disproportionate redemption rule, the percentage limitation of section 303 (b) (2) would impose a hardship upon the decedent's estate.

I appreciate this opportunity to appear here and express my views on this phase of H. R. 8300.

The CHAIRMAN. We have been very glad to have you. Thank you very much, indeed.

Mr. McFarland.

STATEMENT OF ELDEN MCFARLAND, WASHINGTON, D. C.

The CHAIRMAN. Make yourself comfortable and identify yourself to the reporter.

Mr. MCFARLAND. Mr. Chairman and members of the committee, my name is Elden McFarland of Washington, D. C. I have been engaged since 1935 in the practice of law, specializing in matters of taxation, and prior thereto, I was a member of the legal staff of the Internal Revenue Service and the Treasury Department. I am a member of the bars of the States of California, Massachusetts, and the District of Columbia.

Subchapter C of chapter I of subtitle A of H. R. 8300, "Corporate distributions and adjustments," is one of the most far-reaching parts. of the bill from the standpoint of its effect on business. The legislative objectives, according to the House committee report, are threefold, namely:

1. To make the law more certain;

2. To postpone recognition of gain or loss in cases which do not involve any distribution of assets to shareholders, and which involve merely shifts in the form of the corporate enterpise; and

3. To close a number of existing tax-avoidance loopholes.

In order to accomplish the objective of certainty the drafters have provided in general-but not exclusively-a number of objective tests thus eliminating to a large extent the subjective tests-such as intent, business purposes, and so on-inherent in the 1939 code reorganization provisions.

The device of using objective tests undoubtedly promotes certainty. But it also increases rigidity or inflexibility which, unless the provisions are modified, will produce some undesirable results.

With certain important exceptions, the second objective is attained, in general by providing in sections 359, 354, 305, 306, 352, and 353 for tax postponement in the case of corporate mergers or consolidations or corporate acquisitions of stock control or of the corporate assets of other corporations, all of which involve merely shifts in the form of corporate enterprise and do not involve any distribution of assets to shareholders. This is reasonable because the shareholder's interest is still in corporate solution in the continuing enterprise. He has not actually realized any income from the reorganization. Except to the extent which he received "boot"-that is cases or property-which is taxable, he still owns merely a shareholder's interest not yet converted into money.

One of the more important exceptions, referred to above is the case of the small-business corporation, which, as a general rule is closely held. We find such corporations in every city and every town of any size, in the United States. And as a rule the corporate investment

therein represents the life earnings of some individual or small group, frequently related.

This bill is likely to affect most of these small-business corporations, and particularly the successful, growing small corporation that needs to expand its capital, and its production, sales, and distributional facilities.

Such corporations are singled out and severely restricted under the pending bill. This discrimination was particularly emphasized in the statement made before this committee on April 7 on behalf of the American Bar Association.

Section 359 (a) of the bill divides all corporations into two classes, namely, publicly held corporations and all other corporations. A corporation is "publicly held" unless 10 or fewer shareholders own more than 50 percent either of the total combined voting power or of the total value of all classes of stock of the corporation. I have referred to all other corporations as "closely held" corporations.

Any two or more publicly held corporations can merge tax free. But a closely held corporation cannot merge or consolidate tax free with either a publicly held corporation or with another closely held corporation unless its shareholders have a continuing corporation after the merger or consolidation.

Why should mergers or consolidations between closely held corporations be taxed when similar mergers of publicly held corporations are not? Surely, such reorganizations involve merely shifts in the form of corporate enterprise, without involving any distribution of assetsand the specifically stated second basic objective as announced in the House committee report on this bill was to postpone recognition of gain in such cases.

Mergers and consolidations are not taxed under existing law. They are not tax avoidances.

The tax-avoidance possibilities are extremely limited in such cases. True, after a merger the shareholder can sell his new stock and be taxed at capital-gains rates. But he also could have sold his old stock also subject to the same tax. Perhaps his new stock is more saleable. But if so, he sells for more money and the Government collects more

tax.

If he doesn't sell, his interest is still in corporate solution at the risk of the business just as much as the interest of a shareholder of a publicly held corporation would be.

