchased over book value at same date (Art. 851) 168 119. Depreciation of goodwill, patents and copyrights, pro- vided book value plus this adjustment does not exceed legal limitation (Art. 843) 185-189 120. Federal Income and Excess Profits Taxes refunded f. . . . 121. Capital Stock except stock dividends (including any premium realized) added during fiscal year, exclusive of current earnings t (Arts. 850 and 853) 225 122 . Amortization under Munitions Tax Act, if charged off on books. Excess Profits Tax Procedure, 1920, pages 196-197 123 . Discounts on Bonds Sold 177 124. Total (sum of items loi to 123) , , . , . Adjustments to be Deducted: 125 . Portion of book value at date acquired of intangible pro- perty in excess of cash value at same date, when not acquired with stock (Art. 831) 128, 165-168 126. Portion of book value at date acquired of tangible property in excess of actual cash value at same date, when not acquired for stock (Art. 831) 128, 168-168 127. Portion of book value at date acquired of tangible proper- ty in excess of cash value at same date when acquired with stock (Art. 831) 128, 145 128 . Portion of book value at date acquired of intangible prop- erty purchased with stock in excess of the lowest of the following figures: (a) Actual cash value of asset at date acquired, or. . . . (b) Par value of stock issued therefor, or (c) 25% of par value of total stock outstanding March 3, 1917, or beginning of taxable year (Arts. 851 and 865) 165-168 129. Tteasury stock acquired by gift or for consideration sub- stantially less than par, deduct par (Art. 861) 227 130. Cost (or book value, if different from cost) of Treasury Stock held at the beginning of the taxable year (See form 1 1 20) (Art. 862) 227 131. Depreciation, depletion and obsolescence not provided for on the books, except as covered by previous de- ductions (Art. 839) 161-164 132. Value appreciation credited on the books not subject to income tax except as in 111,112 and 113 (Art. 844) 239-241 133. Capital stock reduced during fiscal year by distributions to stockholderst (Art. 860) 250-25 1 134. Dividends paid during fiscal year out of earnings of prior yearst (Art. 858) 264 135. Federal income and excess profits taxes paid out of earn- ings of prior yearst (Arts. 845 and 845A) ...... 242-250 271-272 136. Treasury stock purchased during taxable year not out , of current year's profits f 227 137. Dividends charged to depreciation and depletion reserves (Art. 1549), Income Tax Procedure, 1921, page 582 138 . Discounts on capital stock (Art. 83 1) 177-179 139. Percentage of invested capital equal to percentage of in- admissible assets to total assets (Arts. 831 and 852).. . 128, 190 140 141. Total adjustments to be deducted (sum of items 125 to 140) 142 . Adjusted invested capital (item 124 minus item 141) .... * Corpo"ations which are holding or controlling companies must use consolidated 6gures. but not includinp the irvpsted capital of any affiliated corporation organized after August I, igi4, and not successor to a then existing business, so per cent or more of whose gross income was derived from government contracts or sub-contracts made between .\pril 6, 1917, and November ii, 1918. Such corporation shall be assessed separately. (Section 240.) If corporation has undergone reorganization, consolidation or change of ownership since January i, 1911, or has been organized subsequent to March 3, 1017, see sections 330 and 331. When stating total amount of invested capital accordmg to the books disreg^.rd the asset side of the balance sheet. The article numbe*s cited below refer to Regulations 45. ♦♦Amounts to be added are the balances in these accounts at the beginning of the fiscal year. tThis amount should be such percentage of the amount received or paid as the percent- age which the number of days remaining in the fiscal year including date of payment bears tol365 days for the year 1919 and 366 days for 1920. (In case of item 13 s use due dates of instalments.) 144 INVESTED CAPITAL— ASSET VALUES 145 Tangible Property Assets are first divided into tangible and intangible prop- erty. Tangible property may or may not be included in in- vested capital; likewise intangible property may be included or excluded. Tangible property is divided into admissible and inad- missible assets. There is no short method of determining invested capital. It is necessary to analyze every item on a balance sheet, and then to ask the question : "Has the corporation any assets that should be included, which have been written off or have never appeared on the books?" Tangible property which may be fully included in invested capital.^ — The word "tangible" means something which may be touched. As defined in the following section of the law the term includes many items which ordinarily would not be classed as tangible property. Law. Section 325. (a) . . . . The term "tangible property" means stocks, bonds, notes, and other evidences of indebtedness, bills and accounts receivable, leaseholds, and other property other than intangible property; Tangible assets, bought for cash, are assumed to have been worth the purchase price. When bought with stock the assets must be valued at their cash value at time of transfer. Subsequent appreciation in value must not be added to original '[Former Procedure] 1917 Regulations. "The following classes of property, when paid in for stock or shares in a corporation or partnership, will be regarded as tangible property so paid in : (a) Stocks. (b) Bonds. (c) Bills and accounts receivable. (d) Notes and other evidences of indebtedness. (e) Leaseholds. "But when a corporation pays for intangible property by the issu- ance of its own stock or bonds, this will not be regarded as being a payment bona fide made in cash or tangible property within th? meaning of section 207." (Reg. 41, i9i8. Art. 47.) 146 EXCESS PROFITS TAX PROCEDURE values. If actual value of property at time it was transferred to the corporation was in excess of stock issued therefor, the excess above par may be considered as paid-in surplus. All tangible property, however, cannot be included as in- vested capital. Generally speaking, the items of tangible prop- erty which must be deducted are the so-called "inadmissible" assets, viz., stocks and tax-exernpt bonds, though under certain conditions these inadmissible assets are included as invested capital.* Appreciations in values must not be included. — Unless there has been a sale or transfer of assets to a new owner, no appreciation in values can be used in stating invested capital.' If there has been no sale to an outside interest, there has been no realization of the increases in values. With- 'See Chapter IX, "Inadmissible Assets." '[Former Procedure] When invested capital is increased by appreciation at January 1, 1914, depletion of original value must not operate to reduce invested capital. — The 1917 law [section 207 (a)] permitted a revaluation of tangible property as of January i, 1914, but the restrictions were such that the section did not permit of an increase in the invested capital of many corporations. Regulation. "Tangible property paid in for stock or shares prior to January i, 1914, must be valued at either (a) the actual cash value of such property on January i, 1914, or (b) the par value of the stock or shares specifically issued therefor, whichever is lower. This is one of the few cases in which the law permits allowance to be made for appreciation, and here no appreciation can be recognized unless the original stock or shares were specifically issued in exchange for such tangible property. "Tangible property paid in for stock or shares on or after January i, 1914, will be taken at the actual cash value of such property at the time of payment, irrespective of the par value of the stock or shares." (Reg. 41, 1918, Art. 550 The foregoing regulation does not and cannot refer to any section of the 1917 law except section 207 (a-2) because in no other part of the law is there any reference to the date January I, 1914. As stated in the article, this is one of the few cases wherein appreciation may be in- cluded in invested capital. It is therefore not disputed that the 1917 law and regulations intended for some reason to permit in special cases what was prohibited in most cases. INVESTED CAPITAI^ASSET VALUES 147 out a bona fide realization there can be no trustworthy measure of the alleged appreciation. There is an apparent exception to the foregoing in the case of corporations organized before March 3, 191 7. In The regulations are somewhat more explicit than the law, but there is no appreciable difference. As stated in the regulations, appreciation may be included up to but not exceeding the stock's actual value or par, whichever is lower. If it had been intended that a still lower amount should be computed, it would have been easy to have provided so in the law. In the absence of such provision, the Treasury is not authorized to limit the provision by construction. It may have been inadvisable to permit appreciation as an item of invested capital, but the language of the law is clear and unmistakable. There is no such provision in the 1 91 8 law. It has been suggested that the permission was intended to apply only to corporations which had originally capitalized tangible property far in excess of the actual value of such property, and that no similar relief was intended for corporations which might show appreciation at January I, 1914, but originally had issued stock the par value of which was not considerably in excess of actual value. In the absence of unequivocal language, it cannot be presumed that any such discrimination was intended. It is far more probable that if any discrimination had been intended, it would have favored the more con- servatively capitalized corporation. To illustrate: Corporation A issued stock with par value of $1,000,000 for a "hole in the ground," with no known or actual value. On January i, 1914, the remaining value of the same property was $2,000,000, after substantial values had been realized prior to January i, 1914. It is admitted by the Treasury that the corporation on January i, 1917, could claim invested capital of $1,000,000, even though the entire amount represented apprecia- tion. Corporation B issued stock with par value of $1,000,000 for prop- erty worth $1,000,000. On January l, 1914, the remaining value of the same property was $2,000,000. Between incorporation and January i, 1914, one-half of the mineral content had been removed. The Treasury proposes to allow as invested capital on January i, 1914, the sum of $500,000, even though there is a clear value at that date of $2,000,000. In other words, the element of appreciation allowed to A is wholly denied to B. The Treasury is said to proceed on the theory that prior to January I, 1914, that is, between March i, 1913, and December 31, 1913, a period of only 10 months, the corporation was permitted to claim depreciation of appreciation free of income tax. But the same right was extended to corporation A, so the theory is not sound. 148 EXCESS PROFITS TAX PROCEDURE all such cases, however, there must have been a formal transfer of title to property. (See Chapter XVII.) The disallowance of estimated appreciation does not work a comparative hardship in most cases, although many think that persons who have recapitalized or sold out have derived some special benefit therefrom as compared with those who have retained their pre-war status. In the case of sale : I. There must have been an actual change of ownership or no possible benefit accrues. It is also said that earned surplus must take care of depletion of original cost and, if full depletion has not been written off, it must be deducted in the computation of invested capital. But earned surplus is not at issue and there is no possible connection between sections 207 (a-2) and article 55 and earned or paid-in surplus. On the contrary, the sole question in such section and article is that of permitting appreciation as an item of invested capital — not of seeking means to exclude it. It is urged, therefore, that corporations A and B must be dealt with alike and be allowed invested capital of $1,000,000. If the 1917 law had continued in force, it would have been permissible to claim invested capital of $1,000,000 in each case until the actual value was reduced below $1,000,000. In 1904 a corporation was organized : Par value of stock issued $10,000,000 Actual value of property 500,000 In 1914 actual value of the remaining original property 1,000,000 Property had hfe of 20 years and in 1914 was one-half ex- hausted. Depletion on basis of original value to 1914 250,000 Article 55, Regulations 41, provides that: (a) actual value, or (b) par value, whichever is lower, shall be taken. In this case (a) is $1,000,000. The revenue agent allowed $750,000, that being the actual value in 1914 less depletion for 10 years, but there is no provision in the law for deducting depletion for any period from (a) or (b). The formula in the law is arbitrary but perfectly clear and cannot be radically changed to the detri- ment of the taxpayer. Payment of tax on appreciation does not change its status. Ruling. "A claim for inclusion in invested capital for the year 1917 of an amount representing appreciation in the value of property which appreciation had been taken up on the books in 1914 and returned as tax- able income for that year should be denied for the reason that such tax was erroneously assessed and collected. The taxpayer is entitled to a claim for refund." (B. Digest 7-19-308; T. B. M. 41.) INVESTED CAPITAL— ASSET VALUES 149 2. The sellers, if they sold out at prices substantially greater than book values, must account for the excess realized and pay income taxes thereon. 3. The buyers, having hazarded new capital in what to them is a new enterprise, are entitled to consider as invested capital the full amount of the new capital employed. 4. The amount of new capital automatically equalizes matters, because if by any chance the buyer pays an inflated price and thereby will receive exemption on an inflated amount of invested capital, the seller (who has realized the inflated price) must account for a like amount of profit. 5. It is true that there was no income tax burden on the sellers who sold out before March i, 1913, and in a compara- tively few cases a large benefit now accrues to such persons, but transactions which took place many years ago were not influenced by the imminence of income and excess profits taxes and they cannot be fairly penalized now for avoiding some- thing which no one foresaw. If all items properly classed as invested capital tangible and intangible could be reappraised as of March i, 191 3, or Janu- ary I, 1 9 18, there would be such an increase in values that the rates of tax would have to be greatly increased to raise the same amount of revenue. Reappraisals which exclude appreciation are permitted. — As heretofore stated each taxpayer has the same privilege as every other taxpayer as to what may be included in invested capital. If a corporation wrote down its plant values to $1 in 1908, it may in 1920 or any other year restore to its books the actual cost of the plant, less normal depreciation. Addi- tions or new buildings may have been charged to maintenance, excessive depreciation may have been charged off or in many other ways the books of account on January i, 191 7 (the date when the excess profits tax became effective), may have failed to reflect the items of tangible property permitted by the law to be included in invested capital. I50 EXCESS PROFITS TAX PROCEDURE In other words, corporations may set up on their books full plant values at January i, 19 17, so long as no element of appreciation is included in the revaluation. Ruling. Receipt is acknowledged of your letter of May 15, 1919. "Is it possible to revalue a plant property for inclusion in invested capital on a basis of its actual worth as of March I, 1913, based upon cost less depreciation as of that date and to include property purchased since that time at cost less depre- ciation ?" You are advised that if a taxpayer is of the opinion that the book value of his plant does not present its correct valuation, due either to charging off excessive depreciation in prior years or charg- ing to expense, items which properly should have been charged to some asset account, he may in accordance with the procedure out- lined in articles 840 and 841 of Regulations 45, final edition, re- value such plant and adjust his invested capital accordingly. In this connection, it should be noted that certain items, such as ex- perimental expenses, patent litigation, development of good will, through advertising or otherwise, etc., which were charged to oper- ating expenses when made, cannot now be changed to capital ex- penditures for invested capital purposes for the reason that a charge of this character against income or capital at the time made is optional and therefore cannot be changed after the option is exer- cised. It must be borne in mind that the above referred to articles should not be construed to mean that the taxpayer may exercise the option of revaluing his property as it exists today for the pur- pose of adjusting his invested capital in accordance with its present market valuation. If a taxpayer desires to appraise his property, there will be no objections on the part of this office, but it must be understood that in' the revaluation of any property, the price at which such property was acquired or its cost at the time of its construction, plus any additions or betterments and less proper depreciation up to the time of its valuation will be the basis upon which such prop- erty can be included in invested capital. The fair market value of the assets as of March i, 1913, has no bearing on invested capital. Invested capital within the meaning of the statute is capital actually paid in to the corporation by the stockholders, including the sur- plus and undivided profits, and is not based upon the present market value of the assets, as shown by an appraisal or in any other man- ner. (Letter to J. V. Rourke, New York, from Commissioner Roper, July IS, 1919.) INVESTED CAPITAL— ASSET VALUES 151 Capital invested at March i, 1913. — It is now settled prac- tice that for income tax purposes assets acquired prior to March i, 1913, may be appraised or reappraised at fair market value as of March i, 1913, and such values may be set up on the books of a corporation. For the purposes of the federal income tax the revaluations will be used as a basis for the determination of profits or losses when realizations take place and for subsequent calculations of depreciation, obsolescence and depletion. But such values have not been recognized as invested capi- tal in the excess profits tax laws of 1917 and 1918. Senator Simmons in reporting the Senate draft of the 1918 revenue bill said :* Speaking generally, assets are valued, for the purpose of deter- mining invested capital, at the price paid in acquiring them without recognition of subsequent appreciation. Weighty arguments have been presented in favor of abandoning this rule and valuing property acquired before March i, 1913, as of that date. But the committee believes that such a method would be impracticable; that it would impose upon the Treasury Department the impossible task of valuing nearly all of the durable property of the country as of a date nearly six years in the past. The present statutory rule works well in a large majority of cases. The remaining cases, in which it works injustice, can and should be cared for by adequate relief provisions which the committee has carefully formulated and recommends. It must be remembered, however, that the only purpose of the refusal to recognize values existing at March i, 19 13, was to eliminate appreciation in values. There was no intention to deny the right of a corporation to restore values which had at one time existed but had been written off or written down through ignorance or "ultra conservative methods of book- keeping." In the latter case the restoration of proper values at March i, 1913, is not inhibited by the law. Regulation The fair market value as of March i, 1913, has no bearing on the determination of the invested capital of a corporation for the purpose of the war profits and excess profits tax (Art. 1561.) 'Finance Committee report, page 11. 152 EXCESS PROFITS TAX PROCEDURE Adjustment of asset values resulting in paid-in surplus. — The term "paid-in surplus" is used to distinguish the account from surplus arising from the operations of the corporation. If assets worth $10,000 are acquired for $5,000 par value of capital stock, the proper accounting procedure for reflecting this transaction on the books is to debit asset accounts $10,000, and to credit capital stock $5,000 and capital (or paid-in) sur- plus $5,000. When capital stock has been issued for an amount less than the actual value of assets at the time of acquirement and the assets have been undervalued on the books, it is permissible under the 19 18 law and the 19 17 and 1918 regulations to rectify the books of account as of the beginning of the taxable year. However, if assets have appre- ciated in value since the capital stock was issued in exchange therefor, the law specifically forbids any reflection thereof so far as it affects the determination of invested capital. Law. Section 326. (a) (2) Actual cash value of tangible prop- erty, other than cash, bona fide paid in for stock or shares, at the time of such payment, but in no case to exceed the par value of the original stock or shares specifically issued therefor, unless the actual cash value of such tangible property at the time paid in is shown to the satisfaction of the Commissioner to have been clearly and substantially in excess of such par value, in which case such excess shall be treated as paid-in surplus: Provided, That the Commissioner shall keep a record of all cases in which tangible property is in- cluded in invested capital at a value in excess of the stock or shares issued therefor, containing the name and address of each taxpayer, the business in which engaged, the amount of invested capital and net income shown by the return, the value of the tangible property at the time paid in, the par value of the stock or shares specifically issued therefor, and the amount included under this paragraph as paid-in surplus. The Commissioner shall furnish a copy of such record and other detailed information with respect to such cases when required by resolution of either House of Congress, without regard to the restrictions contained in section 257.° Rulings. Paid-in surplus must consist of tangible property transferred to the corporation, either as a gift or at a value which is less than its actual cash value; and in practically all cases where allowable, involves no substantial change of beneficial interest. 'Section 257 restricts the publicationi of returns. INVESTED CAPITAI^ASSET VALUES 153 Contracts which are regarded as tangible assets can only consti- tute paid-in surplus when such contracts are made between outside parties, and the rights of either of such parties are transferred to the corporation without adequate compensation. Contracts to which the corporation itself is a party may not be so included. (B. Digest 40-20-1227; A. R. R. 233.) Where a corporation exchanges its stock for the assets of a part- nership, which are greatly in excess of the par value of the stock, and there is no written obligation to the partners as to the payment of the excess, the taxpayer is entitled to submit evidence in support of a claim for paid-in surplus ; however, if the corporation is obli- gated to the partners for any portion of the excess, a claim can not be sustained. (B. 13-19-432; O. D. 249.) Where bondholders purchase at foreclosure sale the property cov- ered by the mortgage securing the bonds and form a new corpora- tion to which the property is transferred in exchange for its entire capital stock, the corporation should be allowed to set up an invested capital equal to the value of the property transferred to the corpora- tion as of the date of transfer such value to be established by evi- dence acceptable to the Commissioner. (B. Digest 8-19-334; T. B. R. 32.) The regulations give details of evidence to be submitted in substantiation of a claim regarding paid-in surplus." Regulations. Evidence offered to support a claim for a paid-in surplus must be as of the date of the payment, and may consist among other things of (a) an appraisal of the property by disinterested authorities made on or about the date of the transaction; (fc) cer- tification of the assessed value in the case of real estate; and (c) proof of a market price in excess of the par value of the stock or "[Former Procedure] Regulation. "Where it can be shown by evidence satisfactory to the Commissioner of Internal Revenue that tangible property has been con- veyed to a corporation or partnership by gift or at a value, accurately ascertainable or definitely known as at the date of conveyance, clearly and substantially in excess of the cash or the par value of the stock or shares paid therefor, then the amount of the excess shall be deemed to be paid-in surplus. The adopted value shall not cover mineral deposits or other properties discovered or developed after the date of conveyance, but shall be confined to the value accurately ascertainable or definitely known at that time. "Evidence tending to support a claim for a paid-in surplus under these circumstances must be as of the date of conveyance, and may consist, among other things, of (i) an appraisal of the property by disinterested authorities, (2) the assessed value in the case of real estate, and (3) the market price in excess of the par value of the stock or shares." (Reg. 41, 1918, Art. 63.) 154 EXCESS PROFITS TAX PROCEDURE shares. The additional value allowed in any case is confined to the value definitely known or accurately ascertainable at the time of the payment. No claim will be allowed for a paid-in surplus in a case in which the additional value has been developed or ascertained subsequently to the date on which the property was paid in to the corporation, or in respect of property which the stockholders or their agents on or shortly before the date of such payment acquired at a bargain price, as for instance, at a receiver's sale. Generally, allow- able claims under this article will arise out of transactions in which there has been no substantial change of beneficial interest in the property paid in to the corporation, and in all cases the proof of value must be clear and explicit. (Art. 836.) Where it is shown by evidence satisfactory to the Commissioner that tangible property has been paid in by a stockholder to a cor- poration as a gift or at a value definitely known or accurately ascertainable as of the date of such payment clearly and substantially in excess of the cash or other consideration paid by the corporation therefor, then the amount of the excess shall be deemed to be paid-in surplus. Substantially the same kind of evidence will be required under this article as under article 836 (Art. 837.) Taxpayers claiming the benefit of section 326 (a-2) are required to submit evidence to support their claims. The Commissioner has prepared elaborate forms to be used by claimants, which will be furnished upon application. The information required concerns chiefly the basis of appraisals; values at which property was assessed for local taxation; de- tails of values entered on the books ; reports on sales of similar property in same vicinity within one year prior and one year subsequent to date of acquisition; questions as to litigation, decedents' estates, partnerships, accountings, etc., in which values might have appeared; clear evidence that values were known at time of acquisition and were not based on subsequent discoveries; and, in general, proof sufficient to convince the Commissioner that the effort to upset one's own book values is made on good grounds and in good faith. Paid-in surplus limited to value at time of trans- fer. — Ruling. Where certain commercial leases to oil lands are in- formally transferred to a corporation formed by the lessees for the INVESTED CAPITAI^ASSET VALUES 155 purpose of taking over such leases, no consideration being paid for such transfer, it will be deemed that the transfer was made at the time of taking possession, and the addition to invested capital of the corporation upon such transfer is the fair market price or value of the leases at the time possession is so taken by the corporation. (B. Digest 21-20-965; S. 1387.) In the foregoing case, property which had not been form- ally transferred greatly increased in value before formal trans- fer was made. It was rightly held that appreciation subse- quent to the date of gift could not be included in invested capital. Ruling. The Committee is of the opinion that the real meaning of article 63, Regulations 41, is that the appraisal of property con- veyed to a corporation in exchange for its stock must have been made as of the date of transfer, but not necessarily on the exact date of conveyance. As the evidence produced in this case shows that there was no appreciable increase in the value of real estate in the locality between January i, 1911, the date of transfer, and the subsequent appraisals of the property about a year later, the claim of the cor- poration for an addition to its invested capital as paid-in surplus is allowed. (B. Digest 28-20-1064; A. R. R. 161.) Depreciation of assets represented by paid-in sur- plus TO BE treated SAME AS DEPRECIATION OF ANY OTHER ASSET. Ruling. Reference is made to your letter of March 18, relative to paid-in surplus representing value of property in excess of the consideration paid therefor. In reply you are informed that paid-in surplus representing tan- gible property need not be reduced by reason of depreciation of the property in question. All adjustments necessary on account of in- adequate or excessive depreciation should be made in connection with earned surplus or undivided profits. Therefore, if a corpora- tion is properly entitled to add to its invested capital in the form of paid-in surplus an amount representing excess in value of prop- erty, over the consideration paid therefor, either under article 63 of Regulations 41, relative to the Revenue Act of 1917, or under articles 836 and 837 of Regulations 45, relative to the Revenue Act of 1918, such paid-in surplus need not be reduced on account of depreciation of the property on which the excess value is claimed. It should be borne in mind, however, that while paid-in surplus as indicated above need not be reduced on account of depreciation, such adjustment must be made in earned surplus or undivided profits. 156 EXCESS PROFITS TAX PROCEDURE and the computation must be based not on the cash paid or stock issued for the property, but on its actual value at the time acquired for the purpose of computing the allowable addition to paid-in sur- plus. (Letter to Leslie, Banks & Co., New York, N. Y., signed by Commissioner Daniel C. Roper, and dated April 14, 1919.) The ruling accords with good accounting practice. If property purchased for $10,000 in stock is proved to have been worth $20,000, the additional value will be debited to property and credited to paid-in surplus. When annual de- preciation is charged it could not be debited to paid-in sur- plus. If so it would diminish invested capital and current operating costs would not be properly debited. Intangible property cannot be treated as paid-in SURPLUS. — The law (section 326) limits paid-in surplus to tangible property. Rulings. A partnership prior to incorporation had earnings in- dicating a good will worth at least as much as its tangible assets, 20o;r dollars. The corporation in 189- issued 200J1; dollars in stock in ex- change for the trade name, good will, and physical assets of the partnership, but set up no good will on its books. It now claims good will to the amount of S0;t: dollars as invested capital for 1918. No portion of the good will acquired may be treated as paid-in surplus for invested capital purposes. This is clearly a case of acqui- sition of a mixed aggregate of tangibles and intangibles for stock and the corporation may allocate 150X dollars of the purchase price to the tangibles acquired (principally raw materials and stock in trade) and 50^ dollars to intangibles, which will have the effect of decreasing the cost price of assets from 200.*: dollars to 150X dollars and consequently increasing earned surplus by ^ox dollars. (B. Digest 44-20-1282; A. R. R. 307.) .... Intangibles purchased for stock can never directly or in- directly be treated as paid-in surplus. (B. 37-20-1196; A. R. M. 80.) When book value of assets may be increased. — Plant and similar accounts may be adjusted when excessive depreciation has been written off, and in certain cases, assets, the cost of which was charged to expense, may be restored to invested capital. The following rules must be observed: Regulations. A corporation's books of accounts will be pre- sumed to show the facts. If it claims that its capital or surplus ac- INVESTED CAPITAI^ASSET VALUES 157 count is understated the burden of proof will rest upon it. Addi- tions to such accounts will be accepted to the following extent:' (i) Excessive depreciation heretofore charged off on property still owned and in use, if it is now shown by satisfactory proof to have been excessive and such excess is substantial in amount, whether or not disallowed by the Commissioner as a deduction from net in- come, may be restored to the surplus account. No such amount shall be restored, however, unless it is shown that adequate depre- ciation has been deducted upon all other property of the corpora- ' [Former Procedure] Regulation. "Such additions will be accepted only to the extent and under the conditions stated below: "(_i) Amounts which have been expended in the past for the acquisition of plant, equipment, tools, patterns, furniture, fixtures, or like tangible property, having a useful life extending substantially beyond the year in which the expenditure was made, and which have been charged as current expense, may (less proper reduction for depreciation or obsolescence) be added to the surplus account in computing invested capital when such assets are still owned and in active use by the taxpayer during the taxable year. Special tools, patterns, and similar assets shall not be assigned any value if their cost has been recovered through having been included in the price of goods. If their cost has not been so recovered and they are held for only occasional use, they shall not be assigned a value in excess of the fair value based upon the earnings actually arising from their current use. Assets of this kind not in current use shall not be valued at more than their nominal or scrap value. "(2) Amounts expended in the past for goodwill, trade-marks, trade-brands, franchises, and other intangible assets of a like char- acter, are controlled by the language of the statute which provides that such assets 'shall be included as invested capital if the corpora- tion or partnership made payment bona fide therefor specifically as such in cash, or tangible property.' The Commissioner of Internal Revenue will recognize additions to invested capital on account of intangible assets only if such assets have been explicitly paid for in the manner prescribed by the statute. Where expenditures have been made for the general development of intangible assets, and charged as current expense, no readjustment thereof will be allowed. "(3) Amounts under (i) and (2) above, expended on or after March i, 1913, will, in the case of a corporation, be limited strictly to items which have not been deducted in computing taxable income upon its income tax return. Whenever a corporation has claimed and the department has allowed a deduction in respect to its income tax, the item upon which the deduction is based shall not be restored to the surplus account nor included in the invested capital. "(4) The taxpayer shall in his return to the Commissioner of Internal Revenue make a statement of the proposed additions, specify- ing the kinds and amounts of property involved, the years in which the expenditures were made, and the method followed in distinguish- ing between capital outlays and current expenses. "(S) The taxpayer shall also show that adequate provision has been made for the depletion, depreciation, or obsolescence of such of the assets so acquired as are, under the rulings of the Department, subject to recognized depreciation." (Reg. 41, 1918, Art. 64.) 158 EXCESS PROFITS TAX PROCEDURE tion still in use, nor in any case in which such amount has been allowed as a deduction for amortization under section 234 (a) (8) of the statute, or in which the cost of the property has been recov- ered through being included in the price of goods or services, as for example, in the case of patterns, dies, plates, special tools, etc., or under a munition contract with a foreign government. (2) Amounts which have been expended before January I, 1917, for the acquisition of plant, equipment, tools, patterns, furniture, fixtures, or like tangible property, having a useful life extending substantially beyond the year in which the expenditure was made, and which have been charged as current expense, may (less proper deductions for depreciation or obsolescence) be added to the surplus account when such assets are still owned and in active use by the corporation during the taxable year. Special tools, patterns, and similar assets shall not be assigned any value if their cost has been recovered through having been included in the price of goods. If their cost has not been so recovered and they are held for only occasional use, they shall not be assigned a value in excess of the fair value based upon the earnings actually arising from their cur- rent use, and in no case shall such value be more than the cost less depreciation. Assets of this kind not in current use shall not be valued at more than their nominal or scrap value. (3) Amounts which have been expended in the past for intan- gible property of any kind can be restored to capital or surplus account only to the extent that the corporation specifically paid such amounts for the intangible property as such. For provisions relating to patterns see article 843. (4) Adjustments necessary to correct other errors found in the books of account may be made. But see the following article. (Art. 840.) Additions to surplus which a corporation may desire to make under the preceding article^ fall broadly into two classes: (i) To correct returns of net income for prior years in which actual errors have been made, as for example where excessive de- preciation has been deducted, additions to plant and equipment or other capital charges have been charged off as an expense, invento- ries have been taken upon a wrong basis of valuation, etc. (2) To reinstate in surplus deductions from income which are as a matter of good accounting to some extent optional, such as experi- mental expenses, patent litigation, development of good will through advertising or otherwise, etc. Adjustments falling in class (i) will be permitted for all years whether before or after March i, 1913, provided amended returns of net income are filed for each year in which an erroneous return has •Art. 840. INVESTED CAPITAI^ASSET VALUfiS 159 been made. Due consideration will be given to the assessment of penalties in any case in which a fraudulent return has been made. Adjustments falling in class (2) cannot be permitted, as in such cases it is considered that the corporation has exercised a binding option in deducting such expenses from income. An election of this sort which was made concurrently with the transaction cannot now be revised, and amended returns in respect thereof cannot be accepted. The corporation shall submit with its return a statement of the addi- tions proposed, specifying the kinds and amounts of property in- volved, the years in which the expenditures were made, and the method followed in distinguishing between capital outlays and cur- rent expenses, and showing that adequate provision has been made for depreciation, obsolescence and depletion of such of the assets affected by the additions as are subject to recognized depreciation, obsolescence or depletion. In any case in which there is an operating deficit amounts restored must first be set off against the deficit and only the excess can be actually included in the computation of in- vested capital. (Art. 841.) Where tangible or intangible property has been paid in to a corporation for stock or shares or as paid-in surplus, and has sub- sequently been in whole or in part written off the books, the amount so written off may upon evidence satisfactory to the Commissioner be restored to the capital or surplus account subject to the following limitations : (i) The amount restored must be reduced by a proper deduc- tion for any depreciation, obsolescence or depletion; and (2) The aggregate amount included in computing invested cap- ital on account of such property shall not exceed the amount which might have been included if such property had not been written off. (Art. 842.) ■ Generally speaking, the adjustments specified in the fore- going articles are those which will be made in any event by public accountants under instructions to restate the accounts of a corporation upon a basis which reflects actual assets, ac- tual liabilities and actual net profits. Adjustments are per- mitted when methods sanctioned by good accounting practice have been followed. It is recognized that when the determina- tion of true invested capital is necessary, no corporation should be penalized for having been ultra-conservative in past years. The article limits the adjustment of plant accounts to items acquired before January i, 1917. As of that date an excess profits tax law, requiring the determination of invested capital i6o EXCESS PROFITS TAX PROCEDURE became effective and it is fair to assume that accounts for the period since January i, 19 17, have properly differentiated be- tween capital and income. Ruling. The opinion of the Committee is requested whether the M Company should receive the benefit of an addition to invested capital, for excess profits tax purposes, by submitting amended re- turns for the years 1916 and 1917; in which returns a deduction for amortization, claimed and allowed in the original returns, should be eliminated. The facts as stated are that the above-mentioned company manu- factured munitions. In its income tax returns for the years 1916 and 1917, the company has claimed amortization of the facilities for their manufacture in the same amount as appeared upon their muni- tion manufacturer's returns and the taxpayer now seeks to eliminate from its income tax returns the amount of such amortization which, it is said, has been included therein. This request on the part of the taxpayer has heretofore been de- nied by the Unit. Title III of the Revenue Act of 19 16, known as the "Munition Manufacturer's Tax," imposes a tax upon the entire net profits re- ceived or accrued from the sale or disposition of certain specified articles of munitions manufactured within the United States, and for the purpose of computing such net profits permits certain deduc- tions, among which, under section 302(f), is — A reasonable allowance according to the conditions peculiar to each concern, for amortization of buildings and machinery, account being taken of the exceptional depreciation of special plants; and Regulations 39 promulgated under the provisions of the Act, provide more specifically, in article 21, what shall constitute such "amortization" and how the amount thereof shall be determined. The Revenue Act of 1916, both as passed originally and as amended by the Revenue Act of 1917, not only does not provide specifically for any allowance for amortization for income tax pur- poses, but in Regulations 33, revised, promulgated thereunder, spe- cifically prohibits such an allowance although recognizing an allow- able deduction on account of depreciation in the value of any class of property subject to wear and tear. Article 162 of Regulations 33, revised, provides that: The deduction to be allowed relates solely to loss due to use, wear and tear, and the matter of obsolescence is not relevant inasmuch as when the property becomes obsolete a deduction for the loss sus- tained thereby, representing the difference between the cost and the amount of depreciation previously charged off or which should have been charged off in prior years, will be allowed. INVESTED CAPITAL— ASSET VALUES i6l It appears that in preparing its munitions tax returns and its in- come and excess profits tax returns, this taxpayer deducted in its income tax return the same amount which had been deducted in its munitions tax return; such amount including a charge for amortiza- tion (or obsolescence), as well as a charge for depreciation, and this charge, in the audit of the taxpayer's income tax return by the Unit, was allowed as a deduction although obviously the Unit was in error in making such an allowance. It is, therefore, recommended that this taxpayer be permitted to file amended income tax returns for the years affected, from which returns shall be excluded as deductions the charges for amortization included within the returns as originally filed, and that the deductions thus excluded shall be allowed as additions to the invested capital of the taxpayer for profits tax purposes. (B. 52-20-1367; A. R. R. 349-) The foregoing is of interest in illustrating the scope of amended returns when it is desired to increase invested capital. The corporation saved taxes in 19 16 and 191 7 by claiming amortization. Evidently the subsequent inability to charge depreciation and obsolescence and the decrease in invested capital more than offset the saving in taxes for 1916 and 1917. The company's claim that its 1916 and 1917 re- turns were incorrect was allowed and apparently no penalty was inflicted on the ground of incorrect returns. Assets must be reduced to actucd values. — The provision in the law that invested capital includes all cash and tangible assets "paid in"° has given rise to some misapprehension of the status (a) of property which has depreciated from normal use or has diminished in value for other reasons which can or should be adjusted by charges to surplus account; (b) of prop- erty which has become of less value and the shrinkage or loss of which cannot be adjusted by charges to surplus account because the corporation has no surplus. If depreciation has taken place and there is no provision for it on the books it is necessary to reduce the assets affected to actual value and to reduce surplus accordingly. Regulation. Depletion, like depreciation, must be recognized 'Section 326. 1 62 EXCESS PROFITS TAX PROCEDURE in all cases in which it occurs. Depletion attaches to each unit of mineral or other property removed, and the denial of a deduction in computing net income under the Act of August 5, 1909, or the limi- tation upon the amount of the deduction allowed under the Act of October 3, 1913, does not relieve the corporation of its obligation to make proper provision for depletion of its property, in computing its surplus and undivided profits. Adjustments in respect of depre- ciation or depletion in prior years will be made or permitted only upon the basis of affirmative evidence that as at the beginning of the taxable year the amount of depreciation or depletion written off in prior years was insufficient or excessive, as the case may be. Where deductions for depreciation or depletion have either on the books of the corporation or in its returns of net income been in- cluded in the past in expense or other accounts, rather than spe- cifically as depreciation or depletion, or where capital expenditures have been charged to expense in lieu of depreciation or depletion, a statement indicating the extent to which this practice has been carried should accompany the return. (Art. 839.) The foregoing regulation is sound as expressing a general principle. In practice the restating of depreciation, in its relation to invested capital, for many years prior to 191 7 is questionable. If a taxpayer can clearly show that plant accounts were excessively depreciated the regulations properly allow an adjustment. If the government can clearly show that plant accounts at January i, 191 7, were excessive it is proper that a reduc- tion should be made. But the burden of proof is not on the taxpayer in both cases. In the former invested capital can only be increased when it is shown to the satisfaction of the government that the books did not reflect cost less actual depreciation. The books, however, should be deemed to be correct unless the government assumes and sustains the burden of showing that they are incorrect. In many cases revenue agents, when they fail to find depreciation reserves on the books, go back to the organization of the corporation (some- times 50 years) and restate plant accounts with a result on January i, 19 17, which is absurd. The reason is that the repair and maintenance accounts are not analyzed. In the INVESTED CAPITAL— ASSET VALUES 163 opinion of the author the government's position will not be sustained by the courts if it can be shown that additions and betterments were not capitalized during the years when no depreciation was entered on the books. Furthermore, rates of depreciation do not remain uniform. It is recognized by the Treasury that actual depreciation in the war period frequently exceeded the rates on the same type of plant in the pre-war period. Depreciation adjustments affect present owners ONLY. — The recent purchaser of property is not concerned when it appears that insufificient depreciation has been charged in previous years. The bona fide purchase price of property marks the beginning point of depreciation for the new owner. Even though it is alleged that there was no provision for depreciation at time of purchase, the price paid constitutes the capital which the new owner is entitled to recover through depreciation charges. When book values have been adjusted as of January i, 1 91 7, allowable depreciation thereafter will correspondingly reduce book values. If book values were adjusted as of January i, 1917, and no depreciation has been charged since, a further adjust- ment will have to be made; otherwise invested capital would be excessive. But the additional allowances for depreciation will more than offset the reduction in invested capital so far as taxes are concerned, unless the company is unprofitable. If the property purchased is 10 years old and the effective life of similar property is 20 years the original owner pre- sumably will have used a depreciation rate of 5 per cent and will have written off 50 per cent of book value. The new owner in respect of that particular property should use a de- pieciation rate of 10 per cent per annum because the new owner will start with depreciated values. When diminished values need not be deducted from invested capital. — When capital has been "paid in" in the l64 EXCESS PROFITS TAX PROCEDURE form of cash or other tangible assets, or when cash paid in has been invested in other assets, and such assets have dimin- ished in value through failure to charge depreciation, or by fire and other losses not compensated by insurance, etc., values for the purpose of ascertaining invested capital can only be adjusted by charges to surplus. If no surplus account exists the original investments will form part of invested capital unless and until reductions to actual values can be made by charges to surplus. In other words, the proprietor's original investment forms under our law an irreducible minimum. Ruling. A corporation with a' paid-up capital stock of $100,000 had accumulated a surplus of $20,000 on December 31, 1914. In 1915 the corporation suffered a loss through fire amounting to $50,- 000. Since then it has made up $10,000 of this loss. In computing invested capital must the capital be reduced by the amount of the loss which was in excess of the surplus and which has not yet been made up? In other words, will the invested capital now be reduced to $80,000? No. The invested capital will be $100,000. The loss must be taken into account only to fhe extent that it wiped out the surplus. The amount of the original cash investment need not be reduced for this purpose. However, no new surplus can be included in the invested capital until the full loss of $30,000 chargeable against the capital account has been made good. {Excess Profits Tax Primer, 1918, question 69.) Intangible Property Intangible property bona fide purchased for cash is to be mcluded in invested capital at full value; but intangible prop- erty purchased for stock is subject to certain very definite restrictions as to the amount thereof which may be included in invested capital. These are described in the following. Definition of intangible property. — Law. Section 325. (a) .... The term "intangible property" means patents, ^o copyrights, secret processes and formulae, good will, trade-marks, trade-brands, franchises, and other like property; '"[Former Procedure] Under the 1917 law patents were treated as tangible property in that no limitation similar to the above 25 per cent restriction was imposed. INVESTED CAPITAI^ASSET VALUES 165 Limitation on intangibles as invested capital. — Law. Section 326. (a) That as used in this title the term "in- vested capital" for any year means .... (4) Intangible property bona fide paid in for stock or shares prior to March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par value of the stock or shares issued therefor, or (c) in the aggregate 25 per centum of the par value of the total stock or shares of the corpora- tion outstanding on March 3, 1917, whichever is lowest; (5) Intangible property bona fide paid in for stock or shares on or after March 3, 1917, in an amount not exceeding (a) the actual cash value of such property at the time paid in, (b) the par value of the stock or shares issued therefor, or (c) in the aggregate 25 per 1917 Law. Section 207. "(a.-3-a) .... Provided, That (a) the actual cash value" of patents and copyrights paid in for stock or shares in such corporation or partnership, at the time of such payment, shall be included as invested capital, but not to. exceed the par value of such stock or shares at the time of such payment, . . . . " Other intangible property was limited to 20 per cent. 1917 Law. Section 207. "(a-3-b) The goodwill, trade-marks, trade- brands, the franchise of a corporation or partnership, or other in- tangible property, shall be included as invested capital if the cor- poration or partnership made payment bona fide therefor specifically as such in cash or tangible property, the value of such goodwill, trade-mark, trade-brand, franchise, or intangible property, not to exceed the actual cash or actual cash value of the tangible property paid therefor at the time of such payment; but goodwill, trade-marks, trade-brands, franchise of a corporation or partnership, or other intangible property bona fide purchased, prior to March third, nine- teen hundred and seventeen, for and with interests or shares in a partnership or for and with shares in the capital stock of a corporation (issued prior to March third, nineteen hundred and seventeen), in an amount not to exceed, on March third, nineteen hundred and seven- teen, twenty per centum of the total interests or shares in the partner- ship or of the total shares of the capital stock of the corporation, shall be included in invested capital at a value not to exceed the actual cash value at the time of such purchase, and in case of issue of stock therefor not to exceed the par value of such stock; . . . ." Rulings. "Where since the organization of a corporation its capital stock has been increased or reduced and such change represents an actual acquisition of new property for stock or an actual impairment of original properties, the 20 per cent limitation imposed by section 207, Revenue Act of 1917, will be based upon the par value of the total stock outstanding on March 3, 1917. (Also applicable to partnerships.)" (B. 1-19-120; T. B. M.S.) "Secret formulas should be classed as 'intangible property' under the revenue act of 1917 and are subject to the 20 per cent limitation imposed by section 207 of that act on the amount to be included in invested capital representing intangibles paid in for stock or shares. Additions to invested capital representing revaluation of intangibles are not allowable." (B. Digest g-20-776; A. R. R. 29.) I66 EXCESS PROFITS TAX PROCEDURE centum of the par value of the total stock or shares of the corpora- tion outstanding at the beginning of the taxable year, whichever is lowest. Provided, That in no case shall the total amount included under paragraphs (4) and (5) exceed in the aggregate 25 per centum of the par value .of the total stock or shares of the corporation out- standing at the beginning of the taxable year; Intangible assets acquired in dissolution of a subsidiary corporation. — When a subsidiary corporation is dissolved the assets received by the parent company take the place of the previous asset account (stocks owned). When the subsidiary is dissolved and intangible assets are acquired from the subsidiary, the intangibles cannot be treated as if acquired for stock of the parent company. The parent company issued its own stock for stock of another company, i.e., a tangible asset. When the subsidiary is dis- solved, the intangibles are acquired for property. The 25 per cent limitation imposed by section 326 (a-4) of the 1918 law is highly technical and imposes a very severe penalty on all items which come within its scope. If intan- gibles are otherwise acquired, there is no authority whatever for extending the penalty. Intangibles acquired in the exchange of tangible property (stocks in other companies) therefore apparently come within the provisions of section 326 (a-2) as tangible property paid in for stock and the subsequent exchange of such tangible prop- erty for intangible property. When thus acquired, intangible property is not subject to the limitation in section 326 (a-4). The case is the same as when cash is paid in for stock and a patent is purchased for cash. The cost of the patent is not limited by section 326 (a-4), whereas if the stock were issued directly in exchange for the patent the limitation would apply. 25 per cent limitation when no-par-value stock is issued. — Ruling. Invested capital on account of intangibles bona fide paid in for stock or shares is limited to 25 per cent of stock with par value plus 25 per cent of the amount fixed in articles authorizing no par INVESTED CAPITAL— ASSET VALUES 167 value stock as the capital with which the corporation may do business. If the laws of any State authorize issuance of true no par value stock with no amount of fixed capital such no par value stock may be taken into consideration in measuring the value of intangibles, at the fair market value as of the date or dates of issue of such stock or shares. (B. 30-19-644; O. D. 348.) The foregoing ruling is of questionable validity. Good- will is more likely to be measured by its actual value (even under the limitation section) than by an arbitrary compu- tation dependent on the vagaries of state corporation laws. In other words, it does not seem possible that under exactly similar conditions the allowable value of goodwill would be greater in the case of a New York corporation than in the case of a Delaware corporation. Treasury stock should not be deducted in computation of intangible values. — Treasury stock should not be deducted in calculating the limitation on intangible assets. Section 326 (a-4) defines the 25 per cent limitation on the inclusion of intangible assets in invested capital. The basis of the calcu- lation is the outstanding capital stock at March 3, 1917, or at the beginning of the taxable year. Ordinarily treasury stock is not outstanding stock, as the term "outstanding" should refer only to stock in the hands of the public, but the fact that a corporation at some date may have some of its own stock in its possession has no bearing on the valuation of goodwill, etc. Some corporations buy and sell their preferred stock. Such temporary ownership does not relate in the slightest degree to the original value of the intangible assets. The valuation of the latter is supposed to be based upon the original issue of stock. Treasury stock frequently costs more than par. In many cases it costs nothing. These are factors in determining actual invested capital (article 862, page 227) but are not related except indirectly to the valuation of intangible assets. Treasury stock should not be deducted when making the 25 per cent calculation. l68 EXCESS PROFITS TAX PROCEDURE Intangible property must not be overvalued. — Regulation. The actual cash value of intangible property paid in for stock or shares must be determined in the light of the facts in each case. Among the factors to be considered are (a) the earnings attributable to such intangible assets while in the hands of the pred- ecessor owner; (6) the earnings of the corporation attributable to the intangible assets after the date of their acquisition; (c) repre- sentative sales of the stock of the corporation at or about the date of the acquisition of the intangible assets; and (d) any cash offers for the purchase of the business, including the intangible property, at or about the time of its acquisition. A corporation claiming a value for intangible property paid in for stock or shares should file with its return a full statement of the facts relating to such valua- tion (Art. 851.) Assets which May Require Adjustment The foregoing discussion of tangible and intangible prop- erty deals only with general principles. Most items of book assets require special consideration. In the following pages various classes of assets are discussed in the approximate order in which they appear in the balance sheets of most corpora- tions. Accounts receivable, etc. — No revaluation of accounts or notes receivable should be necessary unless obvious undervalu- ations or overvaluations appear. Accounts receivable and similar assets are held to be tangible assets. Accounts due from officers, directors, employees or stock- holders of a corporation may be treated as accounts receivable if they are bona fide receivables. If such accounts are in reality merely debit balances representing withdrawals of profits, the amount thereof should be deducted from invested capital. In no case was it intended to include among intangibles any assets which are readily convertible into cash in the regular course of business. In a legal sense accounts receivable are intangible assets, but as invested capital such items must be included. INVESTED CAPITAL— ASSET VALUES 169 Notes received for capital stock. — Regulation. Enforcible notes or other evidences of indebted- ness, either interest-bearing or non-interest bearing, of the subscriber received by a corporation upon a subscription for stock may be con- sidered as tangible property in computing its invested capital to the extent of the actual cash value of such notes or other evidences of indebtedness at the time when paid in, but only (a) if such notes or evidences of indebtedness could under the laws of the jurisdiction in which the corporation was organized legally be received in payment for stock, and (6) if they were actually received by the corporation as absolute and not as conditional, payment in whole or in part of the stock subscription. (Art. 833.) Promissory notes, when good, are tangible property and admissible assets. If received in payment for capital stock the status of the notes does not change. Exclusion from invested capital can only be enforced when the agreement for the sale of the stock is the equivalent of a conditional agreement and when the obligations received are not negotiable assets. Such notes might not be carried as cur- rent assets by a corporation, but invested capital as defined in the law has no direct relation to the assets which a corpora- tion may expect readily to convert into cash. Ruling. Notes to be paid for only out of earnings accruing on stock for which they are ostensibly given should not be included in invested capital (B. Digest 22-20-980; S. 1391.) The foregoing ruling is sound, because no possible addi- tional benefit accrues to the corporation. If, however, the notes are negotiable instruments and pay- ment can be enforced even though subsequent earnings are not sufficient to discharge them, there would be no reason to ex- clude the item from invested capital. Inventories. — The subject of inventory valuations of basic materials and merchandise in relation to income' tax practice is fully discussed in Income Tax Procedure, 1921, page 337 et seq. It is not practicable to value inventories on one basis for income tax purposes and on another basis for the excess profits tax. 170 EXCESS PROFITS TAX PROCEDURE The corporation income tax rate prior to 191 7 was so small that the question of the basis of inventory valuations was not considered to be a vital one in tax matters. Th^ con- trolling factor in determining the basis was the effect on the profit and loss account and the balance sheet. Conservative corporations usually took their inventories at a low figure — frequently less than either cost or market. With higher tax rates came a greater sense of accountabil- ity to the government and many corporations have found it necessary to depart from the regulations concerning inven- tories or to file amended returns for past years. It would be manifestly unjust and illegal to compel a corporation which had consistently valued its inventories on an extremely low basis to change its methods at the end of a year when tax rates were increased. Obviously any corporation making the change at the end of the year should be allowed to revise its former returns. The Commissioner is empowered to accept inventories taken on a basis of less than cost or market if such basis most clearly reflects the income of the taxpayer. ^^ In almost all cases the principle of cost or market, which- ever is the lower, is sound and should be followed irrespec- tive of its effect on taxation. There is, however, an important exception in the case of industries in which the successive ap- plication of the "cost or market" basis when prices are rising would result in an aggregate valuation of normal or minimum stocks considerably above the aggregate if based on average cost or market prices over a period of years (including pre- war and post-war years). The application of a special rule to this class of industries must, of course, be safeguarded so that substantial justice will accrue to the government and taxpayers alike. It is believed that an equitable solution is found in the promulgation of a rule permitting a continuing valuation of normal or minimum stocks at prices which may be lower than present cost or mar- "Section 203. INVESTED CAPITAL-ASSET VALUES 171 ket prices, strictly limited to industries using a fixed base price during the pre-war period. As the quantity to be so valued is limited to the average or normal stocks carried in the pre-war period and as it will be assumed that similar quantities will again be carried within a reasonable period after the end of the war, the practice is not detrimental to the government, and manufacturing concerns interested will not be subject to vio- lent fluctuations in profits. Naturally the practice cannot be adopted by concerns which valued their stocks at relatively high prices before the war and now wish to value their stocks at a low figure solely to escape excess profits taxes. Inventory valuations — English practice. — The rule in Eng- land is as follows :^^ The general rule for valuing "trading stocks" in Great Britain is virtually the same as our own, "cost or market whichever is lower," but it has long been the practice of the Inland Revenue to admit, under restricted conditions, inventories appraised in accordance with the so-called "base-value" or "base stock" principle. This principle is used in certain base-metal manufacturing trades such as copper, pig iron, lead, spelter, etc., for part of their materials "on the theory that it is necessary for the undertakings using them to keep a reserve stock to protect themselves against strikes and adverse fluctuations in market values, etc." The basis in such cases represents what may be called a minimum cost over a series of years for a minimum quantity, in theory keeping this minimum quantity untouched and unused, although in practice no actual reserve stock may be left which could be identified at any time; any excess over this amount is valued at cost or market value, whichever is the lower. .... the British .... freely erase the lines between ac- counting periods, charging losses back against previously taxed profits. This has, of course, a profound effect in giving relief to the taxpayer. Valuation of unsegregated tangible and intangible assets.^' — Before public opinion demanded that corporate balance ^Robert Murray Haig, "The Taxation of Excess Profits in Great Britain," The American Economic Remew, Supplement December, 1920, page 6d. "[Former Procedure] Under the 1917 law tangible property paid in for stock or shares prior to January i, 1914, was valued at (a) the 172 EXCESS PROFITS TAX PROCEDURE sheets should contain reasonably accurate classifications of assets, it was a fairly common practice to set up on the books in one lump sum an inclusive valuation of plant, goodwill, patents, etc. The offsetting entry usually was capital stock, preferred and common. Sometimes an amount of cash was paid at the time of incorporation and in that case capital sur- plus or working capital was credited. It may be impossible at this late date to separate the asset account into allowable and non-allowable items. If physical values are not sufiicient, the discrepancy might be made up by setting up patents and goodwill at an amount not to exceed 25 per cent of the capital stock (assuming that its cash value was at least 25 per cent). If the aggregate of the present value of tangible property, plus allowable valuations for intangible assets, does not equal the book value of "property" or similar asset, the difference must be deducted in a computation of invested capital. Regulation. Where stock or shares and bonds or other obli- gations have been issued for a mixed aggregate of tangible and intangible property, it will be presumed in the absence of satisfac- tory evidence to the contrary that the bonds were issued for tangible property and that the stock was issued for the balance of the tangible property, if any, and for the intangible property. Where stock or shares have been issued for a mixed aggregate of tangible and in- tangible property and certain liabilities have been assumed in con- nection with the transaction, it will be presumed that such liabilities are to be charged against the tangible property and the intangible property in the order named, unless it is shown by evidence satis- factory to the Commissioner that this presumption is not in accord- ance with the facts (Art. 835.)" actual cash value of such property on January i, 1914, or (b) the par value of the stock issued therefor, whichever was the lower. This was one of the few cases in which the law permitted an allowance to be made for appreciation. (Reg. 41, 1918, Art. 55.) ** [Former Procedure] Ruling. "Article 59 of Regulations No. 41 is a reasonable interpreta- tion of the act of October 3, 1917, and where a corporation has acquired tangible and intangible property in exchange for its bonds and stocks it will be deemed, in the absence of clear evidence to the contrary, that the intangibles were acquired by the stock- ..." (B. Digest 16-10-467: T. B, R. 49.) INVESTED CAPITAL— ASSET VALUES 173 Buildings, machinery, etc. — The various asset accounts representing plant investment should be carried at cost less proper reserves for depreciation. A revaluation as of March I, 19 1 3, is permissible under income tax practice, but no re- valuation is permitted in determining invested capital under the excess profits tax provisions of the 1918 law.^° If at the time of acquirement the cash value of any part of the plant greatly exceeds the par value of the stock issued in payment therefor, the excess of the actual value over the book value is deemed to be paid-in surplus (see page 152). In most cases no such contingency is probable. There are many cases, however, in which plant accounts have been written down to a point considerably under the al- lowable basis of cost less proper depreciation. No apprecia- tion in values can be considered, but if excessive depreciation has been written off, then an adjustment may be made thereof in order that proper values may be restored to the books. The author strongly advises against any attempt to build up book values by a revision of depreciation allowances claimed in past years, unless there is some extraordinary reason for so doing. Ruling. A conservatively managed manufacturing plant has been charging depreciation on its machinery at the rate of 10 per cent a year. A considerable portion of its equipment has been entirely charged off on its books, although the machinery is in use and at present prices is worth practically all it originally cost. May any of this depreciation be restored to capital account ? Under the conditions imposed by article 64 of Regulations 41, a taxpayer may, in computing invested capital, restore to capital account any depreciation upon property still in use which was charged off prior to March i, 1913, and is now shown to have been excessive, and also any depreciation charged off subsequent to March I, 1913, which has been disallowed by the Bureau of Internal Reve- nue. (^Excess Profits Tax Primer, 1918, question 64.) "[Former Procedure] 1917 Law. When tangible assets on Janu- ary I, 1914, were worth more than cost, a revaluation on that date was permissible, provided the new valuation did not exceed the par value of the original shares specifically issued therefor. [Section 207 (a).] 174 EXCESS PROFITS TAX PROCEDURE Furniture and fixtures. — The book value of furniture and fixtures frequently represents assets of considerably greater actual value. This is due to liberal depreciation charges. Appreciation in value above cost must not be reflected in the books, but when furniture and fixtures and similar assets have been written down far below cost the book values may, if so desired, be restored to cost, less normal depreciation. The author does not advise a revaluation of the furniture and fixtures account, except in special cases, because the asset as a rule is of doubtful value and the sooner it is written down the better. If former excessive depreciation charges are reversed, amended excise and income tax returns will have to be made as to corporations back to 1909, and as to individuals and partnerships back to 19 13. And the normal or low deprecia- tion charges so established for back years will have to be retained hereafter. If corporations have charged off current purchases of fur- niture and fixtures and have not deducted the items in their income tax returns the present value may be included in in- vested capital, and normal depreciation may be charged in the amended returns. Land, water rights, etc. — There is a class of assets for which depreciation may not be claimed in income tax returns. In this class are land, water rights and similar tangible fixed property. The theory is that there is no "wear and tear" due to use. Of course, such property may depreciate in value, but no claim can be made for any fluctuation or decline in value unless and until a sale is made. In the meantime, assets of this nature should be carried on the books at their fair value as of March i, 191 3, or at cost if acquired since, but the appreciation in value, if any, set up at March i, 191 3, must be eliminated in computing invested capital. No subsequent appreciation should appear on the books until actually realized. INVESTED CAPITAL— ASSET VALUES 175 If purchased for stock and if the cash value at time of pur- chase exceeded the par value of the stock the excess may be credited to paid-in surplus. Mines, oil wells, etc. — The book value of mines, wells, etc., should represent the fair value at March i, 1913, or cost if acquired since, less diminution in values by reason of deple- tion charges. If the cash value when stock was issued exceeded the par value of the stock the excess may be credited to paid-in sur- plus. Revaluations as of March i, 1913, if entered on the books, must be adjusted in the return of invested capital so as to exclude appreciation. Leaseholds, bonuses paid for oil wells, etc. — Leaseholds are held to be tangible property and when purchased for cash there is no question about their inclusion as invested capital. When purchased for stock, only the actual cash value of the leases may be included as invested capital. For income tax purposes (including depletion charges) leaseholds may be revalued at March i, 1913, and any appre- ciation in value may be set up on the books. In determining invested capital, however, appreciation must be eliminated. The cost of a lease must be amortized over the period thereof. If such charges have not been made in prior years, invested capital at the beginning of the taxable year must be adjusted properly. Patterns, models, designs, etc. — When carried at cost, less normal depreciation, patterns, designs, etc., may be treated as tangible assets and included as invested capital. If acquired for stock it may be necessary to show that the item is not an intangible asset of the nature of goodwill. Cash value of insurance policies. — Premiums paid by a corporation for insurance on the lives of officers of the cor- 176 EXCESS PROFITS TAX PROCEDURE poration cannot now be deducted as expenses in computing taxable income. Premiums paid were held to be deductible prior to 191 7." Regulation. Where insurance is carried by the corporation on the life of an officer or employee, the policy may be included as an admissible asset and reflected in the surplus account at the cash surrender value as of the beginning of the taxable year. The whole amount of premiums paid on such insurance can not be included in surplus, but the surplus will be considered as increased as of the beginning of each taxable year by the amount added to the cash surrender value of the policy (Art. 846.) Even if part of the premiums paid were charged off as ex- penses the foregoing regulation holds that the entire cash surrender value at the beginning of the taxable year can be set up as an asset and the aggregate can be credited to surplus, but it would seem that some adjustment of the returns of former years, to take care of the items charged off, should be made. If the aggregate of premiums paid has been carried as an asset it is not consistent with other regulations to reduce the amount carried on the books. It is true that the cash surrender value of policies is usually less than the aggregate of premiums paid, unless the policies are old ones, but the premiums paid and not allowed as deductions are in the same class as excessive depreciation and bad debts reserves. In such cases the Treasury holds that the deductions not allowed may be included in invested capital. The net effect of the regulation is to disallow part of a payment which has been capitalized. The law does not require that an asset be written down below its fair value. Insurance policies, except term policies which will expire within the taxable year, are worth to a going business the full amount of premiums paid. '"[Former Procedure] Under the 1917 law (section 32) premiums were disallowed as deductions and this provision was retroactive to January 1, 1917. Prior to the passage of the 1917 law, T. D. 2519 (August 30, 1917) also held that premiums were not deductible. INVESTED CAPITAI^ASSET VALUES 177 When a term policy expires or other poHcies are not continued, proper adjustment should be made in invested capital. Rulings. The cash surrender value of insurance policies carried by a corporation on the lives of its officers may be included in the com- putation of invested capital irrespective of the fact that the premiums paid on such policies may have been deducted as an expense in com- puting the net income of the corporation for prior years. (Over- ruling 3-19-209, O. D. 132, sec. 326, Art. 846, and 21-20-966, O. D. ■524.) (B. Digest 41-20-1239; A. R. R. 229.) •The cash surrender value of a life insurance policy which, under article 846 of Regulations 45, constitutes surplus as at the begin- ning of the taxable year for invested capital purposes, retains its character as surplus even though the policy constituting the admis- sible asset upon the basis of which the surplus was determined, is terminated and paid. (B. 7-19-309; O. D. 179.) Discount on bonds. — If a corporation's own bonds have been sold at a discount, the amount of the discount should be carried as a deferred asset and charged off pro rata, annually, over the Hfe of the bonds. The unamortized balance, if cor- rectly calculated, is an asset which properly appears in the balance sheet. If the discount has been set up as an asset and has not been ratably reduced, an adjustment should be made preceding any determination of invested capital. Regulation. Discount allowed on the sale of bonds is in effect an advance on account of interest, so that the effective rate of in- terest in such a case is equal to the sum of the nominal rate plus the rate necessary to amortize the discount over the life of the bonds. Where, ' under incorrect accounting practices, the discount on bonds has been charged to a property account or otherwise carried as an asset, and is so reflected in the surplus account, it is necessary in computing invested capital to make an adjustment in respect of such discount (Art. 848.) The adjustment referred to in the foregoing regulation requires a writing down of the discount, but does not mean that the correctly calculated unamortized amount may not be included in invested capital. Discount on capital stock. — In some states capital stock may be sold at a discount. It is customary to credit capital 178 EXCESS PROFITS TAX PROCEDURE stock account with the par value of stock issued and to debit "discount on capital stock" with the difference between the aggregate par value and the net proceeds of the sale. This discount is carried on the books as an asset and sometimes written off over a number of years. In a computation of in- vested capital, this asset should be eliminated, unless the so- called discount is in reality an organization expense. Ruling. Reference is made to your letter of December i, 1919, in which you seek to verify the correctness of the ruling contained in a letter from this office dated April 14, 1919, quoted below: "Reference is made to your telegram of April 4, 1919, rela- tive to invested capital for war profits and excess profits tax purposes. Capital stock issued under the conditions stated, viz. : sold at par for cash and a commission of 10 per cent paid after- ward to a broker, is held to be stock sold at a discount, and only the net proceeds realized by the corporation from such transac- tion will be recognized as paid-in capital for invested capital purposes." The inquiry contained in your letter of December i, 1919, was replied to by telegram on December 8, 1919, a copy of which follows: "Your letter December first, Rule contained in Bureau letter April fourteenth incorrect. Reasonable commissions paid by corporations for sale of capital stock need not be deducted in computing invested capital. Letter follows." Section 326 (a) of the Revenue Act of 1918, states that invested capital means "actual cash bona fide paid in for stock or shares; . . . ." These words signify the actual cash paid in to the corpora- tion or to its duly authorized agents by shareholders. The treatment of this question and that of deductibility of such commissions from gross income as ordinary and necessary expenses should be correla- tive. Under all Federal income tax laws, corporations have been denied the right to deduct such commissions either as current ex- penses or as a deferred charge to future years. As it is a fact that such commissions are "ordinarily" paid, and, in the organization of many corporations, "necessarily" paid, the position of the Bureau with respect to the deductibility from income of this expense can rest only on the ground that it is essentially a capital expenditure balanced by the acquisition of a permanent capital asset of equiva- lent worth. Such payments must, however, like other compensation for a personal service, be "reasonable" in amount. Payment of any un- usual or di=oroportionate commission would be subject to examina- INVESTED CAPITAL-ASSET VALUES 179 tion to ascertain whether the cash subscription has been bona fide paid in and whether, under the circumstances of the particular case, the commission was reasonable. (Letter to Herbert F. French and Company, Boston, Mass., signed by Commissioner Daniel C. Roper, and dated December 9, 1919.) The foregoing ruling is consistent with the regulations. Payments for services actually rendered in the formation of a corporation are either organization expenses, as defined by the Treasury, or allowable business expenses. Contracts. — Regulation Most contracts are intangible property and in the absence of a specific ruling by the Commissioner to the con- trary should be so regarded for the purpose of making returns. A contract may be treated as tangible property only after the submis- sion of a full statement as to its exact nature showing to the satis- faction of the Commissioner that it relates to rights in tangible property to such an extent that its value arises chiefly therefrom. .... (Art. 811.) Ruling. A contract may be treated as tangible property when it relates to rights in tangible property to such an extent that its value arises chiefly therefrom, but it may not be treated as invested capital unless it is bona fide paid in for stock or shares in the corporation, in accordance with section 326(a) of the Revenue Act of 1918. (B. 24-19-578; O. D. 307.) It must not be assumed from article 811 that contracts purchased for cash cannot be included in invested capital. If cash was paid for a contract it makes no difference whether it is called tangible or intangible property, because in such case it is fully admissible as invested capital. If ac- quired for stock a contract usually would be of the nature of goodwill. Subscription lists, newspaper franchises, carrier routes, etc. — ^As stated in regard to contracts, the inclusion of fran- chises, etc., in invested capital usually depends on how they were acquired. But if purchased for stock, and a definite cash value can be ascribed to a franchise or list, it might be deemed to be tangible property if it can be shown that the l8o EXCESS PROFITS TAX PROCEDURE asset purchased is not included in the definition contained in section 325 (a). Advertising and other deferred expense items. — In most cases the amounts expended for advertising, clerical and other services, etc., when establishing new businesses are charged to expenses and cannot be included in invested capital even though the actual value of the results accomplished is large. In such cases the value usually relates to the goodwill of the business in general rather than to specific items of assets. If the expenditures were capitalized, as and when made, a claim can be made for their inclusion in invested capital. Ruling. A proprietary medicine company has spent large sums in advertising and has thereby built up a goodwill. May these sums be included as expenditures for a capital asset? If the money was spent from original capital the original capital is of course allowed. But if these advertising bills were paid from income and the amounts charged to general expense they can not be included as capital. Goodwill can be included only when bought and paid for specifically as such. {Excess Profits Tax Primer, 1918, question 37.) If the expenditures cannot be capitalized and the earnings are out of proportion to the invested capital as shown by the books, relief may be claimed under sections 327 and 328.^' The same rule applies to expenses paid in advance for the benefit of subsequent periods, such as traveling and other ex- penses of salesmen, and carried as a deferred asset. If charged off currently the items cannot be included in invested capital. Organization expenses. — The Treasury has ruled that or- ganization expenses are capital payments. When capitalized, or if charged off and not allowed as expenses, organization ex- penses may be included in invested capital. Regulation. Expenses of the organization of a corporation, such as incorporation fees and attorneys' and accountants' charges, constitute investments of capital and are not deductible from gross income (Art. 582.) "See Chapter XV. INVESTED CAPITAL— ASSET VALUES i8l Establishment expenses of subsidiaries. — In one case revenue inspectors disallowed for invested capital purposes payments over a period of years to three subsidiary sales com- panies. The payments were made to establish the subsidiaries in large cities up to the time when they became self-support- ing. These advances were shown on the balance sheet of the parent corporation in the space allotted to goodwill as "Due from subsidiary companies for establishment and introductory expenses representing the goodwill of these companies." Long before the excess profits tax was thought of the advances were carried as assets. After the excess profits tax was enacted the payments justified themselves, as large profits were made by the subsidiaries. Therefore the advances were capital within the meaning of the law and should be included in invested capital. Goodwill.^* — Goodwill may be the most valuable asset owned by an individual, firm or corporation. But goodwill "[Former Procedure] In the 1917 law goodwill when, purchased for stock prior to March 3, 1917, could be included as invested capital only up to 20 per cent of the stock outstanding on March 3, 1917. 1917 Law. Section 207. "(3) .... the good-will, trade-marks, trade-brands, the franchise of a corporation or partnership, or other intangible property, shall be included as invested capital if the cor- poration or partnership made payment bona fide therefor specifically as such in cash or tangible property, the value of such good-will, trade-mark, trade-brand, franchise, or intangible property, not to exceed the actual cash or actual cash value of the tangible property paid therefor at the time of such payment; but good-will, trade- rnarks, trade-brands, franchise of a corporation or partnership, or other intangible property, bona fide purchased, prior to March third, nineteen hundred and seventeen, for and with interests or shares in a partnership or for and with shares in the capital stock of a cor- poration (issued prior to March third, nineteen hundred and seven- teen), in an amount not to exceed, on March third, nineteen hundred and seventeen, twenty per centum of the total interests or shares in the partnership or of the total shares of the capital stock of the cor- poration, shall be included in invested capital at a value not to exceed the actual cash value at the time of such purchase, and in case of issue of stock therefor not to exceed the par value of such stock; . . . . " It may be that 20 per cent of the total capitalization was too large or too small a limit for goodwill, but the arbitrary limitation was not fixed without eareful investigation. l82 EXCESS PROFITS TAX PROCEDURE should never be carried on books of account nor in a balance sheet as an element of invested capital except at a purchase price the equivalent of cash fixed by a buyer and a'seller. The buyer and the seller should be independent contracting parties. Goodwill, to have a sales value, must represent a substan- tial earning power in excess of management salaries and or- dinary interest on capital. ^^ The actual value of goodwill fluctuates from day to day and aside from all other reasons any attempt on the part of owners to capitalize goodwill in the absence of a willing buyer would result only in the wildest kind of estimates. If it were left to the discretion of owners of businesses to value their own goodwill, it might be found that a tax based on earnings in excess of a return of 8 or lo per cent on capital invested would yield no revenue whatever. When there has been a bona fide sale of goodwill the pur- chaser is entitled to at least the same return on the purchase price of goodwill as that to which the purchaser of tangible assets is entitled. A considerable part of the earnings realized by the purchaser must be used to defray the cost of and to amortize the capital invested in the goodwill of the business acquired. Likewise a considerable part of the earnings real- ized by the purchaser of a manufacturing plant must be used to provide for the replacement or amortization of the prop- erty acquired. The owner of a business who has no cash capital invested in goodwill is in the fortunate position of having no carrying charges on a cash investment in goodwill, nor does he have the burden of amortizing the principal of the investment. The re- turn to the owner is reflected in the increased net earnings which his business yields as against the heavily burdened busi- ness in which goodwill has been purchased. The foregoing remarks are based upon the assumption that '' Auditing, Theory and Practice (2nd edition), by R. H. Montgomery, pages 123 to 128 ; see also Income Tax Procedure, 1921, page 413, INVESTED CAPITAI^ASSET VALUES 183 "cost price" means cost in cash or the equivalent of cash. When the purchase price of goodwill is offset by a given amount of common stock and the stock immediately sells at less than par, the inference is plain that an excessive value has been placed upon goodwill. When goodwill has been pur- chased for cash it may be included as invested capital at the full purchase price. When purchased for stock it is subject to the limitations placed upon intangible property.^" When a partnership buys for cash goodwill from a retir- ing partner or from others the cost should be set up as an asset. If subsequently a corporation is formed, steps should be taken to secure the benefit of the cash paid for the goodwill. If stock were issued to the partners it might be held that the limitation of 25 per cent would apply. Ruling. The fact that a corporation issues stock as a bonus to its three principal officers to secure their services and participation in the business is not ipso facto sufficient evidence of the existence of goodwill for which values can be recognized in connection with the computation of invested capital. Such three principal officers were the principal stockholders and were active salesmen and the only salesmen employed directly by the corporation. Each was allotted certain exclusive territory in which he might employ subagents; all sales made by or through these three principal salesmen constituted the basis on which their commissions or bonuses were calculated. There were certain other sales made directly by the house which were not subject to any bonus or com- mission deduction. The business of the corporation appeared to be dependent almost solely upon the personal efforts of these three prin- cipal officers and stockholders. The rates of commission and the salaries for their services were properly voted. In this case it was deemed that commission and salary aggregat- ing 50 per cent of the gross margin on the business developed by each was not unreasonable. (B. 23-19-554; T. B. M. 81.) Goodwill written off. — If goodwill has been purchased and the cost'thereof has been written down on the books out of profits or surplus, it will be permissible to restore the book value to cost. The amounts written off were not allowable "See page 164-168. l84 EXCESS PROFITS TAX PROCEDURE deductions in income tax returns; therefore no adjustment of returns should be necessary. Amount paid to retiring stockholders to refrain FROM entering INTO COMPETITION NOT CONSIDERED GOOD- WILL. Ruling. In the audit of the return of the M Company for the year 1917, the Income Tax Unit refused to admit as goodwill, in invested capital, an amount of x dollars paid from the treasury of the corporation to two retiring stockholders under a contract by which these stockholders agreed to refrain from entering into any competitive business for a period of twenty-five years In 1906, the capital stock of the M Company, a New York cor- poration, was owned and controlled by two groups of stockholders whose interests had become adverse; in June of that year A and B owning a considerable minority of stock, purchased from C and D the entire stock holdings of the latter, amounting to fifty-one per cent (51%) of the total issued by the corporation, and agreed to pay therefor the par value of the preferred stock and the book value of the common stock, which latter should be determined without reference to the goodwill or other intangible assets of the corpora- tion, and in addition to that amount the added sum of x dollars. This sum of x dollars was represented by fifty (50) purchase money notes payable monthly. In the contract of sale it is specifically agreed by the retiring stockholders, as consideration for the purchase of the stock and the payment of the price, that the sellers will not engage in the business carried on by the corporation. The notes representing this item of x dollars were paid not by the purchasing stockholders directly, but by the corporation out of its profits in the following manner : Two or three days prior to the due date of each note the corporation's check for the amount of the note, with accrued interest at five per cent (S%) would be drawn and delivered to A and depos- ited by him in his own bank. A would then draw upon his own ac- count a check for a like amount payable to C and D. All of these notes were paid and the necessary money drawn from the earnings of the M Company. Every three or six months a sufficient dividend was declared to take care of these monthly notes until the last one was paid It is held generally, therefore, that where a corporation controlled by a few individuals uses part of its profits to pay notes of its prin- cipal stockholders previously given as part of the purchase price of the stock of retiring stockholders, the amount of which notes being equal to the excess of the agreed price of such stock over its par or book value, such is not payment made bona fide specifically as such in cash or tangible property for goodwill or other intangible prop- INVESTED CAPITAL— ASSET VALUES 185 erty, even though the retiring stockholders had in the contract of sale of stock agreed to refrain from entering into the business con- ducted by the corporation for a specified number of years. Therefore, it is the opinion of the Committee that the amount of X dollars paid to two retiring stockholders under a certain contract by which they agreed to refrain from entering into competition with the corporation for a period of twenty-five years is not a payment for goodwill, and is not admissible as invested capital' for the year 1917. (B. 34-20-1157; A. R. R. 250.) The foregoing ruling is unsatisfactory, because it relies on the bookkeeping methods of the taxpayers in 1906 and 1907 as conclusive, whereas in many cases the bookkeeping methods of taxpayers have been wholly disregarded. Cash paid to possible and probable competitors, the consideration being that the latter will not engage in the same kind of busi- ness, might in fact represent the purchase of valuable good- will. Ordinarily, it would not do so, but when diverse interests separate, and cash consideration is paid to those previously active in the business, it is a fair inference that the continuing interests acquire something they probably would not have had. The decision relies on the assumption that if anything had been acquired the payments would have been charged to cap- ital or expenses instead of to dividends. It would seem to be a more reasonable inference that the method of charging the payments in 1906 and 1907 would make little difference. If nothing was acquired, why were the payments made? Certainly, the payments were out of capital or income. The Treasury does not permit payments of that character to be charged as expenses; and it would seem that under the law and the regulations the cash payments in 1906 and 1907 actu- ally represented purchase of goodwill. Patents. — Under the 1918 law^'- patents are included with intangible property and are subject to the limitations imposed upon goodwill and items of a similar nature. Under the 191 7 •"Section 325 (a). l86 EXCESS PROFITS TAX PROCEDURE law^^ patents could be included in invested capital up to the par value of the stock issued therefor if cash value equal thereto at time of acquisition could be sustained. Regulation. From the standpoint of assets a patent, or more particularly a group of patents, is closely analogous to good will. Their value . is contingent upon and measured by their earning power.^^ While patents have a definite life, there is a common ten- dency to extend that life by improvements upon the original, and in a successful business the patent value merges more or less com- pletely into a trade name or other form of good will. Therefore, while deductions in respect to the depreciation of patents based upon a normal life period of seventeen years are allowable in com- puting net income for the purpose of the income tax, such deductions are not obligatory, but are optional with each taxpayer. Where since January i, 1909, a corporation has exercised that option to its own benefit in computing its taxable net income the amount so deducted can not now be restored in computing invested capital. Where, however, the cost of patents has been charged against surplus or otherwise disposed of in such a manner as not to benefit the cor- poration in computing its taxable net income since January i, 1909, any amount so written off may be restored in computing invested capital, if it be shown to the satisfaction of the Commissioner that the amount so written ofif represented a mere book entry ascribable to a conservative policy of management or accounting and did not represent a realized shrinkage in the value of such assets. Any amount so restored may not be written off by way of deductions ''^[Former Procedure] Patents and copyrights were distinguished in the 1917 law [section 207 (a-3-a)] from other assets ordinarily termed intangibles and could be valued at cost or, if paid for in capital stock or as a capital contribution to a partnership, were included at their cash value at time of purchase. Section 207 (a) of the law provided that the valuation of patents and copyrights should not exceed the par value of the stock or partnership shares issued therefor. There was no provision for any revaluation of patents, but if patents were written off on the books the cost price could be restored. If only ordinary depreciation had been written off no adjustment could be made, but if amounts in excess of ordinary depreciation were written off and not deducted in federal excise or income tax returns, an adjustment could be made. If heavy depreciation rates had been claimed and allowed in income tax returns, it was possible to file amended returns, but special and good reasons were required. If good evidence could be furnished that the cash value of patents greatly exceeded the par value of stock issued therefor, the excess value could be treated as "paid-in surplus." '''For method of determining the value of patents at March i, J913, see Income Tax Procedure, 1921, page 496 et seq. INVESTED CAPITAL— ASSET VALUES 187 from taxable net income in any subsequent year or years. Where a corporation has charged to current expenses the cost of developing or protecting patents, no amount in respect thereof expended since January i, 1909, can be restored in computing invested capital. In respect of expenditures made before January I, 1909, a corporation now seeking to restore them must be prepared to show to the satis- faction of the Commissioner that all such items are proper capital expenditures. It can not be said that the correct computation of surplus and undivided profits necessarily requires a deduction in respect of the expiration of patents. It follows, therefore, that where a corporation in the exercise of its option has not written down the cost of patents, it is not ordinarily necessary to reduce the surplus and undivided profits in computing invested capital, whether the patents have been acquired for stock or shares or for cash or other tangible property. Due consideration will be given to the facts in any case in which this rule seems obviously unreasonable (Art. 843.) Ruling. The Committee has had under consideration the appeal of the M Company from the action of the Income Tax Unit applying the provisions of article 57, Regulations 41, to certain property acquired for stock prior to March 3, 1917. It appears that the Income Tax Unit in the audit of the return filed by the M Company for 1917 has treated certain assets acquired for stock as being intangible assets and has applied the 20 per cent limitation in accordance with the provisions of the regulations. It is contended by the representatives of the corporation that the prop- erty acquired for stock at the time of organization was in fact pat- ents, and the amount to be included in invested capital should be determined in accordance with article 56, Regulations 41, which reads as follows : . . . . In an analysis of the facts presented the Committee can not concur in the finding of the Income Tax Unit; neither can it fully concur in the contention of the attorneys for the taxpayer with respect to the value of the patentable ideas and formulas transferred to the cor- poration for stock of the par value of 4Sx dollars. It is the opinion of the Committee that had A applied for a patent on his ideas prior to the time of organization of the corporation there could be no question as to whether the property transferred to the corporation should be treated under the provisions of article 56, Regulations 41, for the purpose of determining the invested capital. A different situation does not arise where patentable ideas and formulas have been transferred to a corporation for stock before such ideas and formulas were patented than where the inventor of the ideas and formulas has applied for or secured a patent and then transfers such patent to the corporation for stock prior to 1917, provided the ideas and formulas transferred are later represented by actual patents. l88 EXCESS PROFITS TAX PROCEDURE In view of the foregoing, it is the judgment of the Committee that the value of the embryo patents — that is, the patentable ideas and formulas — should be treated as patents already secured in accord- ance with the provisions of article 56, Regulations 41, and that a value of 30;t: dollars be fixed on such patentable ideas and formulas transferred to the corporation for stock at the date of organization. The i^x dollars, par value, of stock returned by A to the corporation soon after such stock was issued to him should be ignored. The mere fact that A, the inventor, had not secured patents on his ideas and formulas prior to the time of transfer of such ideas and for- mulas to the corporation for stock should not preclude the corporation from claiming the actual cash value of such embryo patents at the time of acquisition, or the par value of the stock or shares issued therefor, whichever is lower, subject, however, to the elimination of the IS.*- dollars, par value, of stock returned to the treasury of the corporation. The Committee recommends that the action of the Income Tax Unit applying the limitation prescribed by the statute and by article 57, Regulations 41, be reversed and that the corporation be permitted to include the patentable ideas and formulas in the computation of its invested capital for the year 1917, at a value of ^ox dollars. (B. 48-20-1329; A. R. R. 328.) When depreciation of patents does not reduce 25 PER CENT ALLOWANCE. — The restriction upon the inclusion of patents and other intangibles in invested capital relates primarily to the outstanding capital stock and next to the actual cash value of the intangibles. Assume patents proved to be worth $100,000 and capital stock $200,000. Patents can be included in invested capital at only $50,000. If depreciation amounting to $20,000 were charged off, patents would still be included in invested capital at $50,000. The law intends that the aggregate of intangibles shall not exceed 25 per cent of the capital stock. Until the in- tangibles are written down below 25 per cent of the capital stock, depreciation cannot affect the computation. Patents transfered from partnership to corpora- tion. — When the patents have been purchased for cash by a partnership and the partnership is incorporated, care should be taken to transfer the patents for cash and not for' stock. INVESTED- CAPITAI^ASSET VALUES 189 Patents when purchased by a corporation for cash are fully allowed as invested capital. It would be discriminatory if a partnership which had paid cash for patents were not per- mitted to secure the same privilege upon incorporation. Corporate stocks. — In stating invested capital, the item corporate stocks as such must be eliminated, except when gains have been realized or when a computation is made as to the ratio between admissible and inadmissible assets.^* The aggregate of the book values at which stocks are carried as an asset is the amount which must be taken into considera- tion. If the book value does not represent the actual value of the stocks, an adjustment may be permissible. The adjustments mentioned above may have some bear- ing on taxes in cases of realizations, as actual values at March I, 191 3, determine whether or not a profit has been realized. Treasury stock. — If any shares of a corporation's own stock are carried on the books as an asset, the amount at which the shares are carried should be deducted in calculating in- vested capital. If treasury stock is carried at a book value of less than par and the total par value of shares owned is deducted from out- standing stock, the deficiency should be adjusted through the account to which it is applicable. Sometimes surplus or capital surplus should be credited, but usually the credit should be made to property account.^^ If carried at more than par, sur- plus account should be debited. In statements of net worth or invested capital, treasury stock should not appear among the assets. For full discussion of effect of treasury stock on in- vested capital, see page 227. Pre-war period — Adjustment of assets. — For treatment of adjustment of pre-war assets, see Chapter XII, "Pre-war Invested Capital," page 276 et seq. ^*See under "inadmissible assets," page 191, 193. ''Reg. 4S, Art. 861, page 227. CHAPTER IX INADMISSIBLE ASSETS Generally speaking, all assets, tangible or intangible, are admissible, except those which fall into the three classes: (i) assets the income from which is not taxable (stocks and municipal bonds) ; (2) goodwill and patents when the total of such intangibles exceeds a given proportion of the par value of the outstanding capital stock; and (3) unrealized apprecia- tions of values. Law. Section 325. (a) .... The term "'admissible assets" means all assets other than inadmissible assets, valued in accordance with the provisions of subdivision (a) of section 326,^ section 330,^ and section 331.