bonds containing a covenant binding the corporation to pay the interest free of all taxes which it may be required to withhold at the source. The law provides that the recipient of income from securities containing a tax-free covenant does not include in gross income the tax of 2 per cent paid by the obligor (payer of the income). The amount of tax so paid may, nevertheless, be claimed as a credit against the total tax. (See Chapter 8.)

...

10

LAW. Section 234. (a) .... (3) In the case of obligors specified in sub-division (b) of section 221 no deduction for the payment of the tax imposed by this title, or any other tax paid pursuant to the tax-free covenant clause, shall be allowed, nor shall such tax be included in the gross income of the obligee. . . . .

Prior to 1921 the law did not contain this provision and the Treasury issued thousands of additional assessments under its claim that the 2 per cent tax withheld at the source constituted taxable income. The author after five and one-half years was finally supported by the federal courts in a case in which the question was squarely presented and fully considered in Pitney v. Duffy, (291 Fed. 621). The case cited was affirmed by the Circuit Court of Appeals [2 F. (2nd) 230], and on February 2, 1925, the Supreme Court of the United States denied an application for a writ of certiorari (267 U. S. 595).

The author hopes that many refunds will arise from the foregoing decision, since taxpayers have been warned to protect their rights by filing claims for refund of such tax which had been required by the Treasury Department to be paid.

The Commissioner in Anderson's Appeal (5 B. T. A. 27) contended that the tax paid at the source was income. Of course the Board overruled the Commissioner. The Supreme Court's decision was on February 2, 1925.

Where an individual mortgagor agreed to refund 4 per cent of the normal tax, and where a corporate mortgagor agreed to refund 2 per cent of the normal tax in addition to paying at the source 2 per cent on behalf of the bondholder, such payments were held to constitute additional interest to the bondholder. (C. B. II-2, 57; I. T.

1762.)

Section 221 (d) still permits the tax paid by the obligor to be

'[Former Procedure] See Income Tax Procedure, 1921, pages 516522; 1926, page 994.

10 See Chapter 10.

used as an offset to the tax due from the recipient as shown by his return.11

Interest from foreign subsidiaries.—

RULING. A domestic corporation owning a majority of the stock of foreign corporations should include in its income tax return any amounts of interest debited to its foreign subsidiaries, but it may claim as a deduction any amount of interest credited to such subsidiaries. (C. B. 1, 239; O. D. 330.)

Usurious interest.

RULING. Inasmuch as the decisions of the Texas court hold that each payment made upon a contract affected with usury is a payment upon the principal, applied by law, notwithstanding it was paid and received as a payment of interest, a taxpayer in Texas who lends money at usurious rates need not report as income any amounts received with reference to such debt until the amount of money loaned has been returned to him. All payments received in excess of the amount loaned are income. (C. B. IV-2, 160; S. M. 4591.)

"For credit where tax-free covenant bonds are sold between interest dates, see page 198.

Three broad statements may be made regarding interest received upon obligations of the United States and obligations issued under the Federal Farm Loan Act of July 17, 1916, the Agricultural Credits Act of March 4, 1923, and the War Finance Corporation Act, approved April 5, 1918:

1. Such interest received by corporations after January 1, 1922, is wholly exempt (C. B. I-1 99; I. T. 1244);

2. No part of such interest received by individuals is subject to normal income tax; and

3. Such interest is subject to surtaxes only in the case of obligations issued after September 1, 1917,2 and as to these, only so far as such interest is not exempt under provisions of the several Liberty Bond Acts and other acts under which these obligations are issued.3

'All Liberty bonds are subject to the estate tax. See Estate Tax Procedure, 1926.

By authority of one of these acts, interest from the 34 per cent Victory notes (redeemed during 1922), although issued after September 1, 1917, was not subject to any surtax.

'Non-resident alien individuals, foreign corporations and partnerships not engaged in business in the United States are not subject to surtax on Liberty bond interest. See page 615.

All the interest from Federal Farm Loan bonds is wholly taxexempt.

Interest which is wholly exempt from tax is excluded from "gross income" as defined in the law. If the income of a taxpayer is wholly from exempt sources, or if his net income from other sources is less than $1,500 (single) or $3,500 (married), he need not make an income tax return unless his gross income (excluding that from exempt sources) exceeds $5,000.