We submit that the distinction between publicly held and closely held corporations is arbitrary and unwarranted insofar as mergers and consolidations are concerned, and constitutes a severe discrimination against closely held corporations, which in general includes most small-business corporations. We believe this discrimination should be eliminated entirely. But if such a distinction is to be retained in the bill we specifically urge that section 354 (b) be revised so as to permit tax-free mergers or consolidations between 1 closely held corporation and 1-or more in the case of consolidationspublicly held corporation.

Similarly corporate acquisitions of corporate stock and corporate assets are severely restricted under section 359, being limited by the relative size of the corporations involved. This limitation would prevent or impede a great many sound business reorganizations which under existing law are nontaxable. Such transactions involve merely

shifts in the form of the corporate enterprise, without involving any distribution or severance of assets. Whatever tax is imposed should be imposed realistically at the time of subsequent realization of income. Otherwise, if the tax is imposed at the time of the corporate reorganization, the shareholder has received nothing with which he can pay the tax. He has only "paper profits" at most.

Furthermore, if in the future he disposes of his stock his actual or real profit may well be much less than his taxed "paper profit.'

Rather than imposing a severe restriction on small-business corporations, the bill should encourage the normal business reorganizations of small corporations, which are often an essential step in the course of their growth and development.

The restriction as to relative size is unrealistic. A small-business corporation frequently will find the necessary business objectives prompting the reorganization only in a much larger corporation which has the financial resources and the broader sales and distributional organization and facilities to assure continued growth and success of the enterprise.

We therefore suggest that the relative size limitations contained in subdivisions (b) and (c) of section 359 be eliminated entirely.

The provisions as to corporate separations contained in sections 359 (d) and 353 (a) continue, and to some extent enlarge, the provisions of existing law with respect to corporate spinoffs, splitoffs, and splitups. But the accompanying provisions with respect to "inactive corporations"-that is, those in section 353-are particularly drastic in that (1) they allow no basis whatever in the event of a sale or redemption of the stock within 10 years and (2) a bona fide operating company which is not in fact an "inactive corporation" may become "inactive" if during a 5-year period it happens to have an operating loss, but at the same time may have a small amount of nonoperating income which qualifies as personal holding-company income. Such a bona fide operating company ought not be classed as an "inactive" corporation.

The bill apparently permits a nontaxable corporate separation such as a spinoff-by that I refer to the spinoff provisions currently contained in section 112 (b) (11) of the 1939 code-to be followed by a nontaxable merger or consolidation or corporate acquisition of stock or property-involving only one corporation involved in the separation. Under existing law, and regulations such transactions are not accorded nontaxable treatment, if at the time of the spinoff the shareholders contemplated the subsequent merger or transfer of stock or assets of either corporation. The theory is that both steps are a part of the same plan of reorganization and hence, cannot be separated even though both steps, taken separately are nontaxable. The new law permits such bona fide business transactions.

There is an area of uncertainty in the present bill, however, which, unless clarified either in the bill or in the committee report may result in extended litigation. The revenue service might choose to interpret the words "single transaction" contained in subsection (b) of section 359 as having the same broad meaning as "plan of reorganization" under the existing law. A clarification by this committee would serve a useful purpose in avoiding a considerable amount of potential litigation.

A change in definition of the term "participating stock" will be required in order to make the bill workable. Many corporations would have no participating stock at all, under the bill. Your technical staff, including the staff of the joint committee as well as that of the Treasury Department is cognizant of this problem, and, therefore there is no need to discuss it at length.

I might point out, however, that the present definition leaves a considerable loophole in the operation loss carryover provisions (section 382) in that by the creation of a small amount of "participating stock" as now defined, a net operating loss carryover could be obtained by the simple expedient of holding the participating stock, but selling the major equity interest in the form of common stock which is not, technically, participating stock.

Bona fide operating loss carryovers ought to be allowed under section 382, provided an appropriate showing of bona fides is made by the acquiring shareholders. A somewhat similar condition or requirement is contained in section 356 and could easily be incorporated in section 382 thus permitting a carryover in cases of a bona fide acquisition.

Lastly, we come to the matter of the effective date which is of considerable concern.

The problem of the effective date is one of considerable concern. The present March 1, 1954, date contained in section 391 undoubtedly would be helpful to some taxpayers, but in the case of many others particularly those which entered into reorganization commitments prior to March 9, the March 1, 1954, date would be disastrous. We respectfully suggest that with respect to corporate reorganizations, as the term is known under existing law, the effective date be set at not earlier than 90 days after enactment of the bill, with the right of a choice election on the part of a taxpayer with respect to the 90-day period after enactment, to be governed by either the 1939 code or the new 1954 code.