^ But the exclusion of an item from admissible assets does not change it to an "inadmissible" asset, as the latter term is defined in the law. The term "inadmissible assets" is used by the statute in a technical sense and is restricted in its appli- cation. When book values are based on revaluations, etc., capital as shown by the books must be adjusted, but the non- admissibility of an asset does not justify its inclusion among "inadmissible" assets. Goodwill, patents, trade-marks, franchises and similar in- tangible items are never "inadmissible" assets. There is a very definite restriction on the valuation of tangible as well as intangible property. Plant values must be justified to war- rant inclusion in invested capital. Intangible values also must be sustained in order to be included in invested capital. In the case of intangibles there is a further restriction, contingent upon the amount of capital stock outstanding, but the amount eliminated does not become an inadmissible asset. 'Section 326 defines the items which enter into invested capital. 'Section 330 covers reorganization before March 3, 1917. 'Section 331 covers reorganization after March 3, 1917, 190 INADMISSIBLE ASSETS 191 The only "inadmissible" assets are stocks, bonds and other obligations, the dividends or interest from which are not in- cluded in computing net income. United States obligations, even though the income is exempt, are admissible, not inad- missible, assets. Law. Section 325. (a) .... The term "inadmissible assets'" means stocks, bonds, and other obligations (other than obligations of the United States), the dividends or interest from which is not in- cluded in computing net income Regulation. Stocks, bonds and other obligations (other than obligations of the United States), the dividends or interest from which are not included in computing net income, when bona fide paid in for stock or shares may like other tangible property be in- cluded in computing the invested capital of the corporation at their actual cash value when paid in (Art. 834.) The inclusion of inadmissible assets as invested capital is merely for the purpose of computation. The inadmissible assets may be wholly excluded, but if profits have been derived therefrom or if interest has been paid to carry them and not allowed in computing net income, or if there are liabilities only a percentage is excluded. Inadmissible assets cannot be treated as admissible even though no income received therefrom. — Regulation. Stocks, bonds and other obligations (other than obligations of the United States), the dividends or interest from which are not required to be included in computing net income, are inadmissible assets even though no such dividends or interest have been actually paid or received during the taxable year. The failure to pay or to receive dividends or interest does not change the status of such securities as inadmissible assets (Art. 815.) Inadmissible assets are not rendered admissible by re- turning income for taxation.* — Regulation A corporation can not by including the in- *It was proposed that banks, bankers and others might, if they so elected, include all income from inadmissible assets and thereby make all assets "admissible." This provision, however, was stricken out before the 1918 bill became a law. When a corporation owns stock of another corporation the amount 192 EXCESS PROFITS TAX PROCEDURE come from inadmissible assets as taxable income create the right to have such assets considered admissible assets. (Art. 815.) The foregoing regulations make it clear that it is the kind of security — not its income-producing power, nor the return of income for taxation — which determines whether or not it is inadmissible. United States bonds are included as invested capital. — Section 325 (a) provides that assets the income from which is not subject to the excess profits tax shall not be treated as in- vested capital, but obligations of the United States are ex- pressly excluded from the prohibition. As to Liberty bonds (except the first issue and the Vic- tory 3^ per cent) and certificates of indebtedness, the section makes little difference except to corporations with very small capital because the interest on these obligations is subject to the excess profits tax (except as to the interest on a restricted amount of each issue), but a substantial advantage may be se- cured through the ownership of 3j^ per cent Liberty bonds and 3^ per cent Victory notes. The interest on the 3j4 per cent and all other United States bonds issued prior to Septem- ber I, 191 7, and on the 3^ per cent Victory notes is entirely tax-exempt. Nevertheless, the cost price of such bonds need not be deducted from the assets of the corporation in comput- ing invested capital. It will be noted that the bonds which must be deducted are tax-exempt bonds (such as municipals)", not so-called tax-free covenant bonds (such as corporate bonds). As stated on page 127, a good test of the aggregate of allowable invested capital can be made by basing the calcula- tion on the capital and surplus accounts rather than on the so invested must be deducted from invested capital, even though no dividends were received during the year. This rule is equitable, other- wise the amount invested in corporate stocks would serve to increase the excess or war profits credit applicable in the computation of the tax on income from other sources. INADMISSIBLE ASSETS 193 asset accounts. It is true that all United States bonds are ad- missible assets but so are cash and other items. The mere purchase of United States bonds during a tax- able year, however, does not of itself increase the invested capital. An increase can come only through the actual con- tribution of additional capital which may then be invested in such bonds or in any other admissible asset. Ruling. In October, 1917, a corporation invested $200,000 of its current earnings in Liberty bonds. May this amount be included in the invested capital for 1917? No. Although the Liberty bonds are "admissible" assets, their acquisition did not affect the invested capital for 191 7. Profits of a taxable year, even though carried to surplus account, can not be included in invested capital for that year. {Excess Profits Tax Primer, 1918, question yj.) State and mvmicipal bonds inadmissible. — Regulation. Obligations of a State or Territory or any mu- nicipal or other political subdivision thereof, of the District of Columbia, or of any possession of the United States, and federal farm loan bonds, not being obligations of the United States within the meaning of the statute, are inadmissible assets (Art. 816.) Ruling. Since the income derived from Porto Rico bonds is not subject to tax, the bonds are inadmissible assets and can not, therefore, be included in invested capital. (B. 1-19-125; O. D. 86.) Stocks of foreign corporation may be admissible or inad- missible. — The stock of a foreign corporation which has no in- come within the United States is an admissible asset because the net income received from such source would be taxable.' If any part of the income of a foreign corporation is from sources within the United States, and hence subject to tax, the stock of such corporation is an inadmissible asset. "[Former Procedure] Regulation. "In the case of domestic corporations or partnerships and of citizens or residents of the United States holding stock in a foreign corporation part of whose net income is subject to the income tax, there shall be included in invested capital such proportion of the value of the stock in such foreign corporation as the net income of such foreign corporation from sources outside the United States is of its entire net income." (Reg. 41, 1918, Art. 46.) 194 EXCESS PROFITS TAX PROCEDURE Ruling. Inasmuch as dividends received by a domestic corpora- tion from a foreign corporation deriving income from sources within the United States are allowable deductions in ascertaining the net income of the domestic corporation subject to tax, there could not be included in the invested capital of the domestic corporation receiving the dividends the amount of capital invested in the stock of the foreign corporation, or any part of the value thereof, except as outlined in article Si;." (B. 24-19-576; O. D. 305.) When foreign corporation has no income from United States sources. — Ruling. Where a domestic corporation exchanges patent rights and cash for stock in a foreign corporation which derives no income from sources within the United States, the shares of stock so received are admissible assets in determining the invested capital of the domes- tic corporation and are to be valued at cost or the amount of cash advanced plus the value of the patent right at the time of the ex- change, which value can not be taken as exceeding the value of the shares of stock issued therefor. (B. Digest 22-19-538; T. B. R. 67.) Although article 636 of the regulations (based on section 240 of the law) forbids the filing of a consolidated return for a domestic holding company and a subsidiary foreign corpora- tion, the stock of the subsidiary is an admissible asset in com- puting the invested capital of the parent company, provided no part of the income of the foreign corporation is derived from sources within the United States. Goodwill and tangible assets should be reduced before computing percentage of inadmissible assets to be deducted^ — Article 852'' refers to the adjustments which must be made to certain assets for the purpose of computing invested capi- tal. The regulation does not state that patents, goodwill and other intangible property must be adjusted. The previous article (851) requires that the actual cash value of intangible property must be ascertained. It will be assumed, therefore, that the intangibles appear in the computation at cash value. Law. Section 326. (c) There shall be deducted from invested capital as above defined a percentage thereof equal to the percentage "See page 205. 'See page 196. INADMISSIBLE ASSETS 195 which the amount of inadmissible assets is of the amount of admis- sible and inadmissible assets held during the taxable year. The words "as above defined" relate to section 326 (a) which includes among other things the limitation on intangible property for invested capital purposes. Therefore, it seems clear that the amount of invested capital which is to be reduced by the method prescribed for the elimination of inadmissible assets is the invested capital inclusive of the inadmissible as- sets, but after reducing intangible property to comply with the Hmitation imposed. It follows that both equity and logic would call for basing the percentage, which is to be used in the reduction of invested capital by reason of the ownership of inadmissible assets, on admissible assets valued in accordance with section 326 (a), which limits the admissible value of intangible property. Section 325 (a) defines "admissible assets" as being: Law. Section 325. (a) . . . all assets other than inadmis- sible assets, valued in accordance with the provisions of subdivision (a) of section 326, section 330, and section 331. Therefore, intangible property included among admissible assets must be valued subject to the limitation imposed by section 326 (a). The foregoing discussion may be sum- marized as follows : 1. Invested capital up to the point of making the deduction for inadmissible assets is to be calculated by deducting from the sum of capital stock and surplus the excess book value of intangible property over the valuation permitted therefor by section 326 (a) and by adding or deducting averaged changes during the year. 2. The respective aggregates of two classes of assets are to be determined : (a) Inadmissible assets, such as corporate stocks, mu- nicipal bonds, etc. (b) Admissible assets, the book value of any intangible property included therein being reduced to the value permitted under section 326 (a). 196 EXCESS PROFITS TAX PROCEDURE 3. There is to be deducted from invested capital [calculated as above under (i)] that percentage thereof which the inad- missible assets are of the total assets, both admissible and inad- missible. The aggregate of both classes of assets will be the total of (a) and (b) as valued under (2) above. Changes in admissible or inadmissible assets. — When changes occur in admissible or inadmissible assets during the taxable year, the average amount of each for the year must be determined and the percentage to be used in reducing in- vested capital must be calculated upon such averaged holdings. In certain cases the calculation may be made by adding the amounts at the beginning and end of the year and divid- ing by two but in other cases the calculation must be based on the dates of each change. The procedure is as follows : Regulation. For the purpose of ascertaining the deductible per- centage the amount of inadmissible assets held during the year may ordinarily be determined by dividing by two the sum of the amount of such assets held at the beginning of the year and the amount held at the end of the year. The total amount of admissible and in- admissible assets held during the year may ordinarily be deter- mined by dividing by two the sum of the amount of such assets held at the beginning of the year and the amount at the end of the year. If at any time a substantial change has taken place either in the amount of inadmissible assets or in the total amount of admissible and inadmissible assets, the effect of such change shall be averaged exactly from the date on which it occurred. In any case where the Commissioner finds that either amount determined as above pro- vided does not substantially reflect the average situation throughout the year, and that the amount of each kind of assets held on a given day of each month throughout the year or at more frequent regular intervals can be determined, the amount of inadmissible assets and the amount of both kinds of assets held during the year shall be determined by averaging the amounts held at such several times. In making the computations under this article the valuation at which each asset is carried shall be adjusted in accordance with the pro- visions of the statute and of the regulations relating to the valua- tion of assets for the purpose of computing invested capital, including in such adjustment the amount of reserves for depreciation, deple- tion, amortization and other reserves which represent the valuation of assets. It is immaterial whether any asset was acquired out of invested capital or out of profits earned during the year or borrowed capital. (Art. 852.) INADMISSIBLE ASSETS 197 The reason for requiring an adjustment of assets is that the ratio between admissible and inadmissible assets is deter- mined by adding together the gross book or allowable values of both classes. It is of advantage to taxpayers to have as high an aggregate of admissible assets as possible, but it would not be proper to include depreciable property at gross values.* Reserves which are directly applicable against specific assets should be deducted therefrom in making the computation, excepting reserves not allowed for income tax purposes. The following statement illustrates some of the adjust- ments to be made and shows the method of computing average inadmissible assets. Balance Sheet of the A Corporation as of January i, 1920 ASSETS Cash $20,000.00 Accounts Receivable $80,000.00 Less: Reserve for Bad Debts 2,000.00 78,000.00 Notes Receivable $12,000.00 Less: Notes Receivable Discounted 3,000.00 g,ooo.oo Inventories 90,000.00 Stocks (domestic corporations) $10,000.00 Stocks (foreign corporations not doing business in the United States) 5,000.00 Bonds, Municipal 8,000.00 23,000.00 Fixed Assets $300,000.00 Less: Reserve for Depreciation 25,000.00 275,000.00 Goodwill 210,000.00 $705,000.00 LIABILITIES Accounts Payable $40,000.00 Notes Payable 25,000.00 Mortgage on Plant 30,000.00 ,95,000.00 CAPITAL Capital Stock $500,000.00 Surplus 110,000.00 $610,000.00 'See Auditing, Theory and Practice (2nd Edition), by R. H. Mont- gomery, pages 182-184. 198 EXCESS PROFITS TAX PROCEDURE The average is computed as follows: Inadmissible Items Purchased During 1920 Number of Days to End Cost of Year Jan. I On hand $18,000.00 366 June IS Purchased 12,000.00 200 Nov. 12 Purchased 26,000.00 50 Fraction of Year Effective Average full year 200/366 SO/366 $18,000.00 6,557-38 3.55 1 -91 Average inadmissibles for year 1920 $28,109.29 Adjusted Values of Assets Shown on Preceding Balance Sheet Computation of Deduction for Inadmissible Assets and Adjusted Invested Capital for 1920 Cash $30,000.00 Accounts Receivable 80,000.00 Reserve for Bad Debts, not being deductible from net income, is regarded as part of surplus, and Accounts Receivable are not reduced. Notes Receivable 9,000.00 This asset is reduced by Notes Receivable Discounted since such notes, having been sold, are no longer an asset. Inventories 90,000.00 Stocks (foreign corporations not doing business in the United States) S,ooo.oo Fixed Assets 275,000.00 Reserve for Depreciation is deducted from the asset. If part of the reserve has been disallowed as a deduc- tion, such part for this computation should be restored to surplus, and should not be deducted from the asset. The Mortgage on Plant does not reduce the value of the asset; it represents capital borrowed. Goodwill- — per balance sheet $210,000 Amoimt allowed — not in excess of 25% of capital stock outstanding at beginning of taxable year (25% of $500,000) 125,000.00 Total admissible assets January i, 1920 $604,000.00 Total admissible assets December 31, 1920 503,000.00* Total ^ $1,107,000.00 Average admissible assets $SS3,Soo.oo Average inadmissible assets 28,i09.29(a) Average total admissibles and inadmissibles $581,609.29 Percentage which (a) is of (b) 4.8330%** *Computed in same manner as at beginning of year. ••This percentage should be applied to adjusted Invested Capital (amount appearina on line 7, schedule B, form 1120) in order to obtain the deduction on account of in- admissible assets, which should be entered on line 8, schedule B of same form INADMISSIBLE ASSETS 199 If securities have been purchased for $80,000 and subse- quently written down to $50,000, the $30,000 written off (except in case of dealers in securities) could be restored to invested capital. In other words, the securities are taken in at their cost, viz., $80,000, and then a computation is made to determine what percentage is to be deducted from invested capital. Liberty bonds for which full payment has not been made. Ruling In computing the amount of admissible assets for the purpose of determining the average percentage of inadmissible assets, the total cost of bonds subscribed for, whether fully paid for or not, may be included in admissible assets. (B. 1-19-40; O. D. 28.) Containers and similar items to be included among ASSETS. — Corporations in businesses in which containers are used for delivery of the product may have considerable items in their balance sheets representing containers both in stock and delivered under an agreement to pay a fixed sum on their return. The common practice seems to be to include in the account for the containers all those in stock and in the hands of customers and to carry reserves both for depreciation and for the liability to customers. The deduction of both reserves from the asset value of the containers results in an under- statement of the actual value. In calculating the amount of admissible assets, it would be proper to include the actual value of the containers. Stock dividends as inadmissible assets. — In the Macomber' case, decided in 1920, the Supreme Court held that stock dividends added nothing to the existing interests of the recipient stockholders. Form 1120 for 1920 therefore calls for amended returns for the years 1917-1919 if stock dividends were received durmg those years and credited to surplus. As the dividends were not taxable, the stock car- "252 U. S. 189. 200 EXCESS PROFITS TAX PROCEDURE ried as an asset became inadmissible except when there were liabihties or when profits were realized on sales. The elimina- tion of the credit from surplus automatically requires the elimination of the stock as an asset. The result will be an increase in the tax for the years 1917-1919, because in prac- tically all cases some part at least of the stock (inadmissible as such) was deemed to be not inadmissible. The following illustrations exemplify (i) a return as made for 1918, and (2) an amended return, eliminating the stock dividend. Illustration I Balance Sheet, January i, 1918 Cash $ 400,000.00 Liabilities $1,200,000.00 Stocks in Other Com- Capital Stock 600,000,00 panics $700,000.00 Surplus 1,200,000.00 Stock Received as Dividends 300,000.00 1,000, 000. 00(a) Other Assets 1,600,000.00 $3, 000, 000.00(b) $3,000,000.00 Invested Capital: Capital Stock and surplus $1,800,000.00 Deduction for inadmissibles : Ratio of (a) to (b) =: 1/3 of $1,800,000 = 600,000.00 Adjusted invested capital* $1,200,000.00 Net taxable income for 1918 $ 200,000.00 Excess profits credit : War profits credit : 8% on $1,200,000... $96,000.00 10% on $1,200,000.. $120,000.00 Specific 3,000,00 Specific 3,000.00 $99,000.00 $123,000.00 Net taxable income.. .. $200,000.00 (all in 30%' bracket) Less: Excess profits credit 99,000.00 Taxable at 30% . . . $101,000.00 = $30,300.00 = Excess profits tax Net taxable income.... $200,000.00 Less: War profits credit 123,000.0a Taxable at 80%.. $ 77,000.00 = $61,600.00 = War profits tax •For sake of simplicity other adjustments (for taxes, etc.) are not considered. INADMISSIBLE ASSETS 20I The foregoing is the method prescribed when stock divi- dends were held to be income (even though not taxable to recipient corporations). Illustration II Invested Capital: Capital and surplus $1,800,000.00 Deduct stock dividends included in surplus 300,000.00 $1,500,000.00 Deduction for inadmissibles 1/3 of $1,500,000 500,000.00 Adjusted invested capital $1,000,000.00 Excess profits credit: War profits credit: 8% on $1,000,000 $80,000.00 10% on $1,000,000. . .$100,000.00 Specific 3,000.00 Specific 3,000.00 3,000.00 $103,000.00 Net taxable income $200,000.00 (all in 30% bracket) Less: Excess profits credit 83,000.00 Taxable at 30% $117,000.00 = $35,100,000 = Excess profits tax Net taxable income $200,000.00 Less: War profits credit.. 103,000.00 Taxable at ?,o% $ 97,000.00 = $77,600.00 = War profits tax The foregoing computation is not correct because the ad- justment for stock dividends is made only in Surplus account. An adjustment of the assets as well must be made. Illustration III : For 1920 and for amended returns in prior years Invested capital: Capital and surplus $1,800,000.00 Deduct stock dividends 300,000.00 $1,500,000.00 Eliminating the $300,000 stock dividends from the asset side of the balance sheet leaves $700,000 of inadmissible assets. Total assets are reduced to $2,700,000. The • ratio then is 700,000/2,700,000 or 7/27 of $1,500,000. . 388,888.00 Adjusted invested capital $1,111,112.00 202 EXCESS PROFITS TAX PROCEDURE Excess profits credit: War profits credit: 8% on $1,111,112... $88,889.00 10% on $1,111,112. . .$111, iii.oo Specific 3,000.00 Specific 3,000.00 $91,889.00 $114,111.00 Net taxable income $200,000.00 (all in 30% bracket) Less: Excess profits credit 91,889.00 Taxable at 30% $108,111.00 = $32,433.00 = Excess profits tax Net taxable income $200,000.00 Less: War profits credit.. 114,111.00 Taxable at 80% =. . $ 85,889.00 = $68,711.00 = War profits tax Illustration II Illustration I (If surplus only Illustration III (Original) is adjusted) (Correct) War profits tax $61,600.00 $77,600.00 $68,711.00 Realized appreciation not a deduction from asset ACCOUNTS. — It is stated in article 852 that reserves for de- preciation should be deducted from the asset accounts to which they relate. Appreciation in value as of March i, 1913, is a proper asset account to set up on the books but it may not be included in invested capital. When the appreciation is realized through charges to op- eration or sale the realized portion of the appreciation will appear in earned surplus and should properly be included as invested capital from dates of realization.^" Inadmissible assets purchased out of current earn- ings. — In article 852 it is stated that in determining the per- centage of inadmissible assets to be deducted, the amount held during the year must be taken into consideration. The article also states that it is immaterial whether or not such assets were purchased out of profits earned during the year. A corporation at the beginning of the year may have held no inadmissible assets. At the middle of the yea,r out of funds readily identified as arising from current profits it purchased corporate stocks. No dividends thereon were received up to '"See page 233 ; also see Income Tax Procedure, 1921, page 925. INADMISSIBLE ASSETS 203 the end of the year. If the amount invested in the stocks is averaged with other assets there will be deducted from invested capital at the beginning of the year a percentage thereof. The tax on the income from other sources depends on the credit of 8 per cent. If the invested capital is decreased because of the purchase of corporate stocks, the tax will be increased. This result is not equitable. The law does not permit current earnings to be taken into consideration during the year by adding such earnings to invested capital. If inadmissible assets purchased during the year with current earnings must be averaged, it will result in the deduction of current earn- ings from invested capital at the beginning of the year. There- fore, when inadmissible assets can be identified as having been purchased out of current earnings, the amount invested therein should be omitted from the computation of deductions from invested capital. This rule applies whether income is received therefrom or not. The same rule applies to admissible assets purchased dur- ing the year with current earnings. If all current earnings were in the form of, or were invested in admissible assets, it might be urged that it would not be equitable to increase the ratio of admissible assets thereby. It would be simple enough to cover such a contingency by a regulation. The point at issue is that the Treasury has no right to construe a tax law to the disadvantage of a taxpayer. Earn- ings accumulated during a year are not added to invested capi- tal as they should be from an equitable point of view. But however that may be, it is certain that no regulation can be enforced which requires that all the earnings during the year plus part of the invested capital at the beginning must be de- ducted from invested capital. When Inadmissible Assets Are Not Deemed to be "Inadmissible" Section 325 (a) provides that where the income derived from inadmissible assets "consists in part of gain or profit 204 EXCESS PROFITS TAX PROCEDURE derived from the sale or other disposition thereof, or where all or part of the interest derived from such assets is in effect included in the net income because of the limitation on the deduction of interest under paragraph (2) of subdivision (a) of section 234, a corresponding part of the capital invested in such assets shall not be deemed to be inadmissible assets." The foregoing provision decreases the deduction for inad- missible assets under two conditions : 1. When gains have been derived from the sale of stocks or tax-exempt bonds. 2. When interest has been paid on money borrowed to purchase or carry tax-exempt bonds. It will be noted that after the calculation is made and the balance sheet items are correspondingly adjusted, in calcula- tions wherein inadmissible assets are a factor, any part of what were previously "inadmissible" which under section 325 (a) are not deemed to be "inadmissible" assets will rank as admissible assets. Section 326 (c) requires that invested capital be reduced by "the percentage which the amount of inadmissible assets is of the amount of admissible and inadmissible assets held during the taxable year." Any assets which under section 325 (a) have been determined to be admissible continue to rank as admissible assets under section 326 (c). It will be helpful, in deahng with sections 325 and 326, to remember that section 325 defines all the various classes of assets and property, whereas section 326 defines invested capital. In other words section 325 governs the final determina- tion of admissible and inadmissible assets, and section 326 deals only with the items previously defined as related to in- vested capital. When gains have been realized on stocks, etc., or interest on borrowed money has not been deductible. — The provisions INADMISSIBLE ASSETS 205 of the law which modify the deduction for inadmissible assets are as follows: Law. Section 325. (a) [Inadmissible assets] .... where the income derived from such assets consists in part of gain or profit derived from the sale or other disposition thereof, or where all or part of the interest derived from such assets is in effect included in the net income because of the limitation on the deduction of interest under paragraph (2) of subdivision (a) of section 234/^ a corre- sponding part of the capital invested in such assets shall not be deemed to be inadmissible assets; The phrase "a corresponding part of the capital invested in such assets" may be understood to mean that the part of inadmissible assets which shall be included will be "an amount which bears the same ratio to the total amount invested in such stocks or bonds as the amount of such gains or profits bears to the total amount of such income." Regulation, (a) Where the income derived from inadmis- sible assets consists in part of profit from the disposition thereof, or (6) where all or a part of the interest derived from such assets is in effect included in net income because the interest paid on indebt- edness incurred or continued to purchase or carry such assets may not be deducted from gross income, in either case a corresponding part of the capital invested in such assets shall be deemed an ad- missible asset. This article applies separately to each issue or class of inadmissible securities held by a corporation. For example, it may hold A company stock costing $100,000 and B company stock costing $200,000. During the year it receives $8,000 in dividends from A company and $S,ooo from B company, and on September 30 sells part of its B company stock at a profit of $3,000. For the period from January I to September 30, $75,000 of its holdings of B com- pany stock become admissible. After September 30, its remaining holdings of B company stock are inadmissible, but the proceeds of the sale are admissible unless invested in inadmissibles (Art. 817.) The benefits of section 325 are in addition to those of sec- tion 326, which has already been mentioned, but the aggregate of the inadmissible assets included in invested capital under "Section 234 (a-2) covers limitation of interest paid on indebtedness incurred to purchase or carry tax-exempt securities. 2o6 ■ EXCESS PROFITS TAX PROCEDURE the two sections must not, of course, exceed the total of the inadmissible assets. When gains have been derived from sales. — ^The reason for deducting inadmissible assets from invested capital is that income derived from the use of the capital so invested is not taxable. When gains have been realized from the sale of stocks or tax-exempt bonds it would be inequitable to im- pose an excess profits tax on such gains unless the capital invested therein were included as invested capital. Section 325 (a) purports to remedy the inequality by treating as ad- missible assets an amount of otherwise inadmissible assets equal to "a corresponding part of the capital invested in such assets." Article 817 of Regulations 45, contained the following illus- tration of the foregoing:^ .12 Municipal bonds carried on books at $100,000.00 Interest received therefrom 2,000.00 Profit on bonds sold for $103,000 3,000.00 Except for the provisions of section 325 (a), the entire $100,000 (if there were no borrowed money) would be ex- cluded from invested capital and the $2,000 interest received would be excluded from taxable inco/ne, but the profit of $3,000 would be taxable without the benefit of any excess or war profits credit (there being no capital invested in the bonds upon which to base the credit). The illustration in the regu- lations applies the term "a corresponding part of the capital invested in such assets" as follows ; Interest received $2,000.00 Profit on sale 3,000.00 Total $S,ooo.oo The ratio of profit to total interest and profit is 3/5 or 60 ^^In the April 17, 1919, edition of the regulations this illustration was omitted and that at the top of the page was substituted. One illustrates the particular point in question as well as the other. INADMISSIBLE ASSETS 207 per cent, therefore it is assumed that 60 per cent of $100,000, viz., $60,000, is not to be deemed to be an inadmissible asset. This leaves in invested capital $60,000 as the base upon which the excess and war profits tax is imposed. When no income has been derived from the otherwise in- admissible asset, the entire amount invested therein is deemed to be inadmissible. This is entirely equitable. In the preliminary edition of Regulations 45 the illustra- tion used^^ did not distinguish between various issues of inad- missible assets. The language of section 325 (a) appears to deal with inadmissible assets as a separate class. It reads "where the income derived from such assets consists in part of gain or profit derived from the sale or other disposition thereof." If it had been intended that the gain plus the income from any one asset of the class should determine the ratio, it must be assumed that the section would have so provided. It seems to be a forced construction of the section to separate the inadmissible assets into issues or classes, and in some cases it would lead to inequalities. If a taxpayer owned some of four issues of city of New York bonds and sold part of two issues at a profit, would it be held that a gain had been realized on the two issues sold, rather than on the inadmissible assets owned ? Or would it be held that a gain had been realized from all New York bonds ? Sometimes the same issue of bonds is divided into different maturities which are described as different series. Would each series be deemed to be an issue? So with corporate stocks, frequently an investment is made in several classes of stock issued by the same corporation and the investment is not considered by the corporation to be separable. Sales are credited against the investment as a whole. It has been stated on good authority that the section in question was suggested by the Treasury, and that it merely enacted into law Regulations 41 which purported to interpret "See page 306. 2o8 EXCESS PROFITS TAX PROCEDURE the 1917 law. In various articles of Regulations 41 and in the 1918 Excess Profits Tax Primer it was provided that the proportion of inadmissible assets not to be deducted from in- vested capital was ascertained by comparing total income and total gains from inadmissibles.^* The 19 1 8 law may be assumed to have confirmed the then existing practice. If it had been desirable to make a radical "[Former Procedure] 1917. The second paragraph of section 207 of the law specified certain items which were not to be included in invested capital, namely: stocks, bonds (other than obligations of the United States) or other assets the income from which was not subject to the excess profits tax. It was necessary to remedy the inconsistency which existed in the law whereby profits arising from the sale of tax-exempt securities were taxed but the capital invested therein was not included in invested capital. The regulations- per- mitteji the inclusion in invested capital of an amount which bore the same ratio to the total amount invested in such securities as the profit from dealing in tax-free securities bore to the total amount of income therefrom. For example, an investment in stocks of $100,000 was of itself to be omitted from invested capital, but if one-half the invest- ment was sold at a profit of $io,ooD and no dividend was received, $50,000 would be added to invested capital. If $10,000 was received from dividends, $25,000 might be added to invested capital. In the former case the proportion of profit to total profits and divi- dends was 100 per cent. In the latter case the proportion was 50 per cent. Regulation. "Whenever income consists partly of gains or profits subject to the excess profits tax arising from trading in stocks, bonds, etc., the dividends or interest on which are not subject to such tax, and partly of such dividends or interest, then, subject to the limitations as to borrowed money, there shall be included in the invested capital an amount which bears the same ratio to the total amount invested in such stocks or bonds as the amount of such gains or profits bears to the total amount of such income." (Reg. 41, 1918, Art. 45.) Ruling. "A corporation having a capital stock of $100,000 is engaged in the buying and selling of securities. During the year 1917 an average of $75,000 of its capital was invested in municipal bonds. Interest on the bonds amounted to $4,500; profits from the sale of the bonds amounted to $18,000. May any of the $75,000 invested in these bonds be included in invested capital? "Yes. The total income from the bonds (interest plus trading profits) was $22,500. The trading profits were four-fifths of this amount. Under article 45 of Regulations 41, four-fifths of the amount ($75,000) invested in the bonds, namely, $60,000, may be in- cluded in the invested capital." {Excess Profits Tav Primer, 1918.) INADMISSIBLE ASSETS . 209 change it would have been extremely easy to have had the present law express the change. The rule prescribed by the Treasury may work in favor of the taxpayer or the government depending upon the ratio of gain from sales of securities to the income therefrom. As stated, however, the rule does not appear to be in accord with the intention of the law. On the other hand, it is argued that such an interpretation, while apparently justified by the language of the law, could hardly have been intended. An investment corporation own- ing $5,000,000 of stocks from which no dividends were re- ceived might sell $10,000 thereof at a profit of $100. The proportion of gains to total income from inadmissibles would be 100 per cent; $5,000,000 of assets otherwise inadmissible would-be deemed not to be inadmissible; and the result might be a saving in tax of several hundred thousand dollars. Such a result is not logical. The author is of the opinion that article 817 is more equitable than the intention of the law. The logical rule would be that the proportion of the inadmissibles not deemed to be inadmissible should be the percentage which the gain on sales bears to total income from the securities sold (not including any other securities, even of the same class). Otherwise, in effect, there is added to invested capital some part of the in- admissibles which has not been sold. Article 817, however, in an attempt to apply the term "such assets," segregates the assets into classes. When part of one class is sold, a part of that entire class is deemed not to be inadmissible. Such a conclusion is not logical. The term "such assets" means all inadmissible assets (as it probably does, even though it was not so intended) or it means "such assets as were sold and no others." Using the transactions in article 817: A stock $100,000.00 B stock ..,,-, 200,000.00 2IO EXCESS PROFITS TAX PROCEDURE Received during year : Dividends on A $ 8,000.00 Dividends on B $ S.ooo.oo September 30, Profit on sale of part of B stock (say, $50,000) : 3,000.00 Total income from B stock $ 8,000.00 Proportion of B profit to total income _. . 37J^% Part of B stock deemed not to be inadmis- sible to September 30, 37^% of $200,000, or $75,000.00 The result is erroneous because the part of the inadmis- sibles in effect admissible is greater than the entire amount sold. If the term "such assets" means only the assets sold, the following is correct : B dividends $ 5,000.00 B profit 3,000.00 $8,000.00 Proportion of B profit to total income, 37j4 per cent. Part of B stock sold, $50,000. Thirty-seven and one-half per cent thereof is $18,750. This is more equitable than $75,000. Article 817 is too liberal in one respect and too strict in another. The dividends on B stock for an entire year are included and thus the proportion attributable to the gain is diminished. Logically the income and the gain should be computed for the same period. In the illustration that would be nine months. When there is borrowed money. — If borrowed money is excluded from the computation of invested capital and if it is not assumed that inadmissible assets may have been pur- chased from the proceeds of borrowed money, injustice will result. Under the provisions of the 1918 law the procedure neces- sary to eliminate the injustice is somewhat narrowed as com- INADMISSIBLE ASSETS 211 pared with the 1917 regulations." The law provides, in effect, that when stocks, tax-free bonds or other inadmissible assets are purchased with the proceeds of borrowed money, it must be assumed that a proportion of the admissible assets also was acquired with the proceeds of borrowed money. Law. Section 326. (c) There shall be deducted from invested capital as above defined a percentage thereof equal to the percentage which the amount of inadmissible assets is of the amount of admissible and inadmissible assets held during the taxable year. ^"[Former Procedure] Permission to offset inadmissible assets against borrowed money was not specifically given in the 1918 regu- lations, but forms iioi, 1102 and 1103 definitely confirmed the permis- sion. The general rule followed was that inadmissible assets could be assumed to have been purchased with borrowed money, but only up to the extent of actual liabilities. Ruling. " .... a corporation or partnership would be permitted to offset corporate stock against liabilities in the computation of in- vested capital, but in no case should such stock in excess of liabilities be considered as invested capital." (Letter to S. D. Leidesdorf & Co., New York, N. Y., signed by Deputy Commissioner L. F. Speer, and dated April 2, 1918.) Averaging indebtedness over the year for purpose of adjusting INVESTED capital.— Ruling. "A corporation having a capital stock of $25,000 had an in- debtedness at beginning taxable year of $44,000; average indebtedness dur- ing the year $48,000; indebtedness at the close of year $20,000. Interest rate 6 per cent. Interest paid over allowable deduction in income tax return $780. Indebtedness all unsecured and in normal course of business varies from day to day, always at a minimum between last of month and tenth succeeding month when bills are paid for pur- chases preceding month. "Can the amount to be added to invested capital under article 44, Regulations 41, be based on $48,000 as permanent indebtedness or is permanent indebtedness limited to $20,000 indebtedness at the close of year? "[Answer.] Your telegram September 9. Return made on basis of averaging indebtedness at frequent regular intervals during the year to determine adjustment by way of addition to invested capital under article 44, Regulations 41, is acceptable if such method proves in other respects to be just and equitable." (Telegram of September 9, 1918, from New, Miller, Camack and Wingner, Kansas City, Mo., to Commissioner Daniel C. Roper, and the Commissioner's reply thereto dated September 26, 1918.) The following ruling illustrates the principle that if the indebted- ness was sufficient to offset the inadmissible assets no part of the latter need be deducted from capital and surplus; also that if at any time during the taxable year the inadmissible assets exceeded the indebtedness some deduction must have been made from capital. 212 EXCESS PROFITS TAX PROCEDURE A corporation has capital and surplus of $400,000 and in- debtedness of $100,000. It has admissible assets of $420,000 and inadmissible assets of $80,000. Under the 191 7 rulings as the indebtedness exceeded the amount of inadmissible assets there was no deduction from capital and surplus. Under the 1918 law [section 326 (c)] it is assumed that all the assets were proportionately purchased from the proceeds of the in- debtedness. That is, there must be deducted from the capi- tal and surplus 8o/5ooths (16 per cent) of $400,000 or $64,000, making the invested capital of the concern $336,000. Or, to put it another way, after ascertaining invested capital by adding capital, surplus, etc., together, there will be deducted therefrom all inadmissible assets, unless there is indebtedness outstanding which might have been available for the purchase Ruling. "Reference is made to your letter of April 20, 1918, same being in reply to office letter of April 12, 1918. In reply you are advised that changes made during the year in inadmissible assets should be taken into consideration together with any change in indebtedness on a monthly pro-rata basis in determining invested capital for excess profits tax purposes. "In the case you cite where a capital of $400,000 is balanced by an equal sum in admissible assets and assuming that the indebted- ness remains constant during the year, if for example, on June 30, $100,000 of admissible assets are converted into inadmissible assets the average invested capital for the year on a monthly pro-rata basis would be $350,000. "If in the same illustration., at the beginning of the year the ad- missible assets were $420,000, the inadmissible assets $80,000, and the indebtedness $100,000, and assuming again that the indebtedness remains constant during the year, the invested capital as of the beginning of the year would be $400,000. If on June 30, $100,000 of admissible assets are converted into inadmissible assets thus mak- ing the total of inadmissible assets in excess of the indebtedness the invested capital for the period from July i, to the end of the year must be reduced to the extent that the inadmissible assets exceed the liabilities. The average invested capital for the year on a monthly pro-rata basis in this case would be $360,000. "In cases where changes are made during the year in both inad- missible assets and in indebtedness the average amount of each of said items for the full year should be ascertained. "If the average total of the inadmissible assets for the full year is equal to or less than the average total of the indebtedness for the full year no reduction in invested capital need be made. "If the average total of the inadmissible assets for the full year is in excess of the average total of the indebtedness for the full year, invested capital must be reduced by the amount of such excess." (Letter to Baker, Goodyear & Co., New Haven, Conn., signed by Commissioner Daniel C. Roper, and dated May 17, 1918.) INADMISSIBLE ASSETS 213 of all or part of the inadmissible assets. If there is such in- debtedness, the capital will be reduced only by the proportion which the inadmissible assets are of the total assets (both ad- missible and inadmissible). If the same concern had no indebtedness, but had $500,000 of capital and surplus, it would result in a deduction of $80,000, i.e., the total inadmissible assets, from the capital. The following ruHng issued in 1920 under the 19 17 law makes it clear that it was necessary to adopt the regulations to the exigencies of the return form. Ruling. .... When Regulations 41 were in course of prepara- tion the method of meeting this situation was given very careful con- sideration and full discussion. It was recognized that in many, if not most, instances it would be impossible to earmark the dollar paid for inadmissible assets and to say whether it represented invested capital or borrowed money. It was therefore determined to give the taxpayer the benefit of the doubt, and this was done by paragraph 129 of article 53, which, after specifying certain adjustments necessary to be made, provides that the sum so found shall be the invested capital at the beginning of the taxable year, "except that in any case where the admissible assets .... are less than the amount of such adjusted total, then the invested capital must be further reduced to an amount equal to the sum of the admissible assets." In drafting the form to put into effect this provision it was found to be an awkward thing to accomplish, and the precisely same result was accomplished in the method prescribed by schedule 8 (c) and the instructions covering same; that is to say, if the admissible assets are in excess of the adjusted capital and surplus, no further deduction is required because of inadmissible assets ; in other words, only the excess of inadmissible assets over total indebtedness is to be deducted from the capital and surplus so found (B. 21-20-964; A. R. R. iii.) In other words when there is no change in the proportion of admissibles and inadmissibles during the year the entire amount of inadmissible assets is excluded from invested cap- ital, unless there is indebtedness, in which event a part of the indebtedness is in effect added to invested capital. Law. Section 325. (a) .... The term "borrowed capital" means money or other property borrowed, whether represented by bonds, notes, open accounts, or otherwise; 214 EXCESS PROFITS TAX PROCEDURE Except in the rare case when admissibles, inadmissibles, capital stock and surplus as related to each other remain sub- stantially unchanged during the year the deduction for inad- missibles has no logical relation to the amount of inadmis- sibles. Clearly the deduction ought not to be greater than the maximum amount of inadmissibles held at any time during the year or, except in the case of borrowed capital, less than the minimum amount of inadmissibles held at any time during the year ; but since the percentage for the inadmissible deduc- tion is derived from amounts of admissibles affected by cur- rent earnings and such percentage is applied to the amount of invested capital not affected by current earnings, the actual deduction may be either greater than the maximum or less than the minimum amount of inadmissibles held, depending on the changes in assets due to the .year's profit or loss. In the case of borrowed capital, although the deduction may properly be less than the amount of inadmissibles held, the result may be otherwise in a given case because of the fact that there is no logical relation between borrowed capital and the increase of assets arising from the year's operations. In other words, although the deduction provided in the statute theoretically eliminates certain non-taxable assets from in- vested capital and theoretically makes some allowance for the fact that such assets may have been acquired with borrowed capital, in practice the result may vary in any degree imagined from the theoretical result, depending on the change in ad- missible assets arising from the year's operations. When inadmissible assets need not be deducted from in- vested capital because interest paid to carry inadmissible as- sets is not an allowable expense. — The reason for deducting inadmissible assets from invested capital is that the income arising from the use of the capital so invested is not taxable. When interest paid to carry the tax-exempt bonds is not allowed as deductible expense, the effect is exactly the same as if an amount of non-taxable income, equal to the amount INADMISSIBLE ASSETS 21 5 of interest paid, were taxed. Section 325 (a) purports to remedy the inequality which would result from the taxation of tax-exempt income and permits the taxpayer to treat as admissible assets an amount of otherwise "inadmissible" assets, equal to "a corresponding part of the capital invested in such assets." The section is not at all clear, and can hardly be understood without the use of several illustrations. The first two illustrations indicate the justice of the rule which excludes inadmissible assets from invested capital when there is no borrowed money (and consequently no interest paid) and no gains from sales. I. Assets (all admissible) $500,000.00 Capital 500,000.00 Net income $ 50,000.00 Excess profits credit 8% $ 40,000.00 Specific exemption 3,000.00 43,000.00 Net income to be taxed $ 7,000.00 20% tax $ 1,400.00 Balance of income after excess profit taxes $ 48,600.00 II. Assets : Admissible $500,000.00 Municipal bonds 300,000.00 $800,000.00 Capital 800,000.00 General income, net $ 50,000.00 taxable Interest on bonds 15,000.00 exempt Total income per books $ 65,000.00 As there are no gains and no interest has been paid, the classification needs no adjustment under section 325. Under section 326 (c) there must be deducted the per- centage which the amount of the inadmissible assets is of the amount of admissible and inadmissible assets, viz., ^ or 375^ per cent of $800,000= $300,000, leaving as allowable invested capital $500,000. The exclusion of bonds from the invested capital and interest from the total income leaves the amount of excess profits tax the same as in illustration I, viz., $1,400. 2i6 EXCESS PROFITS TAX PROCEDURE IS The next example illustrates a fairly common practice. The corporation in illustration I buys $300,000 of municipal bonds, borrows $300,000 on them, receives $15,000 interest thereon and pays $15,000 interest on the loan. III. Assets : Admissible $500,000.00 Municipal bonds 300,000.00 $8eo,ooo.oo Capital $500,000.00 Note payable 300,000.00 800,000.00 General income, net $ 50,000.00 Interest on bonds 15,000.00 exempt $65,000.00 Interest paid 15,000.00 not deductible Net income per books $ 50,000.00 Taxable income $ 50,000.00 Under the general provisions o'f the law inadmissible assets must be deducted from invested capital and borrowed money cannot be included in invested capital, and assuming that in the foregoing case the relief provided under section 325 (a) did not apply, municipal bonds ($300,000) would be deducted from invested capital ($500,000) which would be reduced to $200,000, except for section 326 (c) which provides thiat the deduction shall be the percentage which the inadmissible assets are of the amount of admissible and inadmissible assets. Capital, as in illustration III $500,000.00 The inadmissible assets are ^ or 3714% of the total assets, hence the capital is to be reduced by that percentage or 187,500.00 Net invested capital $312,500.00 Taxable profit $50,000.00 Excess profits credit: 8 per cent $25,000.00 Specific exemption 3,000.00 28,000.00 Income to be taxed $22,000.00 20% $ 4,400.00 Tax under illustration 1 1,400.00 Additional tax $ 3,000.00 "The margin of collateral usually required is ignored as it has no bearing on this illustration. INADMISSIBLE ASSETS 217 It will be seen that the effect, before taking advantage of section 325, is to increase the tax by $3,000, although the tax- payer has not increased his net income at all. It would be inequitable to impose an extra tax of $3,000 solely on the purchase of $300,000 of municipal bonds, the gross income from whith was $15,000. It is obvious that the inhibition against the deduction of interest paid nullifies the "tax-ex- empt" interest on the municipal bonds, which alone is the reason for deducting the investment in municipal bonds from the invested capital. If the income from the bonds is in effect taxed, the investment in the bonds, under section 325 (a), "shall not be deemed to be inadmissible." Taken by themselves the words "a corresponding part of the capital invested in such assets" are ambiguous, but in the light of the foregoing illustration the meaning is quite plain. The "corresponding part" must relate to the income which should be exempt from taxation but in effect is not tax-exempt. In this case the entire interest received is made taxable; that is, the additional tax of $3,000 is equivalent to 20 per cent of the tax-exempt income of $15,000. Therefore under sec- tion 325 (a) the "corresponding part of the capital invested in such assets" is $300,000, which thus is deemed not to be in- admissible. As there are no inadmissible assets remaining to be deducted from the invested capital, section 326 (c) has no bearing on the computation of the tax, and the taxpayer will pay the same excess profits tax as under illustration I, viz., $1,400. This is equitable because .his book net income and taxable net income are the same. It has been claimed (not by the author) that section 325 (a) should apply only when the interest paid exceeds the in- terest received and then only in the ratio which the excess interest paid bears to the interest received. That such could not have been the intention of the law (which reads, in part, that when "interest derived from such assets is in effect in- cluded in the net income because of the limitation on the de- duction of interest .... a corresponding part of the capital 2i8 EXCESS PROFITS TAX PROCEDURE invested in such assets shall not be deemed to be inadmis- sible") is further shown by the following illustration: IV. Assets: Admissible $SOO,ooo.oo Municipal bonds 300,000.00 $800,000.00 Capital $500,000.00 , Note payable 300,000.00 800,000.00 General income, net $ 50,000.00 Interest on bonds 12,000.00 exempt $ 62,000.00 Interest paid 15,000.00 not deductible Net income per books $ 47,000.00 Taxable income $ 50,000.00 The excess of interest paid above interest received is $3,000. The ratio of $3,000 to $12,000 (interest received) is 25 per cent. The ratio of $3,000 to $15,000 (interest paid) is 20 per cent. Using the latter percentage and applying it to the capital invested in such assets, the amount which would not be deemed to be inadmissible would be : 20% of (total bonds) $300,000.00 Or 60,000.00 Leaving as inadmissible $240,000.00 Admissible assets $500,000.00 Deemed not to be inadmissible 60,000.00 560,000.00 Total assets $800,000.00 Invested capital $500,000.00 Deduction under section 326 (c) : 240/800 of $500,000 150,000.00 Net invested capital $350,000.00 Taxable income $ 50,000.00 Excess profits credit: 8 per cent $ 28,000.00 Specific exemption 3,000.00 31,000.00 Income to be taxed $ 19,000.00 20% $ 3,800.00 Book net income 47,000.00 Balance $ 43,200.00 INADMISSIBLE ASSETS 219 If the ratio of the excess of interest paid to interest re- ceived (25 per cent) were taken, the taxpayer would be better off in the final settlement, but there is no logical basis for con- sidering either the 20 per cent or the 25 per cent ratio. Under illustration III the penalty for purchasing munici- pals is $3,000, and under IV it is $2,400. In either case the penalty for holding municipal bonds is relatively so excessive as to make it evident that there was no such intention on the part of the framers of the law. It follows that the computations used in illustrations III and IV are not defensible. By a process of elimination we have determined the pro- portion of inadmissible assets not to be deemed to be inadmis- sible : ( I ) When the interest paid is less than the interest received, we use the percentage of interest paid to interest received. In such a case part only of the inadmissible assets will not be deemed to be inadmissible; (2) If the interest paid is as great or greater than the interest received, the entire amount of inadmissible assets must not be deemed to be inadmissible. In the following illustration the correct method of compu- tation is used: V. Assets: Admissible $500,000.00 Municipal bonds 300,000.00 $800,000.00 Capital $700,000.00 Note payable 100,000.00 800,000.00 General income, net $ 50,000.00 Interest on bonds 15,000.00 exempt $ 65,000.00 Interest paid 5,000.00 not deductible Net income per books $ 60,000.00 Taxable income $50,000.00 In this case the ratio of interest paid to interest received is 33 1/3 psr cent. In effect 1/3 of the "tax-exempt" interest is taxed by reason of the non-deductibility of the interest paid. 220 EXCESS PROFITS TAX PROCEDURE Bonds : Not deemed to be admissible $300,000.00 33 1/3% • 100,000.00 Deemed to be inadmissible $200,000.00 Admissible $500,000.00 Add 100,000.00 600,000.00 Total assets $800,000.00 Invested Capital $700,000.00 Deduction under section 326 (c) 2/8 of $700,000 175,000.00 Net Invested Capital $525,000.00 Excess Profits Credit: 8% of $525,000 $ 42,000.00 Specific exemption 3,000.00 $ 45,000.00 Taxable income 50,000.00 Subject to tax at 20% $ 5,000.00 Tax payable (20% of $S,ooo) $ 1,000.00 VI. There is some foundation in equity for the argument that when the interest paid exceeds the interest received the taxpayer is entitled to add to invested capital an amount suffi- cient to offset the penalty which results from the inability to deduct all interest paid. But section 325 (a) in referring to inadmissible assets extends relief only to the extent to which "a corresponding part of the capital invested in such assets shall not be deemed to be inadmissible assets." It would hardly be possible to interpret this to mean that the amount not deemed to be inadmissible should be greater than the total of the inadmissible assets, which would result in the invested capital being in excess of the total assets. Nevertheless the tax computed in this manner might be fair. Assuming that no greater amount of inadmissible assets may be deemed not to be inadmissible than the total amount of assets used as collateral for loans (even though the interest paid exceeds the interest received), it is important that when possible the collateral used be sufficient to yield an aggregate income equal to the amount of interest on the loan. Otherwise INADMISSIBLE ASSETS 221 the amount of inadmissible bonds not deemed to be inadmis- sible will not be sufficient to offset the penalty suffered by the limitation on the interest deduction. Referring to illustration IV : The excess profits tax should be $ 1,400.00 Net income as per books 47,000.00 Balance , $ 45,600.00 That is to say, the taxpayer receives no relief whatever on account of the interest paid in excess of the interest received. If he were permitted to consider that the corresponding part of the assets invested in inadmissible items related to the income which in effect was taxed when it should not be taxed, the calculation would be as follows: Interest paid $ 15,000.00 Interest received 12,000.00 Ratio of assets not to be deemed to be inadmissible, 15/12 : 15/12 of $300,000 = $375,000.00 Bonds 300,000.00 To be added to invested capital $ 75,000.00 Capital 500,000.00 Total invested capital $575,000.00 Taxable income $ 50,000.00 Excess profits credit 8% $46,000 Specific exemption 3,000 49,000.00 To be taxed $ 1,000.00 20% 200.00 Net income per books $ 47,000.00 Excess profits tax 200.00 Balance $ 46,800.00 Balance as computed above 45,600.00 Difference $ 1,200.00 The saving is too great. The most to which the taxpayer would be entitled would be 20 per cent of the interest not deductible ($3,000), or $600. The saving is greater than $600 because the increased invested capital operates to reduce the tax imposed upon the $50,000 of income from general sources. 222 EXCESS PROFITS TAX PROCEDURE The 8% credit on $75,000 = $6,000.00 The interest paid in excess of interest received on tax-exempt bonds = 3,000.00 Excessive credit $3,000.00 on which a tax of 20 per cent should be imposed, or $600, which in turn represents the insufficient amount of tax, if cal- culated upon the theory that' more than 100 per cent of the inadmissible assets should be restored. When profits are derived from sale of inadmissible assets, and when interest is paid on money borrowed to carry inad- missible assets. — Balance Sheet at End of Year VII. Assets: Admissible $500,000.00 Municipal bonds beginning of year $300,000.00 Sold December 31 200,000.00 100,000.00 $600,000.00 Capital $500,000.00 Note payable 100,000.00 600,000.00 General income, net $ 50,000.00 taxable Interest on bonds 15,000.00 exempt Gain on sale of bonds 5,000.00 taxable $ 70,000.00 Interest paid on average borrowings dur- ing year, $150,000 at 5% 7,500.00 not deductible Net income per books $ 62,500.00 Taxable income $ 55,000.00 Inadmissible assets not to be deemed to be inadmissible. — By reason of profit on sale: Interest received on bonds sold $ 10,000.00 Gain received on bonds sold S,ooo.oo $ 15,000.00 Bonds sold $200,000.00 5/15 of $200,000 $ 66,666.00 *Bonds sold December 31. Calculation for one day omitted. INADMISSIBLE ASSETS 223 By reason of interest paid : Interest received on bonds as collateral, $200,- 000 at 5% 10,000.00 Interest paid on loans 7,500.00 Ratio of interest paid to interest received, 75%. 75% of $200,000 150,000.00 Total not to be deemed to be inadmissible $216,666.00 Average of inadmissible assets for year** $300,000.00 Not to be deemed to be inadmissible 216,666.00 Inadmissible $ 83,334.00 Admissible $500,000.00 Add _ 216,666.00 716,666.00 Total assets $800,000.00 Capital $500,000.00 Deduction under section 326 (c), 83,334/800,- 000 of $500,000 52,084.00 Net invested capital $447,916.00 Taxable income $ 55,000.00 Excess profits credit: 8% $ 35,833-28 Specific exemption 3,000.00 38,833.28 Subject to tax $ 16,166.72 • Tax 20% $ 3,233-34 **Under article 817 the entire amount of bonds ($300,000), if of one class, would be used, but the author is of opinion that only the bonds sold should be used in the computation. (See page 205.) Interest restriction applies only to bonds. — In the forego- ing illustrations it will be noted that when money is borrowed to buy or carry corporate stocks the interest paid on account thereof is an allowable deduction [section 234 (a-2)], hence the provision in section 325 (a) whereby inadmissible assets may be deemed not to be inadmissible applies to gains from the sale of corporate stocks but does not apply to interest paid on account of them. Stock of federal reserve bank is an inadmissible asset. — Ruling. Federal reserve bank stock held by member banks is held to be an inadmissible asset in determining invested capital for excess profits tax purposes. (B. 1-19-118; O. D. 81.) 224 EXCESS PROFITS TAX PROCEDURE War Finance Corporation bonds as admissible and inad- missible assets. — Ruling. Interest on an amount of bonds of the War Finance Corporation, the principal of which does not exceed in the aggregate $5,000, is exempt from Federal income and excess profits taxes. Cor- porate funds invested in such bonds are inadmissible assets to the extent that they are invested in bonds of a face value of not more than $5,000, but funds of a corporation or an association invested in such bonds are admissible assets so far as they are invested in such bonds beyond a principal or face value of $5,000. (B. Digest 1-19- 116; O. 781.) CHAPTER X ADJUSTMENT OF CAPITAL, SURPLUS, RESERVES AND LIABILITIES In the chapters preceding this the various items which ap- pear or should appear as assets on the balancf shr have been discussed. This chapter deals with the lerrn which commonly appear on the liability or credit side ol the balance sheet and books of account. Some of the items in the latter class are Jieither capital or surplus nor liabilities but are proper deductions from assets. Such accounts are reserves for bad debts, depreciation, etc. Asset accounts cannot be adjusted without making corres- ponding changes in surplus or reserves, and it is with surplus and reserve accounts that this chapter chiefly deals. Capital Stock and Capital Surplus As stated in Chapter VII, invested capital usually repre- sents the capital stock and surplus accounts of a corporation with additions or deductions to comply with various provisions of the law. In many cases there is no substantial difference between the book capital and the invested capital for tax pur- poses. Capital stock. — The aggregate capital stock outstanding in the hands of the public, including all issues of common and preferred stock, is prima facie fully allowable as an item of invested capital. The deductions in the case of capital stock issued for goodwill or other assets which are subject to adjustment have been discussed in Chapter VIII. An increase in capital stock during the taxable year will 225 226 EXCESS PROFITS TAX PROCEDURE take effect as of the date or dates when cash or other assets are received in payment for the stock.^ Stock without par value. — Law. Section 325. (b) For the purposes of this title, the par value of stock or shares shall, in the case of stock or shares issued at a nominal value or having no par value, be deemed to be the fair market value as of the date or dates of issue of such stock or shares. In most cases shares having no par value are placed upon the books of the issuing corporation at a value determined at the time of organization. Sometimes a nominal value of $5 a share is carried in capital stock account and the excess of the value of the assets above liabilities is credited to capital surplus. Whether the whole book value of the shares is car- ried in capital stock account or in that account and surplus account, it would seem that the values as determined for pur- poses of the book entries may be the best evidence obtainable of the "fair market value" of the shares. Frequently the shares at or about the time of issue sell at a price in excess of the book value, but market quotations vary to such an extent that apparent market values can hardly be used as being more trustworthy than the book values. The situation is not unlike that when par value shares are concerned. The mere issue of a large number of shares cannot increase or decrease invested capital as defined in the law, nor can the fluctuations of the stock market increase or decrease the invested capital. When shares are issued as a result of a reorganization, old values control. When new interests are involved and a bona fide purchase is made, the cost of the property to the new company is the basis of invested capital, and such cost should be entered on the books. When proper values are imputed to the assets acquired it makes little difference whether the aggregate cost is reflected on the credit side as capital or as capital surplus. 'Reg. 45, Art. 8S3, see page 258. CAPITAL, SURPLUS, RESERVES, LIABILITIES 227 Treasury stock. — ^A deduction from the capital stock ac- count as shown by the books must be made if a corporation's own stock has been issued full-paid and returned to the cor- poration by gift or purchase. The deduction should be made both because it is improper to treat treasury stock as an asset in a statement to be used for tax purposes and because under the excess profits tax law stock investments are eliminated, except under certain conditions. The proceeds of treasury stock sold during the year will increase the invested capital from the day when the cash or other asset is paid in. Regulations. Where stock which has originally been issued or exchanged by the corporation for property (tangible or intangible) is returned to the corporation as a gift or for a consideration sub- stantially less than its par value, the stock so returned shall not be treated as a part of the stock issued or exchanged for such property. The proceeds derived in cash or its equivalent from the resale of the stock so returned shall, however, be included in computing invested capital (Art. 861.) Where a corporation either directly or indirectly, as for example through a trustee, has prior to the taxable year bought its own stock, either for the purpose of retirement or of holding it in the treasury or for other purposes, the entire cost of such stock must be deducted from the aggregate invested capital as of the beginning of the taxable year, if such deduction has not already been made. Where such stock is purchased during the taxable year a deduction from the invested capital as of the beginning of the taxable year and effective from the date of such purchase is required only to the extent that such stock has not been purchased out of the undi- vided profits of the taxable year The full amouiit derived in cash or its equivalent from the resale of such stock may be included in the invested capital from the date of such resale, unless such stock had been purchased out of earnings of the taxable year. (Art. 862.) It will be seen that the adjustments required under the foregoing regulations deal with two distinct situations. That covered by article 861 requires the elimination of the whole par value of the stock, on the theory that the property for which the stock was issued is shown, by the surrender of the stock as a gift, not to have been worth its full value as indi- cated by the stock originally issued. Consequently it is not permitted such value in invested capital. 228 EXCESS PROFITS TAX PROCEDURE The second adjustment, which is required under article 862, merely ehminates from invested capital the amount at which the treasury stock is carried on the books. This is proper because the purchase of treasury stock is a liquidation, to the extent of the amount paid, and the investment is to that extent decreased. The tax return (form 1120) takes up the two adjustments in schedules E and H. It is to be noted, however, that if treasury stock is bought out of current earn- ings, no adjustment under article 862 is needed because cur- rent earnings are not invested capital of the taxable year and a transfer of such earnings into the form of treasury stock does not make them any the less earnings of the taxable year. When treasury stock is purchased for cash or is taken in exchange for a debt, the actu-al capital of the corporation is depleted. It is obvious that no income can be derived from such an investment. It would alter the whole theory of the excess profits tax law if a withdrawal of cash by a stockholder were held to have no effect on invested capital. When the purchase price is paid in interest-bearing notes and the liability is shown on the books, the interest paid is a deduction and invested capital is decreased by the amount of the notes. When treasury stock costs more than par. — The purchase of treasury stock for cash or other property dimin- ishes the income-producing assets of a corporation to the ex- tent of the purchase price. Therefore, when the price paid is more than par, the equivalent of par is, in effect, an offset against a like amount of capital stock and the excess above par is a charge against surplus. Bonus stock. — Regulation. Capital stock issued as a bonus in connection with the sale of a corporation's bonds may not be included in invested cap- ital unless the corporation proves to the satisfaction of the Commis- sioner that such stock bonus enabled the corporation to secure a higher price for the bonds than it could otherwise have secured. CAPITAL, SURPLUS, RESERVES, LIABILITIES 229 Wherever this fact is established such stock shall be included in computing invested capital to the extent of the difference between the selling price of the bonds and the price at which they could have been sold if issued without such stock bonus. The excess of the face value of such bonds over the price at which they could have been sold if issued without the stock bonus is deemed discount and is subject to amortization. (Art. 832.) Stock issued in place of indebtedness. — The control- ling interests in closely held corporations frequently provide the necessary working capital of the corporations by means of cash advances or loans. Sometimes interest is paid on these loans and sometimes interest is not charged or paid. In all such cases the borrowed moneys appear as liabilities of the corporations, and cannot be included as invested capital. How- ever, when the indebtedness does not bear interest and is subordinated to creditors, it assumes the nature of capital.^ No objection can be urged to the exchange of all or any part of a corporation's legitimate indebtedness for capital stock. It means the wiping out of liabilities and the substitu- tion of capital at the risk of a business. It increases the net worth of a corporation and greatly improves its balance sheet. Banks and other creditors look with great favor on any ehmination of liabilities. If interest not previously on the books be added to loan accounts for which stock is issued, individuals must report the receipt of such interest as taxable income. The corpora- tion may deduct the payment of the interest as an expense of the business. The exchange of indebtedness for capital stock cannot take place as of a past date but will be effective as of the date on which the necessary legal authority relieves the corporation of the debt, and the invested capital of the corporation will be correspondingly increased from that date to the end of the taxable year. When the indebtedness has been in the form of bonds, an "Reg. 45, Art. 813, see page 129. 230 EXCESS PROFITS TAX PROCEDURE exchange for stock will result in an increase in invested capital equal to the face value of the bonds retired. There is a Treasury ruling, however, which prescribes the following procedure. Ruling. Where bonds are exchanged for stock in the same cor- poration under the terms of a convertible trust deed, it will be pre- sumed, for the purpose of computing invested capital, that the value of the bonds is equivalent to the value of the stock. The addition to invested capital would accordingly be the amount for which the bonds were originally sold. (B. 24-19-577; O. D. 306.) The foregoing ruling is not sound. Unamortized discount is an admissible asset, and, even if the discount on bonds has been charged to surplus, the face value of the bonds will still be the basis of inclusion in invested capital. Comparison with capital stock means nothing. Stock issued to employees.- — Ruling. Shares of stock distributed by a corporation to its em- ployees in payment of services rendered, where the amount is not excessive, may be included in invested capital to the extent of the actual cash value of the services rendered. (B. 13-19-431 ; O. D. 248.) It all depends on the purpose of the issue. If expense (profit and loss or surplus) is debited, of course invested cap- ital can be increased by a like amount. If an asset account is debited, it will have to be valued under the rules which govern the admissibility of assets. This rule is based on the income- producing possibilities of the asset. Ruling. In the case of stock sold by a corporation to its employ- ees under agreement either for cash, part cash and part deferred payments, or all deferred payments, subject to various conditions as to interest on deferred payments, cancellation of agreements, and divi- dends on the stock, only the amount of the subscription payments actually received by the company may be recognized as invested capital from the date of such receipt. If stock is subscribed for by an officer of the company and charged to his personal account, only so much of the stock as canceled a credit balance in his personal account or was actually paid for by him will be recognized as invested capital. (B. Digest 1-20-664; A. R. R. 10.) CAPITAL, SURPLUS, RESERVES, LIABILITIES 231 The foregoing ruling is sound in principle, because a mere debit to an employee and a credit to capital stock would not in themselves increase the income-producing power of the cor- poration. Ruling. Stock issued to an officer of a corporation which was not issued in accordance with the conditions of a subscription agreement, but was an unconditional subscription charged to his account, bearing interest and subsequently converted into a note, should be included in invested capital. The conclusion in A. R. R. 10, Bulletin 1-20, in so far as stock issued under subscription agreements is concerned should stand. (B. Digest 28-20-1063; A. R. R. 167.) The foregoing ruhng is not inconsistent with- that which preceded it, because the asset item produced income which was taxable and in addition it could be treated as an asset which was the equivalent of cash. Surplus and Undivided Profits Law. Section 326. (a) That as used in this title the term "in- vested capital" for any year means .... (3) Paid-in or earned surplus and undivided profits; not includ- ing surplus and undivided profits earned during the year; If any part of the surplus account as it stood at the begin- ning of the year was not earned or paid in, it will be elimi- nated upon analysis of the asset side of the balance sheet. If any item of assets is undervalued and may be revalued under the law, there will be a corresponding increase in surplus account. Surplus may not include book profits not reported as tax- able income. — Ruling. So much of a replacement fund for steamers lost estab- lished in accordance with Article 50, Regulations 45, as represents excess of the amount of insurance received over the book value of the steamers at the time of their destruction may not be included in invested capital for the purpose of war and excess-profits taxes, even though the interest received from the investment of such excess is 232 EXCESS PROFITS TAX PROCEDURE reported as taxable income, because such excess is not "paid-in or earned surplus" within the meaning of section 326 of the Revenue Act of 1918. (B. 12-20-801; O. D. 417.) The theory of the foregoing is that the book profit has not been reported as taxable income, but is carried as a reserve which is the equivalent of a liability. Ruling. If a taxpayer reports profits on installment sales on the basis of the proportionate part of each installment received represent- ing profit, his surplus account as at the beginning of the taxable year must be reduced in computing invested capital to the extent that the surplus account includes profit on such sales which has not been reported as taxable income. (B. 1-19-131 ; O. D. 92.) Surplus of foreign branches. — Ruling. A domestic corporation has a branch office in London which keeps a separate set of books in English currency and renders a report at the end of the year as to the profits, making remittances to the home office from time to time as they accumulate in excess of the amount required for regular expenses. In order to obtain the correct invested capital as at the beginning of the taxable year 1919, it is necessary to consolidate the balance sheet of the branch office with that of the home office. It is assumed that the net profits earned by the London branch during the year 1918 represent surplus; therefore in determining the amount of earned surplus attributable to the London branch, the amounts re- mitted by it to the home office should be taken into earned surplus at their value in American currency at the time when such remit- tances were made, and the balance of the net profits expressed in English currency should be converted into United States money at the rate of exchange as of the end of the taxable year, regardless of the fact that the profits may not have been remitted to the home office. (See ruling 25-20-1009; sec. 212, art. 22.) (B. 31-20-1109; O. D. 6x8.) Surplus increases from stock dividends. — When stock dividends are received the proper entry is to debit stocks owned and to credit surplus. As the stock dividends are not income, surplus arising therefrom must not be included in invested capital. For the years 1917, 1918 and 1919, when stock dividends were held to be taxable, some part of surplus was in efifect CAPITAL, SURPLUS, RESERVES, LIABILITIES 233 included in invested capital, depending on the ratio of inad- missible to total assets. Form 1 120 for 1920 (G,6) calls for the exclusion of all entries for stock dividends, resulting in a decrease in invested capital for the three prior years. Amended returns are re- quired for the "taxable period or periods in which this error occurred." Instead of being a taxpayer's error in those years, . it was the demand of the Treasury that stock dividends be credited to surplus. It was an error on the part of Congress. The Treasury in calling for amended returns should have referred to the adjustment required by error of Congress. Surplus arising from revaluations. — The law does not indicate that surplus arising from revaluations may be included as an. item of invested capital ; but when all or any part of an asset which was revalued as of March i, 191 3, is realized, there can be transferred immediately to earned surplus such part of the realization as represents surplus from the revalua- tion,^ and, from the dates on which the cash is received and transfer made to earned surplus, the amounts so transferred will constitute earned surplus and be allowable as invested capital. The limitation as to earnings for the current year does not apply, because the realizations are exactly the same as new capital received in cash and allowable from the date of receipt. That part of the realization which represents the original capital requires no adjustments, as the cash received takes the place of the assets realized. If a mining company carried its ore holdings on its books at $100,000 with an estimated quantity of 10,000,000 tons in the ground, the depletion deduction would be i cent a ton. If a revaluation as of March i, 1913, disclosed a value at that date of $200,000, the proper entry on the books would 'The transfers should be made to an account entitled "Surplus accumulated prior to March i, Tqis," to distinguish it from other earned surplus so that when dividends are declared out of the account it will be obvious that they are not taxable to the recipients. 234 EXCESS PROFITS TAX PROCEDURE be to debit the asset account and credit "Surplus arising from revaluation of ore lands" with $100,000. It would then be necessary to file amended income tax returns for the years beginning, with 1913.* The additional charges for depletion should be debited to "Surplus arising from revaluation of ore lands," credited to earned surplus and added to invested capi- tal as explained above. The amounts so transferred are not to be returned as income for the taxable years because the entire amount of appreciation as of March i, 1913, is capital and therefore not taxable, as and when realized, under an in- come tax law." Ruling. The committee is of the opinion that appreciation is in no event a part of earned surplus and therefore can not offset depreciation in the value of assets through wear, tear, and exhaustion. Depreciation must first be figured in order to determine true earned surplus. In other words, earned surplus is believed to consist of real- ized gains or profits and while such realized gains or profits must be reduced by any depreciation in value through use or exhaustion of the assets in which they are invested, any appreciation in value of those assets which is not yet realized can not be taken into consideration for the purpose of offsetting such decrease (B. 18-20-906; A. R. R. 71.) Paid-in surplus.— As fully explained in Chapter VIII, when property is actually worth, at the time paid in, more than its book value, the excess above previous book value may, when substantiated, be included in invested capital. Gifts by stockholders. — In some cases prior to March 3, 191 7, property was conveyed to corporations at much less than its actual value. Usually the transfers were from affili- ated corporations or from stockholders of close corporations and the stockholdings or beneficial ownership of the proper- *Under the 1913 law the allowable deduction for depletion was limited to S per cent of the value of the output at the mine, hence if the depletion claimed for 1913, 1914 and 1915 already equals the maximum allowance amended returns could be made only for the years beginning with 1916. "T. D. 2740 (June 24, 1918) which summarizes recent decisions of the United States Supreme Court. CAPITAL, SURPLUS, RESERVES, LIABILITIES 235 tics remained so nearly the same that at the time of transfer the book value of the property transferred was immaterial. When a corporation organized or reorganized prior to March 3, 1917, acquired tangible property the value of which was substantially in excess of the nominal purchase price, the excess should be taken up in the corporation's books as additional invested capital. It may be that the effect of the foregoing would be to im- pute a profit to the vendors equal to the difference between the actual value of the property transferred and its cost or value March i, 1913. It is logical to assume that, if stock- holders of a corporation admit that the corporation purchased property of a definite value and used such definite value as invested capital, the transaction as to the vendors was a closed one and the profit should be reported, even though the vendors retain a continuing ownership. But in the case of a bona fide gift there is no realization of profit or income by the donor and the recipient corporation may include the actual value of the property as invested capital. Gifts by others than stockholders. — Article 837" provides that the value of gifts by stockholders may be included in paid-in surplus. No mention is made of gifts by outsiders, probably on the theory that no one else would make a gift to a corporation. In some cases a city or board of trade will donate land to a corporation as an inducement to locate in the city making the gift. The value of the land at the date of gift does not fall within the provisions of section 326 (a-2) of the 1918 law, because the par value of the shares issued for the property is a necessary factor. A corporation moving to a new city under an agreement that valuable land would be donated to it might incur special expenses or losses in moving which might offset at least part "Page IS4- 236 EXCESS PROFITS TAX PROCEDURE of the value of the land. In such circumstances it might be proper to credit current earnings with the value of the gift, although it would not be a taxable item. In such case invested capital, in effect, would not be diminished by the losses due to moving to an amount equal to the value of the gift. Assessments on stockholders. — When a corporation as- sesses its stockholders (with their consent) and receives the funds, the amount received should be credited to paid-in sur- plus. It becomes invested capital as and from the dates when received. If such contributions are returned soon thereafter it would seem that the transaction should be regarded as the repayment of a loan rather than as a dividend. Rulings. A corporation assessed its stockholders ratably in order to secure additional working capital. The amount so paid in was set up on the books as reserve capital. No additional shares of stock and no notes or other evidences of indebtedness were issued for this money; there was no obligation to repay same other than that attach- ing to the original capital. The company, however, in its books ap- parently treated the sum advanced as a loan, and in computing its net income deducted interest on the amount. It is the opinion of the committee that in determining whether the amount in question should be included in invested capital or treated as borrowed money, the minute books of the corporation showing the resolutions making a pro rata assessment reflect more clearly the true nature of the transaction than do mere bookkeeping entries regarding it made at a later date. The resolutions authorizing the assessment made no provision for issuing notes or other evidences of indebtedness to the stockholders for the amounts paid in nor for payments of interest thereon. Although the sums so paid on account of these assessments were carried on the books as interest, the facts indicate that such payments were in the nature of dividends. In neither law nor equity would the stockholders be preferred over general creditors as to the amount of these assessments and the interest thereon. Held that the corporation may include in its invested capital for 1917 the amount assessed against its stockholders and paid in by them. (B. Digest 18-20-905 ; A. R. M. 44.) A corporation was organized in 1910 with a capital of lox dol- lars, substantially all of which was subscribed for by A, and he furnished all the capital. During 1915 A paid into the company ^x CAPITAL, SURPLUS, RESERVES, LIABILITIES 237 dollars, no action being taken by the corporation to indicate the nature of this payment, except that it was entered as a contribution to capital and was never treated as an account payable. No stock was issued and no interest was charged. In 1917 this money was re- paid to A, there being no evidence as to the nature of the payment nor how it was treated by the corporation. Held: That this payment of yx dollars to the corporation was in the nature of a voluntary assessment by the one who was practically the sole stockholder of the corporation; that the repayment of this sum to A must be deemed to be out of undivided profits or earned sur- plus so far as possible; that such repayment can not be treated as a return of capital unless the undivided profits and earned surplus accumulated since 1913 are first distributed as dividends; that the corporation be permitted to include in its invested capital for the taxable year 1917 the sum of yx dollars as surplus paid in by the stockholders, proper adjustment being made for any distributions of dividends in excess of available net earnings. (B. Digest 23-19-552; T. B. M. 82.) Premiums on capital stock. — Premiums received on capital stock sold should be credited to capital surplus and may be included in "paid-in surplus." Regulation. The proceeds from the original sale by a corpora- tion of its shares of capital stock, whether such proceeds are in excess of or less than the par value of the stock issued, constitute the capital of the company. If the stock is sold at a premium, the premium is not income. Likewise, if the stock is sold at a discount, the amount of the discount is not a loss deductible from gross in- come. If, for the purpose of enabling a corporation to secure work- ing capital or for any other purpose, the stockholders donate or return to the corporation to be resold by it certain shares of stock of the company previously issued to them, or if the corporation purchases any of its stock and holds it as treasury stock, the sale of such stock will be considered a capital transaction and the proceeds of such sale will be treated as capital and will not constitute income of the corporation. A corporation realizes no gain or loss from the purchase of its own stock (Art. 542.) Reserves Many so-called reserves are in effect segregated surplus accounts and properly appear among the items in that classifi- cation. It is immaterial whether the accounts are called re- 238 EXCESS PROFITS TAX PROCEDURE serves or surplus so far as the determination of invested capi- tal is concerned. The one important factor is their true nature. Reserves for bad debts. — Corporations which have car- ried reserves for bad debts have not been permitted to deduct such reserves in their income tax statements. The result is that, as the Treasury has refused to recog- nize the item as a proper deduction from an asset (accounts receivable), the amount of bad debts reserve has automatically- been thrown into surplus account, as far as the excess profits tax computation is concerned. As it has not been allowed as a necessary expense of the business, it forms part of earned surplus for the purpose of the excess profits tax return. The author does not agree with the position of the Treas- ury, but until the rulings are reversed, reserves for bad debts should be added to surplus at the beginning of the taxable year. The amount of the reserve at the beginning of the taxable year can be used for the entire year even though the reserve is diminished by bad debts charged off during the year. The Treasury has recognized the items as charges against cur- rent income and not as changes in capital. Reserves for inventory fluctuations, obsolescence, contin- gencies, etc. — The procedure in regard to all reserves which have not been allowed by the Treasury as deductions in income tax returns should be the same as that suggested for bad debts. Certain reserves, such as those for contingencies and other indefinite purposes, are in reality segregated surplus' and un- questionably must be included in invested capital. Other reserves are not so clearly part of surplus account but should be added to surplus if disallowed in income tax statements. ^Auditing, Theory and Practice (2nd edition), by.R, H. Montgomery, page 181 et seq. CAPITAL, SURPLUS, RESERVES, LIABILITIES 239 Reserves for depreciation and depletion. — It has been as- sumed by the author that reserves for depreciation and deple- tion should not be considered as such in a computation of invested capital until they have been carefully analyzed be- cause, when a reserve for depreciation and depletion is correct, it is in fact deductible from the asset accounts. When the reserves are correct but when amounts added thereto in previ- ous years were not allowed as depreciation or depletion by the Treasury, the procedure is the same as that indicated for bad debts on page 238. When excessive depreciation or depletion has been charged off and asset accounts are readjusted, the credit arising out of such restoration belongs in surplus ac- count and not in depreciation or depletion reserves. When the reserve for depreciation or depletion includes any realization of appreciation set up as of March i, 1913, the amount should be transferred to earned surplus. The fol- lowing regulation bears out the comments of the author. Regulation. If any reserves for depreciation or for depletion are included in the surplus account it should be analyzed so as to separate such reserves and leave only real surplus. Reserves for depreciation or depletion can not be included in the computation of invested capital, except to the following extent: (i) Excessive depletion or depreciation included therein and which if charged off could be restored under article 840^ may be included in the computation of invested capital; and (2) Where depreciation or depletion is computed on the value as of March i, 1913, or as of any subsequent date, the proportion of depreciation or depletion representing the realization of apprecia- tion of value at March i, 1913, or such subsequent date, may if undistributed and used or employed in the business be treated as . surplus and included in the computation of invested capital. For the purpose of computing invested capital depreciation or depletion computed on the value as of March I, 1913, or as of any subsequent date shall, if such value exceeded cost, be deemed a pro rata realization of cost and appreciation and be apportioned accordingly. Except as above provided, value appreciation (even though evidenced by an appraisal) which has not been actually realized and in respect of amounts accrued since March i, 1913, reported as income for the purpose of the income tax, can not bp *See pages 156-J5S, 240 EXCESS PROFITS TAX PROCEDURE included in the computation of invested capital, and if already re- flected in the surplus account it must be deducted therefrom. (Art. 844.) For a full discussion of the foregoing, see page 159. Appreciation in values of property as of March i, 1913, may not be included in invested capital unless realized. Reali- zation occurs by sale of the property or because of charges to earnings for depreciation and depletion based on the appre- ciated value of the property instead of cost. The part of the depreciation or depletion charge applicable to the excess of the appraised value over cost is deemed a pro rata realization of such write-up similar to a conversion thereof into cash, as indicated in article 844. The following balance sheets illustrate the adjustments to be made so that the realization of appreciation may be included in invested capital. Balance Sheet^ December 31, 191 1 Property (cost) $ 800,000.00 Capital Stock $1,000,000.00 Other Assets 200,000.00 $1,000,000.00 $1,000,000.00 Balance Sheet^ March i, 1913 Mining property (cost). $ 800,000.00 Reserve for depletion Revaluation of mining i 2/12 yrs., 8% on property, March i, cost $ 74,666.00 1913 400,000.00 Surplus arising from Other Assets 500,000.00 revaluation 400,000.00 Earned Surplus 225,334.00 Capital Stock 1,000,000.00 $1,700,000.00 $1,700,000.00 Balance Sheet, December 31, 1913 Mining property (cost) $ 800,000.00 Reserve for Depletion*. $ 154,665.00 Revaluation (Mar. I, Surplus from Revalua- 1913) 400,000.00 tion 373,334-00 Other Assets 700,000.00 Earned Surplus* 372,001.00 Capital Stock 1,000,000.00 $1,900,000.00 $1,900,000.00 CAPITAL, SURPLUS, RESERVES, LIABILITIES 241 Invested Capital December 31, 1913 = $1,000,000 + $372,001 = $1,372,001.00 *EXPLANATI0N OF CHANGES Reserve for Depletion, March i, 1913 $74,666.00 Add: 10/12 year, 8% of Cost ($800,000) $53,333 10/12 year, 8% of Amount added by revalua- tion ($400,000) 26,666 79,999.00 Reserve for Depletion December 31, 1913 $154,665.1 00 Earned Surplus March i, 1913 $225,334.00 Add: Profits for 10 months before giving effect to depletion $200,000 Less: Depletion 10/12 year, 8% of Cost ($800,000). $53,333 Depletion 10/12 year, 8% of Re- valuation ($400,000) 26,666 79,999 120,001.00 Add: Realization of appreciation through charges for depletion t26,666.oo Earned Surplus, December 31, 1913 $372,001.00 tThis amount is transferred from "Surplus from Revaluation" to "Earned Surplus" at the end of each accounting period, from which it will be noted that the realization of appreciation is reflected in invested capital through the earned surplus account. For the purpose of computing invested capital for calendar year 1920 this procedure will be followed for each year to December 31, 1919. The following ruling indicates the method of presenting data from which the Treasury may check the amount of de- pletion included in invested capital. Ruling. Form A, revised (mining) and form N (oil and gas) have been prepared for the use of taxpayers engaged in mining or in the production of oil and gas. A sufficient supply wrill be sent to collectors of internal revenue for distribution. These forms are prescribed to facilitate the compilation and presentation of certain information required for the audit and ex- amination of the returns of these classes of taxpayers. If, however, it is more convenient to use other methods of tabulation, the in- formation so furnished, if complete, will be accepted in lieu of those forms. The information called for by these forms should be filed with the returns in complete detail, either on the forms prescribed or in other suitable manner. This requirement is necessary for the reason that depletion sustained must be taken into consideration in the com- putation of invested capital, regardless of whether or not a deduc- tion for it is claimed or has been claimed for it in the past by the taxpayer. This requirement applies to individuals as well as corporate tax- payers. (T. D. 2849, signed by Commissioner Daniel C. Roper, and dated May 27, 1919.) 242 EXCESS PROFITS TAX PROCEDURE Reserves for sinking funds, retirement of preferred stock, etc. — Reserves of this nature are merely book segregations of surplus and are clearly to be included in invested capital. When sinking fund instalments are paid to trustees and are no longer under the control of the corporation and no re- serve account is created, invested capital is not affected. Should, however, income from the funds in the hands of the trustees be reported by the corporation as a part of its taxable net income, the reserve created thereby would prop- erly form a part of the corporation's invested capital. When funds are paid to trustees and a like amount is transferred from current surplus to reserve for sinking fund, the reserve account is to be included in invested capital. Reserve for taxes. — Accrued taxes as shown by the books of a taxpayer at December 31, 19 17, were part of surplus from the point of view of invested capital within the meaning of the excess profits tax law, because the amount of the taxes had not been an allowable deduction in income tax returns. Ruling. Reserves set aside out of surplus or undivided profits of preceding years for payment of federal or state taxes not yet due can be included in invested capital for the taxable year if, and to the extent that such taxes were not allowable deductions in computing net income for the preceding taxable year. Inasmuch as federal income and excess profits taxes are not deductible in computing the respective net incomes subject to such taxes, reserves set aside for the payment of such taxes may be included in invested capital (Letter to Corporation Trust Company from Commissioner Roper, March 20, 1918.) Relative to the tax on undistributed profits" certain rulings were made by the Treasury to the effect that if taxes paid in 19 18 could be said to be out of 19 18 earnings the reserves for taxes as of December 31, 1917, would not be affected. This position of course violated all rules of good accounting "See Income Tafc Procedjirf, 1921, page 963. CAPITAL, SURPLUS, RESERVES, LIABILITIES 243 and could not have been expected to stand for any length of time.'" Early in 19 19 the Treasury issued the following: Regulation. For the purpose of determining invested capital under Title II of the act of October 3, 1917, income and excess profits taxes shall be deemed to have been paid out of the net income for the taxable year for vifhich such taxes are levied. Amounts payable on account of income and excess profits taxes for any year may be included in computing surplus and undivided profits for the succeed- ing years only for the proportionate part of the year represented by the period of time between the close of the taxable year and the date or dates upon which such taxes become due and payable. (T. D. 2791, February 17, 1919.) Ruling Invested capital of a corporate taxpayer for the year 1917 should be reduced by the amount of its income tax for the year 1916 as of the date upon which such tax became due and payable. (B. Digest 20-19-506; T. B. R. 59.) Therefore the reserve for taxes set up at December 31, 1919, or at the end of the corporation's fiscal year, can be con- sidered as invested capital until the date on which the taxes are due and payable." When the payment is made the reserve account (which in many cases was an estimate when set up) should be adjusted so that the invested capital will be reduced by the proper amount. If by reason of defective bookkeeping a reserve was not set up at the end of the taxable year and the amount of taxes subsequently paid was charged to current expenses of the suc- ceeding year, invested capital will nevertheless be reduced as of the date of payment. Federal taxes represent the govern- ment's share of the profits of specific taxable years and the mere fact that the payment of the amounts due is postponed until a later date in no way affects the question. Taxpayers ""It will be necessary, however, for the government to deal con- sistently with this situation. Public accountants refuse to certify balance sheets unless all liabilities are shown, and 1917 federal taxes are a real liability. Concerns which do not set up the liability must not derive any benefit therefrom." {Income Tax Procedure, 1918, page "It is immaterial how the item was treated on undistributed profits tax return, form 1 112. 