LAW. Section 213. For the purposes of this title, . . . . (b) The term "gross income" does not include the following items, which shall be exempt from taxation under this title: . .

(4) Interest upon (A) the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia; or (B) securities issued under the provisions of the Federal Farm Loan Act, or under the provisions of such Act as amended; or (C) the obligations of the United States or its possessions. Every person owning any of the obligations or securities enumerated in clause (A), (B), or (C) shall, in the return required by this title, submit a statement showing the number and amount of such obligations and securities owned by him and the income received therefrom, in such form and with such information as the Commissioner may require. In the case of obligations of the United States issued after September 1, 1917 (other than postal savings certificates of deposit), the interest shall be exempt only if and to the extent provided in the respective Acts authorizing the issue thereof as amended and supplemented, and shall be excluded from gross income only if and to the extent it is wholly exempt to the taxpayer from income taxes; . . . .

Interest on obligations of states, etc., is covered on page 217 et seq. This chapter relates to the remaining classes of exempt and partially exempt interest.

Interest wholly exempt.-The obligations, interest upon which is wholly exempt for all taxpayers, are:

1. All United States obligations issued before September 1, 1917.6

2. The 32 per cent First Liberty bonds, original issue, unconverted.

Including obligations of federal intermediate credit banks under the Agricultural Credits Act, 1923.

A statement of the number and amount of securities, the income from which is exempt is, however, to be included in returns.

Includes bonds issued under the First Liberty Bond Act, approved April 24, 1917. Certificates of indebtedness issued under this act were also exempt. The 334 Victory Loan notes, which were redeemed in 1922, were also in the wholly exempt class.

3. Postal Savings deposits.8

4. Obligations issued under the Federal Farm Loan Act of July 17, 1916, and the amendment thereto of March 4, 1923.

Interest in no part exempt from surtax.-Treasury notes issued under the Victory Liberty Loan Act are essentially different from Treasury certificates and carry no exemption from surtax.

Interest subject to special exemption.10

LAW. Section 1125. .... (a) On and after January 1, 1921, 4 per centum and 44 per centum Liberty bonds shall be exempt from graduated additional income taxes, commonly known as surtaxes, and excess-profits and war-profits taxes, now or hereafter imposed by the United States upon the income or profits of individuals, partnerships, corporations, or associations, in respect to the interest on aggregate principal amounts thereof as follows:

Until the expiration of two years after the date of the termination " of the war between the United States and the German Government, as fixed by proclamation of the President, on $125,000 aggregate principal amount; and for three years more on $50,000 aggregate principal amount.

(b) The exemptions provided in subdivision (a) shall be in addition to the exemptions provided in section 7 of the Second Liberty Bond Act, and in addition to the exemption provided in subdivision (3) of section of the Supplement to the Second Liberty Bond Act in respect to bonds issued upon conversion of 31⁄2 per centum bonds, but shall be in lieu of the exemptions provided and free from the conditions and limitations imposed in subdivisions (1) and (2) of section 1 of the Supplement to the Second Liberty Bond Act and in section 2 of the Victory Liberty Loan Act.

REGULATION. Liberty bonds, Treasury bonds, Treasury notes, Treasury certificates of indebtedness, and Treasury (war) savings certificates issued under the authority of the Acts of Congress approved April 24, 1917, September 24, 1917, April 4, 1918, July 9, 1918, September 24, 1918, March 3, 1919, and the Revenue Act of 1921, are entitled to the following exemptions on and after January 1, 1921:

(1) 31⁄2 per cent bonds of the first Liberty loan are exempt from all Federal, State, and local taxation, except estate or inheritance taxes. (2) 4 per cent and 44 per cent Liberty bonds, Treasury bonds, Treasury notes, Treasury certificates of indebtedness, and Treasury (war) savings certificates are exempt, both as to principal and interest, from all taxation now or hereafter imposed by the United States, any

[Former Procedure] See Income Tax Procedure, 1926, page 999. 'The_constitutionality of these obligations was affirmed by the U. S. Supreme Court in Smith v. Kansas City Title & Trust Co., et al., 255 U. S. 180. 10 [Former Procedure] See Income Tax Procedure, 1921, page 524 et seq. July 2, 1921. See C. B. II-1, 70; Mim. 3069.