I thank you for the privilege of appearing before the committee. The CHAIRMAN. Thank you very much.

(Mr. McFarland's prepared statement follows:)

MEMORANDUM OF ELDEN MCFARLAND IN RE H. R. 8300, SECTION 403 (c) (1)— TRUSTS EXEMPT Under SECTION 165 (A) of 1939 CODE

Section 403 (c) (1) provides that a stock bonus, pension, or profit-sharing trust established before the date of enactment of H. R. 8300 and which meets the requirements of section 165 (a) of the 1939 code shall continue to be exempt from income tax (even though it may not meet the requirements of section 501 (e) of H. R. 8300) so long as it continues, without interruption, to meet the requirements of such section 165 (a).

Many stock bonus, pension, and profit-sharing trust plans, particularly those older plans which were established many years ago, require minor amendments from time to time in order to meet changing conditions. Section 403 (c) (1) contains no specific reference to the effect of such amendments. It is believed that the legislative intent is to leave undisturbed presently qualified trust plans, as amended from time to time, so long as such amendments would not disqualify these plans under section 165 (a) of the 1939 code.

If such intent is not made clear, it is believed that from time to time in the future, as existing plans face a need for amendment, some trusts may find difficulty in obtaining administrative approval, even though such amendments would not disqualify them under section 165 (a). A clarification on this question would resolve any administrative doubts on this point and undoubtedly would avoid the possibility of needless litigation. The question is one of considerable importance to many existing qualified trusts.

It is, therefore, respectfully suggested that subparagraphs (A) and (B) of section 403 (c) (1) be amended to read as follows [the suggested changes being italic] :

"(A) if such taxable year begins before January 1, 1954, such trust shall be exempt under section 501 (a) for each consecutive taxable year beginning after December 31, 1953, as to which such trust as now constituted or as hereafter amended would qualify for exemption under such section 165 (a), if such section applied to such taxable year, subject, however, to sections 503, 504, and 505; or

"(B) if such taxable year begins after December 31, 1953, such trust shall be exempt under section 501 (a) for such taxable year and each consecutive succeeding taxable year as to which such trust as now constituted or as hereafter amended would qualify for exemption under such section 165 (a), if such section applied to such taxable year, subject, however, to sections 503, 504, and 505."

Respectfully submitted.

ELDEN MCFARLAND.

The CHAIRMAN. Sit down, make yourself comfortable, and identify yourself to the committee.

STATEMENT OF C. ADDISON KEELER, SECURITY MUTUAL
BUILDING, BINGHAMTON, N. Y.

Mr. KEELER. My name is C. Addison Keeler, Security Mutual Building, Binghamton, N. Y. I am attorney for Edwin A. Link and George T. Link, who own controlling interest and substantially all the stock in Link Aviation, Inc., in Binghamton.

I can present a specific, horrible example, I believe, of the effect of the retroactive date in section 391, in connection with the application of the new law to corporate acquisition of stock.

I will not go into the merits of these provisions, because they have been handled very capably by Mr. McFarland before me, and I would just like to cite the situation in which we are.

Twenty-five years ago, Mr. Edwin A. Link, brother of Mr. George Link, who is with me, here, invented what is known as a Link trainer, a device which simulates flying, on the ground, so that pilots could be instructed as to proper flight without risking their necks in the air, before they are proficient.

The original device was considerably simpler than it is today, because it relied on a bellows principle. He has developed the trainer so that now it is used by all of our Armed Forces in this country, and in many other countries, and it has been a very great help to the military service in connection with training aviation pilots.

However, as our technological advances continued, the bellows gave way to the new principles of electronics, to the extent that now, for the proper development of this device, it was necessary for the manufacturers of the trainer to consider a wider acquisition of know-how, particularly along the lines of electronics.

Consequently, last summer definite negotiations were carried on by Mr. Link and his brother for the transfer of their stock to the General Precision Equipment Corp., a corporation with an excellent staff in electronics, and a corporation that can be of great help in the development of this device. In November, there were specific provisions in typewritten form submitted to the Link Bros. as to a transaction whereby General Precision Equipment Corp. would acquire the stock, and Link Aviation would become a subsidiary of that com