244 EXCESS PROFITS TAX PROCEDURE may go out of business or be subject to large net losses in the year following a profitable year, but these and similar con- tingencies do not affect the government's claim to its share of the preceding year's net income. When payment is made it is immaterial whether the payment is charged one way or an- other on the taxpayer's books, or whether the cash to pay comes from current earnings, past earnings or from borrowed money. None of these factors can shift the tax liability of the previous year in such a way that it will be helpful to one tax- payer and injurious to another. Unpaid taxes are now in- cluded in invested capital and all corporations will be treated alike. The only logical way in which to treat taxes of a prior year is to consider the cash (or Treasury certificates) required to meet the taxes a part of the capital of the taxpayer, so long as it is in his possession. After he pays it out it can no longer be considered as part of his capital. Nevertheless some ac- countants and Treasury agents advised corporations which charged 191 7 taxes against a reserve for taxes set up to meet such liability, or against surplus, that such entries should be corrected and that instead the payments should be charged as current expenses for 1918. Calling federal taxes current expenses does not make them so. Of course if a taxpayer pays the tax before it is due, invested capital should not be re- duced until the due date, as the government gets the benefit. This position is sustained in the regulations. Regulation. For the purpose of computing invested capital federal income and war profits and excess profits taxes are deemed to have been paid out of the net income of the taxable year for which they are levied. It is immaterial, therefore, whether reserves for the payment of such taxes for the preceding year have been set up or not, or if set up whether such taxes when paid have actually been charged against such reserves. Amounts payable on account of such taxes for the preceding year may be included in the computation of invested capital only until such taxes become due and payable. A deduction from the invested capital as of the beginning of the taxable year must therefore be made for such taxes or any install- ment thereof, averaged for the proportionate part of the taxable year CAPITAL, SURPLUS, RESERVES, LIABILITIES 245 after the date when the tax or the installment is due and payable. Where as a result of an audit by the Commissioner, or the accept- ance of an amended return, or for any other reason, the amount of any such tax for the preceding year is subsequently changed, a corre- sponding adjustment will be made in the invested capital for the tax- able year upon the same basis as if the corrected amount of the tax for the preceding year had been used in the original computation of the invested capital for the taxable year (Art. 845.) Ruling. Numerous protests against the validity of the principle first adopted in Treasury Decision 2791, approved February 17, 1919, and subsequently embodied in Article 845 of Regulations 45, have been made. A hearing upon the question was held before the Advisory Tax Board at the request of the X Company, at which time its gen- eral counsel appeared and argued against the power of the Com- missioner to make this regulation, which requires that surplus and undivided profits as of the end of the preceding year must be reduced as of the date or dates when Federal income and excess profits taxes become due and payable, by the amount of such taxes for that year. In the original and supplemental memoranda filed by the X Com- pany counsel has set forth at length the several arguments of greater or less weight in support of the position urged by that taxpayer. In the opinion of the board the Commissioner and Secretary in promulgating Treasury Decision 2791 and article 845 have placed the whole matter upon what is the only basis which accords with the requirements of the statute and meets the demands of proper account- ing, although it is true that the arguments advanced by counsel for the taxpayer in this case are well presented and at first blush seem convincing and persuasive. Article 845 of Regulations 45 provides [see above] : . . . . The provisions of Treasury Decision 2791 relating to the tax under Title II of the Revenue Act of 1917 are substantially the same [see page 243]. The relevant provisions of the statute are found in section 207 of the Revenue Act of 1917 — As used in this title "invested capital" does not include .... money or other property borrowed, and means, subject to the above limitations: .... (3) paid in or earned surplus and undivided profits used or employed in the business, exclusive of undivided profits earned during the taxable year. and in section 326 of the Revenue Act of 1918— ; Sec. 326. (a) That as used in this title the term "invested cap- ital" for any year means .... (3) paid-in or earned surplus and undivided profits; not including surplus and undivided profits earned 246 EXCESS PROFITS TAX PROCEDURE during the year; .... but (b) as used in this title the term "in- vested capital" does not include borrowed capital. The term "earned surplus and undivided profits" used in both acts is brief but full of import. In effect, it incorporates into the law by reference the entire body of principles of accounting rela- tive to the determination of surplus. There is in neither act any provision defining this term or modifying what must otherwise be accepted as the guiding principle to be applied in determining what is isurplus. The statute, therefore, requires that the surplus in any case shall be determined exactly in accordance with the accepted principles of accounting; and it is to those principles that both the taxpayer and the Government must turn for light upon the meaning of this provision of the law. The application of these principles to the question at issue brings a speedy response and permits of only one answer. A tax levied as these taxes are, for a definite period, must be considered as a liability which has fully accrued at the end of that period ; and if not already paid, provision for its payment must be made before there can be any true surplus or undivided profits. This is especially true in the case of an income tax — and excess and war profits taxes are income taxes — which must be considered as a sharing by the Government in the income of the taxpayer for the taxable year. The fact that the tax is in terms of the statute imposed "upon" the net income and that there is no specific provision that it is to be paid "out of" net income can not change its inherent nature. The amount of these taxes for any year can not, therefore, after the conclusion of such year be considered as a part of the surplus, but is rather in the nature of a liability, and if this regulation is open to criticism at all, such criticism might much more properly be directed against its further provision permitting the amount of such tax to be included as surplus until such time as the tax becomes due and payable. It is true that in every case the situation is not such that it will be vitally affected by a failure to apply sound "principles, and as a result the development of the rulings already referred to as unsound was very easy, but when the situation happens to be such that the effect of the application of a wrong principle would be critical the difference between the sound and the unsound principle is apparent at once. A single example will suffice to illustrate what is meant: Thus, if a business continues to be owned from year to year by sub- stantially the same interests it becomes relatively unimportant whether such taxes, are charged against the income upon which they are levied or against other funds; but if the control of that business changes hands and it thus becomes important to charge the taxes against the proper funds, there would never be any question but that they are properly chargeable against the income for which levied. CAPITAL, SURPLUS, RESERVES, LIABILITIES 247 The purchaser would never for a moment admit that they might equally as well be charged against his future earnings or that he should become liable to raise them by borrowing from the bank or otherwise, without allowance being made in the consideration which he pays for the business. In the opinion of the board the provisions quoted above from section 207 of the Revenue Act of 1917 and from section 326 of the Revenue Act of 1918 are controlling and sustain the interpretation which has been embodied in the form of a regulation in Treasury Decision 2791 and in article 845 of Regulations 45. It is accordingly recommended that no modification in these regulations be made. (B. S-19-265; T. B. R. 17.) Tax reserves of corporations with fiscal years. — Article 845 is amplified by article 845(a) which reads as follows: Regulation. In the case of corporations having a fiscal year, the federal income and profits taxes for the taxable year 1918 shall, for the purpose of computing invested capital for the taxable year 1919 be deemed to become due and payable as follows: (a) As to such amounts as became due and payable prior to February 25, 1919, under the provisions of section 14 (a). Revenue Act of 1916, such law shall govern; (6) in all other respects the provisions of section 250 of the Revenue Act of 1918 shall govern except that the install- ments which would become due prior to February 25, 1919, shall be deemed to become due and payable on that date; (c) Any amounts which becarne due and payable under said section 14 (a) prior to February 25 shall, so far as possible, be deemed to cancel the earlier installments payable under said section 250. For example, a corpora- tion whose fiscal year ended August 31, 1918, is assessed a total income and profits tax under the 191 7 law of $250,000 and an addi- tional tax under the 1918 law of $110,000. The total tax of $360,000 would for the purpose of computing invested capital be deemed to become due and payable as follows: February 15, 1919,^^ $250,000; '^Correction of above : Ruling. "Reference is made to your verbal inquiry in regard to T. D. 2931, dated October 7, 1919, amending article 845, Regulations 45. You called attention to the following extract from that Treasury Decision: 'For example, a corporation whose fiscal year ended August 31, 1918, is assessed a total income and profits tax under the 1917 law of $250,000 and an additional tax under the 1918 law of $110,000. The total tax of $360,000 would for the purpose of computing invested capital be deemed to become due and payable as follows: February IS. 1919. $250,000; May 15, 1919, $20,000; August 15, 1919, $90,000.' "In reply to your inquiry as to whether the date February 15, 1919, is correct you are advised that the date as designated is five and one-half calendar months after the close of the fiscal year of the corporation, whereas the date should have been February 12, 1919, 248 EXCESS PROFITS TAX PROCEDURE May 15, 1919, $20,000; August 15, 1919, 190,000. If, assuming the same taxes, the fiscal year ended September 30, 1918, the total tax would for the purpose of computing invested capital, be deemed to become due and payable as follows: February 25, 1919, $90,000; March 15, 1919, $90,000; June 15, 1919, $90,000; September 15, 1919, $90,000. The provisions of this article apply solely for the purpose of computing invested capital and do not affect the provisions of T. D. 2797 in regard to the time and manner of paying taxes where cor- porations have filed returns for fiscal years ending in 1918. (Art. 845 (a), issued as T. D. 2931, signed by Commissioner Daniel C. Roper, and dated October 7, 1919.) Under the Revenue Act of 19 16, in the case of a fiscal year corporation, return was due within 60 days after the close of the fiscal year and tax was due within 105 days after the last due date of the return (not after the date of filing), hence, for fiscal year ended August 31, 1918, the return was due on or before October 30, 1918, and the tax on or before February 12, 1919, or on or before the 165th day after Au- gust 31, 1918. Ruling. In the case of corporations which filed returns under the Revenue Act of 1916 for a fiscal year ending June 30, 1917, upon which the tax imposed by that Act and by the Excess Profits Tax Act of March 3, 1917, became due and payable on December 12, 1917, the additional tax imposed by the Revenue Act of 1917 shall be deemed to be due and payable on the same date. The invested capital of these corporations for the fiscal year ending June 30, 1918, shall be reduced by the amount of taxes imposed by the Acts referred to on December 12, 1917, prorated to June 30, 1918, the close of such fiscal year. (B. Digest 45-20-1299; A. R. M. 87.) Effect of additional assessments on tax reserves. — Ruling. The rulings contained in Treasury Decision 2791 and article 845 of Regulations 45 require income and excess profits taxes levied for the particular year to be considered as liabilities which have accrued at the end of such year and which must be taken into account in determining the surplus and undivided profits which may thereafter be included in invested capital, and state that such taxes may be in- cluded in the surplus until they become due and payable. These rulings are in general applicable to additional assessments. It is the essence of any system of accrued accounting that items one hundred sixty-five days after August 31, 1918, the close of the fiscal year." (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated October 27, 1919.) CAPITAL, SURPLUS, RESERVES, LIABILITIES 249 of income and outgo be estimated as they accrue and that the proper entries be made upon the books at that time. The books for any fiscal period are deemed to clearly reflect the history, of that period and are not changed even though subs'equent events demonstrate that certain accruals, to a minor degree, were incorrectly estimated. The necessary adjustments to correct such errors are made in the current accounts. It is only where major adjustments are necessary that it is good accounting practice to make adjustments for past errors in the surplus account. For these reasons the Advisory Tax Board recommends that ad- ditional assessments of income and excess profits taxes, for prior years which are relatively small or unimportant be considered paid from current earnings; but that where the additional assessment is relatively large and important such assessment be considered a liabil- ity of the taxable year in question and that the necessary adjust- ments of the surplus account be made. In such cases the phrase "due and payable" in article 845, Regulations 45, means the due date for taxes of the taxable year and not the date fixed for the pay- ment of the additional assessment. It is suggested that in all cases in which the additional assessment is less than 5 per cent of the original assessment or is less than $5,000 it be considered paid out of current earnings and that no adjustment of invested capital be made. (B. 12-19-411; T. B. M. 51.) As federal taxes are included in invested capital until paid and as additional taxes are not "due and payable" until assess- ment has been made, there are strong reasons for holding that the foregoing ruling is not sound. If there is any logical justi- fication at all for invested capital as a basis it is that the term comprises assets or capital which have income-producing power. When the income is taxable the source of the income should be included in invested capital. A taxpayer on Decem- ber 21, 1920, may have been assessed $100,000 for additional taxes for 1917. The $100,000 may have been paid December 31, 1920 — that is, within 10 days after assessment. Is it not obvious that the tax was not due and payable until December 31, 1920, that the entire $100,000 was an income-producing asset up to December 31, 1920, and that it would be improper and inequitable to reduce invested capital as of June 15, 19 18, because of subsequent assessment? If the taxpayer makes an incorrect or fraudulent return or 250 EXCESS PROFITS TAX PROCEDURE is guilty of negligence, the law prescribes and limits the penal- ties therefor. The Commissioner cannot extend the penalties nor invent new ones. Reducing invested capital of a past date by the amount of an additional assessment (which the Com- missioner has no power to apply as of a past date) is equiva- lent to a heavy penalty which if legal would be additional to the penalties prescribed in the law. Ruling. Where a corporation has filed a claim for determination of war-profits and excess-profits tax for 1918 under section 328 and has made payments on the basis of 50 per cent of the net income, the claim not having been acted upon when its 1919 return is due, the invested capital for 1919 should be adjusted on the basis of the tax payments actually made, subject, however, to readjustment when the correct amount of tax for 1918 is determined. (B. 11-20-788; O. D. 410.) Certain reserves of insurance companies. — Regulation. The reserve funds of insurance companies, the net additions to which are deductible from gross income under the pro- visions of section 234 of the statute, cannot be included in computing invested capital (Art. 870.) Reserve for discounts — Banks. — Regulation. Only the amount of discount which has actually been reported by a bank in a prior year as taxable income and credited to surplus account may be included in surplus as of the beginning of the taxable year (Art. 849.) Miscellaneous Deficit or loss accounts. — Surplus accounts are added to capital stock accounts to determine the correct amount of in- vested capital. The question therefore arises: "Should book accounts representing losses or accumulated deficits be de- ducted from capital stock accounts and thus decrease the amount of invested capital?" Good accounting practice re- quires that deficit accounts shall be shown on the liability side of a balance sheet and be so stated as to be in effect a deduc- tion from capital stock. CAPITAL, SURPLUS, RESERVES, LIABILITIES 251 Of course, it is not claimed that a deficit account reduces the par value of capital' stock, but whenever the net worth of a corporation is less than the par value of its outstanding capi- tal stock, it is obvious that the book value of the capital stock has been diminished. The deficit is the explanation. As we have seen, however, the excess profits tax law does not pretend to adopt book values and it is fairly clear that it was intended that book losses should be ignored. If the deficit account represents net operating losses or losses allowable for income tax purposes, there can be no ques- tion that the amount has been part of the paid-in capital. The law apparently continues to recognize it as capital. If all or part of the deficit is made good with subsequent earnings, invested capital will remain unchanged — that is, any part of the deficit will drop out of invested capital and the sur- plus (earned prior to the beginning of the taxable year) will take its place. When, however, consolidated returns are made, the deficit of one corporation would operate to reduce the sur- plus of a profitable corporation.^^ When a deficit is made good by assessments or contribu- tions from stockholders, invested capital is only increased by any excess of the new capital over the deficit. It would be im- proper to include the original capital with the new capital and ignore the deficit. It would seem to be more advanta- geous to issue additional capital stock than to pay in assess- ments to be credited against the deficit. Regulation. Capital or surplus actually paid in is not required to be reduced because of an impairment of capital in the nature of an operating deficit, except where there has been directly or indi- rectly a liquidation or return of their investment to the stockholders, in which case full effect must be given to any liquidation of the original capital. (Art. 860.) =See Chapter XIV. CHAPTER XI CHANGES IN INVESTED CAPITAL DURING THE TAXABLE YEAR The most important changes in invested capital during the taxable year arise from current profits and losses. Ac- cumulated surplus at the beginning of the taxable year forms part of the invested capital. Earnings realized during the taxable year do not increase, and losses during the taxable year do not decrease, invested capital for the current year, but in turn afifect invested capital at the beginning of the succeeding year. Law. Section 326. (a) .... "invested capital" .... means .... (3) .... surplus .... not including surplus and undivided profits earned during the year;^ It is claimed that it is not equitable to exclude current profits as a factor in determining invested capital because in some cases earnings are realized in cash early in a taxable year, are reinvested and produce further earnings during the year, the effect being that no invested capital at all is ascribed to the later earnings. The same argument, however, applies conversely to losses. On the whole, it would be impracticable ^[Former Procedure] The 1917 law provided that there should be included as invested capital, "paid-in or earned surplus and un- divided profits used or employed in the business, exclusive of undi- vided profits earned during the taxable year." [Section 207 (a-3).] The word "surplus" which appears in the 1918 law and as applied to the taxable year was omitted in the 1917 law, but there was no doubt as to the obvious meaning of the provision. Calling any part of 1917 earnings "surplus" instead of "undivided profits" would have been an unwarranted subterfuge and evasion. It would have been a violation of the law as well as of accepted accounting practice. "If a corporation's fiscal year ended prior to December 31, 1916, it was not permitted to add to invested capital at January i, 1917, any portion of the current earnings for the fiscal year which ended in 1917, although part was earned prior to January i, 1917." (Letter to Corporation Trust Co. from Deputy Commissioner Speer, Aoril 25, 1918.) 252 CHANGES IN INVESTED CAPITAL 253 to permit profits or losses during the taxable year to be con- sidered in computing invested capital. If a corporation actually realizes unusually large profits during the early part of a year it may be feasible for it to secure relief under sections 327 and 328." If the excess profits tax law were to be permanent it would probably lead most corporations to change their fiscal years to the month immediately following their most profitable period. For an interesting computation of the net effect on taxes of additional invested capital, see page 125. It is inaccurate to state that current earnings or losses have no effect on invested capital. Earnings or losses corre- spondingly change gross assets; therefore, the proportion of admissible and inadmissible assets at the beginning of the year must be preserved during the year or invested capital will be affected favorably or unfavorably as the case may be. The purchase of corporate stocks with current earnings actually decreases invested capital at the beginning of the year. In effect admissible assets at the beginning of the year are reduced because an investment in inadmissible assets is made from current earnings. It is difficult to lay down any rule which will work equi- tably in all cases. Like many other features of a law based on factors which cannot be determined, many arbitrary and inconsistent rules must be adopted. Taxpayers who are unfavorably affected by the rules can no doubt secure relief from the courts. Those who are fa- vorably affected will probably feel that an unexpected dif- ferential in their favor merely offsets an unfavorable decision against them in some other place. Increases in Capital during Year All new capital received during the taxable year should be included in invested capital commencing with the day of its ''See Chapter XV. 254 EXCESS PROFITS TAX PROCEDURE receipt. New capital usually is derived from one of the fol- lowing sources : Capital stock : Premiums on capital stock. Assessments on or contributions by stockholders. Such part of depletion and depreciation reserves as represents realization of appreciation at March i, 1913- When property acquired prior to March i, 1913, is sold the realization of the appreciation at March i, 1913, is new capital, because the appreciation, even if on the books, could not be included as invested capi- tal prior to realization. When the ratio of inadmissible assets to total assets at the beginning of the year is decreased by changes during the year the net effect is to increase invested capital. All the foregoing classes of new capital have been fully discussed under their appropriate headings in other chapters. Increase in capital through proceeds of stock or special cash dividends. — The law specifically provides that additional capital contributed during the taxable year shall be en- titled to the benefit of the exemption accorded to the capital invested at the beginning of the year. If the additional capital consists of cash, or its equivalent in property, full credit will be given as of the day of payment. An increase in capital stock through a stock dividend will not increase invested capital. Corporations are required to reduce invested capital by the amount of any dividend paid during the first sixty days of any taxable year, as such dividend is deemed to have been paid out of surplus accumulated prior to the beginning of the taxable year.' This is a very reasonable assumption. In- "See page 263. CHANGES IN iNVESTEt) CAPITAL 255 vested capital will be decreased as of the date of payment of the dividend. If a corporation with fiscal year ended De- cember 31, 1920, pays a dividend on March 2, 1921, or later, the amount paid will be deemed to be paid out of the earnings of the taxable year to the amount of such earnings accumulated to the date of payment of the dividend and will not affect the invested capital for the taxable year. It is not necessary that the books should show accumulated profits monthly or otherwise to justify the charging of divi- dends to current earnings, as the law assumes where the con- trary is not shown by the books, that the earnings accumulate ratably over the taxable year,* but if no profit is realized dur- ing the taxable year any cash dividends paid have, in fact, reduced the invested capital from and after the dates of the dividends, because the dividends have been paid out of surplus accumulated prior to the taxable year. Regulation. Profits earned during any year can not be included in the computation of invested capital for that year, even though during the year such profits are set up as surplus on the books or assumed to be distributed in the form of stock dividends. If a divi- dend is declared and paid during any year out of the profits of that year and the stockholders pay back into the corporation all or a substantial part of the amount of such dividends, the amount so paid back can not be included in the computation of invested capital unless the corporation shows by evidence satisfactory to the Com- missioner that the dividends were paid in good faith and without any understanding, express or implied, that they were to be paid back. (Art. 850.) Little difficulty should be experienced in complying with the regulation regarding payments of a capital nature to a corporation. It is not usual to pay dividends, which become subject to surtax in the hands of recipients, and soon there- after ask the return of an equivalent amount to the corpora- tion, unless the controlling reason is a need for additional capital not known at the date of the dividend declaration. The surtaxes imposed would ordinarily more than offset the ad- vantage of additional invested capital. ^Section 201 (e). See also Art. 857, page 266. 256 EXCESS PROFITS TAX PROCEDURE Surplus from sale of capital assets may be addition to in- vested capital during taxable year.— The entire profit realized on sales of capital assets at a price in excess of book value should be credited to surplus account, but only that part of the profit which has accrued since March i, 1913, is taxable at the rates in force during the year in which the sale is con- summated. This part of the profit, however, cannot be in- cluded in invested capital until the beginning of the following taxable year. The proceeds of the realization of the appreciation as of March i, 1913, are capital and increase invested capital from and after the date of realization. The following ruling, however, is not in accord with the author's contention: Ruling the committee is clearly of the opinion that appre- ciation prior to March i, 1913, realized in the taxable year, is an earn- ing of the taxable year and not an earning accumulated prior to March I, 1913- In the Baldwin Locomotive case (Baldwin Locomotive Works v. McCoach, 221 Fed. 59) it was held that appreciation in values is not earnings or profits until realized. This decision was rendered under the Act of 1909, and following it no appreciation in the value of corporate properties to March i, 1913, was reported or tax paid as income or earnings notwithstanding the Act of October 3, 1913, gave to such corporations the right to fix value as of March i, 1913, including appreciation, as the basis for any subsequent gain or loss. Following this decision and the decisions of the Supreme Court as to the taxation of appreciation to March i, 1913, it is clear that the realization of such appreciation is an earning of the year in which such appreciation is realized, although under the latter de- cisions it is not a taxable earning. Since the excess profits tax law definitely holds that earnings of the taxable year are not to be in- cluded in earned surplus or undivided profits, realization of appre- ciation in values to March i, 1913, is not a proper addition to invested capital as the realization takes place, as contended for by the com- panies. It is therefore held . . . that realization during the taxable year of appreciation in values to March i, 1913, can not be included in the invested capital of the taxable year. (B. 20-20-943; A. R. M. 51.) The author has read the decisions cited but is unable to find any justification for the interpretation placed upon them CHANGES IN INVESTED CAPITAL 257 by the Treasury. The decisions lay down the general prin- ciple ; "Appreciation in value is never taxable until realized" ; therefore the attempts of the Treasury to tax book profits have been defeated. When appreciation accrued before and after January i, 1909, and March i, 1913, the decisions say in effect: "'Appreciation accrued before 1913 is never taxable whether or not realized, because for the purposes of these acts it is capital^ but appreciation after March i, 1913, is taxable when realized because capital gains accruing after March i, 1913, are taxable." When capital is added it becomes part of invested capital at the date of receipt. The courts in the cases cited were not defining capital and income for the computation of invested capital. When they do they will find that the only reason why current earnings are temporarily excluded is the difficulty of determining how and when earnings accumulate during a taxable year. All legitimate additions to invested capital must be included at the earliest possible date. The restriction on current earnings, deemed for purposes of simple computation to accrue at the end of the year, cannot be extended to other items not in doubt, which if they are to be included in capital at all surely belong there as soon as the new capital is available to the business. A mine cost $100,000. On March i, 191 3, it was worth $1,000,000. On March i, 1920, it was sold for $1,000,000. The appreciation at March i, 19 13, is not taxable at all. Com- mencing March i, 1920, any earnings from the use of the $900,000 are subject to the excess profits tax. What possible reason is there for fixing January i, 1921, as the date when the $900,000 can be added to invested capital? Why not fix the date at January i, 1951? In Doyle v. Mitchell the court said: When the act took effect, plaintiff's timber lands, with whatever value they then possessed, were a part of its capital assets, and a sub- sequent change of form by conversign into money did not change "247 U. S. 179. 258 EXCESS PROFITS TAX PROCEDURE the essence. Their increased value since purchase, as that value stood on December 31, 1908, was not in any proper sense the result of the operation and management of the business or property of the corpora- tion while the act was in force. If the realization of "part of its capital assets" was not "the resuU of the operation and management of the business .... while the act was in force," how could the realization of a similar item be held to be "undivided profits earned during the year"?' Surplus arising from revaluations — Property taken for debt. — The following regulation merely confirms the general rule that appreciation cannot be included in invested capital. If the value of the property taken over is in excess of its cost and its value is written up, the current profit and loss account must be credited in order that the increased value may be reflected in invested capital commencing with the beginning of the succeeding year. Regulation. Real or personal property taken by a corporation in payment or satisfaction of a debt, or property received in exchange ■ for other property, will be an admissible asset at its fair market value upon receipt. The profit or loss, if any, resulting from the transac- tion will not be reflected in invested capital until the succeeding tax- able year (Art. 847.) Changes in invested capital during taxable year may be averaged. — Law. Section 326. (d) The invested capital for any period shall be the average invested capital for such period, but in the case of a corporation making a return for a fractional part of a year, it shall (except for the purpose of paragraph (2) of subdivision (a) of section 311') be the same fractional part of such average invested capital Regulation. The invested capital as of the beginning of any period of one year or less should be adjusted by an appropriate addi- tion or deduction for each change in invested capital during the period. The amount so added or deducted in each case is the amount 'Section 326 (a-3). 'Section 311 (a-2) covers the war profits credit. CHANGES IN INVESTED CAPITAL 259 of the change averaged for the time remaining in the period during which it is in effect. The fraction used in finding such average is the number of days remaining in the period (including the day on which the change occurs) over the number of days in the period. (Art. 853.) Computation of average invested capital. — Regulation. For the purpose of computing invested capital for any period of one year or less each corporation shall add together its paid-in capital and its paid-in or earned surplus and undivided profits (under whatever name it may be called) as shown by its books at the beginning of the period. The total so obtained shall be adjusted (a) for any property paid in, or for any asset reflected in surplus and undivided profits, which is not carried on the books at the valua- tion prescribed by the statute or by the regulations, and (b) for any changes in paid-in capital or in paid-in or earned surplus and un- divided profits (not including surplus and undivided profits earned during the period) occurring during the period, averaged for the time for which such changes are effective The total so obtained and adjusted is the average invested capital for the period, unless the corporation at any time during the period held any inadmissible assets, in which case such total must be reduced by a percentage thereof equal to the percentage which the amount of inadmissible assets held during the period is of the total amount of admissible and inadmissible assets held during the period The invested cap- ital for any year during the prewar period is determined in the same manner as for the taxable year. The invested capital can not be determined by adding the amounts of the assets of a corporation. (Art. 854.) Computation of invested capital for part of year. — In- vested capital for less than a full year will have to be computed in each of the following cases: 1. When the corporation is in existence less than twelve months prior to the end of its first fiscal year or is dissolved during a fiscal year. 2. When the taxable year is changed from a calendar year to a fiscal year basis and vice versa, or the date of ending of the fiscal year is changed. In either case full weight is given to the actual invest- ment for the fraction of a year covered by the return. 26o EXCESS PROFITS TAX PROCEDURE Regulation In the case of a corporation making a return for a fractional part of a year, its invested capital for such period is the same fractional part of the average invested capital for such period, except that for the purpose of section 311 (a) (2) of the statute it is the full average invested capital for the period. In com- puting the tax under a return for a fractional part of a period the same purpose may sometimes be more readily effected by using the full average invested capital and taking a fractional part of the result, as in schedule III of form 1120. In schedule IV of the same form, however, the fractional part of the full average invested capital for the period should be used. . . . (Art. 855.) In the new form 1 120, issued by the Treasury for the year 1920, schedules C and D will be used instead of schedules III and IV mentioned in the regulation quoted above. The regulations quoted above are explained in the fol- lowing illustrations, showing: (i) the effect of changes in invested capital during the year, where return is for a period of a full year; (2) the effect of changes in invested capital where return is made for a fraction of a year, and the change is averaged for such fractional period. Both of these illus- trations are official ones, taken from Regulations 45. u o U X K < K <; u > 9 2 S •gg i^ » rt fii ^S o H S P < CX) H U P P W Q ^1 1) a G u IS d a> o o -— s 8 o 6 8 00 8 o" ti-g fe o" 6e- M-l o j:: - d 4«- ^3, r: n! ■ — ^Cfi •a °^ •o J3 ^ fe .13 '3 M j:! fO (U PL, ^ GO P cfi o o U*^ 0\ l-H t^ » <^13 On r^ d c'p 5. 2-. rC ti c fi m CO ions ribu utio .2 Ui u +-1 +-» ^ ■4-.T3 rt H ^ o P4 fe n , ►—4 H w w U S ^ 8 o o o o Uk Q D O o u D O o" o" fc 7. «6- M iz; CA rt w 13 H H o w NO p< hJ M <; £ > H f^ to CO o : " ^ s w f5 u <; sis tn tt en >< ■ N ;x • o c &3 o Q d o ; o ■ o" • o 2 d; 1 ;z; M t-t (0 eg HH •> HI - T3 ^ >l O s ^1 < 1= 1—1 d w s o Q u N M • o" fe •< u o o <» M fl ;z; o o IE is is H- 1 o rt rt H H P^ PLh g O 0^ CA) « O ON P o U *^ (—1 1 o o d o o o .>;2 ?5- as a V 1 a „- . ■* m P • iH P^m's a" : 2^2 »i § ■ Q &■« o ° •^ " JD 4J +J OJ o,^ jj M g a b j3 3i I" -a -a +^ -H cj w " .-«.<».„ o-d P- m & O o 4J >» ti H a " CI >,S S b o _ •-I H S— « 9 3 fl -a ,Q o_ ■i2 " o .tl fl o rt *J +^ S, a "^ "d 8 S »ii;v*. cSC; Ph CO O'^^ 1 "« 262 CHANGES IN INVESTED CAPITAL 263 Decreases in Capital during Year The withdrawal of capital or accumulated surplus during the taxable year decreases invested capital as of the date of withdrawal, unless otherwise provided. The most common ways of decreasing capital during a taxable year are the pay- ment of dividends during the first sixty days (and thereafter if current earnings are not equal to the dividends paid) and the payment of federal taxes. Decrease in capital through dividends.* — The regulations provide that a dividend paid after the expiration of the first sixty days of the taxable year reduces invested capital as of the first of the year to the extent to which the earnings for the year are insufficient to pay the dividend. If pay- ments had been made to stockholders in anticipation of the dividend the payments reduce invested capital in the same manner as a dividend would operate to reduce invested capital. Law. Section 201. (e) Any distribution made during the first sixty days of any taxable year shall be deemed to have been made from earnings or profits accumulated during preceding taxable years ; but any distribution made during the remainder of the taxable year shall be deemed to have been made from earnings or profits accumu- lated between the close of the preceding taxable year and the date of distribution, to the extent of such earnings or profits, and if the books of the corporation do not show the amount of such earnings or profits, the earnings or profits for the accounting period within which the distribution was made shall be deemed to have been accumulated ratably during such period. '[Former Procedure] Effect on invested capital pur 1917 — when DIVIDENDS WERE HELD TO BE TAXABLE AT RATES OF PRIOR YEARS. — When a corporation paid a dividend during 1917 and advised its stockholders that all or part thereof was applicable to the earnings of a prior year, obviously the dividend could not be charged against current earnings. Therefore, the payment of the dividend reduced the surplus account of the corpora- tion, instead of the current profit and loss account. As the surplus account formed part of the basis for the determination of invested capital the charge of the dividend to surplus account reduced invested capital from and after the date of payment. If subsequently the corporation's action was disallowed and additional taxes were imposed upon the stockholders the corporation was entitled to adjust its invested capital, file an amended return and receive a refund of the tax overpaid. 264 EXCESS PROFITS TAX PROCEDURE Ruling. In applying subdivision (e) of section 201, Revenue Act of 1918, to any case, the "first sixty days of any taxable year" in- cludes March i, except during leap years. (B. 1-19-8; O. D. 4.) For the calendar year 1920 (a leap year) February 29 should be substituted for March i. Effect of ordinary dividend. — Regulation. A dividend other than a stock dividend affects the computation of invested capital from the date when the dividend is payable and not from the date when it is declared, except that where no date is set for its payment the date when declared will be con- sidered also the date when payable for the purpose of this article. For the purpose of computing invested capital a dividend paid after the expiration of the first sixty days of the taxable year will be deemed to be paid out of the net income of the taxable year to the extent of the net income available for such purpose on the date when it is payable The surplus and undivided profits as of the beginning of the taxable year will be reduced as of the date when the dividend is payable by the entire amount of any dividend paid during the first sixty days of the taxable year and by the amount of any other dividend in excess of the current net income available for its payment. In the case of a dividend paid during the first sixty days of a taxable year which exceeds in amount the surplus and undi- vided profits as of the beginning of the taxable year the excess will be deemed to be paid out of earnings of the taxable year available at the date when the dividend is payable, and to the extent that such earnings are insufficient it will be deemed to be a liquidation of paid- in capital or surplus. From the date when any dividend is payable the amount which the several stockholders are entitled to receive will be treated as if actually paid to them, whether or not it is so paid in fact, and the surplus and undivided profits, either of the taxable year or of the preceding years, will in accordance with the foregoing provisions be deemed to be reduced as of that date by the full amount of the dividend. Amounts paid to stockholders in anticipation of dividends, or amounts withdrawn by stockholders in excess of divi- dends declared, will in computing invested capital have the same effect as if actually paid as dividends. (Art. 858.) Effect of stock dividend. — Regulation. The payment of a stock dividend has no effect upon the amount of invested capital. Such items as appraised value of good will, appreciation in value of real estate or other tangible property, etc., although carried to surplus and distributed as stock CHANGES IN INVESTED CAPITAL 265 dividends, can not in this manner be capitalized and included in computing invested capital. If a corporation has paid a stock divi- dend in excess of its true surplus, it can not be deemed to have any greater invested capital than could have been computed had no such stock dividend been paid. (Art. 859.) Rulings (2) .... the increase in value of plaintiff's ore lands, which was first declared to be surplus, and afterwards treated as the basis of a stock dividend, did not thereby become earned surplus or undivided profits or invested capital within the meaning of the Act of 1917. The stock dividend added nothing to, and took nothing from, the corporation's invested capital.^ . . . (B. 34-20- 1158; T. D. 3051.) .... Held, in view of section 201. of the Revenue Act of 1918, which provides that a distribution whether paid in cash or in other property is not a dividend for income tax purposes unless representing earnings accumulated since February 28, 1913, and the decision of the Supreme Court in Eisner v. Macomber, that a stock dividend issued as a result of the transfer of earnings accumulated subsequent to February 28, 1913, to capital account or other bookkeeping proce- dure equivalent thereto, is not a distribution which is taxable under the Revenue Act of 1918, or previous income tax statutes, that the portion of the dividend which is paid in cash will be deemed to have been paid out of the surplus accumulated since February 28, 1913, to the extent of the earnings and profits accumulated since that date and subject to tax, while that portion of the dividend which is paid in stock will not be taxable as income. (B. Digest 29-20-1065; O. D. 587.) It is a reasonable assumption that cash dividends should apply against most recent earnings. When dividends during first 60 days should not reduce invested capital. — When a corporation has a substan- tial surplus at the beginning of a taxable year the rule that dividends paid during the first sixty days shall be deemed to be paid from such surplus is fair. But in the case of a new corporation, which declares a dividend during the first sixty days of its existence from earnings definitely known to have accumulated during such period, the same rule becomes in- equitable. °La Belle Iron JVorks, a corporation, v. U. S., Ct. of CI., U. S., No. 34603, decided June 28, 1920. 266 EXCESS PROFITS TAX PROCEDURE New corporations or corporations with no surplus at the beginning of the taxable year desiring to pay dividends should wait for sixty-one days before actually paying their first divi- dend. Method of determining income available for dividends. — The regulations provide that net income of a taxable year will be deemed to be allocated (i) to federal taxes, (2) to divi- dends paid after the expiration of the first sixty days. If dividends are in excess of the net income after allowing for federal taxes and if the payment of such dividends decreases the invested capital at the beginning of the year, the net earn- ings for the year will be afifected, because the amount of in- vested capital will be reduced, federal taxes increased and the amount available for dividends decreased. This calculation would require the use of an algebraic formula,^" but the regu- lation eliminates the necessity for using such a complicated method. Regulation. Whether at the time of any payment made during the taxable year there is sufficient income of the taxable year avail- able for such payment, or whether the surplus or undivided profits as of the beginning of the taxable year must be reduced by the amount of such payment, shall be determined according to the fol- lowing principles : (i) The aggregate amount of earnings of the taxable year available for all purposes up to any given date will be determined upon the basis of the same proportion of the net income for the taxable year (as finally determined for the purpose of income and war profits and excess profits taxes) as the part of the year already elapsed is of the entire year (determined in the manner provided in article 853), unless the corporation shows from its books or other records that a greater proportion of its earnings for the year was available on such date. (2) The aggregate amount available will be deemed to be applied for the following purposes in the order in which they are stated: (a) accrued federal income and war profits and excess profits taxes for the taxable year .... and (b) dividends paid after the expi- ration of the first sixty days of the taxable year . . . and other '"See Income Tax Prncedure, 1921, page 313. CHANGES IN INVESTED CAPITAL 267 corporate purposes, including the purchase of outstanding stock of the corporation previously issued In any case where the above computation would be indeterminate because of the effect of the provisions of this article upon the invested capital for the year, the amount of such invested capital for the purpose of this com- putation may be deemed to be the invested capital as of the beginning of .the taxable year, plus any additional capital paid in during such year and minus any specific withdrawal or liquidation of capital during such year. (Art. 857.) It will be noted that the usual assumption that earnings accumulate ratably over a whole year is waived in the fore- going regulation. If a dividend is paid, say, in May and is in excess of the earnings to that date, calculated on a pro rata basis for the entire year, invested capital will be decreased, unless it is shown that during the period elapsed since the beginning of the year the net current earnings (after pro- viding for taxes) were in fact sufficient to pay the dividends. Section 201 (e) specifically permits this method, the only condition being that the books of corporations must show that the earnings did not accrue ratably during the year, but actually accrued in certain months. Many corporations now keep their accounts on a basis which permits the determination of profits monthly. Such corporations will be in a position to take advantage of the law. The determination of the amount available for dividends is and should be affected by accrued taxes, but the accrual should not aflfect invested capital." Dividends paid from surplus created by deduction of capital stock. Ruling The taxpayer, the M Company, is a holding com- pany owning the stock of about y companies. On December 31, 1917, the taxpayer had a surplus. Such surplus was produced in past years largely by the cancellation of common stock in this manner — x shares of common exchanged for one preferred. An analysis of the Surplus account, it is stated, will show that most of the surplus is ^See page 242. 268 EXCESS PROFITS TAX PROCEDURE the result of the exchanges of stock, and if such items were eliminated there would be a deficit (i) What is the nature and the result of the transaction by which X shares of common stock were exchanged for one of preferred stock? Such a transaction whereby the capital stock is reduced is a capital transaction and does not give rise to net income or earned surplus. Whether such a surrender of stock gives rise to a paid-in surplus or not is a question depending upon facts which are not dis- closed by the taxpayer, and no decision is made upon this question. (2) What is the effect of payments to stockholders from capital or paid-in surplus? A distribution of any part of the capital or paid-in surplus is to be regarded as a return to the stockholder of part of the capital represented by his shares of stock That a surplus such as here considered is capital and not subject to distribu- tion as dividends has been expressly held many times. (See Roberts v. Roberts-Wick Co., 184 N. Y. 257, yy N. E. 13, and cases therein cited.) .... An amount taken from capital or paid-in surplus to meet dividend requirements is deemed a liquidation of capital to that extent and necessitates a reduction in the invested capital .... Allocation of dividends with reference to effect UPON invested capital when there is an operating deficit. (3) What is the nature and effect of the dividend payment in this case? The dividend paid in February, 1918 (assuming that the taxable year of this corporation is the calendar year), is deemed to have been paid, first, from earnings and profits accumulated since February 28, 1913, and on hand at the beginning of the year; second, if that fund is insufficient, from earnings of the taxable year avail- able on the date that the dividend is paid; third, if those funds are insufficient, from earnings and profits accumulated prior to March i, 1913 ; fourth, if those funds are insufficient, from capital or paid-in surplus. In this case there is no earned surplus on hand at the beginning of the year, so that th'e only question is whether the earnings of the taxable year (class 2) are available for the payment of dividends when there is an operating deficit, or whether such dividends must be deemed to be a distribution of capital. This is not a question which should turn upon the legality of such a dividend in the par- ticular jurisdiction, but is a question depending largely on accounting principles and business practice. From that standpoint there is no doubt but that current profits should be applied to make good the existing deficit before aiiy dividends are distributed. (Dickinson, Ac- counting, p. 73.) It is the weight of authority in the United States, CHANGES IN INVESTED CAPITAL 269 moreover, that the declaration of a dividend out of current profits, while there is an operating deficit, is contrary to law. (Conyngton, Corporate Organization and Management, p. 399.) It is, therefore, held that the dividend in this case was the distribution of capital. It reduces the invested capital and should be treated as a return of capital to the stockholder. This decision is based on the fact, as stated by the taxpayer, that the M Company is a holding company, owning the stocks of y different corporations. Whether this principle is applicable to a corporation operating a property where the investment of the capital in wasting assets is contemplated, is not decided. Operating deficit reduces amount of earnings OTHERWISE available FOR PAYMENT OF DIVIDENDS. (4) Does the fact that an operating deficit would exist if the items in the surplus account resulting from such cancellation of stock were eliminated affect the result in this case? The Regulations do not require a reduction in invested capital because of an operating deficit. They do require, however, a reduction in invested capital where there has been a distribution in liquidation, or a return of capital to the stockholders. The existence of an operating deficit, therefore, does not directly affect the invested capital and is signifi- cant in this case only as it throws light upon the sources from which the dividend here in question was paid. Current earnings must be applied first to operating DEFICIT.- — (5) May invested capital be increased by the accumulation of an earned surplus when an operating deficit existed, or must the earnings of the taxable year be applied to repair the deficit? The law defines invested capital as cash or property paid in for stock, earned surplus, and undivided profits and paid-in surplus. The act does not require a reduction of invested capital on account of an operating deficit. It is obvious, however, that no earned surplus can be accumulated until the deficit or impairment of paid-in capital has been made good Dividends paid while there is an operating deficit shall be deemed to be from capital or paid-in surplus, even though there are earnings of the taxable year sufficient to pay the dividend in whole or in part. (B. 26-19-598; O. 942.) The principles enunciated in the foregoing ruHngs may be illustrated as follows: 270 EXCESS PROFITS TAX PROCEDURE Corporation M, at Deiicmber 30, 1919 Capital : Common stock $1,000,000.00 Deficit 50,000.00 Net worth .$ 950,000.00 The stockholders on December 31, 19 19, exchange $600,- 000 par of common stock for $200,000 preferred stock. Con- currently, surplus is credited with the difference, $400,000, and on February 29, 1920, a dividend of $200,000 is paid. After giving effect to the above transaction at December 31, 1919, the capital accounts would appear: Common stock $400,000.00 Preferred stock 200,000.00 $600,000.00 Surplus $400,000.00 Less: Operating deficit 50,000.00 350,000.00 Net worth $950,000.00 Net earnings to February 29, 1920 $80,000.00 Under the Treasury's method, the dividend paid February 29, 1920, would be allocated as follows : Earnings to February 29, 1920 $ 80,000.00 Less: Operating deficit 50,000.00 Available $ 30,000.00* Dividend paid 200,000.00 Excessive dividend by which invested capital ($1,000,000) as of January i, 1920, must be reduced $170,000.00 *Effect has not been given here to accrued federal taxes for 1920. For details of this adjustment see page 266. Assume in the foregoing illustration that the corporation, instead of having an operating deficit of $50,000 as at Janu- ary I, 1920, had the following: Surplus : Accumulated prior to March i, 1913 $ 40,000.00(3) Accumulated since February 28, 1913 50,000.00(1) Total surplus, January i, 1920 $ 90,000,00 CHANGES IN INVESTED CAPITAL 271 Also that the surplus created as outlined above was $400,000.00(4) Earnings for 1920 to February 29, 1920 $ 80,000.00(2) The dividend of $200,000 paid February 29, 1920, in such case would be allocated as follows : (a) Surplus at January i, 1920 (accumulated since February 28, 1913) $50,000.00(1) (b) Earnings for 1920, to date of dividend 80,000.00(2) (c) Surplus at January i, 1920 (accumulated prior to March I, 1913) 40,000.00(3) (d) Capital surplus (created by reduction of capital stock) 30,000.00(4) Total dividend paid February 29, 1920 $200,000.00 (a) plus (b), or $130,000, would be taxable to recipient stockholders, (c) plus (d), or $ 70,000, would not be taxable to recipient stockholders. Invested capital at January i, 1920, can be reduced only by $120,000, even though it was paid during the first 60 days of the taxable year, because in fact $80,000 of the dividend was earned during the taxable year. This is in accordance with the foregoing ruling. Accruals of taxes should not be deducted from in- vested CAPITAL. — Article 857 requires that accrued federal taxes must be deducted from current earnings before the amount available for dividends can be determined. A corporation earns During the first 6 months $10,000.00 Federal taxes estimated 3,000.00 Available for dividend $7,000.00 Dividend paid July i 8,000.00 Dividend excessive $1,000.00 The theory is that as taxes estimated at $3,000 will eventu- ally have to be paid, earnings available for dividends are re- duced to $7,000, and a dividend of $8,000 means that sur- plus at January i is reduced by $1,000 averaged for the re- maining days in the year. If invested capital were actually reduced by the $3,000 reserved for taxes, the deduction of the 272 EXCESS PROFITS TAX PROCEDURE $i,ooo excess dividend would be in order, but the estimated tax reserve remains in the business as invested capital until some time during the following year. The Treasury has definitely taken the stand that accrued federal taxes need not reduce invested capital until such taxes are due and payable. ^^ It must be assumed that article 857 is erroneous and that dividends do not reduce invested capital unless the net income exclusive of federal taxes for the current year prior to the date when the dividends are paid is insufificient. Ruling. . . . tlie corporation did not close its books eacli month, but it made a fairly accurate memorandum estimate of tlie earnings of each month for the use of the officers of the corporation. This estimate was not carried into the balance sheet of the corpora- tion, but is asserted to be simply a memorandum for use as above stated. The examining officer, however, accepted this memorandum as a sufficient record of the earnings of the corporation for the three months in question, which estimate was less than the average for those three months would show. But the corporation does not close its books at the end of each month, and tlie memorandum in question was an informal approximation, insufificient to overthrow the general presumption in favor of the average or prorating method, which in this and many other similar situations under the law has frequently been applied against the desire of the taxpayer. It is recommended, therefore, that the tax liability be computed on tlie basis of average monthly earnings instead of the figures shown by the memorandum. (B. 18-19-491; T. B. R. 54.) Decrease in invested capital by payment of federal taxes. — It has been stated in the foregoing pages that accrued federal taxes should not be deducted from invested capital. When such taxes are paid, however, it is proper that invested capital should be reduced. For full discussion see page 242. Definition of net income available for dividends. — Article 857 (i) refers to net income for the taxable year as "finally determined for the purpose of income .... taxes." It is obvious that the amount available for dividends is the amount actually available. Some income may be non-taxable "'See Art. 845, page 244. CHANGES IN INVESTED CAPITAL 273 but it is none the less available for dividends ; and certain - deductions may be non-allowable but they must reduce the amount available for dividends. Likewise "write-downs" of stocks and bonds, although not deductible in tax returns, reduce book net income and thus the amount available for dividends. Method of determining accrued tax and income available for dividends paid during the year. — Ruling. In the last sentence of article 857, Regulations 45, it is recognized that in some cases the computation of the amount of net income available for distribution as dividends will be indeter- minate. This will be true in any case in which the amount distributed as a dividend exceed the earnings of the taxable year to the date of the dividend payment plus the accrued Federal income and profits taxes on such earnings. The computation under such conditions is shown in the following illustration : Capital stock, January i, ipig $400,000.00 Surplus, January I, 1919 100,000.00 Invested capital, January i, 1919 500,000.00 Total earnings for 1919 120,000.00 Dividend paid April i, 1919 40,000.00 Proportionate part of earnings to April I, 1919 30,000.00 Income and profits taxes accrued to April i, 1919, as computed below 7,315.00 8 per cent of invested capital 40,000.00 Specific exemption 3,000.00 Excess profits credit 43,000.00 Proportionate part of credit to April i, 1919 I0,7S0.00 20 per cent of invested capital 100,000.00 Proportionate part of $100,000 to April i, 1919 25,000.00 Tax under bracket i, 20 per cent of $25,000 — $10,750 ($14,250) . 2,850.00 Tax under bracket 2, 40 per cent of $5,000 2,000.00 Accrued excess profits tax 4,850.00 Net income to April I, 1919 30,000.00 Excess profits ta.x $4,850 Proportionate part of specific exemption 500 5,350.00 Subject to income tax at 10 per cent 24,650.00 Accrued income tax 2,465.00 Accrued profits tax 4,850.00 Total accrued income and profits tax 7i3l5.00 Income to April i, 1919 30,000.00 Reduced by taxes to April i, 1919 7,315.00 274 EXCESS PROFITS TAX PROCEDURE Amount net income available for dividends 22,685.00 Amount of dividend 40,000.00 Amount of income available 22,685.00 Amount chargeable against surplus i7,3iS.oo The adjustment on account of this amount ($17,315.00) averaged from April i, 1919, to the end of the year must be made in Schedule H of Form 1120. (B. 31-20-1110; O. D. 619.) As heretofore stated, in the determination of the amount available for dividends accrued federal taxes are a factor, but in the computation of invested capital the accrued taxes should not be deducted from invested capital. In other words, the accrued taxes may be deducted for one purpose but, using the foregoing case as an example, it is illogical to deduct $17,315 of accrued taxes from invested capital in 1919 when no part of the item of $17,315 was paid until March 15, 1920. The following is quoted from a letter from the Treasury to a taxpayer, imposing an additional assessment. Net income $ 80,577.30 Capital and surplus January i, 1918 $237,782.51 Less: Changes, Schedule H 31,818.34 Invested capital 205,964.17 Date Paid Amounts Days Affected Schedule H : Character Averaged Amounts Dividend Tax Dividend* Feb. 15, 1918 June IS, 1918 Mar. IS, 1918 $20,000.00 6,650.87 20,000.00 320 200 292 $17,534-26 3.64411 10,639.97 $31,818.34 •Computation of dividend adjustment. War profits credit $237,782.51 X 10% = $23,778-35 f $3^000 — $26,778.55 War profits tax $80,577.30 less $26,778.25 ~ $53-799-05 X 80% = $43,039-24 Net Income $80,577.30 Less: War profits tax $43,039.24 Liberty bond interest 222.00 Exemption 2,000.00 45,261.24 $35.316.06 X 12% = 4,237.93 Total income and war profits tax before adjustment $47,277.17 Adjusted net income to March 15 1= $80,577.30 at 73 days $16,155.46 Income and war profits tax computed without adjustments per schedule H. $47,277.17 at 73 days .' 9.455-43 Current income available for distribution $ 6,700.03 Dividend $20,000 less available earnings $6,700.03 = $13,299.97 at 292 days. . $10,639.97 CHANGES IN INVESTED CAPITAL 275 It is apparent that in this computation the revenue in- spectors used the invested capital at the beginning of the year, writhout adjustment for changes during the year. The divi- dend of $20,000 paid February 15 (during the first 60 days of the year) was not deducted from invested capital for the purpose of determining the accrued tax for the current year. Using the invested capital at the beginning of the year, with- out the adjustments of schedule H, for the particular pur- pose of ascertaining the accrued tax makes for simplicity and is in favor of the taxpayer. When the accrued tax is ascertained, however, on this basis, and the proper adjustment, if any, for excess of divi- dends paid over earnings available is made in schedule H, the total of sechedule H (in the above case, $31,818.34) is de- ducted from invested capital at the beginning of the year. CHAPTER XII PRE-WAR INVESTED CAPITAL For the calendar year 1920, except in the case of govern- ment contracts, the question of pre-war invested capital is academic, because under the excess profits tax as it applied for that year it is immaterial whether a corporation had any pre-war experience or not. But as most returns for 19 18 and 191 9 have not yet been examined, the determination of pre-war invested capital is still a live issue. Law. Section 310. That as used in this title the term "prewar period" means the calendar years 191 1, 1912, and 1913, or, if a cor- poration was not in existence during the whole of such period, then as many of such years during the whole of which the corporation was in existence. Under the 1918 law the importance of accurately deter- mining invested capital for the pre-war period is far greater than was the case under the 1917 law. Regulation. The prewar period in the case of each corporatioc covers so many of the calendar years 19H, 1912 and 1913 during^ the whole of which it, or a predecessor trade or business, was in ex' istence If a new enterprise was launched in corporate forni in June, 1912, its prewar period would accordingly be the calendai year 19 13. The prewar period when mentioned without reference to any particular corporation means the calendar years 191 1, 1912 and 1913. (Art. 771.) The suggestions relating to the determination of invested capital as of the beginning of the taxable year' apply to a great extent to the pre-war period. The importance of an accurate balance sheet as of March I, 1913, in income tax procedure is sufificient reason for careful analysis of all items of assets and liabilities as they appeared on the books during the years 191 1, 1912 and 1913. Adjust- 'See page 143. 276 PRE-WAR INVESTED CAPITAL 277 ments as of March i, 1913, can hardly be made without giving due attention to the years immediately preceding. The determination of invested capital means an inquiry into assets, liabilities and net worth. Many corporations made up their excise and income tax returns without regard to the effect on assets or liabilities. The result is that many corporations for the first time find that the connection between the two is a vital one and that items which seemed to be unim- portant when dealing with low income tax rates become of great importance when applied to an excess profits tax. It may be the case, therefore, that amended income tax returns back to 1913 and amended excise tax returns from 1909 to 1912 inclusive xwill be necessary to clear up apparent incon- gruities. It is true that March i, 191 3, revaluations which involve appreciation will not increase invested capital, but if revalua- tions as of March i, 19 13, serve to restore to the books items of cost which were written ofif before that date, the adjusted asset accounts will be included as items of invested capital. Pre-war computation when corporation has fiscal year which differs from calendar year. — Ruling. ... It is recommended that the computation be made as follows : The starting point for each year is the beginning of the fiscal year ending in 191 1, 1912, and 1913, respectively, and the invested capital should be ascertained as at those dates. To these sums should be added any contributions of capital between the beginning of each such fiscal year and January i, 191 1, 1912, and 1913, respectively, and corresponding deductions should be made in respect of any dividends and any refunds of capital during those respective periods. To these balances should be added a pro rata share of the earnings of the respective fiscal years, and the totals thus arrived at will be deemed to be the invested capital of the taxpayer at January i, 191 1, 1912, and 1913, respectively. Taxpayers should file with their re- turns copies of their balance sheets at the beginning of each fiscal year and a schedule for each year showing the adjustments made in computing the invested capital as at the beginning of each calendar year during the prewar period. 278 EXCESS PROFITS TAX PROCEDURE Where a taxpayer has such accounting records as will enable him to prepare an accurate balance sheet showing the true surplus and undivided profits at the beginning of each one of the prewar calendar years and an accurate income account for such years, he may make the computation upon this basis and explain the method used in such detail as will enable the Commissioner of Internal -Revenue to deter- mine whether such basis is proper. Where a taxpayer has not been in business during the whole of the prewar period the above methods will be applicable to such full calendar years during the' whole of which years the taxpayer was in business. (B. Digest 5-19-264; T. B. R. 16.) Adjustment of extraordinary items in pre-war period. — Balance sheets as of the beginning of the calendar years 191 1, 1912 and 1913 (or the fiscal years ending within those years) should be prepared from the books." The various items of assets, liabilities, capital and surplus should be com- pared with the comments on the same class of items discussed elsewhere in this book and any necessary adjustments should be made. It is quite possible that extraordinary items of profits or losses, which under the excise (not income tax) law of 1909 were not taxable or were not allowable deductions, would be otherwise treated under the provisions of the 1918 law. All such items should be considered. If the prorating method referred to in the ruling quoted in foot-note 2 does not work out equitably because of large contributions of capital or large losses, an effort should be made to construct balance sheets for the calendar years. Importance of credit for pre-war earnings. — After the bal- ance sheets are adjusted the average of the three years should be calculated. Upon this average will be based one of the most important credits in the determination of the war profits 'Ruling. "In those cases where the taxpayer has established a fiscal year in effect during the pre-war period, it will be permissible in ascertain- ing the amount of the capital invested and the percentage of profit, to prorate the amounts pertaining to the respective fiscal years in arriving at the amounts applicable to the calendar years." (Letter to WoUman and Wollman from Deputy Commissioner Speer, February 36, 1918.) PRE-WAR INVESTED CAPITAL 279 tax for the taxable year, viz., the 10 per cent credit which will be allowed for the additional invested capital contributed or allowed to remain in the business between the average pre- war date and the beginning of the taxable year. If the in- vested capital at the beginning of the taxable year is less than the average pre-war capital, the war profits credit for the tax- able year will be reduced by 10 per cent thereof. If abnormal conditions affected the net income of the pre- war period, relief may be obtained under sections 327 and 328. For full discussion, see 0-iooo-A, B. 19-20-927, Chapter XV. Method of determining pre-war credit. — Law. Section 326 (d) The average invested capital for the prewar period shall be determined by dividing the number of years within that period during the whole of which the corporation was in existence into the sum of the average invested capital for such years. This means that changes in capital during the year (by days) will be added to or deducted from the capital at the beginning of each pre-war year. After the average for each year is determined the total of these averages will form the sum of the average invested capital, which will then be divided by the number of years (three or less). Assets must be valued on the same basis for the pre-war period and for the taxable year. — Law. Section 330 If any asset of the trade or business in existence both during the taxable year and any prewar year is included in the invested capital for the taxable year but is not in- cluded in the invested capital for such prewar year, or is valued on a different basis in computing the invested capital for the taxable year and such prewar year, respectively, then under rules and regu- lations to be prescribed by the Commissioner, with the approval of the Secretary, such readjustments shall be made as are necessary to place the computation of the invested capital for such prewar year on the basis employed in determining the invested capital for the taxable year. Regulation. In any case in which as a result of a reorganiza- tion or for any other reason any asset in existence both during the 28o EXCESS PROFITS TAX PROCEDURE taxable year and any prewar year is included in computing the in- vested capital for the taxable year, but is not included in computing the invested capital for such prewar year, or is valued on a different basis in computing the invested capital for the two years, the differ- ence resulting therefrom shall not be included in determining the difference lo per cent of which is added to or deducted from the war profits credit under section 311 (a) (2) of the statute. In any such case the corporation shall make the readjustment required by the statute, and shall submit with its return a full statement of the differ- ence in such valuations and of the facts which give rise to such dif- ference (Art. 934.) When invested capital and net income of pre-war period need not be determined. — If the net income for the taxable year 1918 was less than 10 per cent of the invested capital for the same taxable year (plus the $3,000 exemption), it was not necessary to ascertain the invested capital or the net income for the pre-war period because no matter how large or how small it might have been there was no war profits tax to pay upon the net income for the taxable year 19 18. The credit of 10 per cent for the taxable year 1918 was at least sufficient to eliminate any liability to the war profits tax. If the net income for the taxable year 19 18 was more than 8 per cent (plus the $3,000 exemption) and less than 10 per cent, there was an excess profits tax to pay, in which case the invested capital and net income for the pre-war period had no bearing on the computation of the tax. Adjustments of pre-war assets. — There were several items of assets which required adjustment for the pre-war period differing from that for the taxable year 19 18. Cash surrender value of life insurance. — Ruling. The cash surrender value of insurance policies carried by a corporation on the Hves of its officers may be included in the computation of invested capital irrespective of the fact that the pre- miums paid on such policies may have been deducted as an expense in computing the net income of the corporation for prior years (over- ruling 3-19-209 and 21-20-966). (B. Digest 41-20-1239; A. R. R. 229.) PRE-WAR INVESTED CAPITAL 281 Plant assets. — Revaluations involving appreciation are not allowable in the taxable year nor in the pre-war period. If adjustments have been made since the pre-war period in depreciation, obsolescence, restoration of items incorrectly charged ofif, etc., the items should be examined to see if any of the entries affect the pre-war accounts. Goodwill and patents. — When purchased for stock or shares, goodwill, patents and other items of intangible property are included as invested capital for the taxable year not in ex- cess of cash value at time of acquirement or 25 per cent of the outstanding stock. If the book value is in excess of such 25 per cent or cash value it should be reduced not only for the taxable year but also for the pre-war period. Adjustment of pre-war capital stock and surplus. — Undivided profits. — The balance of the undivided profits account for each year should be carried forward to the follow- ing year and form part of the invested capital for that year. Adjustments of pre-war liabilities and reserves. — Reserves for taxes. — Federal excise taxes paid were al- lowable deductions during the pre-war period, but reserves for taxes were not. Therefore any reserves carried as liabilities should be included in invested capital until taxes were paid. Ruling. The rule expressed in article 845, Regulations 45, that taxes are deemed to be paid out of earnings for the year for which levied, applies to any year of the prewar period as well as to the taxable year. In such cases the amount or amounts payable in a suc- ceeding year on account of such taxes may be included in the compu- tation of invested capital until due and payable. (B. 11-19-392; O. D. 222.) Dividend reserves. — Dividends do not reduce invested capital until dates of payment. Therefore dividend reserves should be ignored and payment dates should be followed. CHAPTER XIII GENERAL PRINCIPLES OF CONSOLIDATED RETURNS In the United States as in no other country there seems to be an unnecessary multipHcation of separate corporations. In many cases the organization of separate corporations is not only unnecessary but also wasteful, and adds an adminis- trative burden which is not offset by the alleged advantages. In many other cases, however, corporations which are com- pelled to establish offices or plants in states other than the state of original incorporation find that restrictive and discrimina- tory state laws practically force the organization of subsidiary or affiliated corporations. This is the controlling reason for the vast number of cor- porations now in existence. So long as state regulation con- tinues the number of separate corporations will increase. If federal incorporation becomes established there will probably be a decided decrease in the number of holding and subsidiary corporations. The holding company enables the co-ordination and con- trol of industries operated in different states to be brought to a focus under the eyes of those possessing the financial control. The mixed operating-holding company combines the functions of operation in its own right and the financial possession of other corporations. As a resultant of the holding company — frequently described as the "parent" company, although it often comes into existence long after its subsidiary children — intercorporate relations arise much in the same way as inter- departmental transactions occur between the various factories and departments of the ordinary, large, single corporation. While the intercorporate activities are in progress, there is, through the executive head of the holding company, the regu- 282 CONSOLIDATED RETURNS 283 lation and direction of all the energies of the combination toward the consummation of the objects for which the group exists. Thus all the operations of the various plants are con- trolled and co-ordinated in such a way that the combination acts as a whole instead of as a multitude of independent and unrelated units. In the case of the holding company and its subsidiaries, the presentation of a balance sheet and a profit and loss statement for the holding company alone does not truly reflect the finan- cial position and commitments of the unified group. True it is that the holding company by the issue of stocks and bonds has acquired the stocks and bonds — in whole or in part — of the subsidiary corporations, which appear on its books as invest- ment a"ssets, and that the holding company may be owed vari- ous sums by the subsidiaries in repayment of advances, yet such a simple showing will often give little information, and may be entirely misleading. It is only by means of a consolidated balance sheet and a consolidated profit and loss account, made up from the indi- vidual balance sheets and profit and loss accounts of all the integral corporations, that a true presentation of the accounts of the combination can be obtained. Sir Arthur Lowes Dickinson, in his Accounting, Practice and Procedure, page i '/'y, sums up the case thus : .... the whole organization is considered as merely a series of separate works under the same ownership; and the same accounting principles which would apply to a corporation owning several fac- tories, are applied to the one owning the stocks of a number of sub- sidiary companies Having in mind the unity of operation and control, which is the predominant factor in any combination, it follows that, in stating the accounts, the formal constitution of the separate corporations should be disregarded in order to determine the substance and the underlying facts. To quote William M. Lybrand : 284 EXCESS PROFITS TAX PROCEDURE A consolidated balance sheet is intended to reflect tlie financial position of the whole group of affiliated companies, considered as one undertaking.^ Yet it is only of recent years that recognition of the poten- tialities for manipulation in the publication of the mere bal- ance sheet of the parent company has caused corporations whose integrity is above suspicion to use the consolidated bal- ance sheet in self-defense. The time will be when any state- ment other than a consolidated balance sheet in the case of parent company and subsidiaries will at once arouse a sus- picion that there are facts which the ofificers desire to hide. Even if the foregoing arguments are not convincing, the preparation of consolidated statements of affiliated companies has been rendered necessary — in some cases at least — by the excess profits tax laws of 1917 and 1918. Corporations so related as to come within the provisions of these laws and the pertinent regulations have been obliged to prepare con- solidated statements and in many cases have realized for the first time that such a presentation is the only truly satisfactory one. Much as the tax laws may be the subject of criticism, it must be admitted that they have caused everyone to under- stand at least two things : the importance of proper provision for depreciation, and the necessity for consolidated balance sheets in the case of affihated corporations. In order to bring together the somewhat scattered account- ing literature on the subject of consolidated statements, it is proposed in this chapter to treat the general accounting theory and practice as to consolidated statements, with an illustration. The following chapter deals with the requirements of the tax laws as to consolidated returns of affiliated corporations. Readers who desire to study the accounting questions further are referred to books and articles which have been pub- lished on this subject.^ 'William M. Lybrand, "The Accounting of Industrial Enterprises," Journal of Accountancy, Volume VII, page 40. 'William M. Lybrand, "The Accounting of Industrial Enterprises,'' CONSOLIDATED RETURNS 285 Conditions Precedent to Consolidation Although, in general, a few moments' consideration will be sufficient for a decision as to whether the consolidated form of statement should be adopted or not, cases will arise whose circumstances are such that decision shades off into opinion. In some cases the dividing line may be vague, but even then there is one test which will usually decide the matter and that is : What form of statement will best present the true finan- cial position of the combination to the public? If the answer to this question necessitates a consolidated statement, then from the general accounting point of view, such a statement should be prepared. However, it should be noted here that this test cannot be decisive in tax matters, as the law and regulations have ex- cluded certain types of corporations which might be included on the principles of pure accounting. These exceptions are taken up in detail later, but for completeness they are sum- marized here. They include: 1. Foreign corporations. 2. Corporations organized after August i, 1914 (and not successors to existing businesses), when 50 per cent of the gross income is from war contracts en- tered into between April 4, 191 7, and November II, 1918. 3. G€nerally, subsidiary corporations in which the par- ent company owns less than 95 per cent of the stock.^ Journal of Accountancy, Volume VII, pages 32, ni, 224. Walter A. Staub, "Consolidated Returns," Columbia University Lectures, The Federal In- come Tax. Sir Arthur Lowes Dickinson, Accounting Practice and Pro- cedure, 1918 edition, . page 175 et seq. Roy B. Kester, Accounting Theory and Practice, Volume 11, 1918, page 600 et seq. George R. Webster, "Con- solidated Accounts," Journal of Accountancy, Volume XXVIH, page 258. ''Article 633 (see page 311) provides that if 95 per cent or more of the stock of a subsidiary company is owned or controlled within the meaning of the law, a consolidated return must be made. This article also provides that when less than 95 per cent but more than 50 per cent of the stock is owned or controlled, a consolidated return may be filed, but the approval of the Commissioner must be obtained. • 286 EXCESS PROFITS TAX PROCEDURE On the other hand the law requires consoHdated statements of corporations owned or controlled by affihated interests or by the same interests, a condition which might not warrant such statements from the point of view of correct accounting. Assuming the presentation of the true financial position of the group to be the criterion as to the desirability of consoli- dated statements, it follows that a requirement that the vari- ous subsidiary corporations be engaged in the same general kind of business is not relevant. What is desired is a presenta- tion of the financial position of the group, and it is quite im- material that one corporation mines ore, another coal, a third owns a railroad, a fourth a line of steamers, while another manufactures a finished product which in turn is marketed, b}- a sixth corporation in the group. If the parent company really controls the various companies as a unit, a consolidated statement is essential to a true showing of the financial posi- tion. When an individual owns all the stock of several corpora- tions, the necessity for a consolidated statement for the rea- son given above is not so definite, as outsiders are not usually much concerned with an individual's personal accounts. Yet even in such cases it cannot be maintained that a mere entry under the caption "Investments" on an individual's balance sheet conveys to him his real financial relationship to the vari- ous companies. However, in the 19 18 law consolidated re- turns of corporations (excluding the individual) so owned are required. When the parent corporation owns the entire capital stock of each of the subsidiaries, there is no doubt that consolidated statements are necessary to sound accounting. In case of an ownership less than 100 per cent, it is not so easy to make a decision. The regulations require consolidated statements when the ownership is between 95 and 100 per cent (with cer- tain exceptions noted above and mentioned again later) and provide that the Commissioner may require such statements in case of an ownership of less than 95 per cent. This arbitrary CONSOLIDATED RETURNS 287 percentage has only a passing interest for the accountant, who will be guided by the necessities of a correct financial state- ment, independent of the exact percentage of ownership. With the percentage of ownership near 100, there is little difficulty in coming to a decision; but as the percentage de- clines to 51, the necessity for consolidated statements will not be so pronounced. Bare majority holdings, when control is not actively employed, are best treated as pure investments, taking up as income only the dividends actually received. In such a case, however, it is possible that this method will not reflect the true value of the investment holding. Should the facts in a particular case warrant this asssumption, consideration should be given to the general desirability of a consolidated statement, making due allowance for the (active) minority interest. It should be remarked in passing that the market price of the stock (held as an investment rather than for oper- ating purposes) would normally reflect the financial condition. This indication can be transferred to the balance sheet of the corporation owning the majority interest by a valuation of the stock or, preferably, by a notation as to the market price on the balance sheet date. In the alternative case of a bare majority ownership in which the control is actively exercised, it is generally best to bring the share of the undivided profits inhering in the stock ownership upon the books of the owning corporation by a charge to "Undivided Profits, X Company" and a credit to profit and loss. On these twu points the following quotation is instructive : Certainly where there is a control which is not exercised it would not appear that the proportion of the earnings of the controlled com- pany should be taken up, but that only dividends actually received should be credited to profit and loss. Where, however, control is exer- cised, there seems no reason why the proportion of profits or losses of the controlled company should not be taken into the accounts. The en- try to be made on the books of the holding company would be to charge undivided profits of controlled companies — which in the published accounts might be added to the investment in controlled 288 EXCESS PROFITS TAX PROCEDURE companies— and credit profit and loss. As dividends are received cash will be debited and undivided profits of controlled companies cred- ited.* Procedure in Preparation of Consolidated Balance Sheet In order to prepare a satisfactory consolidated statement of profit and loss or of assets and liabilities, there are certain preliminary requirements which demand attention. Some of these may necessitate a good deal of research in the past records of the corporation; nevertheless, such labor is by no means wasted, as only when the information is obtained can a trustworthy showing be made. One essential is that a standardized classification of ac- counts be used throughout the group and that this classification be observed by all concerned. In some cases there is a diffi- culty which is almost insuperable, as, for example, when the caption "Land, Buildings, Plant, Goodwill, Patents, etc.," has been used and no analysis has been made of the separate items. So far as possible attempts should be made to state the accounts in such a way that items bearing similar names can safely be added. This requirement is well put by Roy B. Kester : .... The first essential condition to facilitate the consolidation of the balance sheets of the various subsidiaries with that of the holding company is that standardized methods of accounting resulting in a similar classification of accounts and presentation of results be used by all the subsidiaries. The consolidated statement is then merely a combination of the values of similar items in all the balance sheets to determine the valuation at which the consolidated items shall appear.'* Another matter which requires attention is the statement of the intercompany accounts — loans from one company to another, sales of merchandise, remittances of cash, etc. — in such a way that these accounts shall correctly reflect the asset and liability aspects of the transactions. Accounts receivable 'George R. Webster, "Consolidated Accounts," Journal of Accountancy Volume XXVIII, page 265. °Roy B. Kester, Accounting Theory and Practice, Volume 11, page 603. CONSOLIDATED RETURNS 289 and accounts payable should always be divided into intercom- pany items and trade debtors. Should the amounts of inter- company accounts receivable and payable not agree, steps should be taken to adjust the discrepancies before making the consolidated statement. Goods or cash in transit may require adjustment by a debit to inventory or cash and a credit to the item Accounts Payable — Intercompany. In short the inter- company asset items relating to current transactions should equal the liability items relative to such transactions. When the notes of subsidiaries have been accepted by the parent or by another company in the group and have been dis- counted, it must be remembered that in the consolidation such notes mt'.st appear as a full, not contingent, liability of the consolidation. An asset which may present some difficulty is that of in- ventories in cases in which the product passes in turn through several companies and is transferred from one company to the next at a figure higher than the cost of manufacture to the selling company. Such transactions result in loading into the inventories of the various subsidiaries an amount of profit which is not realized until the goods are finally completed and sold. It is necessary, therefore, when such a chain of sales takes place, to record accurately the intercompany profit which is contained in the inventories and to reduce the inventory valuation by credits to the respective accounts and a debit to surplus. In these cases the intercompany profit in the inventory both at the beginning and end of the period should be ascertained and entries made charging surplus at the beginning of the period with the inter- company profit at the beginning of the period, crediting inventories with the intercompany profit at the end of the period and charging or crediting the profits of the year with the increase or decrease of the intercompany profit in the inventories at the end of the year com- pared with that at the beginning of the year.^ This requirement is indicated by William M. Lybrand in "George R. Webster, "Consolidated Accounts," Joitrnal of Accountancy Volume XXVIII, page 265. 2go' EXCESS PROFITS TAX PROCEDURE the Journal of Accountancy, November, 1908, page 113, as follows : The principle that profits must not be anticipated would seem therefore to be applicable in such instances, and it would follow that a reserve should be provided equal to the amount by which such merchandise at intercompany prices exceeds its actual manufac- turing cost. An example in simplified form showing how the intercom- pany profit can be eliminated from the inventory is given by Sir Arthur Lowes Dickinson in Accounting Practice and Pro- cedure, pages 180 and 181. A study of those pages will demonstrate the principle involved and will also indicate how the method can be adapted to any specific case. There are, however, two cases in which special thought must be given to this problem, since in them are features which may modify the ordinary procedure. The first case is found when the goods manufactured reach, at an intermediate point of transfer between companies, a state in which, although not completed, they may be purchased from other sources. This point is of particular importance when sales of goods in this condition are made not wholly to another subsidiary of the group but are made as well direct to independent buyers, or when purchases are made from outside manufacturers. A distinct claim may be made for the valuation of these goods by the subsidiary to which they are sold at a price which, while including a certain amount of intercompany profit, is still not higher than the market price for such commodities. Even in such a case as this, the practice of the large corporations is to set up a reserve for the intercompahy profit and not to take advantage of it until the material has passed through all the necessary stages and an actual sale to outsiders has been made. A second point arises when the parent company is not the owner of the entire stock of the subsidiary or subsidiaries. From th^ viewpoint of the minority stockholders the inventory is correctly valued to include the intercompany profits added prior to the progress of the material through the hands of CONSOLIDATED RETURNS 291 their particular company. In such a case it is considered advisable to reduce the inventory by a charge against the share of surplus inhering in the stock owned by the parent com- pany and to leave the surplus belonging to the minority share- holders intact. In order to facilitate the elimination of the intercompany stockholdings in the preparation of the consolidated balance sheet, it is desirable to segregate the capital stock of each com- pany into two classes : 1. Stock owned by the parent company or by some other subsidiary. 2. Stock owned and in the hands of the public. The reasons for this separation will be apparent later. Similarly a segregation should be made of the surplus ac- counts of each of the subsidiaries so as to show : 1. Surplus at date of acquisition of such stock as is owned by the parent or other subsidiary company, if neces- sary further dividing this as to the portion of the surplus attaching to each acquisition of stock by the parent, when the purchase of the controUing inter- est has been a step-by-step process. 2. Earned surplus, since date of acquisition, attaching to the parent company's holding of stock. 3. Earned surplus, since date of acquisition, attaching to the minority interest. 4. Paid-in surplus or capital surplus (if any) attaching to the parent company's interest. 5. Paid-in surplus or capital surplus (if any) attaching to the minority interest. This division of the surplus account can be made on the balance sheet while in process of consolidation — in the author's opinion the preferable method — or the same result can be reached by using a separate working sheet for the surplus account and showing thereon the separation outlined above. 292 EXCESS PROFITS TAX PROCEDURE The latter method is used by Webster in his paper in the Journal of Accountancy, October, 1919. In practice the reader should use whichever method appeals to him as the sim- pler or as showing the relevant facts the more clearly. If there has been an operating loss, it is considered advis- able for the whole of this loss to be assumed by the parent com- pany, unless there is good reason for thinking that ultimately it will be made good proportionately by the parent company and the minority interest/ Method of Elimination To prepare a consolidated balance sheet, a working sheet is necessary. It is recommended that analysis paper be used for this purpose and that the various asset and liability cap- tions be listed on the left from top to bottom in the usual bal- ance sheet order. The columns from left to right should be used for the balance sheets of the parent and each subsidiary company, with a total column on the right of this group. The balance sheet figures will be set up in the columns against the various captions and will be cross-totaled into the total column. To the right of the last-mentioned, a column for eliminations should be provided; and finally there should be a column for the difference between the total and elimination columns, which forms the desired consolidated balance sheet. In considering the procedure to be adopted in making the necessary eliminations from the aggregate of the individual corporations' assets and liabilities to prepare the consolidated balance sheet, the object to be attained must always be kept clearly in mind, namely, to show the financial position of the group as it relates to the public. All intercompany transac- tions must be eliminated as none of them affects the relation- ship of the group to the public. Consider the simplest item first, that is, intercompany ac- 'R. H. Montgomery, Auditing, Theory and Practice (2nd edition), page 518. CONSOLIDATED RETURNS 293 counts receivable and payable. If the procedure outlined in the foregoing pages has been followed, the total of these items on the debit side will exactly equal that on the credit side. By eliminating the corresponding figures from both sides, all these intercompany transactions will disappear from the balance sheet, which will then show only the accounts receivable, etc., which have arisen from transactions between the consolidated group and the public. This procedure is applicable not only to accounts receivable and payable but will apply to any inter- company assets and liabilities, such as loans, advances, notes payable and receivable, etc. In a consideration of this ques- tion Webster's paper (page 266 et seq.) will repay study. With respect to the elimination of the intercompany stock ownership relations, the procedure is not so definite nor so simple. About certain eliminations there can be no dispute; but as to others the opinions of accountants vary, as will appear later. In should be clearly understood that when a (parent) cor- poration purchases the whole of the stock of a subsidiary, it is really buying the net worth or, in other words, the capital stock plus surplus at the date of acquisition or the capital stock minus the deficit at the date of acquisition, according to the status of the subsidiary at the time. If only part of the stock is acquired, only that portion of the surplus or deficit apper- taining to the stock is to be considered as part of the purchase. Further it should be remembered that there can be no oper- ating profit accruing to a parent corporation in respect of a subsidiary pvirchased except what may be earned subsequent to the date of purchase.* These premises being granted, their application to the par- ticular problem of elimination in a consolidated balance sheet can now be considered. If the stock of the subsidiary stands on the books of the parent at a figure exactly equal to the sum of the par value "A. Lowes Dickinson, Accounting Practice and Procedure, page 183. 294 EXCESS PROFITS TAX PROCEDURE and the amount of surplus of the subsidiary on the latter's books at the date of acquisition by the parent, it is easy to ehminate these amounts from each side of the balance sheet. But, even in this hypothetical case, there may arise the prob- lem of the value of the assets of the subsidiary acquired, which may complicate the procedure. As this last question may arise in any case of stock and surplus elimination, attention will be devoted to it at this point before proceeding with other cases. It will be granted that in comparatively few cases does the balance sheet of a corporation reflect the net worth of the business as it would be valued by a purchaser. In some cases a balance sheet does not reflect the true net worth to the- corporation itself, because of secret reserves, intentional or otherwise. From this it follows that the sum of the capital stock and the surplus of the corporation at any date does not of necessity represent the true net worth of the busi- ness from the outsider's point of view. If, then, an outside corporation offers to pay in cash or bonds a sum in excess of the sum of the capital stock and sur- plus of the corporation in question for the "stock" of that corporation, one of three statements must be true : 1. The book net worth — assets less liabilities — of the cor- poration is actually worth more in hard cash than is reflected on its balance sheet. 2. The net worth of the tangible assets is correctly valued at the sum of the capital stock and surplus, but the purchasing corporation is willing to pay a sum in excess of the net worth of the tangibles for the goodwill of the corporation. 3. A combination of factors (i) and (2) exists. The foregoing is based upon an offer to purchase for cash. If stock of the purchasing corporation were offered as the con- sideration, the question would be more complicated, but it would resolve itself into one of the same three classes, the governing factor being, not the amount of stock received as consideration, but the cash value of the net worth of the pur- chased corporation and its goodwill, if any. CONSOLIDATED RETURNS 295 In cases (i) and (3) there were really secret reserves hid- den in the corporation's balance sheet, and, in order to make the true elimination, the real cash value of the assets and lia- bilities should be reflected on the balance sheet by a revaluation of the assets and liabilities on a cash basis. This procedure would result in a paid-in surplus or an increase in the earned surplus of the subsidiary prior to its acquisition by the parent, and this would be added to the earned surplus and the capital stock in making the elimination against the book value of the investment on the parent company's books. Bearing in mind this possibility of a revaluation on a cash basis of the assets of the subsidiary prior to acquisition by the parent, we shall now consider the two most usual types of purchase by a parent company. The first case is that in which the cost of the subsidiary is carried on the books of the parent at a value in excess of the real (i.e., cash) net worth of the subsidiary at date of acquisition. Here we have an asset to be offset against a cap- ital item of less face value. It is generally conceded that the difference is to be attributed to the "capitalized hopes" in the minds of the purchasers and as such it is to appear on the consolidated balance sheet as goodwill. Kester states this principle as follows : It is to be presumed that the values at which the securities are held on the books of the holding- company represent the latter's esti- mate of the value of its interests in the various subsidiaries. If this value is more than the net worth of the subsidiary as shown by its capital stock outstanding and surplus at the time of purchase by the holding company, the difference between the value at which the securi- ties are carried by the holding company and the net worth of the subsidiary must represent the value placed by the holding company on the good-will of the subsidiary. This good-will does not appear, of course, on the books of the subsidiary. Hence, in consolidating the balance sheet of the subsidiary with that of the holding company, it is necessary to set up the asset good-will and thus increase the net worth of the subsidiary to the point where it can be exactly canceled against the value of the securities on the balance sheet of the holding company.' 'Roy B. Kester, Accounting Theory and Practice, Volume II, page 604 296 EXCESS PROFITS TAX PROCEDURE In the second case, the parent company's books show the investment in the subsidiary company's stock at less than the real net worth as reflected or adjusted on the subsidiary com- pany's balance sheet. There are several theories as to how the discrepancy should be treated. Where the book value of the stock of a subsidiary company on a balance sheet of the company holding that stock is less than the capital stock plus the surplus of the subsidiary company at date of acquisition, the difference should be credited to capital surplus, unless there is goodwill of a greater amount either on the accounts of the holding company or of the subsidiary company, or if there is goodwill of a greater amount arising from purchases of stocks of other subsidiary companies.^" On the other hand, Kester" states that it is possible to credit goodwill account with this difference, even if such pro- cedure "result in reducing the value of goodwill to a negligible figure, or in writing it off the books entirely, or even in show- ing it as a credit balance," although he states his personal preference for a credit to Depreciation Reserve (or capital surplus), apparently in all cases. The theory held by Sir Arthur Lowes Dickinson is as follows : The amount by which the value of the stocks of any company on the books of another exceeds or falls short of the par value thereof, represents an addition to or diminution of the asset of goodwill in the final balance sheet; . . . .^^ The author's practice has been to credit the difference to goodwill if there be sufficient in the consolidation to cover such an entry; but if there be no goodwill, or an insufficient amount, to credit it to capital surplus. At this point reference is made again to the method to be adopted when the controlling interest in a subsidiary has been acquired by progressive stages. It is considered that there should be associated with each purchase of stock the propor- "George R. Webster, "Consolidated Accounts," Journal of Accountancy Volume XXVIII, page 263. "Roy B. Kester, Accounting Theory and Practice, Volume II, page 605. '^A. Lowes Dickinson, Accounting Practice and Procedure, page 177. CONSOLIDATED RETURNS 297 tion of earned surplus belonging thereto at the date of such acquisition, so that when the control is consummated the aggregate cost to the parent will be eliminated against the sum of the capital stock of the subsidiary and the relevant instal- ments of "surplus at date of acquisition" as outlined above. Example of Procedure In order to put the procedure in a more definite form, an example will be given and the eliminations discussed. It should be noted that these eliminations are all in journal form and keyed to the balance sheet — a procedure which is recom- mended for use in all cases. i o o o o O o o o o o s d d d d d o o o o o o vixr, o J d tC tC ci in 9 00 ^s. rsio n 00 00 oo 6 «- «* «■ vy D 3 3 3 31 O o d o d" o o o o 66 o o oo. o o 00 m COM o o g o d 49- o o o o d d o o ■i i O o d o o dl N o o d o o m" o « *9- O O 13 O O O 6 6 6 o o o O in O CO vo o o o d o o lO o m O o o o o o o lO Ul «ft «■ o o o n m Cn s5 " W W c/i W U < < Q w < 1— I o ;z; o u o [I. H W W K t/} o g o o o o o O o o o o o d d 6 6 d o o o o o UlO^ mm o tCm « pf d" tN. n M\D tn 00 M O o» «- *9- «■ o o o o O o o o o o d d d d d o o o o o o m o o o d in do" d m <3> 00 m fO ts. ■* (OM m «■ «■ 4A- «■ o o o o o H o t^ « w- «- o o o o o o o m o o O o U o o o o o o o o o o d d o o o^ o in m lO o o o o o o^ O m o o o o o o o ^^Ift ■* m- o o o o o o PI p) «^ 69- < 2 a f^ o On] m o o o o o o o o o o d d d d d o o o o o mo m m o N m t^fi" in O M N M w- «^ » <=> 1 O o o S 1 O o O d 6 d d o Q o O o^ m o o m in M N t/3- «■ 69- W o o o n «■ vy o o o o o o o o o o d d d d d o o o o o o o o o^ o 6 6 6 6 d mo \f%iri o ■*« m «- 4» «• o o O O o o o O O o d d d d d o o o o o o o o o o m d d in m tx. Oi m « tv \a w- «9^ «■ «■ o o o o "* «* 49- o o o o o o o m o ; a " a M a ^S U3 uu C/1 <: 1^ > > 'S'B u u U V «« to [Q ■M 4-> Q a o ^ a. 6 ■< : > s s ■ ,cS ^ « 5 • o • o I ■■ 5 Sm "OS C>M o (4 V O i-lfiO 298 e o o o d d o o o o »n lO W vo « o » «9- o o - 900 K d d ?! h o_o a u^ o V^ M IN O d d d" to 00 49- o o o o o o d d 6 t>. 10 «■ •69- _, < K S s. a 6^ ■ - ra ii^*^ PQ 1-. a - -. t-1 ^"^ ^ ^ 33 nj rt m m 3 S 0) V o o ■"■woo O O O o m -w SI E o o " Oh rt rt 4j J-^ u> ¥ > >.3 -a -,-3 i' S T a 3>' a, a* }hPQ ^ ^ < H M Ph ■< u M .s 's. ^ - H «£ lM CO .'2 : ■ o 3 ; " : 1 S' :•« :•« d 6 n 0» (^ t^ "M n «■ ;{ «1 rt ft ft is s 5 U Urr, O P ?? tic;-<^ u bo 5"^Ph cT.S c 2S.2 O C w ft PL, O 299 300 EXCESS PROFITS TAX PROCEDURE Journal Entries Covering Eliminations (I) Capital Stock A Company $100,000.00 Surplus A Company at date of acquisition 15,000.00 Paid-in Surplus A Company at date of acquisition 10,000.00 To Stocks of Other Companies A $125,000.00 (2) Capital Stock B Company, Intercompany 190,000.00 Surplus B Company at date of acquisition, Inter- company 38,000.00 Goodwill 72,000.00 To Stocks of Other Companies B 300,000.00 (3) Capital Stock C Company, Intercompany 200,000.00 To Stocks of Other Companies C 120,000.00 To Surplus C Company at date of acquisi- tion 50,000.00 To Goodwill 30,000.00 '(4) Bonds B Company, Intercompany 150,000.00 To Stocks of Other Companies Bonds B.. 110,000.00 To Reserve for Redemption B Company Bonds 40,000.00 (S) Notes Payable, Intercompany 10,000.00 Accounts Payable, Intercompany 125,000.00 To .Accounts Receivable, Intercompany. . . . 