(b) As the income of a partnership is taxable to the individual partners, each partner is entitled to exemption as if he owned directly a proportionate part of the bonds held by the partnership. (Art. 83.)

Fiduciaries. Liberty bond interest received by executors, administrators, guardians, trustees, and other fiduciaries is taxable to them only in case it is not distributable to the beneficiaries of the estate or trust.18 When liable to tax, they are entitled to the same exemptions as individuals.

Corporations

The general statements on pages 607 to 613 in this chapter apply to interest on Liberty bonds received by individuals. Interest on all obligations of the United States is exempt from normal tax and accordingly is not taxable when received by corporations. The following special provisions apply to affiliated corporations.

Exemptions of affiliated corporations.

RULING. Each of several affiliated corporations included in a consolidated return under section 240 of the Revenue Act of 1918 is entitled to the same full benefits under the exemption provisions of the several Liberty bond acts to which it would be entitled if not affiliated. (C. B. 1, 87; T. B. R. 7.)

Parent corporation may not apportion Liberty bond holdings to its subsidiaries.-A parent corporation may not apportion Liberty bonds held by it among the affiliated corporations. If the parent corporation should make a bona fide sale of bonds to the subsidiary corporations, then such corporations would be entitled to the exemptions consequent on the holding of the bonds purchased.

United States Obligations Owned By Non-Resident Aliens,19 Etc.

LAW." Section 4. That section 3 of the Fourth Liberty Bond Act is hereby amended to read as follows:

"Section 3. That, notwithstanding the provisions of the second Liberty Bond Act or of the War Finance Corporation Act or of any other Act, bonds, notes, and certificates of indebtedness of the United States and bonds of the War Finance Corporation shall, while bene

18 See Chapter 43. See also Art. 83, quoted above.

"See Chapter 41.

Victory Liberty Loan Act, approved March 3, 1919, 40 Stat. at Large, Part 1, 1311.

ficially owned by a non-resident alien individual, or a foreign corporation, partnership, or association, not engaged in business in the United States, be exempt both as to principal and interest from any and all taxation now or hereafter imposed by the United States, any State, or any of the possessions of the United States, or by any local taxing authority."

Rentals which are in part a return of capital. The income which a lessor receives under a lease constitutes gross income. There may be deducted therefrom depreciation of physical property, depletion of natural resources, taxes and all other annual charges which are not of a capital nature. When the entire freehold property is leased in perpetuity, questions arise which are not present when the lessor expects to get his property back. In Pennsylvania such leases have been held to be sales. (See page 575.) Ordinarily the relationship between lessor and lessee continues to exist. In Farmer's Appeal (1 B. T. A. 711) the taxpayer sought to segregate the physical ownership in his lands from the right to lease the lands for oil exploitation. He contended that the leases executed by him constituted a severance and sale of the oil and gas in place and the estate created by such leases in the lessee was a determinable fee, and hence that a portion of his purchase price of the freehold should be allocable to the cost to him of such a determinable fee. The Board quoted court decisions holding that the ordinary oil and gas lease is not, strictly speaking, a lease at all; that it conveys no interest in the land and gives the lessee only on option to drill and extricate the minerals if found; ". . . . that leases similar to those here under consideration confer on the lessee, not an estate in land, but only a lease or option to enter upon the land described in the lease and develop it for oil and other minerals."

1

Rentals from "ground rents" as existing under laws of the state of Maryland should be returned each year as rent and are subject to tax as such. (C. B. 5, 98; O. D. 1089.)

It is, of course, possible that income from diminish in any way the owner's interest or value. case, gross income becomes net taxable income.

rentals may not

When that is the

A taxpayer leased certain property owned by it in 1917 to a corporation engaged in the manufacture of munitions for a foreign government. The lessor agreed to purchase and install certain machinery fixtures and equipment designed for the manufacture of munitions and the lessee was to pay the lessor a certain amount per month as "contractual amortization" of the cost of such installations. The Treasury held that such payments were rent and not a return of capital. (C. B. IV-2, 128; I. T. 2229.)