135,000.00 (6) Operating Surplus since date of acquisition, In- tercompany 25,000.00 To Inventories 25,000.00 To eliminate intercompany profit in latter. Notes on foregoing example. — In the example of the prepa- ration of a consolidated balance sheet, which appears on the preceding pages, a combination consisting of an operating- holding company M, the parent, and three subsidiaries, A, P> and C, has been presented. M Company owns all the capital stock, par value $100,000, of A Company; of B Company, $190,000 of $200,000; of C Company, $116,666.67 °^ $200,000, and also holds 7 per cent bonds of B Company of a par value of $150,000. It has also $100,000 of intercompany accounts receivable, being the amount due from A Company. CONSOLIDATED RETURNS 301 A Company has a capital stock of a par value of $100,000, all of which is owned by the parent company M. At the date of acquisition by M it had an earned surplus of $15,000 and a paid-in surplus of $10,000. The sum of capital stock, earned surplus and paid-in surplus is $125,000, and at this figure the investment is carried on the parent company's books. These items are ehminated in journal entry ( i ). A Company also has intercompany accounts receivable due from C Company, and this item is eliminated in entry (5). It owes the parent com- pany $100,000, which is also eliminated in entry (5). Of B Company's capital stock of $200,000 par value, $190,000 is owned by M and the remaining $10,000 by the outside public. At the date of acquisition by M, there was an earned surplus of $40,000, of which 19/20 appertains to the parent company's holding and 1/20 to the stock held by out- siders. The elimination of capital stock, $190,000, plus sur- plus, $38,000 — total, $228,000 — against the value at which the investment is carried on M's books — $300,000 — is shown in entry (2) wherein the difference of $72,000 between the price paid by M and the net value on the books of B is set up as goodwill. B Company has outstanding bonds of a par value of $350,000, $150,000 held by M and the remainder by the public. As the former amount is carried on M's books at $110,000, it is necessary in elimination entry (4) to set up a reserve for redemption of bonds amounting to the difference, $40,000. When these bonds mature and are redeemed, this reserve will be closed into surplus as a profit on M's purchase. As to intercompany debts, B has a note payable of $10,000 due to C Company, which is eliminated by entry (5). The capital stock of C Company has a par value of $200,- 000, part held by M and the remainder by B Company. This stock is carried on M's books at $70,000 and on B's books at $50,000 — total $120,000. At the date of acquisition C had a deficit of $50,000, giving it a net worth of $200,000 less $50,- 000 — $150,000. The difiference between $120,000 and $150,- 000 is set up as a credit to goodwill in entry ( 3 ) . The inter- 302 EXCESS PROFITS TAX PROCEDURE company accounts receivable item of $10,000 is eliminated in entry (5). Entry (6) covers the reduction of inventory due to inter- company profits arising from the sale of merchandise by one company to another at an advance on cost. The entry elimi- nates the intercompany profit of $25,000. It should be noted that this entry adjusts only the total inventory of $495,500 shown in the total column. It is presumed that a similar elimination at the beginning of the period had already been made in a previous balance sheet or through the current profit and loss if this be considered as the first consolidated state- ment made by the group. With these explanations and by following the journal en- tries through the key numbers on the balance sheet, the reader should have Httle difficulty in familiarizing himself with the procedure to be followed in reaching the consolidated figures in the last column. As a summary, the consolidated balance sheet is reproduced below : Consolidated Balance Sheet of M, A, B and C Companies ASSETS Cash $ 280,000.00 Accounts Receivable, Trade $877,500.00 Less: Reserve for Doubtful Accounts 62,500.00 815,000.00 Stocks of Other Companies : Miscellaneous 95,000.00 Inventories 470,500.00 Machinery and Equipment $380,000.00 Buildings 150,000.00 $530,000.00 Less: Reserve for Depreciation, Machinery and Equipment $206,500.00 Reserve for Depreciation, Buildings 22,500.00 Total Reserves $229,000.00 Net Value 301,000.00 Land 35,000.00 Deferred Charges 1,500.00 Goodwill 1,067,000.00 Total Assets $3,065,000.00 CONSOLIDATED RETURNS 303 LIABILITIES Notes Payable, Trade $ 150,000.00 Accounts Payable, Trade 400,000.00 7% S-Year Gold Bonds in hands of public 200,000.00 Reserve for Redemption of Bonds 40,000.00 CAPITAL Capital Stock in hands of public 2,010,600.00 Surplus, Majority Interest 262,500.00 Surplus, Minority Interest 2,500.00 Total Liabilities $3,065,000.00 Consolidated Profit and Loss Statement The preparation of a consolidated statement of profit and loss should present little difficulty if the principles enunciated in the foregoing pages have been understood. The chief items of elimination will be intercompany dividends and any pay- ments by one company to another for administrative expenses. Intercompany profits included in inventories at the beginning and end of the period should be adjusted through this state- ment. It is suggested that the profit and loss statement be set up in the form required for income tax so that, after the necessary eliminations have been made, the consolidated state- ment will be in a form for submission on the consolidated return. CHAPTER XIV (,:ONSOLIDATED RETURNS OF AFFILIATED CORPORATIONS General Under the 191 7 regulations based on no specific authority of law, consolidated tax returns were required in all cases in which there was either stock ownership or such business or financial relationship as would permit manipulation of profits or losses between companies. The requirement of the 1918 law is in many ways differ- ent from that of the 191 7 regulations, particularly as to the definition of an "affiliated corporation." The provision of the 1918 law requiring consolidated returns reads as follows: Law. Section 240. (a) That corporations which are affihated within the meaning of this section shall, under regulations to be prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income and invested capital for the purposes of this title and Title III, and the taxes thereunder shajl be computed and determined upon the basis of such return : The principles underlying the requirement of section 240 (a) are stated below: Regulation. The provision of the statute requiring affiliated corporations to file consolidated returns is based upon the principle of levying the tax according to the true net income and invested capital of a single business enterprise, even though the business is operated through more than one corporation. Where one corpora- tion owns the capital stock of another corporation or other cor- porations, or where the stock of two or more corporations is owned by the same interests, a situation results which is closely analogous to that of a business maintaining one or more branch establishments. In the latter case, because of the direct ownership of the property, the invested capital and net income of the branch form a part of the invested capital and net income of the entire organization. Where such branches or units of a business are owned and controlled through the medium of separate corporations, it is necessary to require a 304 CONSOLIDATED RETURNS 305 consolidated return in order that the invested capital and net income of the entire group may be accurately determined. Otherwise oppor- tunity would be afforded for the evasion of taxation by the shifting of income through price fixing, charges for services and other means by which income could be arbitrarily assigned to one or another unit of the group. In other cases without a consolidated return exces- sive taxation might be imposed as a result of purely artificial con- ditions existing between- corporations within a controlled group. . . (Art. 631.) It will be noted that the regulation aims at consolidating the income and invested capital of the group as "of a single business enterprise." This should not be interpreted so as to restrict the consolidation to subsidiary corporations engaged in the same industry as the parent, but should be applied from the viewpoint of financial control, irrespective of the nature of the business carried on by the corporations. Therefore, if a holding company owns the stock of a street railway and also owns the stock of an oil company or if corporations conducting any such dissimilar businesses are controlled by the same inter- est, section 240 (a) requires that consolidated returns be made. General instructions as to technique in the preparation of consolidated returns are given in article 864. While the regu- lation states that the preparation is to be "in accordance with standard accounting practices," it must be understood that the principles outlined in the preceding chapter will not hold when they are in conflict with the law. Regulation. The invested capital of affiliated corporations, as defined in section 240 (b) of the statute and article 633, for the taxable year is the invested capital of the entire group treated as one unit operated under a common control. As a first step in the computation a consolidated balance sheet should be prepared in accordance with standard accounting practices, which will reflect the actual assets and liabilities of the affiliated group. In preparing such a balance sheet all intercompany items, such as intercompany notes and accounts receivable and payable, should be eliminated from the assets and the liabilities, respectively, and proper adjustments should be made in respect of intercompany profits or losses reflected in inven- tories which at the beginning or end of the taxable year contain merchandise exchanged between the corporations included in the 3o6 EXCESS PROFITS TAX PROCEDURE affiliated group at prices above or below cost to the producing or original owner corporation. Such consolidated balance sheet will then show (a) the capital stock of the parent or principal company in the hands of the public; (&) the consolidated surplus belonging to the stockholders of the parent or principal company; and (c) the capital stock, if any, of subsidiary companies not owned by the parent or principal company, together with the surplus, if any, be- longing to such minority interest. In computing consolidated in- vested capital the starting point is furnished by the, total of the amounts shown under (a), (&) and (c) above. This total must be increased or diminished by any adjustments required to be made .... (Art. 864.) The columnar method of preparing consohdated state- ments, mentioned in tlie preceding chapter, is required by article 637. Regulation. ... In respect of the statement of gross income and deductions and the several schedules required under form 1 120, a corporation filing a consolidated return is required to prepare and file such statements and schedules in columnar form to the end that the details of the items of gross income and deductions for each corporation included in the consolidation may be readily audited. (Art. 637.) Although this regulation requires merely the filing of statements in columnar form, it is well at this point to add cer- tain notes on the preparation of a consolidated balance sheet relative to points on which other provisions of the tax law and regulations will necessitate a modification of the usual account- ing practice. Previous chapters in this volume and in Income Tax Pro- cedure, 192 1, have brought to notice the various require- ments of the law and regulations as to asset values at March I, 1913, calculation of depreciation, adjustment of the value of intangible assets, etc., and the reader should refer to them. The adjustments mentioned would be required in the tax return of a separate corporation, and similar adjustments must be made in a consolidated return. For ease of reference it is suggested that balance sheets for each corporation be made in columnar form to show in order from left to right : CONSOLIDATED RETURNS 307 Captions of Assets and Liabilities Book Figures Ad j ustments — Debit Ad j ustments — Credit Adjusted Balance Sheet All the adjustments necessary should be made in the form of journal entries, with explanations, and should be keyed when posted to the balance sheet, for convenience. If this method be adopted it will be possible at a later date to state readily the reason for any adjustment made. The adjusted balance sheet figures shown in the final column will be those used in the preparation of the consoli- dated balance sheet, as indicated in the example on page 298. There is an interesting and instructive paper on the "Technique of Consolidated Returns," by John W. Roberts, C. P. A., in the Journal of Accountancy for January, 1920, which will repay careful study. Form of return. — Form 1120 will be used for a consoli- dated return and, in addition. Affiliated Corporation Ques- tionnaire, form 819, is required with the submission of the first consolidated return. The latter "form" (it is a small volume) may also be required at any time by the Commis- sioner to determine whether the relationship between corpora- tions is such as to require a consolidated return or not. Regulation. Affiliated corporations, as defined in the statute and in article 633,^ are required to file consolidated returns on form 1120. The consolidated return shall be filed by the parent or principal re- porting corporation in the office of the collector of the district in which it has its principal office. Each of the other affiliated corpora- tions shall file in the office of the collector of its district form 1122, along with the several schedules indicated thereon. The parent or principal corporation filing a consolidated return shall include in such return a statement specifically setting forth (a) the name and address of each of the subsidiary or affiliated corporations included in such return, (6) the par value of the total outstanding capital stock of each of such corporations at the beginning of the taxable year, (c) the 'See page 311. 3o8 EXCESS PROFITS TAX PROCEDURE par value of such capital slock held by the parent corporation or by the same interests at the beginning of the taxable year, (_d) in the case of affiliated corporations owned by the same interests, a list of the individuals or partnerships constituting such interests, with the percentage of the total outstanding stock of each affiliated corpora- tion held by each of such individuals or partnerships during all of the taxable year, and (e) a schedule showing the proportionate amount of the total tax which it is agreed among them is to be assessed upon each affiliated corporation. Foreign corporations and personal service corporations need not file consolidated returns (Art. 632.) Consolidated return of information at source not per- mitted. — Subsidiary and parent corporations must file their returns of information separately and a consolidated return of information cannot be permitted.^ Conditions Precedent to Consolidated Returns In order to file consolidated returns, the corporations in- volved must first meet the requirements of affiliation set forth in the law. "Affiliated corporation" defined. — Law. Section 240 (b) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated ( I ) if one corporation owns directly or controls through closely affili- ated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if substantially all the stock of two or more corporations is owned or controlled by the same interests. There are cases in which consolidated returns are pro- liibited by the law itself or in which the circumstances may prevent the filing of consolidated returns. Foreign corporations excluded. — Regulation. A domestic corporation which owns a majority of the stock of a foreign corporation shall not be permitted or required to include the net income or invested capital of such foreign corpora- tion in a consolidated return.^ .... (Art. 636.) 'Bulletin 16-20-868; O. D. 469. "But credit may be claimed for taxes paid by the foreign corporation, see Income Tax Procedure, 1921, Chapter XXVI. CONSOLIDATED RETURNS 309 Ruling. Receipt is acknowledged of your letter dated April 11, 1919, in which you state: "A client of mine, a New Jersey corpora- tion, owns all of the outstanding stock in a foreign corporation, which in turn owns all of the outstanding stock in a New York corporation. Although under article 636 of Regulations 45 relating to the income tax a domestic corporation is not required or permitted to file a con- solidated return with a foreign corporation, it seems to me that the New Jersey and New York corporations above mentioned are affiliated as that term is defined in article 633, and that, on that account the New Jersey corporation should file a consolidated return for both, under the provisions of section 240 of the Revenue Act " In reply you are advised that in accordance with section 240 of the Revenue Act of 1918 it will be necessary for the New Jersey cor- poration and the New York corporation above mentioned to file a consolidated return, excluding the foreign corporation. (Letter to a subscriber of The Corporation Trust Company, signed by Acting Deputy Commissioner P. S. Talbert, and dated April 23, 1919.) It should be noted that the stock of any foreign corpora- tion not transacting business or deriving income from sources in this country is an admissible asset to the corporation hold- ing such stock [section 325 (a)]. (See pages 191, 193.) Certain government contract corporations excluded. — Law. Section 240. (a) .... That there shall be taken out of such consolidated net income and invested capital, the net income and invested capital of any such affiliated corporation organized after August I, 1914, and not successor to a then existing business, 50 per centum or more of whose gross income consists of gains, profits, commissions, or other income, derived from a Government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. In such case the corporation so taken out shall be separately assessed on the basis of its own invested capital and net income and the remainder of such affiliated group shall be assessed on the basis of the remaining consolidated invested capital and net income. Regulation. In the case of any affiliated corporation organized after August i, 1914, and not a successor to a then existing busi- ness, 50 per cent or more of whose gross income consists of gains, profits, commissions or other income derived from a Government con- tract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, the net income and invested capital of such corporation shall be taken out of the consolidated net income and invested capital of the group of affiliated corporations and the cor- poration so segregated shall be separately assessed on the basis of its 3IO EXCESS PROFITS TAX PROCEDURE own invested capital and net income, the remainder of such affiliated group being assessed on the basis of the remaining consolidated invested capital and net income. See section i of the statute and article 1510. (Art. 635.) Where individual ownership not in same proportion. — Regulation when the stock of two or more corporations is owned by two or more individuals or by two or more partnerships a consolidated return is not required unless the percentage of stock held by each individual or each partnership is substantially the same in each of the affiliated corporations. (Art. 633.) Regarding the phrase "substantially the same" see page 311- When stock ownership is less than 95 per cent. — If less than 95 per cent of the stock is owned, a consolidated return may not be required but, on the other hand, the Commissioner, on receiving form 819 (affiliated corporation questionnaire), may decide that a consolidated return is necessary. Regulation. . . . Consolidated returns may, however, be re- quired even though the stock ownership is less than 95 per cent. When the stock ownersliip is less than 95 per cent, but in excess of 50 per cent, a full disclosure of affiliations should be made, showing all pertinent facts, including the stock owned in each subsidiary or affiliated corporation and the percentage of such stock owned to the total stock outstanding. Such statement should preferably be made in advance of filing the return, with a request for instructions as to whether a consolidated return should be made. In any event such a statement should be filed as a part of the return (Art. 633.) Changes in ownership may prevent consolidated return. — Regulation.' When one corporation owns substantially all the stock of another corporation at the beginning of any taxable year, but during the taxable year sells all or a majority of such stock to outside interests not affiliated with it, or when one corporation during any taxable year acquires substantially all the capital stock of an- other corporation with which it was not previously affiliated, a full disclosure of the circumstances of such changes in ownership shall be submitted to the Commissioner. In accordance with the peculiar cir- cumstances in each case the Commissioner may require separate or consolidated returns to be filed, to the end that the tax may be equi- tably assessed. (Art. 634.) CONSOLIDATED RETURNS 311 Commercial or financial relationship (other than stock ownership) does not warrant consolidated returns. — A ruling in bulletin 22-20 makes it clear that commercial or financial relations alone would not be sufficient ground to warrant a consolidated return. In this respect the 1918 regulations differ from those of 1917. Ruling Where only commercial or financial relations exist between corporations and there is no stock ownership or control of the character prescribed in the statute they may not be classed as affiliated corporations. (B. Digest 22-20-976; A. R. R. 123.) Consolidated returns only include corporations. — In theory, consolidated returns should be permitted or required whenever business, relations are so close that a shifting of income or expenses might be resorted to in order to save or equalize tax. The excess profits tax, however, is only imposed on corporations so that an individual trader, or a partnership, no matter how closely related to a corporation (even to the extent of 100 per cent joint ownership) cannot file consoli- dated returns. "Substantially all the stock." — The phrases "substantially all the stock" and "the same interests" are interpreted by the Treasury in the following manner: Regulation The words, ''substantially all the stock'' can- not be interpreted a smeaning any particular percentage, but must be construed according to the facts of the particular case. The owning or controlling of 95 per cent or more of the outstanding voting capital stock (not including stock in the treasury) at the beginning of and during the taxable year will be deemed to constitute an affiliation within the meaning of the statute. Consolidated returns may, how- ever, be required even though the stock ownership is less than 95 per cent. When the stock ownership is less than 95 per cent, but in excess of 50 per cent, a full disclosure of affiliations should be made, showing all pertinent facts, including the stock owned in each sub- sidiary or affiliated corporation and the percentage of such stock owned to the total stock outstanding. Such statement should prefer- ably be made in advance of filing the return, with a request for in- structions as to whether a consolidated return should be made. In any event such a statement should be filed as a part of the return. The words "the same interests" shall be deemed to mean the same 312 EXCESS PROFITS TAX PROCEDURE individual or partnership ur the same individuals or partnerships, but when the stock of two or more corporations is owned by two or more individuals or by two or more partnerships a consolidated return is not required unless the percentage of stock held by each individual or each partnership is substantially the same in each of the affiliated corporations. (Art. 633.) It should be noted that when the stock ownership is be- tween 50 and 95 per cent a disclosure of affiliation must be made on form 819. After this form has been filed once it need not be filed again unless a change occurs. Rulings. A corporation, the majority of whose stock is owned by its president and manager, turned over a branch of its business to a new company, not incorporated, the president and manager of the corporation retaining control of the new company. There was no transfer of corporate assets. The new company simply used the assets of the corporation without consideration of any kind but was operated as a separate and distinct enterprise. Held that the new company is merely a branch of the corporation and not a separate entity for Federal income tax purposes. Its income should be in- cluded in the return of the corporation and is subject to both income tax and excess profits tax. (B. Digest 16-20-866; O. D. 467.) A partnership, upon becoming a corporation in accordance with the provisions of the law, and owning 99 per cent of the capital stock of three other corporations, should file a consolidated return. (B. Digest 6-19-286; T. B. R. 27.) Interpretation of the phrase "the same interest." — Rulings. It appears that there are two corporations, one owning and operating properties in the Hawaiian Islands and the other own- ing and leasing various pieces of property in California. The stock of the California corporation is held by the members of one family, four male members of the family each owning five-twenty-fourths and a sister one-sixth of the entire stock. The Hawaiian corporation is held by the same family principally, with the exception that one- sixth of the stock is held by each of the four male members afore- mentioned, one-sixth by the sister aforementioned, and one-sixth by the husband of a deceased sister to the other stockholders. The affairs and operations of the two corporations have in the past been, and are now being, actively conducted by and in the control of the male members of the family. The two corporations, it is stated, are in purpose and effect only one enterprise. In accordance with Regulations 45, where substantially all of the stock of two or more corporations is held by the same interests, such holdings must be in substantially the same proportions in order to CONSOLIDATED RETURNS 313 require a consolidated return. It is therefore held that these cor- porations should file separate returns. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated April II, 1919.) The application to make a consolidated return was denied in the case of two companies in one of which 24.26 per cent of the stock of the first company was owned by individuals who held no stock whatever in the second company, and more than 6 per cent of the stock of the second company was held by individuals who held no stock in the first company. Such a division of ownership can not be considered either under the statute or the regulations as a case in which substantially all of the stock of two or more corporations is owned or controlled by the same interests. (B. Digest 16-19-465; T. B. R. 52.) It is very difficult to ascertain what was the Treasury's real basis for rejection in the above cases, particularly the former. If the stockholders of one corporation are identical with those of another, or nearly so, the author feels that the law intends that consolidated returns shall be filed and that regulations in conflict with this intent must eventually be modified. An effort must be made .to get below the mere form of the com- bination to the actual facts of the relationship. Taxpayers permitted to file consolidated feturns only when such returns could be required by Commissioner. — The following ruling is of interest to tax-paying corporations which, although not within the letter of the regulation for consolidation, desire to file consolidated returns for their pecuniary advantage. Ruling. If, on account of the disparity of holdings of the stock- holders in the corporations, the Bureau would be unable to compel such corporations, seeking to file a consolidated return, to pay a tax based upon a consolidated return, provided the corporations failed to pay such tax voluntarily, the corporations should not be permitted to file a consolidated return. Corporations should not be permitted to do that which they could not be required to do. (B. Digest 7-19- 304; T. B. M. 32.) Affiliated public service corporations. — Ruling. "T. D. 2662, issued March 6, 1918, provided in 'B' that railroads, gas, electric, water and other public service corpora- 314 EXCESS PROFITS TAX PROCEDURE tions when operated independently and not physically connected or merged — particularly when situated in different jurisdictions and sub- ject to regulation by Public Service Commission — will not be required or permitted, without special permission obtained in advance, to make a consolidated return. "The Revenue Act of 1918, section 240, makes statutory provision for consolidated returns, both for income and for war profits and excess profits tax purposes, setting forth quite definitely just what shall be considered to be affiliated corporations. The amplifying regulations of the Department as contained in Regulations 45, Part II-A, contain nothing indicating that the rule relating to public service corporations laid down by the Department in connection with the Revenue Act of 1917 will be held to apply to the Revenue Act of 19 18, section 240. "We shall appreciate word from the Department as to whether or not public service corporations which otherwise would be deemed to be affiliated corporations are to be taken out of that class because of the fact that they are public service corporations and otherwise meet the conditions outlined in T. D. 2662." In reply you are advised that subdivision (b) of T. D. 2662, issued March 6, 1918, in connection with the Revenue Act of October 3, 1917, does not apply to the Revenue Act of 1918. In other words, public service corporations which otherwise would be deemed to be affiliated corporations are not to be taken out of that class because of the fact that they are public service corporations and otherwise meet the conditions outlined in T. D. 2662. (Letter to The Corpora- tion Trust Company, signed by Acting Commissioner J. H. Callan, and dated April 17, 1919.) The Consolidation of Net Income The method of preparmg the consoHdated statement of net income, outHned in the previous chapter, is indicated in the following': Regulation. Subject to the provisions covering tlie determina- tion of taxable net income of separate corporations, and subject further to the elimination of intercompany transactions, the consoli- dated taxable net income shall be the combined net income of the several corporations consolidated, except that the net income of cor- porations coming within the provisions of article 635* shall be taken out. In respect of the statement of gross income and deductions and the several schedules required under form 1120, a corporation filing a consolidated return is required to prepare and file such statements 'Refers to corporation deriving chief income from government contract. CONSOLIDATED RETURNS 315 and schedules in columnar form to the end tliat the details of the items of gross income and deductions for each corporation included in the consolidation may be readily audited. (Art. 637.) The above article requires that the income accounts of the parent and subsidiary corporations (each prepared as if to be separately submitted on form 1120) be consolidated. This is a departure from the provision under the 191 7 law that the consolidation of income was not permitted for income tax purposes but only for the calculation of excess profits tax. Under the present law an operating deficit of one corporation — which would absolve it from income tax if it filed a separate return — -is offset against an operating profit of other corpora- tions, thus reducing the group's liability to income tax below what the sum of the taxes for the separate corporations would be. (For illustration see Appendix A.) Only one $2,000 credit permitted in a consolidated re- turn. — Law. Section 240. (a) . . . . There shall be allowed in com- puting the income tax only one specific credit of $2,000 (as provided in section 236) ; . . . . Liberty bond exemptions. — By the ruling contained in bul- letin 2-19-171, T. B. R. 7, the tax exemptions arising from holdings of Liberty bonds are calculated by adding together the exemptions to which each corporation of the group would be entitled were it rendering a separate return. This provi- sion, adopted perhaps partly from motives of ex])ediency, in- dicates one of the cases in which the consolidated total is not the deciding factor in the tax return. Credit for taxes when domestic corporation controls for- eign corporation. — Law. Section 240. (c) For the purposes of section 238 a do- mestic corporation which owns a majority of the voting stock of a foreign corporation shall be deemed to have paid the same propor- tion of any income, war-profits and excess-profits taxes paid (but 3i6 EXCESS PROFITS TAX PROCEDURE not including taxes accrued) by such foreign corporation during the taxable year to any foreign country or to any possession of the United States upon income derived from sources without the United States, which the amount of any dividends (not deductible under section 234) received by such domestic corporation from such foreign corporation during the taxable year bears to the total taxable income of such foreign corporation upon or with respect to which such taxes were paid: Provided, That in no such case shall the amount of the credit for such taxes exceed the amount of such dividends (not de- ductible under section 234) received by such domestic corporation during the taxable year.^ Dividends guaranteed by holding company. — Regulation A holding company which guarantees divi- dends at a specified rate on the stock of a subsidiary corporation for the purpose of securing new capital for the subsidiary and increasing the value of its stock holdings in the subsidiary may not deduct amounts paid in carrying out this guaranty in computing its net income, but such payments may be added to the cost of its stock in the subsidiary (Art. 582.) Intercompany profits in inventories. — As stated earlier in this chapter, any intercompany profit existing in the inven- tories at the beginning and end of the taxable period must be eliminated through the statement of income. There is no regulation requiring this to be done in the case of income, but, as it has to be done for the computation of invested capital, it is only reasonable to imply an adjustment of income. Reconciliation of tax income with book figures. — While some accountants advocate other methods, the author, as the result of his experience, is of opinion that the most satisfac- tory method of preparing that part of schedule L of form 1 120 relating to income in a consolidated return is to prepare a separate reconciliation for each corporation as if a separate return were to be filed for each, and then to combine these separate reconciliations, eliminating any intercompany adjust- ments. The result will be a reconciliation of the consolidated 'See Income Tax Procedure, 1921, Chapter XXVI. CONSOLIDATED RETURNS 317 taxable income. Form 1120 for 1920 combines in one sched- ule (L) the reconciliation of net income (formerly schedule M) and the analysis of surplus account (formerly schedule L). Invested Capital The general provisions relating to the computation of in- vested capital have been considered in earlier chapters of this volume so far as they affect a separate corporation ; it is there- fore necessary in this place to deal only with the points espe- cially applicable to consolidated returns. Reorganization subsequent to March 3, 1917. — Law. Section 331. In the case of the reorganization, consoli- dation, or change of ownership of a trade or business, or change of ownership of property, after March 3, 191 7, if an interest or control in such trade or business or property of 50 per centum or more re- mains in the same persons, or any of them, then no assets transferred or received from the previous owner shall, for the purpose of deter- mining invested capital, be allowed a greater value than would have been allowed under this title in computing the invested capital of such previous owner if such asset had not been so transferred or received: Provided, That if such previous owner was not a corpora- tion, then the value of any asset so transferred or received shall be taken at its cost of acquisition (at the date when acquired by such previous owner) with proper allowance for depreciation, impairment, betterment or development, but no addition to the original cost shall be made for any charge or expenditure deducted as expense or other- wise on or after March i, 1913, in computing the net income of such previous owner for purposes of taxation. Regulation. Where a business is reorganized, consolidated or transferred, or property is transferred, after March 3, 1917, and an interest of 50 per cent or greater in such business or property re- mains in any of the previous owners, then for the purpose of deter- mining invested capital each asset so transferred is valued (a) as if still in the possession of the previous owner, if a corporation, or, if not a corporation, (6) at its cost to such previous owner, with proper adjustments for losses and improvements. This provision is accordingly concerned with the computation of invested capital for the taxable year, while section 330 of the statute is chiefly concerned with the determination of invested capital for the prewar period. .... (Art. 941.) 3i8 EXCESS PROFITS TAX PROCEDURE Stock of subsidiary acquired for cash. — Regulation. When all or substantially all of the stock of a subsidiary corporation was acquired for cash, the cash so paid shall be the basis to be used in determining the value of the property ac- quired. (Art. 867.) The 1 91 7 regulations were brought into line with the above article by T. D. 2901 published in bulletin 20-19-518. Stock of subsidiary acquired for stock. — Regulation. Where stock of a subsidiary company was acquired with the stock of the parent company, the amount to be included in the consolidated invested capital in respect of the company acquired shall be computed in the same manner as if the net tangible assets and the intangible assets had been acquired instead of the stock. If in accordance with such acquisition a paid-in surplus is claimed, such claim shall be subject to the provisions of article 837. (Art. 868.) In order to reflect correctly the financial position of the group and to comply with the above regulation, it is jnecessary that the cash value at the date of acquisition of the assets of the subsidiary be ascertained and that adjustment be made be- fore consolidation. This may result in a paid-in surplus, proof of which will be required under article 837. Should a revalua- tion of assets show that the stock of the subsidiary is held by the parent at a value higher than the revalued net worth, the difference should be treated in the consolidation as a debit to goodwill. Intangible property paid in. — Regulation, (i) In respect of corporations whose affiliation is in the nature of parent and subsidiary companies: (o) in the case of intangible property bona fide paid in for stock or shares prior to March 3, 1917, there may be included in invested capital an amount not exceeding the actual cash value of such property at the time paid in, or the par value of the stock or shares issued therefor, or in the aggregate 25 per cent of the par value of the total stock or shares- of the consolidation outstanding on March 3, 1917 (deter- mined as indicated in items (a) and (c) in article 864),° or in the "See page 305. CONSOLIDATED RETURNS 319 aggregate 25 per cent of the par value of the total stock or shares shown on the consolidated balance sheet, being the amount of the capital stock included in items (a) and (c) in article 864 at the be- ginning of the taxable year, whichever is lowest; and (6) in the case of intangible property bona fide paid in for stock or shares on or after March 3, 19 17, there may be included in invested capital an amount not exceeding the actual cash value of such property at the time paid in, or the par value of the stock or shares issued therefor, or in the aggregate 25 per cent of the par value of the total stock or shares shown by the consolidated balance sheet, being the amount of the capital stock included in items (a) and (c) in article 864 out- standing at the beginning of the taxable year, whichever is lowest. (c) When intangible property has been acquired in part before and in part after March 3, 1917, the amounts shall be ascertained, re- spectively, under (a) and (&) above and in the aggregate shall in no case exceed 25 per cent of the par value of the total stock or shares outstanding at the beginning of the taxable year shown in the consolidated balance sheet, being the amount of the capital stock included in items (a) and (c) in article 864. (2) In respect of corporations affiliated by reason of ownership by the same interests, the limitations set forth in paragraphs (4) and (5) of subdivision (a) of section 326 of the statute shall be applied to each corporation separately and the aggregate of the in- tangible property, so valued, shall be included in invested capital in the consolidated return. In respect of each of the affiliated corpora- tions the aggregate of the amounts ascertained under the provisions of paragraphs (4) and (5) shall in no case exceed 25 per cent of the outstanding capital stock of such corporation at the beginning of the taxable year. (Art. 865.) It should be noted that when intangible assets were ac- quired before March 3, 191 7, the limitation of 25 per cent applies to the stock of the parent company in the hands of the public, plus the .stock of affiliated corporations not owned by parent company at March 3, 1917, or the limitation applies to the par value of the total stock shown on consolidated bal- ance sheet at beginning of taxable year, whichever is lower. If intangible assets were acquired after March 3, 191 7, the Hmitation applies to the amount at the beginning of the taxable year as above stated. If acquired in part before March 3, 1917, and in part after that date, the amount admis- sible is determined by the two calculations respectively. Special attention should be paid to paragraph (2) which 320 EXCESS PROFITS TAX PROCEDURE provides lur different procedure for corporations owned by the "same interest." This special provision is discriminatory and difficult to justify. As a result of the above limitations on the value of intan- gible assets permitted for inclusion in invested capital, it is sometimes desirable that corporations be required to consoli- date. If a parent company has intangible assets held at a book value of more than 25 per cent of its capital stock and if it has a majority (but not 100 per cent) interest in subsidiaries hav- ing no goodwill of their own, consolidation will permit the inclusion of additional intangible assets by the group to the extent of 25 per cent of the minority stock interest. Again, if a subsidiary has intangible assets carried at more than 25 per cent of its capital stock, but such intangible assets are not in excess of 25 per cent of the parent company's stock, there will be an advantage from consolidation if the parent has no intangible assets or has an amount less than 25 per cent of its capital stock by the excess of such intangibles over 25 per cent of the subsidiary's capital stock. To illustrate, assume that a subsidiary had intangibles of $100,000 and capital stock of $120,000, only 25 per cent of $120,000 or $30,000 of in- tangibles would be allowed. If the subsidiary consolidated with another corporation which had capital stock of $400,000, and no intangibles, the full amount of the subsidiary's in- tangibles of $100,000 would be allowed, since it would n6t exceed 25 per cent of the capital stock shown on the consoli- dated balance sheet, viz., $400,000. In other cases consolidation will result in a loss, as, for example, when the intangible assets of the parent are greater than 25 per cent of its capital stock plus that of the minority interest in the group, presuming that some subsidiary has in- tangibles that would be allowed were separate returns to be made. The justification in all cases is that the Treasury is at- tempting to tax the profit of a single business enterprise and is therefore no more interested in what would happen were CONSOLIDATED RETURNS 321 the integral parts assessed separately than it is in the internal organization of a separate corporation with several factories. Inadmissible assets of affiliated corporations. — Regulation. Where adjustment 'is required in respect of in- admissible assets in accordance with the provisions of subdivision (c) of section 326 of the statute, such adjustment shall be made on the basis of the consolidated balance sheet with due regard to the adjustments and eliminations set forth in articles 864 and 865 and to the provisions of articles 815-818. (Art. 866.) Chapter IX, on "Inadmissible Assets," appHes in general to affiliated corporations. For the purpose of computing the deduction for inadmissible assets, the consolidated balance sheet of course will be used. It will not be necessary to in- clude stock of subsidiary corporations owned by the parent company as inadmissible assets because such stock will have been eliminated in the preparation of the consolidated balance sheet. It should be observed in passing that there is no discrimi- nation in the computation of inadmissible assets of corpora- tions owned by the same interests as there is in the computa- tion of intangible assets in article 865 (2). Sales by subsidiary to parent. — Sales from a subsidiary company to a parent company, or vice versa, are intercompany transactions and are to be eliminated in preparing federal tax returns. If the property transferred has declined in value because of depreciation or obsolescence, the loss should be taken up on the subsidiary's books before transfer. This revaluation of the asset will then be reflected in the consoli- dated return. Operating deficit of subsidiary. — Regulation. Capital or surplus actually paid in is not required to be reduced because of an impairment of capital in the nature of an operating deficit, except where there has been directly or indi- rectly a liquidation or return of their investment to the stockholders, 322 EXCESS PROFITS TAX PROCEDURE in which case full effect must be given to any liquidation of the origi- nal capital. (Art. 860.) In the ordinary preparation of a consolidated balance sheet the operating deficit of one company is offset against the profit of another, the result being that the final net surplus is not the sum of the profits of the group but is the profits less the losses. This results in reducing the consolidated invested capital to a sum below what it would be were operating deficits ignored as in the case of separate corporations. It should be remembered, however, that the object of a consolidated return is to tax the group as a whole; even a separate corporation could not get relief for the loss in a particular department but only for its final and net loss. Should a consolidation show a net operating loss^ article 860 would apply to the consohdation. As an example of the alleged inequity of the disallowance of the deficit of an affiliated corporation, let us consider the following hypothetical consolidation: A B Consolidation Assets $100,000.00 $100,000.00 $200,000.00 Liabilities $ 50,000.00 $ 70,000.00 $120,000.00 Capital Stock 40,000.00 40,000.00 80,000.00 Surplus 10,000.00 10,000.00 $100,000.00 $100,000.00 $200,000.00 The invested capital of A, independently, is $50,000 and that of B, $40,000 (the deficit of $10,000 being ignored) — a total of $90,000. If, however, these two corporations were owned by the same interests and a consolidated return were therefore required, the invested capital permitted would be only $80,000 — an apparent loss of $10,000. But it must be repeated that the tax law is trying to assess on the basis of the ownership group, not on the aggregate of individual corporations, arid as such the deficit of B must be offset against the surplus of A. Had A, however, had lia- bilities of $70,000 and a deficit of $10,000, its invested capital would have been $40,000, and the consolidation would not CONSOLIDATED RETURNS 323 have reduced the aggregate invested capital of A and B which would be $80,000. Distribution of the tax among the subsidiaries. — Law. Section 240. (a) .... In any case in which a tax is assessed upon the basis of a consolidated return, the total tax shall be computed in the first instance as a unit and shall then be assessed upon the respective affiliated corporations in such proportions as may be agreed upon among them, or, in the absence of any such agree- ment, then on the basis of the net income properly assignable to each Ruling. In connection with the assessment and payment of in- come and profits taxes of affiliated corporations, the opinion appar- ently prevails among taxpayers that the tax must be assessed against and paid by each corporation within an affiliated group. Unless a subsidiary has made a payment, the Bureau greatly prefers that the parent or principal reporting corporation take up and pay the entire tax, making any desired adjustment thereof by charging the affiliated corporations through their own records. The amount reported by the subsidiary in answer to question 9, form 1 122, will be used as the basis for assessment and payment. If the subsidiaries have reported an apportionment in this manner, but the parent corporation has paid the tax instalments on account of such subsidiaries, an amended form 1122 showing "none" in answer to question 9, should be filed. If the last condition obtains, but the taxpayer insists upon apportionment, the collectors of the subsidiary's district will request abatement of such portion of the subsidiary's tax as may have been previously paid by the parent corporation in another district. As a basis for such advice, the latter collector will secure from the parent corporation a schedule showing apportionment of the total tax and instalments to the respective affiliated corporations. If a subsidiary has filed a tentative return and paid an instalment of the tax, it should be assessed the amount shown on form 1122, and will pay future instalments as they fall due. (I. T. — Mim. 2221, August 8, 1919.) Treatment of tax overpaid in previous years. — Bulletin 41-20-1237; O. D. 683, contains a ruling on this subject, in which the Treasury virtually considers the subsidiary's tax as directly assessed and thus subject to credit or refund for previ- ously overpaid taxes as if it were a separate corporation.' 'See Income Tax Procedure, 1921, page 228. 324 EXCESS PROFITS TAX PROCEDURE Taxable year when affiliated corporations have different fiscal years. — Regulation. In the case of all consolidated returns, consoli- dated invested capital must be computed as of the beginning of the taxable year of the parent or principal reporting company and consolidated income must be computed on the basis of its taxable year. Whenever the fiscal year of one or more subsidiary or other affiliated corporations differs from the fiscal year of the parent or principal corporation, the Commissioner should be fully advised by the taxpayer in order that provision may be made for assessing the tax in respect of the period prior to the beginning of the fiscal year of the parent or principal company. (Art. 638.) Ruling. In any case where an affiliated corporation has made its income tax return on the basis of a taxable year different from that on the basis of which a consolidated excess profits tax return in which it is included has been made under the provisions of articles yj and 78 of Regulations 41 and T. D. 2662, an amended income tax return may be made on the basis of the same taxable year as the consolidated return, even though notice was not given within the time prescribed in articles 211 to 215. In such a case an amended income tax return shall also be made for any unaccounted for portion of the corporation's taxable year. Collectors of internal revenue may accept returns made under the provisions of this Treasury decision. (T. D. 2805, March 14, 1919.) The manner in which the adjustment shall be made to cover the fraction of the subsidiary's fiscal year is indicated in the following letter : Ruling. "A corporation owns all the capital stock of another corporation. The corporation owning the capital stock makes its income tax return on fiscal year basis ending March 31, 1919 — the other corporation makes its income tax return on calendar year basis ending December 31 The question therefore arises as to the return for the three-month period of the corporation whose fiscal year ends December 31, and it appeared to us that if your ruling would be to the effect that the return should be made on the basis of the fiscal year of the parent corporation, such corporation being the corporation holding 95 per cent of the stock of the second corpora- tion, that there should be a return made for the corporation whose year ended December 31 for the period between December 31, 1917, and March 31, 1918, and then a consolidated return made for the year March 31, 1918, to March 31, 1919. The corporation whose taxable year ends December 31 and whose stock is held by corpora- tion having its taxable year end March 31 is a public service cor- CONSOLIDATED RETURNS " 325 poration. I assume from letter of Acting Commissioner J. H. Callan to The Corporation Trust Company, dated April 17, 1919, that it would make no difference whether one or both corporations were public service corporations and they would not be taken out of the class of affiliated corporations because of that fact "On the foregoing state of facts will you, therefore, wire us: First: Should there be a consolidated return filed? Second: Shall the corporation whose taxable year ends December 31 file an income tax report for the period between December 31, 1917, and March 31, 1918? Third: Should the taxpayer file a statement giving the rea- sons for filing the return for the period between December 31 and March 31?. Fourth: In computing the normal tax on income for the three-month period should the exemption be $500, one-fourth of the $2,000 allowed, under section 236? Fifth: If the company whose stock is owned by the principal company is a public service corpora-- tion would a consolidated return be required?" (Answer to above inquiry.) Consolidated return including parent and fully owned public service subsidiary corporation should be filed for fiscal year parent ended March 31, 1918. Tax is computed in first instance on basis of twelve-month period ended March 31, 1918, with full deductions under Revenue Act of 1918 and then prorated. With return file complete statement facts. (Letter of inquiry from The Cleveland Trust Company, Cleveland, Ohio, and the answer thereto, signed by Acting Commissioner J. H. Callan, and dated May 20, 1919.) Only one excess profits credit allowed. — Regulation In the case of affiliated corporations making a consolidated return only one specific exemption of $3,000 is allowed. .... (Art. 791.) Reconciliation of consolidated surplus. — In the prepara- tion of that part of schedule L of form 1120, relating to sur- plus account, the author recommends using a similar method to that suggested on page 316 for that part of schedule L relating to income. A separate reconciliation of surplus for each company should be made and the whole set should then be consolidated, eliminating any intercompany items. The result will be the consolidated reconciliation. Returns for 1918 As the Treasury has not yet audited the returns of all cor- porations for 19 18, and as appeals have been taken on some 326 -EXCESS PROFITS TAX PROCEDURE which have been audited, it is imperative that some attention be devoted here to the spetial problems concerning 191 8 returns. The chief difference between 19 18 and later years is that in the former year the war profits tax with all the problems of pre- war income and invested capital was in existence, whereas it was eliminated for 1919 and subsequent years, excepting as to income derived from government contracts. For this rea- son most of the comments at this point will deal with phases of the war profits tax. It .should be remembered, in passing, that the conditions precedent to consolidated returns were the same in 1918 as at present. Only one specific exemption allowed on war profits credit. — Regulation. In the case of affiliated ' corporations making a consolidated return only one specific exemption of $3,000 is allowed. (Art. 785.) War profits credit when there was no pre-war period. — Section 311 (d) states that in the case of any corporation which was not in existence during the whole of at least one calendar year during the pre-war period, if a majority of its stock at any time during the taxable year is owned or con- trolled; directly or indirectly, by a corporation which was in existence during the whole of at least one calendar year during the pre-war period, then the war profits credit shall be the sum of: (i) a specific exemption of $3,000; and (2) an amount equal to 10 per cent of the invested capital for the taxable year. Similar is the provision of the regulations : Regulation. If a corporation had no prewar period, but (a) if a majority of its stock at any time during the taxable year was owned or controlled by a corporation which was in existence during the whole of at least one calendar year during the prewar period .... then the war profits credit is to be determined as provided in article 782 instead of in the manner provided in article 783 (Art. 784.) CONSOLIDATED RETURNS 327 Pre-war invested capital. — In order to determine a just basis of comparison between the earnings of pre-war years and 19 18, the regulations provide as follows: Regulation. The invested capital of affiliated corporations for the prewar period shall be computed on the same basis as the invested capital for the taxable year, except that where any one or more of the corporations included in the consolidation for the taxable year were in existence during the prewar period, but were not then affili- ated as herein defined, then the average consolidated invested capital for the prewar period shall be the average invested capital of the corporations which were affiliated in the prewar period plus the aggregate of the average invested capital for each of the several corporations which were not affiliated during the prewar period. Full recognition, however, must be given to the provisions of section 330 of the statute, particularly the last paragraph thereof, and of articles 931-934. (Art. 869.) Law. Section 330 If any asset of the trade or business in existence both during the taxable year and any prewar year is included in the invested capital for the taxable year but is not in- cluded in the invested capital for such prewar year, or is valued on a dififerent basis in computing the invested capital for the taxable year and such prewar year, respectively, then under rules and regu- lations to be prescribed by the Commissioner with the approval of the Secretary such readjustments shall be made as are necessary to place the computation of the invested capital for such prewar year on the basis employed in determining the invested capital for the taxable year. It will be observed that special emphasis is placed on the requirement that the computation of the pre-war invested cap- ital shall be "on the same basis as the invested capital for the taxable year" and that "such readjustments shall be made as are necessary to place the computation of the invested capital for such pre-war year on the basis employed in determining the invested capital for the taxable year." This basic principle is just, but it is sometimes difficult to decide the exact procedure which will give the required result. The latter half of article 869 deals with the problem of a group of companies affiliated for the purpose of the 1918 law, which were not affiliated in the pre-war period. To make a true comparison we should treat the unaffiliated corporations in the 328 EXCESS PROFITS TAX PROCEDURE pre-war years as if affiliated and prepare a consolidated re- turn. Here we are confronted by the problem of how to pre- pare a consolidated statement if there were no intercompany relations. It is possible to imagine that the same relationship existed before the war as in the taxable year and to eliminate on the same basis. All sorts of problems might arise if an attempt were made to proceed in this way, so the framers of Regulations 45 used the more definite method of combining the separate invested capitals of the unaffiliated corporations in the pre-war years. This method gives a fair basis of comparison, but it is significant that a liberal interpretation of the "same basis as the invested capital for the taxable year" is necessary and is sanctioned by the regulation. When we consider the converse of the proposition — a set of unaffiliated corporations in 19 18 some of which in the pre- war years came within the present classification of affiliated corporations — the law and regulations give us no help what- ever, excepting the guiding principle in the last paragraph of section 330 of the law. This was well stated as follows :^ From an ideal standpoint it would be desirable to state the pre- war invested capital on the same basis as for the taxable period, i.e., eliminating from the pre-war figures those of the subsidiary which is no longer in the group. The elimination of the pre-war income of the subsidiary would be a simple matter but not so as to the invested capital. What corre- sponding elements are to be eliminated from the parent company's balance sheet when ehminating the investment in the subsidiary ? Is an amount corresponding to the investtpent in the subsidiary to be eliminated from the capital stock and surplus of the parent company? Or, is the elimination to be made from the liabilities of the parent company, on the assumption that the proceeds of the sale or disso- lution of the subsidiary have in effect been used to reduce the parent company's liabilities? Or, are the proceeds simply to be considered as increasing the current assets of the parent company? Each of 'Walter A. Staub, "Consolidated Returns," Columbia University Lec- tures, The Federal Income Tax. CONSOLIDATED RETURNS 329 these methods would have a different effect on the consohMated in- vested capital. Any one of the above mentioned methods offers difficulties in applying it. From a practical standpoint, it would seem best not to attempt to eliminate the subsidiary in determining the pre-war in- vested capital of the group and to allow the adjustment to come through that section of the law which provides that in determining the war profits credit there shall be added or deducted from the average pre-war income "10 per centum of the difference (increase or de- crease, respectively) between the average invested capital for the pre-war period and the invested capital for the taxable year."^ Adjustment for asset differently valued in pre-war in- vested capital. — Regulation. In any case in which as a result of a reorganiza- tion or for any other reason any asset in existence both during the taxable year and any prewar year is included in computing the in- vested capital for the taxable year, but is not included in computing the invested capital for such prewar year, or is valued on a different basis in computing the invested capital for the two years, the differ- ence resulting therefrom shall not be included in determining the difference 10 per cent of which is added to or deducted from the war profits credit under section 311 (a) (2) of the statute. In any such case the corporation shall make the readjustment required by the statute, and shall submit with its return a full statement of the differ- ence in such valuations and of the facts which give rise to such dif- ference. See also section 331 and article 941. (Art. 934.) Pre-war period reorganization. — Law. Section 330. That in the case of the reorganization, con- solidation, or change of ownership after January i, 191 1, of a trade or business now carried on by a corporation, the corporation shall for the purposes of this title be deemed to have been in existence prior to that date, and the net income and invested capital of such predecessor trade or business for all or any part of the prewar period prior to the organization of the corporation now carrying on such trade or business shall be deemed to have been the net income and invested capital of such corporation. If such predecessor trade or business was carried on by a partner- ship or individual the net income for the prewar period shall, under regulations prescribed by the Commissioner with the approval of the Secretary, be ascertained and returned as nearly as may be upon the same basis and in the same manner as provided for corporations "Section 311 (a-2). 330 EXCESS PROFITS TAX PROCEDURE in Title H, including a reasonable deduction for salary or compensa- tion to each partner or the individual for personal services actually rendered. Regulation. The first two paragraphs of section 330 of the statute relate only to the prewar period and not to the invested capital or net income for the taxable year. Under their provisions in the case of a reorganization, consolidation or change of ownership, the corporation is regarded as having been in existence prior to the date of such reorganization, consolidation or change in ownership, and the net income and invested capital of the predecessor trade or busi- ness for all or any part of the prewar period prior to the organization of the present corporation are deemed to have been the net income and invested capital of such corporation. (Art. 931.) Pre-war net income of affiliated corporations. — Regulation. The consolidated net income of affiliated corpora- tions for the prewar period shall be the average consolidated net in- come for the prewar years of such of the several corporations included in the consolidation for the taxable year as were affiliated during the prewar period, plus the aggregate of the average net income for each of the corporations not affiliated during the prewar period which were in existence during all of the prewar period or during at least one full year within the prewar period. The net income of a subsidiary cor- poration organized during the prewar period by an existing corpora- tion shall also be included. See also sections 240 and 330 of the statute and articles 631-638 and 931-934. (Art. 802.) CHAPTER XV INVESTED CAPITAL IN SPECIAL CASES "THE RELIEF SECTIONS" In the most favorable conditions a tax which utiHzes capital values is apt to cause inequalities, even though there be agreement between taxing authorities and taxpayers as to the basis of determining what is and what is not capital. But if no such agreement is possible because many taxpayers are unable to furnish trustworthy information regarding their own capital values, the government on its part cannot lay down rules for the determination of capital which will work even approximate justice in many cases. Taxpayers frequently are not at fault in their inability to supply information which can readily be measured by the yard- stick used for the measurement of the capital of other tax- payers. Until 19 1 7 no controlling reason existed for the placing of specific values upon assets. One manufacturer might have written down the value of his plant on his books to $1 — and he was commended for his sound and conservative business methods. Another manufacturer might reappraise all his assets at the highest possible valuation, appraise his good- will at a very high value and sell out to a corporation, owned by himself, on the basis of the high values. Such a man was not regarded as conservative, but neither was he regarded as unsound. Under the 191 7 law, literally interpreted, the conservative man was penalized; the other was favored. In other words, the law flew in the face of sound business methods and placed a premium upon overvaluations. The legal status of the regulations under the 1917 law is an interesting one. Unquestionably the regulations are more liberal than the law itself. Such being the case it is hardly 331 332 EXCESS PROFITS TAX PROCEDURE probable that a taxpayer would appeal from a decision of the Commissioner, unless it were felt that rehef as defined by the regulations had been refused. But could it be expected that the courts would follow the regulations, rather than the law itself? Precedents say not. Courts are supposed to i'titerpret laws. In the case of the excess profits tax, however, there is a strong chance that the courts will follow the Commissioner's lead as to the mysterious section 210, and from there to the regulations, and thus will protect and confirm every tax- payer's right to relief as set forth in the regulations. The 19 18 law has removed part of the differential in favor of the overcapitalized corporation, but there will always re- main many isolated inequalities which no law, general in its application, can avoid. Method of invoking relief sections. — It cannot be expected that taxpayers will be permitted to file returns in which is reflected the relief which is claimed. While as a matter of right taxpayers can take advantage of the provisions of the law which extend relief under certain conditions, the deter- mination of the measure of relief is specifically left to the Commissioner. Therefore returns in the first instance must accord as nearly as possible with the sections of the law which deal with usual cases, and the taxpayer must await the action of the Committee on Appeals and Review and the Commis- sioner before definite assurance can be obtained that the final amount of tax to be paid will be no more than the taxpayer believes to be correct. To some extent, however, the taxpayer in 19 19 was re- lieved from being required to pay the full amount of the tax which would have had to be paid if his return were prepared without the benefit of the relief sections. The law provides that if the tax is computed without taking into consideration the relief sections and it amounts to more than 50 per cent of the net income of the taxpayer, no tax greater than 50 per cent need be paid unless and until the claim for relief is heard INVESTED CAPITAL— RELIEF SECTIONS 333 and determined. This means that the first instalment payable was approximately 14 per cent of the taxpayer's net income. It is to be noted that reference is here made to the war and excess profits tax and not to the income tax. In addition to 50 per cent of the income, taken in the first instance as the estimated amount of the excess profits tax, there must be included an allowance for income tax on the balance of the total income, since the war and excess profits tax is a deduc- tion from net income before calculating income tax. Conse- quently for the calendar year 19 19, the first instalment to be paid would be one-quarter of 55 per cent of the total net in- come. If in 1919 a corporation was sure that its total tax for the calendar year 19 18 would be less than 56 per cent of its income it was permissible to make an initial payment of one- quarter of the tax as estimated, and file a claim for abate- ment of the difference between such payment and one-quarter of 56 per cent. The latter procedure was followed only by those corpora- tions which had been granted relief in former years, or when trustworthy information as to taxes paid by competitive con- cerns, etc., was at hand. Article 913^ suggests that when relief was granted under section 210 of the 191 7 law, the first instal- ment of the tax should be based on the constructive capital allowed. The foregoing procedure is of interest in 1921 only to corporations subject to the war profits tax (government con- tracts) because under the excess profits tax the amount pay- able in any event would not amount to 50 per cent. Law. Section 328. (b) .... In cases in which the tax is to be computed under this section, if the tax as computed without the benefit of this section is less than 50 per centum of the net income of the tax- payer, the installments shall in the first instance be computed upon the basis of such tax; but if the tax so computed is 50 per centum or more of the net income, the installments shall in the first instance be computed upon the basis of a tax equal to 50 per centum of the net income. In any case, the actual ratio when ascertained shall be 'See page 336. 334 EXCESS PROFITS TAX PROCEDURE used in determining the correct amount of the tax. If the correct amount of the tax when determined exceeds 50 per centum of the net income, any excess of the correct installments over the amounts actually paid shall on notice and demand be paid together with in- terest at the rate of J4 of I per centum per month on such excess from the time the installment was due. It is expected that the taxpayer in presenting his claim for relief will not merely state that an injustice will be done if he does not receive relief under sections 327 and 328 (see pages 339, 348). The claim should be complete and be supple- mented by evidence sufficient to enable the examiners in Wash- ington to study the case on its merits. If the case as sub- mitted is not deemed to contain sufficient information the taxpayer will undoubtedly have a right to be heard in person or by attorney, either at his own request or upon notice that the papers submitted are an insufficient basis for claim. The provision in the law which protects a taxpayer in his right to have his questions considered by the Advisory Board does not specifically require the board to conduct oral hearings.^ The successor to the board (the Committee on Appeals and Re- view) follows the procedure usually observed by similar boards and grants oral hearings. Method of payment of tax for 1920 when relief is ex- pected. — When taxpayers are reasonably sure that the maxi- mum graduated rates for 1920 will not be assessed because of exceptional circumstances or when relief has been grantee^ for previous years, it is possible to pay the first instalment on a basis which it is believed will be the maximum assessed and file claim for abatement for the difference between the amount paid and the amount which would be payable if section 328 were not invoked. Assume that a corporation applied for relief for 1919 and the final assessment was equivalent to 30 per cent of the net income. Assume net income of $100,000 on which the in- ^Section 1301 (d-2). INVESTED CAPITAL— RELIEF SECTIONS 335 come and profits tax computed under section 301 would be $38,000. It would be reasonable to assume that the final as- sessment under section 328 would not exceed $30,000; there- fore the first instalment should be $7,500 and a claim for abatement for $8,000 should be filed with the return and claim for relief. If no relief was granted in previous years or if claims for relief for previous years are still pending the same course can be followed, but the amount to be paid will have to be estimated upon a fair and reasonable basis. If the final assessment is more than the estimate, interest will have to be paid, commencing with the due date of the first instalment. Statement to be filed when relief is requested. — Regulation. In the cases specified in section 327 of the statute the tax will be specially determined under the provisions of section 328, but the tax will not ordinarily be computed under section 328 merely because the corporation's form or manner of organization, or the limitations imposed by section 326, result in a greater tax than would otherwise be payable. A corporation which comes within the provisions of subdivision (d) of section 327 may make application for assessment under the provisions of section 328, which applica- tion shall be attached to its return in the form of a statement setting forth in full: (a) the reasons why the tax should be so determined; (fc) the facts upon which such reasons are based; (c) an exact de- scription of each trade or business or important branch of a trade or business carried on by it; (d) a statement of the invested capital and net income for each year since the beginning of the prewar period; and (e) a statement showing the amount of gains, profits, commissions or other income derived on a cost plus basis from Gov- ernment contracts made after April 5, 1917, and before November 12, 1918, and showing the per cent which such income is of the total income of the corporation (Art. 901.) Determination of first instalment of the tax in special cases. — Regulation. In the case of any corporation, other than a for- eign corporation, where absolutely no data are available for the determination of the invested capital for the taxable year, the in- stallments of the tax shall in the first instance be determined upon the basis of a war profits and excess profits tax equal to 50 per cen' of the net income. In any other case under section 328 of the statute, 336 EXCESS PROFITS TAX PROCEDURE other than the case of a foreign corporation, but including a case where the invested capital for the taxable year can not be accurately determined, but where a minimum amount of invested capital as to which there is no question can be determined, the installments shall in the first instance be determined upon the basis of a war profits and excess profits tax computed by using the minimum invested cap- ital, such tax not to exceed an amount equal to 50 per cent of the net income. (Art. 912.) In spite of the lower rates now in force the foregoing article has not been amended. Therefore for procedure in 1 92 1, seepage 334. Determination of first instalment of tax in the CASE of foreign CORPORATION. Regulation. In the case of a foreign corporation the install- ments of the tax shall in the first instance be determined upon the basis of a war profits and excess profits tax computed by using its invested capital for the taxable year 191 7, such tax not to exceed an amount equal to 50 per cent of the net income. For the purpose of this article the invested capital for 1917 shall be adjusted for any subsequent changes in its amount due to cash or property paid 'in or withdrawn or to surplus or undivided profits of prior years retained in the business and properly attributable to its business within the United States. If the tax for 19 17 was determined under section 210 of the Revenue Act of 1917, the constructive capital which would result in a tax equivalent to the tax determined under that section shall be used. (Art. 913.) Ruling. The installments of the tax for 1919 of a foreign cor- poration shall be determined upon the basis of an excess profits tax computed by using its invested capital for the taxable year 1917 properly adjusted by reason of subsequent changes. Because of the provisions of section 302 this tax can in no case be more than 20 per cent of the amount of the net income in excess of $3,000 and not in excess of $20,000, plus 40 per cent of the amount of net income in excess of $20,000. Final determination of the tax will be made according to the provisions of sections 327 and 328. (B. 6-20-735; O. D. 402.) If a foreign corporation beHeves that its total tax for 1920 will be less than at the graduated rates under section 301, the procedure suggested on page 334 should be followed. It should be noted that foreign corporations are not entitled to the $3,000 exemption. INVESTED CAPITAL— RELIEF SECTIONS 337 Payment of tax in special cases. — Regulation. In any case falling under the last two articles the installments shall be paid upon the basis therein provided until the Commissioner notifies the corporation of the amount of tax computed under section 328. The installments shall then be re- computed upon the basis of a war profits and excess profits tax of such amount, and if the amount already paid is less than the amount which would have already become due if the installments had origi- nally been computed upon that basis, the additional amount shall be due and payable ten days after notice and demand from the col- lector (Art. 914.) Claims for abatement when relief not determined at date instalment is due. — The following rulings hold that if claims for relief were made subsequent to the original return, claims for abatement must be filed. Ruling. In cases where application has been made at the time of filing the return for assessment of war profits and excess profits tax in accordance with section 328, Revenue Act of 1918, and the installments of tax determined and assessment made on the basis of 50 per cent of the net income for the taxable year, no abatement claim is required to cover the difference between the tax so computed and the tax computed without the benefit of section 328. If the tax has been computed and assessment made without reference to section 328, and application is made subsequently for assessment of the tax in accordance with section 328, payment of the entire tax as originally computed will be required unless a claim is filed for the abatement of the amount assessed in excess of 50 per cent of the net income. (B. 31-19-655; O. D. 356.) Claims for relief may be filed within five years. — The fore- going ruling gave rise to an erroneous conclusion that corpo- rations which desired to seek rehef for the calendar year 1918 under sections 327 and 328 of the 1918 law were required to file their claims prior to December 15, 1919. There is no justi- fication for such assumption under the rulings or in the law. Taxpayers desiring to make claims for refunds may do so at any time within five years from the date when the return in question was due.^ ^Section 252. See Income Tax Procedure, 1921, page 212. 338 EXCESS PROFITS TAX PROCEDURE Conditions Under Which Relief May be Obtained General scope of relief sections. — ^As already stated, a revenue law cannot be made elastic enough to deal with un- usual problems. It is, however, possible to delegate to admin- istrative officers power to issue regulations which are more comprehensive than a law can be and further to delegate to the same or other administrative officers power to modify the regulations when the circumstances of an individual case call for individual treatment. In referring to the so-called relief amendment to the 191 8 revenue bill as originally drafted by the House, Senator Simmons said in the Senate : The general opinion of the conferees and of the Department, and I concur in that opinion, is that the amendment as redrafted broadens rather than restrains the powers of the Commissioner in the matter of relief against injustice, inequality, and discrimina- tion They [referring to the business interests of the country] may know that there is some provision here by which the Commissioner can help them in case of difficulties of the kind I have described, but I do not think they have yet come to realize the breadth of the dis- cretion which is lodged in the Commissioner in this amendment and what it may be worth to them under the conditions which now con- front us.* Statement by the Commissioner.- — Confirming the in- tention of Congress to extend relief in meritorious cases the Commissioner made the following statement in his 1919 report. [The law provides] an alternative method of tax computation to be applied, at the discretion of the administrative authority, in cases in which abnormal conditions with respect to capital or income of a corporation would result under the ordinary method of tax com- putation provided by the law in exceptional hardship on account of a tax liability grossly disproportionate to the tax liability of other corporations engaged in the same line of business and similarly cir- cumstanced with respect to business operations. Such conditions have been found in the cases of business con- ducted on abnormally small amounts of invested capital but large amounts of borrowed money; businesses realizing income arising out of intangible assets excluded under the ordinary items of income representing the reward of effort carried on through a number of 'February 11, 1919, Congressional Record, page 3776. INVESTED CAPITAL— RELIEF SECTIONS 339 prior years ; and businesses sustaining losses on account of amortiza- tion, obsolescence, or depreciation of character not recognized by other provisions of the law. The effect of these several equitable provisions necessarily was to complicate the interpretation and administration of the law, be- cause it became necessary, in the case of every return of income or profits, for the taxpayer to consider whether special circumstances warranted the application of the relief provisions. On the other hand, the Bureau was under the necessity of advising taxpayers as to their rights in these respects and of reviewing and passing upon the claimi based on the relief provisions. General authority for relief appeals. — Law. Section 327. That in the following cases the tax shall be determined as provided in section 328: (a) Where the Commissioner is unable to determine the invested capital as provided in section 326 ;'' This clause may be used as general permission to apply for relief if none of the particular reasons hereinafter enumerated specifically cover the inequality of a particular case. Abnormal conditions may entitle a taxpayer to relief. — Conditions occur in almost every concern which seem to justify the term "abnormal" but most of these abnormal conditions result in a decline of profits. Abnormal profits occur more rarely, and no relief can be claimed from the imposition of the tax upon such profits unless "an exceptional hardship" would fall upon the corporation, because of a "gross disproportion" between the tax which would be imposed by the other sections of the law and the rate of tax paid by representative' corpora- tions in the same line of business. Law. Section 327. (d) Where upon application by the corpora- tion the Commissioner finds and so declares of record that the tax if determined without benefit of this section would, owing to abnormal conditions affecting the capital or income of the corporation, work upon the corporation an exceptional hardship evidenced by gross dis- proportion between the tax computed without benefit of this section and the tax computed by reference to the representative corporations specified in section 328 'Section 326 defines invested capital, both tangible and intangible, and refers to inadmissible assets and to borrowed money. 340 EXCESS PROFITS TAX PROCEDURE Illustrations of "abnormal conditions/' — When re- lief is invoked for the year 1918 pre-war earnings are an im- portant factor. In the spring of 191 3 (one of the pre-war years) a flood practically submerged Indianapolis, Dayton and other cities in that section of the country, and earnings of many concerns were cut off entirely. During 191 7 and 19 18 large book profits were realized by certain corporations from the enforced sale or commandeering of ships or property useful for war purposes. These profits arose from the disposition of capital assets. Not only were such profits abnormal but because of them corporations were prevented from continuing existing profitable businesses. In such cases corporations could establish replacement funds but it was not always possible or feasible to do so. In some cases litigation extending over a period of years terminated in 1918, and during that year large profits were shown which did not have the shghtest relation to the war period and were abnormal in every sense of the word. Obviously ho general rule can be laid down, because, if general rules can be applied, conditions to which such rules relate are normal, not abnormal. Shortages in production usually result in high prices and large profits, hence unusually large profits from such causes cannot be deemed to be abnor- mal profits. Claims for relief under the "abnormal conditions" clause must specify particular facts or transactions not common to the corporation seeking relief nor to an industry as a whole. When accounting records are defective. — Ruling. While the fact that a company may have defective accounting records, and can not accurately compute its invested capi- tal, may under certain circumstances justify an assessment under sec- tion 210 of the 1917 Revenue Act, or section 328 of the 1918 Revenue Act, it does not permit valuation of assets as at a time subsequent to the date on which they were paid in for stock for computing in- vested capital. The assets of a corporation can not be valued as of March i, 1913, for the purpose of computing invested capital. (B. Digest 14-19-440; T. B. M. 57.) INVESTED CAPITAL— RELIEF SECTIONS 341 Relief for fiscal year corporations. — The 19 1 7 and 19 18 laws were intended to apply the respective rates of tax to all taxpayers without discrimination. In some cases corporations with fiscal years ending in 19 18 would have paid less tax if their fiscal years had ended with the calendar year. Other corporations paid less tax because of the fact that the profits actually earned in the part of their fiscal years falling in 1918 were much larger than the actual profits earned in 191 7, but owing to the statutory method, which assumes that profits are earned ratably over the whole taxable year, the 191 8 earn- ings were in effect decreased and the 19 17 earnings corre- spondingly increased. It may be argued that corporations which have a fiscal year other than the calendar year must bear the burdens, if they reap the advantages, incident thereto, but, under a tax law which imposes such high rates that relief provisions were deemed to be absolutely necessary, the corporation which is unduly penalized should not be denied relief because some other corporation has received an equivalent benefit. In some cases corporations dealt in commodities which were increasing in price in December, 191 7, and decreasing in December, 1918, so that corporations reporting on a calendar year basis had a great advantage so far as federal taxes are concerned over fiscal year corporations in 1918. It would seem that the corporations which paid taxes out of proportion to net income, because of conditions which affected them adversely, would have good grounds upon which to claim relief, provided the abnormal conditions were not general in the trade or business. Corporations in certain industries whose fiscal years ended June 30 or July 31, 1920, before the great decline in prices, will be at a serious disadvantage compared with corporations whose fiscal years ended after September 30. Of course it is possible that in another year corporations with fiscal years ending June 30th or July 31st may have an advantage over those with fiscal years ending at other dates. It is equitable, 342 e;xcess profits tax procedure however, that actual abnormal conditions should be recog- nized, and a possible benefit in another year should not be used to offset unfavorable conditions in the taxable year. Constructive capital under 191 7 law not used under 1918 law. — Ruling Where possible, it would be desirable to consider the application for assessment under section 210 and the application for assessment under section 327 together. Where, as in this case, the assessment under section 210 has already been made, the taxpayer should be notified to file with its supplemental return an application for assessment under section 327. Pending decision upon its appli- cation it will be necessary for the taxpayer to compute the additional tax due upon the assumption that the excess profits tax computed under the Revenue Act of 1918 will be not more than 50 per cent of its net income, as is provided in section 328 and article 912-914, Regulations 45. In- no case would the constructive capital deter- mined under section 210 be used in making the assessment under section 328. (B. 6-19-285; T. B. M. 30.) Abnormal income due to sale of capital assets. — Ruling A case in which income as compared with in- vested capital has been abnormally increased by the sale of all capital assets, may be considered under section 210, Revenue Act of 1917. (B. 15-19-454; T. B. M. 60.) The principle laid down in the foregoing ruling may also be applied under the 19 18 law. When competing corporations have capitalized goodwill, etc. — The strongest argument in favor of relief is a reference to the inequalities which would exist if no consideration were given to the method of capitalization of competing concerns. It may be alleged that the law prescribes the methods of determining invested capital and that goodwill, patents, devel- opment costs and other items are not admissible unless pur- chased and not merely developed by the taxpayer. The answer is that the law provided relief clauses in the 1918 law (thereby ratifying the extra-legal relief extended in the ad- ministration of the 1917 law) expressly to take care of cases INVESTED CAPITAL— RELIEF SECTIONS 343 wherein the application of the usual computation of tax would work a hardship. One corporation incorporated in 1916 had capitalized its goodwill, patents and other assets at fair value as of that time. Its only competitor previously incorporated did not carry on its books any assets, such as those mentioned and had written down or written off most of its other assets. The net income of each corporation in 1918 might be substantially the same. It would be most unfair if the tax of one greatly exceeded the tax of the other. The law definitely offers relief in such cases, and imposes upon the Commissioner the duty of extend- ing relief in all meritorious cases. It may be difficult to render justice to all, but approximate justice can be obtained under the law. Advertising expenditures as invested capital. — Ruling. It is the judgment of the Committee in case of claims by proprietary medicine companies for recognition as invested cap- ital of a portion of the amount spent in prior years for advertising and developing trade-marks and trade brands, that it is impossible to allocate any definite percentage of such expenditures as between cap- ital investment and selling cost. Cases in which large sums have been spent in advertising, thus creating a good will or earning capacity far in excess of recognizable invested capital, may reasonably be regarded as cases in which there are abnormal conditions affecting invested capital and therefore within the scope of section 327 of the Revenue Act of 1918. (B. Digest 2-20-679; A. R. M. 12.) Intangibles paid in specifically at nominal value. — Ruling. Held, that taxpayer having clearly shown substantial intangible value in a business with small capitalization, the success of which business is not dependent on personal services except as may be normally required for the management of any property of any com- pany, is entitled to relief under section 210 of the Revenue Act of 1917, and may not establish his invested capital for excess profits tax in any other manner. (B. Digest 50-20-1348; A. R. R. 332.) Subscription lists, newspaper franchises, etc. — Assets of the nature of development or establishment expenses are 344 EXCESS PROFITS TAX PROCEDURE deemed to be intangibles." When purchased for cash and capi- taHzed, such assets are fully allowable as invested capital, but when purchased for stock or written off on the books, the items are not fully allowed as invested capital. It may be that the admissible assets or invested capital (as defined in the law) of such a corporation are purely nom- inal. The assets may have large earning power and the impo- sition of a graduated rate of tax on such earnings may work great hardship. It is believed that reHef has been or will be extended to all corporations in regard to which it can be shown that large expenditures for, or value of, subscription and circulation lists/ franchises, contracts, etc., cannot be considered under the prescribed methods of computing invested capital. When valuation of patents is. reduced by 1918 law. — The 19 18 law works particular hardship when a considerable part of the net income of a corporation is derived from the use of patents. Under the 191 7 law patents were deemed to be tangible property, but it was claimed that some corporations received undue benefits, and consequently in the 19 18 law patents are deemed to be intangible assets. As a result of this reclassification their actual cash value may be reduced for computing invested capital by as much as 75 per cent. In view of the fact that there is a direct connection be- tween invested capital and income from invested capital, it is obvious that any reduction, for invested capital computation, in the value of the asset which produces the income will work great injustice and compel a taxpayer to pay in taxes a much greater proportion of its net income than is paid by other tax- payers, whose assets happen to be called tangible. If invested capital is arbitrarily reduced below its actual value, sufficient cause exists for a claim for relief based on the showing that the net income is disproportionate to the allow- able invested capital. "See page 179. INVESTED CAPITAL— RELIEF SECTIONS 345 Ruling. The principal stockholder of a close corporation invented an article and turned over to the corporation his rights to the inven- tion. After some litigation a patent was granted to the inventor who turned it over to the corporation without consideration. The corporation has been engaged in the manufacture and sale of the article both before and since the patent was issued. The Committee is of the opinion that under the 191 7 Act the corporation would be entitled, upon establishing the value of the patent, to include such value as invested capital. However, since the inventor turned over to the company his rights to the invention long prior to the issuance of letters patent thereon, the amount which could be recognized as paid in surplus would be the value of the invention at the time it was turned over and before commercial de- velopment rather than its value when letters patent were issued. The Committee believes that the value of the invention at that time can not be satisfactorily determined, and that no value could be proved in excess of the value which would be given the invention in practical effect by the application of section 210; that is to say, the difference between the statutory capital and the constructed capital under that section. Recommended that section 210 of the 1917 Act be applied for 1917 and sections 327 and 328 of the 1918 Act for 1918 and subsequent years. (B. Digest 17-20-882; A. R. R^ 70.) When capitalization is small through conservative account- ing.— Ruling. A corporation appeals from the action of the Income Tax Unit in disallowing an addition to invested capital on account of patents, good will, and other assets, tangible and intangible, which were turned over to the corporation by A, its president, at the time of or- ganization. It is stated that it would have been impossible for this company to have succeeded on its small capitalization had it not been for the property thus contributed ; that the property was turned in at a value largely in excess of the par value of the stock issued to A ; that the corporation is penalized through not having issued capital stock to the full valuation of tangibles and intangibles paid in. The Committee is of opinion that the corporation has capital which is earning income but which can not be used in the computation of its invested capital for 1917 under the provisions of section 207. In view of this fact, and pursuant to article 52 of Regulations 41 which provides for the relief of corporations placed at a disadvantage by reason of the ultra conservative accounting or the form or manner of their organization, the Committee recommends that this corporation be taxed under section 210 of the Revenue Act of 1917. (B. Digest 20-20-945; A. R. R. no.) 346 EXCESS PROFITS TAX PROCEDURE Business conducted with large amount of borrowed money. — In some corporations, the personal credit standing of one or more of the stockholders is used to secure from banks large loans that would not be extended were it not for the financial standing of the individual stockholder or stock- holders. In such cases the corporation's income is abnor- mally large as compared with that of a corporation having the same invested capital. Ruling. Where a corporation operated its business with a large amount of borrowed capital during the year 1918, and thereby created an abnormal condition which rendered its invested capital dispropor- tionate to its net income as evidenced by comparison with representa- tive corporations engaged in a similar or like trade or business, and wnere it received insurance on the life of one of its officers which created an abnormal condition with respect to its net income, it may properly receive consideration with the view of determining its ex- cess profits tax liability for 1918, in accordance with sections 327 and 328 of the Revenue Act of 1918. (B. 48-20-1330; A. R. R. 327.) If one corporation prior to 19 17 was financed by bonds and a competing corporation by stock it is possible that relief would be granted to the former under the foregoing ruHng. When nominal salaries only have been paid. — Ruling. If a corporation has paid no salaries to its officers dur- ing 1917, or has paid them salaries which were unusually low in com- parison with the salaries paid to the officers of the competing concerns, and thereby created an abnormal condition which seriously affected its net income and tax liability, it may properly receive consideration with the view to determining its excess profits tax liability for 1917 in accordance with section 210 of the Revenue Act of 1917. (B. 47- 20-1318; A. R. R. 326.) Receipt of proceeds of life insurance policy creating ab- normal income. — Ruling. It is also the opinion of the Committee that the receipt of the proceeds of the life insurance policy in question by this cor- poration creates an abnormal condition which affects the income of the corporation for the taxable year 1918. It is thought that the receipt of this income brings this corporation clearly within the pro- visions of section 327 (d) of the Revenue Act of 1918. It is therefore recommended that the tax in this case be com- INVESTED CAPITAL— RELIEF SECTIONS 347 puted in accordance with the provisions of section 328 of the Act. (B. 50-20-1345; A. R. R. 335.) Relief extended when abnormal conditions affect pre-war period. — Ruling The prewar data is used in computing the war profits credit. Section 311 defines the war profits credit. It may con- sist of (a) $3,000 plus the average net income for the prewar period with an adjustment for changes in capital; or (b) $3,000 plus a per- centage of the invested capital for the taxable year based on the median average established by the prewar experience of a general class of trade or business. This credit is used by concerns having no prewar history; or (c) a minimum war profits credit of $3,000 plus 10 per cent of the invested capital for the taxable year. It is suggested that because of the minimum war profits credit pro- vided for in section .31 1 (b) in case a corporation had no income in the prewar period or earned less than 10 per cent of its invested capital, it should be presumed that Congress intended to include in section 311 all relief which should be granted because of abnormal conditions existing in the prewar period, and that there is a clear and necessary inference that Congress did not intend to grant further relief of the same nature under section 327 on account of the same conditions. Relief is in addition to that obtained by using me- dian PERCENTAGE AND APPLIES TO SPECIFIC CASES. It should be noted, however, that the relief granted in section 311 and that granted in section 327 are not of the same nature. Section 311 establishes certain rules applicable to general classes and which apply in all cases whether hardship actually exists or not. It gives relief to industries which passed through a period of depression in the prewar years. It also applies to concerns which earned less than 10 per cent in- the prewar period, even though their tax is not grossly disproportionate to that of their competitors. Neither of these cases would be helped by section 327. Section 327 on the other hand deals not with general classes but with specific instances and grants relief in special cases according to the facts of each case where, without such relief, there would be a hardship as compared with representative concerns because of some abnormal condition affecting the capital or income of the corpora- tion. The two sections are of a different nature. Section 311 would give no relief to a corporation belonging to a class which normally earned 20 per cent if that corporation, due to some abnormal con- dition affecting the income of the prewar period, earned only 12 per cent during the prewar period. Such concerns do not receive 348 EXCESS PROFITS TAX PROCEDURE even partial relief under section 311. They would receive relief under section 327 if that applies. Section 311 lays down a number of gen- eral rules applicable to general classes which apply in all cases with- out reference to their effect. Section 327 deals with specific cases and applies only where the failure to give relief will cause hardship. These sections have different purposes, apply to different classes of cases, and measure the relief in a different way. In my opinion, the fact that they may both affect the same case does not make section 311 exclusive in that case. It is concluded that the fact that the general rules established by section 311 will in some cases grant partial relief against an ab- normally low income in the prewar period, does not clearly and necessarily limit the application of section 327 to cases of hardship arising out of abnormal conditions affecting the capital and income for the taxable year only. No other reason has been suggested for limiting the literal interpretation of the general words used in sec- tion 327 (d). They should, therefore, be given their ordinary and natural meaning so that section 327 (d) will apply to cases of hard- ship due to abnormal conditions affecting the capital and income of the prewar period or of the taxable year. (B. 19-20-927; O. looo-A.) Standard of Representative Concerns Method of computing the tax when relief is granted. — When the Commissioner decides that a taxpayer has estab- lished his claim for relief the tax must be computed as follows : Law. Section 328. (a) In the cases specified in section 327 the tax shall be the amount which bears the same ratio to the net in- come of the taxpayer (in excess of the specific exemption of $3,000) for the taxable year, as the average tax of representative corporations engaged in a like or similar trade or business, bears to their average net income (in excess of the specific exemption of $3,000) for such year If a taxpayer should sell part of its plant in 1918 at a very large profit because of gradual appreciation m values over a period of years and if none of its competitors earned a similar profit, it would seem to be fair that a rate of tax should be imposed on the abnormal profit, which was earned without the aid of invested capital, somewhat less than that imposed on the normal profits of similar businesses. If another taxpayer, by reason of the personal skill and ap- plication of stockholders who are active in the business, should INVESTED CAPITAL— RELIEF SECTIONS 349 earn $100,000 per annum upon an invested capital of $50,000. whereas its principal competitors did not average more than 30 per cent per annum upon invested capital several times greater, it would seem that the first taxpayer should not pay a higher rate of tax than its competitors, as it is obvious that in its case such personal services were the controlling factor in earning an abnormal percentage of profit on capital. The law provides that the Commissioner shall determine the ratios between the average tax and the average net income of representative corporations. Law. Section 328. (b) For the purposes of subdivision (a) the ratios between the average tax and the average net income of representative corporations shall be determined by the Commis- sioner in accordance with regulations prescribed by him with the approval of the Secretary. No relief possible unless earnings of representative cor- porations show lower ratio of earnings. — After a taxpayer's claim for consideration under section 327 has been granted it does not follow that the tax as computed under the relief sec- tions will be any lower than if computed under the other sections. Law. Section 328. (a). . . . In computing the tax under this sec- tion the Commissioner shall compare the taxpayer only with represen- tative corporations whose invested capital can be satisfactorily deter- mined under section 326'' and which are, as nearly as may be, similarly circumstanced with respect to gross income, net income, profits per unit of business transacted and capital employed, the amount and rate of war profits or excess profits, and all other relevant facts and cir- cumstances. It will be noted that in order to qualify under section 327 the Commissioner must find other corporations whose net capital can be ascertained, and, having found them, the re- quired points of similarity to "the claimant are so numerous that many taxpayers seeking relief will find none, because it will be ascertained that other corporations in the same line of business have earned the same or a greater ratio of profits 'Section 326 defines invested capital. 3SO EXCESS PROFITS TAX PROCEDURE to capital. There is, however, a saving clause in the words "as nearly as may be." Corporations apparently may be very similar but if not exactly so the section would seem to extend wide discretion to the Commissioner. The term "representative corporations" does not in- clude A general average. — Taxpayers must not confuse the relief sections under discussion with the section which directs the Commissioner to determine the pre-war profits of corpora- tions in all lines of business.* The compilation Bulletin D issued by the Treasury does not show that any industry during the pre-war period earned a high rate of profit upon invested capital. The compilation no doubt took into consideration insolvent as well as highly profitable corporations and struck a general average. For the purposes of the relief sections, comparison must be made with "representative" corporations. Regulation. In the cases specified in section 327 of the statute the tax is to be computed by comparison with representative corpora- tions whose invested capital can be satisfactorily determined under section 326 and which are engaged in a like or similar trade or busi- ness and similarly circumstanced. The provisions of section 328 do not permit the determination of a general average for any trade or business. In each case which comes under the provisions of section 327 the Commissioner will determine, as nearly as may be, the group or class of corporations with which the corporation should be com- pared and the amount which bears the same ratio to the net income of the corporation (in excess of the specific exemption of $3,000) for the taxable year as the average tax of such representative cor- porations bears to their average net income (in excess of the specific exemption of $3,000) for such year (Art. 911.) Earnings of "representative" corporations— -How determined. — It is easier to determine the average earnings of a group than to select representative corporations from the group. Obviously representative corporations are those which most nearly approach the conditions of the corporation with which comparison must be made. 'See page 114. INVESTED CAPITAL— RELIEF SECTIONS 351 Of great interest in this matter is the compilation prepared by the Treasury in response to a Senate resolution of June 6, 1918, containing information taken from "returns of 31,500 of a total of approximately 55,000 corporations in the United States which in the calendar year 191 7, earned 15 per cent or more on their capital stock. The corporations included in the list are believed to be representative."" Great weight must be given to the computation by the Treasury, based on its selection of representative corporations. It may not be feasible to compel the Treasury to disclose the names of those selected, but it is reasonable to demand a statement regarding the method used in a particular industry; and, if the announced result does not seem to be reasonable or accurate to the taxpayer, the latter may ask for a rehearing at which evidence should be submitted in support of the tax- payer's contention that representative corporations have not been selected. Many public accountants have compiled information of this kind, and it is believed that the Treasury will not hesitate to reverse its decision if it is clear that a mistake has been made. It is obvious that any selection of representative corporations by the taxpayer or the Treasury is a difficult matter and either one or both may be wrong in any given case. Method used by the Treasury. — P. S. Talbert, until recently chairman of the Committee on Appeals and Review, recently explained the method used by the Treasury in select- ing comparatives in the following language : The department has endeavored to meet the situation by classify- ing all industry into major divisions, such as manufacturing, trading, financial, transportation, etc. These divisions are subdivided, manu- facturing for example, into concerns manufacturing textiles, iron and steel, etc., the process of subdivision being repeated until the groups are comparatively narrow. It is when we come to compare corpora- tions belonging in the same final group that the difficulty begins. There are so many factors entering into the problem that the decision as to which should be used in the final analysis is more or less arbi- 'See Senate Document No. 259, 6sth Congress, 2nd Session. 352 EXCESS PROFITS TAX PROCEDURE trary. When the grounds for applying these sections has been some abnormality of income or invested capital, my own method of ap- proach has been to figure out what the tax would have been had the abnormality not existed, regarding the amount so found as the equit- able tax, and then selecting comparatives that would result in approxi- mately this figure. This, however, is not always practicable. Since to disclose the names of the comparatives used would in effect disclose information as to their taxes, which the law forbids, it is impossible in many instances to satisfy the taxpayer that he has been fairly dealt with.^" When corporations in same class are not repre- sentative. — The following ruling illustrates some of the dif- ficulties attending the selection of representative concerns. Ruling In computing the tax of this taxpayer for the year 1917, the Income Tax Unit applied the provisions of sections 203 and 205 of the Revenue Act of 1917 and established comparisons with cor- porations with capital between $1,000,000 and $1,500,000 which were engaged in a similar line of business. In this classification were found only three corporations beside the taxpayer, and the earnings of these were about 7 per cent of their invested capital. From this comparison by the Unit the taxpayer appeals on the ground that the corporations selected are not representative so far as its business is concerned, for the reason that none of them engages in all the different lines of activities which comprise the business of the taxpayer, and also on the ground that its own average earnings of 26.1 per cent over a period of 12 years prior to the prewar period and 44.5 per cent for its tax- able year 1917 are more truly an indication of its earning power than can justly and equitably be arrived at by the use of the com- paratives selected by the unit For the alternative consideration of this case under section 205, the committee requested the Unit to furnish statistics covering a broader field than that represented by the three comparatives pre- viously used, in view of the taxpayer's protest that these are not truly representative for the reason that, so far as it knows, it is the only corporation of this character which engages in the purchase of raw material direct and disposes of such material after the portion used for the finished product has been separated therefrom. From the statistics presented by the Unit in compliance with this request, and which include 249 corporations capitalized at from $10,000 to $10,000,000, it appears that 103 of them had prewar earn- ings of 7 per cent, and 124 had prewar earnings between 8.80 per cent and 8.99 per cent — the average for the entire 249 corporations being 8.1 per cent. "Columbia University Lectures, The Federal Income Tax, pag^ 253. INVESTED CAPITAL— RELIEF SECTIONS 353 The committee is of the opinion that, under the circumstances, this broader field presents a truer basis of comparison than do the three companies whose capital is in the class with that of the taxpayer but whose business, according to the taxpayer, is much more limited in its scope (B. 20-20-944; A. R. R. 104.) Method of computing tax when stock has been issued for unsegregated property.— It will be noted that the caption at the head of this paragraph does not mention "rehef." It has been claimed that many corporations which issued their capital stock for unsegregated totals of mixed tangible and intangible property 'were unduly benefited by the 191 7 excess profits tax law, because they were able to claim large invested capital consisting of greatly inflated assets. Law. Section 327 (c) Where a mixed aggregate of tangible property and intangible property has been paid in for stock or for stock and bonds and the Commissioner is unable satisfactorily to determine the respective values of the several classes of property at the time of payment, or to distinguish the classes of property paid in for stock and for bonds, respectively; The foregoing section provides that if there is a mixed aggregate of tangible and intangible property and the respec- tive values of each cannot satisfactorily be determined, the tax shall be the same as that paid by representative corpora- tions in the same business. It is generally supposed that this provision will increase the tax of the corporations whose returns are brought within its scope. As to such corporations, "relief" section is a misnomer. Relief will not be granted merely because corporation earned a high rate of profit. — It is not unusual for corpora- tions to earn very high percentages of profit upon invested capital. Some corporations earn from 100 to 200 per cent per annum on invested capital as defined for excess profits tax pur- poses. Under the unusual conditions of the past few years phenomenal rates of earnings by industrial corporations have, comparatively speaking, been the rule rather than the excep- 354 EXCESS PROFITS TAX PROCEDURE tion. If a corporation has, in fact, sufficient capital of its own or has means of securing borrowed money at a low rate of in- terest and earns a very high rate of return upon its capital, there is no provision in the law under which a claim for a lower rate of tax can be sustained. On the contrary the law clearly states that the benefit of the relief sections shall not apply in such case. Law. Section 327 (d) .... This subdivision shall not apply to any case (i) in which the tax (computed without benefit of this section) is high merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital, .... Ruling The present case does not arise in either of these ways, or in any similar manner. Properly speaking, this is a case where taxable income is "high" with respect to invested capital rather than where invested capital is "seriously disproportionate" to such income. Section 210, as interpreted in the Regulations, like paragraph (d) of section 327 of the Revenue Act of 1918, was not intended to afford relief where the only reason therefor is a high rate of tax — that is, a high ratio of taxable income to invested capital. There must be in addition some abnormality with respect to invested capital, taxable income, or both. There is no such abnormality in the present case. (B. 14-19-441; T. B. M. 58.) Profits high because of liquidation. — Ruling. A taxpayer who has liquidated all or part of his business in a particular year is not entitled to assessjnent under section 210, Revenue Act of 1917, unless such liquidation results in throwing into a single year profits so abnormally high as to result in a tax which compared with the taxes imposed upon representative business con- cerns in the same line of business, is seriously disproportionate and productive of exceptional hardship. (B. Digest 15-19-453; T. B. M. 53-) The detailed ruling in this case, however, stated : .... A comparison of the return of A with representative con- cerns in the same line of business discloses the fact that no material change in the tax would result by fixing his tax on the basis of the experience of such representative concerns In a recent ruling" the Treasury refused to consider the following when denying relief under section 327 : ''Bulletin 51-20-1359; A. R. R. 338. INVESTED CAPITAL— RELIEF SECTIONS 355 1. Value of waterpower site, when its cost is reflected in invested capital. 2. Abnormal condition in pre-war period due to inefficient man- agement. Relief when there is abnormal income from sale of min- eral property. — Ruling. The fact that a company is entitled to the benefit of sec- tion 337 will not disqualify it for special treatment under section 328, neither can the fact that it is entitled to the benefit of section 337 be used as a basis for claiming special treatment under section 328. If a corporation falls within the class specified in section 327, the tax will be determined under the provisions of section 328. The effect of sec- tion 337 is to limit the amount of tax attributable to the profit made on the sale of mines, oil and gas wells discovered by the taxpayer and can only be applied after the tax computed on such profit has been computed without the benefit of this section. (B. 5-20-723; O. D. 395.) Relief will not be granted if 50 per cent of gross income was from "cost-plus" government contract. — Yielding to more or less accurate statements that many contractors were realiz- ing enormous profits from government contracts placed on a cost-plus basis, under which the government financed the jobs and the contractors furnished little, if any, capital, Congress declined to admit to the relief provisions any corporation when 50 per cent of its gross income was derived from government contracts placed on a cost-plus basis. As the term government contract extends to subcontracts^^ it will be seen that the re- lief provisions are practically withheld from many corpora- tions which were engaged directly or indirectly in war work during 1918. The benefits of section 327 shall not be ex- tended to any case — Law. Section 327. (d) .... (2) in which 50 per centum or more of the gross income of the corporation for the taxable year (computed under section 233 of Title II) consists of gains, profits, commissions, or other income, derived on a cost-plus basis from a Government contract or contracts made between April 6, 19 17, and November 11, 1918, both dates inclusive. "Section i. 356 EXCESS PROFITS TAX PROCEDURE Ruling. The provision of section 327 of the Revenue Act of 19 18, denying the benefits of that section to corporations 50 per cent or more of the gross income of vsfhich consists of income derived from Govern- ment contracts on a cost-plus basis was, in the opinion of the Commit- tee, designed to cover cases in which the contractor was assured of a profit irrespective of cost, and in which the Government rather than the contractor assumed the risk of loss. Where the unfinished work of a contractor was commandeered by the Government and it was agreed that he should receive the same compensation as he would have received under the private contract, the fact that he was subsequently compensated on a cost-plus basis after the work was completed does not, in the opinion of the Com- mittee, operate to change the legal situation in this respect.^^ (B. 45- 20-1288; A. R. M. 89.) Relief is not denied if government contract income IS on "per unit" basis. — Ruling. The provisions of section 327 (d) of the Revenue Act of 1918 will not debar a corporation deriving income from Government contracts on the "per unit" basis from filing a claim for assessment under the provisions of section 328 (B. 26-19-599; O. D. 321.) Computation of tax of foreign corporations. — Law. Section 327. That in the following cases the tax shall be determined as provided in section' 328: .... (b) In the case of a foreign corporation; Section 328. (a) .... In the case of a foreign corporation the tax shall be computed without deducting the specific exemption of $3,000 either for the taxpayer or the representative corporations. Regulation. Inasmuch as the war profits and excess profits tax in the case of a foreign corporation is not based on the invested capital of the corporation, but is computed in accordance with sec- tion 328 of the statute, the provisions of section 326 and of articles 831-870 have no application to foreign corporations. For the same reason, when rendering a return of income on form 1120 for a for- eign corporation, no entry of invested capital should be made thereon. .... (Art. 871.) Special record to be kept of all corporations whose tax is computed under the relief section. — Law. Section 328. (c) The Commissioner shall keep a record of all cases in which the tax is determined in the manner prescribed 'Tor definition of ''government contract," see page 404. INVESTED CAPITAL— RELIEF SECTIONS 357 in subdivision (a), containing the name and address of each tax- payer, the business in which engaged, the amount of invested capital and net income shown by the return, and the amount of invested capital as determined under such subdivision. The Commissioner shall furnish a copy of such record and other detailed information with respect to such cases when required by resolution of either House of Congress, without regard to the restrictions contained in section 257. 1* "See Income Tax Procedure, 1921, page 127. Refers to returns as public records, but with specific restrictions on their being made public. [Former Procedure] Relief Section 210, 1917 Law The 1917 law would have been grossly inequitable in many cases had it not been for the construction placed by the Commissioner upon section 210 of the law. When amount of "invested capital" cannot be determined satis- factorily by the Secretary of the Treasury. — 1917 Law. Section 210. "That if the Secretary of the Treasury is unable in any case satisfactorily to determine the invested capital, the amount of the deduction shall be the sum of (i) an amount equal to the same proportion of the net income of the trade or business received during the taxable year as the proportion which the average deduction (determined in the same manner as provided in section two hundred and three, without including the $3,000 or $6,000 therein referred to) for the same calendar year of representative corporations, partnerships, and individuals, engaged in a like or similar trade or business, bears to the total net income of the trade or business re- ceived by such corporations, partnerships, and individuals, plus (2) in the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000. "For the purpose of this section the proportion between the deduc- tion and the net income in each trade o.r business shall be determined by the Commissioner of Internal Revenue in accordance with regu- lations prescribed by him, with the approval of the Secretary of the Treasury. In the case of a corporation or partnership which has fixed its own fiscal year, the proportion determined for the calendar year ending during such fiscal year shall be used." Based on the foregoing section, regulations were prepared which have afforded relief in many cases in which the taxes could not satis- factorily be determined under other sections of the law. Regulation. "Where, through defective accounting or the lack of adequate data, it is impossible accurately to compute invested capital. "Where upon application by a foreign taxpayer the Secretary of the Treasury finds that the expense of securing the data necessary for the computation of the invested capital would be unreasonable in view of- the amount of tax involved, or that it is impracticable to determine either the 'entire invested capital' or the 'entire net in- 3S8 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] "Where the invested capital is seriously disproportionate to the taxable income. Such cases may arise through : "(a) The realization in one year of the earnings of capital un- productively invested through a period of years or of the fruits of activities antedating the taxable year. "(b) Inability to recognize or properly allow for amortization, obsolescence, or exceptional depreciation due to the present war, or to the necessity in connection with the present war of providing plant which will not be wanted for the purposes of the trade or business after the termination of the war. "Long-established business concerns which by reason of ultra- conservative accounting or the form and manner of their organiza- tion would, through the operation of section 207, be placed at a serious disadvantage in competing with representative concerns in a like or similar trade or business." (Reg. 41, 1918, Art. 52.) I918 RULINGS APPLIED TO CASES UNDER I917 LAW. — Ruling. "The same principle stated in the Revenue Act of 1918 that assessment will not be made a!s a special case under section 328, when the tax is high 'merely because the corporation earned within the taxable year a high rate of profit upon a normal invested capital' is applicable to the Revenue Act of 1917 in cases in which application is made for assess- ment under section 210 of that act." (B. 1-19-119; T. B. M. 7.) Method of computation when, relief was granted. — In order to make effective the relief which article 52 afforded, it was necessary to devise a method of calculation. In theory the rate as adjusted was based on a constructive capital, but in effect the adjustment was made by applying an arbitrary percentage (depending on the rate paid by representative concerns) of the net income reported. Regulation. "If the Secretary of the Treasury is unable satis- factorily to determine the invested capital, the deduction shall be the sum of — "(i) An amount equal to the same proportion of the net income of the trade or business for the taxable year as the average deduc- tion (determined in the same manner as provided in article 21 with- out including the $3,000 or $6,000 therein referred to) for the cor- responding calendar year, of representative corporations, partner- ships, and individuals engaged in a like or similar trade or business, is of their average net income, plus "(2) In the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States, $6,000. "The Commissioner of Internal Revenue in determining for any calendar year the proportion which the average deduction of repre- sentative corporations, partnerships, and individuals engaged in any particular trade or business is of their average net income, will in- clude the deductions and net income of representative corporations and partnerships for fiscal years ending during such calendar year. "For the purpose of applying this article in the case of a corpora- tion or partnership which has fixed its own fiscal year, the proportion determined for the calendar year ending during such fiscal year shall be used. "In every case of a trade or business having invested capital a return shall be made in the first instance in accordance with article INVESTED CAPITAL— RELIEF SECTIONS 359 [Former Procedure — Continued] 21 or 23, but the taxpayer may submit therewith a statement of reasons why in his opinion the tax should be assessed in accordance with this article." (Reg. 41, 1918, Art. 24.) Constructive capital for application of rates. — Regulation. "Where the deduction allowed to a taxpayer is de- termined under ' article 24 [as above] the invested capital _ for the purpose of applying the rates of taxation under article 16 "shall be deemed to be an amount which bears the same ratio to the net income of the trade or business for the taxable year which the average invested capital for the corresponding calendar year of representative corporations, partnerships, and individuals engaged in a like or simi- lar trade or business bears to their average net income. "The Commissioner of Internal Revenue in determining for any calendar year the ratio which the average invested capital of repre- sentative corporations, partnerships, and individuals engaged in any particular trade or business bears to their average net income, will include the invested capital and net income of representative cor- porations and partnerships for fiscal years ending during such cal- endar year. "For the purpose of applying this article in the case of a corpora- tion or partnership which has fixed its own fiscal year, the ratio determined for the calendar year ending during such fiscal year shall be used." (Reg. 41, 1918, Art. 18.) Constructive capital need not be used when it is less than in- vested capital if the latter ClMX BE ESTABLISHED. — Ruling. " .... It is manifestly the purpose and intent of the excess- profits tax law that the taxpayer shall have a deduction upon all the statu- tory invested capital which he can establish, and if in any case the tax- payer is able to show to the satisfaction of the Unit that he has statutory invested capital which can be recognized in excess of constructive capital found upon application of section 210 the taxpayer should not be deprived of his right to have assessment based upon such statutory capital as he can show, because there are other items of invested capital which cannot be determined and which the taxpayer concedes the right of the Unit to ignore." (B. 31-20-1111; A. R. R. 209.) Subscription lists, newspaper franchises, etc. — If in fact the earn- ings of a corporation were largely derived from intangible assets which could not be included in invested capital, the law of 1917 did not intend to impose the graduated rates of tax upon the small or nominal invested capital. Rather it was intended to apply to such corporations the benefit of the 8 per cent rate (section 209). The regulations, perhaps wisely, refused to extend the 8 per cent rate to those corporations: Regulation. "Where the capital is largely covered by .... in- tangible assets built up or developed by expenditures which have been regularly deducted as items of current expense." (Reg. 41, 1918, Art. 74.) If a corporation had only nominal capital and could not qualify as being entitled to the 8 per cent rate, it had the right to claim relief under section 210. 36o EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] Relief extended to individuals. — If an individual was penalized because he owned inadmissible assets purchased with borrowed money or if he suffered other unintentional penalties, the regulations per- mitted him to apply for relief under section 210, and to be assessed on the same basis as representative individuals in the same line of business. Ruling. "An individual dealer in bonds began business in Janu- ary, 1917, with a capital of $20,000. He carried on an average through the year $700,000 municipal bonds and $100,000 corporate bonds. His average indebtedness for the year was $600,000, on which he paid interest amounting to $30,000. His corporate bonds yielded interest to the amount of $S,ooo. The interest received from municipal bonds was $21,000; but the interest paid on indebtedness incurred for carry- ing municipals amounted to $26,250, leaving a deficit of $5,250. The municipals were sold at a loss of $8,000; but the industrial bonds were sold at a sufficient figure to leave the dealer net trading profits for the year — after deduction of all expenses other than interest — of $48,000. His taxable net income then consists of $53,000 (trading profits plus interest on corporate bonds) less deductible interest paid ($3,750), or $49,250; but since the non-deductible interest paid ($26,- 250) exceeds the tax-free interest received ($21,000), his net income as computed on his own books is only $44,000, and he is, in effect, taxed on a $5,250 loss. May he include any part of the municipal bonds in his invested capital? "No. No part of the municipal bonds may be treated as admis- sible assets under article 45 inasmuch as a trade loss and not a gain was sustained from their sale. Moreover, indebtedness upon which an interest deduction is denied cannot be included in invested capital under article 44 when incurred for the purchase of inadmissible assets. However, under circumstances such as those recited above, application for assessment under section 210 (article 52) will be considered." (Excess Profits Tax Primer, 1918, question 87.) Determination of capital under section 210 applied only to tax- able year 1917. — When there was difficulty in determining the cepi- tal for the pre-war period only, the Treasury held that the relief clauses did not apply. In any event the only effect the readjustment of pre-war income and pre-war invested capital could have would be to alter the rates of deduction (7 to 9 per cent.) Regulation, "(i) Article 18 of Regulations 41 (which provides for a constructive capital for the purpose of applying the graduated rates prescribed by section 201 of the act of October 3, 1917, in cases in which the deduction is determined under section 210) applies only to cases in which the Secretary of the Treasury is unable satisfactorily to determine the invested capital for the taxable year (including cases arising under article 52 of Regulations 41). "If the deduction is so determined only upon the ground that the Secretary of the Treasury is unable satisfactorily to determine the amount of invested capital for the pre-war period, but the invested capital for the taxable year can be satisfactorily determined, the graduated rates prescribed by section 201 will be applied upon the basis of such actual invested capital for the taxable year and not upon the basis of a constructive capital. INVESTED CAPITAI^RELIEF SECTIONS 361 [Former Procedure — Continued] "(2) If neither the income nor the invested capital for the pre-war period can be satisfactorily determined by the Secretary of the Treasury the deduction will be computed under section 20s (article 23 of Regulations 41) if the invested capital for the taxable year can be computed as provided by section 210 (article 24 of Regulations 41)." taxable year cannot be satisfactorily determined the deduction will be computed as provided by section 210 (article 24 of Regulations 41)." (T. D. 2683, March 26, 1918.) The foregoing should be considered in conjunction with a much later ruling (B. 19-20-927; looo-A, see page 347.) which in effect overrules the principle laid down in T. D. 2683. CHAPTER XVI ADJUSTMENT OF NET INCOME FOR TAXABLE AND PRE-WAR YEARS Determination of Net Income for Taxable Year In most cases no adjustment of net income as shown by income tax statements for the taxable year will be necessary. In general all the provisions and limitations of the 1918 in- come tax law and all the Treasury regulations relating thereto control the determination of net income subject to the excess profits tax. The exceptions will be explained in detail. Law. Section 320. (a) That for the purpose of this title the net income of a corporation shall be ascertained and returned — .... (3) For the taxable year upon the same basis and in the same manner as provided for income tax purposes in Title II of this Act. Interest received.— Interest from United States 3>^ per cent Liberty bonds and 3^ per cent Victory notes is not tax- able and should not appear in the 1920 returns, except in the reconciliation in Schedule L. Interest on obligations of the United States issued after September i, 191 7, also is not subject to the income tax of 10 per cent on corporations. The excess profits tax, however, is imposed on such interest except for the interest on a possi- ble maximum amount of principal of $160,000. The maxi- mum amount exempt for 1920 (and for five years after the end of the war) will be dependent on the holdings of the cor- poration and the various exemptions thereof under the several Liberty bond acts. For a full discussion of these exemptions, see the chapter on "Interest from Obligations of the United States," Income Tax Procedure, ig2i, page 524. Interest paid.— All interest paid is an allowable deduction except interest paid on indebtedness to purchase or carry 3>^ per cent Liberty bonds and state and municipal securities. 362 ADJUSTMENT WITH PRE-WAR INCOME 363 Dividends. — Under the 19 17 law dividends received by corporations from other corporations were subject to the war income tax of 2 per cent, but under the 1918 law divi- dends received from corporations (excepting from foreign corporations not deriving any income from United States sources) are wholly tax exempt. Inventory valuations. — As the excess profits tax is based on the income tax returns,- all adjustments of values of stock-in- trade must be made before the income tax returns are pre- pared. No further adjustments can be made, so far as the excess profits tax returns are concerned. If corporations have set up reserves against inventory valuations in excess of the reserves which are permitted by the Treasury, such reserves must not be deducted from the inventory values in determin- ing invested capital. If shrinkages occurred subsequent to the end of the taxable year 19 18 and claims were filed when returns were made it was necessary to adjust the excess profits tax accordingly. Depreciation, obsolescence and amortization. — The 19 18 law permits full allowances for declines in value due to or- dinary wear and tear and in addition adequate deductions to cover losses caused by the decline in values which followed the end of the war. These deductions are discussed in the appropriate chapters of Income Tax Procedure, 192 1. Depletion. — Under the 1918 law (as well as under the 1916 and 1917 laws) there is a specific provision permitting a reasonable allowance for depletion.^ On the other hand, it was held by the Supreme Court of the United States in the case of Von Baumhach v. Sargent Land Company,^ that the 1909 excise tax law (which had no specific reference to deple- tion) did not permit depletion as an allowable deduction. 'igi8 Law, sections 214 (a-io) and 234 (a-p), quoted in Income Tax Procedure, 1921, page 923. "242 U. S. 503 (1917)- 364 EXCESS PROFITS TAX PROCEDURE This decision affected the net income of the first two of the three years embraced in the pre-war period and as a result a great advantage accrued to mining and similar corporations for the reason that the pre-war net income being stated for taxa- tion purposes at a higher figure than the actual earnings, gave an increased war profits credit. The 19 13 law allowed deple- tion only up to 5 per cent of the value of the output of the mine, again increasing the net income used in the calculation of the war profits credit. Any corporation which deducted depletion in 191 1 and 1912 can obtain the advantage referred to above by the pay- ment of a trifling i per cent tax on filing amended returns for those years. Salaries. — Salaries to officers, etc., should be amply pro- vided for in income tax returns. In view of the heavy burden imposed by taxes under the 1918 law, adequate salaries should be permitted to officers of corporations. The law specifically permits the deduction of reasonable salaries. Care should be taken to fix compensa- tion so that it represents fair value for services rendered as distinguished from distributions of net profits. If salaries are reasonable in amount they must be allowed. Ruling. A corporation in which most of the stock is owned by its officers has in the past voted to its officers only nominal salaries as drawing accounts. In computing net income for purposes of the excess profits tax may the corporation deduct as items of expense amounts which would constitute reasonable compensation for the services actually rendered by its officers? Yes, if a satisfactory explanation is given. For any period prior to March i, 1918, reasonable salaries for services actually rendered may be deducted, even though the full amounts had not been for- mally voted as salaries by the corporation. (Excess Profits Tax Primer, 1918, question 51.) " £ k •" ^ —I tfl M ° C H OJ ^ ri g Mi.a o o g-S rt - pq 13 w O t« y w ^2; ><^ <: a ., -^ ■" ■^ -^ CO to eg o nJ i-; d d " a "" o Jh d cd to TO --j (U O d S MP. tn . •S o '" "* ■ W ui^ ■!-> +^ o d 2.3°- 5 o o o p. a ." rt a ^^'+^ ^ ' , ri .5 OJ ■"5.S P. ■o s " a ■ "! -d 0) J X SdSftSi ;-! (U u H O Pi PL, .2 W O u H W O o m o H ;2; W w I— I u o u w g» ■a c o o IN as fe 3 CTJ d o o J3 H o o s d 3§ $,< OJ to oj d a "> .as d^ to !* O 1) -I li o ^ +-> 0) M-° d-d ^"3 '?!. ° — -^ 13 -^^ a bo d o I: ?2 O .< a s* a 5 !:!•« 0) P (1) a! to >• X o S d'Sid O d 4) c3 d o o •d C 5 t«'d d g-'S o -^ p tl M t" d d lu ^ d 2 b0T3 •^ Lo "sO t^OO O O i-" t^ ir^ 00 i>- l>- ^-M3 t^ c*-> o CO t^ ■^10 00*0 ^ O M t^ CO -^ (^ tn 365 "A O < Do CIS s ^ o o Si o 5 > S c o +j ^2 cU p. ,5 ca •a M ca ^/^ ft " CS " o •a '•g t « m -75 rj *'> +j ca TJ 7: M ■t-' aj OJ 5 O" i^m en T3 s 9 '^'"- o o . o o +J-Mi3-^ en m m C cn-a e ?; " tn .-H w oj ca ^ AJ t^ en ^3 o l-t 13 3 ca ■83a 2^ o-rt g 3 M ?<^ X w.g ID m 3 OJ 1! Ill's CO " 'J- p*' S 3 g r^ aj« 8-1:! 'U^'q. H >.u- ca -S ♦^ ^ t! ^•-J ° O en 11 o " §-gtH »i fern s <* -^ S G ti a +j cj a S3 o •s "! a 8" s '-' di a n-i en ^ ^ en -^ ca O 1^ 3 H +J 13 +J a; .^ (U On « CO Iv Tj- O O •1^ LTJ C*^ t*^ -^ -ij- -^ 366 c^ 00 00 00 ^^ c^ 3 01 u J3 H S J3 ^'^ S! la "S BO «S •5 a i .S -J-'-o n ™ o d « ■*-• -3 b .2 a *^ " a 8 a^o " „ S«.S| ..2m| a^5.sg.s§a T3 ".3 „ " o a ij 2 I o S ^ s j-as r oJ= 3 «j13 _S u— o ^g o .S ADJUSTMENT WITH PRE-WAR INCOME 367 Comment on form 1120, issued January, 1921. — Schedule L, Reconciliation of Net Income, page 4 of return, makes no specific provision for taking up adjustments between book profit or loss and the amounts reported when capital assets are sold or losses not compensated by insurance are sustained, reported in items 22 and 23, schedule A. Specific provision was made for such adjustment as item 4 or item 8 of schedule M in form 11 20 for 19 19 returns, but in the new form these items have been omitted from the reconciliation. It will be necessary, however, to enter such an adjustment in schedule L if the value of the property at March i, 1913, referred to in schedules A-22 and A-23 was greater or less than the amount at which it is carried on the books. Adjustment of Net Income for Pre-War Period Under the 1918 law the war profits credit is computed on the basis of the actual net income for the pre-war period, unless the net income is less than 10 per cent of the average invested capital for the taxable year. The excess profits credit is 8 per cent, irrespective of the actual pre-war net income. Under the 191 7 law the excess profits credit was 7 to 9 per cent, and, as corporations which did not claim more than 7 per cent were not required to state their pre-war capital and income, many corporations did not make an accurate cal- culation of their pre-war income. In other cases where the pre-war net income was far in excess of the 9 per cent maxi- mum exemption a showing was made sufficient to sustain the maximum without any attempt to be precise. In the former cases if the net income for the pre-war period was believed to be less than 7 per cent it is not likely that any allowable read- justments of the accounts would produce an average pre-war net income of more than 10 per cent of invested capital for the taxable year, and 10 per cent was allowed in any event in the 19 18 war profits tax computation. But if the net income in the pre-war period was substantial- ly more than 9 per cent it was of great importance to analyze 368 EXCESS PROFITS TAX PROCEDURE all the income and expense accounts in order to ascertain the maximum average amount of net income (when in ex- cess of lo per cent) which would be allowed as a credit in the computation of the 1918 war profits credit. Law. Section 310. That as used in this title the term "pre-war period" means the calendar years 1911, 1912, and 1913, or, if a cor- poration was not in existence during the whole of such period, then as many of such years during the whole of which the corporation was in existence.^ Section 320. (a) That for the purpose of this title the net in- come of a corporation shall be ascertained and returned — (i) For the calendar years 1911 and 1912 upon the same basis and in the same manner as provided in section 38 of the Act entitled "An Act to provide revenue, equalize duties, and encourage the in- dustries of the United States, and for other purposes," approved August 5, 1909, except that taxes imposed by such section and paid by the corporation within the year shall be included; (2) For the calendar year 1913 upon the same basis and in the same manner as provided in section II of the Act entitled "An Act to reduce tariff duties and to provide revenue for the Government, and for other purposes," approved October 3, 1913, except that taxes imposed by section 38 of such Act of August 5, 1909, and paid by the corporation within the year shall be included, and except that the amounts received by it as dividends upon the stock or from the net earnings of other corporations subject to the tax imposed by section II of such Act of October 3, 1913, shall be deducted; .... It will be noted that the corporation excise tax returns as filed for 191 1 and 1912 were to be used as a basis, except that in order to equalize the returns for the pre-war period and the taxable year the federal taxes actually paid in 191 1 and 19 12 and deducted from net income were to be added. For the year 191 3 the income tax returns as filed were to be used, except that federal taxes were to be added to the amount reported. As dividends received are not taxed under the 1918 law it was necessary to deduct any dividends included by the corporation in its 19 13 return. If the returns for 191 1, 1912 and 1913 are found to be "[Former Procedure] This provision is the same as part of section 200 of the 1917 law except that the 1917 law also referred to partnerships and individuals. ADJUSTMENT WITH PRE-WAR INCOME 369 inaccurate, it is not too late to prepare accurate returns for those years and use the corrected returns as a basis for pre- war figures. Appreciation in pre-war period excluded even though taxed. — Ruling. With respect to the inquiry whether or not value appre- ciation of property taken up on the books of the taxpayer and re- turned as a part of his taxable income for the year in which the appreciation was written up may be included as a part of the income for the pre-war period, a negative reply must be given. Appreciation is not and has not been at any time under the income tax laws proper taxable income, and where such appreciation has been taken up on the books of the taxpayer the item must be excluded in computing income, even though an income tax has been paid upon it. (B. 8-19- 335; T. B. M. 42.) Computation of "average" net income. — On the whole the years 191 1, 1912 and 1913 were not prosperous years in the United States. It would have been fairer to have allowed the taxpayer to make a selection, as is allowed under the English law. In many cases a corporation did not realize any net in- come during one or two years of the pre-war period. If a net loss was sustained it need not be deducted in calculating the average net income. Law. Section 320. (b) The average net income for the pre- war period shall be determined by dividing the number of years within that period during the whole of which the corporation was in existence into the sum of the net income for such years, even though there may have been no net income for one or more of such years. Ruling. A corporation had a net income of $10,000 in 191 1, $8,000 in 1912, and a loss of $2,000 in 1913. What is the "average amount of the annual net income of the trade or business during the pre-war period" for the purpose of determining the percentage de- duction ? $6,000 ($18,000 divided by 3). The loss of $2,000 is disregarded inasmuch as the income tax law does not permit the loss of one year to affect or reduce the profit of another year. {Excess Profits Tax Primer, 1918, question 14.) During the pre-war period returns were required on a cal- endar year basis, even though a corporation did not close its 370 EXCESS PROFITS TAX PROCEDURE books on December 31. Tlie result in many instances was that wild guesses were made in estimating the net income for the calendar years. It made very little difference so long as the tax rate remained the same, but it might make a considerable difference if a substantial error was made at the beginning or close of the pre-war period.* Income of years 191 i and 1912. — Returns made under the excise tax law of 1909 are to be used as a basis. Any sub- sequent adjustments thereof should be taken into account. Dividends were not taxed under the 1909 law and should not have appeared in the return. The federal income (excise) tax for 1910 was not deducti- ble in the returns for that year as an accrued expense, and therefore the deduction should have been taken when paid, i.e., in 191 1. The amount thus deducted in 191 1 should be added to the net income reported for 191 1. Likewise the 191 1 tax paid in 19 12 should be added to the net income reported for 1912. Income of year 1913. — The corporation income tax re- turn for the year 1913 (subject to corrections, if any) is to be used as a basis. Dividends received by corporations were taxable in 1913. The aggregate of dividends received should be deducted from the net income reported. The excise tax paid in 1913 for account of 1912 should be added to the net income reported. Regulation (c) For the calendar year 1913 by adding (i) the amount of the entire net income shown in item 8 of the return made under section II of the Act of October 3, 1913, for the calendar year 1913, and (2) the amount of taxes paid within the calendar year 1913 under section 38 of the Act of August 5, 1909, and section II or IV of the Act of October 3, 1913, and deducting from the total so obtained the amounts received during the calendar year 1913 as dividends upon the stock or from the net earnings of other corpora- tions, joint-stock companies or associations, or insurance companies, *For methods of computation on fiscal year basis, see page 277. ADJUSTMENT WITH PRE-WAR INCOME 371 subject to the income tax imposed by section II of the Act of October 3, 1913. (Reg. 41, 1918, Art. 28.) In a considerable number of cases, income-tax and excise- tax retm-ns for 191 1, 1912 and 1913 have been changed or modified by the action of the corporations themselves or by the findings of income tax examiners. The majority of these corrections resulted in the assessment of an additional tax, in which case the original net income reported will be corre- spondingly increased. Pre-war net income of affiliated corporations.^ Regulation. The consolidated net income of affiliated corpora- tions for the prewar period shall be the average consolidated net income for the prewar years of such of the several corporations in- cluded in the consolidation for the taxable year as were affihated during the prewar period plus the aggregate of the average net income for each of the corporations not affiliated during the prewar period which were in existence during all of the prewar period or during at least one full year within the prewar period. The net income of a subsidiary corporation organized during the prewar period by an existing corporation shall also be included (Art. 802.) [Former Procedure] Procedure under 1917 Law As many returns for 1917 have not been examined, it will be of interest to mention briefly the more important adjustments of income required by the 1917 law. Interest paid. — In the 1917 return interest paid was not fully de- ductible in certain cases. The amount not deductible should be ascertained, as the amount of indebtedness represented thereby could be added to the invested capital. As it works out, corporations which were restricted in the interest deduction were fortunate because the advantage derived from the increase in invested capital (on which an exemption of at least 7 per cent was allowed) more than offset the interest disallowed. In addition to the foregoing, in 1917 there was a limitation on the amount of interest payable on indebtedness incurred for the pur- chase of $5,000 of Second Liberty bonds, the income from which was wholly exempt. Ruling. "A corporation whose entire authorized capital stock has been paid up to the amount fixed in its charter is entitled to deduct interest on 372 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] only so much of its indebtedness as does not exceed the fixed amount of its authorized capital stock plus such other sums as the taxing Acts pre- scribe." (B. Digest 39-20-1217; Sol. Op. 23.) The comprehensive opinion of the solicitor in the foregoing case is of interest as it gives many definitions and quotes many court decisions re- garding the meaning of the terms "paid-up capital stock," "capital stock," "capital" and "capital stock paid-in." Taxes assessed against local benefits. — Under the 1917 laws no taxes assessed against local benefits were deductible even though the payment of such taxes did not result in any permanent improvement to the property affected by the assessment. Dividends received. — In the 1917 returns dividends were taxed at 3 per cent for the income tax, but no excess profits tax was imposed. Inventory shrinkages.^ — Under the 1917 law' inventories could be taken at cost or market, whichever was the lower, but no special allowance was made for shrinkage in market value after the end of the taxable year. Hence, for the 1917 period the inventory at the end of the year was valued on the same basis as at the beginning of the taxable year unless the corporation proposed permanently to change its method of inventory valuation. When a change was made the regulations governing such cases were to be followed. (See Income Tax Procedure, 1921, page 341.) Amortization and obsolescence. — The 1917 law did not permit any deduction for amortization or accrued obsolescence. It was, how- ever, permissible to deduct liberal depreciation charges. Depletion of leaseholds. — The regulations issued by the Treasury under the 1917 law did not permit lessees to deduct amortization of appreciation in values as of March i, 1913, but as the right fully to depreciate the fair value of leaseholds at March i, 191 3, commenced in 1916, amended returns should be made for 1917 in order to increase invested capital (by the amount of realized appreciation) and to claim deduction for the increased depletion and depreciation charges. Determination of Net Income — Individuals Graduated rate. — The proper starting point for the computation of an individual's net income subject to the graduated excess profits tax rates was the 1917 income tax return. The net income shown in the return as realized from a business having invested capital was the basis of assessment subject to the following adjustments: Salaries. — From the net income realized from his business an in- dividual was entitled to deduct (unless deduction was made as a busi- ness expense) a reasonable salary for his services. ADJUSTMENT WITH PRE-WAR INCOME 373 [Former Procedure— Continued] Regulation. "An individual carrying on a trade or business having an invested capital may in computing the net income of the trade or busi- ness for purposes of the excess profits tax deduct a reasonable amount designated by him as salary or compensation for personal services actually rendered by him in the conduct of such trade or business. In no case shall the amount so designated be in excess of the salaries or cpinpensation customarily paid for similar service under like respon- sibilities by corporations or partnerships engaged in like or similar trades or businesses. "In the case of a non-resident alien individual, the amount shall be limited to that portion of the salary or compensation which is for services rendered with respect to trade or business carried on in the United States. "The amount so designated shall, however, be included in comput- ing his net income of class A under article 35 (of the excess profits tax_ regulations) ; and the balance of the income from his trade or business shall be included in computing his net income of class B under article 36." (Reg. 41, 1918, Art. 39.) Ruling. "An individual carrying on a trade or business having an invested capital may in computing the net income of the trade or business for purposes of the excess profits tax deduct a reasonable amount desig- nated by him as salary or compensation for personal service actually rendered by him in the conduct of such trade or business. In no case shall the amount so designated be in excess of the salaries or com- pensation customarily paid for similar service under like responsibilities by corporations or partnerships engaged in like or similar trades or businesses. "In the case of a non-resident alien individual, the amount deducted shall be limited to that portion of the salary or compensation which is for service rendered with respect to trade or business carried on in the United States. "The amount so designated shall, however, be included in computing his net income of class A under article 35 ; and the balance of the in- come from his trade or business shall be included in computing his net income of class B under article 36. "Illustration : — An individual owns and runs a newspaper having an invested capital of $50,000. The net income from the newspaper, without making any allowance for the salary of the owner, is $20,000, and, as income of class B, is subject to the graduated rates prescribed in article 16. His deduction, as provided for in subdivision (b) of article 21, would be $4,500 (9 per cent of his capital) plus $6,000, a total of $10,500. If, however, he allows himself a salary of $3,000, the net income from the newspaper will be $17,000, and the deduction of $10,500 will be applied against that amount. "His salary of $3,000 must be included in his return as income of class A, which is subject to the 8 per cent rate under article 15. If it constitutes his only income of that class he will pay no tax thereon, inasmuch as it is less than the deduction of $6,000 to which he is entitled as to that class of income. But if, for example, he receives in addition a salary of $4,000 as president of the local bank, his total net income of class A will be $7,000, and he will be required to pay a tax of 8 per cent on $1,000 thereof, or $80." (Extract from letter to M. Blau, signed by Commissioner Daniel C. Roper, March 14, 1918.) Interest. — An individual cannot lend money to himself. Interest on a proprietor's capital could not be deducted as an expense. 374 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] Dividends. — The aggregate of dividends received from corpora- tions subject to the income tax could be deducted from the net income assessable for excess profits tax. Contributions. — Section 206 provided that the excess profits tax for 1917 payable by individuals and partnerships should be assessed upon the basis of their income tax returns. It evidently did not occur to the framers of the law that personal income tax returns include items of income (such as interest on investments) and items of de- ductions (such as contributions, taxes on residence, etc.) which should not appear in a return of net income subject to an excess proiits tax, and this applied whether an individual paid at the 8 per cent or graduated rates. The regulations eliminated from the excess profits tax return all items other than those incident to a business enterprise, but if an individual had insisted on his right to calculate his net income for excess profits tax purposes as clearly called for by section 206, it is questionable if he could have been restrained from doing so. Regulation. "Contributions or gifts for religious, charitable, etc., purposes allowed as a deduction for purposes of the income tax under paragraph 'Ninth' of subdivision (a) of section 5 of the Act of Septem- ber 8, 1916, as amended, may, subject to the limitations therein contained, be deducted in computing the net income of the trade or business for purposes of the excess profits tax only when it is shown to the satisfac- tion of the Commissioner of Internal Revenue that such contributions or gifts are made by the trade or business and not by the individual in his personal capacity." (Reg. 41, igi8, Art. 39.) Ruling. "The Committee has had under consideration the appeal of the M Company from the action of the Income Tax Unit in disallowing as a deduction in the return of the partnership for excess profits tax pur- poses for 191 7, X dollars representing charitable contributions the principal part of which went to the American Red Cross. "The appeal is based upon the provision of the law, section 206 : "... There shall be allowed (o) in the case of a domestic partner- ship the same deductions allowed to individuals in subdivision A of section 5 of such Act of September 8th, 1916, as amended by this act "which section 5 provided for tlie allowance to individuals of contributions or gifts made within the year to corporations or associations organized and operated exclusively for religious, charitable, scientific or educational purposes, with certain limitations. "Although Regulations 41 does not specifically cover the question at issue as to partnerships, the subject matter was carefully considered by the tax reviewers, who co-operated in the drafting of the regulations and rules for the enforcement of the Act of 1917. Article 37, dealing with deductions allowable in the case of an individual holds that such deduc- tions may be made in determining the income subject to excess profits tax of an individual 'only when it is shown to the satisfaction of the Commissioner of Internal Revenue that such contributions or gifts are made by the trade or business and not by the individual in his personal capacity.' ADJUSTMENT WITH PRE-WAR INCOME 375 [Former Procedure — Continued] "In the excess profits tax primer, the purpose and intent of which was to illustrate the application of Regulations 41, and which was most carefully compiled under the direction of the tax reviewers, the following question and answer are given : ''21. A partnership has been in the habit of making contributions to various churches, local charities, and the Y. M. C. A., and charging the amounts off to profit and loss at the end of the year. Will it be allowed to deduct these contributions in computing its net income for purposes of the excess profits tax? "No. These contributions are not connected with the trade or busi- ness. The same rule applies in the case of a partnership as in the case of an individual. (See section 206 of the law and article 2i7 of Regulations No. 4I-) "It is the understanding of the Committee that this rule has been consistently followed in the administration of the excess profits tax law in its application to partnerships, and it is the judgment of the Committee that this ruling and practice should not now be disturbed. It accordingly recommends that the action of the Unit in disallowing the item above should be sustained." (B. 34-20-1156; A. R. R. 245.) It is obvious from the foregoing that the Committee was of opinion that the taxpayer was right and the regulations were wrong, but that it would be inadvisable to change the latter. Taxes. — The law provided that an individual should use his in- come tax return as a base for the excess profits tax. In his return, taxes on private residences were allowable deductions. The regula- tions held otherwise. Rulings. "A grocer in business as an individual pays taxes of $i,8ao on his stock and store building and $800 on his (separate) resi- dence, may he deduct all of these taxes in computing his net income for purposes of the excess profits tax? "No. The taxes on his store and stock, being incident to the busi- ness, may be deducted ; but the tax on his residence is not deductible for purposes of the excess profits tax. "May an individual working on a salary of $10,000 deduct taxes of $500 on his residence on the ground that the residence is necessary to his personal service business? "No." (Excess Profits Tax Primer, 1918, questions 54, 55.) Determination of net income for taxable year when there is in- vested capital. — Regulation. "The net income which is derived from a trade or business having invested capital (constituting net income of class B, as defined in article 14) shall be determined for the taxable year by adding the total net income from such sources (or in the case of a non-resident alien individual the total net income from such sources within the United States) as reported for income tax purposes for the same year and deducting therefrom the deduction, if any, for salary allowed by article 39, if such deduction has not already been made. "There shall be excluded the amounts received during the year upon the stock or from the net earnings of corporations, joint-stock compa- nies or associations, or insurance companies, subject to the income tax imposed by Title I of the Act of September 8, 1916, as amended. 376 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] "In the case, however, of an individual dealing in securities or otherwise using securities in trade or business there shall be included (l) the amount, if any, received -as interest on bonds or obligations of the United States, issued after September 24, 1917 (other than the in- terest received on an amount of such bonds or obligations the^aggregate principal of which does not exceed $5,000), and (2) such proportion of dividends received upon the stock of foreign corporations as is required to be included by article 27. "Illustration : — An individual owns a farm representing an invested capital of $25,000, a country store with an invested capital of $6,000, and a flour mill with an invested capital of $10,000. His net income from the farm is $4,000, from the store $3,000, and from the mill $3,000. Thus his total net income 01 class B is $10,000. His total invested capital is $41,000. Assuming that his deduction is at the rate of 8 per cent, his total deduction will be $3,280 plus $6,000, or $9,280, to be applied against his net income of $10,000 in computing the tax at the graduated rates under articles 16 and 17. "The same individual allows himself a salary of $l,oao for working the farm and $900 for running the store, draws a salary of $1,200 as president of the local bank, and receives $250 in compensation for per- sonal services of various kinds, such as road work, helping neighbors in harvest, etc. He also receives $300 in dividends on an investment in certain stocks and $100 as supervisor's fees. The last item — that is, supervisor's fees — is exempt under the law (section 201, subdivision a). The $300 in dividends is not taxable, inasmuch as it is derived from a mere investment not connected with his trade or business. His net in- come of class A will therefore consist of his salaries and his compensa- tion for personal service, a total of $3,3So. Since he is entitled to a deduction of $6,000 as to this class of income, he will have no tax to pay at the 8 per cent rate under article 15." (Reg. 41, 1918, Art. 36.) Consolidated return. — Ruling. "I conduct two entirely separate businesses, both employ- ing invested capital. Should I make a combined return for the two businesses, or a separate return for each business? "You should make one return covering the two businesses.'' {Excess Profits Tax Primer, 1918, question 23-) Pre-war income. — An individual subject to the graduated rates of taxes, desiring to ascertain his average net income for the three pre- war years used as a starting point the amount of net income shown by his business books for those years. It was not sufficient to use the net profit as shown by the profit and loss account. The various book accounts representing gross in- come and deductions had to be analyzed and a draft form of income tax return had to be prepared therefrom. Suggestions in regard to the treatment of salaries, dividends, etc., which will be found on pages 372 and 374 apply to the pre-war period as well as to the taxable year, as the basis is the same. The determination of the net income of individuals and partner- ships for the years 191 1 and 1912 "upon the same basis and in the same manner" (section 206) as for the taxable year involved a con- siderable amount of work because no income tax law was in force ADJUSTMENT WITH PRE-WAR INCOME 377 [Former Procedure — Continued] during 191 1 and 1912. Even when the estimated average for the pre- war period was near 7 per cent and not well over 9 per cent, the work incident to making out the best legitimate showing was often profitable to the taxpayer. Determination of net income for the pre-war period where THERE IS invested CAPITAL. — Regulations. "The net income which is derived from a trade or business having invested capital (constituting net income of class B as defined in article 14) shall be determined for each of the calendar years 191 1, 1912, and 1913 upon the same basis and in the same manner as provided in article 36. If deduction is made under article 39 corresponding DEDUCTION MUST also be made FOR PRE-WAR PERIOD. — "If, ini computing net income for purposes of the excess profits tax, an individual deducts a reasonable amount designated as salary or cornpensation for personal services rendered by himself, as allowed by article 39, he must also in computing net income for the pre-war period, make a corresponding deduction." (Reg. 41, 1918, Art. 40.) "This does not mean a salary 'in the same amount as for the taxable year, but a reasonable amount.' " (Extract from letter to M. Blau, signed by Commissioner Roper, March 14, 1918.) Determination of Net Income — Partnerships Under the several income tax laws partnerships were not re- quired to make returns of their net income unless specifically re- quested to do so by the Commissioner of Internal Revenue. Under the excess profits tax law, however, they were required to prepare excess profits tax returns (form 1102), and in addition form 1065, "Partnership income return for taxable year 1917," containing the following instructions : "Every domestic partnership having a net income of $6,000 or more, without deducting salaries or interest paid to partners .... and every foreign partnership having a net income of $3,000 or over from sources within the United States, is required to make a return on this form, unless it carries on or does the same kind of business as corporations that are exempt from income tax under section 11 of Title I of the Act of September 8, 1916. . " No double tax on partners. — In order to remove any doubt about double taxation of partners on their shares of partnership profits, T. D. 2612 (December 20, 1917) ruled definitely that such was not the intention of the law: Regulation. "A partner in his individual capacity will not be com- sidered as engaged in trade or business with respect to his share in the profits of the partnership, and consequently will not be subject to excess profits tax thereon. He is, however, subject to the excess profits tax, if any, at the 8 per cent rate under section 209 with respect to any salary or compensation from the partnership for personal 378 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] services (including any amount allowed to the partnership as a de- duction for the period prior to March i, 1918)." Ruling. "A partnership engaged in the practice of law has a net income of $15,000. One partner draws a salary of $3,000 and the other $6,000, leaving $6,000 net for the partnership. The deduction for the partnership is $6,000, leaving no tax to be paid. The $6,000 profits, however, is paid to the partner drawing the $6,000 salary. Does he pay excess profits tax on the basis of an income of $12,000? "No. He has a $6,000 deduction which covers his salary, and the $6,000 received in the form of partnership profits is not taxable to the individual partner under the excess profits tax law. In the above case, neither the partnership nor the individual partners will have any excess profits tax to pay." {Excess Profits Tax Primer, 1918, question 66.) Net income — ^taxable year. — Regulation. "The net income of a partnership for the taxable year shall be determined by adding the amount of its entire net income (or in the case of a foreign partnership, its entire net income from sources within 'the United States) ascertained upon the same basis and in the same manner as provided with respect to individuals for income tax pur- poses by Title I of the Act of September 8, 1916, as amended (income tax regulations, article 30), including the amounts, if any, received during the year as interest on bonds or other obligations of the United States issued after September 24, 1917 (other thanthe interest on an amount of such bonds or obligations, the aggregate principal of which does not ex- ceed $5,000), and deducting therefrom — Deductions — dividends. — "(i) The amounts received during the taxable year as dividends upon the stock or from the net earnings of corporations, joint-stock companies or associations, or insurance companies, subject to the income tax imposed by Title I of the Act of September 8, 1916, as amended, except as otherwise provided in article 27; and Deductions — salaries and interest. — "(2) The deductions, if any, for salaries or interest allowed by arti- cles 32 and 33, if such deductions have not already been made." (Reg. 41, 1918, Art. 30.) The exigencies of excess profits taxation made it necessary in 1917 to assign salaries, more or less arbitrarily, to partners and to sole proprietors. Serious inequalities would otherwise result. Now since the excess profits tax no longer applies to individuals and partner- ships, the same reason does not exist for entering salaries of sole proprietors and partners in the business books as a business expense. The rulings on this practice follow: Regulation. "In computing net income for purposes of the excess profits tax a partnership will be allowed to deduct as an expense rea- sonable salaries or compensation paid to individual partners for per- sonal services actually rendered during the taxable year, if the pay- ments are made in accordance with prior agreements and are prop- erly recorded on the books of the partnership. In no case shall the salaries or compensation so deducted be in excess of salaries or com- ADJUSTMENT WITH PRE-WAR INCOME 379 [Former Procedure — Continued] pensation custornarily paid for similar services under like responsibili- ties by corporations engaged in like or similar trades or businesses. "With respect to any period prior to March i, 1918, regardless of whether a previous agreement has been made as to salaries or com- pensation a similar deduction will be allowed for services actually rendered. "In case of a foreign partnership the deduction shall be limited to those portions of salaries or compensation which are paid for serv- ices rendered with respect to trade or business carried on in the United States. "A partner in his individual capacity is, however, subject to the excess profits tax, if any, at the 8 per cent rate under article 15 (of the excess profits tax regulations) (there is no excess profits tax on salaries under the 1918 law) with respect to any salary or com- pensation from the partnership for personal services (including any amounts allowed to the partnership as a deduction for the period prior to March i, 1918)." (Reg. 41, 1918, Art. 32.) Deductions for gifts. — For full discussion of contention that partner- ship gifts were deductible in 1917, see page 374. Definition of trade or business. — Regulation. "In the case of a corporation or partnership all income from whatever source derived is deemed to be received from its trade or business, and the terms 'trade,' 'business,' and 'trade or business' include all sources of income." (Reg. 41, 1918, Art. 7.) Interest paid on loans from partners. — The author does not be- lieve that it was an advantage for a partnership to charge interest on partners' so-called loans as an expense of the business. But if it was considered advisable to do so, the regulations pointed the way: Regulation. "In computing net income for purposes of the ex- cess profits tax a partnership will be allowed to deduct amounts paid during the year to an individual partner as interest upon any bona fide loan, but no deduction for so-called interest upon capital will be allowed." (Reg. 41, 1918, Art. 33.) Ruling. "Two partners invested $4,000 each, with the understand- ing that the partnership would pay them 8 per cent on this amount before distributing any other profits. Should the partnership deduct as expense the $640 so paid? "No. It is a division of profits. However, if the notes of the partnership were issued for money actually loaned by the partners, the interest would be deductible but the amount of the loan could not be included in the invested capital." (^Excess Profits Tax Primer, 1918, question 60.) Income from securities contributed to partnership. — When part- ners had turned over securities as part of their contributions to firm capital and the value -of the securities was carried as part of the firm's invested capital, the income from the securities had to be included in the firm's income. If Liberty bonds had been contributed the interest had to be 380 EXCESS PROFITS TAX PROCEDURE [Former Procedure — Continued] reported in order that the excess profits tax could be collected thereon. The rule that interest on tax-exempt or partly tax-exempt bonds could be reported separately by partners and be subject only to the surtaxes did not apply if the bonds had been used as part of the firm's invested capital. If the interest was omitted from the firm's income the bonds would have to be omitted from the firm's invested capital. Certain exemptions under the Fourth Liberty Loan Act would have applied to partnership income for the year 1918 if the excess profits tax had been imposed upon partnerships. A ruling relative thereto is inserted here as a matter of historical interest only. Ruling. "When the income of a partnership is taxable to the partnership as such, as under the present excess profits tax law, the partnership is treated as the owner of the bonds held by it and en- titled to exemption from taxes assessed upon the income of the part- nership as such. "With reference to a tax assessed to the partnership upon the partnership income as a whole, such partnership is the original sub- scriber and entitled to the collateral exemption of interest on bonds of previous issues, on account of such original subscription for bonds of the Fourth Liberty Loan." (T. D. 2762, October 18, 1918.) Pre-war period. — The average net income of partnerships for the years 1911, 1912 and 1913 could be determined by reference to the books of account. The aggregate of the distributive shares of partners as credited to the partners' accounts in those years should have represented the annual net income of the partnership. This amount could be used as a starting point. It was necessary to analyze the items entering into the profit and loss account in order that the book net income might be adjusted to correspond with the net tax- able income as defined by the 1916 law, amended by the 1917 law. It was important to analyze the invested capital and net income of the pre-war period whenever the rate of profit as shown by the books appeared to be less than 9 per cent. For suggestions as to adjustments and procedure required to secure a higher rate of deduction than that shown by the books, see page 375- Salaries and interest — Pre-war period. — Regulation. "If, in computing net income for purposes of the excess profits tax, a partnership makes a deduction as allowed by article 32 for salaries paid to partners during the taxable year, it must also in com- puting net income for the pre-war period make a corresponding deduc- tion; and if it makes such a deduction as allowed by article 33 for interest paid to partners, it must also in computing the net income for the pre- war period make a corresponding deduction for any such interest actually paid during that period." (Reg. 41, 1918, Art. 34.) Returns for fiscal year acceptable.' — Ruling. "Receipt is acknowledged of your letter of February 7, igi8, ADJUSTMENT WITH PRE-WAR INCOME 381 [Former Procedure — Continued] which reads as follows: 'A firm of New York stock brokers have adopted a fjscal year ending May i, and propose to render their excess profits tax return on the basis of such fiscal year. JMay this firm, in ascertaining the profits for the pre-war period, use the fiscal years ending May i, 1911, May i, 1912, and May i, 1913, or the fiscal years ending May i, 1912, May i, 1913, and May i, 1914? Unless they are permitted to do this, it will practically require a reconstruc- tion of their books.' "In reply you are advised that under article 6, Regulations 41, relative to the excess profits tax imposed by the war revenue act, approved October 3, 191 7, the pre-war period means the calendar years 1911, 1912 and 1913. "However, in those cases where the taxpayer had established a fiscal year in effect during the pre-war period, it will be permissible in ascertaining the amount of the capital invested and the percentage of profit, to prorate the amounts pertaining to the respective fiscal years in arriving at the amounts applicable to the calendar years. For example, where the fiscal year terminated on April 30, 1911, as in the above case, the amount of invested capital and percentage of profit would be four-twelfths of the amount for the fiscal year ending on that date, and eight-twelfths of the amount for the suc- ceeding fiscal year, and the same method should be continued to cover the entire pre-war period." (Letter to Wollman & Wollman, New York, N. Y., signed by Deputy Commissioner L. F. Speer, and dated February 26, 1918.) When a return of information as to the invested capital and net income for the pre-war period will not be required. — Regulation. "For the purposes of the excess profits tax, a return of information with respect to the invested capital and net income for the pre-war period will not be required of a corporation, partner- ship, or individual in the following cases: "(i) If the taxpayer accepts the minimum percentage, viz., 7 per cent, as the percentage to be used in computing the deduction under article 21; or "(2) If the trade or business is taxable only at the 8 per cent rate under article 15. "This article must not be construed as not requiring a return of information as to all facts which may be necessary for the ascertain- ment of the capital and income for the taxable year whenever such a return is required by the Commissioner of Internal Revenue." (Reg. 41, 1918, Art. 7S-) CHAPTER XVII REORGANIZATIONS The restrictions against revaluations which applied under the 1917 law to reorganizations, etc., after March 3, 1917, did not apply to reorganizations before that date. Under the 191 7 law corporations organized prior to March 3, 191 7, which were substantially continuations of old businesses might have recapitalized on an inflated basis by overvaluing goodwill or tangible assets or might have issued capital stock against ap- preciation of fixed assets which were revalued upon a basis much higher than cost. Nevertheless, if the new corporations started business before March 3, 191 7, it must be presumed that they could not have been guilty of an attempt to evade a tax based on property values. Prior to March 3, 1917, there was no federal law imposing a tax which depended upon the use of property values (except the corporation excise tax law which has no bearing on the excess profits tax). If new corporations can sustain book values set up to represent assets acquired by purchase or gift, they will be able to include such book values in their invested capital, even though the assets are obviously carried at values in excess of cost to the vendors or donors to the new cor- poration. The one important condition is that, if there is a claim that the assets acquired exceeded the par value of the stock or cash paid therefor and the excess above such pay- ments is set up as paid-in surplus, proof satisfactory to the Commissioner must be submitted to sustain the claim.^ The principal problems arising from reorganizations fall into two main classes : I. Has a new corporation emerged as a result of reorgani- zation, merger, consolidation or change of ownership? Tor regulations, etc., as to paid-in surplus, see page 152. 382 REORGANIZATIONS 383 2. If such reorganization took place before March 3, 191 7, what values may be used in determining invested capital of the new organization? Determination of New Corporate Entity One of the most troublesome problems in excess profits tax procedure is that of reorganizations. Where such took place prior to March 3, 1917, those responsible were not charged with the knowledge that a revenue law would be passed in which invested capital, as defined in a restricted and arbitrary manner, would be the chief factor. When no change was made in the corporate form the problems are difficult enough but when changes in corporate form took place the problems are multiplied. Intention of law regarding new corporate entity. — In any consideration of the question : "Was a new corporation or- ganized prior to March 3, 1917?" the intention of the 1917 and 1918 laws must be understood, because in many cases the distinction between a new and an old corporation is so slight that intention may have a substantial bearing in the result. The laws did not intend to deal harshly with cor- porations organized prior to March 3," 1917. If such had been the intention the language of the laws would have been materially different. On the contrary it was clearly intended that the requirements for the computation of invested capital should be liberal and that when changes in ownership had taken place the valuations put upon the assets should not be subject to the same restrictions as those imposed upon reor- ganizations after March 3, 1917. The underlying principle was to permit the taxpayer to include cost in invested capital in all cases and to include appreciation when a change in ownership had taken place. There was no intention to vest in the Commissioner power to reduce physical assets to less than cost and to exclude intan- 384 EXCESS PROFITS TAX PROCEDURE gible values whenever possible. It would seem, however, from the acts of some of the revenue agents as though they were proceeding under instructions from the Commissioner to re- duce invested capital in every possible way and to throw upon taxpayers a burden of proof which is unreasonable — and, in all probability, illegal. The purchase by a new corporation of the assets of one' or more old corporations usually included tangible and in- tangible assets. The valuation of the tangibles as shown by the books is certainly prima facie evidence that the values are correct. It may be that no depreciation was charged, but in a great many cases charges to maintenance and operation included the cost of additions and betterments to an extent which more than offset the failure to charge depreciation. In the case of intangibles the book value may have reflected the optimism of the directors, but the action of revenue agents in disallowing the entire amount is unwarranted. In the opinion of the author book values are prima facie evidence of admissibility and if the government wishes to question the items (as it has a right to do) the burden of proof should be thrown on the government. When a tax- payer claims values gr£ater than are shown by the books, the burden of proof should be on the taxpayer. When a disadvantage to be considered new corporate entity. — In some cases it is not advantageous for a corpora- tion to compute its invested capital on the basis of a new entity. When intangible assets have been acquired for cash and in a subsequent reorganization new securities are issued, it may be that the intangibles lose their identity as ha'C^ing been acquired for property and the 20 and 25 per cent limita- tion reduces invested capital. When reorganizations are deemed not to be reorganiza- tions. — As above stated, there was no intention on the part of Congress to impose harsh restrictions on reorganizations REORGANIZATIONS 385 which took place prior to March 3, 191 7. In certain cases it is of advantage to show that a change in corporate entity occurred in a reorganization, and in other cases it is detrimen- tal to impute a change in corporate entity. Rulings which hold that changes in corporate entities were not sufficient to permit the revaluation of assets, and rulings which hold that changes were not sufficient to require the application of the regulations to the new entities, follow. Reincorporation may not be "reorganization." — Ruling the M Company, a corporation organized in a cer- tain State, decided that its development would be hampered by its organization in that State and it was therefore decided to reincorpor- ate the company in another State. Accordingly, a new corporation was formed in another State which exchanged its stock directly with the stockholders of the old corporation for their stock, share for share. No change was made in the capitalization or the surplus, but after it had acquired all of the stock of the old corporation the assets of the old corporation were transferred to the new corporation and the charter of the old corporation surrendered. This was in essence merely a reincorporation in a different State without essential change as to business, capitalization, or surplus. The change of a domicile took place in 1916, and the Committee has considered a number of precedents established under the acts of 1913 and 1916 with regard to the treatment of essentially similar transactions. It finds that under such conditions it was the practice of the Bureau to require only one return as covering the income of both the old and the new corporation. It also finds that in numer- ous cases it was held that no income accrued to the stockholders by reason of exchange of their stock in the old for stock in the new corporation. The Committee is of the opinion that it is not necessary to make any radical departure from the "distinct entity" theory which has been the guide of the bureau in the past, but feels that where there is merely a transfer of domicile through the surrender of the charter issued in one State and the taking out of a new charter in another State, without any change in the business or amount of the capital and surplus of the corporation, that the new company is entitled to the same invested capital as the old. It is therefore recommended that the M Company (new) be per- mitted to use the invested capital which would have been permitted the M Company (old) if there had been no surrender of charter, and change of domicile. (B. 3-20-697; A. R. R. 16.) 386 EXCESS PROFITS TAX PROCEDURE Reincorporation in another state has been sometimes un- dertaken, and operating deficits have been written off or asset values written down concurrently with an issue of no-par- value stock. The invested capital of the new corporation would then appear as much smaller in amount than that shown by the old corporation. Under the Treasury's ruling, however, the invested capital of the old corporation might be used. Change of name with increase of capital stock DOES NOT' change IDENTITY. — To accompHsh the consolida- tion of two corporations in 1916, the certificate of incor- poration of one of them was amended so as to change its name from the M Company to the Z Company, and to increase its capital stock. The Treasury held: Ruling Restating the rule of section 208, Revenue Act of 1917, for the determination of invested capital : . . . . where there is no change of identity of the absorbing organization, its prior assets must be valued under section 207 and not at the time of the reorganization, consolidation, or transfer, since there was no transfer of its assets at that time. Applying the rule to the present case, the mere change of name by amendment with an increase of stock did not involve a change of identity as to the M Company, and there could not have been there- fore, a transfer of the assets of that organization within the meaning of the statute It will be necessary, therefore, in determining the invested capital of the Z Company to add .... such a sum as represents the invested capital of the M Company as defined by section 207(a) of the Revenue Act of 1917. The valuation of the assets of the latter company made in 1916 will have to be disregarded, and its assets valued on the basis that no change of ownership or control has occurred as to those assets. There was no transfer or receipt from "a prior trade or business" as to such assets. (B. 10-19-365; O. 872.) When stockholders of new company were credit- ors OF PREDECESSOR COMPANY. Ruling. It appears that the Y Company went into the hands of a receiver, the plant being worth, on the basis of cost less depreciation, approximately 8x dollars. The creditors acquired the assets at a re- ceiver's sale at a nominal figure in order to cover loans. They turned the business over to the Z Company, a new corporation formed for the REORGANIZATIONS 387 purpose of taking over the property. The conditions of this latter sale were: (i) the Z Company was to supply x dollars working capital; (2) the Z Company was to assume the unpaid liabilities of the Y Company and pay them off within a period of years; (3) the Z Company was to have the assets of the Y Company in return for meeting the liabilities. Upon these conditions the Z Company was duly incorporated with a capital stock of x dollars subscribed. It is claimed that the stock- holders of the new corporation are the same as those of the defunct Y Company, and for that reason the new corporation requests to be permitted to set up an invested' capital equal to that of the defunct corporation. There is a difference of opinion as to whether the x dollars actu- ally paid in to the Z Company in return for their stock should be con- sidered the total invested capital of the new corporation or whether the view should be taken that the new business is substantially a reor- ganization of the old, and, therefore, the invested capital be fixed upon that basis The new corporation having been formed, it took over the prop- erty which had been taken by the creditors in satisfaction of their claims on the following conditions : They were to furnish x dollars working capital, to raise which they sold stock; and they were to assume the unpaid liabilities of the old corporation in exchange for the property taken over by the banks. The invested capital of the Z Company, therefore, would appear to be the x dollars received for the stock sold. The value of the property received on condition of the assumption of the unpaid liabili- ties of the Y Company can not be included in invested capital because it is borrowed capital. (B. 11-19-389; T. B. M. 49.) The foregoing ruling seems to work a hardship, as a sHght change in the form of reorganization would have per- mitted the new company to claim greater invested capital than was allowed. Change of corporate entity — same officers and stockholders.- — Ruling. Where there was a change of corporate entity prior to March 3, 1917, without a change of officers or directors, or propor- tions of stock holdings, the new corporation is entitled in the com- putation of invested capital, to the actual cash value of the tangible and intangible property paid in for its stock, subject only to the lim- itations provided in section 207 of the Revenue Act of 1917 as to the value of the intangibles which may be recognized. (B. Digest 25-20- 1022; A. R. M. 60.) 388 EXCESS PROFITS TAX PROCEDURE In the detailed ruling the Treasury stated: The only question, therefore, left in the case is : Was there such a change of entity in the corporations named as to create in effect a new corporation? The uniform practice for some years in dealing with the question of sales of stock has been to treat every change of corporate entity as the creation of a new organization. The only exception to this has been in the case of a mere change of domicile; that is to say, surrender of charter in one State and the taking out of a new charter in a different State, without change, however, in the amount of the stock, the identity of the stockholders or capital and surplus as it appears on the books of the corporation. It is clear that under the rulings of the office stockholders who, in either of the cases above mentioned, surrendered their stock, reqeiv- ing therefor stock in the new corporation, would have been held liable to income tax if the value of the stock received was in excess of the cost of the stock surrendered therefor, or the value of such sur- rendered stock on March i, 1913, on the ground that there had been an exchange of property of one kind for property of a different kind. Securing of new charter upon expiration of old — new corporation created. Ruling In determining the invested capital of the cor- poration the field agent undertook to establish values as of 1898, on the theory that the company has been in continuous existence since that date. It appears, however, that the charter of the original cor- poration expired in 190-, which fact was not called to the attention of the officers or stockholders until 190-, at which time a new charter was secured. The question at issue, therefore, between the Unit and the taxpayer is whether the present company was in fact organized in 190-, or has been in continuous operation at least since 1898. As this was a question of law involving the scrutiny of the Georgia statutes, an opinion of the Solicitor upon the point involved was re- quested and the Committee is in receipt of an opinion from him as follows: .... The rules in question are not peculiar to Georgia, but are of gen- eral application and have been variously stated as follows : On the termination of the corporate life, either by lapse of time or decree of court or otherwise, stockholders are at least the equitable owners of its assets, and it seems that, after the debts are paid, the legal title to real property vests in them as tenants in common, where the title of the corporation or its officers is not continued by statute or where the time during which the corporate life is extended by statute has expired, or where the term of the statutory trusteeship of the corporate officers has expired. (8 Fletcher Cyc. Corp. par. 5591, 5593 (37) ; Stearns Coai and Lbr. Co. v. Van Winkle, (Ky.) 221 Fed. 590). REORGANIZATIONS 389 Pezvabic Min. Co. v. Mason, 145 U. S. 349, 356, 36 L. Ed. 732. When the charter expires, the corporation ceases to be a corpora- tion either de jure or de facto and can thereafter exercise no cor- porate powers, (i Fletcher Cyc. par. 285.). . . . It is tlierefore held that for the purpose of determining invested capital for the taxable year a new and distinct corporation is created, where, upon the expiration of the corporate charter of the old organi- zation, a new corporation is formed under a different charter, and property and assets of the old corporation are transferred by the old stockholders as legal owners thereof to the new corporation prior to March 3, 1917, in return for capital stock, and that the provisions of section 207, Revenue Act of 1917, and section 326, Revenue Act of 1918, embodying with some modifications its terms, are applicable in determining the invested capital of the corporation in question. In this conclusion the Committee concurs, and it will be necessary for the Income Tax Unit to redetermine the invested capital paid in at the date of organization in 190-. (B. 41-20-1238; A. R. R. 268.) In the foregoing case the Treasury seems to have gone to the Hmit in recognizing form as distinguished from sub- stance. If the laws of the state had happened automatically to extend the life of a corporation the corporation would have been required to compute its invested capital differently! Irrespective of the merits of the case it would seem that the mere application for renewal of a charter is of less signifi- cance than a change of name or domicile, and in the latter cases it is held that no change in corporate entity takes place. Change of name and organization of new corpora- tion — separate return required for each corporation. — Ruling It appears that the N Company, a Massachusetts corporation, was organized in 1907; that in 1917 the M Company was organized under the laws of the State of Connecticut, with an author- ized capital stock of 150^ dollars, of which 8o;r dollars was issued for the purpose of taking over all the assets and liabilities of- the N Com- pany, a Massachusetts corporation. The charter of the reorganized corporation was drafted so that the corporation could engage in the collateral business of owning and renting real estate in addition to its regular business In the examination of this case the revenue agent has apparently erred by treating the return filed by the corporation under the first two sentences of article 206 of Regulations 33, revised, which read as follows ; 390 EXCESS PROFITS TAX PROCEDURE A mere change in name does not constitute a new corporation. If the business was continuous throughout the year, no change in management or operation other than the change in name having occurred, the return should be made covering the business transacted throughout the year, such return to be made by the corporation in the name which it bears at the end of the year, with a notation on the return to the effect that the name had been changed, giving both the old and the new names. If, however, a distinctly new corporation was organized to take over the property of the old, both corporations will be required to make separate returns covering the periods of the year during which they were respectively in charge of the business. It appears that a new corporation was created to take over the assets of the old corporation, that the authorized capital stock was increased, and that by the new charter the new corporation was authorized to hold title to real estate. A distinctly new corporation came into existence, which took over the property of the old cor- poration; therefore both the old and the new corporations will be required to file separate returns covering the periods of the year during which they were in active control of the business. The last sentence of the above-quoted article of the regulations in the judg- ment of the Committee covers the situation in the instant case. There- fore it is recommended that the action of the Income Tax Unit accepting the revenue agent's recommendation on this point be re- versed and that both the old and the new corporations be required to render separate returns for the respective periods of the year (B. 42-20-1252; A. R. R. 285.) Invested Capital of Corporations Reorganized Before or After March 3, 1917 Reorganizations prior to March 3, 1917. — The 1918 law provides that when a reorganization or change of ownership has taken place since January i, 191 1, the net income and in- vested capital of the predecessor business (individual, partner- ship or corporation) shall be deemed to be the pre-war net in- come and invested capital of the new corporation. Law. Section 330. That in the case of the reorganization, con- solidation, or change of ownership after January i, 191 1, of a trade or business now carried on by a corporation, the corporation shall for the purposes of- this title be deemed to have been in existence prior to that date, and the net income and invested capital of such predecessor trade or business for all or any part of the prewar period prior to the organization of the corporation now carrying REORGANIZATIONS 391 on such trade or business shall be deemed to have been the net in- come and invested capital of such corporation. Regulation. The first two paragraphs of section 330 of the statute relate only to the prewar period and not to the invested capital or net income for the taxable year. Under their provisions in the case of a reorganization, consolidation or change of owner- ship, the corporation is regarded as having been in existence prior to the date of such reorganization, consolidation or change in owner- ship, and the net income and invested capital of the predecessor trade or business for all or any part of the prewar period prior to the, organization of the present corporation are deemed to have been the net income and invested capital of such corporation. (Art. 931.) If the new corporation paid more for the assets of the old business than the valuation of such assets by the former own- ers, the valuation by the new corporation would not be af- fected, except that if patents or goodwill were acquired the limitation of 25 per cent would apply.^ In the 19 1 7 law the limit on goodwill purchased for stock prior to March 3, 191 7, was 20 per cent, but patents were not included in the limitation. Value of assets owned in taxable year must be ad- justed TO same basis in pre-war years. — The following section provides for uniformity in determining invested capital for the taxable year and the pre-war period respectively. The result is accomplished by making the adjustments in the pre- war period, and not by changing the invested capital of the taxable year. Law. Section 330 If any asset of the trade or business in existence both during the taxable year and any prewar year is included in the invested capital for the taxable year but is not in- cluded in the invested capital for such prewar year, or is valued on a different basis in computing the invested capital for the taxable year and such prewar year, respectively, then under rules and regu- lations to be prescribed by the Commissioner with the approval of the Secretary such readjustments shall be made as are necessary to place the computation of the invested capital for such prewar year on the basis employed in determining the invested capital for the taxable year. 'Spction 326 (a-/jj). 392 EXCESS PROFITS TAX PROCEDURE The following illustration sei'ves to show how an adjust- ment, such as is indicated in the foregoing paragraph, is handled : Assume a partnership with average invested capital in 191 1, 1912, 1913 $ 65,000 Original investment was $ S6,7oo* Incorporation took place in 1914 (at which time goodwill was capitalized) — stock issued $170,100 'Deduct: Tangible assets 1914 ' 65,000 Stock issued for goodwill $105,100 Allov/ed for goodwill — % of capital stock outstanding March 3, 1917 ($170,100) 42,525 Amount of goodwill disallowed $ 62,575 Partnership invested capital, Jan. i. 1918, Capital Stock. $255,100 as above $ 65,000 Surplus 86,297 Add: Adjustment for good- • ■ — will 42,525 $341,397 — Deduct: Goodwill disallowed 62,575 Adjusted pre-war invested capital $107,525 Adjusted invested capital =^= taxable year $278,822 Consisting of: Goodwill $ 42,525 Tangibles — pre-war period 65,000 New capital 85,000 Surplus 86,297 $278,822 *Not used ill computation, since in the pre-war period it had increased to $65,000. In other words, since the goodwill which is valued in the taxable year at $42,525 was in existence during the pre-war period, although not on the partnership books, such asset must be valued on the same basis in computing pre-war invested capital. When corporation is successor to individual or part- nership. — When the predecessor business (in case of reorgan- ization, etc.) has been carried on by an individual or partner- gthip and net income and invested capital are to be used by the REORGANIZATIONS 393 successor corporation it will be necessary to restate the ac- counts of the individual or partnership to conform so far as may be practicable to corporate returns. Law. Section 330 If such predecessor trade or business was carried on by a partnership or individual the net income for the prewar period shall, under regulations prescribed by the Commis- sioner with the approval of the Secretary, be ascertained and re- turned as nearly as may be upon the same basis and in the same manner as provided for corporations in Title II, including a reason- able deduction for salary or compensation to each partner or the individual for personal services actually rendered. Regulation. If the predecessor trade or business was carried on by a partnership or individual, the corporation shall make its return of the net income and invested capital of such trade or business as nearly as may be in the same manner as if such trade or business had been carried on by a corporation. It shall submit with its return a statement setting forth (a) the manner in which such trade or busi- ness was carried on and (fe) the points, if any, in which the provisions of the statute and of the regulations are not fully applicable to the determination of the net income or invested capital of the predecessor trade or business for the prewar period. In no case shall the deduQ- tion from gross income for salary or compensation for personal services exceed the salaries or compensation customarily paid at that time by corporations or partnerships of similar size and standing engaged in similar trades or businesses for similar services under like responsibilities. (Art. 932.) Transfer of stock control held to be determining FACTOR. Ruling The original M Company dealt in raw product, and the Y Company bought and manufactured it. It was, however, decided that the entire business could be better conducted under one management; and with this end in view the M Company increased its capital stock and issued it in exchange for the stock of the other two companies. The result was to vest complete control of the entire business in the Z Company, and to transfer to that company the con- trol of the property of the Y Company as of the time when such merger so became legally effective, which was in 1916. The general rule indicated in the statute is that the value of invested capital is to be determined at the time when it is "paid in." It must now be decided when such payment is deemed to be made in cases where there has been a transfer or substitution of stock made in 1916, followed by a formal transfer of tangible assets in 1917. 394 EXCESS PROFITS TAX PROCEDURE Restating the rule of section 208, Revenue Act of 1917, for the determination of invested capital: A. By express provision where there is a reorganization, con- solidation, or change of ownership, (i) after March 3, 1917, and (2) 50 per cent or more of an interest or control remains in the same per- sons, corporations, associations, partnerships, or any of them, then as to assets transferred or received from the prior trade or business, no greater value shall be allowed therefor than if there had been no transfer, unless paid for in cash or tangible property. B. In cases not covered by the provision quoted, that is, cases where the reorganization, consolidation, or change of ownership occurred before March 3, 1917, or after March 3, 1917, with less than 50 per cent remaining in the same control, the invested capital will be determined under the general rule As to the Y Company, there was a transfer of control, and under the facts this transfer was consummated before March 3, 1917, and its assets may therefore be valued as of the time of such transfer. (B. 10-19-365; 0.872.) Value imputed to no-par stock. — Ruling. Where a company incorporated under the laws of one State takes over the assets and business of a corporation of another State at its book value, which included divers parcels of improved real estate, paying for same with an issue of stock of no nominal or par value, the properties so acquired may be included in invested capital in an amount not exceeding the actual cash value at the time so acquired. (E. Digest 11-19-390; T. B. R. 38.) Transfer of same assets through several reorgani- zations. — Ruling Prior to March, 1914, the M Company was a corporation organized and existing under the laws of the State of Louisiana and owned property located there. In March, 1914, this corporation, pursuant to a resolution of its stockholders, duly transferred, sold, and conveyed all of its property to certain stockholders as trustees for themselves and the other stock- holders of the company. It was provided in the resolution authoriz- ing such transfer that the trustees named should have authority to conduct the business theretofore carried on by the corporation in the form of a limited partnership under the name of the M Company (Ltd.), and that the trustees should also liquidate the corporation affairs of the M Company of Louisiana. In June, 1914, the M Company of Texas was duly incorporated under the laws of the State of Texas, having been organized by the above named trustees. The entire issue of capital stock of the new REORGANIZATIONS 395 corporation was thereupon issued to the trustees and beneficiaries of the M Company (Ltd.), the above named limited partnership, in return for all of the assets of that partnership owned jointly by the principals thereof, who were the sole and only stockholders of the original M Company of Louisiana. It is represented that the assets of the limited partnership were in value greatly in excess of the par value of the stock issued by the M Company of Texas, as purchase price thereof, and that company contends that the excess in value of said property when transferred to it in return for its capital stock over the par value of that stock shall be regarded as paid in surplus under the Revenue Act of 1918 The fair inference to be drawn from section 208 is that in the case of such reorganization before March 3, 1917, the general rule shall apply, viz. : Assets should be valued as of the date of transfer to the new corporation for the purpose of determining the invested capital of such corporation. . . . (B. 34-20-1159; Sol. Op. 41.) Reorganizations after March 3, 1917. — Both the 191 7 and 19 18 laws have attempted to prevent the inclusion in invested capital after March 3, 191 7, of any appreciation in values, ex- cept v^rhen a bona fide purchaser acquired more than a major- ity interest in the assets transferred. When less than 50 per cent of the interest of the predecessor business changes hands no asset transferred will be allowed a greater value than if the asset had not been transferred. If a corporation buys out another corporation during a fiscal year, and transfers the assets at book values, undivided profits for the elapsed part of the year would in effect be included as invested capital, as the net assets would be in- creased accordingly.' If the previous owner was not a corporation, the assets transferred shall be valued as of the date when originally ac- quired. Any charges deducted as expenses since March i, 1913, in computing the net income of the previous owner shall not be added to the original cost. Law. Section 331. In the case of the reorganization, consoli- 'See page 397. 396 EXCESS PROFITS TAX PROCEDURE dation or change of ownership of a trade or business, or change of ownership of property, after March 3, 1917, if an interest or con- trol in such trade or business or property of 50 per centum or more remains in the same persons, or any of them, then no asset trans- ferred or received from the previous owner shall, for the purpose of determining invested capital,' be allowed a greater value than would have been allowed under this title in computing the invested capital of such previous owner if such asset had not been so trans- ferred or received: Provided, That if such previous owner was not a corporation, then the value of any asset so transferred or received shall be taken at its cost of acquisition (at the date when acquired by such previous owner) with proper allowance for depreciation, impairment, betterment or development, but no addition to the origi- nal cost shall be made for any charge or expenditure deducted as expense or otherwise on or after March i, 1913, in computing the net income of such previous owner for purposes of taxation. Assume that in 191 7 a corporation took over the business of an individual. In 1903 the individual had bought a coal mine for $100,000. The corporation in 1917 (including the old owner with a 55 per cent interest) took over the mine for $1,000,000, the valuation being at the fair market value of the property. The Treasury has ruled that the transaction is a closed one as to the old owner and assesses income tax on the gain realized above the March i, 1913, valuation. On his books the former owner set up the valuation as of March i, 191 3, at $500,000, and thereafter deducted depreciation and depletion as provided for in the regulations. The new interests have paid in cash $450,000 for a 45 per cent interest in the property but the corporation may claim as invested capital no more than $100,000. Cases such as these are not infrequent and great injustice would be done were it not for the relief sections (327 and 328), which adequately cover the case cited. It may be as- sumed that relief would not be claimed unless the net income were, say, $200,000. On allowable invested capital of $100,- 000 the net income would be 200 per cent. The Committee on Appeals and Review would certainly consider the case on its merits. REORGANIZATIONS 397 Regulation. Where a business is reorganized, consolidated or transferred, or property is transferred, after March 3, 1917, and an interest of 50 per cent or greater in such business or property re- mains in any of the previous owners, then for the purpose of deter- mining invested capital each asset so transferred is valued (o) as if still in the possession of the previous owner, if a corporation, or, if not a corporation, (6) at its cost to such previous owner, with proper adjustments for losses and improvements. This provision is accordingly concerned with the computation of invested capital for the taxable year, while section 330 of the statute is chiefly concerned with the determination of invested capital for the prewar period. .... (Art. 941.) The provision as to the 50 per cent ownership applies only to date of transfer. If more than 50 per cent of the stock of a corporation were actually sold to new interests, section 331 would not be operative. If subsequently the old owners bought enough stock to regain control, invested capital would not be aflfected. Invested capital is based on balance sheet of pred- ecessor AT date of reorganization. Ruling. In the case of a reorganization, the new corporation is required to base its invested capital on the adjusted balance sheet of its predecessor as of ihe date of reorganization. Appreciation in the value of the assets so transferred from the old organization to the new can not be included in the invested capital of the new corpora- tion. The statute, however, does not prohibit the treatment of the date of reorganization as the beginning of a new taxable year. Con- sequently, it does not require the exclusion from the invested capital of the new corporation of surplus and undivided profits earned between the beginning of the then taxable year of the predecessor corporation and the beginning of the taxable year of the new cor- poration. (B. Digest 1-19-137; T. B. R. 2.) "Change of ownership of property" effective under 1 9 18 LAW only. Ruling. In a reorganization subsequent to March 3, 1917, in- volving the dissolution of one corporation and the formation 'of another, the new corporation issued to A, who was principal stock- holder in both corporations, stock in exchange for tangible property. Under the Revenue Act of 1917 (sec. 208), the new corporation may include in its invested capital the actual cash value of the prop- erty at the date of acquisition, even though 50 per cent or more of 398 EXCESS PROFITS TAX PROCEDURE the ownership or control remains in the same person or persons, viz., A. Under the Revenue Act of 1918 (sec. 331), the amount which may be included in invested capital on account of an asset so trans- ferred is limited to its cost to the previous owner with proper adjust- ments for depreciation and improvements, since the limitation pre- scribed by this section applies also to "change of ownership of prop- erty after March 3, 1917." (B. Digest 42-20-1252; A. R. R. 285.) This simply means that the 1918 law is more inclusive and covers the "change in ownership of property" whereas the 1917 law deals with the reorganization or "change of ownership of a trade or business," only. Depreciation and depletion values not limited to OLD COST. Ruling. The provisions of section 331 of the Revenue Act of 1918 relate only to the computation of invested capital. In the re- organization of a corporation owning timber lands and engaging in the manufacture of lumber, the basis for deductions for depletion of the timber and depreciation of the plant, machinery and patents claimed by the reorganized company is the cost of these assets at the time they were acquired in reorganization, or their fair market value as of March i, 1913, if acquired prior thereto. (B. 15-20-855; O. D. 458.) Incorporation of an individual or a partnership before July I, 1 919. — The 19 1 8 law extended to partnerships the (doubt- ful) privilege of incorporating before July i, 19 19, coupled with the further privilege of being subject to the excess and war profits tax for 1918 and 1919. In order to qualify: (i) capital must have been a material income-producing factor; (2) the net income for the taxable year must have been at least 20 per cent of the invested capital for the taxable year; and (3) the taxpayer was required to pay all federal taxes imposed upon corporations since January i, 19 18, such as the 1916 capital stock (excise) tax for the first 6 months of 1918 and the 1918 capital stock (excise) tax for the fiscal year be- ginning July I, 1918. As the taxpayer will have had no out- standing capital stock during that period the basis of the capi- REORGANIZATIONS 399 tal stock tax will be the same as for corporations issuing stock of no par value.