Permanent improvements by lessees.-The Treasury holds that the lessor must report the income arising from permanent 2 improvements made by the lessee at the time when the improvements are made or, at the lessor's option, may spread such income over the period of the lease.3 (See page 619 et seq.)

REGULATION. When buildings are erected or improvements made by a lessee in pursuance of an agreement with the lessor, and such buildings or improvements are not subject to removal by the lessee, the lessor may at his option report the income there from upon either of the following bases:

(a) The lessor may report as income at the time when such buildings or improvements are completed the fair market value of such buildings or improvements subject to the lease.

(b) The lessor may spread over the life of the lease the estimated depreciated value of such buildings or improvements at the termination of the lease and report as income for each year of the lease an aliquot part thereof.

If for any other reason than a bona fide purchase from the lessee by the lessor the lease is terminated, so that the lessor comes into possession or control of the property prior to the time originally fixed for the termination of the lease, the lessor receives additional income for the year in which the lease is so terminated to the extent that the value of such buildings or improvements when he became entitled to such possession exceeds the amount already reported as income on account of the erection of such buildings or improvements. No appreciation in value due to causes other than the premature termination of the lease shall be included. Conversely, if the buildings or improvements are destroyed prior to the expiration of the lease, the lessor is entitled to deduct as a loss for the year when such destruction takes place the amount previously reported as income because of the erection of such buildings or improvements, less any salvage value subject to the lease 2 "Improvements" where used in this chapter means "permanent improvements."

[Former Procedure] See Income Tax Procedure, 1920, pages 441-443. and 1921, pages 549-553.

to the extent that such loss was not compensated for by insurance. If the buildings or improvements destroyed were acquired prior to March 1, 1913, the deduction shall be based on the cost or the value subject to the lease as of that date, whichever is higher, less any salvage value subject to the lease to the extent that such loss was not compensated for by insurance. (Art. 48.)

The Treasury's interpretation of the earlier regulation illustrates the application of option (a) of the present regulation, quoted above, as follows:

RULING.

A, in 1915, leases certain land to B for 20 years. B agrees, in part consideration for the lease, to erect on the leased ground a building, specifications agreed upon, of an estimated life of 25 years and to cost $50,000, which building is not to be subject to removal by B. The building is completed in 1920.

A realizes income in 1920, the year in which title to the building passes. The measure of the income is the present value to A of the building, of an estimated life of 25 years and cost of $50,000, the use and enjoyment of which is postponed for 15 years. The depreciated value of the building at the termination of the period of the lease will be approximately $20,000-that is, cost less depreciation sustained. The income of A, then, is the discounted value of $20,000 receivable at the end of 15 years. If market value reflects intrinsic value, this amount should equal the difference between the value of the land free from the lease without the buildings and the value of the land subject to the lease with the building. However, any other evidence available should be considered in determining this present worth to the taxpayer of the legal title to the encumbered building. Since A has included in income only the depreciated value of the building, he is entitled to a depreciation deduction with respect to such building only for the years after the termination of the period of the lease when A has come into possesssion. This depreciation deduction to which A is entitled for 1935 and subsequent years should be computed on a basis of the estimated remaining life of the building and a "cost" value equal to the market value placed on the encumbered building by A in the year of its erection, i. e., the annual depreciation deduction for 1935 and subsequent years will be the quotient obtained by dividing (a) the value of the improvements to A as determined by him when the same completed became part of the realty, by (b) the number of years in the estimated remaining life of the improvements from the termination of the lease.

In any case in which the term of the lease is greater than the estimated life of the improvement no income should be accounted for by the lessor at the time of the passage of title. Also if the improvements will have no value at the termination of the lease, as is often the case in mining leases, no income is realized by the lessor. (C. B. 4, 90; Mim. 2714.)

Option (b) in Art. 48 is a reasonable basis if it can fairly be assumed that income arises annually out of the improvements paid for by the lessee.

Improvements made by long-term lessees on unimproved land