* Distributions made on or after January i, 1918/ were subject to the surtax in the returns of the individual recipients as in the case of corporation dividends. In all other respects the taxpayer was required to conform to the procedure laid down for corporations for the taxable year. Law. Section 330 In the case of the organization as a corporation before July i, 1919, of any trade or business in which capital is a material income-producing factor and which was pre- viously owned by a partnership or individual, the net income of such trade or business from January i, 1918, to the date of such reor- ganization may at the option of the individual or partnership be taxed as the net income of a corporation is taxed under Titles II and III; in which event the net income and invested capital of such trade or business shall be computed as if such corporation had been in existence on and after January i, 1918, and the undistributed profits or earnings of such- trade or business shall not be subject to the surtax irnposed in section 211, but amounts distributed on or after January i, 1918, from the earnings of such trade or business shall be taxed to the recipients as dividends, and all the provisions of Titles II and III relating to corporations shall so far as practicable apply to such trade or business : Provided, That this paragraph shall not apply to any trade or business the net income of which for the tax- able year 1918 was less than 20 per centum of its invested capital for such year : Provided further. That any taxpayer who takes advan- tage of this paragraph shall pay the tax imposed by section 1000 of this Act and by the first subdivision of section 407 of the Revenue Act of 1916, as if such taxpayer had been a corporation on and after January i, 1918, with a capital stock having no par value. Regulation. A business enterprise (a) which is organized as a corporation before July i, 1919, (6) in which capital is and has been a material income-producing factor, and (c) which was previ- ously owned by a partnership or individual, may elect to be taxed as a corporation on its net income from January i, 1918, to the date of organization of the corporation. In such event the corporation shall be treated as if in existence since January I, 1918, for the purposes of the income tax, the war profits and excess profits tax, and the capital stock tax. The adoption of any other date than January i, ■"See page 226. "The sixty-day provision would presumably apply. See page 263. 400 EXCESS PROFITS TAX PROCEDURE 1918, for such purpose is not permissible. But this option is not. ex- tended to a business enterprise with a net income for the taxable year 1918 less than 20 per cent of its invested capital. (Art. 933.) The following ruling sets forth in detail the tests applied by the Treasury. Ruling The M Company was a partnership engaged in manufacturing during the calendar year 1918. Early in 1919 the advisability of incorporating and obtaining the benefits of section 330 of the Revenue Act of 1918 was considered and a determination to incorporate prior to July i was reached. So far as appears only the following events took place prior to July I : The determination to incorporate was reached. The plant closed down on June 27, and an inventory was taken as of June 27. No business was transacted as a partnership after June 27. The plant reopened on June 30; and the accounts of the corporation began as of June 30. So far as appears the only work done on June 30 was manufacturing. Articles of incorporation were drafted, signed, and acknowledged, and mailed to the Secretary of State on June 30. Minutes of the first meeting and by-laws were drafted by counsel, and it was decided who the temporary dummy directors should be. ..... Because of defects in the articles, they were returned by the Sec- retary of State, amended, and actually filed on July 2, 1919. It was stated orally that the first meeting was held, directors were elected, and the property was formally transferred from the partnership to the corporation after July 2. It is the contention of the company that it became a de facto corporation on June 30, 1919 This is a remedial provision and should be liberally construed. It will be assumed that in this controversy the Government stands in the same position as 'an ordinary creditor, and that it is sufficient if the existence of a de facto corporation is shown. The requisites of a de facto corporation are, first, the existence of a charter or law under which a corporation with the powers assumed might lawfully exist; second, an effort in good faith to in- corporate thereunder ; and, third, an actual user or exercise of cor- porate powers. (Tulare Irrigating District v. Sheppard, 185 U. S. i.) In applying these tests, however, there is considerable conflict in the decisions even from the same jurisdiction. It may be ad- mitted that the first two requisites were complied with in this case on June 30; but there is great doubt whether there was a sufficient user or exercise of corporate powers prior to July i, 1919, to justify a decision that a de facto corporation existed. Only one day's user of corporate powers is claimed, and so far as appears no business of a peculiarly corporate nature was transacted on that day. "It is essential to the existence of such a corporation (a de facto cor- poration) that there be user of such corporate rights as could be REORGANIZATIONS 401 authorized by law and not merely such as might be exercised by individuals or unincorporated societies. If such a user, therefore, consists only of acts or proceedings that might be exercised without incorporation, a corporation de facto will not usually be inferred therefrom. (Citing cases.) Under the allegations of the bill the name 'Elgin Jewelry Company' was so used by defendants under which to conduct their business before any attempt at incorporation, and the use of such name is entirely consistent with individual or copartnership capacity." (Elgin National Watch Company v. Love- land, 132 Fed. 41, 45, '1904.) Merely manufacturing under the name of M Company is, there- fore, not a sufficient user of corporate powers, since they were merely doing what had been done for a long period under the same name by the copartnership. In fact it affirmatively appears that the acts, which are usually the first acts, such as first meeting, adoption of by-laws, and election of officers, took place after July i. A recent authority, discussing the question of user in this connec- tion, says: Generally, it is sufficient to show that the corporation was acting as a corporation and transacted business as such. But there is no fixed rule for determining just how much business must be done. Taking subscriptions to and issuing stock, electing managers and direc- tors, adopting by-laws, buying a lot and constructing and leasing a building upon it; electing officers and trustees, who manage the cor- porate property for years, and lease and mortgage it, and expend large sums of money, executing powers of attorney, and loaning money and taking a loan and mortgage therefor, have been held to be sufficient. (Fletcher, Cyclopedia of Corporations, Vol. I, p. 625.) It is significant that the illustrations given all include action of a peculiarly corporate nature and all include acts which are not present in the case under consideration. It is clear that mere execution of the articles of incorporation is not a sufficient basis for inferring the existence of a corporation de facto. (Stevens v. Episcopal Church History Co., 125 N. Y. Supp. 573.) The mailing of such articles to the Secretary of State may indicate an attempt in good faith to comply with the statutory re- quirements, but can not be said to be a user of corporate powers. (Fletcher, Cyclopedia of Corporations, Vol. I, p. 625.) In the case of Childs v. Smith, 4$ N. Y. 34, principally relied upon by the taxpayer, meetings were held, officers were elected, by- laws adopted, minutes kept, and business done. These were pecu- liarly corporate acts and indicated a state of facts very different from the one now in question. (So in re Cordova Shop, 216 Fed. 818.) No case has been found which would justify a decision that there was a sufficient user of corporate powers prior to July i, 1919, in 402 EXCESS PROFITS TAX PROCEDURE this case from which to infer the existence of a corporation de facto. Under these circumstances administrative officers are not justified in extending the definition of de facto corporation beyond the limits established by the courts. Nor can the administrative officers extend the time limit established by Congress in section 330. Some reliance is placed by the taxpayer upon the language of section 330 which requires the "organization as a corporation before July I, 1919, of any trade or business." Under any interpretation of these words, however, it seems clear that a corporation de jure or de facto must exist prior to July i. No such' corporation existed at that time in this case, and the taxpayer must therefore be denied the benefits of section 330. (B. 16-20-872; O. 1023.) Partners' salaries to be deducted.— Ruling. Partnership net income as contemplated in section 330, paragraph 3, Revenue Act of 1918, means the net income after deduct- ing salaries of partners. (B. 1-19-138; O. D. 95.) [Former Procedure] Businesses reorganized after March 3,-1917. — Section 208 of the 1917 law provided for the reorganization, consolidation or change of ownership of a business after March 3, 1917 (the date of enactment of the first excess profits tax law). If the controlling interests in the old business remained in con- trol of the new business to the extent of 50 per cent or more, no asset transferred from the old business was allowed a greater value than would have been allowed if such asset had not been transferred. An exception was made where the asset transferred was paid for specifically as such, in cash or tangible property, not to exceed the cash value of the particular asset at the time of payment. It was a fair inference that such reorganizations as took place before March 3, 1917, could not have had in view the act of March 3, 1917. Thereafter it was obvious that a saving in taxes could be effected if capital values could be inflated. If there was a bona fide sale of more than 50 per cent of a business, it was evident that no inflation occurred. In some cases the section worked a hardship. In most cases it worked substantial justice. Regulation. "In case of the reorganization, consolidation, or change of ownership of a trade or busihess after March 3, 1917, if an interest or control in such trade or business of 50 per cent or more remains in con- trol of the same persons, corporations, associations, partnerships, or any of them, then in ascertaining the invested capital of the trade or business no asset transferred or received from the prior trade or busi- ness shall be allowed a greater value than would have been allowed under these regulations in computing the invested capital of such prior trade or business if such asset had not been so transferred or received, unless such asset was paid for specifically as such, in cash or tangible REORGANIZATIONS 403 [Former Procedure — Continued] property, and then not to exceed the actual cash or actual cash value of the tangible property paid therefor at the time of such payment." (Reg. 41. 1918, Art. 50.) Reorganization on or after January 2, 1913. — Section 204 of the 1917 law referred to reorganizations since January 2, 1913, as affecting invested capital and net income. Regulation. "A trade or business carried on by a corporation, part- nership, or individual, which has been formally organized or reorganized on or after January 2, 1913, but which is substantially a continuation of a trade or business carried on prior to that date, shall, for the pur- poses of the excess profits tax, be deemed to have been in existence prior to that date and the invested capital of its predecessor prior to that date shall be deemed to have been its invested capital. This arti- cle relates to the pre-war period and does not apply to the invested capital for the taxable year." (Reg. 41, 1918, Art. 49.) Ruling. " . . . . The excess profits tax law of 1917, explicitly provides that the term 'invested capital' includes the actual cash value of tangible prop- erty paid in other than cash for stock or shares in the corporation. (Sec- tion 207.) This is the general provision and applies to the term 'invested capital' whenever used in the title. One qualification is found in cases in which it is sought to determine invested capital for the prewar years, viz: 1911, 1912, and 1913. This qualification is found in section 204, which provides, in substance, that if the trade or business carried on by the corporation existed prior to January 2, 1913, although the reorganization took place later, the invested capital of the new organization shall be deemed to be no greater than that of its predecessor. This provision, however, applies only to determination of invested capital for prewar years, and has been so regarded by the Bureau." (B. 34-20-1159; Sol. Op. 41) CHAPTER XVIII INCOME FROM GOVERNMENT CONTRACTS Under section 301 (c) of the 1918 law, corporations which during the taxable year 1919 and subsequent years receive net income from government contracts (made between April 6, 191 7, and November 11, 19 18, both dates inclusive) in ex- cess of $10,000 are subject to an excess profits tax specially calculated in the manner described below. Government con- tracts include: (i) a contract with the United States, (2) a contract with an agency of the United States, (3) a contract with an agency of such agency, and (4) a subcontract with a contractor under any such contract. The income tax of such corporations is at the same rate as for other corporations. Law. Section 301 (c) For the taxable year 1919 and each taxable year thereafter there shall be levied, collected, and paid upon the net income of every corporation which derives in such year a net income of more than $10,000 from any Government con- tract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive, a tax equal to the sum of the following: (i) Such a portion of a tax computed at the rates specified in subdivision (a) as the part of the net income attributable to such Government contract or contracts bears to the entire net income. In computing such tax the excess-profits credit and the war-profits credit applicable to the taxable year shall be used; (2) Such a portion of a tax computed at the rates specified in subdivision (b) as the part of the net income not attributable to such Government contract or contracts bears to the entire net income. For the purpose of determining the part of the net income attribu- table to such Government contract or contracts, the proper appor- tionment and allocation of the deductions with respect to gross in- come derived from such Government contract or contracts and from other sources, respectively, shall be determined under rules and regu- lations prescribed by the Commissioner with the approval of the Sec- retary. Government contract defined. — Law. Section i The term "Government contract" means (a) a contract made with the United States, or with any 404 INCOME FROM GOVERNMENT CONTRACTS 405 department, bureau, officer, commission, board, or agency, under the United States and acting in its behalf, or with any agency, controlled by any of the above if the contract is for the benefit of the United States, or (b) a subcontract made with a contractor performing such a contract if the products or services to be furnished under the subcontract are for the benefit of the United States. The term "Gov- ernment contract or contracts made between April 6, 191 7, and November 11, 1918, both dates inclusive" when applied to a contract of the kind referred to in clause (a) of this paragraph, includes all such contracts which, although entered into during such period, were originally not enforceable, but which have been or may become enforceable by reason of subsequent validation in pursuance of law; Regulation. Government contracts may include (o) a contract with the United States, (6) a contract with an agency of the United States, (c) a contract with an agency of such agency, and (d) a subcontract with a contractor under any such contract; provided in every case the contract or subcontract is for the benefit of the United States. Unenforceable contracts subsequently ratified are treated as though made when originally executed. The Commissioner may re- quire any contractor to file with him copies of his Government con- tracts entered into on or after April 6, 1917, and shall have access to the information in the possession of the Government relating to such contracts The realization by a corporation of income from a Government contract may affect its status under the consoli- dated returns provision and the amount of its war profits and excess profits tax. . . . The agreements for the operation of transporta- tion systems while under federal control and for the just compensa- tion of their owners made pursuant to the act of March 21, 1918, are not Government contracts within the meaning of this article. .... (Art. 1510.) The rulings in the ofificial bulletins place the following in the government contract class: Rulings. . . . oral or written contracts and those relating to sales of standard goods and services at open market prices as well as those of a special nature (B. Digest 21-19-519; O. 916.) A Government contract entered into in 1917, amended as to some of its provisions in 1918, and further modified in 1919, is in effect the same contract as entered into in 1917 if the original contract has not been revoked or supplanted by a new contract (B. 24-19- 557; CD. 295.) .... However, contracts with the American Red Cross are con- sidered Government contracts (B. 17-19-468; O. D. 261.) 4o6 EXCESS PROFITS TAX PROCEDURE The following were considered as not being included in the government contract class: Rulings. A contract entered into May i, 1918, with the Director General of Railroads for certain cars for the account, use, and benefit of the various railroad companies under Federal control (B. 12-19-394; O. D. 224.) Contracts entered into between a taxpayer and the Knights of Columbus or the Young Men's Christian Association. (B. 17-19-468; 0. D. 261.) The foregoing rulings are inserted for general informa- tion and need not be discussed in detail. It is not generally known that the American Red Cross is an official govern- mental agency. From the literature which was distributed when funds were solicited it appeared that the Red Cross was under private control and management and that the govern- ment was not responsible for its actions. The intent of Congress in extending the high rates in force in 191 8 to income earned after 19 18 was to reach cor- porations which made large profits from government contracts. The section is one of the most drastic in the 1918 law and imposes the equivalent of a severe penalty. Accordingly, the section must be construed strictly and when a doubt appears it must be decided in favor of the taxpayer. The word "con- tract" should not be construed according to its common mean- ing but in the limited sense intended by the law. In this as in some other cases the Treasury actually ignores the settled policy of the Supreme Court of the United States and when a doubt appears it is settled in favor of the govern- ment.^ Contracts need not be connected with the prosecu- tion OF THE WAR. Ruling. The term "Government contract" as defined in section 1, of the Revenue Act of 1918, and referred to in sections 240(a), 301(c), and 327(d) of that Act, includes contracts made with the 'See Income Tax Procedure, 1921, page 201. INCOME FROM GOVERNMENT CONTRACTS 407 United States, etc., even though not connected with the prosecution of the war. (B. 41-20-1228; O. D. 677.) Contract to manufacture machinery to be used by a government contractor not a government contract. Ruling. Receipt is acknowledged of your letter of November 21, 1919, in which you submit the following statement of facts: "The A Company received an order from the B Company in 1918, for the manufacture of twenty-five cartridge loading machines. The order stated, as appears from photostat copy of the original attached hereto, 'It is understood in placing this order that the equipment is to be used by us for the manufacture of ammunition for the United States government or its Allies.' " Of the twenty-five cartridge loading machines, all but three were shipped and invoiced in 1918. Owing to the termination of hostilities the contract was canceled on November 13, 1918, in accordance with its terms — but reinstated on May i, 1919. Under the reinstatement the three remaining machines were completed and billed to the B Com- pany on October 31, 1919. It is beyond dispute that the purchaser of these machines utilized them in manufacturing cartridges under contracts with the United States. The particular government contracts filled, in part, by the use of the machines are believed by the A Company to be numbered 14066 and 14626, although its information on this point is not definite. You request a ruling concerning whether in respect of the order of the B Company above mentioned, the A Company was a subcon- tractor within the meaning of section i and section 301 (c) of the Revenue Act of 1918. In reply you are advised that from the facts it appears the A Com- pany did not produce or furnish ammunition or any component part thereof, nor did it perform any direct service in connection with the production of ammunition, which was the subject of the contracts between the United States and the B Company. Its contract being limited solely to the manufacture and delivery of machines to be used in the manufacture of ammunition, this office is of the opinion that in this transaction the A Company is not a subcontractor within the meaning of the act. (Letter to Barry Mohun, Washington, D. C, signed by Commissioner Daniel C. Roper, and dated December 17, 1919.) Is compensation paid by government for property seized "income from government contracts"? — The law provides that the excess profits tax imposed by section 301 (c) applies to any corporation which "derives .... a net income of more 4o8 EXCESS PROFITS TAX PROCEDURE than $10,000 from any government contract made between April 6, 1917, and November 11, 1918." In many cases between those dates the plant and other property of taxpayers were taken by the government for war purposes on "commandeer" proceedings of some department. The United States Supreme Court has held^ that the right to compensation when property is taken for government purposes rests on implied contract. Presumably the courts will eventu- ally pass on whether the language of the statute above quoted embraces such implied contracts for compensation for taking of property for war purposes. It would seem that the statute is not clearly enough inclusive of such income to require the excess profits tax upon government contract income to be im- posed upon any gain which may arise from use of property by the government, when no express agreement for compensa- tion was made. It is not likely that members of Congress, who were in- sistent that all who profited by government contracts should be heavily taxed, could have had in mind as a "government contract" compensation such as that paid for commandeered property. The author was a member of the War Department Board of Appraisers and can state authoritatively that in fixing values for property taken for war purposes by so-called "comman- deering" tjie understanding was that no contract, express or implied within the usual meaning of the word, existed. There was a duty on the part of the government to pay just com- pensation to the former owner. If the cases had come within the usual meaning of the term "contract" compensation would have been awarded by the Board of Contract Adjustment and not by the Board of Appraisers. Allocation of income from government contracts. The tax is based on a division of total income between income from government contracts and other income. In order to show the 'United States v. Lynch, 188 U. S. 445. INCOME FROM GOVERNMENT CONTRACTS 409 method of arriving at net income from government contracts a schedule of income and expense on government contracts must be attached to the tax return. The regulations' require that expenses be apportioned to government contracts as fol- lows : all expenses, losses and deductions that apply directly to government contracts must be allocated to them, and all gen- eral expenses, losses and deductions, as, for example, overhead and depreciation, must be allocated to government contracts in the ratio of gross income from government contracts to total gross income. If, however, as should be the case if accounts are properly kept, the taxpayer allocates general expense on a basis other than relative gross income, the schedule accompanying the return should show clearly the basis of allocation. A new form, 1120S, which is reproduced in the Appendix, has been issued by the Treasury, for the purpose of computa- tion of the tax on income from government contracts, and should accompany the income tax return, form 1120. The following instructions which appear on the form, indi- cate the scope of the supporting schedules which are required : A schedule should be submitted respecting Government contracts made between April 6, 1917, and November 11, 1918, both dates in- clusive, from which net income in an amount exceeding $10,000 was derived during the taxable period. In the case of affiliated companies, this information should be shown separately for each company. This schedule should be in columnar form and should contain the following information as respects each contract : (a) Amount of contract. (fe) Gross income from contract during period. (c) Expenses directly applicable to each contract. Total of each column should be shown. There should also be shown in the most practicable form ; (rf) Total gross income of corporation. (e) Percentage which total of column (&) is of (d). (/) Total general expenses, losses, and deductions of corpora- tion. (g) Amount of (/) allocated to Government contracts (total). (h) Percentage which (g) is of (/). 'See Reg. 45, Art. 715, page 79. 4IO EXCESS PROFITS TAX PROCEDURE The instructions also provide : If the allocation of general expenses, losses, and deductions differs from the percentage which the gross income from the Government contract or contracts bears to the total gross income, there shall be submitted a statement showing the items and the amounts thereof which have been otherwise allocated, and the reasons therefor. If a claim is made under Section 327 of the statute, gains, profits, commis- sions, or other income derived on a cost-plus basis from a Govern- ment contract or contracts made between April 6, 1917, and Novem- ber II, 1918, both dates inclusive, should be shown separately from income from Government contracts of different character. Allocation of net income when income arising from government contracts cannot be distinguished. Ruling. If exact determination of income arising from Gov- ernment contracts distinctively from other income is impossible, an approximation based on the proportion which sales to the Government bears to other sales should be used only in case approximations based on the respective cost and selling price are inapplicable. The approx- imation should be based upon the allocation of costs and allocation of selling price, in the most accurate manner possible from available records. Amortization is not to be charged exclusively against income from Government contracts, and selling and administrative expenses not applicable to the Government contracts should not be so charged. (B. Digest, 26-19-597; A. R. M. i.) Computation of the tax. — The excess profits tax on gov- ernment contract income and other income is the sum of the following two items : 1. Such a portion of a tax figured at the 1918 rates, upon the whole net income, as the government con- tract net income is of the whole net income. 2. Such a portion of a tax figured at the 19 19 rates, upon the whole net income, as the net income from sources other than government contracts is of the whole net income. The excess profits credit and the war profits credit are figured for the taxable year in the above calculation in the same way as if there were no government contract income. INCOME FROM GOVERNMENT CONTRACTS 411 Net loss from other operations may be applied against income from government contracts. Ruling. In 1919 a corporation derived a profit in excess of $10,000 from Government contracts, but sustained a net loss on other operations. Held that it may deduct the amount of such loss in as- certaining its net income subject to tax. If the amount of the excess- profits credits exceeds the company's total net income from all sources for 1919 no tax will be imposed upon the portion of its net income for that year which was derived from Government contracts. Since the Company's net income included an item of net profit from Government contracts in excess of $10,000, it will be required to supply fully all of the data called for by the supporting schedules of Form 1120-S. (B. 22-20-979; O. D. 532.) Credit for computation of tax on income from government contracts to be based on the invested cap- ital for the taxable year.- — • Ruling. The excess-profits credit and the war-profits credit, as provided in section 301(c) i. Revenue Act of 1918, and article 714 of Regulations No. 45, are computed on the basis of the invested capital for the taxable year, not on the invested capital for 1918. (B. 3-20- 695; O. D. 378.) The maximum limitations provided in section 302 apply in case of the excess profits tax on government income. Law. Section 302. That the tax imposed by subdivision (a) of section 301 shall in no case be more than 30 per centum of the amount of the net income in excess of $3,000 and not in excess of $20,000, plus 80 per centum of the amount of the net income in excess of $20,000; the tax imposed by subdivision (b) of section 301 shall in no case be more than 20 per centum of the amount of the net income in excess of $3,000 and not in excess of $20,000, plus 40 per centum of the amount of the net income in excess of $20,000; and the above limitations shall apply to the taxes computed under subdivisions (a) and (b) of section 301, respectively, when used in subdivision (c) of that section. Nothing in this section shall be construed in such manner as to increase the tax imposed by section 301. For computation illustrating the operation of the above section, see page 64. Fiscal year corporation. — In the case of returns for fiscal years ending in 1919, if net income aggregating more than 412 EXCESS PROFITS TAX PROCEDURE $10,000 is received from government contracts, the excess profits tax is such part of the tax calculated as above as the portion of the fiscal year falling in 1919 is of twelve months, plus such part of an excess profits and war profits tax at 1918 rates as the portion of the fiscal year falling in 1918 is of twelve months/ In fiscal years ending in 1920 and subsequently, the non- government contract income is all taxed at the same rate, so that no apportionment of such tax is needed, as is the case when the rate for each year is different. Law. Section 335. (b) If a corporation makes return for a fiscal year beginning in 191 8 and ending in 1919, the tax for such fiscal year under this title shall be the sum of: (i) the same propor- tion of a tax for the entire period computed under subdivision (a) of section 301 which the portion of such period falling within the calendar year 1918 is of the entire period, and (2) the same propor- tion of a tax for the entire period computed under subdivision (b) or (c) of section 301 which the portion of such period falling within the calendar year 1919 is of the entire period. Limitation of war profits credit. — If a corporation was not in existence during the whole of one year during the pre-war period, the 1918 law provides^ that it shall have as a credit in computing its 19 18 tax amount equivalent to the credits of cor- porations engaged in a similar business. But its war profits credit shall be $3,000 plus 10 per cent of the invested capital for the taxable year, if Law. Section 311. (d) . . . . (2) 50 per centum or more of its gross income (as computed under section 233 for income tax purposes) consists of gains, profits, commissions, or other income, derived from a government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive. This provision is equitable, as there were no corporations which could be said to be engaged in 1911-13 in business similar to war business." 'For illustration of, computation, see page 57. "Section 311 (c). "See page 115. INCOME FROM GOVERNMENT CONTRACTS 413 Invested capital "relief" denied. — In the regulations under the 19 1 7 law and in the 191 8 law itself certain provisions are made for the equalization of the invested capital of corpora- tions without which undue hardship would ensue. The bene- fit of the relief sections in the 19 18 law is denied to a corpora- tion in any case, in which Law. Section 327. (d) .... (2) 50 per centum or more of the gross income of the corporation for the taxable year (computed under section 233 of Title II) consists of gains, profits, commissions, or other income, derived on a cost-plus basis from a Government contract or contracts made between April 6, 1917, and November 11, igi8, both dates inclusive.' The term "cost-plus basis" must be strictly construed. — Some government contracts were settled on the basis of the payment of a lump sum contract price, and there were paid or rather repaid in addition, under the terms of the contract, certain amounts which the contractor had to pay because of increases in cost of labor and materials. The contractors were paid a fee for handling the additional payments, the fee being a percentage of such additional payments. The term "cost- plus basis" could not be applied to such transactions because the contractor made his main contract on a lump sum basis and the additional payments were due to causes beyond his control. 'See Chapter XV. CHAPTER XIX NOMINAL CAPITAI^-THE 1917 TAX FORMER PROCEDURE Under the 19 17 law an 8 per cent flat tax was levied on income derived from trades or businesses with nominal or no capital. 1917 Law. Section 209. That in the case of a trade or busi- ness having no invested capital or not more than a nominal capital there shall be levied, assessed, collected and paid, in addition to the taxes under existing law and under this act, in lieu of the tax im- posed by section 201, a tax equivalent to 8 per centum of the net income of such trade or business in excess of the following deduc- tions: In the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000 ; in the case of all other trades or business, no deduction. There has been much discussion regarding the meaning of the word "nominal." Technically it means "in name only," but the lawmakers used it in the sense of "small."^ As the Treasury is now examining 3917 returns and as some examiners are holding that certain isolated investment transactions were subject to the 8 per cent tax, the regulations are reproduced here in full. The question of "nominal capital" corporations is not raised under the 1918 law, because this class of corpora- tions were covered, in effect, by providing for personal service corporations, which are defined as follows: 1918 Law. Section 200 The term personal service cor- poration means a corporation whose income is to be ascribed pri- marily to the activities of the principal owners or stockholders who are themselves regularly engaged in the active conduct of the affairs of the corporation and in which capital (whether invested or bor- rowed) is not a material income producing factor; but does not in- clude any foreign corporation, nor any corporation 50 per centum 'See Income Tax Procedure, 1918, pages S45-S47. 414 NOMINAL CAPITAI^THE 1917 TAX 415 [Former Procedure] or more of whose gross income consists either (i) of gains, profits or income derived from trading as a principal, or (2) of gains, profits, commissions, or. other income, derived from a government contract or contracts made between April 6, 1917, and November 11, 1918, both dates inclusive; .... Presumably those corporations which were able to qualify under the 191 7 law as "nominal capital" corporations and which desire under the 1918 law to be classed as personal service corporations will be able to do so, but it was difficult under the 19 17 law and regulations so to qualify. The line of demarcation between the corporation whose capital was "nominal" and the corporation whose capital was more than "nominal" was a difficult one to draw, because the 1917 law was not as drastic as the 1918 law in its treatment of "cap- ital (whether invested or borrowed)." Numerous cases are now pending, which involve the definition of the term "nom- inal capital," and the decision of the Treasury in these cases, with the litigation which is likely to follow, will serve to clear the way to a comprehensive definition of what constitutes "nominal capital." Classification of trades or businesses. — Regulation. For the purpose of the excess profits tax trades or businesses which are subject to the tax shall be divided into two classes, as follows : A. Trades or businesses having no invested capital or not more than a nominal capital, including, in the case of individuals, occupa- tions in which they receive salaries, wages, fees, or other compen- sations; and B. Trades or businesses having more than a nominal capital. In the case of a corporation or partnership, all the trades and businesses in which it is engaged shall be treated as a single trade or business (as provided in sec. 201), and all its income from what- ever source derived shall be deemed to be received from such trade or business, and if in such trade or business, considered as a unit, such corporation or partnership employs more than a nominal capital (whether invested, borrowed, or of any other character), it will not be entitled to be assessed under the provisions of section 209. 4i6 EXCESS PROFITS TAX PROCEDURE [Former Procedure] Inasmuch as all the trades or businesses in which a corporation or partnership is engaged are treated as one, a corporation or a part- nership shall be allowed either the deduction provided for in section 203 or the deduction provided for in section 209 (depending on the character of its trade or business), but not both. In the case of an individual each trade or business in which he is engaged, the net income from which is subject to the excess profits tax, shall be classified as provided in this article. Each trade or business in class A shall \)e taxed as provided in article 15, and each trade or business in class B shall be taxed as provided in article 16. If an individual is engaged in two or more trades or businesses, in one of which he employs more than a nominal capital (whether in- vested, borrowed, or of any other character) he will be assessed under the provisions of section 209 only as to those trades or busi- nesses in which he employs no invested capital or not more than a nominal capital; and as to all others, he will be assessed under sec- tion 201. If an individual has more than one business with invested capital, they will all be regarded as one, and (under the provisions of section 203) only one deduction will be allowed; if he has more than one busi- ness with not more than a nominal capital, they will be regarded as one, and (under the provisions of section 209) only one deduction will be allowed. If he has both kinds of businesses he will be re- garded as having two businesses and there will be two deductions — but not more than two. (Reg. 41, 1918, Art. 14, as amended by B. 20-20-946; T. D. 3017.) Rate of tax on trades or businesses in class a. — Regulation. The tax upon trades or businesses in class A as defined in article 14 shall be computed at the rate of 8 per cent upon the net income thereof in excess of $3,000 in the case of a domestic corporation; upon the net income thereof in excess of $6,000 in the case of a domestic partnership or of a citizen or resident of the United States ; and upon the net income thereof without deduction in the case of a foreign corporation or partnership or of a nonresident alie*i individual. (Reg. 41, 1918, Art. 15, as amended by B. 20-20-946; T. D. 3017.) Rate of tax on trades or businesses in class b. — Regulation. The tax upon trades or business in class B, as defined in article 14 shall, except as otherwise provided in article 17, be computed at the following rates: 20 per cent of the amount of the net income in excess of the deduction (determined as provided in articles 21, 23, and 24) and NOMINAL CAPITAL— THE 1917 TAX 417 [Former Procedure] not in excess of 15 per cent of the invested capital for the taxable year; 25 per cent of the amount of the net income in excess of 15 per cent and not in excess of 20 per cent of such capital ; 35 per cent of the amount of the net income in excess of 20 per cent and not in excess of 25 per cent of such capital; 45 per cent of the amount of the net income in excess of 25 per cent and not in excess of 33 per cent of such capital ; 60 per cent of the amount of the net income in excess of 33 per cent of such capital. (Reg. 41, 1918, Art. 16, as amended by B. 20-20- 946; T. D. 3017.) It must not be forgotten that many corporations which equitably belonged in class A have been assessed under section 210^ and not under section 201. In many such cases substan- tial justice has been done. Rulings. A partnership engaged in the produce commission business, which enjoyed a "substantial credit" in addition to capital invested by the partners and derived approximately half of its in- come from buying produce outright and selling same for its own account, was properly assessed under section 210 of the act of Octo- ber 3, 1917, and was not entitled to consideration under section 209 of that act. (B. Digest 5-20-722; A. R. R. 19.) The claim of A, for the refund of a portion of his individual income and excess-profits taxes assessed for the year 1917, raises the question whether a merchant selling coal at wholesale on a commis- sion basis and also selling coal at retail from his own yard is entitled to divide his income from the business and pay the excess-profits tax at the rate of 8 per cent upon the net income derived from the com- mission business, and at the graduated rates of tax upon income de- rived from the sale of coal at retail It is true that in the case of a person carrying on entirely unre- lated businesses, one of which requires invested capital and one of which does not, the regulations permit him to separate the income from those businesses. Thus, in the answer to the tenth question contained in the excess-profits tax primer, it is held that a doctor who also manages and directs a small factory which he owns will be subject to a tax of 8 per cent upon the fees received from his medi- cal practice and to a graduated tax on the income from the fac- tory. It is held, however, in the answer to question seven of the primer, that a person who owns and operates a dry-goods store and ''See page 357. 4i8 EXCESS PROflTS TAX PROCEDURE [Former Procedure] also owns and operates a shoe store may not separate the businesses for the purpose of computing the tax, and in the ninth question it is held that a contractor and dealer in real estate who also lists property owned by others and does business as a real-estate agent or broker has only one business. It is stated "these activities are so interrelated as to constitute one business." It does not clearly appear that the taxpayer is entitled to any relief. If he is, apparently it should be granted under section 210. (B. 8-20-759; S. 1317.) Application of section 209. — Regulation. Section 209 (article 15) applies primarily to occu- pations, professions, trades, and businesses engaged principally in rendering personal service in which the employment of capital is not necessary and the earnings of which are to be ascribed primarily to the activities of the owners. In determining whether a trade or business is taxable under article 15 no weight will be given to the fact that it is carried on by means of personal service unless the principal owners are regularly engaged in the active conduct of the trade or business. (Reg. 41, 1918, Art. 71.) The author has been informed that professional men are being taxed at the 8 per cent rate for 191 7 on income such as that derived from profits in underwritings, although the trans- actions were purely isolated investments. The foregoing regulations and those following make it clear that it never was intended to impose the tax on isolated or investment profits. Application of section 209 not to be affected by mere size of capital, form of organization, etc. — Regulation. Business concerns which render professional or personal service and are of the class normally taxable under article 15 shall not be taken out of that class merely because of the size of the capital if the employment of such capital is necessitated by delay and irregularity in the receipt of fees, etc., or if such capital is wholly or mainly used as a fund from which to advance salaries, wages, etc., or to provide office furniture, accommodations, and equip- ment, nor because of the form of organization, whether corporation NOMINAL CAPITA^-THE 1917 TAX 419 [Former Procedure] or partnership, nor in the case of a partnership because of the number of partners. (Reg. 41, 1918, Art. 72.) Ruling. Profits realized from the sale of fractional interests in various vessels by an individual having no control of the manage- ment of such vessels are not subject to excess profits tax unless it can be shown that the owner of the fractional interests gave enough time and attention to the buying and selling thereof as to constitute a trade or business. (B. Digest 16-20-870; A. R. R. 65.) Meaning of "nominal capital"; businesses which will not be deemed to have nominal capital. — Regulation. The term "nominal capital" as used in section 209 means in general a small or negligible capital whose use in a partic- ular trade or business is incidental. The following will not be con- strued as businesses having a nominal capital for purposes of excess profits tax: (a) A business which because of conditions arising from the war or exceptional opportunities for profits earns a disproportionately high rate of profit during the taxable year, if it belongs to a class which necessarily and customarily requires capital for its operation. In the determination of doubtful cases, stress will be laid upon the normal relation of net income to capital during pre-war years; (b) Corporations which, although their capitalization is nominal, employ a substantial amount of capital in their business; (c) A business having a substantial capital, but whose invested capital within the meaning of section 207 is reduced to a nominal amount by the operation of the restrictive clauses of that section, e.g., where the capital, consisting originally of a small amount of cash paid in, has since appreciated in value, or where the capital is largely covered by indebtedness or consists principally of tax-free securities or of intangible assets built up or developed by expenditures which have been regularly deducted as items of current expense. (Reg. 41, 1918, Art. 71.) Decision of District Court of the United States for THE Western District of Michigan, Southern Divi- sion. — Decision (Syl.) : I. Partnership — Single Trade or Business. In determining liability under section 209 of the act of October 3, 1917, income derived from a single timberland deal by a partnership whose principal business is dealing in lumber can not, by reason of 420 EXCESS PROFITS TAX PROCEDURE [Former Procedure] section 201 of the act, be considered and treated separate and apart from other partnership income or profits. 2. "Invested Capital" Defined. The term "invested capital," as used in section 209 of the Act of October 3, 1917, includes all working capital consisting of money or property, employed in the business or for its benefit, and furnished or paid in by one or more of the partners. 3. Partnership — Rate of Assessment Where Hai'ijig Invested Capital. Where, during the year 1917, a partnership had invested capital, as above defined, more than nominal in amount, excess profits taxes upon its income could not be assessed at the lower rate provided by section 209 of the act of October 3, 1917. 4. Partnership — Objection to Method of Delermining Invested Capital, A partnership which had invested capital more than nominal in amount can not complain of regulations promulgated or of the method employed in determining the amount of such capital, where the arbitrary or supposititious invested capital fixed upon was larger in amount than the invested capital actually possessed and employed, and the taxes imposed were correspondingly dimiivished. 5. Partnership — Brokers. Members of a partnership, who are paid neither a salary nor commissions for their services, but who buy and sell lumber and undertake and assume all the risks and enjoy all the benefits of a merchandising business, employing a large amount of capital, are not brokers. 6. Partnership — Property Pledged as Collateral Security as Part of Invested Capital. Property of member of partnership deposited with bank and pledged as collateral security for the repayment of a loan by or for the benefit of the partnership in pursuance of the articles of partner- ship, is part of the invested capital of such partnership. (B. 44-20- 1284; T. D. 3080.) In the foregoing case it was admitted by the taxpayers that they were engaged in the lumber business; so a deal in timber land could hardly be deemed to be outside their trade or business. Ruling. If the income of a corporation is derived chiefly from the possession of a tangible asset, such as a lease of wharf property, NOMINAL CAPITAI^THE 1917 TAX 421 [Former Procedure] the corporation can not be construed to have no capital or only a nominal capital and is not entitled to assessment under section 209. (B. Digest 46-20-1307; A. R. R. 315.) In the foregoing case the Treasury said that the taxpayer owned "a capital asset which was not capital in name only, but a real tangible asset, to wit, its lease upon the wharf prop- erty." As the lease cost nothing and as its value was due to appreciation, the ruling is not convincing. As the corporation v/as assessed under section 210 the ruling was not unfair. Rulings. Section 209, Revenue Act of 191 7, is not applic- able when 45 per cent of the income of a taxpayer is from commissions, the balance from trading as a principal, and borrowed capital is used in the business. (B. Digest 18-20-904; A. R. R. 78.) M & Company, a partnership, has been in process of liquidation for a number of years, gradually disposing of certain unsold securi- ties without incurring the loss which might have resulted from a forced sale. In 191 7, the firm claims that it was not engaged in a trade or business; that the income received consisted of dividends and interest on the unsold and undivided securities on hand. There was realized, however, on four transactions in foreign sugars the sum of X dollars, which it is claimed did not require the use of capital by the partnership. The profits so realized were distributed in the same proportions as other profits accruing to the- firm. Held, that the partnership although in liquidation at the time, was for the year in question actively engaged in business and it is accord- ingly subject to excess profits tax at the graduated rates under the provisions of sections 201 and 207 of the Revenue Act of 1917. (B. Digest 31-20-1108; A. R. R. 211.) Individual members of partnership. — Regulation. Inasmuch as a partner in his individual capacity is not considered to be engaged in trade or business with respect to his share in the profits of the partnership, he is not subject to excess profits tax thereon. Consequently, in computing his net income for purposes of the excess profits tax he need not include his share of the partnership profits. He shall, however, in computing his net income of class A under article 35, include any salary or compensation from the partnership for personal services (including any amount allowed to the partner- ship as a deduction on his account for the period prior to March i, 1918, in accordance with article 32). (Reg. 41, 1918, Art. 41.) 422 EXCESS PROFITS TAX PROCEDURE [Former Procedure] Individuals — determination of net income when there is no invested capital or only nominal capital. — Regulation. The net income which is derived from a trade or business having no invested capital or not more than a nominal capital, including salaries, wages, fees or other compensations (constituting net income of class A as defined in article 14) shall be determined for the taxable year by adding the total net income from all such sources (or in the case of a non-resident alien individual the total net income from all such sources within the United States) as reported for income tax purposes for the same year. (Reg. 41, 1918, Art. 35.) Barbers. — Ruling if the principal stockholders of the corporation are actively engaged as barbers, etc., in the various shops, the cor- poration would be taxed at the 8 per cent rate under section 209, even though other barbers, etc., are employed, but if the principal stockholders are not so actively engaged, the corporation would be taxed at the graduated rates under section 201. (Letter to Ivans, Wolff & Hoguet, New York, N. Y., signed by Commissioner Daniel C. Roper, and dated March 25, 1918.) (T. D. 2689.) Photographers. — Ruling. If an individual or partnership engages in the photo- graph business and owners devote their time to the business so that the income may be clearly ascribed to their personal services, such income will be taxable under section 209, but in determining whether the business is taxable under section 209 no weight will be given to the fact that it is carried on by means of personal services unless the owners are regularly engaged in the active conduct of the trade or business. This condition would scarcely obtain in the case of a corporation which conducts "a number of photographic studios." The business would no doubt be carried on by employees other than the owners and would necessitate the use and employment of a substantial capital to the use of which the income would be ascribed. Indeed, the very purpose of the corporation would be to secure a return upon the capital invested in the business. There is, therefore, an actual pre- sumption that "a corporation conducting a number of photograph studios" does not come within the purview of section 209 but is taxable under section 201 of Title II of the Act of October 3, 1917. It should make its return accordingly submitting therewith any ex- planatory statement tending to support the contention that it is en- gaged in rendering personal services to which the income to the NOMINAL CAPITAL— THE 1917 TAX 423 [Former Procedure] corporation may be ascribed. (Letter to Gallert & Heilborn, New York, N. Y., signed by Deputy Commissioner L. F. Speer, and dated April 8, 1918.) Vaudeville theaters. — Ruling. It is the opinion of this office that the vaudeville theatre business, almost without exception, is a business which ordinarily and necessarily requires for its operation and conduct, invested capital. The income which it receives and upon which it is taxable cannot be primarily ascribed to personal services and is a direct result of the capital used and employed in the business. It is held therefore that unless otherwise conclusively shown, the profits arising from the business or trade, namely, the operation of a vaudeville theatre, are subject to the excess profits tax to be com- puted at the graduated rates prescribed by section 201 of Title II, Act of October 3, 1917. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated May 18, 1918.) Salesmen. — Ruling. I am a traveling salesman, working wholly on a com- mission basis. I earn $15,000. My traveling expenses are $3,000. My house advances me $6,000 per year, giving me the rest of my commissions at the end of the year. May I consider that I am in business and allow myself a salary of $6,000, leaving a profit of $6,000 for the business itself? In that case I should be entitled to a deduction of $6,000 for the business and $6,000 against my salary and I should have no excess profits tax to pay. No. You should enter the $15,000 in block A on form 1040, making proper deduction for expenses. You would then have a net income of $12,000, of which $6,000 would be taxable at the 8 per cent rate. {Excess Profits Tax Primer, 1918, question 32.) Minor children. — In a sample return prepared by the col- lector of the second New York district a man with a personal salary of $6,000, who had two sons, one earning $3,000 and the other $1,200, was shown as being subject to an excess profits tax of 8 per cent upon $4,200 ($10,200 less $6,000 exemption). The sample return was erroneous as shown by the following: Ruling. An individual who received a salary of $8,000 during the taxable year has a minor sop (not emancipated) who earned $800 424 EXCESS PROFITS TAX PROCEDURE [Former Procedure] during the taxable year in a separate occupation. Must the $800 be included in the income of the parent subject to excess profits tax? No. The father is not engaged in business with respect to the income of his minor children earned in a separate and distinct occu- pation. (Excess Profits Tax Primer, 191 8, question 22.) Stock exchange seat. — Ruling. Your telegram twenty-first ultimo. In determining in- vested capital for purpose of excess profits tax a taxpayer doing busi- ness with invested capital may include the cost of a seat on the stock or other exchange among admissible assets, but a broker owning seat on an exchange and employing no invested capital in his business will not because of his ownership of such seat be subject to the gradu- ated rates prescribed by section 201 of Title II of Act of October 3, 1917. (Telegram to O'Brien, Boardman, Harper & Fox, New York, N. Y., signed by Commissioner Daniel C. Roper, and dated March 5, 1918.) When capital was not used in business. — Ruling. Reference is made to your letter of the 2nd instant, in which you state that a corporation is engaged in selling merchandise on commission, and instead of distributing the earnings of the cor- poration by way of dividend, they are desirous of permitting such earnings to accumulate. Such accumulated earnings are not used in the business, but are kept for investment purposes, merely for the convenience of the stockholders. In reply to your second inquiry, you are informed that a business concern which renders professional or personal serviceSj or one which requires no invested capital for its operation or not more than a nominal amount will not be taken out of the classes of business which are normally taxable under article 15 of Regulations 41, merely because the earnings are permitted to accumulate. The burden of proof is at all times on the taxpayer to show that the business in which he is engaged actually belongs to that class which is taxable under article 15. (Letter to Rose & Paskus, New York, N. Y., signed by Deputy Commissioner L. F. Speer and dated May 15, 1918.) Will every partnership reporting income from business under block B, page 3 of form 1065, be taxable at the graduated rates under section 201 ? Not necessarily. Every partnership reporting income under block B must make a return on form 1102. But if it is clear that its principal trade or business consists in rendering persona! service (income reported under block A) and is taxable at the 8 per cent rate. NOMINAL CAPITAL— THE 1917 TAX 425 [Former Procedure] all of its income will be taxed at that rate even though a part of it may be derived from "invested capital." (Excess Profits Tax Primen, 1918, question 44.) Agents and brokers. — Regulation. Agents and brokers requiring and using no capital or merely a nominal capital in their business are taxable under article 15, but commission houses regularly employing a substantial amount of capital, whether to lend to principals or to carry goods on their own account, are not deemed to be agents or brokers and are taxable under the provisions of article 16. (Reg. 41, 1918, Art. 73.) It was clearly intended to tax, at the 8 per cent rate, brokers without sufficient capital to take title to propery. Deductions permitted. — Section 209 levied the tax on "the net income of SLUch trade or business." It therefore followed that all deductions incident to earning the gross income were deductible before the net income coul4 be ascertained. The same class of deductions to which professional men and others deriving their income from personal services were entitled applied in the case of all those who were compelled to pay the 8 per cent tax. In computing income subject to war excess profits TAX under class "a" DEDUCTIBLE ITEMS ARE THOSE ONLY WHICH ARE INCIDENTAL TO THE PRODUCTION OF THE CLASS "a" INCOME. Rulings. Receipt is acknowledged of your letter of January 31, 1918, in which you state that form 1040 revised, individual income tax return, contemplates that the excess profits tax imposed under section 209 of the Act of October 3, 1917, will be computed on the total shown in block A, salaries, etc., without allowing the general deductions to which a taxpayer is entitled for income tax purposes. You present the case of a person whose sole source of income is a salary of $12,000 and whose paid expenses were $500 [for interest on a mortgage covepng his home], $500 in taxes on his home and $1,000 for subscriptions to charitable and religious organizations, the aggre- gate total being $2,000 and inquire whether these allowable deductions 426 EXCESS PROFITS TAX PROCEDURE [Former Procedure] for income tax purposes may also be deducted wlien computing the 8 per cent excess profits tax. In reply you are informed that for the purpose of computing the excess profits tax under section 209, the amount reported in block A, form 1040, will be considered net except in the case of salesmen who pay their own expenses out of commissions or salary received and of professional men who are engaged in business on their own account and pay actual necessary expenses incident to the conduct of their business. In the case cited the taxpayer will be required to pay the 8 per cent tax on the total income of $12,000 less the specific deduction of $6,000 or a tax of $480. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated February 18, 1918.) A, an expert oil man, devotes his time and money to the purchase and sale of oil and gas leases and to the promotion of corporations developing oil and gas leases. In 1917 he disposed of his entire hold- ings of the capital stock of the M Co. and of the N Co., corpora- tions in which he owned all the stock except the necessary quahfying shares and was an active officer. The question presented is whether A was engaged in business or trade in 1917 for the purpose of determining his liability ^for excess profits tax on the profits realized from the sale of his interests in the two companies. The committee is of the opinion that A was engaged in the busi- ness of dealing directly or indirectly in the purchase and sale of oil, gas, and mining leases and his ownership of the stock was inci- dental to his business and along the lines of his general activity. The profits derived from the sale of the stock of the M Co. and the N Co. in 1917 are therefore properly to be classed as profits from a trade or business and subject to excess profits tax. The sale of rights acquired through the ownership of stock in any corporation in which he was not a managing officer or employee is considered an isolated transaction and any profit derived therefrom would not be subject to excess profits tax. (B. Digest 16-20-871; A. R. M. 41.) The reasoning in the foregoing case is inconsistent with rulings under the 191 7 and former laws. Business men who owned stocks in corporations with which they were directly- connected and for business reasons sold such stocks at a loss were not permitted to deduct the losses on the ground that a transaction of this kind was not a taxpayer's trade or business unless he was a member of a recognized stock exchange. NOMINAL CAPITAL— THE 1917 TAX 427 [Former Procedure] In the foregoing ruling it does not appear that the tax- payer was a member of a stock exchange. Definition of "trade or business." — Regulation. In the case of an individual, the terms "trade," "business," and "trade or business" comprehend all his activities for gain, profit, or livelihood, entered into with sufficient frequency, or occupying such portion of his time or attention as to constitute a vocation, including occupations and professions. When such activi- ties constitute a vocation they shall be construed to be a trade or business whether continuously carried on during the taxable year or not, and all the income arising therefrom shall be included in his return for excess-profits tax. (Reg. 41, 1918, Art. 8.) Rulings. A physician owned a farm and a part interest in cer- tain oil leases. He spent practically his entire time in 1917 in prac- ticing his profession. The farm was rented out on a cash rental basis; and the management of the interest in the oil leases was in the hands of another individual, the physician merely receiving his share of the net proceeds. Both the farm and the interest in the oil leases were sold at a profit in 1917. Held that the physician was not engaged in the business of farming in 1917, neither did he devote sufficient time and attention to the purchase, promotion, or sale of oil properties during 1917 to constitute a trade or business within the meaning of the Revenue Act of 1917. The profits derived from the sale of the farm and the interest in the oil leases were therefore not subject to excess profits tax. The terms "trade" and "business" as used in the Revenue Act of 1917 include professions and occupations. The term "business" has been defined as that which occupies and engages the time, attention and labor of any one for the purpose of livelihood, profit, or im- provement; that which is his personal concern or interest; employ- ment; regular occupation; but it is not necessary that it should be his sole occupation. Under this definition of business it appears that regular service performed constitutes an occupation or business. Whether or not the income from this service is subject to excess profits tax is dependent upon the time and attention devoted to the occupation or business. (B. 17-20-879; A. R. M. 40.) A is president of two colleges, from which institutions he re- ceived in the calendar year 1917, aggregate salaries amounting to gx dollars. In addition he received for certain professional and literary work due in 1916, but not paid until 1917, the sum of 2x dollars, upon which latter item, in making his return for the calendar year 1917, he computed the tax at only the normal rate. 428, EXCESS PROFITS TAX PROCEDURE [Former Procedure] In the audit of his return this item was included for purposes of surtax in his total net income on line i8 of the return, and was combined, for purposes of excess profits tax, with the salaries re- ported in Block A of the return, and an additional tax was assessed thereon. From this additional assessment A has appealed. Counsel for A contends that the sum received for literary work done in 19 1 6, is not a gain or profit properly subject to excess profits tax, in that A does not with any frequency engage in literary work for compensation; further that his litcary activities are not such as to constitute a vocation, and therefore do not come within the terms "trade or business" as defined in article 8 of Regulations 41. Article 8 of Regulations 41 referred to above is as follows : Art. 8. "Trade" in the case of individuals. — In the case of an individual, the terms "trade," "business," and "trade or business" com- prehend all his activities for gain, profit, or livelihood, entered into with sufficient frequency, or occupying such portion of his time or attention as to constitute a vocation, including occupations and pro- fessions. When such activities constitute a vocation they shall be construed to be a trade or business whether continuously carried on during the taxable year or not, and all the income arising therefrom shall be included in his return for excess profits tax. In the following cases the gain or income is not subject to excess profits tax, and the capital from which such gain or income is derived shall not be included in "invested capital": (a) Gains or profits from transactions entered into for profit, but which are isolated, incidental, or so infrequent as not to constitute an occupation, and .... It will be observed that this article provides that when activities are such as to constitute a vocation they shall be construed to be a trade or business whether or not continuously carried on during the taxable year, and that all the income arising therefrom shall be included in a return for excess profits tax. In a letter addressed to the Bureau A states: This item constituted all payments made to me for additional professional and literary work, due in 1916, but not paid until 1917. It was probably entered in line 20 by error and should, I presume, have been entered under the general heading A, but at all events it ought to have come under the category of "income from salaries, wages, etc.," and not on line 20. It will be noted that A makes the specific assertion that this amount was received by him for additional professional and literary work, or, in other words, from a similar kind of work arising from his profession as that which regularly occupied his attention. The considerable amount of the sum so received indicates that sufficient NOMINAL CAPITAL— THE 1917 TAX 429 [Former Procedure ] time and attention must have been devoted to this "professional and literary" production as to constitute a part of his vocation. It is well known that heads of educational and religious institu- tions frequently receive a very material part of their income from literary work, the commercial value of which is largely derived from the professional reputation gained through the author's connection with such institutions, and that his writings receive acceptance by reason of such fact; and it is the opinion of the Committee that in- come so derived should be regarded as from a part of the "trade or business" of the taxpayer. It is therefore recommended that in the instant case the amount of 2,x dollars be included for the purpose of computing the excess profits tax of this taxpayer. (B. 34-20-1155; A. R. R. 247.) FEDERAL CAPITAL STOCK (EXCISE) TAX CHAPTER XX FEDERAL CAPITAL STOCK (EXCISE) TAX As a means of raising additional revenue, Congress in 1916 imposed an excise tax, commencing January i, 1917,^ on cor- porations for the privilege of doing business. In view of the income and excess profits taxes imposed upon corporations this tax should have been discontinued, but instead of taking such action Congress merely increased the rate and reduced the exemption. The provisions of the 1918 lav^r were made retroactive to July i, 19 18. The rate now in force for domestic corporations is $1''' for each full $1,000 of the average fair value of the capital stock for the year preceding the taxable year in excess of the ex- emption of $5,000.' The rate is comparatively low and the exemption such that the total tax is not excessive. In his report for 19 19 the Commissioner states: "The early regulations touching valuations have been radically elaborated and modified until under present approved methods it has become necessary to individualize each case, consider- ing all elements and factors which throw light on values and harmonizing them so far as possible in the ultimate values found." This is an admission that the earlier regulations were wrong. The early administration of the law did not reflect credit on the Treasury. Originally an attempt was made to divide corporations into a few classes and value the capital stock of all companies in each on practically the same basis. Theoretically, the tax is on the privilege of doing business in a corporate capacity, but it is difficult to assess a tax on the 'Title IV of the revenue act of September 8, 1916, Public No. 271, 64th Congress. 'The former rate was 50 cents for each $1,000 and the exemption was $99,000. 'Foreign corporations, however, are not permitted any deduction. 433 434 FEDERAL CAPITAL STOCK (EXCISE) TAX "fair" value of capital stock without, considering past earn- ings, so that in this respect the tax amounts to a duplication of the income tax. This condition is overcome to some ex- tent by reason of the fact that the capital stock tax is an al- lowable deduction from gross income in determining the net income subject to the income and excess profits taxes. When the law was enacted all the arguments as to the difficulty of administering a property tax were ignored. The injustice of placing a burden upon an unprofitable business was brushed aside. The tax does not apply to individuals and partnerships. It is somewhat similar to various state laws imposing what are known as taxes on "corporate excess." Tax commissions have frequently commented on this system of taxation as having caused much difficulty, and litigation has been frequent. Apparent market value is never taken as con- clusive, because the courts will permit a taxpayer to point out any unfairness in an assessment based thereon. Earning power is never taken as the sole factor of valuation because earnings fluctuate too greatly. All the corporations (educational, fraternal, etc.) exempt under the income tax law are also exempt from this tax. In addition, many corporations organized for profit but not "doing business," as interpreted by the Supreme Court of the United States, are also exempt. This applies to lessor, inactive and similar corporations. The tax is due in advance and the next return will be due in July, 192 1. The law [section 1000 (a-i)] provides that the computation of the tax of a domestic corporation shall be based on "the fair average value of its capital stock for the preceding year." Therefore, the return due in July, 1921, will be based on the average value, etc., during the year July I, 1920, to June 30, 1 92 1 — the government's fiscal year.* 'The following provision is made on form 707 for a corporation's fiscal year which ends at some date other than June 30: "In item 7 on page I hereof the taxpayer will show the closing date of its fiscal year ended between July I, 1920, and June 30, 1921, if other than June 30, and the information furnished under exhibits A, B and C will be as of the year or years ended on such date, which should be used annually," FEDERAL CAPITAL STOCK (EXCISE) TAX 435 The Treasury has issued regulations^ which are reproduced in the following pages, governing the preparation of returns, etc. The law is wisely silent as to many details which usually encumber tax bills. In his report for 1920 the Commissioner states that — Owing to the retroactive feature of the Revenue Act of 1918, which was passed February 24, 1919, changing the rate and lowering the exemption, the work of the division was greatly increased; but the audit of returns for the taxable period ended June 30, 1919, was practically completed by January i, 1920, except in the case of cor- porations delinquent in filing returns, or cases reopened by reason of additional information contained in subsequent returns or obtained by field investigation. The audit of the returns for the taxable period ended June 30, 1920, was begun immediately, and it will be completed by the time the returns filed for the coming year are arranged for audit. Difficulty has been encountered in procuring and retaining capable examiners, owing to the qualifications required. This division has evolved into a staff of valuation experts on questions of estimating the worth of collateral securities and all forms of property. It requires men of sound judgment, a general knowledge of business conditions, and some knowledge of law, accounting practice, and financing procedure. During the year the number of employees was reduced from 148 to an average working force of 115, and at the same time the work has been kept on a current basis. A revision of capital stock tax regulations has been accomplished with a view to putting into taxpayers' hands complete information '[Former Procedure] Regulations 38 were issued October 19, 1916. Regulations 38 (revised) were issued August 9, 1918. Regulations SO were issued April 29, 1919. In the opinion of the author the require- ments of the 1916 regulations were reasonable but T. D. 2503 (June 25, 1917) imposed new methods of ascertaining the "fair value" of the cor- porate stock which were fallacious, not in accord with the law and unen- forceable. As the valuation of capital stock is the basis for the assessment of the tax, the importance of a correct formula for calculating "fair value" should not be underestimated. Detailed criticism of the regula- tions will be found in Income Tax Procedure, 1918, pages 628 to 677. Regulations 38 (revised, 1918) and Regulations 50 (April, 1919) did not continue the former objectionable instructions. Therefore, it is con- sidered unnecessary to repeat in this book most of the comments on the original regulations. But taxpayers whose returns for the fiscal year ended June 30, 1918, and earlier periods have not been examined or finally settled should refer to the 1918 edition of this manual. From information which has come to the author it seems that very many close corporations were over-assessed, but that practically no corporation whose stock was listed on an exchange was so treated. The corporations which were over-assessed should apply for a refund. 436 FEDERAL CAPITAL STOCK (EXCISE) TAX for the preparation of returns. The modifications in the regulations are not extensive, but changes of importance have been made in the provisions relative to tentative returns; to cases where a change in number of shares has occurred in the outstanding stock of a cor- poration during the year immediately preceding the taxable period; to questions of parent and subsidiary corporations or affiliated cor- porations; and to questions of classifying corporations exempt on account of personal service. Returns are checked with those of previous years to detect in- consistencies. Periodical conferences are held between group heads and administrative officers of the division, in order that the examining force may receive the benefit of conclusions reached and the inter- pretations placed upon the law and regulations, from the considera- tion of intricate cases actually before the division for determination. For convenience the text of the law and of Regulations 50 (revised June, 1920) will be reproduced herein. Domestic Corporations Effective date. — Law. Section 1000. (a) That on and after July i, 1918, in lieu of the tax imposed by the first subdivision of section 407 of the Revenue Act of 1916 — .... Regulation. The tax became effective as of July i, 1918, and is to be paid annually in advance for each year beginning July i," in lieu of the capital stock tax imposed by the Revenue Act of 1916. The tax for the year ending June 30, 1919, although necessarily not payable in advance, was payable upon notice and demand by the collector Special taxes, of which this is one, become due on the first day of, July in each year, or on commencing any trade or business on which such tax is imposed. ■ In the former case the tax is for one year, and in the latter case it is for the period from the first day of the month in which the liability to the special tax is incurred to the first day of July following No portion of the tax is refundable where a corporation ceases to do business during the year.^ (Reg. 50, revised, Art. i.) The foregoing regulation is based on section 3237, revised statutes, which appHes to the assessment of special taxes. As 'Corporations whose fiscal years end at dates other than June 30 may submit figures based on their own fiscal years. (Instructions 2. form 707.) 'Law. "All special taxes shall become due on the ist day of July, 1891, and on the ist day of July in each year thereafter, or on commencing any trade or business on which such tax is imposed. In the former FEDERAL CAPITAL STOCK (EXCISE) TAX 437 to corporations organized and beginning corporate activities after July i in any year, however, section 3237 is superseded by the act imposing the federal capital stock tax. Section 1000 (c) of the law, quoted on page 443, specifically provides that the tax "shall not apply to any corporation which was not engaged in business during the preceding year ending June 30." This limitation is recognized in article 26 of Regulations 50, which will be found on page 444. Scope of tax. — Law. Section 1000. (a) .... (i) Every domestic corpora- tion .... Definition of domestic corporations. — Regulations. A domestic corporation is a corporation created or organized in the United States, which includes the States, Terri- tories of Alaska and Hawaii, and the District of Columbia. (Reg. 50, revised. Art. 8.) The term "corporation" includes associations, joint-stock com- panies, whether created by statute or by contract, and insurance com- panies, but not partnerships, properly so called, and whether or not organized for profit or having a capital stock represented by shares. (Reg. so, revised. Art. 2.) Personal service corporations not included. — Per- sonal service corporations, as defined in the law, are taxed as partnerships for income and profits tax purposes. Such cor- porations retain their corporate identity but are not subject to the capital stock tax because personal service corporations are specifically exempt under section 231 of the law. However, to be exempt from the capital stock tax personal service corporations must be granted full classification as such for the purpose of the income and profits taxes. Regulation To be exempt from capital stock tax, cor- porations must have previously been granted full classification as case the tax shall be reckoned for one year, and in the latter case it shall be reckoned proportionately from the ist day of the month in which the liability to a special tax commenced to the ist day of July following." [Section 3237, Revised Statutes, as amended by Section S3 of the act of October i, 1890 (26 Stats., 567)-] 438 FEDERAL CAPITAL STOCK (EXCISE) TAX personal service corporations for the purpose of Federal income and profits taxes under Regulations 45, revised. (Reg. 50, revised. Art. 27.) Associations and limited partnerships which are included. Regulations. Associations and joint-stock companies include organizations, by w^hatever name known,^ which act or do business in an organized capacity, whether created under and pursuant to State laws, agreements, declarations of trust, or otherwise, the net income of which, if any, is distributable among the members or share- holders on the basis of the capital stock held by each, or, where there is no capital stock, on the basis of the proportionate share of capital which each has or has invested in the business or property of the organization An organization, the membership interests in which are transferable without the consent of all of the members, however the transfer may be otherwise restricted, and the business of which is conducted by trustees or directors and officers without the active participation of all the members as such, is an association. (Reg. 50, revised, Art. 3.) The test of liability in all cases involving trusts of the Massa- chusetts type is whether the cestuis que trustent have by the terms of the trust agreement a voice in the management or control of the trust. Where the trustees are in complete control of the business, the beneficiaries having no control except the right of filling vacan- cies among the trustees or of consenting to a modification of the terms of the trust or of dissolving the trust, no association exists. If, however, the cestuis que trustent have a voice in the control or management of the business of the trust, whether through the right to elect trustees periodically or to remove the trustees or to restrict the trustees as to the management of the trust or otherwise, the trust is an association within the meaning of the statute. Where the trustees hold in their own right a sufficient number of the cer- tificates of beneficial interest to constitute control as between the beneficiaries, the trust will be held to be an association regardless of the powers conferred upon the trustee by the instrument creating the trust. (Reg. 50, revised, Art. 7.) A partnership bank, conducted like a corporation and so organ- ized that the interests of its members may be transferred without the consent of the other members, is a joint-stock company or asso- '"Massachusetts trusts'' were held to be exempt from the excise tax in Eliot v. Freeman, et al. [220 U. S. 178 (T. D. 1686)], and corpora- tions in hands of a receiver are exempt. (T. D. 2424.) In Crocker v. Malley (249 U. S. 223) certain types of Massachusetts trusts were held not to be "associations" of the corporate type. FEDERAL CAPITAL STOCK (EXCISE) TAX 439 ciation within the meaning of the statute. A partnership bank, the interests of whose members can not be so transferred, is a partner- ship. (Reg. 50, revised, Art. 6.) Partnerships with limited liability or partnership associations au- thorized by the statutes of Pennsylvania and a few other States are only nominally partnerships. Such so-called limited partnerships, offering opportunity for limiting the liability of all the members, providing for the transferability of partnership shares, and capable of holding real estate and bringing suit in the common name, are more truly corporations than partnerships, and are taxable as cor- porations. In all doubtful cases limited partnerships will be treated as corporations unless they submit satisfactory proof that they are not in effect so organized. Michigan partnership associations are corporations. The liability of Virginia limited partnerships is deter- mined in each case from a consideration of the certificate of part- nership and all pertinent facts relative thereto. (Reg. 50, revised, Art. 4.) As the tax is imposed upon the privilege of doing busi- ness as a corporation the foregoing article appears to be too sweeping in its terms. The courts may be expected to interpret the law so as to exclude rather than include doubtful cases.* Article 1506 of Regulations 45, issued in regard to income and profits taxes, originally provided that "Michigan and Vir- ginia partnership associations are corporations" ; but this arti- cle was amended by T. D. 2943 (November 6, 19 19) to ex- clude Virginia partnership associations. Limited partnerships which are not included. — RfeGULATiON. So-called limited partnerships of the type author- ized by the statutes of New York and most of the States are partner- ships and not corporations within the meaning of the statute. Such limited partnerships which can not limit the liability of the general partners, although the special partners enjoy limited liability so long as they observe the statutory conditions, which are dissolved by the death or transfer of the interest of a general partner, and which can not hold real estate or sue in the partnership name, are so like common law partnerships that they can not be differentiated there- from for tax purposes. Michigan and Illinois limited partnerships are partnerships. California special partnerships are partnerships. (Reg. 50, revised. Art. 5.) 'Crocker v. Malley, 249 U. S. 223. 440 FEDERAL CAPITAL STOCK (EXCISE) TAX Insurance Companies Law. Section looo (c) . . . . The taxes imposed by this sec- tion shall apply to mutual insurance companies, .... Stock companies. — Regulation. Insurance companies having a capital stock as dis- . tinguished from mutual insurance companies are taxable upon the same basis as other corporations, whether domestic or foreign, except that in computing the tax such reserve funds, which include deposits, as they .are required by law or contract to maintain or hold for the protection of, or payment to, or apportionment among, policyholders, are not to be included. In the case of such companies the tax will be computed by deducting from the total book value of the assets the amount of the actual liabilities and legal reserves, unless the facts in the case indicate that the book value of the assets is substantially different from their fair market value, in which case it is permissible to make proper adjustment. In a case requiring such adjustment the market value of the shares of stock as shown by Exhijbit B or the net earnings of the company as shown by Exhibit C in Form 707 (Revised) shall be considered, as well as the fair value of the assets. (Reg. 50, revised. Art. 22.) Mutual companies. — Regulation. ' The tax applies to domestic and foreign mutual insurance companies. A mutual protective association organized under a statute, whose only source of revenue is the assessments paid by its members and whose net income for each year is paid into a reserve fund, constituting the sole resource of the company, aside from current assessments for the payment of losses, is an insurance company within the meaning of the statute. A voluntary unincor- porated association of employees formed for the purpose of relieving sick and aged members and the dependents of deceased members is an insurance company, whether the fund for such purpose is created wholly by membership dues or partly by contributions from the em- ployer. (Reg. 50, revised, Art. 23.) Corporation Must be "Doing Business" to be Taxed Law. Section 1000. (a)....(i)... shall pay annually a special excise tax with respect to carrying on or doing busi- ness, .... Regulation. The basis of the tax in the case of a domestic cor- poration is "carrying on or doing business" in the capacity of a cor- poration, association, or insurance company. The words "carrying FEDERAL CAPITAL STOCK (EXCISE) TAX 441 on or doing business" must be given their ordinary and natural sig- nification. "Business'' is a very comprehensive term and embraces whatever occupies the time, attention or labor of men for the purpose of livelihood or profit. In other words, business necessarily involves the idea of gain. The true basis of distinction is, in the first instance, between — (a) A corporation organized for the purpose of doing business as above defined, and (b) A corporation organized for the sole purpose of owning and holding property and distributing its avails; and, in the second instance, between — (f) A corporation of class (a) which is continuing the body and substance of the business for which it was organized or is still active and maintaining its organization for the purpose of continued efforts in the pursuit of profit or gain, and (d) A corporation which, although included in class (a), has substantially retired from the business for which it was organized and has reduced its activities to the mere owner- ship and holding of property, distributing its avails, and doing only the acts necessary to the maintenance of its corporate existence and the private management of its purely internal affairs. The distinction in each case must depend upon the peculiar facts in the case. Corporations of class (a) will be presumed to be sub- ject to the tax unless they submit proof, satisfactory to the Com- missioner, that they are not actually carrying on or doing business. If a corporation claim exemption on the ground that it belongs to class (&), it will be required to file an excerpt from its charter set- ting forth its corporate powers together with a full and comprehensive statement showing the nature of the activities in which it is and has been actually engaged. If it claim exemption on the ground that it belongs to class (d), it will be required to furnish a copy of any amendment of its charter, resolution of its board of directors, or other evidence, satisfactory to the Commissioner, showing that it has reduced its activities to the mere ownership of property, receipt rif its avails, and the doing of only what is necessary to the maintenance of its corporate existence. i" (Reg. 50, revised. Art. 10.) "Doing business" illustrated.^' — Regulation. Corporations organized for the purpose of and actu- "This regulation elaborates the former regulation but makes no im- portant change in substance. "For court decisions bearing on liability and non-liability to tax, see Income Tax Procedure, 1918, pages 654-659. 442 FEDERAL CAPITAL STOCK (EXCISE) TAX ally engaged in such activities as buying, selling, or dealing in mineral or timber land, or other real estate ; leasing property, collecting rents, managing office buildings, making investments of profits ; leasing lands and collecting royalties, managing wharves, dividing profits; and in some cases investing the surplus, are engaged in "carrying on or doing business" within the meaning of the statute. A corporation organized for the purpose of, and actually engaged in, buying mineral or timber land or other real estate and holding it with a view to future sale at an advance is carrying on or doing business. A corporation organized for the purpose of owning and leasing real estate which has leased all of the property under its control is still engaged in doing business unless, under the terms of its lease, its activities have been reduced to the mere receipt and distribution of the avails of the leases at the actual cost of so doing. If it is still maintaining its organization for the purpose of continued effort in the pursuit of profit and gain it is doing business. A corporation owning or managing real estate which leases all of its property but under the terms of the lease is required to maintain or keep the property in repair is doing business. A corporation engaged in mining or in developing and speculat- ing in mineral lands is doing business. A corporation engaged in buying and selling securities or other property is doing business even though for a period it makes no purchases or sales because of unfavorable market conditions. A corporation formed to take over miscellaneous stocks, bonds or other property (as of an estate), to negotiate sales of various items from time to time as opportunity and judgment dictate, and to dis- tribute the profits from time to time as liquidation is effected, is, while so engaged, carrying on or doing business. A parent corporation which finances or manages the operations of its subsidiaries is doing business. A so-called holding company which, under its charter, is author- ized to and does, in addition to receiving and distributing the avails of the property or securities, held by it, finance the operations of its subsidiaries, is engaged in doing business. A corporation organized for the purpose of taking over and hold- ing securities, timber lands, coal lands, or other real estate, is held to be doing business, if it makes investments or reinvestments of its surplus income or funds in excess of an amount necessary to main- tain its original investments.^^ Not "doing business" illustrated. — Regulation. Holding companies as distinguished from parent "This is elaboration of a former regulation only, FEDERAL CAPITAL STOCK (EXCtSE) TAX 443 corporations, and corporations all of whose property and business is operated by, or is in the hands of, a receiver or the Alien Property Custodian, are not doing business. A holding company is defined as one whose corporate powers are limited to the mere owning and holding of property and distribution of its avails, or one which, although incorporated for the purpose of doing business as defined in article 10, has substantially retired from the business for which it was organized and has reduced its activities to the mere ownership and holding 'of property, distributing its avails, and doing only such acts as are necessary to the main- tenance of its corporate existence and the private management of its purely internal affairs. A holding company, as above defined, will not be considered to be doing business by reason of the reinvestment of its surplus income or funds to the extent only of maintaining its original in- vestments.^? {Reg. 50, revised, Art. 12.) Corporations Which Are Not Subject to the Tax Law. Section 1000. (c) The taxes imposed by this section shall not apply in any year to any corporation which was not engaged in business (or in the case of a foreign corporation not engaged in business in the United States) during the preceding year ending June 30, nor to any corporation enumerated in section 231. If on June 30, 1921, or prior, a corporation formally de- cides to liquidate no return need be made thereafter. Period of doing business determines tax liability.^^ — Regulation. The tax being payable in advance does not apply "[Former Procedure] T. D. 2429, dated January 4, 1917, held that a holding company (having several subsidiaries), the only busi- ness of which was "to receive dividends and interest from the oper- ating companies, pay interest on its own indebtedness and distribute its surplus income as dividends among its own stockholders," is en- gaged in business within the meaning of the act of September 8, 1916, and is subject to the capital stock tax. It will be noted that this decision has been reversed and corporations with activities limited to those described are not liable to the tax. "[Former Procedure] "Doing business" by railroad corporation under federal control. — Regulation. "A corporation owning a railroad controlled and operated by the Government is exempt from liability for a given tax year only in case it does no business during such year. The liability of a corporation which actually does business is not affected by the control over its rail- road exercised by the Government " (Reg. 50, Art. 20.) For detailed procedure regarding railroads, see Reg. 50, Arts. 20 and 21, and T. D. 2800, March 12, 1919. 444 FEDERAL CAPITAL STOCK (EXCISE) TAX to any corporation which was not engaged in business during any part of the fiscal year preceding the year for which the tax is due, but if it was in business even one day of the preceding year and one day of the taxable year it is subject to the tax. There is no relation between the amount of the tax payable and the length of time the corporation was in business. A corporation engaged in business during a part of the preceding year, but not engaged in business at the beginning of the' taxable year, is not required to make any return if it is dissolved or in process of dissolution, but if it is only temporarily inactive and subsequently during the year reengages in business it should file a return in the month in which it recommences business and pay the tax due from the first of such month to the end of the taxable year. A corporation organized and beginning corporate activities on or after July i is not subject to tax for the remainder of the taxable period in which the com- pany was organized, unless as of July i, it takes over the business of an organization which was subject to capital stock tax, in which event the new corporation is required to file a return and pay the tax. In the case of foreign corporations "engaged in business," means the transaction of any business within the United States. (Reg. so, revised, Art. 26.) Exempt corporations. — In addition to corporatioijs not "doing business" the fourteen classes of corporations enu- merated in section 231 of the income tax law are exempt. For details, see page 57. Return by corporation claiming exemption. — Regulation. Where the ofiicers of a corporation are of the opinion that it is exempt from the tax under section 231 of the Revenue Act of 1918, or on account of not being engaged in business, Form 707 (Revised) [page 492] should be filled out and filed with the collector, together with a comprehensive statement of the reasons for claiming exemption. In such case the fair value should be reported on page i of the form, but the tax not computed, notation "Exemption claimed" being made instead. If exemption has been allowed for the preceding taxable year and there has been no change in the status or conditions of the company then the first 14 lines of Form 707 (Revised) should be completed and a statement attached to the effect that exemption is claimed for the same reasons as for the previous year and that the same status and conditions of the company exist for the taxable period in question. In this way the records of the collectors' offices will be complete and corpora- tions will avoid requests for the filing of returns and unnecessary FEDERAL CAPITAL STOCK (EXCISE) TAX 445 correspondence. The determination of liability rests in the first in- stance with the Commissioner of Internal Revenue and without com- plete information it is impossible to make a decision. (Reg. 50, revised, Art. 28.) Rate and Computation of Tax for Domestic Corporations Law. Section 1000, (a) . . (i) Every domestic corporation shall pay annually a special excise tax .... equivalent to $1 for each $1,000 of so much of the fair average value of its capital stock for the preceding year ending June 30 as is in excess of $5,000. In estimat- ing the value of capital stock the surplus and undivided profits shall be included; .... (b) In computing the tax in the case of insurance companies such deposits and reserve funds as they are required by law or con- tract to maintain or hold for the protection of or payment to or apportionment among policyholders shall not be included. (c) .... and in the case of every such domestic [mutual insur- ance] company the tax shall be equivalent to $1 for each $1,000 of the excess over $5,000 of the sum of its surplus or contingent reserves maintained for the general use of the business and any reserves the net additions to which are included in net income under the pro- visions of Title II, as of the close of the preceding accounting period used by such company for purposes of making its income tax return. Regulation. The tax is at the rate of $1 for each full $1,000 of the fair average value of the capital stock of the corporation in excess of the prescribed deduction of $5,000. The tax is com- puted not upon the par value of the stock, but upon the fair average value for the preceding year, or for the period during which it has been issued, if less than a year, of the capital stock outstanding at the date of the incidence of the tax. In the case of a domestic cor- poration it is on an entirely different basis from the excess profits tax, which is concerned with invested capital and not with the fair average value of the capital stock. Stock in the treasury of a cor- poration is not regarded as outstanding unless pledged as security for a debt. No deduction is allowed corporations organized in the United States for capital invested outside of the United States. If the corporation is doing business it is taxed on its entire capital stock even though most of it may not be employed in the business. (Reg. 50, revised, Art. 13.) Mutual insurance companies, domestic — How taxable. — Regulation. The tax is $1 for each full $1,000 of the excess over $5,000 of the sum of (a) the surplus or contingent reserves maintained for the general use of the business, and (b) any re- 446 FEDERAL CAPITAL STOCK (EXCISE) TAX serves the net additions to which are included in net income for the purpose of the income tax, in both cases figured as of the close of the last taxable year of the company. The net addition required by law to be made within the taxable year to reserve funds, including in the case of assessment insurance companies the actual deposit of sums with State or Territorial officers pursuant to law as additions to guarantee or reserve funds and, in the case of corporations issuing policies covering life, health, and accident insurance combined in one policy, issued on the weekly premium payment plan, continuing for life and not subject to cancellation, including such portion of the net addition not required by law, made within the taxable year to reserve funds as is needed for the protection of the holders of such combination policies, is not included in net income for the pur- pose of the income tax. See Regulations 45 and particularly articles 568-570 thereof. (Reg. 50, revised, Art. 24.) Mutual insurance companies, foreign — How taxable. — Regulation. The tax is $1 for each full $1,000 of the same proportion of the sum of (a) and (b) in the last article which the reserve fund upon business transacted within the United States is of the total reserve upon all business transacted, calculated as of the close of the last taxable year of the company. (Reg. 50, revised. Art. 25.) Methods of ascertaining fair value. — Regulations. Every domestic corporation shall make return on Form 707 (Revised) regardless of the par value of its capital stock. Also see articles 28 and 33. The fair average'^^ value of the capital stock of a corporation and the tax payable thereon shall be deter- mined in accordance with the instructions in the form, which pro- vides in Exhibit A for the book or fair value of the assets, in Exhibit B for the market value of the shares, and in Exhibit C for the value of the capital stock based on the capitalized earnings. All the in- formation called for must be given in every case where it is pro- curable. (Reg. 50, revised, Art. 31.) "Form 707 (revised 1919) calls for the total stock outstanding on the last day of the corporation's fiscal year. The law [section 1000 (a-i)] provides that the amount of the tax shall be computed on the basis of the "fair average value of its capital stock for the preceding year." Regulation. "If a corporation has increased or decreased its capital stock during the fiscal year, a statement should be attached to the back of the return setting forth the number of shares of stock outstanding each month, with the average fair value of the stock for that month, com- puted under one of the three cases." (T. D. 2503, June 25, 1917.) FEDERAL CAPITAL STOCK (EXCISE) TAX 447 The fair average value of the capital stock for the purpose of determining the amount of the capital stock tax must not be confused with the market value of the shares of stoek where it may be neces- sary to determine such value under other provisions of the revenue laws. The fair average value of the capital stock, the statutory basis of the tax, is not necessarily the book value or the value based on prices realized in current sales of shares of stock or evert the value, determined by capitalization of earnings, although it may be more directly dependent upon the last. It should usually be capable of appraisal by officers of the corporation having a special knowledge of the affairs of the corporation and general knowledge of the line of business in which it is engaged. Provision is accordingly made in Exhibit C of Form 707 (Revised) for the tentative determination of the fair value of the capital stock by capitalizing the net earnings of the corporation on a percentage basis fixed by its officers as fairly representing the conditions obtaining in the trade and in the locality. But such fair value, except in the case of insurance companies, must not be set at a sum less than the reconstructed book value shown by Exhibit A, unless the corporation is materially affected by extra- ordinary conditions which support a lower valuation. In any such case a full explanation must accompany the return. The Commis- sioner will estimate the fair value of the capital stock in cases regarded as involving any understatement or undervaluation. For the method of computing the fair average value of capital stock in the case of insurance companies see articles 22 and 24. (Reg. 50, revised. Art. 14.) The capital stock tax except on domestic mutual insurance companies is measured by the fair value of the total capital stock, including the surplus and undivided profits, for the year preceding the taxable year, whether the conduct of the busi- ness is profitable or otherwise.^® Regulation. The surplus and undivided profits of a corporation must be included in estimating the fair average value of its capital stock. If the fair average value be determined from the book value, the surplus and undivided profits are included in the assets, if from sales, they are necessarily a factor in determining the market price, and if from net income, they are reflected to a greater or less extent in the earnings. (Reg. 50, revised, Art. 15.) For the purpose of this tax the fair value of the entire capital stock of a going concern, regardless of stock ownership or the ability of individual stockholders to liquidate their hold- "■Form 707, page 4, instructions (see Appendix). 448 FEDERAL CAPITAL STOCK (EXCISE) TAX ings, is required. The sales prices for any number of shares of stock less than a majority interest are not necessarily indica- tive of the fair value of the entire capital stock. The capital invested, the nature of the business, the kind of assets (slow or quick turning), goodwill, franchises, earning capacity, etc., are important factors that affect the worth of enterprises and must be given due consideration in arriving at the fair value at any given date." The three exhibits, A, B and C, are provided to indicate the information desired and the manner in which it should be furnished. So far as adaptable these forms should be com- pleted by taxpayers, but if they find it more convenient they may attach to this return their own statements, provided sub- stantially the same information is furnished. In any event, taxpayers should attach any additional statements that will aid in a comprehensive understanding of the taxpayer's return, so that the Commissioner of Internal Revenue may more equitably determine the correctness of the fair value reported in item 15 on page i hereof.^* Exhibit A provides for adjusting any overstated or under- stated values contained in the taxpayer's books of account, and exhibit C provides for showing an adjusted income, which should be the actual operating income to be used for capitaliz- ing on a percentage basis fixed by its officers as fairly repre- senting conditions obtaining in the trade and in the locality. If the reconstructed book value shown by exhibit A or the market value shown by exhibit B is greater than the valua- tion returned by the taxpayer, a comprehensive statement showing any extraordinary conditions which are relied on in support of the valuation claimed must be submitted. In any case in which the fair value is understated the amount will be redetermined by the Commissioner.^^ It will be noted that the balance sheet to be furnished under "Form 707, page 4, instruction i. '°Form 707, page 4, instruction 3. "Form 707, page 4, instruction i. FEDERAL CAPITAL STOCK (EXCISE) TAX 449 exhibit A is as of the close of the year preceding the taxable year. As such a balance sheet will not reflect the "average" book value for the year, especially when material changes have been made in either the assets or liabilities, additional statements which will reflect the desired value should be fur- nished. The foregoing is a clear statement of corporations' rights under the law. Briefly stated, a corporation should follow this procedure: Fill in the answers called for by exhibits A, B or C — any or all. If the result does not produce a fair value, additional statements supporting the value claimed to be fair should be prepared and attached to the form.^° It is wholly unnecessary for a corporation to accede to an assessment which overesti- mates the "fair average value of its capital stock." The exhibits called for in form 707 are described in the official instructions (page 4, form 707) as follows: Exhibit A: Condensed balance sheet. — Furnish under exhibit A a condensed balance sheet as of the closing date of the fiscal year given in item 7 on page I hereof. "Books of account." — These columns must show the amounts as carried in the taxpayer's books of account. "Fair value." — Refer to article i above, defining the value re- quired, and in the event the columns ''books of account" contain any overstated or understated values show herein the actual values. "Difference." — These columns will show the difference between the columns "books of account" and "fair value." Any material dif- ferences must be explained in such manner as to enable the Commis- sioner of Internal Revenue to determine if they are proper and acceptable. For this purpose the differences shown herein need not be covered by corresponding adjustments in the taxpayers' books of account. "Treasury stock"^'^ and "treasury bonds." — In the event the tax- payer holds in its treasury any of its own stock or bonds, advice must ^°For comments on methods of arriving at fair value, see Income Tax Procedure, 1918, pages 628-654. ^Tn arriving at the fair value of a corporation's own stock, treasury stock should always be first deducted from the nominal amount outstand- ing. This greatly simplifies the calculation and prevents complications which develop when stock is worth either more or less than par. ^ 450 FEDERAL CAPITAL STOCK (EXCISE) TAX be furnished as to whether such stock and bonds are pledged or unpledged. "Other assets" and "other liabilities." — If material amounts are shown, a comprehensive analysis of them must be attached. "Profit and loss." — If the "profit and loss" balance is a debit the amount should be shown in red. Exhibit A of form 707 calls for the deduction of treasury- stock from the gross amount of capital stock so that the net outstanding stock is shown. This is the correct basis for valu- ation of the stock. Stock in. the treasury has in effect been paid off so far as the former holders thereof .are concerned. Therefore, only the stock still outstanding in the hands of stockholders represents capital actually employed in the busi- ness. Why "advice must be furnished as to whether such (treas- *ury) stock and bonds are pledged or unpledged" is not clear, as it can neither increase nor decrease the net outstanding stock, the fair value of which is the basis of the tax. It must be borne in mind that the tax is to be computed "on the basis of the fair average value of the capital stock for the preceding year." [Law, section 1000' (a-i).] If the book value of the shares is used as a proper measure for taxation, and if a net profit has been earned during the preceding year, the average value of each share will be less than the value at the ^nd of the year. A statement of net worth, prepared by adjusting book values to actual values,, is of great service in ascertaining the fair value of corporate stock, but book value is only one factor. It is, however, not always practicable to place a "fair value" on fixed assets ; in fact it is usually impossible to assign any value to such assets other than the book value. Also, the value of manufactured or partly manufactured goods on hand is extremely difficult of determination in the case of an un- profitable concern. The fair value of such goods at a given date is certainly influenced by the profitableness or otherwise of tlje manufacturing operations. FEDERAL CAPITAL STOCK (EXCISE) TAX 451 Capital stock is not worth book value even when book values are adjusted, unless recent earnings produce an ade- quate return. In a vast majority of cases when earnings of one or more years are poor, there is a reflection of this unsat- isfactory condition in the fair value of the capital stock. In such cases or when the earnings have greatly fluctuated or when the average annual earnings, capitalized at a proper rate, do not fully support the book value or the adjusted book value, it is quite evident that the real "fair value" is an amount less than the book value and possibly more than the capitalized income value, depending upon the character of the assets, i.e., quick or slow turning, liquid or otherwise, etc. Buyers simply will not pay book value for the shares of a corporation unless a fair average annual return is being real- ized on the total investment. If a corporation reports that the fair average value of its capital stock is equal to the aggregate of capital stock and sur- plus when its average net earnings thereon for several preced- ing years have been less than 20 per cent, it is in effect placing a higher value on its fixed assets than has usually been found to be justified. Exhibit B : Quotations or outside sales prices. — Furnish under exhibit B the prices quoted on a recognized stock exchange or on the New York curb, or the prices at which outside sales were made if the stock is not listed, for the period of 12 months ending with the close of the taxpayer's fiscal year as given in item 7 on page i hereof. If the stock is listed the name of the exchange from which re- ported quotations are taken must be shown in the space provided therefor, and the prices reported will be the mean of the highest and of the lowest bid^^ price during each month, from which the average for the year will be obtained. If the taxpayer prefers, a schedule may be attached to this return showing the highest and lowest bid price at which stock was quoted for each day of the year and the average obtained therefrom. If the stock is not listed and outside sales have been made at ^This is a correct basis. Regulations 38, 1916, Art. 6 (a) called for averaging highest bid prices. 452 FEDERAL CAPITAL STOCK (EXCISE) TAX prices known or determinable by the officers making this report, such prices will be reported herein. A statement of the number of shares involved and the conditions under which sales were made at other than exchange quotations must accompany this return. Sales to employees or directors for qualifying purposes, or sales which are restricted as to resale, or sales at prices otherwise specially influ- enced, will not be considered representative of the fair value of the entire capital stock and should not be included. In the column "No. shares outstanding" should be shown the total number of shares outstanding at the close of each month. The average value per share will be determined as follows : First. If no change occurred in the number of shares outstand- ing during the year, total the quotations or sales prices for the months reported and divide by the number of months in which quotations or sales prices are shown. Second. If any change occurred in the number of shares out- standing during the year, total the quotations or sales prices for the months reported during which the number of shares outstanding at date of incidence of the tax has been outstanding and divide by the number of months used in the computation. "Date of incidence of the tax" is July i of the taxable year.^' Exhibit C : Annual income. — Furnish under exhibit C the annual income and other data for the five fiscal years ended with the close of the taxpayer's fiscal year as given in item 7 on page i hereof, or for the period during which the corporation has been engaged in business if for a shorter period. "Net income." — In this column will be shown the income re- turned for the purpose of the income tax and excess profits tax. "Deductions" and "additions." — Refer to article i of these special instructions, and show in these columns such amounts as should be deducted from or added to "net income" to arrive at the adjusted income which may be capitalized to determine the fair value of the capital stock. A comprehensive analysis of any amounts reported therein should be attached to this return. Some of the principal items frequently requiring adjustment follow: ^[Former Procedure] Form 707 for tax year July i, 1919, to June 30, 1920, provided: "If any change occuTed in the number of shares outstanding during the year, calculate the total value of the outstanding shares each month upon the reported prices and divide the total of such monthly valuations by the sum of the number of shares outstanding each month." The former regulation is sound but it is doubtful if the present regu- lation is equitable. FEDERAL CAPITAL STOCK (EXCISE) TAX 453 Deductions : Income and profits taxes not deductible in computing income subject to tax. Depreciation and depletion. Interest charges not deductible in computing income subject to tax. Losses not fully deductible in computing income subject to tax. Additions : Dividends from other corporations not included in computing income subject to tax. Income from securities of a state, municipality, or of the United States, not included in the income tax return. Expenditures made for additions and betterments, or reserves for such purposes, made against income whether direct or through expenses. "Adjusted income." — This column will reflect the amounts result- ing from adjustment of amounts shown in three preceding columns. "Number shares." — Herein should be given total number of shares of all classes of stock outstanding at close of each fiscal year. "Dividends declared." — Herein should be reported the percentage of dividends declared on the par value of each class of stock out- standing each year. The amount represented by the percentages shown in this column must not be deducted from the columns "net income" or "adjusted income." "Depreciation." — Hereunder will be reported the amount actually charged against income each year in the taxpayer's books of account for depreciation. "Depletion."- — In the case of mines, oil and gas wells, other natu- ral deposits, and timber, valuations reported as the basis of depletion in computing Federal income and profits taxes should be shown in the "Fair value" column [of Exhibit A]. Capitalizing net income. — The officers making the return will capitalize the average annual income on a percentage basis that fairly represents the conditions obtaining in the trade in the locality that representative enterprises must earn in order to maintain their, stock at par. In other words, if enterprises engaged in a similar business must on the average earn 12 per cent on their issued capital stock to keep the value of their stock at par, the net income should be capitalized by dividing it by .12. Some, of the best stocks in this country, which are valued for the purpose of this tax at their average quotations on the New York Stock Exchange (a fair basis in many cases, as the sales are numerous and actual transactions between willing buyer and willing seller are after all the best indication of 454 FEDERAL CAPITAL STOCK (EXCISE) TAX value) have during recent years shown 30, 40 or even 50 per cent per annum earned on their par value, though their selling prices in the open market have often not been above par. An industrial stock to be valued at par should have net tangible assets equal to par, unless the average earnings exceed 20 per cent per annum on the capital stock. If the earnings are considerably above 20 per cent per annum, fair value may be more than par, but the physical assets must always be considered. If earnings are on a downward trend, the average may be disregarded. Only in exceptional cases should the item of goodwill be a factor in valuations under this act. If the goodwill actually has a pres- ent value, it will be reflected in the earnings shown in Exhibit C. An excise tax imposed on the privilege of doing business as a corporation should be construed in favor of the taxpayer, and speculative values and other items which sometimes in- fluence high prices for shares should be ignored. In considering earnings as a basis for valuation, it should be remembered that if the earnings include unusual profits, which it is not expected will recur periodically, a prospective purchaser of the stock would not pay a price 'based on cap- italizing such extraordinary profits. Unless Exhibit A sup- ports the capitalized value of profits of an unusual nature, it would be fallacious to capitalize them for valuation purposes. Income and excess profits taxes should be deducted before earnings are capitalized for the purposes of the excise tax. When net profits of past years are used in calculating aver- age earnings, net losses must also be used in the computation. Issuance of new stock does not affect average in- come CAPITALIZED. Ruling. Should adjustment be made in determining average in- come under Exhibit C, when capital increased from ten thousand to fifty thousand in nineteen nineteen? (Answer.) Your wire twenty-sixth. Disregard number shares outstanding when capitalizing net income, Exhibit C of Form 707.. (Telegram of inquiry from Morris F. Frey, the Guaranty Trust FEDERAL CAPITAL STOCK (EXCISE) TAX 455 Company, New York, N. Y., and the reply thereto signed by Deputy Commissioner James Hagerman, Jr., and dated July 27, 1920.) Preferred and common stock. — As many corporations have more than one class of stock, provision must be made for a calculation which gives due weight to the fair value of the en- tire outstanding capitalization. It is believed that a short and simple rule will settle any apparent difficulties in determining a proper valuation. As TO PREFERRED STOCK. — If preferred stock has a market value, the actual number of shares of preferred stock outstand- ing multiplied by the average market value of each share will produce the desired result. If preferred stock has no market value, but if its book value is in excess of par, and if some value is ascribed to the common stock, the preferred stock should be hsted at par. There are, however, many classes of preferred stocks. When there is no cumulative provision as to dividends ; no or only partial preference as to assets ; a low rate of dividend, or other factors which, as compared with similar preferred stocks having a market value, would tend to lower the fair value of the preferred stock, full weight must be given to all factors and that value must be placed upon each share of preferred stock which can be supported as being a fair value. As TO COMMON STOCK.- — If it be borne in mind that the one base of the tax is the net worth of the corporation, it will simplify the calculations whenever more than one class of stock is concerned. In all cases (exclusive, of course, of corpora- tions the market value of whose shares can be ascertained) the fair value of a corporation's entire capitalization will have to be determined. This should be done regardless of the dif- ferent classes of shares, if any. After a trustworthy estimate has been made, the aggregate valuation placed upon the one or more classes of preferred stock should be deducted ; and the balance represents the proper valuation for the common stock. 456 FEDERAL CAPITAL STOCK (EXCISE) TAX Deductions and Credits Law. Section looo. (a) .... a tax .... equivalent to .... so much of the fair average value of its capital stock .... as is in excess of $5,000. Corporation must file return even though the fair average value of its stock does not exceed $5,000. — Regulation. From the total fair average value of the capital stock the Sum of $5,000^* is to be deducted, and the tax is upon each full $1,000 of any balance. Accordingly, corporations the fair aver- age value of whose capital stock is not more than $5,000 are not subject to tax, but for the purpose of avoiding error every corpora- tion is required to file a return as directed in article 31. (Reg. 50, revised. Art. 16.) Returns Time of making returns. — Regulation. It shall be the duty of every corporation liable to the tax on or before the 31st day of July in each year to make a return, verified by oath, to the collector of the district in which its principal place of business is located. If any corporation fails to make and file a return within the time prescribed by law or by regulation made under authority of law, or makes, willfully or other- wise, a false or fraudulent return, the collector or deputy collector shall make the return from his own knowledge and from such infor- mation as he can obtain through testimony or otherwise. In any such case the Commissioner may, from his own knowledge and from such information as he can obtain through testimony, or otherwise, make a return or amend any return made by a collector or deputy collector. Any return so made and subscribed by the Commissioner, or by a collector or deputy collector and approved by the Commis- sioner, shall be prima facie good and sufficient for all legal purposes. If on account of sickness or absence of the officer of the corporation charged with making the return, it is impossible to prepare and file a return on or before the 31st day of July (the due date), the collector, upon application in writing, may allow an extension of time not exceeding 30 days from July 31, in which to file the return. If extension is granted, the letter of the collector should be attached- to the return. On no account is the Commissioner of Internal Revenue or the collector authorized to grant an extension of time in which to file capital stock returns in excess of 30 days from July 31, the due date. If for reasons, other than absence or sickness, beyond ''Prior to July i, 1918, the exemption was $99,000. FEDERAL CAPITAL STOCK (EXCISE) TAX 457 the control of the officers making the return, it becomes impossible to file a completed return within the time prescribed by law, a tenta- tive return may be filed, thus avoiding penalty for failure to file within the prescribed time. See following article. (Reg. 50, revised, Art. 33.) Tentative return. — Regulation. The filing of a tentative return will avoid the penalty for delinquent filing, but does not authorize the withholding of the tax. The regulations do not permit the filing of a tentative return to stay indefinitely the filing of a completed return and the collection of the tax due; therefore, a tentative return clearly marked "Tentative return" should be prepared in as complete a manner as possible, including, among other information, a basis for the com- putation of the tax — that is, an estimate by the officers of the cor- poration of the approximate fair value of the capital stock in order that an initial assessment may be made. When the completed return is filed, it should be clearly marked "Completed return," showing that a tentative return was filed. Such action will prevent duplicate assessments and ordinary penalties. In every case -a statement should be attached to the tentative return, indicating the approximate date the completed return may be expected. Upon receipt of the com- pleted return any adjustment necessary in the assessment of the cor- rect tax due will be made. (Reg. 50, revised, Art. 34.) When return must be filed before information is available.— Ruling. Answering your letter of July 3, 1919, in which you make inquiry as follows : "What is the best procedure for reporting net income under exhibit C of capital stock tax returns, form 707, in the case of corporations whose fiscal year ends June 30, and who have not filed return for Federal income tax purposes before the time for filing capital stock tax returns has expired?" you are advised paragraph 3, special instructions i, page 4, form 707, states : " . . . . and the taxpayer will complete each exhibit or state why the required data are not available." The law provides that capital stock tax returns shall be filed dur- ing the month of July for the taxable period beginning July i and that the collector is empowered to grant an extension of thirty days beyond the due date of filing only in case of sickness or absence of the officer charged with the preparation of the return. You will therefore note there is no authority under the law for granting an extension for any reason beyond thirty days from July 31, 1919. 458 FEDERAL CAPITAL STOCK (EXCISE) TAX Capital stock tax returns should therefore be completed so far as practicable and filed with the collectors within the prescribed time with the statement that unavailable data will be furnished in a sup- plemental report at the earliest possible date. In the case of any failure to make and file a return within the prescribed time a penalty of 25 per centum of the amount of the tax attaches, except that when the failure to file was due to a rea- sonable cause and not to willful neglect no such addition shall be made to the tax. The above procedure will avoid any assertion of the penalty or question as to what constitutes a reasonable cause. (Letter to The Corporation Trust Company, signed by Deputy Commissioner J. Hagerman. and dated July ii, 1919.) The law should be amended to provide ample time within which to file accurate returns. Affiliated corporations, returns of. — Regulation. Although section 240 of the Revenue Act of .1918 requires a consolidated return for affiliated corporations for the pur- pose of income tax, for the purpose of capital stock tax each cor- poration must render a separate return in complete form. So-called subsidiary corporations, all or a part of the stock of which is owned by another corporation, must render separate returns, the same as every other corporation. No deductions from the assets are per- mitted on account of inter-company balances, and the shareholdings must be reported in the "Fair value" column at their actual worth at the time of making the return. No deduction is allowed in the return of one corporation for the tax paid by another. If the fair value is determined by any method other than herein provided, the following requirements must be complied with: (a) The parent company must submit with its return a list of all subsidiaries and the districts in which the returns were filed; (b) the return of the sub- sidiary company must show the name of the parent company and the district in which the return was filed; (c) the method of determining the fair value, if other than by Exhibits A, B, and C, must be fully explained; (d) a copy of any agreement existing between parent company and subsidiary must be furnished, or a statement made that none exists; and (e) a combined balance sheet and a combined net income statement must be submitted for consideration in connection with any estimate of fair value made on behalf of the reporting corporation. (Reg. 50, revised, Art. 35.) Rulings. In reply to your letter of May 17, 1919, requesting an interpretation of article 106 of Regulations 50,^^ regarding capital ^°Art. 35 of Reg. 50, revised, is substantially the same. FEDERAL CAPITAL STOCK (EXCISE) TAX 459 stock tax returns required of affiliated corporations, you are advised that the sentence, "If the fair value of its capital stock is based upon a consolidated report, a copy of such report should be attached to the capital stock tax return of each affiliated corporation," refers to each corporation of an affiliated group, that is, the parent company as well as each subsidiary. Article loi, Regulations 50,^" requires every domestic corporation to file a return regardless of the par value of its capital stock unless specifically exem^jt under section 231, An exemption of $5,000 is allowed. In many cases, as for instance, in the case of seHing agencies separate corporations are formed in order properly to handle certain business under various state laws and in reality are branches or de- partments of the parent corporation. The business is controlled by the parent corporation and the result of operations is a matter of bookkeeping. The capital stock tax being imposed upon the fair value of the capital stock of corporations it makes little difference by what method such fair value is determined. Therefore, if affiliated corporations are best able to determine the fair value of the respective companies through a consolidated report such privilege is permitted by the De- partment, but it seems preferable to leave this to the corporations interested subject to approval by the Commissioner of Internal Rev- enue rather than attempt to outline a specific method that would apply to all. (Letter to The Corporation Trust Company, signed by Deputy Commissioner J. Hagerman, and dated June 2, 1919.) Referring to office letter of June 2, 1919, it has come to the attention of this office that a number of taxpayers are construing this letter as granting special privileges not intended and not per- mitted under the law and regulations. This letter properly inter- preted refle'-.ts the views of this office and is applicable to such cases. The taxpayers, however, may have been misled by the wording of the heading, which reads : "Consolidated Returns of Affiliated Corporations" and it is suggested with a view to avoiding further misunderstand- ing that the heading be revised, as follows : "Returns of Affiliated Corporations based upon a Consolidated Report." The difficulty of outlining a general ruling that covers all ques- tions relating to affiliated corporations should be appreciated and the taxpayer must realize that the tax is imposed upon the fair value of the capital stock of each individual corporation as disclosed by the facts in a given case, regardless of corporate affiliations. Only under certain conditions are corporations permitted to arrive at the fair "•Art. 33 of Reg. 50, revised. 46o FEDERAL CAPITAL STOCK (EXCISE) TAX value of the capital stock of the respective companies through a con- solidated report, that is, where the fair value cannot be determined independently. In interpreting the letter above mentioned, distinction must be drawn between the word "return" and the word "report." Under all circumstances individual returns are required of every corpora- tion regardless of the basis used in arriving at the fair value. (Let- ter to The Corporation Trust Company, signed by Deputy Commis- sioner J. Hagerman, and dated November ii, 1919.)^'' Payments^* Time of payment of tax. — Regulation. All assessments shall be made by the Commissioner. The collector shall within 10 days after receiving any list of taxes "'[Former Procedure] Additional returns for taxable year ended June 30, 1919, when required on account of retroactive features of law. — Regulation. "Under the Revenue Act of 1916 the time for filing capital stock tax returns for the fiscal year ending June 30, 1919, was extended to September 30, 1918, and in the case of Hawaii to October 31, 1918. Any corporation which failed to file a return for such fiscal year for the former tax, whether or not it was liable thereto, rnust file a return for such fiscal year under the present statute before June I, 1919 Where returns were filed for the fiscal year ending June 30, 1919, such returns will be used so far as practicable in making the additional or orig- inal assessments for such taxable period. In the case of domestic and foreign mutual insurance companies, the new basis for the tax will neces- sitate supplemental statements, which should be furnished upon request. For the taxable period July i, 1918, to June 30, 1919, letters will be for- warded to taxpayers showing how the original or additional assessment has been determined, in order that the collector's bill when presented may be understood and payment promptly made. . ." (Reg. 50, Art. 105.) As previously stated the provisions of the 1918 law were made retro- active to July I, 1918. Formerly some corporations were not required to file returns but due to the small exemption provided by the 1918 law the Treasury decided to require returns from all corporations beginning with returns for the taxable year July I, 1918, to June 30, 1919. Returns made, necessary by the new regulations of the Treasury were due before June I, 1919. So far as practicable the tax at the increased rate after giving effect to the reduced exemption for the year ended June 30, 1919, was computed by the Treasury from information contained in the returns pre- viously filed. '^[Former Procedure] Tax paid under former law, credit for. — Regulation. "Where a corporation has paid the tax for the fiscal year July i, 1918, to June 30, 1919, under the Revenue Act of 1916, the amount so paid may be credited against the tax imposed by the present statute for such period and only the excess of the tax over such amount FEDERAL CAPITAL STOCK (EXCISE) TAX 461 from the Commissioner give notice to each corporation liable to pay any tax stated therein, to be left at its place of business or to be sent by mail, stating the amount of such tax and demanding payment thereof. If such corporation does not pay the tax within 10 days after the service or the sending by mail of such notice, it shall be the duty of the collector to collect the tax with a penalty of 5 per cent additional upon the amount of the tax and interest at the rate of i per cent a month. A collector has no authority to extend the time for payment of the tax, and any extension granted by him will be at his own risk. All taxes are payable direct to the collector of internal revenue of the district in which return is filed. The col- lector may accept payment of the tax when the return is filed as an "advance collection," subject to any adjustment later found neces- sary, but no corporation is required to pay the tax until after notice and demand. Tax due from a corporation is legally collectible from the stockholders or others who have received its assets upon liquida- tion. (Reg. 50, revised. Art. 36.) Penalties Failure to pay. — Regulation, (a) Any corporation which fails to pay the tax when due and payable is liable to a penalty of $1,000. If it willfully refuses to pay or willfully attempts to evade the tax, it is liable also to a fine of $10,000.00 and costs and to a 100 per cent penalty to be added to the tax. See also article 41. (b) Any officer or employee of a corporation who in the course of his duty fails to pay the tax when due and payable is liable to a penalty of $1,000. If he willfully refuses to pay or willfully attempts to evade the tax, he is liable also to a fine of $10,000 and costs and to imprisonment for a year, and to a penalty of the amount of the tax unpaid or evaded. (Reg. 50, revised, Art. 42.) It is to be noted that the specific penalties of $1,000 and $10,000 are additional to the 5 per cent penalty and i per cent per month interest penalty referred to in article 36. (See page 460.) Failure to make return and penalty for false return. — Regulation, (a) Any corporation which fails to make a return will be collected. For the rates of the former tax and its other provisions see Reg. 38 (revised). Because of the reduction of the exemption from $99,000 to $5,000 in the case of domestic corporations and of the abolition of any exemption in the case of foreign corporations, many corporations must now pay the tax which were formerly exempt. . . " (Reg. 50, Art. 81.) 462 FEDERAL CAPITAL STOCK (EXCISE) TAX within the required time is liable to a penalty of $1,000. If it will- fully refuses to make a return it is liable also to a fine of $10,000 and costs, (b) Any officer or employee of a corporation who in the course of his duty fails to make a return within the required time is liable to a penalty of $1,000. If he willfully refuses to make a return he is liable also to a fine of $10,000 and costs and to imprison- ment for a year, (c) Section 3176 of the Revised Statutes, as amended by section 1317 of the Revenue Act of 1918, also provides: In case of any failure to make and file a return or list within the time prescribed by law, or prescribed by the Commissioner of Internal Revenue or the collector in pursuance of law, the Commis- sioner of Internal Revenue shall add to the tax 25 percentum of its amount, except that when a return is filed after such time and it is shown that the failure to file it was due to a reasonable cause and not to willful neglect, no such addition shall be made to the tax. In case a false or fraudulent return or list is willfully made, the Com- missioner of Internal Revenue shall add to the tax 50 percentum of its amount. The amount so added to any tax shall be collected at the same time and in the same manner and as part of the tax unless the tax has been paid before the discovery of the neglect, falsity or fraud, in which case the amount so added shall be collected in the same manner as the tax. (Reg. 50, revised, Art. 43.) Doing business without payment of tax. — Regulation. Every corporation which does business without having paid the tax is liable to a penalty of $1,000. A corporation paying the capital stock tax is not on that account exempt from any occupational tax. For other penalties see articles 42 and 43. (Reg. 50, revised, Art. 41.) Foreign Corporations Law. Section 1000. (a) .... (2) Every foreign corporation shall pay annually a special excise tax with respect to carrying on or doing business in the United States, equivalent to $1 for each $1,000 of the average amount of capital employed in the transaction of its business in the United States during the preceding year ending June thirtieth. Definition of foreign corporation. — Regulation. A foreign corporation is a corporation created or organized outside the United States as defined in Article 8. (Reg. 50, revised, Art. 9.) FEDERAL CAPITAL STOCK (EXCISE) TAX 463 Scope of tax. — Regulation. The basis of the tax in the case of a foreign cor- poration is "carrying on or doing business in the United States." A foreign corporation is carrying on or doing business in the United States if it maintains an agent or an office or warehouse in the United States, or, in the case of an insurance company, if it writes insurance policies here, or in any other way enters the United States for the purposes of its business. The purchase of supplies in the United States in the furtherance of continued efforts in the pursuit of profit or gain is carrying on or doing business in the United States. (Reg. 50, revised. Art. 17.) Foreign mutual insurance company. — Law. Section 1000. (c) . . . Provided, That in the case of a foreign mutual insurance company the tax shall be equivalent to $1 for each $1,000 of the same proportion of the sum of such surplus and reserves, which the reserve fund upon business transacted within the United States is of the total reserve upon all business transacted, as of the close of the preceding accounting period used by such com- pany for purposes of making its income tax return.^^ Rate of tax. — Regulation. The tax is at the rate of $1 for each full $1,000 of the capital of a foreign corporation actually employed'" in the transaction of its business in the United States, and is in all cases to be computed on the basis of the average amount of capital so employed during the preceding year ending June 30. The measure of the tax is accordingly different from that in the case of domestic corporations which pay a tax measured by the fair average value of their capital stock. No deduction from the total fair average amount of capital so employed is allowed in computing the tax. (Reg. 50, revised. Art. 20.) Capital "employed" in the United States. — Regulation. The "capital employed in the transaction of its business in the United States" means the portion of the total capital, surplus, and undivided profits, of the foreign corporation, utilized for the purpose of doing business in the United States. A foreign corporation may have income from sources within the United States for the purpose of the income tax, and yet not have capital em- ployed in the transaction of business here for the purpose of the ^'See Reg. SO, Art. 25, page 446. "The word "invested" was used in the igi6 law. 464 FEDERAL CAPITAL STOCK (EXCISE) TAX capital stock tax. Compare articles 91-93 and 550 of Regulations 45. A foreign corporation not actually doing business in the United States is not subject to tax, and accordingly the investment of a part of its funds in United States stocks and securities will not con- stitute capital employed in its business in the United States. For the definition of "doing business" see article 10. If a corporation does business here, then, although the mere investment of funds in United States securities is not such a taxable employment of capital, such investment will constitute capital employed in the transaction of business in the United States, if made in a subsidiary corporation which the foreign corporation uses as an instrumentality for the suc- cessful conduct of its own business in the United States. Thus the investment of the funds of a foreign corporation in the purchase of facilities, although apparently independent, for the purpose of its business here, or the purchase of stock and securities of a subsidiary corporation for the same purpose, will constitute the employment of capital in the transaction of business in the United States. A foreign corporation may not escape taxation by organizing, or purchasing the stock of another corporation to own the facilities which the for- eign corporation needs in its business. See article 352, Regulations 4S- (Reg. 50, revised, Art. 18.) If the foreign corporation does no business whatever in the United States, a separate domestic corporation being util- ized for the carrying on of business in this country, it is obvi- ous that the law imposes the capital stock tax only on the sub- sidiary. The mere ownership of the stock of an American corporation by a foreign corporation does not of itself con- stitute doing business by the latter in the United States. "Capital "employed' in the United States" illustrated. — Regulation. A foreign corporation may employ capital in the transaction of its business in the United States in various ways. For example, the investment of funds in property in t;he United States used in its business, in stocks and securities of subsidiary corpora- tions as explained in article 18, in bills and accounts receivable repre- senting business done in the United States, in merchandise kept here for sale, in materials manufactured here, and in deposits in United States banks maintained for use in business here. Generally speaking, approximately such proportion of the entire capital of a foreign corporation will presumably be employed in the transaction of its business in the United States as the gross amount of its busi- ness in the United States bears to its total gross business, but this will not always be true, since a corporation may conceivably transact FEDERAL CAPITAL STOCK (EXCISE) TAX 465 a greater or less volume of business in one country than in another on the same amount of capital. (Reg. 50, revised, Art. 19.) Basis of tax, foreign corporation. — Regulation. The measure of the tax is the average amount of capital employed in the transaction of business in the United States during the preceding fiscal year. It will usually be sufficient to determine the amount of capital so einployed at the beginning of each year and the amount so employed at the end of such year, and to divide the sum of such amounts by two. Where, however, there have been material changes in the amount of capital, the average amount should be determined with due regard to the times at which such changes occurred. A foreign corporation may, if it so desire, compute the average amount of capital employed on a monthly basis. (Reg. 50, revised, Art. 21.) Capital "employed" includes borrowed capital. — Ruling. Following question submitted on behalf our client the Company, a foreign corporation. Referring Article 33 [Art. 18], Reg. 50, is capital stock tax to be computed on entire amount of capital employed in this country irrespective of whether that capital consists in part of company's own capital ,and in part of borrowed capital? Kindly wire reply collect. (Answer.) Your wire 25th. Capital stock tax is imposed upon capital employed irrespective of its nature whether borrowed, paid in or earned. (Telegram of inquiry from E. G. Shorrock & Co., Seattle, Washington, and the reply thereto, signed by Deputy Com- missioner J. Hagerman, and dated October 30, 1919.) Form 708, which provides for determining the capital em- ployed in the United States by a foreign corporation, calls for a statement of the total capital, surplus and undivided profits (whether employed within or without the United States) and a statement of the assets employed in the trans- action of business in the United States. The latter statement makes no provision for deducting liabilities incident to the transaction of business in the United States. In the case of a foreign corporation all of whose capital was employed in the United States, this would lead to the absurd result of show- ing a larger amount of capital employed in the United States than its actual total capital. Of course, if the corporation had absolutely no liabilities the result would be the same in both 466 FEDERAL CAPITAL STOCK (EXCISE) TAX Statements, but as practically all corporations have liabilities, proper deduction should be made from the United States assets for the liabilities incident to the business in this country. Return by foreign corporations. — Regulation. Every foreign corporation carrying on or doing business in the United States shall make return on Form 708 (Re- vised) irrespective of the amount of capital employed in this coun- try in the transaction of its business. The capital actually employed in the transaction of the business of a foreign corporation in the United States and the tax payable thereon shall be calculated in accordance with the instructions on the form.^^ See also articles 17, 18, 19, 20 and 21. (Reg. 50, revised. Art. 32.) Inspection of returns. — Regulation. The returns upon which the tax has been deter- mined by the Commissioner, although public records, are in general open to inspection only to the extent authorized by the President. All bona fide stockholders of record owning i per cent or more of the outstanding stock of any corporation shall, upon making request of the Commissioner, be" allowed to examine the annual income re- turns of such corporations and of its subsidiaries, but such privilege of examination is personal and can not by power of attorney be dele- gated by the stockholder to another. Only such officers of any State as are charged with the enforcement of a State income-tax law shall have access to the returns of any corporation, or to an abstract thereof showing the name and income of the corporation, at such times and in such manner as the Secretary may prescribe, and then only in case the information is to be used by them in connection with such enforcement. Any stockholder who is allowed to examine the return of any corporation, and who makes known in any manner whatever not provided by law the amount or source of income, profits, losses, expenditures, or any particular thereof, set forth or disclosed in any such return shall be guilty of a misdemeanor and be punished by a fine not exceeding $1,000, or by imprisonment not exceeding i year, or both. (Reg. 50, revised. Art. 30.) Section 257 of the law, which referred specifically to in- come tax returns and on which the foregoing regulation is based, was by section 1000(d) also made applicable to capital stock tax returns. "See Appendix. FEDERAL CAPITAL STOCK (EXCISE) TAX 467 Abatement and refund of taxes. — Regulation. Section 3220 of the Revised Statutes, as amended by section 1316 of the Revenue Act of 1918, provides: Sec. 3220. The Commissioner of Internal Revenue, subject to regulations prescribed by the Secretary of the Treasury, is authorized to remit, refund, and pay back all taxes erroneously or illegally assessed or collected, all penalties collected without authority, and all taxes that appear to be unjustly assessed or excessive in amount, or in any manner wrongfully collected ; also to repay to any collector or deputy collector the full amount of such sums of money as may be recovered against him in any court, for any internal-revenue taxes collected by him, with the cost and expenses of suit; also all damages and costs recovered against any assessor, assistant assessor, collector, deputy collector, agent, or inspector, in any suit brought against him by reason of anything done in the due performance of his official duty, and shall make report to Congress at the beginning of each regular session of Congress of all transactions under this section. Section 3225 of the Revised Statutes, as amended by section 1316 of the Revenue Act of 1918, however, provides : Sec. 3225. When a second assessment is made in case of any list, statement, or return, which in the opinion of the collector or deputy collector was false or fraudulent, or contained any understatement or undervaluation, such assessment shall not be remitted, nor shall taxes collected under such assessment be refunded or paid back or recovered by any suit, unless it is proved that such list, statement, or return was not willfully false or fraudulent and did not contain any willful understatement or undervaluation. For the procedure regarding claims for abatement or refund, see Regulations 14 (Revised). (Reg. 50, revised, Art. 37.) Medium of payment of tax. — Regulation. Collectors may accept uncertified checks in payment of taxes, provided such checks are collectible at par — that is, for their full amount, without any deduction for exchange or other charges. The collector will stamp on the face of each check before deposit the words, "This check is in payment of an obligation to the United States and must be paid at par. No protest," with his name and title. The day on which the collector receives the check will be considered the date of payment so far as the taxpayer is concerned, unless the check is returned dishonored. If one check is remitted to cover the taxes of two or' more corporations, the remittance must be accompanied by a letter of transmittal stating (a) the name of the drawer of the check, (b) the amount of the check; (c) the amount 468 FEDERAL CAPITAL STOCK (EXCISE) TAX of any cash, money order, or other instrument included in the same remittance; (d) the name of each corporation whose tax is paid by the remittance; (e) the amount of the payment on account of each corporation; and (f) the kind of tax paid. (Reg-. 50, revised, Art 39.) Dishonored checks, procedure. — Regulation. If the bank on which any such check is drawn shall refuse to pay it at par, the check shall be returned through the de- positary bank and be treated in the same manner as a bad check. All expenses incident to the attempt to collect such a check and the return of it through the depositary bank must be paid by the drawer of the check to the bank on which it is drawn, since no deduction can be made from amounts received in payment of taxes. See section 3210 of the Revised Statutes. If any taxpayer whose check has been re- turned uncollected by the depositary bank shall fail at once to make the check good, the collector shall proceed to collect the tax as though no check had been given. A taxpayer who tenders a certified check in payment for taxes is not released from his obligation until the check has been paid. See chapter 191 of the act of March 2, 191 1. (Reg. 50, revised, Art. 40.) Credit of munition manufacturer's tax. — Regulation. From the tax payable as above determined the amount, if any, of the munition manufacturer's tax imposed by Title III of the Act of September 8, 1916 (no longer in effect since Janu- ary I, 1918), actually paid by the corporation since making its last previous return hereunder is deductible. If a munition manufacturer's tax is due and payable but has not been paid at the time the capital stock tax becomes due and payable no credit of the munition manu- facturer's tax is permissible, until after the munition manufacturer's tax has been paid. After it has been paid the credit may be availed of by a claim for the refund of so much of the capital stock tax actually paid as is not in excess of the munition manufacturer's tax which became due and payable within the same calendar year. (T. D. 3009, signed by Commissioner Wm. M. Williams, and dated April 22, 1920.) (Reg. 50, revised. Art. 10.) [Former Procedure] Election to be taxed as corporation. — Regulation. "A business enterprise (a) which was organized as a corporation before July i, 1919, (b) in which capital is and has been a material income-producing factor, and (c) which was previously owned by a partnership or individual, may elect to be taxed as a corporation on its net income from January i, 1918, to the date of organization of the corporation. In such event the corporation shall be treated as if in existence FEDERAL CAPITAL STOCK (EXCISE) TAX 469 [Former Procedure — Continued] since January i, 1918, for the purposes of the income tax, the war profits and excess profits tax, and the capital stock tax. The adoption of any other date than January i, 1918, for such purpose is not permissible. But this option is not extended to a business enterprise with a net income for the taxable year 1918 less than 20 per cent of its invested capital. "The clauses of section 407, Revenue Act of 1916, as amended, and section 1000, Revenue Act of 1918, which require that a corporation must have been engaged in business some part of a year preceding the taxable period in order to be liable for the tax, are not applicable to corporations filing returns under section 330 of the Revenue Act of 1918; that is to say, organizations electing to report as corporations under the provisions of this section, are required to file capital stock tax returns for the six months' period from January i to June 30, 1918, and for all subse'quent taxable periods." (Reg. 50, revised, Art. 29.) APPENDICES APPENDIX A ILLUSTRATIONS OF RETURNS On the following pages are shown illustrations of returns for corporations under varying conditions. Pages Schedule A, Form 1120. Taxable net income. Calendar year 1919 474-47S Schedule L, Form 1120. Reconciliation of taxable income with books of account and analysis of surplus account. Calendar year 1919* 476 Schedule A, Form 1120. Taxable net income, three com- panies, consolidated. Calendar year 1919 477-479 Schedule L, Form 1120, Reconciliation of taxable net in- come with books of account, and analysis of surplus ac- count, three companies, consolidated. Calendar year 1919* 480-481 Calculation of income tax for fiscal year ended March 31, 1919 482 *Since schedules L and M of form used in 1919 have been modified and combined in the 1920 form, the latter has been used. 473 o o o q O o (u aj « " O o o W < X < O H O o u o\ M Pi < >> M i-I ■< u ^ 8 a 5 CO g M < < O u : B ■T3 • c ■ a ■ w -- • c<. : g^o) (1) X 3 O (UT3 CO (U CO -2 3 O S mo" ^ as o 0) OJ tfl m " 0) O J? OJ rtX! 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" -- 1 482 APPENDIX B FORMS On the following pages will be found reproductions of the forms listed below : Form No. Abatement, Claim for 47 Taxes erroneously or illegally assessed (but not paid). Alien, Certificate of, Claiming Residence in the United States 1078 To be filed with withholding agent (employer) by alien residing in the United States, for the pur- poses of claiming the benefit of such residence for income tax purposes. Bond, Income and Profits Tax (Corporation) 1 1 ig Accompanies form 1118 Certificate of Inventory 1 1 26 To accompany form 1120, or to be filed with the collector if return has already been filed. Credit for overpayment of Taxes, Claim for 47A To be credited against the tax due under any other return. Credit for Foreign Taxes (Domestic Corporation), Claim for 1118 Government Contracts Profits Tax Return 1120S Ownership Certificate 1000 When tax is to be paid at source — to be attached to interest coupons when presented for collection. Ownership Certificate looi Tax not to be paid at source — to be attached to interest coupons when presented for collection. Ownership Certificate — Foreign Dividends and Interest looiA Dividends on stock of foreign corporations and interest on bonds of foreign countries and foreign corporations. To be attached to these items when presenting for collection. Ownership Certificate — Disclosing Actual Owner of Stock 1087 To be filed with representative in the United States by foreign principal to disclose actual ownership of stock of domestic corporation. 483 Pages 488-489 507 535-536 490-491 521-524 533 498 499 500 508 Form Personal Exemption, Non-Resident Alien, Claim for. . 1115 Refund, Claim for Taxes erroneously or illegally col- lected 46 Replacement Fund, Application under T. D. 2706 to establish 1114 Report of Income Paid to Non-Resident Alien Indivi- duals and Foreign Corporations during the Calendar Year 1920 1098 This return accompanies form 1042, on which each form 1098 is listed. Report of Income of $1,000 or More Paid during the Calendar Year 1920 to each Citizen or Resident of the United States and Domestic Partnership io99 These forms are summarized on form 1096 and are filed with that return. Return, Annual, Information 1096 Payments of interest, salaries, rent, etc., of $1,000 or more to be filed annually, accompanied by returns on form 1099 by every individual or organization making such payments to a citizen or resident of the United States or to a domestic partnership during the calendar year 1920. Return, Monthly, Information 1096A Payments of interest on bonds of domestic and foreign corporations and countries and dividends on stock of foreign corporations. To be made by paying corporation, and to be accompanied by forms looi and looiA. Return, Annual, Information 1096B This summarizes monthly returns made on form 1096A. Return, Monthly of Normal Income Tax to be Paid at Source 1012 To be filed monthly by withholding agent with collector. Return, Annual of Normal Income Tax to be paid at Source loi 3 To be filed annually by withholding agent with collector. Return, Annual (Non-Resident Alien) of Normal In- come Tax to be Paid at Source 1042 To be filed annually by withholding agent of pay- ments to non-resident aliens. Return, Corporation Income and Profits Tax, 1920 .... 1 1 20 To be filed by every corporation, joint stock company, association and insurance company, whether or not it has net income. Return, Information, Subsidiary or Affiliated Corpora- tion 1122 Return, Capital Stock Tax, Domestic Corporation .... 707 Return, Capital Stock Tax, Foreign Corporation .... 708 Pages 519-520 486-487 515-518 513 514 509-510 5" 512 502 503 504 526-532 534 492-495 496-497 Form Pagbs Statement of Income Received by Non-Resident Alien from Sources within United States (Personal Exemp- tion Claimed) looiB $01 To be filed with withholding agent by non-resident alien owning bonds of a domestic corporation which contain a tax-free covenant clause. Substitute Certificate (Ownership) 1058 505 Tax not to be paid at source. Used by resident collecting agents and responsible banks to re- place form 1 00 1 (original ownership certificate) Form 100 1 should be detached and sent direct to the Commissioner. Substitute Certificate (Ownership) 1059 506 Tax to be paid at source. To be used in the same manner as form 1058, except it replaces form 1000. The use of substitute certificates is not permitted in case of ownership certificates pre- sented with coupons for collection by non-resi- dent alien individuals, partnerships or corpora- tions. 485 T]ftBABVItV OBPARTUBHT, D. e. UniKKAI, Bbtxnux. Fona 46— Bartwd Maicb, 1918. CI-AIM FOR REFUND. TAXES ERRONEOUSLY OR ILLEGALLY COLLECTED. MSO AMOUNTS PAID FOR STAMPS USED IN ERROR OR EXCESS. Stat^of^ County of^ IMPORTANT. TMt dum iliould be fomnled to ^ CoDKlar •( btrnnl RcTCOiM lo- wfaom tha Tu «u pud uu) mut ,1m ■wyMBwl bj Colhctar'* Rsccipt tb«c(ar. DiUtoffilAigtobe ptaSatjfttamjHdhert (Name oldalnunt.) (Ad4iMio(GlaIiiiut; give Btnat and BmalMr H vellM clt7 Of tows, ud 8tet«,} ^ This deponent being dulr sworn according to law deposes and says that tliis claim is made on beh^ of the claimant named>aboTe, and toat the.facts stat^ below witn reference to tbo claim are true end complete: 1. Business engf^d ia hj claimaat 2. CWacter of asBessment or tuc (Stat«|(Di 01 npoa vbat tha tax vfea m 9. Amoiiatof assessment or stamps * «.. 4. Amount now asked to be refunded (or such greater amount as is legally refundable) t. or tha atampa affixed.) S. Date of payment of assessment or purchase of stamps - _«. Deponent verily believes that the amount stated in Item 4 should be refunded and claimant now asks and demant^ refund of said amount for the following reasons: And this, deponent further alleges that the said cl^uuant is not indebted to the Umted States in any amount whatever, and that no claim has heretofore been piresented, except as stated bereiBf for the refunding of the whole or any part of the amount stated in Item 3. SipoFn to and aubserihed "before me tMa.. {Name.) (TlUa.) (Xhiff affidavit may he ewom. to before a Deputy Collector of lateinal Reveoue without charge.) 486 CERTIFICATES. I certify that an examination of the records of the Commissioner's Office shows the following facts as to the assessment and, payment of the tax: KAKV or XUFAYKK. ChBTBctar of assessment and poilod Qovend. List, Yett Hontb. Page. Lino. Amount Date paid. Distilotln which palcL $ Auetsment Clerh, Internal Revenut Bureau, I certify that the records of my office show the following facte as to the purchase of stamps: EbuL Homber. DstootGato otlsaue. Amount Uspedol tax stamp, state: To WBOH BOU> OB nnncD. Serial nnmbar. „™sa,_ $ Sdildtlhi KnmlKf ■ JUlswed orBejected Number. Oumant Addtess. ._ -^ District . CUaaaaiaedby— * *j'l'^ if'fl ^y ~ Examined end submitted for action — » - , 19.. COMMITTEE ON CLAIMS. Amonnt dumeiLM, $~. Amount allowed $^ Amount rejected — S~ 487 TBEABtniY DEPABTireNT. U. B. iNmUTAL RXTSNCX. Wwrnil^RvTlata April, lOlB. Ed.soo;x». State of ^ CLAIM FOR ABATEMENT TAXES ERRONEOUSLY OR ILLEGALLY ASSESSED Cduntff cf— IMPORTANT Thb claim ihaulcl b* forwarded to tlia CoDactor of Intamal Ravsnua fcmn whom nottca of aiaaa^ DATE OF FaMG TO BE WritaNuM ID II caa ba ■uOr rwd. (HamQ ol clnlmant.) (Address of clalmaot; gin street and oumbei u well as dt; or town, and Bute.} ' This deponent being duly sworn according to law, deposes and "Bays that this claim is made on behalf of the claimant named above, and that the facts stated below with reference to said claim are true and complete: 1. Business engaged in by claimant r 2. Character of assessment or tax . 3. Amount of assessment , — S _„„„..„ „,__^ 4. Amount now asked to be abated $ , ,...^ Deponent verily believes that the amount stated in item 4 should bo abated, and ckumant nov asks and demands abatement of said amount for the following reasons: to and subscribed before me this . day of , 19_ Signed: WrilaNuiia » il can ba uiDt rud. (TUa affidavit may bo sworn to tefore a Dojputy Collector of Internal Revenue wiUiout chaige.) 488 CERTIFICATE OF ASSESSMENT I certify tiat an examination of the records of the Commissioner's Office shows the following facts as- to the assessment and payment of the tax: Naue and address. Character of Article Taxbd. Period Covered by LIST. Year, Month. Page. Lnre. Akodht. i 1 i ; i ; 1 1 1 1 i ! ! ' 1 1 Aisasment Clerk, Inlenutl Beiienue Bureau. Ab.ue Bureau. Collector of Internal Revenue. Abatement Order J/d. .. District. Claimant . Address ^. Chili ^ Dltltkn. Amount claimed, S— Amount allowed, $.. Amount rejected, f.. Examined arid submitted for action . COMMITTEE ON CLAlMSi 491 TREASURY BBPARTUENT, H, B. Istcrnal Revenue. Form 707— novlsod Juno, 1920. 1921 RETURN CAPITAL STOCK TAX RCTURN FOR DOMESTIC COHPORATIONS (itt K«.TITVtK.»CVEmC*lTWnil> . (PaE«-) Aiviited by; 10 o[ coiparadoD, JoInt-stoclEcnDpany or assoclatloa.} (SLOW [onncr name IF dunged.) it be that oltbo principal place ol bualncss. 01vs"&tnotiuid Dumber," "Clcjoi 3. Nam&oE parent company— (Difltrict filed .. 6. Nature of buBincsa in detail ... C. Incorporated or organized in Stato of... ' 7. Ketum as of closo of fiscal year ended j I (Sco Gpedal Instructions Ho. 2, page i hGieot.) fJuno SO, 1920, Dato of incorporation or oiganization.. (Nearest oaillor dole.) Fire insuranco conied, as of date, line 7, $.. (Or itato not appUcsbls^ Cnm-M Dividend IBtB. Number al share*. Par value per Bbare, Total par VBlne. Total. . , Capital stock outstanding: XXX XXX XXX $ XX XX XX XXX XXX XXX 11. Total 14. Ghand Total. TAX PAYABLE ANNUALLY IN ADVANCE RETURN FOR TAXABLE PERIOD JULY 1, 1920. TO JUNE 30, 1921, BASED ON FAIR AVERAGE VALUE OF CAPITAL STOCK FOR PRECEDING YEAR CAREFULLY READ ALL INSTRUCTIONS BEFORE MAKING RETURN « COICPUTATION OF TAX. This column tor uao ol taipayer. ThlB column loF two or DepartmeoL "* Domestic corporatioEs will report: Domeatic mutual insurance companies will report: Z 10. (a) Sum of suiplua or contingent reserves mtuntained for general use of the $ Q (6) Plug any reaerve3 the net additions to wtich are included in net in- 17 Tnff.1 IS, Deduction allowed by law. „ ____ 6 00 5 00 19. Amount in excess of 85,000. _ _ 20. Tax at rate of $1 for each full 51,000 in excess of $5,000 "1 ■Pftinlty 22. Total tax and penalty .._ • CLAIM SETTLEMENT RECORD Allowed S - Every corporation must lUo a rotum or snl>iiilt coxLCliislvo eviuonco that lb Is not liable. Detor- mlnatlon of llaUtUty rests ■wltU lHo Commissioner. Tilts applies to companies claiming exemption on accoonc of not being encased in bmilncsa or as porsonnl aorvlce corporations, etCt under Sootlon 231, Title H, of tno Revenue Act or 1918. Sqo Arts. 23 and SI, Becrulations CO, Bovlsod. ADDITIONAL ASSESSHCENT RECORD ADDmoxAL Tax, 5... ALL TAXES ARE PAYABLE TO THd COLLECTOR OF THE DISTRICT IN WkICH RETURN 13 FILED. (See IN3TBUCTI0K3 OH FADE 4.] 492 EXHIBIT A. (See Special Instructions No. 4, page 4.) CONDEN3ED BALANCE SHEET AS OF (Same dnto u Horn 7, pBEO !■) DEBITS AND ASSETS, BOOKS OP ACCOUHT. VAIRTALtnL DIFPEREKCB. * (Sifflaln ui; Urge ammiati.) Real estate.. ._ ... . $-. ¥ 1 BuildrngB Uacliiuery Ckah ..„ " Deterred charges - .. ._ _ $ $ $ CREDITS AND LIABILITIES. BOOKS OF ACCOmiT. FAIR VALUE. DIFFERENCE. OthpT liohiUfiM ■T«T«i ■ ■ iri4>rf>rn>f1 ^iHif« Capitol Btockr Trf™iTiT««" Common. . _ $ - Profit and lt>ra „ ' Totals s ¥ ? RECAPITULATION OP EXHIBIT A. TbiatxAumntaraatol tupayer. rhlfi eoIoDUi lor uat ol DepartmenL DouESTic Corporations. f 5— lot lebl sf crediti aitd fiibiEliec after iiJuUtnt capital sbxk, lurplia. onj otier Items not Stock iMauHANCE Coupasies, Less actual liabilitiea and reserves, including Differenco (value of total capital stock reflec ted by Exhibit A^ s $._ 1 *U3teTlal dlilereiicea will not bo ulloffoil unless satkl&ctotlly oxpLiIned. (See iHsTaucnoHS on Paqx 4.) (2) 493 EXHIBIT B. (Se QUOTATIONS OR OUTSIDE SALES 3 Special Inefructlona ifo. B, page 4.) SPECIAL INFORMATION. <01va tume ol exchange or specUy " Outalde salca.") llaDiifacttijiiig ani trading corpotatiqiu COMMON. pmST PKEFERHSD. Till report annual' groea mlea for tlie five MOHTH. KnmbM ol Ouiea PllM. Kambn at ehuM Frici. nscAL TEAR ? _ . . t. ^ _ _ „. EKDBD- %.., _ " "" "" , lu Total, . ~— X X X X X X ' X X X X X X , _ RECAPITULATION OP EXHIBIT B. ' | TtalBwlwimtMnMotUiwtt. ' Tut cotanm. t<>r.a4B pf DepntmenL Average sale -ralue o£ coi f f Averoee sole value of firat prefeiwd Btocf by _, — . : — , — number of Bhorec Averagesale TOlue of eecond preferred efoc 1>UtntflT'(ll''[' ToTAi. (value of k tftl capital Btocfc r eflected by Exhibit B) _ . _.^ Approximate number of shares traded in during the ye«r: Conun Capital stock outstimding as of June 30, 1920: Common EXHIBIT C. (See special Instructions No. 6, page 4.) ANNUAL INCOME. ( nSCAL RETIRCOME. (DcflcltlniMl.) DEDUCnONS, ADDrnoNs. 'S^o^ nUMBES DIVmBIIDS DECLAEED. OH.. iSSf- CanUDan. Seomd ?- .. -a fS — % ■ -*. % % j6 f, .- * Mi 191 19 :_\ Averaw- $ X X X X r X X X X X X X $..-.. .„....% » -« ? E ECAP ITU] LATION OF EX HEBIT C. TbiM talaaa In bh ol Uipayer. Tlito column hi DM oil toputo sat. ]'llBtp/l $ >- ' - (^pitab fiibit zed at 0)„_ „per cent (value of iapii. capital Btock reflected by Ex- ...„. of the above-named company, whoso return for apecial excise tax is herein set forth, being severally duly sworn, each for himseU, deposes and saya that tho itema entered in the foregoing report and in any additional list or lists attached to or accompanying this return are, ia his best Knowledge and belief and from such information as he has boon able fo obtain, true and coirect. Sworn to and subscribed before me this -. .day faaAL.] (OiUdal cafacll?.} (3) Trauurtr. (SEElKsravcsoKaDiiFAaK.) ( 494 SPEOAL INSTRUCTIONS 1. ItEQuiEED Valub. — ^Tho capltitl filMk tax except on domestic mutuni In- enrance compnotes Is measured by tbe fair valne of the total capital stocU for the year precedloe the taxable year, wbetlier or not It 1b orgnnlicd for proDt or has a capital etock represeoted by shares. For domeetlc mutual Inaurancc companlea, aee page 1, Form 707, Revised. For the purpose of this tax the fair value of t ho -entire capital stock as a EsloK coQCcrn, regardless of slock ownership or the ahlllt; ol InUvldual etock- olders to liquidate their holdings, is required. The bqIos prices for aay num- ber o( Bbares of stock less than a majority Interest ore not necessarily Indic- ative of the fair value of the entire capital stock. The book value, tbe kind of assets (aloiy or quick turning}, the nature of tbe buslnesa, good will, fran- chlaes, eamlne capacity, etc., ace important factors that affect the worth of enterprises ana must be c'vea due consideration In arriving at the fair value at amy glnn date. In order that constderatton may be iriven the varlotis factors affoctlng fair value, three ezblblts are provided for furnlsbing Information, and the taxpayer will complete cadi exhibit or state why tbe required data ar« not available. Exhibit A provides for adjusting any overstated or understated values con- tained In the taxpayer's books of account, and Exhibit C provides for showing an adjusted Income, whldi aboatd be the actual operating income to be used for capitalisms on n percentage basla fixed by its officers as fairly rcprcscntlQR conditions obtaining In the trade and in tbe locality-. If tbe reconstructed book value shown by Exhibit A or the martet value shown by Exhibit B la Bieater than the valuation returned by tbo taxpayer, a comprchenBlvc state- ment sbowlng any extraordinary conditions which ore relied on In support of the valuation claimed must be submitted. In any case In which the fair valna la understated tbe amount will be redeterrolDed by tba Commissioner and the correct tax assessed ; also any penalty Incurred wul bo asaertcd. 2. Closing Date of Fiscal Teab. — In item 7, on page 1 bereof, the tax- payer will tbow tbe closing date of Its fiscal year ended between Jnly 1, 1010, and June SO, 1920, If other than June 80, and the information furnished under Exhibits A, B, and C will bo as of the year or yean ended on such date, which ■hould be used annnally. Untnal insurance companies frill show June 50 or tbe nearest earlier date of tbe doslne of the preceding accounting period used by such company for pur- pose of making Its Income-tax return. 8. Exhibits. — Tbe three exhibits. A, B, and 0, are provided to Indicate tho information desired and tbe manner In which It should be fumlabed. So far as adaptable tlicsc forma should be completed by taxpayers, but If they And it 'more convenient tbcy may attach to this return tbclr own statementa (as In tbe case of banks and Insurance companies), provided substantially the same Information Is turnlshGd. la any event, taxpavcrs should sttach sdv addi- tional Btatemebts thot will aid in a comprebenslve understanding of the tax- payer's return, so that tbe Commissioner of Internal Beveoue may equitably oetermine tba correctness of the loir value reported in Item 17 on page 1 hcreoC. 4, £XHIDIT A: CoNDBNSED Balance Sheet. — Pumlsh under Exhibit A a. condensed balance sheet as of the closing date of tbe fiscal year given In Item 7 on page 1 hereof. "Boolu of acoount." — ^Theec columns must show the amonnts na carried In tbe tozpayei'B books of account. "J^olr value." — Befer to article 1 above, defining the value required, and In tbe event that tbe columns "Books of account" contain any overstated or under- stated values, show herein the actual vaiaea. "Difference." — These columns will show the difference between the colniAns " Books o( account " and " Fair value." Any material differences moat be es- pbUned In aoch manner as to enable tbe Commissioner of Internal Revenue to determine U they arc proper and acceptable. For this purpose tbo differ- ences shown herein need not be covered by corresponding adjustments In the taxpayer's books of account. " TrtoMury a(oet " ond " Treaturu tonda." — In the event the tsipayer bolda In Its treasury snv of its own stoclc or bonds, advice must bo lurtUshed as to whetber ancb stock and bonds are pledged or unpledged. "Other aaseti" and "Other llabtlltlei." — If material omonnta arc shown, a comprehensive anolyals of them must be ottacbed. "Profit and Ion." — ^11 the " Profit and loss " balance la a debit; the amount should be fibowa la red. Beserves for the payment o( future dividends, whether declared or not, will not be eooaidered as liabilities, hut a reasonable amount to cover the preceding dividend period may be so considered if the dividend has been declared and not diabursed. 5. Exhibit B : QtroTATioirs OB OoTaiDB Saues Prices. — Fumlah nndcr Ex- hibit B tbe prices quoted on a recognized stock exchange or on tbe New Toric corb, or the pflcca at which outside sales were made if tbe stock Is not listed, for tbe period ol 12 months ending with the close of the taxpayer's fiscal year given In Item T on page 1 ho'eof. r added to " Net Income " to arrive at the adjuated Income which may be capl- .blitzed to determine tbe fair value of the capital atock. A comprehenafve analysis of any amounts reported therein should be attached to this return. If the stoclc Is listed, the none of the cxchaage froin which reported quolntlons ore taken must bo shown In the space provided therefor, and the prices reported will be tbe moan of tbe highest and of the lowest bid price during each month, from which the ovrraKc for the year will bo obtained. U the taxpayer prefers, a achedule may be attached to this return^' ahowlag ths blghcsc and. lowest bid price nt which stock was quoted- for each day- pf the year and the average obtained tberefi'om. If the stock Is not listed and outside ealcgthavo been mode at prices Icnown or determinable by tbe oinccrs making tlils report, such prices will be reported herein. A statement of the number of shares involved and the conditions under which sales were made at other than cxcbangc quotations must accom-, pany this return. Sales to employees or directors for qualifying purposes, or sales which are restricted as to resale, or saica at prices otlicrwue diJeclally Influenced, will not bo considered representative of the fair value of the entire capital Etock and should not be Included. | In the column "Number of shares outstanding" should be ahown the total number ot-sbares outstanding at tbo close of each month. Tbe average value per iihare will be determined as follows : FLrst. If no change occurred In tbo number of sbarea outstanding during the year, total tbo quotations or sales prices for the months reported and divldo oy tbo number of months In which quotations or sales prices ore shown. Second. If any change occurred In the number of shares outstanding during tbo j'ear, totnl the quotations or sales prices for the months reported during which the number of sbarcH outstandJag at date of Incidence of the tax baa been outstanding and divldo by the number of months used In the imputation. 6. Exhibit C: Annual Incomg. — T^mlsh jindbr Exhibit C the annual In- come and other data tor tbe five fiscal yeara ended with the close of the tax- payer's fiscal year as given In item 7 on page 1 hereof, or for the period during which the corporation has been engaged In buslnesa If for a shorter period. "Net income." — In tbis column will bo shown the Income returned for the purpose of the Income tax and excess profits tax. "Deduotiona" and "'Additions." — Befer to article 1 of these Special Inatme- tlons, and show in these coluntna such amounts as should be deducted from or added ""*'-" ' "' ' ' "■' " " "' "'" taltzed t onalyaia , . , ..._.... Bome of the principal Items freqnently requiring adjustment are: Deduellonj; Income and profits taxes not deductlblo In computing Income subject to tax- Depreclatlon and depletion. Interest charges not deductible In computing Income subject to *»■* , Losses not fully deductible, in computing Income subject to tax. . ' Iddltiona: Dividends from other <:prporatIons not Included In computing Income sat>- Ject to tax. Income from securities of a State, municipality, or of the United States, not Included in tbe income-tax return. Kxpendltures made for additions and betterments, or reserves for audi purposes, made against income, whether direct or through expenses. "Adfuatei tncome." — This column will reflect the nmonnta resulting from the adjustment of the amounts ahown In the three preceding columns. "I^utnbor of aharea." — Hci^In should be given tbo total number of aharcs of all dosses of stock outstandtng at the close of each fiscal year. "Dividends declared." — Herein should be reported tbe percentage of divi- dends declared on tbe par value of each class of stock outstanding each year. Tbe amount represented by tbe perccntBges shown In this column muat not be deducted from tbe columns "Net Income" or "Adjuated Income." "Depreciation." — ^Hereunder will he reported the amount actually charged against Income each year in the taxpayer's books of account for depreciation. "Deletion," — In the ease of mlnca, oil and gas wells, other natural de- posits, and timber, valuntlons reported as the basis of depletion In computing Federal income and prollts taxea should be sbown in the " Fair value "column. Capitalizing net income. — The offlccrs making tbe return will capitalUe tbo average annual Income on a perccntuge baslB thflf fairly representa, under the conditions obtaining In the trade In the locality, what representatlve-entorprlsea must earn in order to malniatn tbclr stock at par. In other words, if enter- prises engaged In a similar business must on tbo average earn 12 per cent on their Issued capital stock to keep tbe value of their etock at par, the net Income should be capitalized by dividing It by .12. 7. Domestic Insurance companies (other than mutual companies) must attach to tbe return a list of such deposits and reserve funds as tbey are re- quired by law or contract to maintain or bold for the protection of or payment to or apportionment among policyholders, stating the name and nmoimt of each such deposit or fund. 8. Domestic mutual Insurance companies must attach to the return a supple- mcntary list showing the name and amount of each reserve, the net addlttona to which are Included In the net Income. GENEEAL INSTRUCTIONS 1. Natudb of Tax. — ^The capital atock tax due July 1, 1920, Is an excise tax payab1« In advance tor the privUege of doing business from July 2, 1020, to June 30, 1921. 3. nuTATivE JtETunx. — Filing of n tentative return will avoid penalty for delinquent filing, but does not authorize withholding of the tax. Complete return as far as possible and submit an approximate estimate as a basts In order tliat on initial assessment may be made. See Art. 34, Beg. BO, Bevlsed. 4. Tbb CoLLKCToa Mat Make Retubn. — If any corporation or association foils to make and file a return within tbe time prescribed by law or by regula- tion made under authority of law, or makes, willfully or otherwise, a false or freadulent return, the collector or his deputy la authorized to make the return from such bformatlon as he can obtain through testimony or otherwise. Such return, when aubacrlbed by the collector or his deputy, shall be prima facie good and BUl&clent for all legal purposea. C. SioNATuaBa and Tebtpicatiok. — Eetums muet be signed and verified by two efilcers of tbe corporation, that Is, by the president, vice president, or other principal ofilcer, and by tbe treasarer or other financial ofilcer. and must be' sworn to before an officer authorized to administer oaths, and the aeal of the attesting ofilcer. If be Is required to have a seal, must be Impressed on the return. Tbe name of the corporation and tbe names of tbe officers signing the return should be plainly written or printed on the return. 7. Tax. — From the total fair average vr-lue of the capital stock the sum of £5,000 la deductible and tbe tax Is at (he rate of $1 for eacb full $1,000 of any balance except In the case of mutual Insurance companies busines8, plus reserves the net additions to which are included in net income under the pro visions of Title II as ol the close o( the preceding accounting period used by such company for ptuposes of making its income-tax return , ?._ 12. Total reserve fond upon all business transacted within the United- States and elsewhere (excluding surplus or contingent reserves maintained tor the general use of the business) _. 13. Reserve fond upon business transacted within the United States ._ 14. 15. US. 17. 18. Proportion (expressed in percentage) which the item 13 bears to item 12._ Taxable smount (apply percentage to item 11) Tax at ttie rate of $1 for each full $1,000 - Penalty for delinquency in filing return Total tax and pendty „ Coimrr op _ . I, , of \h.o United States branch of Uie above-named foreign company, (A^t, attorney, or other offlclal capacity.) whose return tor special excise tax is herein set forth, being duly sworn, depose and say that the items entered in the fore^ing report and in any additional list or lists attached to or accompanying this return are, to my best knowledge and belief, and from such infonaation as I have been able to obtain, true and correct in each and every particular. Sworn to and subacribed before mo this -. . day of . .., 19__ LTAiaHO AimiAVIT J (Agent, attorney, or other official capacity.) (Official capacU;.) (Name of officer or agent to wliom craTOSpandance should be addressed.) SEE INSTRUCTIONS ON REVERSE StDE. 496 GENERAL INSTRITCTIONS, 1. Nature of tax.— The capital stock tax. due July 1, 1919, is an excise tax, payable in advance, for the privilege of doing business from July 1, 1919, to June 30, 1^20. The amoxmt of the tax is computed upon the capital employed by a foreign corporation in the transaction of its business in the United States for the preceding fiscal year, except in the case of foreign mutuaUnsurance companies, see lines 11, 12, and 13 on the face of this form. The tax is payable to the collector at any time after July 1, 1919, but penalties for nonpayment do not attach until ten days after notice and demand has been served by the collector upon the taxpayer. 2. Time of filing returns. — On or before July Si, 1919, and annually thereafter. 3. Foreign corporations required to make returns. — Every corporation engaged in business in the United States, ihall make return on this form irrespective of the amoxmt of capital employed in this coimtry in the transaction of its businiess, unless such corporation was not engaged in business in the United States during the preceding fiscal year, July 1, 1918, to June 30, 1&19, or is specifically exempt under the provisions of Section 231, Title II, of the Revenue Act of 1918. (a). In answer .to question 7, details relating to real estate, mortgage loans, etc., may be omitted, but each such company should in a supplementary statement explain how the average amoimt of capital employed in the transaction of its business in the United States has been computed; and should furnish in a supplementary list the name and amount of such deposits and reserve funds as they are required by law or contract to maintain or hold for the protection of or payment to or apportionment among polic;^holders. (b). Foreign mutual insurance companies shall retiirn in a supplementary list the name and amount of all reserves the net additions to which are not included in the net income. 4. Collector may make return. — If any corporation or association fails to make and file a return within the time prescribed by law, or by regulation made under authority of law, or makes willfully or otherwise a false or fraudulent return, the collector or his deputy is authorized to make the return from his own knowledge and from such information as he can obtain through testimony or Otherwise. In any such case the Commissioner mafy, from his own knowledge and from such information as he can obtain through testimony or otherwise, make a return or amend any return made by a collector or deputy collector. Any return so made and subscribed by the Commissioner, or by a collector or deputy collector and approved by the Commissioner, shall be prima facie good and sufficient for all legal purposes. 5. Extension of time. — If failure to file a return is due to the sickness or absence of an officer required to sign the return the collector may allow an extension of not more than thirty days for making and filing the return, provided an application in writing is made prior to the expiration of the period in which the return should have been filed. 6. Signatures and verification. — Returns must be signed and verified by the agent or attorney, or other principal officer, in charge of the United States branch of the foreign corporation, and must be sworn to before an officer author- ized to administer oaths, and the seal of the attesting officer, if he is required to have a seal, must be impressed on the return in the space provided for that purpose. > 7. Corporations liable to tax. — Every corporation created or organized outside the United States and engaged In business in the United States, shall be liable to the capital stock tax except such companies and associations as are specifically exempt under Section 231 of Title II of the Revenue Act of 1918. 8. New corporations. — ^This tax shall not be imposed upon any corporation not engaged in business in the United States during the fiscal year July 1, 1318, to June 30, 1919, 9. Computation of tax. — The method of computation is prescribed on the face of this form. 10. -Praalties. — Section 3176 of the Revised Statutes, as amended by the Revenue Act of 1918, provides: In case of any failure to make and file a return or list within the time prescribed by law, or prescribed by the Commissioner of Internal Revenue or the collector in pursuance of law, the Commissioner of Internal Revenue shall add to the tax 25 per centum of its amount, except that when a return is filed after such time and it is shown that the faQure to 'file it waa due to a reasonable cause and not to wiUful neglect, no such addition shall be madeto the tax. In case a false or fraudulent retmn or list is willfully made, the Com- ^ 'missioner of Internal Revenue shall add to the tax 50 per centum of its amount. , 31-. Regulations. — ^For further information regarding the tax see Regulations No. 50. 2— saau 497 St t ^ T II 1 1 a ' 1 : 1 1 1 ! 1 [ ^ J . 5 i i ; &< 1 j3» M W « 9 *r V w 1 ^— N» •— N iS i 1 ! ic^ i ■<] ^ II h lis g i 8 J la' n 11 a ;i 3 O 1 o ^ eti 5 1 4s i So 1 go s: 7 .Xw g d a m 1 1^ o m •S *> 1 4a ' 43 vQ pq Q £ €^: ^ 6? ^ i ^ i h S •< «>« ■^ w "U O M n s Nl o 1 i 1 1 1 j H 3 1 1 1 i \ ^ 1 1 1 ! a i t±: 1 • 1 I g B < 1 1 1 I i 1 e i 1 £ ^ J ^1 ^. ,^« ^» ^J - Sa ia CO Pi ^|:| E a 1 j Hi 1, If- So ■ a z £ SI O si ^ Is 1 5o IS 1 s 1 1^ 1- 1 If 1 WW N Zw- ^* •d CO 1 *»M i ^ la i ! >, S „a III i 43o IS O |1 s| (0 S'! a.-B-9 § .a o pS ^^■s «> £ n Sfg l"g » £•^•3 !! A ill 8 (I §■! p III 1 ill ' 1 1 1 T !2; «< 1 P-o P 8S ^ < ^ "S 400 a O =9 « !■ ^ « H S g •0 — ' ^ m o tv »fl £ § ^ M '^ u « > ft '•a i 3 500 So." .e&2 a o 1 1^ TREASURY DEPAHTMENl' U. 8. iNTERWAt'.llBVENUB Form 1001 B— December, 1919 This form will not be accepted untias all informatton called for is furnished. STATEMENT OF INCOME RECEIVED BY NONRESIDENT AUEN FROM SOURCES WITBIN UNITED STATES PERSONAL EXEMPTION CLAIMED. To be fllrf with wltJilioldJnR Bgcnt by nonrealdont ollon Individual ownlnt; bonds of d dornostlo corporation which contain ft tfli-fioa ooTenftnt clause. 7*8 C3ttcu- Hon or tma cortmcate aoea not reUovo the bend owner from flUng owneishlp certificates required by the regulations. NAMES MUST BEI PRINTED OR WRITTEN PLAINLY. DEBTOR ORGANIZATION, Nomo.. Street- City OWNER OF BONDS. Na-Ttio .. Street .. City.... -State Subject o£... This is to certify that the owner.of the above-described bonds is a nonrcBident alien as to the United States and is a subject of the coQntry as stated above, and is entitled to personal exemption and credit for dependents in accordance with paracraphs ( c} and (d), Section 21G of. the Revenue Act. of 1918, and Article 307, Relations 45. Bond interest received during calendar _year with respect to tax-free covenant bonds issued by above-named corporation $.., All other incpme from sources in United States... S^ Total $^ Personal exemption $... Credit for dependents _ $_ TotaU..L S-. In the cjisa of n single person, a personal exemption of SI ,000, or In the caso of the head of n family or n married pcreon IlTlng with husband or wife, a peisonal exemption of 32,000. A lia<;band and wife living together shall rM!clve but ono personal exemption ofEZ.OOO against their aggregate net income; and 1q cose they make separate retiuru, the personal o-xcmptlon of 82,000 may bo taken by either or divided 'bet woon, them; S200 for each person (other than husband or wife) dependent upon and recch'Ing his chief support from the taxpayer, If such dependent person Is under eighteen yeara of age or is Incapable of self-support because menlaUy or physically defective. Citizens or subjects of the countries cnumemted in Class (b) of Article 307 will be allowed theboneUt of the personal exemption but no credit for dependents. CItlreos or subjects of the countries enumerated In Class (c) of Article 307 will not bo permitted to claim the beneQt olpersonal exemptfon or credit for dependents and should tbereforo not use this form. TO BE FILLED IN BY WITHHOLDING \ AGENT. District in which return Form 1013 is filed Amount of tax required to be withheld at source as shown by Form 1013, for lOlli, ? To be reduced on account of personal exemption claimed as indicated by this certificate, the items appeirinjr on the following monthly returns, Form 1012: Month,. Month.., Month.., Month.., Page Amount of tax. $.. ... . Page— .imountoftas Page. Amount of tax P^e Amount of tax- Total- Name of withholding agent... Address. SOI Form Ion.-ItivnED Jatvua, UMi-UinTBD STATES IHTSKKAI. SEV^KOB fiBIlVICi: MONTHLY RETURN OF NOR MAL INCOME TAX TO BE PAID AT SOURCE INTEREST ON BONDS AND OTHER SIMILAR OBLIGATIONS OF DOMESTIC AND RESIDENT CORPORATIONS AND FOREIGN CORPORATIONS HAVING A PAYING AGENT IN THE UNITED STATES CTo Im Dwd b7 paying B^Dnt o( IdtbIjh eorporstlan only In cass fbt bonds coa^n a tax-fmnxvanaat claiua.) FOR MONTH OF„ -„.. 19 THIS RETURN, IN DUPU- CinE. ACCOMPANIED BT CER'nnCATES ON FORM IIHD AND FORM ll»9 MUST BE niED WITH THE COL- LEaOR OF INTERNAL REV- ENUE FOR THE DISTRICT IN VHICH THE WITHHOLDING AGENT ES LOUTED ON OR BEFORE THE ZUrn DAY OF THE MONTH SUCCEEDING THAT FOR WHICH MADE le of dobtoc orgBoIiatlon.} (Full poot-oiDco addnu.) (Nune of wlthboldlng agont.) Date received INSTRUCTIONS If debtor organization makce ita own withholding totum, no entries need bo made on lines provided above for name and addiesa of withhaliltng A. Totum on thiH form must bo made to cover the following claaaca of paymente: 1. InUrat on bondg vnCh lox-free-covenant elavui paid to dtizens and loaidcnta of the Tnited States (individuals and fiduciaries) not claimini; SGTsonal exemption, to domestic and rcaidcDt partneiahipe, to nonresident alien individuals or fidudarico, to foreign partnerships, and > foreign corporations having no office or place of business in the United States, or in case owner ia unknown. A normal lax of 2 per centum is rec]ow and inclosed herewith: CLAM. IstMEsi Paid, TiWlTmnu,. , (BIjnMme.) 2(0) 2(6) {CapadtylnwhlohBttlnr) « » Totals.- (AddiMi In lull.) NaKS 01 P*TM. Ton Ornca urn Btt.n, Akotmi Paid. Tax tTrnaaiB. asEr^.! isja. CONTINUE OH FORM lOlU S02 eelkdir «ai MlMm, W. lb. Form lOlS-Serliea Jonoiry, IWI UKITED STATES DfTBRNAL BEVENXIB SEBV1CB ANNUAL RETURN OF NORMAL INCOME TAX TO BE PAID AT SOURCE INTEREST ON BONDS AND OTHER SIMILAR OBLIGATIONS OF DOMESTIC AND RESIDENT CORPORATIONS AND FOREIGN COR. PORATIONS HAVING A. PAYING AGENT IN THE UNITED STATES For the Calendar Year 1920 Dd not write in lliitfiuM PAYMENT i (Cuhlcr'i StAiDp) (Nomoal debtor DrgaulullOD) TUB RCTnU HDST BE WDE TOROFIHTCIHUIIETEHDE FOR lUE DSTRO IN VHICn THE VITRHOLDINC AGEKT tS (Addrass In full) LOt^TED, OH OK lEFORE Ei>d«db, (AddnssinluU) mSTRUCTIONS If debtor organizELtioii malceB ita o^m return, no entries noed be made on linoa provided for name and address oi withholding agent. This retnm must be made by debtor oigonizations, or their duly authorized vitbholding agents, and must ahoir, by months in which the income waa paid and reported on Form 1012, the total amount of tax to be paid at source on each of the foUowii^ classos of payments: 1. lotereEt on bonds with tax-free-covenant clauses paid to citizens lAid residents of the TTnited States (individuals and fiduciaries) not claim- ing personal exemption, to domestic and resident partnciships, to pcrson&I service corporations, to nonrcaidGnt alien individuals or fiduciaries, to foreign partueTshipe, and to foreign corporations having no office or place of buaineas in the United States. A normal tax of 2 per centum is required to be withheld and paid at source in such cases. 2. Interest on bonds without tax-free-covenant clauses: ■ (a) If puid to a nonresident alien individual, a normal tax of S per centum is required to be withheld and paid at source. (b) If paid to a foreign coqxiration having no office or placo of business in the Unitod States, a normal tax of 10 per centum is required to be withheld and paid at source. MOHTH CtASS 1 CLASS 2 (» CLASS 2(b) TOTAL JANnABT J $ $ $ frmWHABT MARrTT APPR ^^ea. ... TOTAIS i it 1- $ 1 5 ff-"" Amonntoftaxi > be esse SBed.„ _._ * - ^..-^ I swear (or aifirm) that the above return is a full and complete summari/ of the amounta of normal tax (heretofore reported on rrumtldy returns on Form lOlS, which are hereby made a part of this return) required to be withheld from pcqfmenta -made by the above organization during the year 1920. Sworn to and subscribed before me this - day of , 19S1. (Ctpaciij ia which ocUng) 503 il««f fiUflf ITlbartlumi ;<«nipuiUd b7 nmUliaci THIS teiOSS MUST BE MADE IN DUrUUIE TO THE COLLEC- TDI OF 1HTEIHAL leVENOE rOH THE DBTlin IK WHICH THE WnHHOLWHC «CENT IS LOCATED, ON 01 lEFOlE WBCH I, mi. AND THE TU HOSI IE PJUD ON 01 lEFOlE JIIMEIS, IKI. ANNUAL RETURN OF NORMAL INCOME TAX TO BE PAD) AT SOURCE SALARIES, WAGES, RENT, ETC., PAID TO NONRESIDENT ALIEN INDIVIDUALS AND FOREIGN CORPORATIONS (NOT ENCAGED IN TRADE OR BUSINESS WITHIN THE UNITED STATES AND NOT HAVING ANY OFFICE OR PLACE OF "BUSINESS THEREIN) For the Calendar Year 1920 (Muno of withholding agml) Do ml orilB [n thi* n (Cuhlar'* 9tunp) CASH CHECK M.O. IMSTRDCTIONS Thie rotum is required to bo mado by all individuaU, corporatioiu, and partncrahipB, in wbat«ver capacity acting, including lessees or mortgocora of real or perBonal property, fiduciaries, employers, and officore and omployocs of tho United States having the control, receipt, custody, disposal, or payment of interest, rent, eaiarics, wages, premiums, annuities, compensation, remuneration, emoluments, or other fixed or determinable annual or periodical gains, profits, and ineoino ofnonreflidcnt alien ihdiyiduals or foreign corporations not engaged in trade or business within the United States and not having any office or place of buaineas within the United States. Tho law requires that a tax equal to 8 per centum of the amount paid as aaloriea, wogce, rent etc., to individuals and 10 per centum ol the amount paid to corporations shall bo deducted and withheld. If any tax required to be deducted and withheld is paid by the recipient of the income, it shall not bo recoUoctcd from the withholding agent Income derived from dividends on the capital stock or from the net eamings of a corporation. joiD^stock company, or insilrance company, ivhich is taxable upon its not income under the Revenue Act of 1918 is exempt from with- holding and should not bo reported. This return must bo accompanied by a report OQ Form 10S8 of incomo paid for every item entered hereon. I ffirear (or oflirm) that the following is a true and complete return of alt paymonta of ealaricfl, wages, interest, rente, etc., mode during the cal- endar year 102O by the above withholding aeent and of the tax withheld on payments of income, asabove described, to nonresident alien individuals and foreign corpoiationB as defined above, vio aevoral items being evidenced by reports which are listed below and inclosed herewith showing tho name and addrc» of the recipient of the income, tho kind and amount of income pud, and tho amount of tax withheld. I further declare that the amount of tax trithheld is $... Swom to and subscribed before me this ^ day of .. (Slgmiture.) CTEllo.) (Capacity In which actlog.} NAME OF INDIVIDUAL OR CORFOBATION TO WHOKPAID ADDRESS IN FULL. ^^VJ^ TAX WITHHELD % 1 ^ - — Totals . i_ — 1 504 I •3 S. ■S9 r M .a o 1 11 k a o a si • 2 5P si ft 1H C4 IS IS U CD a 8 ■° i ■II p. II <4i d I ''"^ll .9 " III a i.2 ii 8§ §11' * ^ 2 5i ra liPi ffl P* S4 o g "■6 S (J S 3 •' lipii ■§ g: pe of*' "ca ■e « s p 2 < ^ «f P s « lii as 9 Uo o § o td g is o § Q % u g CQ § P B U OS O Cd ^ (3 SI e3 SB g a ■a; on ea o N n iz; -1 « o « o ft 5 IS OP" MO. i _ra s ^t\ i § a h •a 3 9 B O S a ■gsa £OT> OoS §23 M •o a. p a a < a izi < I .g o !> C3 ,15 a •"8 5.g "as a> t "" •^ o 52 CO 5 "52 ^"2 -§ A M W 507 13 ra A 3 >> a 1 >> M 0? -^ %^ PI . -i g OJ 8§ rJ2 '"S t:) Q) TO a> -^,13 ^ ® ■B 03-3 ^ s S a 1.3 o -d d o oi a a o at is O a pF bo O £ SI « s o •- £1 p^ it si a" M CO I H i •"1 Pi A o CO ■ w W Pi Q < ■T3 o o rm 10MB (Be^Md lonnaiy, 1920>-nNITED BTATSS tltfSAKAL REVENUE SERVICE ANNUAL INFORMATION RETURN PAYMENTS OF INTEREST ON BONDS OF DOMESTIC AND FOREIGN CORPORATIONS AND COUNTRIES AND DIVIDENDS ON STOCK OF FOREIGN CORPORATIONS For Calendar Year 19 THIS REniWJ MUST BE FORWARDED SO its (D«t«nc«lTMl) TO REACH THE COMMISSIONER OF INTERNAL REVENUE SORTING DIVISEON WASHINGTON, D. C ON OR BEFORE MARCH 15, OF THE FOLLOWING TEAR (Name of baolc or pa;iiiK agent.) (Full postolDca address.) MONTH A. Israaxn ow bohdb and other sonLut OBUOATiONa of DOlf BSnO AMD BESIDUrr COBPOEASION3 B, INTEEE3T ON BONDS Or TOREIOM CORPOaATIONH AND COUWTSlEa AND DIVIDKNDa ON STOCK OS FOSKIOK COEPOEATIOHB Humt>prof(»rtUest«t Amonn^ Nnmbflr of cfirtiflcates Amonnt April May - . July December Total 9 $ This return muat be made by debtor corporationa, paying agenta, or banks, and mugt Bhow, by months in which the income wa3 p.i.id and reported on monthly retuma, the total number of exemption certificates filed with such returns and tho total income paid without deduction of tax, as shown by each certificates and returns. I swear (or affirm) that this return is a full andcompleteBummaryof tiie number of exemption certificatee and amount of inrome of the classes shown above (heretofore reported on monthly returns, which are hereby made a part of thU return), paid during the year , Sworn to and aubscribed before me this of , 19. -day (Cnpaciiy in wliicli ireLiug.) (Adiiru.ssluJuil.j 512 Ck a U o O S as S 3 O in K « £ nj z: z S n §« g ^ o g f=^5 H H 1 o p « w Eh S o o si 00 M PS' m o 4 a-o d d .3 o •M a -^ 5-2 ® "s it; A A ^ 'I'i i 3 -S O Q » I •§ -9 -a ^ 5 -a I la >, 12^ « !z; S'aai-3a°o"" « sS.glitS'sei m -Sgaaggj-sg-s a .rt™s§a§^9°F' ■^ I i ^ fi s >^ I " s I 1 a is.! 2 >>a * = tpi ■« ■a ja g-s s aE.f| " ^•9 S; IlLl •oe: V. — '^ b -^ " > " s ° & -2 .2 .,§ £ a a 513 Oi u u ef» «» «» eS' ^ o tj 02 w o O ■J3 g. rj » i -^ *-< ^ II 5 t*' if §ia o a 8 3 o -i . " .2 a -a 3 s .a a B"" o c:! (S ^ ui < H -3 g "„■ 5S 1 a <*i ja ^ o S SS I- 3 •S ~ ■« g > H u D •u S 3 " ^ ifiii ^ •! 5 s ■§ i-9 .2 W.9: 514 INCOME AND EXCESS PROFITS TAXES. APPUCATION UNDER T. D. 2706 FOR PERMISSION TO ESTABLISH A BEPUCEMENT FUND. To the CgmmisBloner of Internal Revenue t 1. The undersigned (individual) (partnerBhip) (corporation) repreeents that as a result of suit or otherwise }ie has secured payment by way of damages or compensation for property title to wHch has been lecimBitioned for war uses, or property which hos bean lost or destroyed in whole or in part through war hazards, to an amount in excess of .the value of the property on March 1, 1913, or of its cost if acquired after that date, and that he deeires and intends to use the entire simi received as compensation for the replacement in kind of the lost or damaged property 2. It being impracticable owing to war conditions to make euch replacement for a considerable time, the undersized hereby makes application for permisaion to establish a replacement fund in which the entire amount of the compensation so rec«ived will bo held (iinless the property requisitioned, lost or damaged, constituted all or part of the security under a mortgage or trust inden- ture, in which event the amount carried to the replacement fund will, subject to the approval of the Conmiissioner of Internal Revenue, be the amount of compensation rec^ved, leea the aOiount, if any, whidi becomes payable out of such comi)enBAtion under the terms of euch instrument or the obligations thereby seonred). 3. Attached hereto as Schedule A and made a part hereof is a statement reciting all the facts relating to the transaction, including the nature of the property, the character and extent of the Iobs, the manner and date of securing compensation, the .date of acquisition of the property and its cost ot fair value on March 1, 1913, the amount of compensation, the amount neceesaiy to make the damage good, a description of the replacement intended an4 tho etops already taken to that end, the probable date of completion, , the estimated additional excess profits and income taxes assessable upon the income carried to the replacement fund, and all other matters which might affect a determination. 4. The undersigned (a) has executed and will cause to be executed by a surety company in good etanding the bond hereto annexed as Schedule B in an amount not less ikaa the estimat^' additional excess profits and income taxes assessable by the United States upon the income carried to the replacement fund, or (&) has executed the agreement hereto annexed as Schedule and will deposit as security for euch estimated additional amount of tax obligations of the Uuted States issued after September 1, 1 917, to at least an equal amount, to bo held in trust as such security in a bank or trust company approved by Uie Commissioner of Internal Ilevenue. 5. The \mderaigned undertaken that he will proceed as expeditiously as possible to replace or restore such property, and covenants that When the replacement or restoration is inadeij tUe new or restored propertT* \rill not be valued in his accounts at an amount in excess of thai at which CGie requisitioned, damaged, or destroyed proper^ was carried, except and to the extent that such new or restored property has an increased productive capicity In witness whebbof, the undeisigned individual has hereunto set his hand and seal, or the undereigned partnership has executed this instrument under the band and seal of one of ita members, or tlie undersigned cotporation has caused these presents to be subscribed by one of ita oflScerfe and its corporate seal to be hereunto affixed, all the .... day of , 16 , in triplicate. (L. a.) — - (l.. 6.) State of .. .., bemg duly sworn, deposes and says that he is the individual applicant above-named, or is a member of the partnership above-named, or is an officer of the corporation above-named, and that the statements made in the foregoing application ore true to the best of deponent's knowledge, information, and belief. Subscribed and sworn to before, me .. 515 Schedule A./ STATEMENT OF FACTS. Name of applicant... Address- Business Nature of property involved.- How requisitioned, lost, or destroyed... HoTv compensation socurod — Date of receipt of payment __ Date of acquisition of property : _ __ _ - Cost (or fair value on March 1, 1913) S- Amount of compensation _ S.. Excess over coat or value on March 1, 1913 _ - S- Amount necessary to niake damage ,go0d _ - S- Nature of replacement intended.^. ^ _ Steps already taken . . Probahle date of completion of replacement.. Amount deductible from replacement fund pursuant to any mortgage. . Estimated ad-sn» S20 Form lllS— Umr^D gTAT^ajHTEBifAi Hrvkkub Bafevioa, CUIM FOR CREDIT ON INCOME AND PROFITS TAX RETURN OF DOMESTIC CORPORATION FOR TAXES PAID OR ACCRUED TO FOREIGN COUNTRIES OR TO POSSESSIONS OF THE UNITED STATES Name of corporation ,. . Addreas {Street imd number.^ •On bohalf ol the above-named domestic corporation, credit is hereby claimed, on the attached corporation income and profits tax return, which is based on income . ' for the tajcable yeaf . . . (EocgIy,c<] or Qccnied.) (If calendar year, give year; iC fiFcal year, eivo moulhs.) of the above-named corporation, for taxes aa follows: (Paid or accrued.) Taxes P^id or Accrued' During the Taxable Year to Possession? of the United States qn Behalf of the Corporation. SCHBDUIB Al Nam© of possesaion imposing ta;t ..,..^ ., -,„ - , ,_, Character of tax . (Income, wniproUts, or oxccss profits.) Date of accrual _ _ Date of payment (if paid) ^ Statute imposijQg tax ._ , _ (To 1>c named fully and clearly bo as to be easily Idcntifled.) 1. Amoxmt of tax payment (evidenced by attached receipt or return) " which (converted (In rorelgD money ) at an exchange rate of *) equals in dollars S Taxes Paid or Accrued' During the Taxable Year to Possessions of the United States on Behalf of the Corporation. SC^BDULE A2. Name of possession imposing tax , Character of tax (Income, war proftCs, or cwess protita.) Date of accrual ^. Date of payment (if pijid) Statute imposing tax (To bo named fully and clearly so as to bq ooslly IdcntlflodO 1 Amoilnt of tax payment (evidenced by attached receipt or return) ' which (converted (Inlorcign money.) at an exchange rate of ^) equals in dollars. _ '. Taxes Paid or Accrued' During the Taxable Year to a Foreign Country on Behalf of the Corporation. ScnEDULE Bl Name of foreign country imposing tax _ _ _ Character ol tax .. Dato of accrual -,- - Date of payment (if paid) Statute imposing tax — r proCta, or excess profits.) (To bo named fully end clearly so as to be cosily Idontiflcd.} 1 Total net income on which tax was baaed ' 2. That amount Of such total net income which was derived from sources in that foreign country * -^ a, Jlatio of total net income derived from.sources in that foreign country to total net income on which tax was based (item 2 divided by item 1) .; _ 4, Total amount of tl^is.taS payment br accnial to that foreign country (evidenced by attached receipt or return) _ 6. That amount of this tax payment or accrual which was based on iucome derived from sources in that foreign country (item 3 multiplied by item 4) — ' which (converted at an exchange rate (In foreijjn money ) of ") equals indollars _ ...'. ,„ ^. _ _ $.. See notes on pane 3. 521 Taxes Paid or Accrued' During the Taxable Year to a Foreign Country on Behalf of the Corporation. Schedule B2. Name of foreign country impoaing tax , -1- Character of tax Date of acaiinl (Income, war proflti, or excess proOtsj Date of payment (if paid) . (To bo named (aliy and cicaily so us to be euUy Identlflod.) Statute impoaing tax 1. Total not income on which tax waa based . 2. That amount of such total net income which waa derived from Bouixea in that foreign country * 3. Batio of total net income derived from sources in that foreign country to total net income on which tax waa based (item 2 divided by item 1) _ — 4j Total amount of thia tax payment or accrual to that foreign country (evidenced by attached receipt or return)... 5. That amount of thia tax payment or accrual which was based on income derived from sourcee in that foreign ,..' which (converted at an exchanee rate country (item 3 multiplied by item, 4) . of ^) equals in dollars „. (In forolgn money.) Taxes Paid" during the Taxable Yeat to a Foreign Country oi a Possession of the United States by a Controlled Foreign Corporation. ScnCDDLE C. (NoTK,'— No credit can be claimed for taxes p:ild on bohaU of a (orolgn corporation tho dividends (ram which oro deductible from gnns Income under section 234 ol Uteoct.] Name _ Address — Foreign , Corporation ' (Street and number.) (City or town.) Incorporated under the laws of (Country.) Preferred. Common. Total. Capital stock Number of eharea outatanding.. Number of shares owned by above-named domestic corporation _ Has preferred stock voting rights? . f Yes or no.) Character of tax:., Name offoreigncountryor possession of United States imposing tax Statute impoaing tax _ _ (To bo named fully and cloarly so as to be cosily identified.) Was any part of the net income on which this tax was baaed derived from sources within the United States? . (Income, war promts, or excess pro&ta.) Date of payment of tax.. 1. Period of accrual of this tax payment ■_ _.. 2. Amount of this tax payment (evidenced by attached receipt)' _, 3. Netincomeonwhichthis tax was "based", Total 4. Amount received during the toxable year by tho above-named domestic corporation as dividends from such foreign corporation ^ ■. r 5. Ratio of the amount of "such dividends to totil net iocom^ on which this tax waa based (item 4 divided by- total items 3) .'. •- -^ 6. That amount of this tax payment which is available for credit on return of ab^ve^named domestic corporation (total items 2 multiplied by item 5, unless this product is in excess of total items 2, in which case total items 2 must be entered here instead of such product).. exchange rate of ') equals ij;! dollars (In foreign mon^y.) — ', which (converted at an See notes on page 3. 522 StTMBIARY" OF CREDITS CLAIUED FOR TAXES PAID OR ACCRUED ON BEHALF OF CORPORATION. ■ To a poseeasion of the United States (item 1 of Schedule Al) $ To a posseasion of the United States (item 1 of Schedule A2) $. To a foreign country (item 5 of Schedule Bl)_^..>. „ „ | To a foreign country (item 6 of Schedule B2).., To a foreign country or a poeaession of the United Statea'on behalf of si controlled foreign corporation (iterti 6 of Schedule C)^ : ;. $„ Total credit claimed (to be entered in Schedule TV of atttached corporation return — as item 19 if retiun is on Form 1120, as item 29 if return is on FornK120-A)_ $.. ^'e, the undersigned, president and treasurer of the corporation for wliich this claim is made, being Beverally duly sworn, each for himself deposes and says that this claim has been examined by him and is to the best of his knowledge and belief a true and com- plete statement of facts in connection with the credit for income, war profits, and excess profits taxea claimed herein. , Sworh to and subscribed before me this, .,„. day of '. - , 19 President, (Official capacity.) Treasurer. I Tfattac^edlncomotoxrotumlsbasodonlncomo ''received '',thon ''paid or &ccri]od''whorovGrltnppe&r3in this [orm(axcoptlnSclied means "paid"; Ifbasod onlncome "accniod," then "paid or accrued" moans "accmod." (See soctlqn 200 of tlio Rovonue Act of 1918.) > State thlsltcm In terms of the curroAcy usod In making the rotuiu on which this tax vras based (e. g., pounds, francs, marks). 1 ciMmant must here state rate of excli^ige used and fiiust also attach a statcmont describing In reasonable detail why and bow be detonnlned upon tbls particular rate. < The person making this claim must attach to It a statement describing In reasonable detail the method by which ho^etennlned the amount of Item 3. > Credit can be claimed for taxes paid on behalf of a forolgn-«ontrollod corporation only in the taxable year during vhldb such taxes are paid. There Is no siicb credit for taxes accrued. e Where this tax i>ayment was of taxes accrued during only one year, give dates of beginning and ending of such ycat in first column (e. g., July 1, 1917— Tunc 30, ISIS). Where this tax payment was of taxes accniod during more than one year, eive in separate columns tbe dates of each annual period during which any i»r^ of this tax payment accm^.| 1 State In column under each >min»ftl poriodnomod In Item 1 the amount of this tax payment whicli accrued In such period. > State In column under each part of this tax payment as given In Item 2 tbo amount of the net Income upon ^vhich such part of the tax payment was'bosed. > Where there are more than two possessions of the TTnlto^ States or forolgn countries to which taxea are paid by the domestic corporation, or'mne thui one controlled tordgn corporation, or more than one possession of the United States or foreign country to which taxes are pai<^' on behalf of a controlled foreign «nporatioD, additional schedules should be attached, and the credit claimed on each such schedule should bo written Into this Summary. a—MSS 523 INSTRUCTIONS REGARDING USE OF FORM 1118 CREDIT FOR TAXES Provisions of Revenue Act of 1918 Seo. 23S. (a) That in the case of a domestic corporation the total taxes imposed for the taxable year by this title and by Title III shall be credited with the amomit of any income, war-profits and excess-profits taxes paid during the taxable year to any foreign comitry, upon income derived from sources therein, or to any possession of the United States. ^ If accrued taxes when paid differ from the amounts claimed as credits by the corporation, or if any tax paid is refunded in whole or in part, the corporation shall at once notify the Commissioner who shall redeter- mine the amount of the taxes due under this title and imder Title III for the year or years affected, and the amount of taxes due upon such redetermination, if any, shall be paid by the corporation upon notice and demand by the collector, or the amoimt of taxes overpaid, if any, shall be credited or refunded to the corpora- tion in accordance with the provisions of section 252. In the case of such a tax accrued but not paid, the Commissioner as a condition precedent to the allowance of this credit may require the corporation to give a bond with suretira satisfactory to and to be approved by him in such penal sum as he may require, conditioned for the paym.ent hy the taxpayer of any amount of taxes found due upon any such redetermmation; aiid the bond herein prracribed shau contain such further conditions as the Commissioner may require. (6) This credit shall be allowed only if the taxpayer furnishes evidence satisfactory to the Commisisioner showing the amount of .income derived from sources within such foreign coxmtry or such possession of the United States, as tha case may be, andaU other information necessary for the computation of such credit. (c) If a domestic corporation makes a return for a fiscal year beginning in 1917 and ending in 191S, only that proportion of this credit shall be allowed which the part of such period within the calendar year 1918 bears to the entire period,. Seo. 240. (c) For the purposes of, section 238 a domestic corporation which o*ns a inajority of the voting stock of a foreign corporation shall be deemed to' have paid the same proportion of any income, war-profits and excess-profits taxes paid (but not including taxes accrued) by such foreign corporation during the taxable year to any foreign country or to any possession of the United States upon income derived from sources without the United States, which the amount of any dividends (not deductible under section 234) received by such domestic corporation from such foreign corporation during the taxable year bears to the total taxable income of such foreign corporation upon or with respect to which such taxes were paid: Provided, That in no such case shall the amount of the credit for such taxes exceed the amount of such dividends (not deductible under section 234) received by such domestic corporation during the taxable year. CoNumONS OF Allowance of Credit. — (a) When credit is sought for income, war-profits or excess- profits taxes paid other than to the United States, the income and profits tax return of the corporation must be accompanied by this form, carefully filled out with all the information called for and mth the calculations of credits indicated, and duly signed and sworn to. When credit is sought for taxes already paid the form must have attached to it the receipt for each such tax payment. When credit is sought for taxes accrued the form must have attached to it the return on which 'each such accrued tax was based. This receipt or return so attached must be either the original, a dupUcate original, a duly certified or authenticated copy, or a sworn copy. In case only a sworn copy of a receipt or return is attached, there must be kept readily available for comparison on request the original, a duplicate original, or a duly certified or authenticated copy. (&) In the case of a credit sought for a tax accrued but not paid, the Commissioner may require as a condition precedent to the allowance of credit a bond from the taxpayer in addition to this form. If such a bond is required, Form 1119 shall be used for it. It shall be in such penal sum as the Commissioner may prescribe, and shall be conditioned for the payment by the taxpayer of any amount of tax found due upon any redetermination of the tax made necessary by such credit proving incorrect, with such further conditions as the Commissioner may require. This bond shall be executed by the taxpayer, its agent or representative, as principal, and by sureties satisfactory to and approved by the Commissioner. See also section 1320 of the Revenue Act of 1918. Articles 611 and 383, Regulations 45. *-wh 524 'treasury ©epartment IKTSRKAL REVENTTE BtntBAU Form 1119 Income and Profits Tax Bond TINDBR SIJCTION 2S8 (a) OF THE REVENUE ACT OF 1918 KNOW ALL MEN B"i: THESE PRESENTS, That we. ; of __ , as principal, and , of as surety, are held and firmly bound unto tlie xpNixED States of America in the sum of.. _ _ _ dollars, lawful money of the United States, for the payment whereof we bitid ourselves, our heirs, executors, administrators, suc- cessors, and assigns, jointly and severally, firmly by these presents. Whereas, at the time of filing its return of income for the taxable year 1&18, the above-bounden principal claimed a credit on its income tax -return for income or war-profits and excess-profits taxes accrued but not paid to foreign countries or to possessions of the United States, and duly attached thereto Form 1118 prescribed for such purpose; and Whereas, section 238 (a) of the Revenue Act of 1918 provides that, in the case of such a tax accrued but not paid, if the tax when paid differs from the amount claimed, or if any tax paid is refunded, the Connnissioner shall redetermine the amount of tax due, and, as a condition precedent to the allowance of tlte credit, may require the taxpayer to give bond, Vith satisfactory sureties, in such penal sum as the Commissioner may require, conditioned for the payment by the taxpayer of any amount found to be due upon any such redetermination, and the Commissioner has required that the bond given in such a case shall be in the amount of the credit claimed, and this bond is in the amount of the credit claimed ; Now, THEREFORE, the coudition of the foregoing obligation is such that if the principal shall, on notice and demand by the Collector, duly pay any income or war-profits and excess-profits tax found by the Commissioner upon any such redetermination to be due from the principal, under the Kcvenuo Act of 1918, and shall otherwise weU and truly perform and observe all of the provisions of law and the regulations thereunder, then thia obligation is to be null and void; otherwise to remain in full force and effect. Witness our haiids and seals,' this day of , 1919. Signed, sealed, aiid delivered in the fvesence of-^~ [L. 8] .....,...,.[L. a.l .[L. S.] Surety. Bond appeoved this. day or , 1919. CommissioTier of Internal Revenue. Comment on form 1120, issued January, 1921 Schedule L, Reconciliation of Net Income, page 4 of re- turn, form 1 1 20, for 1920, makes no specific provision for taking up adjustments between book profit or loss and the amounts reported when capital assets are sold or losses not compensated by insurance are sustained, which have been reported in items 22 and 23, schedule A. Specific provision was made for such adjustment as item 4 or item 8 of schedule M in form 11 20 for 19 19 returns, but in the new form these items have been omitted from the reconciliation. It will be necessary, however, to enter such an adjustment in schedule L if the value of the property at March i, 1913, referred to in schedules A-22 and A-23 is greater or less than the amount at which it is carried on the books. 526 IF KETURN IS FOR CALENDAR YEAR 1920 FILE IT WITH THE COLLCaOR OF INTERNAL REVENUE FOR YOUR DISTRICT ON OR BEFORE MARCH IS, 1921 IF FOR A PERIOD OTHER THAN A CALENDAR YEAR THE RETURN SHOULD BE FILED ON OR BEFORE THE 15TH DAY 'OF THE THIRD MONTH FOLLOWING THE CLOSE OF SUCH PERIOD Pago 1 of Kotum Form H20— UNITED STATES INTERNAL EBVENl/E SERVICE CORPORATION INCOME AND PROFITS TAX RETURN FOR CALENDAR YEAR 1920 Or for period begun. ., , 19...... and ended , 19.._ (PRINT PLAINLY CORPORATION'S NAME AND BUSINESS ADDRESS) (DO NOT WRITE IN THIS SPACC Examined b; Audited by FIRST PAYMENT Cashier' • Stamp KIND OF BUSINESS., IS THIS A CONSOLIDATED RETURN?. SCHEDULE A— TAXABLE NET INCOME. GROSS INCOME. .. GroMealos, lesaretumaandallowonceB _ k I. I^ cort of goods sold, OKClualva of eiponaoa, ropaiM! and otboriiomBcaUed lorMDniDlclv below (from Bchodulo A2) _ _ ' I' ^''"vV"^'?^ ^""^ 0P?f*'^°P* "Uior than tradino or manufftcturiiiB, less nllowancea (trom Schedule A3)„ aJ? "'**™^* '"' oblisaUona of tho United StateH and War Finnnco Corporation Bonds {from Form 1125, boo Schedule i. Taxable inteioat from all other sourcoa (from Schedule AS)... I. RoDtalB I. Share of net income carood by porsooal Borvice corporation durine ita accounlinc period (whothor received or not) I. Dividendfl on 8tock.or_(a) toreifpi corporations {from Schedule AS), ? :. ; and (5) domoatic corporationB, except perBonal eervieo corporationa from oamingB occumulated on and after January 1, 1918 $ ' Total s (not including any a I. Gross income from all other k Total o» Iteus 1 to 10 „_ DEDUCTIONS. I. Ordinary and necoMiiry oxponsea (escopt amounts reported in Item 2 above i it reported in Item 22, below) {from Schedule A10)._ A12)... r called (or separatoly below) (from Schedule i. Compensation of officera (including sal aries, conimiaaiona, ond other compensation in whatever form paid) (from Schedule A13) I. Bopaiia {including labor, Bupplioa, etc.) (from Schedule AH) I. Interest (see page 2 of Injtructions, paragraph 3) ;. Taxea (from Schodulo AJ6) '. Debts asccrtuned to bo worthlosa and chaigod oU witbia the tasablo period (from Schedule A17) I. Eihaustion, wear and tear (including obsolescence) (from Schedule AlB) I. Depletion (from Schedule A19) t. Total of Items 12 to 19 '. -.^..-, DiFi^REHCB Bktwben Items 11 and 20 !. Profit or loss on sales of capital assets and miscellaneous investments, including hquidatinfc dividondsffrom Schedule A22). I r otherwise. (From Schedulo A23.) 1. Loraea auBtalned during the taxable period and not componaated (Extend to last (»lunin sum of or diSerence between Itams 22 arid L. Notincome for taxable period oxcluaivoof deductiona for dividcnda and ainortizatian (sum of or diEtcience between ItciDs21and 23, the latter i. Dividends on stock of (a) foreign corpomtions taxable by the United States on their net incomes, and (b) dommbc porotiona, excopt personal aarvice corporationa from earnings accumulated on and aftor January 1, ISIg >. Amoitiiation pf wu fadlitice (from Schedulo A26) (extend total of Items 25 and 2G) , , , '. Net Lvooub Taxable Pebioq (dlEFerence between Items 21 and 2G, the latter aa extended — to be entered as Item 6, Schedulo D)... Lees deduction provided in tho fiiat paragraph of Section 23, Merchant Marino Act of 1920 (eoo page 1 of Ixutructions, paragraph 4) Wot income of a corpomtion o^rning shipfl engaged in foreign trado (amount to bo nand only in computing profita tax io Schedule D) SCHEDULE B— INVESTED CAPITAL. ITEK. A«OU>-T. , i J SCHEDULE C— EXCESS PROFITS CREDIT. , S. Eic«« ProGls Credit (Ilflm 1 plus Item 2). (If return is (or a period lora than a lull year, ace page 2 of Inatrucliona, paragraph 11) < SCHEDULE D-COMPUTATION OF TAXES. ..Bn^rs. . i. DiULscc Edbizct to Til. nf^ t. Akocki or Tax. 1. Net income, not in excess of 20^ of . I 2d!S 40 J5 f 1 3. Totals computed under Section 301(b !, S ..^ Sectiona3D2. 303. 3 M(c) or 337 of the Revenue Act of 1918 (see page 2 of Inatructiona, paragraph 14) -.. s ..._ 11. TaiodOjSonltoinl j:>s A^rd-^mV isssfe^r 13. Lon; Tnrama ond prcBU Hios paid lo ' '■V^b?i"riJnr"""''"*'"""°! "■ — — . a EiCTst nronu and w pmBU taxa (lum ID, Farm 1I»IS. hmmg rram a«(c) ot Rorenue Ail o( It. iDHiniO tM «11hhcld fll Ih t&JiDnrwf fsBopis^IollQiilmcUDM, ea^td In B iTDdB or^iulous wllhin IhBUBllcdaiolcB.iuidnolhavIniiany 10. Balance aubject tO income tax (Item 0, or Item B. Icsa Items 6, 8, and 9) ,JeasltemB6,7,and . 1 15. Balance of tax (Item 12 minus Itoma 13 and 14) 8 _. AMENDED RETURNS. An amended return must bo plainly marked "Amended" across tho fnoo of the rpl"ni CHECKS AND DRAFTS. Checlm and drafta will be accepted onl/ if pawble at par at your CoUector's ofRco. 527 Pag© 2 of Hetum E4.Si«:bn(duall;oulitaDTl]nEst(bF«DdaItbgprioodlai;laiDblDpoilDiIibau]aiManteTed[iithl3icbi>dule tolhaBTtantthfltltlapaldup. ir&tackaiiboroaitTorvisauDrlataiiiniiiliialTalDearwltbautpnrvalUDtlioaJitriaa sbould nQKl IbD nnKmuU dd tbo boolu in rupDct tbmoof at (bs dun a! tbo piochkUde luiBblB porisd. BS. TlilsIteinEtiaiiJdiDcluiiepold-luniipbioiuabinnib7bDaliaiittha*Bnd afthoprBCwUnElnifthlspfiiliid. If my imoiml U dalmtd uiidw a»UDii3I6{ii) (2) ol IhB Ilovmuo :Ui of ISU Of nndoi Artlcla 837 ot RumloUonii Ur tboammmtcliiimcdAliaalcIbQoaliircdiuidor tt6]nl,Scb«1ulL^ F, and oat In this HcbodnlOp ET. Ituurra wlilcb npnsscnt dUdcUIdiu at luiplos nnd vest Dot nccuoiulatsd thrrTugb dflducUcwi mndo tncompntuJ[raBllni!omoaATatuniBdInpiQvi[ias7eiiTBniAy^irpiopr>r1yai:pUJnfdj bo onLorod aa Itftm 7. Such DntriegiboaldboldeDLllJcd BElttnueneryrajoDcUiKl wilb boluictahoct nBcrrBs. ElO. II IbemparatliinlindDD bond D( Buy time dnrinK tbo tniabLDperiuliuiytisisar7Bl«ck, copies ottbD JotmuUfintriDCOverlDEtbaorlKinAlluaiUico' ropDssHdODBDdoBy nibscquimtDd^ujtnicntSBbouldbotaifUl^^ Troasury stock inoludei All sEook nacquircd by tbaooipomtlonnadnotcBiioolDdiTonArdlaooltbiiroiLionforlliB Bci!rlo.liw«i(jiTOb>-l«nl.-s SCHEDULE F.-ADJUSTMENTS B WAY OF ADDITIONS. PI. II (n sddltlim to Intnlod CBpltal I> dslmod in Itud 1, Sobulnlo F, submit a atalanunt sbawtng (a) th«Und alpiDporty, (A)theycarln nblchit nu paid In, U) (rom wbom arqulred, eipIalzdnEbiirQlBtlon- lbJp to theoorpo'^llQiif Id) thoactnalcajb TBlDcol such property at tba date vhuD paldlD,(f)lhi:parTaliiaof itock or obarcs Issued tbeiAfarand thaomomi tat vhlcb mob prnpffty^voa entered In tbo occoLm to, (pLhobu^is upon vljicb tbo actual covh valtto of tbo proporty voj dotejmiitod and Ibe data irboi oich dBtcriDlTulkm was madf, and (p)IbBamonnl or dcpTHlBtlansiistBlocd on aucb property Iromthodato of ocqulnlUiD to tbebctdnnlDG odlio Ijnuhlo pufloil. F3. If on addition to loTstad capital is dalmod In litna X Schedolo Y, submit a atatDD^ont showing (d) tbo kind of property, y Iho coiporaUonr II net enlarsd ip«illcsUy an mab, la the intanglhlD value morgied ondeT any oUier tlibi or titles an the books or balance ituet; submitted wllb thlaretumT IglCentoRid ootlioboaka at a value In Gsnaollte vctnaloadhTDlue when paid InT In exccoe of tbe par valoa of the stock issued theteforf - lathe ar^eitate or luoh tssete acqubed prior lo Uarch 3, 1S17, entuwl on On booln at a raiue In eiona ol .U ps omt of the par TBlue of the ttoek outstartdisg an Uarch 3, 19177 la tbeBsgrogBtooIjuehaesetf (mlergd on the books al a TOloe In excea ol !£'per cent of the poi voloa of tbe stock ontstandln; at ttu bsgiimlQE al tbe taxable period? II the anmror lo any of the forcgola g queations is"yM,"inhmlta itatemnnt ahowinc aepaialely with roapect (oaach>siolsaaialred{l)beC]ieMarch3, lW7,aDd(Z}Dnoratterthat date, (a)dateofBCiinlxlUon;(ft)o*ih vahB at (hat date, -with a complete cipIansUen al tlm bada upon vhich lacli cosh vabiD vas detnmlned; (c] par Talm of the Mock isnied tberafoi; (d) pai tbIuo of tola! stock ontatandlnj Uaich 3, IBIT; fr ) par voJoo of total atock culjlandlnB at (he begbmliw of tbo taxable period; (n tbe Taha at wljich Budi asselB ore entered on the booke o( the eorporalion. If oil the iDtaugibles were acqnlrwl boloro Match a, IBlT, Iheamoontby whlcli t/) axcoHlii (i), (f),li per ami of (if),orMp«r cent otW.wblchBrorlsloireat.mnit bo eutered OS Itcml.ecbeduloO, for the tixablB period. IfthalntauWblo! wore acquired on or ndcr Itordia, IWT, the nmouDl hr "'hich Ihonnlrrfn (Jl relBlIng to SDCb Intangibles exceeds (t]ar (r) nlatlon therela, or 2S per cent of (r), vbichercrialDvrst, muit bolnehided in Item ), Bcbodule a, for the taxable peihxl; JV.7rldnf, That If Intanjlblia «CfO acquired beloro March a, IS17, and Blu on or after that date, dcductlDQ thallbemadeBo that the amount InchidM In inveilcd capital lor the ascrOEato ol Intanidbloa ahail not exceed ?i per cent of (ho par vnhia of (ho total iUxk oulstendlSE at the bc):builn[: ffOTE.— "yes," atale in detail for each stock dividend rccdved, (o) dole received, (,b) from whom taoeivod, (0 number af'ihan^ rooelvod, (if}par valuo of aharrs received, *(e} volao at vhlcb entered on III books of aooount, {/) whotliBr or not ouiplns was Inoroased hy this vnkia. ItanBwcrIs"yea,"onlotlbeBiBonnt ' by whloheurptnivRufmiraasgd as ItomB, SdicduloO. If aruwarla "nD,"ita(ethe acconnt nwhlchltwag inoluded, {»daleofsBltof ony of the shares of stock resdvod ae a stock dlvldstid, (A) numlwr of sbaraiold. — If anawoia to lbeforc£otngquaatlanalndlcalo that olock dividends received 91 ed OS an Increase of surplm, and such Incraaso is roQeclad in tfag compDiatiou of 7U for any or all of the taxable periods 1017, llflS, and 1010, amended returaa sJiculd 1 period or poiiods In which this orror occurred. jiy tlmoluvobc Item. Amoant. 1. Valuation ol pslenla, oo[m-l(hU, s-crot proccsici. or lormilto, KOod will. t A iall 7. Total DnocrnoK — - , SCHEDULE H.— CHANGES .IN t. (Thangos in invuLBd ca^tol dorlag Additions— By sale of eai>llal :Lock for ca^ or by Ihe Isiui (a by sIockboMers CAPITAL DURING TAXABLE P taxabia period ordinarily arise in dds or mora out-DIcu of stock ct by purcboaa of traasory ^(ock not . Should no ohan^ be no (il] BypaymentofeashdivIdtadiontDfoBmlagiofprloryi (c) Hypayment of FedamtincnrnD and proQts taxes for prev Thoehansrawtthrsq^gcl lo toxoi will Docur in nearly every eas for tbo omission should ba alated. S. The loUoniug InsimcUoDs abcald be [ollowod in making the abovo edJurtiDanIs; esch Item should be leslpialed aa an addition or deduction, dednctian being drelgnaled by red ink; (a) If stock Is issued for cash, the actual ea.-di rocdvod (but not the amount of diswunt) iboold be enteted ' lu this ■chodule. Assets (ottier than cosh) paid In for stack mail bo vahiod in aceardaiica with Becllon azCa) '3) ofthelleranueAclormB. fc) If CBpilalatcek of the corporation is reacquired Itut not paid for out of current profits, the cost of suclt stock should be deducted fnm Invested capital. (i) Report divldonda paid out of proai! of prior yean but not dividooda paid ont ofproDta of (ho taxable period. Any distribution mode during the Br^l GO days of (ho taiahlo period shall be deemed to bavo becD modo iRimaunlnEiDi.IitQlUsaecuiuilatnlduiliigtboprccAdingtaiiablD period, botany distribution made dnrliul tba romalnder of the taxable period ahall bo datmM to have hccn madefrom tbe profits for that period to theextent that such profits are sntnolcul. (Bee Artldesai7 and IMS, Itegulatious 4s.) (e) Tho amount ol Fodural Ineomo and prollta taiei payable should be prorated and deducted as of tha dates when due and payabto whether resarvea have been set up on tbe books or not. (Scv Article gU.) Tbo avorage adjusted dedudlcn to bo anlered in colomn 7 equals tclallncomo and proDIs tax muitlplltd by «H. 3. Tbo data eallod for In colmiuu 1 bs 9 ibeold ba glvon for oU transocuoss, except that columns 3 and * are applleat>lB only to the Issue or rDarquisl lion of tha CDiiKjrBtlon's stack. 4. Inoolumnll en ter the number of days ramalning in thn laxableperiod(lnoludInB the dote of change). fl. ThenotchangBnattopoclodln Bcbeduls L. ifiutiiioecordanae with (ho Incteasas or decrease) reSuteO. In Uia balanoa sheets, ohould be fully r,icondlsd Iherawllh. '•SSlfflSV™ D^io. 3. Number St ■^r 0. Amount nfcssb or ana value aoluallyroMlyod ofdays 7.A4uslodBTHase. , 0. Net IMCBBAHK OB DECREim _ _ *- - SCHEDULE J.— INADMISSIBLE ASSETS. sbKki, hosds, ami other otjUgatlons, exc^t obli^domr Has (he cocpBraUoD any IsadmiralhiB asset of tho United Stales, (bo ineomo froai which Is If BO, attaoh hereto Qstotamanl showing far tho toxoblo period Ibofaclsmilod for In Items (a' tofJl of this schedule. ' " If tho Income from mob B?sots nonjlslo In part uf gain or profit from tlia isle or other disposition tbtceof, or ifallorpartotlbelQlorQilderivodlrDmounhametsIslneffcctlndudodinlhBncllnoomobteanMof tbo limitation .,._ .., . j._ _ _.. ,jj jC^j Kavanuo Act ot IBIB, then a oorroaponding part of ID computation oTthe part ot (ho capital the oapltal Invested in such assoti is doomed ai (al the various kinds of income derived from inch assets Invested therein which is docmod on admlEslblo as For Ibo purpose of this scboduki Inadmls«lbto aasola ahnll bo voluBd at cost ot acquiilUaii, except that if tho corixaollun Isadealorlnscaiiltlos and InvontorioB such ossBlalnaocordanco with ArUDblSS5,Itoeulatliinj4S, such Inventory ngureob»Uconslllulethom«i>uroafvaluo. AdmlssibloassotssboUbevaluedasprovidedlnBeoUona 3!C, 330, and OTi of tbo RovAnuo Ao t of Wis aud Arllelcosai-sm, g31-S3i, and Wi of Rogulallom 4s. ThoavWsgD amoupl ol aamls ol each kind liold during any yoar may ordinarily bo dolorinlned t)y dividing by 2 the mm ol Ihn amount of Buob assets held ot tho boglnnlnE ot iba taiabl epertodandlbeamoonl held at tho end of tba toiabb period. luajwhcosolhoamouulofBdmlBiibioassetamaybostbaJlotorTOlBOdlrDraOjthobBUnto^ottasuttho beginning ol tho period oiUioad with raepoct lo tbo llcms In Sebfldnica F rmd a aud (!) Iho balance sheet osat IbocodoflhepoTTodoortOBpondlnglyadJu^kil. But Ilolanytlmcdurbgi'ioUurableperlodQouhstaaUalchangB iias taken plaoi in tho amount of such assols, Ibo avotBga amount must 1» dclonnlnod as provided In Attlde 9113 ol licgabtlans 4S. Iniuehcsiioihowlndatail— (b) ThooompubitloLOfoicbamouEt; nountorinadmlssiblo assets held (il) A Isslbloas ■) Avorago amoun I o (/) Amount of admlsilblD assets held at bogirmlng ofTaiabio pistod; ll) Amount of Ddmlsslblo assotohcld at tho end of taxable pctlod; (ft) Avorago amountof admlralMD assets held during tarablo period; (DflumoKOplnflM U) Porc(!ntagnwhich(s)lsof ()). This poramtnso (J) sboalil be applied to tho amount appearing on Uno 7, Schedulo B, In order to oblaln'the . »diictlQO on acoountoUuaaDilJalblOBHicts, which should bo onleredoallno 8, ScbcduloB. »— loira 528 Vage S of B«turD QUESTaONS. 1 Ity producing o{ Uio ■- - KIND OP BUSINESS. IB of the key lottera ^ven below, idonUIy tho corpo ■'y with onu of Ihu general cllssca, and follow thia b; HulTiaorLt to gii'o the iiijormalioa called (or under each ecni;nil claia A. — AgncuUiuo and related indualrics, including fishiug, logging, ice harwrting, otc including Iho loJfling of Biirh proiwrtv SUito tho product or products D.— Mioing nnd (luarrving. includiiiB gas and oil wolla Include tho lojaing of aueh proporty Ktato the produrt or products. C— Manu/acturiug. Slato Uio product and aleo the mntcrial if rot implied by tho umbo of tho product D.— Cennlnjclion— excavatiouB, buildings, briJgCB, rulroadB, ehips, etc , nl'o'o quip ping and inatallujg aamo wiih ByalcuiB, dovicca, or inarhincr>', without thoir wanufacturo Stale nature ol structuree built, materials used, or kind ol luatjllalionB El.— TnuuTrortation— mil, wutor, local, cic Stnto tlio kind and epocial nrodurt traoHportcd, it auy, E3.— Public vitiliboa — gna (niitural, coal, or water), elertricIightorpowGr (hydro or Btcomgoneratcd), healing (Bieaul or hot water). telophoDo; wntem'orka or power E3.— Storage— without trjilineor profit from aalca — (olovatoiB, warehouBca, stockTarda, etc) State product Btored E4.— I/snaog trauapor- tation or utilities Stale kind o[ property F. — TraduiR in goods bought and not pro- duced by the trading concern Slate manner of trade, whether wholesale, retail, or com- mlBsion, and product hnndlod. SjIcb with storage nith profit primanW from salea. G. — Service— domoatic, including hotels, rcstauranis, etc , anauremen la; 'other profeHioonl, l>crsoDal, or technicid Ber\ico, Stale tho «.-r\itij n.— Finance, including banking. real estate, insuranco. I. — Concoms not falUng in above cJas-acs {a} bccauLo ol combining Bovoral of them with no predominant buanoai, or (61 for oUier rcaeona. 2 Concerns whoEo buranoaa involves activity IfllUng in, two or moro o( the abovo gonoral classes, whore tho sam^ praJiiri is concerned, ehould report buaineap ha identified with but one of the aboio gonoral classes; for oxamplo, concerns in /i or B which also Iraneport and market their own product cxcluaively or cmiuly, should still bo idontified with cbi^pa A or B; concorua in C (manufiicluringi which own or control their source of material supply in A or B and which also transport, sell, or install Uieir own product c^cluxively or mainly, should bo identified with manufacluiing. concerns in D may control or own source of auppljf of watenulB uaod exeliian oly or mainly in their construc- tivo work: concerns in El or L2 may own or control tho source of their material or powpr. concema in F may tiansjiort or store their own merchandise, but ita production would identify them with A, B, or C (a) Geoeral class (use key letter deagnation) „ _^ (i) Mam income-producing buriQess (givo Bpecificiilly Iho iuformation culleil for under each key lclta ■ (0 Inwrait on Finn Lou Bondi isiwii uilSf FcdViiii Form Loon ■ *" ■ • J ^'' ■SSSS.;sriS£i"Sr*'L'f.^rn^-' ?' ™f!.^.. (ni'x'ra.ryAS'siKrjSt'sSfiTSi-if." "'aSaH£«S— ™« (1) Addlillirti .frWi timd ,«orvc.oEd rnorvos (or b«l d.bb „d oUior oonllngonolM (W bo dolflliod): _ _ ■ . , 1^ ' '" ■ .' (I) S. .. . ~ U. Dlvldmdi jald durtnf (bo (uoblo pofiod (imia wbother paid In (ub, ■ tuck of Ibli omipaDy, « olhoi pioptny). T. Burpliu ud nndiTldwl proflu u ibo'mi by taluM sittat at don el ^ 1 OUaf<«dmU.iiiiplnJ(lol>.d.[aUtd)i 11. Soiplos ud ondlvlilri pnSu'iij ihoira by tuitaoi ib«t at closi of l.»bl»|>irtod(ll«m(HnlnialUD>lQ) _ s ' . .. ._..- I| SCHEDULES SUPPORTING SCHEDULE A. Xlifl fallowing Bchedulcfl must bo fumiahed, and Qioao prepnnKi on Qcpai^to shcots should bo Urtnly attached to this TOlu. le uid addroM of coiporation o SCHBDUIS AI: COST OF O OS KXPBHSES, ITEHS CAIXED for SBPAHATEIX. II obfisod la trodo or builDBOo in wblcb the productloD, purcbASO, or oolo ol mflrohojidLu ol any Und ll nn iDeomii-produclnr locui, (a) HCUn Irom tho Collector al tatornol itnvtnue and flis do b tnrt ol Ihl) ntum,Canu)eotioIloi(olnTT,ri>r]iillJB,ondr6iaillnib*la1l[>nlniuh«Iula,iiniFKiiEanIlDBi3iiiidS.liiim>dl- ■toly balora tbo omount column, iho lilion "C/' or "C or U," toludloii* tbst lovEDUulB] on Tatued oialUur iboiriiiRpr (1) LomliiTUiiary ot on (t) Coit of goodi lotd,^ SCHBDm.B A3i OROSS tHCOMB rACTDHINO. Is Ty Uborty Loon 34% Notca), or Wot ^^Inonoo Corporotl'on .,.t. "-'■-dulooITajioljIoIntBrailonLlbmyBondj, ol Foortb LIbcny Loon 41% Di mrPlnono inJoDi of jlio Unliad U IDd itlll ( and still onnod octboi! or tho obovo nnoiOoni tor oacb of tho ocrrorottono la p(rTli>d Uiobbi ohllgDtlDnl ot thi Unliibo7inclarticbomcw(l)nomt,(:) Btock oBnod or conirnllrd: (a) praloTed, (fr> anunmMS) i Submit B Mbednlt ohf li al Iba rot* o[ KflXi or m SCHEDULE A14I REPAIRS (li BubmlcoBcbadnIa showing (h _utlH, D) (I mo devoted to lolAl (omponullon tor ibc 3u snpBTlr cbiiiBobla to od herein, tbo minor Itomo 3, paisgTopb S.) £t ot loici daductad, (< ben onto al ■ Uod toudlnE to luorouo the i EDiDp-Jtlne uuohle Inoome oliucb afrpomtlotu.lSooArUcto'Eiiis, iropartyoflKaifld, and Slate, county. and mun Jua ol Ihalr copltnl lUKk ara not allowablo do_ ._._. Kipiladjn»iJ,onaH«rthJii»l(D)(a)ol TAXABLE p: (») aiWMlrom I: DEBTS ASCERTAIHED TO BE WORTHLESS A rayalllr '' I, elcj pnitioujly r«pOTl& I). {SwArtlclelJl.RofulBl tvloDily ropoTlcd oo Dt eltlmod ibonit IhuoipsclnedDh EXRAUSTIOU, WEAR AND TSAR (Initudini obaoK ount ol depndotlon, tha lo!lBv1n£ sobtdu rrnpood uiib tha Bium roflectid In tho (B»i poco I 6l iDstnictloni, jnragnqib It mtut b* aOad In, and tlis toiol Lancaihaat. Landvolaoa miut and Artlctao 111 toiin, ItofU' S'^SSSi ,^^. ia. Coit.arll sSSSr [•robibl. 1110 mm .asisa ■nd.y«r r„^,^. 1 ._ Toul , •^ I ■ ololmid lor tbe id SCHEDULE A 19 II a dodunlonlo alolin«l on oocouti i ol danloiliin - — ~._, ,_. -onncfcalloi laiiln; Uio Di complato TsluoiloD dnin hoi boon iSlni ivlth , tlon nneauary to biioe I'our doplitlnii ichnluli able period tau l>«si deiormlned. Inaioolil ._lnonilj),Fonii T (tlmbocl, nil In Dnd fllo .u.i w. ». u - labovtha lalr muikn tdIuo oa ibat data n ol ptopuiy, lubmli avldgnu (ubiuuitlotlni tht txull oihI lb snlrlnE at tbo oivtot SCHEDULE AH: LOSSES SUSTAINED DURING THE TAXABLE I PEHSATEO FOR B mSURAHCB C ; OTUERWISE. 1 tbali, ond ni J AND HOT COM- ■) ol prbparty orb- I T ibould ibow "iDiuroDco ai itlalMl bT MhadaJo prcpond In lo ulTD, olRflpilotions uT oAct ol lBI<«,Aii[dcain DISCOUNT ANS PREMIUM ON BONDS SOLD. Thoto must bo oituhod lo (he roliim o iEh«ItiIa ibonlni- In detail cocb Isino and ulo ol bonds ot IM ropordni rarpoTDllon irlvlnj; lh« loltonlni Inrormilion' (o) CIoh; (6) date olinto, (<> motuilly, (fl amnml ooM; (') omninl rralIrM (r) nrrmlum or dimuni p lor ciludir ;ur 1920, H» it on or l»- lon Mircb 15, 1921, with the CoDictor ol Intemil RoToouo lor Uio dislrki in obich Die Snbiidiu; or Alfiluled Corporatioa hu its prindpa] office. II lor. period othor Hun a calendor year, Uifl return FOR CALENDAR YEAR 1920 Or for period begun , 19... ., and ended — , 19 (Date Received) {Nome) ahonMbeliledonorbelore Hie ISIh dar ol tlie Uiird ol ukIi period. (StTMt and number or ninl route) (Fort Offlctt and Btat«) 1. Date incorporated- 2. Kind of business... UndQT laws of what State ?.. 3. Fax value of capital stock outstanding at }>eginning of taxable period: (ffi) Common, S ; (6) preferred, $^_. 4. Name of parent corporation 6. Address of parent corporation , 6. Internal revenue district in which, consolidated return has been filed-^.. (Qlve district, or dtj and atato) 7. The department prefers that the entire tax shown on a consolidated return be paid by the parent or principal reporting corporation, instead of being apportioned among the corporations composing the affiliated group. If apportionment is made, state the amount of income and profits taxes for the tax^le period to be assessed against the subsidiary or aflSliated corporation making this return S We, the xmdersigned, president and treasurer of the above-named subsidiary or aflSliated corporation, being severally duly sworn, each for himself deposes and^ says that the foregoing return, including the accompanying list (if any), has been examined by him and is to the best of his knowledge and belief a true and complete return of information made in good faith pursuant -to the Revenue Act of 1918 and the Kegulations issued thereunder. SwoBN to and subscribed before me'tbia . day of . .., 1921. President. (Signature of offlcer admlnlBUrins oath) Treasuref. 534 Form I126.t-UN1TED STATJIB INTEENAIi BEVBNUE SEHVICE CERTIFICATE OF INVENTORY (To be GIm] with CoUactor of Intornal Rannus with laoom* Tu Ratum) FOH CALENDAR YEAR X920 Or for period Icgan , /J , and enjej Name _ Address ... 19... PRINCIPAL CERTIFICATE I swear (or affirm) that the closingiii ventory of the taxpayer named above, amounting to $. _, was taken under my direction, and that to thp__beat of my knowledge and belief ia true and complete in every respect; that the method of pricing the raw material, work in process, and finished goods was at *„ that I liave carefully read all of the instructions on the reverse side of this form; that this inventory was taken in accordance therewith; and that the following-named persons whose sepaiato certificates are subscribed hereon or attached hereto are the officers and employees under "whose personal direction the -various parts of this inventory were taken: Title or position. Part of inventory taken. Jmount. Sworn to and subscribed before me this .. . day of _. ,., 19... (SlgiiBtOTO or officer administerlDg oatb.) (Titlo.) (Title.) "cost or market, whieliever Is lower." If any other basis was usod, describe taUy, state why nsed aod date on which Inventory -was last SUBSIDIARY CERTIFICATE I (or we), the undersigned employees of the taxpayer named above swear (oraffirm) that I (or we) personally directed and observed the taking of the parts of the inventory set opposite my (or our) names, and, to the best of my (or our) knowledge and belief, is true and complete in every respect; that I (or we) have carefully read the instructions on the reverse side of this form and that the parts of the inventory for which I am (or we are) responsible was taken in accordance therewith. Title or position. Part of inventory taken. Sworn to and sabacribed before me this .. .. day of ., (Slgnaturo of offlcer administering oath.) 535 INSTRUCTIONS. This certlflcate of Inventory must be snbmltted by all toxpnyera CQEBged In a trade or business In wtalcb the production, purcbaee, or Bale of mercbandlae of an? kind Is an In come- producing factor. The principal certlflcate will be signed by the taxpayer or an eiecu- Mts— omcer, and the subNldlary certlflcate by oIBcera and emploTeea (bUcta as department heads, euperlntendents, etc.) designated by the taxpayer or executive officer. If the taxpayer who fills In the prin- cipal certificate actually -directs and observes the taking of the ) Inventory, the subsidiary certificate need not be fliled in. In case there l3 not sufflcleat space on this form to enter the names of those directed to take the Inventory, or it Is not convenient for them to take the oath jointly, additional copies of this form should be used, but the oath of the principal otDcer need only be mado on the first sheet, statins thereon the number of sheets submitted. If the return has already been filed, the certificate should be sent to the collector of the district in which the return waa filed. The attention of taxpayers is called to the followlne methods which, amoDE others, are sometimes used In taking or valuing Inven- tories, but which are not in accord with the regulations, viz : (o) Deducting from the inventory a reserve for price chooges, or an estimated depreciation In the. value thereof. (6) Toting work in process, or other parts of the inventory, at a nominal price or at less than Its proper valu^ !o> Omitting portions of the stock on hand. a) Using a constant price or nominal value for a ao-called normal aLiantlty of materials or goods In stock, udiog stock in transit, either shipped to or from the tax- BBcnoN 203 oi* thb Bevendo Act op 1918. That whenever in the opinion of the Commissioner the use of Inventories la necessary in order clearly to determine the Income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe ns conforming as nearly as may be to the best accounting Eractlce In the trade- or business and as most clearly reflecting the ICO me. Extracts Fbom BBanuTiOKS 45. Art. 1681. Tfeed of luTentorleB.— la order to reflect the net Income correctly, invcntorlea at the beelnnlng and ending of each year ore necessary in every case in which the prod action, purchase or sale of merchandise la an income-producing factor. The Inven- tory should include raw materials and supplies on hand that have been acquired for sale, consumption or use in productive processes, together with all finished or partly finished goods. Title to the tnercbandlso included In the inventory should be vested in the tax- payer and goods merely ordered for future delivery and for which no transfer of title has been effected should be excluded- The inven- tory should IncUide mcrcbandlse sold but not shipped to the cus- tomer at the date of the inventory, tocetber with any merchandise out upon consignment, but if such" goods have been included in the sales of the taxable year tbey should not be taken in the inventory. It should also Inclndo merchandise purchased, although not actually received, to which title has passed to the purchaser. In this regard care should be exercised to take Into the accounts all Invoices or other charges in respect of ■ -■ Inventory, but which Is- In tn reduced to phy steal possessloi.. Abt. 1582. Valaatloa oC In-rentorfes, — ^Inventories sboold bs valued at (o) cost or (6) cost or market whichever Is lower- ■Whlchever basis Is adopted must bo applied to each Item and not merely to the total of the inventory; that is, If for instance, basis (6) Is adopted, the value of each Item In the inventory will be measured by market If that is lower than cost, or by cost If that Is lower than market, A taxpayer may, regardless of his past practice, adopt the bosls of cost or market whichever is lower, for bis 1918 Inventory, provided a disclosure of the fact and that it represents a change is made In tbe return. Thereafter changes can be made only after permission Is secured from tbe Commissioner. But seo article 1585 for Inventories by dealers tn securities. Inventories should be recorded In a legible manner and properly computed and summarized, and should be preserved ns a part of tbe accounting records of the taxpayer. Goods taken in the Inventory which hnvo been 60 intermlngiea that they can not bo Identified with specific invoices will be deemed to be the goods most recently purchased. Abt. 1583- InvcntorlcM nt cost. — Cost means: (1) In the case of merobandlse purchased, the Invoice price less trade or other discounts except strictly cash discounts approximat- ing a fair interest rate, which may be deducted or not at the option of the taxpayer provided a con.sistent course is followed. To this net Invoice price should be added transportation or other necessary charges incurred in acquiring possession of the goods. (2) In tho case of merchandise produced by toe taxpayer, (a) the cost of raw materials and supplies entering into or constimed In connection with the product, (o) expenditures for direct labor, (c) Indirect expenses Incident to and necessary for tbe production of the particular article, including In such Indirect expenses a reason- able proportion of management expenses, but not Including any cost of selling or return on capital whether by way of interest or profit. In any industry in wblcb tbe usual rules foi- compntatlon of cost of production are inapplicable, costs may be approximated upon such basis as may be reasonable and In conformity with established trade practice In the particular Industry. Art, 1D84. ImventorlcN at market. — Market means tho cur- rent bid price prevailing at tho date of the Inventory for the par- ticular merchandlBe, and is applicable to goods purchased and. on hand and to basic materials In goods in process of manufacture and In finished goods on hand, exclusive, however, of goods on hand or in process of manufacture for delivery upon firm sales contracts at fixed prices entered Into before tlie date of the Inventory, which ffoodB must be Inventoried at cost.) Where no open market quota- tions are available the taxpayer must use such evidence of a fair market price at the date or dates nearest the Inventory as may be (available to him, such aa speclQc transactions In reasonable volume entered Into In Eood faith, or compensation paid for cancellation of contracts for purchase commllmente. The burden of proof will rest upon the taxpayer In each case to satisfy tho Commissioner of the correctness of the prices adopted. Apt, 1585. InTentorlea by dealers In Mecnrltlea. — ^A dealer la securities, who In his books of account regularly inventories un- sold securities on hand cither (a) at cost or (b) at cost or market value whichever Is lower, may make hfa return upon the basis upon which his accounts are kept; provided that a description of the method employed sbnll be Included in or attached to the retnrn, that all the securities must be Inventories by the same method, and that such method must be adhered to In subsequent years, unless another be authorized by the Commissioner. For the purpose of this rule a dealer In securities is a merchant of securities, whether an Indl- Tidual, partnership or corporation, with an established place of business, regularly engaged In the purchase of securities and their resale to customers; that is, one who as a merchant buys securities, and sells them to customers with a view to the gains and profits that may be derived therefrom. If such business is simply a branch of the activities carried on by such ncrsoii, the securities Inventoried ag here provided may Include only those hold for purposes of resale and not for Investment. Taxpayers who buy and sell or hold securities for Investment or speculation, and not In the course of an established business, and ofllcers of corporations and members of partnersblps, who in their Individual capacities buy and sell securities, are not dealers In securities within the meaning of this rule. AaT. 1585 (a). Inventories of llve-stocU raisers and other farmers. — Because of the impracticability of Identifying live stock purchased and live stock raised, and the dlmculty of ascertain- ing actual cost of live stock and other farm products raised, farmers who render their returns upon an accrual basis may at their option value their inventories for the taxable year according to the farm price method which contemplates a valuation of Inventories at market price Jess cost of marketing- It the use of tbe farm price method of valuing Inventories for any taxable year represents a change In method of taking inventories from that employed in prior years, the opening inventory for tho taxable year in which the change is mado should be broup;ht In at the samo value as tbe closing inventory fur the preceding taxable year (this being the same In effect as valuing the opening inventory on the new basis and crediting Income with the excess valuation brought In). However, If such treatment of the opening inventory for the taxable year In which 'he change Is made results In abnormally large Income for that year, by reason of the fact that certain live stock, or other farm products wlifeh were on hand at the beginning, is still on hand at the end of the year, then adjustments in the form of an adjustment sheet attached to the return for such taxable year may be made of tbe taxes for 1915 and each succeeding year to tho year In which tho change Is made. In making such adjustments the farm price method of valuing Inven- tories should be used for each oC the prccetUug taxable years. Abt. 1585 (6), Inventories of Inmber mannfaetnrers. — 1. Because of the Impracticability of determining accurately the costs properly assignable to each species, grade, and dimension of lumber making up the product of the mill, lumber manufacturera may use as a basis for pricing inventories the average cost to the manufac- turer of producing the inventoried products during the taxable year for which the return of not income Is made. 2. If the quantity of lumber on hand at the time of Inventory Ig greater than the total quantity of lumber produced during the cur- rent taxable year. It is evident that the excess stock has been carried over from the previous year's production, and such excess shall be valued at the average cost of production for the preceding taxable year. 8. A taxpayer who regularly allocates In lila books of account such average cost to the different kinds and grades of lumber In proportion to the selling vaiue of such kinds and grades may subject m each case to tbe approval of the commissioner upon audit of the return, make his returns of net income on that basis, 4. The term lumber manufacturer, ns used In thla article, means a. person who manufactures lumber from logs, as distinguished from a reman ufacturer of lumber. Art. 1688. Inventories of retail drr eroods dealerfl, — (1) Betull dry goods dealers who employ the "retail method," which Is essentially a "cost" method or valuing inventories, will be per- mitted to make their returns upon that basis, provided (o) that the use of such method Is designated upon the return, (6) that accurate accounts are kept, and (o) that such method be adhered to In subse- quent years, jinless a change Is authorized by tbe Commlasloner. The " retail method " consists In computing tho " cost " of goods on hand from the "percentage of purchase mark-up" and the "retail value" of goods on hand. (2) A taxpayer employing the " retail method " of valuing Inven- tories shall maintain and preserve In permanent form, for the Inspec- tion ot internal revenue officers, the accounts and re'-ords of each year, together with a schedule of all mark-) 333. 349 (c) 356 330 190, 279, 327, 328, 329, 390 et seq., 399 331 190, 317. 395, 397 335 (a-c) 39, 40, 93, 412 336 14, 22, 29 iZ7 89 Capital Stock Tax of Title X 1000 (a-d) 433 et seq. Merchant Marine Act 23 24 INDEX TO ARTICLES OF REGULATIONS 45 AND REGULATIONS 50 When an article is referred to several times, heavy faced type indicates that it has been quoted in part or in full. When only reference is made {without quotation) light faced type is used. When an article is not quoted, it is either repetitious with some section of the law which appears in the hook, or it per- tains to a part of the law which does not apply to 1920 returns. Article Numbers Page References Regulations 45 504 16 542 237 582 180, 316 631 304 632 307 633 285, 310, 311 634 310 635 38, 309 636 38, 194, 308 637 306, 314 638 37. 324 715 24, 79, 409 716 50, 52 7T^7 50, 51 718 43, 44 719 55 720 72 731 63, 66 732 68, 69 733 70 741 79, 87 742 80, 87 743 81, 87 751 •• 22 753 : 25 761 32 553 554 INDEX TO ARTICLES OF REGULATIONS 45 Article Numbers Page References 771 276 781 118 783 114 784 326 78s 326 791 317. 325 802 330, 371 811 179 812 134 813 129, 134, 229 814 134 815 191 816 193 817 205, 206, 209 831 127 832 228 833 83, 85, 169 834 "• 191 835 172 836 153 837 154, 235, 318 839 161 840 156, 158 841 158 842 159 843 186 844 239, 240 845 244, 24s, 247, 272 845 (a) 347 846 176 847 258, 272 848 177 849 250 850 255 851 168, 194 852 194, 196, 202 853 226, 258, 261 854 128, 259 855 260 856 262 857 83, 255, 266 858 264 859 r 264 860 ^ 251, 321 861 189, 227 INDEX TO ARTICLES OF REGULATIONS 45 555 Article Numbers Page References 862 167, 227, 228 863 137, 142 864 , 305 865 318, 321 866 3;2i 867 318 868 318 869 327 870 250 871 137. 356 901 335 9" 350 912 335 913 336 914 337 931 330, 391 932 393 933 399 934 279, 329 941 397 952 96 954 93 955 94. 104 961 30 962 31 971 89 972 90 1504 • 15, 23 1505 23 1506 439 1507 16 1510 40s 1561 151 Capital Stock Tax — Regulations 50 1 436 2 437 3 438 4 439 5 439 6 438 7 438 8 437 9 462 556 INDEX TO ARTICLES OF REGULATIONS 50 Article Numbers Page References 10 440. 468 12 442 13 445 14 447 .15 447 16 -. . 456 17 463 18 463 19 464 20 443. 463 21 465 22 440 23 440 24 445 25 446 26 437, 443 27 437 28 444 29 469 30 466 31 446 32 ■■• 466 33 456, 459 34 457 35 458 36 460, 461 37 467 39 467 40 468 41 462 42 461 43 462 63 463 81 460 105 460 GENERAL INDEX Abatement Claims (See "Claims for abate- ment") Abbreviations for Citations, 4-5 Accounting Procedure (See "Computation o£ tax") Accounts Receivable, As tangible assets, 168 Adjustments (See also "Deductions," "Valuations") Additional assessment, 248-250 Assets, 190, 224 Book values in ascertaining invested cap- ital, 126 Capital stock, 225-231 Book and actual value, 1S9 Consolidated returns, 316 Inadmissible assets, 190-224 Interest paid, 362 Interest received, 362 Inventory valuations, 363 Net income, during taxable year, 362-381 Deductions, 362-381 Pre-war period, 367-381 Reconcilement, form 1120, 367 Reconcilement, illustration, 365-366 Pre-war assets, 280 Pre-war capital stock and surplus, 281 Pre-war invested capital, 276-281 Pre-war period, Balance sheets, 278 Liabilities and reserves, 281 Realization of appreciation included in invested capital, illustration, 240-241 Reorganizations, 382-403 Surplus, 231-251 Tangible property, 145-164 Appreciation excluded, 149 Reconciliation statement, 142 Representing value in excess of con- sideration paid, 155 Taxes as liabilities, 249 Taxes previously paid, 243-250 Treasury stock, 227-228 Administrative Provisions, Administration and application of the law, 12-17 Admissible Assets, • Actual values, 161-163 Appreciation, not a part of, 124 557 Admissible Assets — (Continued) Borrowed money, when included in, 129- 132 Changes in, 196 Containers, 199 Contracts bought for cash, 179 Earnings, current used to buy, 202-203 Foreign corporations having no income from United States sources, 194 Foreign subsidiary corporation, 194 Inactive majority holdings of capital stock of affiliated corporations, 287 Liberty bonds as, 199 Liberty bonds when not fully paid for, 199 Paid-in surplus, 153-154 Promissory notes as, 169 Property received in exchange at fair market value, 258 Property received in payment of debt, at fair market value, 258 Purchased out of current earnings, 202 Purchased with borrowed capital, 210-223 Stocks of foreign corporations, 193, 309 U. S. bonds, 191 War Finance Corporation bonds, 224 When diminished values need not be de- ducted, 163, 164 Advertising, As expenses, 180 As invested capital, 180 Expenses for, as invested capital, 343 Advisory Tax Board, 12 Affiliated Corporations, Adjustment for asset differently valued in pre-war invested capital, 261 Allocation of net income from government contracts, 409-410 Assessments, 323 Capital stock tax, 458 Cash paid basis in determining stock value, 318 Cash value of stock at date of acquisition, 318 Changes in stock ownership, 310 Claims for credit or refund, 323 Conditions precedent to consolidation, 285-287 Consolidated accounting applied to, 283- 2S4 558 GENERAL INDEX Affiliated Corporations — (Continued) Consolidated balance sheets, 283 Columnar form of, required, 306-307 Items contained m, 306 Required in determining invested capi- tal, 30s Use of, 284 Working sheet for, illustration, 298-299 Consolidated profit and loss account, 283 Consolidated returns, 34-37. 282-330 (For full entries see "Consolidated returns") Controlled as a unit, consolidated state- ments necessary, 286 Credits, 113 Credits for taxes, 37 To domestic owning foreign, 315-316 Decrease in number of, due to federal incorporation, 2S2 Defined, 35, 36, 308 Depreciation provision, importance of proper, 284 Distribution of tax among, 323 Dividends guaranteed by holding corpor- ation to, not deductible, 316 Exemptions, Specific of $3,000, 325 War profits tax, 326 Fiscal year differing from that of parent, 37 Fiscal years differing, 324-325 Foreign corporations doing business in U. S„ 464 Form 819, questionnaire, 37, 307, 310, 312 Form 1122, information, 307, 323 Government contracts after August i , 1914, not included among, 38 "Holding" defined, 442-443 Intangible assets acquired in dissolution of, 166 Intangible property paid in, 318-321 Intercompany profits in inventories, 316 Intercompany sales, 321 Intercorporate relations defined, 282-283 Liberty bond exemptions, 315 New "government contract" corporations not classed as, 38 1917 and igi8 laws require consolidated returns from, 284 191 8 law, Basic principles of consolidated returns, 304-305 Defining affiliated corporations, 304 1918 returns, special problems of, 326-330 Non-existing during pre-war period, 326- 329 Operating deficit, computation of, 321-322 Organization expenses, 181 Affiliated Corporations — iConttnued) Pre-war invested capital, 327, 328 Same basis of valuation as for taxable year, 327, 328 Pre-war net income, 371 Computation of, 330 Public service corporations as, 314 Reconciliation of consolidated surplus, 325 Reconciliation of net profits with taxable net income and analysis of changes in surplus account. Form 1 1 20L, illustra- tion, 480-481 Reorganization after January i, ig^J, 329* 330 Reorganization after March 3, I9i7» 3^7 Reserves of intercompany profit, 290 Restrictive and discriminatory state regu- lation forces multiplication of, 282 Returns when fiscal periods of parent and subsidiary differ, 37 Separate returns, capital stock tax, 458- 460 Stock ownership. Determines extent of affiliation, 36 Necessary to constitute, 35 Treasury interpreting phrase ^'substantially all the stock," for consolidated returns, 311-312 Treasury interpreting phrase "the same interest," for consolidated returns, 312- 313 War profits tax, exemption, 326 Agents, nominal capital tax, 1917 law, 42s Agricultural Insurance, Exemptions for non-profit undertakings, 20 Agricultural Organizations, Exemptions, 20 Aliens, Certificate of residence in the U. S., Form 1078, 507 Non-resident, Exemption claim, Form 1115, 519-520 Nominal capital tax, 1917 law, tax rates, 416 Return for income received in 1920, Form 1098, 523 Return of information at source. Form 1042, 504 Statement of income for personal ex- emption. Form looiB, 501 "All the Same Interests," defined, 311 Allocation, Net income from government contracts, 409-410 When such income cannot be dis- tinguished, 410 GENERAL INDEX 559 Amended Returns (See "Returns, amend- ed") American Red Cross, Gifts to, allowable deduction, 406 Government agency, 406 Government contracts, 405 Amortization, Allowance, under munitions tax, 160 Deductions, 363 Leaseholds, 175 Apportionment of Tax (See "Prorating") Appreciation (See also "Earnings," "Profits") Accrued after March 1 , 1 9 1 3 , taxable when realized, 257 Accrued before 1913, not taxable, 257 As of March 1, 1913, not included in in- vested capital unless realized, 240 Excluded from computation of invested capital, 174, 17s Excluded from valuation, 149 Not a part of earned surplus, 234 Not taxable until realized, 257 Profit accrued since March i, 1913, 256 Realized, 202 As source of increase in invested capi- tal, 254 Sale of assets, 256 Sale of invested capital, 146-149 Former procedure, 146 Unrealized, 123 Assessment of Taxes, Additional, effect of on reserves for taxes, 248 Affiliated corporations, 323 Fiscal year differing from that of par- ent, 37 Capital as, 236 Manner of, same as for income tax, 13, 14 Returned may be considered loans, 236- 237 Stockholders, sources of increase in in- vested capital, 254 Assets, Accounts receivable as, 16S Acquired by corporations in different state, 394 Acquired by gift, 234-236 Actual values, 161-163 Adjustment of values, 142-224 Prior to January i, 1917, 159-160 Resulting in paid-in surplus, 152 Taxable year and pre-war period, 391, 392 Admissible (See "Admissible assets") Advertising, 180 Book value may be increased, 156-161 Borrowed money exclflded as, 123, 126 Assets — ( Contmv^d) Buildings, 173 Cannot be valued as of March 1, 1913, for computing invested capital, 340 Carrier routes, 179-180 Changes in, 196 Classification of, 202 Contracts, 179 Deductions for those subject to adjust- ment, 142-189 Deductions of tax-free, 124 Deferred, currently charged of as ex- penses, excluded from invested capi- tal, 180 Depletion of invested capital, 161-162 Depreciation, Reserves, 202 Treatment of, 155 Designs, 175 Discount, On bonds, 177 On capital stock, 177-179 Fair market value as of March i, 1913, does not affect "invested capital," 128 Fixtures, 174 Foreign corporations, 193 Furniture, 174 Goodwill, 125, 181-185 Ad j ustments, 1 94 Represented by differences between pur- chase price and net worth of aJffili- ated corporations, 295, 301 Inadmissible ' (See "Inadmissible assets") Insurance policies, cash value, 176-177 Intangible (See "Intangible property") Land, 174 Leaseholds, 175 Life insurance policies, formerly, 141 Machinery, 173 Mines, 175 Miscellaneous requiring adjustment, 168- 189 Models, 175 Newspaper franchises, 179-180 1917 law, 7 Oil wells, 175 Organization expenses, when capitalized or charged off, 180-181 Patents, 166, 185-189 Patterns, 175 Pre-war, adjustments of, 189, 279 Purchased with borrowed capital, 210-223 Purchased with stock of no par value, 394 Realized appreciation, 202 Reconciliation of book capital with in- vested capital, 142 Reinvested earnings, as, 124 S6o GENERAL INDEX Assets — (Continued) Reorganizations, Transferred through several organiza- tions, 394-395 Valuation, 382-384 Revaluations involving appreciation not allowable, 281 Sale of capital, 342 Subscription lists, 179-180 Surplus from sale of, 256 Tangible (See "Tangible property") tJnsegregated, valuation of, 171-172 War Finance Corporation bonds, admis- sible and inadmissible, 224 Water rights, 174 Associations, Corporation status, 15 Defined, which are subject to capital stock tax, 438-439 Exemptions for non-profit undertakings, 20 Authority for Regulations, Regulations and rulings, excess profits tax, 14 Treasury Regulations 45, excess profits tax, 4 Averages, Invested capital, 258 For stated period, 258 Median in determining credits, 54, 117 Net income, Pre-war period, 118 Pre-war period, computation of, 369 Pre-war invested capital, 278-279 War profits credits, 54 Bad Debts (See "Debts, bad") Balance Sheets, Condensed, exhibit A, capital stock tax, 449-451 Consolidated, 283-284 Columnar form of, required, 306-307 Goodwill as a credit balance, on final, 296 Items contained in, 306 Journal entries covering eliminations, 300 Preparing profit and loss statement, 303 Procedure in preparing, 288-292 Required in determining invested cap- ital, 305 Working sheet, 292, 298-299 Pre-war period, 278 Required to determine invested capital, 31 Balance Sheets — (Continued) Separate working sheet showing division of surplus accounts, 291 Bank Deposits, As liabilities, 134 Banks, Co-operative, exemptions, 20 Mutual savings, exemptions, 20 Reserves for discounts, as surplus, 250 Barbers, Nominal capital tax, 19 17 law, 422 Benefit Societies, exemptions, 20 Boards of Trade (See "Chambers of Com- merce") Bonds (See also "Securities," "U. S. Bonds") Corporate, Form 1119, accompanying Form 1118, 525 Discount on, 177 Inadmissible assets, interest-bearing de- benture bonds, are, for 191 7. I34 Interest on borrowed capital for, 223 Bonus, Paid for oil wells, 175 Stock, how included as invested capital, 228 Book Value, Adjustment of in computing invested cap- ital, 1 26 Assets, when increased, 156-161 Capital stock, more trustworthy than market values, 226 Consolidated returns, 316 Surplus, 234 Borrowed Capital (See "Invested capital, borrowed") "Brackets," defined, 41 'Brokers, Considered as personal service, 81 Defined under nominal capital tax, 420 Nominal capital tax, 1917 law, 425 Building and Loan Associations, Exemptions, 20 Buildings, as invested capital, 173 "Business," defined, formerly, 427-429 Business Leagues, exemptions, 20 Calendar Year, Changed to fiscal year, computation of in- vested capital during taxable year, when, 259 California Special Partnerships, As partnerships, 439 Not treated as corporation, 15, 23 GENERAL INDEX 561 Capital (See "Invested capital") Borrowed (See "Invested capital, bor- rowed") Capital Stock, 225-231 Active majority holdings treated as un- divided profits, 287 Adjustment of income when capital in- creased by, 454 Adjustment permitted between book and actual values of, 189 Affiliated corporations, stock ownership determines extent of affiliation', 36 Analyzed as to whether invested capital, 225 As compensation for personal services, 229 As invested capital, 225 Bonus, as invested capital, 228 Cash paid, basis in determining value of affiliated corporations, 318 Cash value at date of acquisition, 318 Commissioner of Internal Revenue re- determines understated fair value of, 448 Consolidated returns, If stock ownership is between 50 and 95%, 310 Not permitted if changes in stock own- ership, 310 Not permitted if percentage of indi- vidual stock ownership is unequally proportioned, 310 Corporate stocks, when treated as, 189 Date, when increase in, is effective, 225 Debts, taken for, 229 Deductions, Deficit accounts, 250 Stock issued full paid and returned by gift or purchase, 227 Discount on, 177-179 As actual organization expense, ; 78 Distribution of, to employees, to what extent invested capital, 230 Dividends, Accounting procedure, 255 After first 60 days, but not out of cur- rent earnings, 263 Amended return, illustration, 200-202 Assumed to accumulate ratably over tax- able year, 255 Decrease in capital, former procedure, 263 Eliminating intercompany dividends in consolidated returns on profit and loss, 303 Exempt, 363 Guaranteed by holding company, 316 Capital Stock — (Continued) Dividends— ^(Continued) Inadmissible assets, 199 No effect on computation of invested capital, 264, 265 Not source of increase to invested cap- ital, 254 Paid in excess of surplus, 265 Paid out, a decrease in invested capi- tal, 254 Received," former procedure, 372, 374 Reserves for should be ignored, 281 Surplus from, in 1917, 1918, and 1919, 232 Surplus from, not invested capital, 232 Exchanged or sold, 227 Foreign corporations, as admissible assets, 309 Good-will purchased with, 183 Inactive majority holdings treated as in- vested capital, 287 Increase in. By consolidations, 386 Effective date, 225 Methods of ascertaining fair value of, for capital stock tax purpose, 446-454 Mixed property taken for relief, 353 No par value, 26, 394 Limitation on, 166, 167 Patents, exchanged for, 166 Plus surplus as invested capital, 250 Preferred, Reserve fund for retirement, treated as surplus, 242 When included in invested capital, 135 Premiums, Are surplus, 237 Source of increase in invested capital. Pre-war period, 281 Purchase of, with current earnings, effect on invested capital, 253 Reorganizations, transfer of control, 393 Illustrations, 393 Sale of, 206 Decreases deduction of asset, 202 Segregation of intercompany stockhold- ings into two classes, 291 Stock participation by employees, 229 Treasury stock, 167, i8g, 227, 228 Valuation, 226 As affected by stock market, 226 For capital stock tax, 459 Intercompany ownership purchased for cash in affiliated corporations, 293- 296 Under reorganization, 226 562 GENERAL INDEX Capital Stock Law, 1917 Law (Federal Excise Tax), 4, 136, 43*3-469 Abatement and refund of, 467 Affiliated corporations, Consolidated reports, 458-460 Returns, 458-460 Amendment dated November 6, 191 9, ex- empts Virginia partnerships, 439 Associations and limited partnerships which are included, defined, 438-439 Average earnings vs., 454 Basis of computation for domestic cor- porations different from basis of ex- cess profits tax, 445 Bearing on invested capital, 137 Commissioner, extracts from 1920 report on returns, 43S-436 Computation of tax. Average earnings vs. capital stock, 454 Fair average value vs. market value of capital stock, 447 Surplus and undivided profits included in fair average value, 447 Consolidated returns not allowed', 458 Corporations, inspection of returns, 466 Credits, 456 Deductions, 456 For payment during pre-war period, 281 Income and excess profits taxes, 454 Dishonored checks, procedure, 468 "Doing business," basis for taxing do- mestic corporations under, 440-442 Domestic corporations, 436-439 Capital invested outside the United States not deductible, 445 Deduction of $5,000 permitted, 445 Defined, 437 "Doing business,'' defined and dis- tinguished, 441 "Doing business," illustrated, 441-442 Exempt from, 443-445 Mutual insurance companies, how tax- able, 445,446 "Not doing business," illustrated, 442- 443 Scope of tax, 437 Tax rate and computation for, 445-455 Due in advance, 434,436 Effective date, 436 Effective January i, 1917, 433 Election to be taxed corporation, former procedure, 468 Exempt corporations, 444 Exemptions, Corporations exempt from income tax law, 434 Domestic corporations, data necessary to claim, 441 Capital Stock Law, 1917 Law — (Coti- tinued) Exemptions — {Continued') Foreign corporations not doing business in the United States, 443 Personal service corporations, 437 Fiscal year ending June 30, 457 Fiscal year of government ends June 30,434 Foreign corporations, 462-466 Basis of tax, 465 Borrowed capital, 465 Capital "employed" in U. S., 463 Capital invested in United States se- curities, 464 Computation of tax, 463 Deduction for liabilities, 465 Mutual insurance companies, how tax- able, 446 Keturais, Form 708, 466, 496-497 Scope of tax, 463 Using subsidiary corporations to trans- act business here, 464 What constitutes "doing business" in United States, 462-465 Former procedure, 443 Holding company, defined, 442-443 Income, adjustment, 454 Insurance companies subject to, 440 Insurance stock companies, subject to, 440 Medium of payment, 467-468 Munition manufacturer, credit for, 468 Mutual insurance companies, subj ect to, 440 1911 and 1912 basis, 370 1913 basis, 370 No connection with excess profits tax, 136 Partnership bank, defined, 438-439 Partnerships, limited, defined, which are exempt, 439 Not included, 434 Payment of tax. Does not exempt corporation from o^ cupational tax, 462 Former procedure, 460 Penalties, 461-462 Penalties for disclosing returns, 466 Period of "doing business" determines tax liability, 443-444 Preferred and common stock, valuation of, 455 Return, Form 707, 492-495 Affiliated corporations, 458-460 Corporation claiming exemption, 444 Former procedure, 460 Inspection of, 466 Must be filed, 456 None demanded of corporations liquidat- ing prior to June 30, 1921, 443 GENERAL INDEX 563 Capital Stock Law, 1917 Law — (.Con- tinued) Return — {Continued) Tentative, 457 Time for filing, 456 Tax rates retroactive to July i, 1918, 433, 435, 436 Taxable year, date of incidence of tax is July first, 452 Time of payment, 460-462 Valuation, methods of ascertaining fair value of capital stock, 446-454, 459 Carrier Routes, As invested capital, 179-180 Cemetery Companies, exemptions, 20 Certificate of Ownership (See "Owner- ship certificate") Chambers of Commerce, Exemptions, 20 Changes in Invested Capital During Taxable Year, 252-275 Abnormal increase by sale of assets, 342 Addition of capital becomes part of in- vested capital at date of receipt, 257 Admissible or inadmissible assets chang- ing, average to be taken, 196-203 Appreciation as capital, 257 Averaging, 258 Computation of, average, 258 Capital stock, 225-231 Causes of, 198 Computation of tax. Effect of ordinary dividends, 264 Effect of stock dividend none, 264-265 Fractional part of year, 259 Fractional part of year, illustration, 262 Illustration, 261-262 Decrease, Accrual of taxes, 271-272 Allocation of dividend, when there is an operating deficit, 26S Dividends paid from surplus created by reduction of capital stock, 267 Dividends paid in first 60 days, 254 Dividends paid in first 60 days, but not out of current earnings, 263 Dividends paid in first 60 days when not equitably a reduction, 265 Income available for dividends, 266-267 Income available for dividends, illus- tration, 270-271 Methods of, 263 Payment to stockholders in anticipa- tion of dividend, 263 Return of capital to stockholder, 269 When dividends taxable at rates of prior years, former procedure, 263 Changes in Invested Capital — {Continued) Earnings, Applied to operating deficit, 269-270 Dividend paid from invested capital for taxable year, not affected, 255 Do not affect invested capital till fol- lowing year, 252 Stocks Tiurchased with, 253 Fractional part of year, 258, 259 Increase, 253-263 Appreciation, realized, 254 Depletion reserves, 254 Depreciation reserves, 254 Dividends, assumed to accumulate ratably, 255 Gifts, 254 Inadmissible assets, ratio of to total, 254 Premiums on capital stock, 254 Sale of property acquired prior to March i, 1913, 254 Sources of, 253 Stock dividends are not, 254 Surplus, 256-258 Indebtedness added to invested capital, 213 Losses during taxable year, do not affect invested capital till following year, 252 Pre-war jieriod, 277 Averaged, 279 Profit and loss not reflected until suc- ceeding taxable year, 258 Profits and losses, current, as causes of, 252 Reorganizations, when change of name also, 386 Charitable Corporations, Exemptions, 20 Charters of Corporations, securing new, 388 Checks, dishonored, Capital stock tax, procedure, 468 Citations, abbreviations for, 4-5 Civic Leagues, exemptions, 20 Claims for Abatement, Capital stock tax, 467 Credit exceeding 10%, 117 Form 47, 488-489 Overpayment of taxes. Form 47A, 490- 491 Relief claim pending, 333, 334, 337 Claims for Credit, Adjusted by amended returns, 62 Affiliated corporations, 323 Foreign corporation by domestic. Form 1118, 521-524. S64 GENERAL INDEX Claims for Refund, Capital stock tax, 467 Credit exceeding 10%, 117 Filed within five years, 337 Form 46, 486-487 Paid-in surplus, evidence needed to sup- port, 153-154 Claims for Relief (See "Relief'*) Clubs, Social, Exemptions, 20 Commission, "Reasonable" commissions paid, are al- lowable expenses, 178 Commission Business, Considered as personal service, 81 Commissioner of Internal Revenue, Authority for relief appeals, 339 Capital stock tax, extracts from 1920 re- port, on returns for, 435-436 Must act on claim for relief, 332 Must keep special record of all corpora- tion§ computing tax under relief sec- tion, 356 Redetermines understated fair value of capital for capital stock taxation, 448 Statement by, to extend relief, 338 Committee on Appeals and Review, Functions, 12-13 Must act on claim for relief, 332 Comparisons Necessary to Secure Relief, 350 Compensation for Personal Services, Reasonable salary must be allowed, 364 Shares of stock in payment of, 229 Computation of Tax, 41-108 (See also "Illustrations, computation of tax") Affiliated corporations, 35, 36 Appreciation of invested capital from sale or exchange, 146-149 Assets, sale of, 209 Capital stock tax. Average earnings vs. capital stock, 454 Different from basis for excess profits tax, 445 Domestic corporations, 445-455 Fair average value vs. market value of capital stock, 447 Income and excess profits taxes de- ductible, 454 Surplus and undivided profits included in fair average value of capital stock, 447 Changing from fiscal to calendar year, 72-74 Corporations not in existence during pre- war period, 113 Credits not allowed, 41 Computation of Tax — (.Continued) Deductions, normal capital tax 1917 law, 425-426 Dividends, effect in invested capital, 264- 265 Excess profits tax, calendar year 1 9 1 8, 48-53 Exemptions, specific apportionment for period less than twelve months, 32 Fiscal year, Benefit of credit denied when fiscal year did not end in 191 7, 107 Change from to calendar year, illustra- tion, 72-74 Change of, 32 Differing for parent and affiliated cor- porations, 37 Ending March 31, 1 9 1 8, illustration, 104-106 Ending March 31, 1 9 1 9, illustration, 94-95, 482 Ending 1919, 93-95 Returns within two calendar years at different rates, 32 Foreign corporations, under relief section, 356 Former procedure, 96-97, 107-108 Formulas for proof, 46 Fractional part of year, 32 Fiscal year changed to calendar year, illustration, 72-74 Limitation prorated, 17, 67-74 Gas wells, sale of, 89-92 Gold mining, 23-24 Illustration, 24 Government contracts, 42, 410-411 Application of limitations, 65 Illustrations, 54-61 Ratio of expenses to total expenses, 62 Taxed at 1918 rates, 54 Illustrations, 48-53 Inadmissible assets, 214-223 Invested capital, 126 Averaging, 258 Fractional part of year, 258, 259 Less than $50,000, former procedure, 107 Less than $100,000, former procedure, 107 1917 law, 99-103 Limitations, 62-71 Applicable to consolidated net income, 67 Illustrations, 64-74 Lowered in certain cases, 62 Mines, sale of, 89-92 Net income, reconcilement of, illustra- tion, 365-366 GENERAL INDEX 56s Computation of Tax — iContinttred) Net loss established, illustrated, 75-77 1920, 41 Formulas for proof, 46 Illustration, 43-47 Nominal capital tax, 1912 law, 416-417 Oil wells, sale of, 89-92 Illustration (correct method), 92 Illustration (incorrect method), 90-91 Personal service corporations, 78-80 Illustration, 82-86, .87 Pre-war period, fiscal year differing from calendar year, 277 Relief granted, method of, 348 Relief, when granted, former procedure, 358 Ships operated in foreign trade, 25-28 Table showing taxes payable with varying amounts, 47 War profits tax (See also "War profits tax" Calendar year 1918, 49-53 Government contracts, 41 0-41 1 Pre-war period, 114-117 Consolidated Returns, 34-27, 282-330 Adjusting intercompany accounts, 288-289 Adjusting inventory valuation, 289, 302- 303 Allowed one specific exemption only, 37 Assessments, 323 Capital stock tax, not allowed, 458 Cash paid, basis in determining stock value of affiliated corporations, 318 Cash value of stock at date of acquisi- tion, 318 Changes in stock ownership may prevent, 310 Claims for credit or refund, 323 Computation of pre-war net income, 330 Computation of tax, 34-37 Conditions precedent to consolidation, 285- 287 Consolidated balance sheets, 283, 284 Columnar form of, required, 306-307 Defined, 284 Items contained in, 306 Procedure in preparing, 288-292 Required in determining invested cap- ital, 305 Working sheet, 298-299 Corporations only included, 311 Credit for taxes to domestic controlling foreign corporation, 315-316 Difference between purchase price and net worth of affiliated corporations appear- ing as good-will, 295-301 Distribution and manner of payment, 323 Consolidated Returns — (Continued) Dividends guaranteed by holding to affili- ated corporations, not deductible in, 316 Division of surplus accounts of affiliated corporations, 291 Eliminating intercompany dividends in consolidated profit and loss statement, 303 Exemption, specific. Only one permitted, 37, 325 $3,000 allowed, 325 War-profits tax, 326 Filing, 308-314 Fiscal year differing from that of parent, 37 Fiscal years differing, 324-325 Foreign corporations. Net income or invested capital not in- cluded, 38 Not required of, 37, 285, 308-309 Foreign subsidiary, 194 Form 819, affiliated corporation question- naire, 307, 310, 312 Form 1120, tax return, 306, 307, 314-317, 325 Form 1120A, illustrated, 477-479 Form 1122, information, affiliated corpora- tions, 307, 323 Former procedure, 376 General principles of, 304-307 Goodwill credited to capital surplus,, 296 Goodwill credited to depreciation reserve, 296 Government contract corporations, not permitted to make, 54, 285, 309 If controlled as a unit, consolidated state- ments necessary, 286 Inadmissible assets of affiliated corpora- tions, 321 Information at source not permitted, 308 Intangible property paid in, 3.18-321 Intercompany profits inventories, 316 Intercompany sales, 321 Invested capital, 317-325* Journal entries covering eliminations, 300 Liberty bonds exemptions, 315 Makeup of working sheet in preparing, 292 Method of elimination, 292-297 Illustrations, 297-303 Net income, 314-315 1917 and igi8 laws, 284 1918 law, Basic principles of consolidated returns, 304-305 Defining affiliated corporations, 304 ' 1918 returns, special problems of, 326-330 566 GENERAL INDEX Consolidated Returns — ^Continued) Not permitted where parent ownership is less than 95% of stock, 285 Not permitted where percentage of in- dividual stock ownership is unequally proportioned, 310 Not warranted by other than stock ownership, 311 Operating deficit, computation of, 321-322 Permitted only if required by law, 313 Personal service corporations, not re- quired of, 308 Pre-war invested capital. Adjustment for asset differently valued, 261 Comparative basis for 1 9 1 8 and, 327, 328 Same basis of valuation as for taxable year, 327, 328 Pre-war net income, 371 Pre-war period, 326-329 Profit and loss account, 283-303 Public service corporations, 314 Reconciliation of consolidated surplus, 325 Reconciliation of net profit with taxable net income and analysis of changes in surplus account, form 1120L, illustrated, 480-481 Reorganization after March 3, 1917, 317 Reserves of intercompany profit, 290 Segregation of intercompany stockhold- ings into two classes, 291 Taxable net income, three companies, calendar year 1919, form 1120 A, illus- trated, 477-479 Treasury interpreting phrase "substan- tially all the stock,". 311-312 Treasury interpreting phrase "the same interest," 312-313 Treatment of intercompany profit, 289- 291, 302-303 Valuation of intercompany ownership pur- chased for cash in affiliated corpora- tions, 293-296 Where stock ownership is between 50% and 95%, 310 Working sheet for consolidated balance sheet, illustration, 298-299 Consolidations (See also "Reorganiza- tions") Contingencies, Reserve for, As surplus, 238 Contracts (See also "Government con- tracts") As good-will, 179 As invested capital, 179 As paid-in surplus, 153 Valuation of, relief, 344 Contracts — ^Continued) War profits tax, applies after January i, 1919, if unfinished, 3 Contributions (See "Gifts") Corporate Stocks (See "Capital stock") Co-operative Associations, Exemptions, 20 Corporations (See also specific subject headings) Advantage of consolidation, 320 Affiliated, Consolidated returns, 34-37» 282-303 (For full entry, see "Affiliated cor- porations" and "Consolidated re- turns") Pre-war net income, 371 Capital stock tax, Basis for capital stock tax different from basis for excess profits tax, 445 Capital invested outside the United States not deductible, 445 Data necessary to claim exemption from capital stock tax, 441 Deduction of $5,000 permitted for cap- ital stock tax, 445 "Doing business," as basis for capital stock tax, 440-442 "Doing business," illustrated, 441-442 Domestic defined, 437 Domestic, scope of, 437 Domestic, subject to, 436-439 Effective date of, for domestic, 436 Exempt from, 443-445 Exempt from income tax law also exempt from, 434 Holding, defined, 442-443 Lessor, inactive and similar, exempt from, 434 Liquidating, prior to June 30, 1921, no return demanded, 443 Mutual insurance companies, how tax- able, 445, 446 "Not doing business," illustrated, 442- 443 Period of "doing business" determines tax liability, 443-444 Railroad, "doing business" under fed- eral control, formerly, 443 Rate and computation for, 445-455 Returns required, 456 Changes in invested capital during tax- able year, 252-275 Charters, securing new, 388 Credits, For foreign taxes paid, 37 Pre-war period, 111-113 When non-existing during pre-war period, zxz GENERAL INDEX 567 Corporations — (Continued) Dissolving (See "Liquidating corpora- tions") Earnings from vessels in foreign trade, 18 Establishment expenses of subsidiaries, 181 Excise tax (See "Capital stock tax") Exemptions, 18-28 Income less than $3,000, 18, 22 Interest received, 362 1917 law, 6 igi8 law, 18 Expenses, "reasonable" commissions paid, are allowable expenses, 178 Fiscal year (See "Fiscal year") Foreign (See "Foreign corporations") Foreign branches, surplus, 232 Gifts received, 234-236 Gold mining, Exempt, 18, 23 Net income, segregation, 23 Government contracts, 404-413 (See »also "Government contracts") Applied to 1920 profits, 41 Computation of tax, 38, 54-61 Relief not allowed on cost-plus con- tracts, 355 War profits tax applies after January I, 1919, if unfinished, 3 Great Britain, tax rate, s Holding title to property, exemptions, 20 Income less than $3,000 exempt, 18, 22 Income tax on net income after payment of excess profits tax, 19 Invested capital (See also "Invested cap- ital") Less than $50,000, computation of tax, former procedure, 107 Old values control in reorganization, 226 Liable to tax, types, 14 Liquidating (See "Liquidating corpora- tions") Liquidating during taxable year, 32 Michigan partnership associations, 439 Net income, Basis of taxation, 41 Limitation of tax, applicable to, 67 Lower rates for small income, 42 Net loss established, illustration, 75-77 Net loss, excess, deductible next taxable year, 78 Newly organized during taxable year, 32 Newly organized prior to March 3, 1917* 383 1917 law, 3, 6 1918 law, 3> 14 Corporations — {Continued) Nominal capital (See "Nominal capital tax law, 191 7" and "Personal service corporations") Nominal capital tax, 19x7 law, tax rates, 416 Not organized for profit, exempt, 19 Officers' salaries deducted in computing net income, 364 Organized after August i, 1914. not affili- ated corporations, 38 Patents transferred from partnership, 189 Pennsylvania limited partnerships, 439 Personal service (See "Personal service corporations") Prorating of dividends, paid, 267 Receiving income from foreign, 193 Relief measures, 331-361 (For full entries see "Relief") Reincorporations may not be reorganiza- tions, 385 Reorganizations, 382-403 (For full entries see "Reorganizations") Representative, as defined in relief sec- tions, 350 Returns, 29-40 Amended, illustrating scope of, 161 Consolidated, 34-37, 282-330 (See also "Consolidated returns") Form 1 120, information return, 136, 137 Fractional part of year, 32 Fractional part of year when capital changes, 260 Fractional part of year when capital changes, illustration, 262 Manner of, same as for income tax, 14 Sale of vessels in foreign trade, 18 Stock (See "Capital stock") Subsidiary (See "Affiliated corporations") Successor to individual or partnership, 392 Tax rates, 1 91 7 law, 5 1918-1919, lowered in certain cases, 62 Tax reserves for fiscal years 191 7-1 91 8, 247 Types of, taxable, 14-15 Cost Basis, 124 Cost or Market Price, Inventories, 169 Cost-plus Basis (See "Government con- tracts") Credits, 109-121 Based on invested capital for taxable year in government contracts, 411 Benefit of, denied when fiscal year did not end in 1917, 107 568 GENERAL INDEX Credits — ( Continued) Capital stock tax, 456 Consolidated returns, 37 Different from income tax, 41 8% of invested capital, no Excess profits, no Foreign corporations, owned by domestic, tax credit given, 37 Fractional part of year, 32 Government contracts, 113 Based on invested capital for taxable year, 411 Income tax credit, no Income tax exemption of $2,000 not al- lowed, 41 Interest on obligations of U. S. and War Finance Corporation subject to excess profits tax, 41 Median used in determining, 54, 117 1917 law, no 191S law, no Pre-war period, in 390 Returns for, special problems, 326 Revaluation of plant investment denied, 173 ■Transportation corporations under federal control, 16 1919. Changes since 1918, 9 Rates, 10 Lowered in certain cases, 62-64 1920, February 29 substituted for March 1, 264 Changes since 1918, 9 Rates (See "Tax rates") Nominal Capital Tax, 1917 Law, 414-429 Agents, 425 Application of law, 418 Barbers, 422 Brokers, 420, 425 Capital not used in business, but invested, 424 Classification of trades and business, 415 Decisions of United States District Court, 419 Deductions permitted, 425 Individuals, 415, 421 Investment transactions, 414, 418 Meaning of, 4^9 Minors, 423 Net income, determination of, 422 Nominal Capital Tax, 1917 Law — iCon- Hnued) Partnerships, 415, 416, 419-420 Personal service corporations, 418 Photographers, 422 Professional men, 418 Property pledged as collateral security as part of invested capital, 420 Salesmen, 423 Stock exchange seat, 424 Tangible assets, income irom, not sub- ject to assessments, 421 Tax rates, 414, 416-417 Vaudeville theaters, 423 Which business will not be deemed to have, 419 "Nominal," Meaning of, 414 Non-Resident Aliens (See "Aliens, non- resident") Notes, As inadmissible assets, i6g As tangible assets, 169 Promissory, as invested capital, 169 \ , o Obsolescence, Deductions, 363 Reserves for, as surplus, 238 Occupational Tax, Payment of capital stock tax does not exempt corporation from, 462 Officers of Corporations, Salary deductions in computing net in- come, 364 Ohio Partnerships, Corporate status under sections of the Ohio code, 15 Oil Wells, As invested capital, 175 Bonus paid for, 175 Sale of, 89-92 Illustration of computation of tax (cor- rect method), 92 Illustration of computation of tax (in- correct method), 90-91 Relief, when abnormal income from, 355 Organization Expenses, As capital payments, 180-181 As invested capital, 180-181 Not deductible from gross income, 180 Ownership Certificate, Foreign dividends and interest. Form looiA, soo Form 1087, 508 Substitute, Forms 1058-1059, 505-506 Tax not paid at source. Form looi. 499 Tax paid at source, Form 1000, 498 584 GENERAL INDEX Paid-in Surplus (See "Surplus, Paid-in") Par Value, Stock of no, 226 Tangible property, 152 Partnerships, Capital stock tax, Limited, defined, 438, 439 Partnership bank, defined, 43S-439 Computation of tax, capital less than $100,000, former procedure, 107 Exempt under rgi8 law, 18 Exemptions under 1917 law, 6 Fiscal year, rates, 96 Gifts made, former procedure, 374-375 Goodwill bought with cash, as invested capital, 183 Incorporating before July i, 1919, 398-401 Invested capital, special accounts not in- cluded in, 131 Joint ventures not treated as corpora- tions, 15 Limited, As corporation, 15 Not treated as corporations, 15 Which are not subject to tax, 23 1917 law, 3, 6, 39, 138-141 Not subject to capital stock tax, 434 Notes are not preferred stock, 131, 132 Nominal capital tax, 1917 law, 415, 416, 419, 420 Patents transferred to corporation, 188 Pre-war income, former procedure, 376- 381 Refunds, of rgi8 tax, in former pro- cedure, 40 Returns, for fiscal year ending in 1918, in former procedure, 39 Tax rate under 191 7 law, 5 Taxability of, former procedure in, 17 Patents, As invested capital, 185-189 Capitalized by competitors, relief, 342 Depreciation of, when it does not reduce 25% allowance, 188 Exempt from limitation, if purchased for cash, 166 Intangible property, 1918 law, 344 1917 law, treatment of, 185-186 1918 law, as intangible property, 185 Pre-war period, 281 Purchased for stock, r66 Relief, 344 Tangible property, Formerly, 164 1917 law, 344 Transfer of, 188 Patterns, As invested capital, 175 Bought for stock, 175 Payment of Tax, Capital stock tax. Former procedure, 460 Time for, 460-462 Manner, same as for income tax, 13, 14, 29. 30 Medium of, capital stock tax, 467-468 Pending claim for relief. First instalment, 333 First instalment for foreign corpora- tions, 333 First instalment in special cases, 335 Foreign corporations, 336 Method for 1920, 334 Special cases, 337 Penalties, Capital stock tax, 461 Failure to make returns, 30 For disclosing capital stock tax returns, 466 Pennsylvania Limited Partnerships, As corporations, 439 Corporate status, 14 Personal Service Corporations, Commissions and brokerage considered as, 81 Computation of tax, 78-80 Illustrations, 82-86, 87 Consolidated returns, not required of, 308 Defined under 1918 law, 414 Exempt from capital stock tax, 437 Exemptions, 18, 21-22 Nominal capital tax, 1917 law, 418 Part of corporation only is, 8r, Illustration, 82-86 Refunds, of 1918 tax, in former pro- cedure, 40 Returns, for fiscal year ending in 191 8, in former procedure, 39 Segregation of earnings, 22 Taxability of, 14 "Per-Unit" Basis, Income from government contracts, on, relief, 356 Photographers, Nominal capital tax, 1917 law, 422 Plant Assets, Revaluations involving appreciation not allowed, 281 Premiums, Capital stock. As surplus, 237 Source of increase in invested capital, 254 GENERAL INDEX 585 Pre-War Net Income, Reorganizations, 390 Pre-War Period, Abnormal conditions due to, relief, 347 Affiliated corporation, computation of tax, 35 As basis for computing war profits and excess profits tax, log British practice, 109 Assets, adjustments of, 189 Credits, Corporations did not exist during whole calendar year, 54, 326-329 Pre-war period, 111-118 Deductions, former procedure, 120 Defined, 112, 368 Depletion allowance, 363 Earnings, Data as to, when not required, 31 Test of excessiveness of profits, 8,. 9 Exemptions, proportionate reduction, 118 Invested capital, 276-281 Adjustments, 276-281 Adjustment for assets differently valued in pre-war period, 261 Application of, 276 Assets, adjustment of, 280 Averaging changes, 128 Balance sheets, adjustment of, 276, 278 Computation for averaging, 278-279 Computation for fractional part of year, 277-27^ Computation when fiscal year differing from calendar year, 277 Computed same as for taxable year. Defined, 276 Determination of, 276-277 Determining, same as for taxable year, 128 Goodwill, 281 Intangible property as, 281 Liabilities, adjustment of, 281 Life insurance, cash surrender value of, 280 Patents, 281 Plant assets, 281 Reserves, adjustment of, 281 Same basis of valuation as for taxable year, 327, 328 Stock, adjustment of, 281 Surplus, 281 Uniformity in determining, with taxable year, 391, 392 When not necessary to determine, 280 Net income. Adjustment. 367-381 Affiliated corporations, 371 Pre-War Period — ^Continued) Net Income — (Continued) Appreciation excluded, 369 Average, computation oi, 369 Former procedure, 371-381 Greater than 10% of invested capital, 112 Individuals, 376-3S1 When not necessary to determine, 280 1911, 1912, and 1913 basis, 370 Not covered by relief, former procedure, 360 Returns, When not required for, 39 When not required in former pro- cedure for, of partnership and per- sonal service corporations, 40 Professional Men, Nominal capital tax, 1919 law, 418 Profit and Loss Account, Consolidated return, 283, 303 Profits (See also "Appreciation," "Earn- ings") Abnormal, Due to liquidation, relief, 354 Not sufficient claim for relief, 353 Relief from tax, 339 Accrued since March i, 1913, taxable, 256 Affiliated corporations, treatment of inter- company profit, 289-291, 302-303 Current, as cause of change in invested capital, 252 Derived from sales, 204-210 Distributed, distinguished from salaries, 364 Dividends paid from, 263 Exemptions for non-profit making under- takings, 18 Inadmissible assets purchased out of cur- rent, 202-203 Industries earning more than 10%, iig- 117 Not reflected in invested capital until succeeding taxable year, 258 Realized, Not included in invested capital during current year, 255 Sale of capital assets, 256 Reserves for intercompany, in affiliated corporations, 290 Sale of inadmissible assets, illustration, 222 Undivided, 231-237 Active maj ority holdings treated as, 287 As invested capital in reorganizations, 39S Capital stock tax, 447 586 GENERAL INDEX Profits — {Continued) Undivided — (Continued) Earned in current year, not capital, 231 Instalment sales, 232 Invested capital includes, 128, 231 "Nominal capital," business having, . 424 Pre-war period, 281 Reserves for taxes, 242 Property, Compensation for commandeered, whether income from government contracts, 407- 408 Intangible (See "Intangible property") Mixed aggregate of tangible and in- tangible, stock issued for, 353 Pledged as collateral, nominal capital tax, 420 Realized appreciation from sale of, source of increase in invested capital, 254 Tangible (See "Tangible property") Valuation of, 154-^55 Valuation of mixed aggregate of tangible and intangible, 1 71-172 Proprietor's Salary, Deductible under 1917 law, 7 Prorating, Credits, 32 Dividends paid, 267 Limitations for fractional part of year, 17, 67-74 Public Service Corporations, As affiliated corporations, 314 Publisher's Subscription List, 134, 179, 344-359 Quotations or Outside Sales Prices, Exhibit B, capital stock tax, 451-452 R Railroads, Under federal control not government contracts, 405 Valuation of carrier routes, 179-180 Rates (See "Tax rates") Ratio of Tax to Net Income, In representative corporations, determines relief, 348 Reconciliation, Capital invested, 142 Net income and analysis of changes in surplus, Form 1120L, illustrated, 476 Refund, Claim for (See "Claims for refund") Partnerships, of 1918 tax, in former pro- cedure, 40 Refund — (Continued) Personal service corporations, of 191 8 tax, in former procedure, 40 Regulations, Authority for (See "Authority for regu- lations") Articles 4S, 14 (See special index, 553) Article 50, (See special index, 553) Reincorporation, 385 Relief, 33:-36i Abnormal conditions, Affect pre-war period, 347 May entitle to, 339-340 Additional, 347 Amendment to 1918 law, criticism of, 338 Business conducted with large amount of borrowed money, 346 Capitalization, small through conservative accounting, 345 Claim for, Abatement required, when, 333, 337 Five-year limit for filing, 337 General permission to apply for, 339 Should be complete, 334 Under abnormal conditions, 339-340 Commissioner, Determines ratio of representative cor- perations, 349 Must act en claim, 332 Must keep special record of all corpor- ations computing, tax under relief section, 356 Statement by, 338 Committee on Appeals and Reviews, must act on claim for, 332 Computation of tax. Foreign corporations, 356 When granted, 348, 358 Conditions under which obtained, 338 Constructive capital, 342 Contracts, 344 Fiscal year corporations, 341 Foreign corporations, 336 Computation of tax, 356 Method of determining first instalment, 336 Former procedure, 357-361 Franchises, 344 Former procedure, 359 Gas well, sale of, 355 Goodwill capitalized by competitors, 342 Government contracts. Cost-plus, not granted, 355 Denied on cost-plus basis, 413 Exceeding 50% of net income, 333 Income from, on "per-unit" basis, 356 Individual, former procedure, 360 GENERAL INDEX 587 Relief — (Coniinued') Intangibles of substantial value paid in specifically at nominal value, 343 Invested capital. Former procedure, 357-361 Indeterminable, 336, 357 Interest paid while pending, 335 Life insurance policy, 346 Method of invoking, 332 Mines, sale of, 3SS Minimum capital only determinable, 336 Newspaper franchises, former procedure, 359 Oil wells, sale of, 355 Patents, Capitalized by competitors, 342 Valuation of, 344 Payment of tax pending, First instalment, how determined, 333, 335 Method for 1920, 334 Special cases, 337 Profits, abnormal, 339 Due to liquidation, 354 Not sufficient claim for, 354 Ratio of tax to net income in same line of business, 34S Records for, 356 Representative corporations, 348 Comparison must be made with, 350 Showing lower rates of earnings, 349 Salaries, nominal, paid to officers, 346 Sale of mineral property, abnormal in- come from, 335 Special record for, 356 Statement to be filed, 335 Stock, issued for unsegregated property, 353 Subscription lists, 343 Former procedure, 359 Tax in excess of 50% need not be paid until claim is heard and determined, 332 Tax not exceeding 50% of net income, 333 Religious Corporations, Exemptions, 20 Reorganizations, 382-403, Adjustment of assets, 391 Pre-war with taxable year, 391, 392 Affiliated corporations, after March 3, 1917, 317 Assets, Acquired by purchase or gift, 382 Goodwill, 391 Majority and minority holdings, 395 Pre-war period, 391 Purchased in excess of old value, 391 Reorganizations — (Continued) Assets — (.Continued) Purchased with stock of no par value, 394 Transfer of, 394-401 Transfer of stock control, 393 Transferred through several reorganiza- tions, 394 Valuation of, 382-384 Change of corporate entity. Intentions of law, 383 Stockholders same, 387 When a disadvantage, 384 Without change of officers and stock- holders, 387 Change of name does not change iden- tity, 386, 390 Change of ownership of property, 1918 law, 397 Charters, 388 Corporation buying out another during fiscal year, 395 Corporation taking over business of an- other corporation in another state, 39s Date of reorganization at beginning of new taxable year, 397 Depletion, values, 398 Depreciation, values, 398 Individuals, before July i, 1919, 398-401 Invested capital. Based on balance sheet of predecessor, 397 When deemed pre-war, 390 January a, 1913, former procedure, 403 Majority holdings in previous ownership, 397 March 3, 1917 After, 394-402 Prior to, 390-394 Not deemed to be organizations, 384-386 Partnership, before July i, 19x9, 398-401 Previous ownership, net income of, when expenses, 395 Pre-war incom'e when changed before March 3, 1917, 390 Retaining majority holdings, 397 Returns for, 392-393 When same in new, 386, 387-388 Pre-war period, after January 1, 191 1, 329- 330 Prior to March 3, 1917, 382-395 Problems arising from, 382 Profits, As invested capital, 395 Distributions made on or after Janu- ary 1, 1918, 399 588 GENERAL INDEX Reorganizations — (Contintied) Reincorporations, In another state, 386 May not be, 385 Returns, Accounts of former business must be restated, 392,393 Separate required, 389 Stock control, 392-393 Stockholders, rights and obligations, 386- 389 Successor corporation must restate ac- counts of former, 392-393 Successor to individual or partnership, 39^-393 Valuation assets, 382-384 Replacement Fund, For loss, not included as invested capital, 231 Form 1114, 515-518 Representative Corporations, As defined in relief sections, 350 Reserves, Bad debts for, 238 Computed in invested capital, 126 Contingencies, 238 Depletion, 239 As source of increase in invested capi- tal, 254 Method of presenting data, 241 Depreciation, 239 As source of increase in invested cap- ital, 254 Deducted from asset account, 202 Discounts, bank, 250 Insurance companies, when not capital, 250 Intercompany profit, in affiliated corpora- tions, 290 Inventories, 238 National banks, when not invested capi- tal, 133 1917 law, for federal taxes, 141 Obsolescence, 238 Pre-war period, 28% Retirement of preferred stock, 242 Whether surplus, 242 Sinking funds, 242 Surplus account, 237-250 Taxes, 242-251 Additional assessments, effect of, 248- 250 Are surplus, 242-250 Considered invested capital until date tax is paid, 243, 281 Fiscal years 1917-1918, 247 Restored Amounts, 152-160 Returns, 29-40* Affiliated corporation (See "Consolidated returns") Amended, Additions to surplus, 158 Depletion allowance in 1911 and 1912, 364 Difference between amount of claim and amount received, adjusted by, 62 Excise and income tax, required, 174 For prior years, 31 Illustrating scope of, 161 Net income of prior years corrected, 158 Stock dividends, illustration, 199, 200- 202 Stock dividends, prior years, 232-233 To secure Liberty bonds, retroactive ex- emption, 33 To secure Victory Loan Act uncondi- tional exemption, 33 Victory Loan exemption, 33 Balance sheets required, 31 Capital stock tax, Affiliated corporations, 458-460 Corporation claiming exemption from, 444 Corporations required to file, 456 Extracts from Commissioner's 1920 re- port on, 435-436 Fiscal year ending June 30, 457 Foreign corporations, 466 Former procedure, 460 Inspection of returns, 466 None demanded of corporations liquidat- ing prior to June 30, 1921, 443 Penalties for disclosing, 466 Tentative, 457 Time for filing, 456 Computation of tax, fiscal year ending March 31, 1919, illustration, 57-61, 94- 95 Consolidated (See "Consolidated returns") Corporations, Capital stock tax, Form 707, 492-495 Income and excess profits, Form 1120, 526-532 Liquidating during taxable year, 32 Covering parts of 1918 and 1919, 31 Details not needed, if no taxable income, 30 First taxable year, same as income tax, 30 Fiscal year, Apportionment of credits, 32 Changed, 32 Corporations newly organized during taxable year, 32 Ending in 1919, 411-412 GENERAL INDEX 589 Return s — ( Continued) Fiscal Year — {Continued) Within two calendar years at different rates, 32 Foreign corporations, Capital stock tax, Form 708, 496-497 Income received during 1920, Form 1098, 513 Form 1 120, information return, 136-137 Fraction part of year, 32-33 Exemption reduced, no Illustrations, 67-74 Invested capital, changed during, 260, 262 Limitations of tax prorated, 17 Proportionate reduction for exemptions, 118 Prorated, 22 Government contracts. Form 1120S, 533 In general, 29-34 Income, Annual, Form 1096B, 512 From vessels engaged in foreign trade, 29 1920, Form 1096, 509-510 Income tax, Monthly, Form 1096A, 511 1909* 370 1910, 370 1911, 370 1911 and 1912, 370 1912, 370 1913, 370 Individuals, Form 1040, fiat rate tax return, 39 Form iioi, tax return, graduated rates, 39 Former procedure, 39 Income tax, as basis, 375 Married woman as sole trader, separate return formerly, 39 Non-resident alien, 39 Information at source. Annual, Form 1013, 503 Monthly, Form 1012, 502 Non-resident alien. Form 1042, 504 Information for pre-war period, former procedure, 381 Liberty bonds, first and last issues not returnable, 362 Manner of making, 14, 29, 30 1920 income, Form 1099, 5^4 Non-resident aliens. Form 1098, 513 Partnership, Form 1102, tax return, in former pro- cedure, 39 Returns — (Continued) Partnership — (Continued) March i, 1918, date for filing, formerly, 39 Penalties for failure to make, 30 Place of filing, same as of income tax, 29 Pre-war data, when not required, 31 Pre-war period, 369-370 Dividends, 1909 and 1913, 370 When not required, 39, 40 Reconciliation of net income and analysis of changes in surplus, Form 1120L, illustrated, 476 Relief measures, 331-361 (For full entry see "Relief") Reorganizations, Accounts of former business must be restated, 392-393 Separate required, 389 Taxable net income calendar year 1919, Form 1120 A, illustrated, 424-475 Time for filing, 30 Treasury stock, 228 Who must make, 29, Revaluations (See "Valuation adjust- ments") Roberts, J. W., "Technique of Consoli- dated Returns," 307 Rulings, Abbreviations for citations, 4-5 Salaries, As income deductions for, 364 Former procedure, 372 Distinguished from distribution of profits, 364 Nominal, paid to officers, relief, 346 Sales, Assets, capital, 342 Gains realized from, 204-210 Illustration, 206 Gas wells, How taxed, 89-92 Relief, when abnormal income from, 355 Inadmissible assets, gain from, illustra- tion, 222 Mines, How taxed, 89-92 Relief, 355 Oil wells. How taxed, 89-92 Relief, 355 Securities, deductions for inadmissible asset decreaged, 202 590 GENERAL INDEX Salesmen, Nominal capital tax, 1917 law, 423 Savings Banks, Mutual, Exemptions, 20 Scientific Corpokations, Exemptions, 20 Securities, Bonus stock, sale of, 228 Debenture bonds, interest-bearing, 134 Discount on, i77'^79 Exchange and transfer of, adjustments in, IS3-IS3 Exempt, Loans to purchase, 202 Sale of, 206 Sale of, decreases deduction of asset, 202 Gain from sales of, 204-210 Inadmissible assets, 191 Liberty bonds, 33, 34 Exemptions, 315 Municipal, 193 Ownership certicates, forms, 498-500, 508 State, 193 Tax-free covenant bonds not tax-exempt, 192 Test for, in determining invested capital of partnerships, 138 U. S., interest on, not allowed as credit, 41 Victory Loan notes, 33 Ships, Operated in Foreign Trade, Computation of tax, 25-28 Exemptions, 18, 25-27 Returns on Form 1120M, 29 Sale of, 25-27 Simmons, Senator, Criticism of relief amendment, 338 Sinking Funds, Reserves for, whether surplus, 242 Social Welfare Organizations, Exemptions, 20 Societies, Exemptions for non-profit undertakings, 20 Statements, Reconciliation of invested capital, 141 Illustration, 142-143 Statement to be Filed with Claim for Relief, 335 Stock (See "Capital stock," "Dividends") Stock Exchange Seat, Nominal capital tax, 191 7 law, 424 Stockholders, Amounts received for refraining from en- tering into competition not considered purchase of good-will, 184 Stockholders — (Contmiied) Assessments on, as source of increase in invested capital, 254 Assessments paid by, Capital, 236-237 Returned, may be considered loan, 236- 237 Credit balances of, when considered as surplus, 133 Gifts by, nominal value and actual value, 234. Gifts to corporations, source of increase in invested capital, 254 Personal service corporation, 21 Reorganizations, 386-389 Reserve accounts in national banks, 134 Subscriptions, As invested capital, 179-180 Relief, former .procedure, 359 Unexpired, of publishing concern, not in- vested capital, 134 Valuation as capital, relief, 344 Subsidiary Corporations (See "Affiliated corporations") "Substantially all the Stock," Defined, 311 Surplus, 231-251 Adjustments, taxes as liabilities, 249 Amounts restored to, 158 As result of exchange of stock, 267-268 Bad debts reserve, 238 Bank discounts, 250 Book profit not reported as taxable in- come, not included as, 231 Capital stock tax and undivided profits included in fair average value of capital stock, 447 Contingency reserve, 238 Deduction for excessive depreciation re- stored to, 157 Depletion reserve, 239-241 Depreciation reserve, 239 Dividends, 232 Paid from, 267 Division of surplus accounts of affiliated corporations, 291 Earned (See "Surplus, paid-in") Good-will credited to capital, 296 Insurance companies reserves, 250 Inventory reserve, 238 Invested capital includes, 128 Invested capital increased by sale of assets from, 256 Life insurance, cash surrender value of, as, 177 Net income. Analysis of changes in surplus account, form 1 120 L, illustrated, 480-4S1 GENERAL INDEX 591 S URPLUS — ( Continued) Obsolescence reserve, 238 Paid-in. 231 Accounting procedure, 152 Adjustment of asset values, 152 Amended returns, 158 Appreciation not, 234 Assessments on stockholders, 236-237 Contracts as, 153 Defined, 152 Depreciation figured first to determine, Depreciation of assets, 155 Dividends, not included as invested capital, 232 Evidence needed to support a claim, 153-154 Excess above par for tangible property, 146 Excess of book value, 234 Excess of cash over par value is, 173, 175 Exchange of stock for assets over par value, IS3 Foreign branches, 232 Gifts, 234 Intangible property, cannot be treated as, 156 Limited to value at time of transfer, 154-155 Premiums on capital stock is, 237 Realized earnings, 233 Plus capital stock as invested capital, 250 Pre-war period, 281 Reconciliation of consolidated, 325 Reconciliation of net income and analysis of charges in, form 1120L, illustrated, 476 Reserves (See "Reserves, surplus") Retirement fund reserve, 242 Sinking fund reserve, 243 Stock dividend paid in excess of, 265 Stockholders' credit balances, when, 133 Tax reserve, 242-251 Effect of additional assessment on, 248 Fiscal year, 247 Valuations arising from, 233-237 Tables, Corporatxon Taxes, 1920, 47 Tangible Property, 145-164 Accounts receivable as, 168 Adjustment of values, 152-156 Amount restored to surplus, 158 Appreciation in sale of, 146-149 Former procedure, 146 As paid-in surplus, 152-155 Tangible Property — {Continued) Book values increased, procedure, 156-164 Cash value basis, 145 Defined, 145 Depreciation adjustments affect present owners only, 163 Depreciation, treatment of, 155 Excess above par as paid-in surplus, 146 Excess value, 234-235 Land as, 174 Leaseholds as, 175 Limited to value at time of transfer, 154- 155 Notes as, 169 Notes received for capital stock, 169 Paid in as a gift, 154 Patents as under 1917 law, 164, 344 Reorganizations, valuation, 383-385 Revaluation of property, 149 Sale or change in ownership, 146-149 Stock issued for, 166 Treasury stock, 189 Value as of March 1 , 1 9 1 3 , not recog- nized, 151 Water rights as, 174 When diminished values need not be de- ducted, 163. 164 Tax Rates, 41-108, (See also "Computation of tax") Capital stock tax, Domestic corporations, 445-455 Due in advance, 434, 436 Effective January i, 1917, 433 Retroactive to July i, 1918, 433, 435, 436 Classification, 41 Excess profits tax, rates affected by in- vested capital, 123 Former procedure, 96-97, 107-108 Fractional part of year, limitation of tax prorated, 7, 67-74 Government contracts, 42, 54 Great Britain, s Individuals, . 1917 law, 39 Limitations, 62-71 Formulas for , calculation under section 302, 64-65 Problem calculated at 1918 rates, 67 1917, 6 1918, 9 Computation of, 48 Lowered in certain cases, 62-64 1919, -3, 10 Lowered in certain cases, 62-64 1920, 10, 41 Compared with igi8, 42 Computation of, 41 592 GENERAL INDEX Tax Rates — (Continued) Nominal capital tax, 1917 law, 414, 416, 417 Personal service corporations, 78-80 Reduced for 1919 and 1920, 3 Taxable Year (See also "Computation of tax") Capital stock tax, date of incidence July I, 452 Changed from calendar year to fiscal year, computation of invested capital, 259 First taxable year, same as income tax, 30 Invested capital. Basis for credits in government con- tracts, 411 Changes, during, 252-275 (See also "Changes in invested capital during tax- able year") Uniformity in determining, with pre- war period, 391, 392 Net income (See "Net income, taxable year") Reorganizations, 397 Accrued, reduce income available for divi- dends, 267, 271 Assessment and payment, manner of, 13, 14 Foreign corporation owned by domestic, credit for, 315-316 Income tax returns as basis of, 375 Method of determining accrued, illustra- tion, 273 Refunds of 1918 tax erroneously collected from partnership and personal service corporations, former procedure, 40 Reserves, As invested capital, 141 As surplus, 242-250 As surplus, additional assessments, effect of, 248 Fiscal years 1917-1918, 247 Tax-free Covenant Bond, Not tax-exempt bonds, 192 Telephone Companies, Co-operative, exemptions, 20 Test of Excessiveness of Profits, 8 Text of Excess Profits Law, 537-S47 Theatres, Nominal capital tax, 1917 law, 423 Time for Filing Returns, Partnerships, March 1, 1918, former date, 39 "Trade or Business," Defined, Formerly, 427-429 Transportation Corporation Under Fed- eral Control, Not government contracts, 405 Taxable, 16 Treasury Regulations, 454 Treasury Stock, As capital stock, 189 Invested capital, to what extent, 227-228 Less than par value, 227 More than par value, 228 Not deductible in computing intangible values, 167 Sale of, increases invested capital, 227 Trusts, Exemptions, 23 Twelve Months, Less Than (See "Frac- tional part of year") u Undivided Profits (See "Profits, un- divided," "Surplus") United States, Excess profits tax, origin, of in, 5 United States Bonds, Admissible assets, igr Foreign corporations owning, 464 Included as invested capital, 192 Issued after Sept. i, 1917, 10% tax for corporations, 362 Liberty, Exemptions in consolidated returns, 315 First and last issues not on 1 920 re- turns, 362 Owned by foreign corporations, 463 Unsegregated Assets, Valuation of, 1 7 1 - 1 72 V Valuation (See also "Adjustments") Accounting records defective, 340 Accounts receivable, 168 Adjusting inventories in intercompany transactions, 289, 302-303 Adjustments for depreciation, prior to January i, 1917, 159-160 Advertising, 180 Aifiliated corporations, adjustment of tax among, 35, 36 As of January 1, 1917, 124 As of March i, 1913, 124, 189, 233-237 Basis for subsequent gain or loss, 256 Acquired by corporations in different state, 394 Acquired prior to March i, tgij, 151 Reorganizations, 382-384 Buildings, 173 GENERAL INDEX 593 Valuation — iContinued) Capital stock, 226 Fair average value vs. market value of, for taxation, 447 Under capital stock tax law, 136 Carrier routes, 179-180 Cash paid, basis in determining capital stock, 318 Contracts, 179-180 Depreciation, correct excessive, 157-158 Designs, 175 Discounts, On bonds, 177 On capital stock, 177-179 Expenses, deferred items of, 180 Fixtures, 174 Furniture, 174 Gifts received, 234-236 Good-will, 182-185 Insurance policies, cash value, 176-177 Intangible property, 159 Intercompany stock ownership, purchased for cash, 293-296 Inventories, 1 69-17 1 ; 363 Invested capital, 127 Involving appreciation of plant assets not allowable, 281 Land, 174 Leaseholds, 175 Machinery, 173 Mines, 175 Miscellaneous assets, 168-189 Models, 175 Newspaper franchises, 179-180 Notes received for capital stock, 169 Oil wells, 17s Patents, 185-189 Under 191S law, 344 Patterns, 175 Subscription lists, 179-180 Surplus arising from revaluation, 233-237 Unsegregated assets, 1 7 1 -i 72 Water rights, 174 Venture Associations, Not partnerships, 16 Vessels (See "Ships") Victory Loan Act, Exemption granted by, 33 Victory Notes, 192 Not returnable, 362 Virginia Partnerships, Corporate status under Virginia Code of 1904, 15 Virginia Partnerships — ^Continued) Exempt from capital stock tax under amendment of November 6, 1919, 439 Liability determined by certificate of part- nership, 439 w War Finance Corporation, Bonds, as admissible and inadmissible assets, 224 War Profits Tax, Affiliated corporations, exemption allowed, 326. As applied to 1920 profits, 41 Classification of rates, 41 Computation of tax (See "Computation of tax") At 1 918 rates, 49-53 Corporations now applicable to, 109 Credit for, not allowed, 41 Credits, 111-118 Affiliated corporations, 112-113 Basis for calculating pre-war capital, 278-279 Consolidated returns, 37 Corporation non-existing during pre-war period, 326-339 Corporations existing fractional part of year during pre-war period, 54 Fractional part of year, 32, 54 Government contracts, computation of, 410 Limitation of, 412 Net income exceeding 10% of invested capital, 112 Pre-war income less than 10% of in- vested capital, 112 Pre-war period, 54, rri-ii8 Summary of, in Government contracts, 404-413 (See also "Government contracts") Applies after January i, 1919, if un- finished, 3 Credits, 113 Credits for, based on invested capital for taxable year, 411 Exceeding 50% of net income, relief, 333 Median used in determining credits, 117 Pre-war invested capital, 276-281 Basis for 10% credit on three-year averages, 278-279 Credits, 113-115 Pre-war net income. Credits allowed, in Too small to be charged, 112 594 GENERAL INDEX War Profits Tax — (Continued) Pre-war period, Affiliated corporation, credits for, 113 Computation of tax, 35 Credits for corporation not existing dur- ing, 113, 326-329 Returns, First taxable year, same as income tax, 30 Fiscal year ending 1919, 109 Water Rights, As invested capital, 174 X Dollars, Meaning of, 5 Y. M. C. A., Not included in government contract, 406 ■''■'/>'-!v;ii),' ( II Ft 1 11 'J