been sold.41 For example, the cost of a supply of fertilizer sufficient to last for several years may be deducted in full in the year in which purchased. A farmer may deduct as business expense the cost of ordinary tools, but not the cost of farm machinery of a more permanent character. Such farm machinery, however, is subject to depreciation as is other property subject to wear and tear.

Public Utility Under Contract with a State. In the case of a public utility constructed, operated or maintained under any contract with any city, state or territory or the District of Columbia, where a portion of the net earnings of such public utility is payable, under the contract, to the state, territory, etc., the amount so paid may be deducted by the public utility operating under such contract as an expense of its business.42 This deduction is allowed under an express provision of the statute.43

41 T. D. 2153. A different rule seems to be applied in the case of manufacturers where it has been held that the cost of materials and supplies should be included only to the extent that the materials and supplies are actually used in the operations for the year. Reg. 33, Art. 123.

42 T. D. 2090.

43 Act of September 8, 1916, § 11 (b).

CHAPTER 29

DEDUCTION OF INTEREST

The law provides in the case of citizens and residents that all interest paid within the year may be deducted. In the case of a non-resident alien there may be deducted such proportion of all interest paid within the year by such person on his indebtedness as the gross amount of his income for the year derived from sources within the United States, bears to the gross amount of his income for the year derived from all sources within and without the United States, but this deduction is allowed only if such person includes in his return of annual net income all the information necessary for its calculation. In the case of a corporation there may be deducted the amount of interest paid within the year on its indebtedness to an amount of such indebtedness not in excess of the sum of (a) the entire amount of the paid-up capital stock outstanding at the close of the year, or, if no capital stock, the entire amount of capital employed in business at the close of the year, plus (b) one half of its interest-bearing indebtedness then outstanding. It is further provided, as to corporations, that in case of indebtedness wholly secured by property collateral tangible or intangible, the subject of sale or hypothecation in the ordinary business of such corporation, as a dealer only, in the property constituting such collateral, or in loaning funds thereby procured, the total interest paid by such corporation within the year on any such indebtedness may be de

ducted as a part of its expense of doing business, but interest on such indebtedness shall only be deducted to an amount of such indebtedness not in excess of the actual value of such property collateral. In the case of a bank, · banking association, loan or trust company, interest paid. within the year on deposits or on moneys received for investment and secured by interest-bearing certificates of indebtedness issued by such bank, banking association, loan or trust company, may be deducted in full. Foreign corporations are allowed to deduct the amount of interest paid within the year under the same limitation as imposed on domestic corporations and in such proportion as the gross amount of income for the year from business transacted and capital invested within the United States bears to the gross amount of income derived from all sources within and without the United States. The privilege of deducting the total amount of interest paid on indebtedness secured by property collateral is not allowed to foreign corporations, but the privilege of deducting all of the interest paid by a bank, banking association, loan or trust company, is extended to foreign corporations or the branches thereof to the extent that the interest is paid on deposits by or on moneys received for investment from either citizens or residents of the United States. The special rules applicable to each of the four classes of taxpayers enumerated above are discussed in the chapters relating to each.1 In all cases indebtedness incurred for the purchase of obligations or securities, the interest upon which is exempt, may not be deducted.

1 As to citizens and residents see Chapter 4; as to non-resident aliens see Chapter 5; as to domestic corporations see Chapter 12; as to foreign corporations see Chapter 14.

F.I. Tax.-21

Indebtedness Incurred for the Purchase of Tax Exempt Securities. Prior to the amendment of October 3, 1917, it was held under the 1916 Law that interest paid on indebtedness could be deducted regardless of whether or not the indebtedness was incurred for the purchase of bonds, the interest upon which was exempt from taxation. This ruling in effect permitted a double deduction, that is, the interest paid on the money so borrowed could be deducted and the income derived from the money so borrowed and invested could also be deducted. The 1917 Law does not permit the deduction of interest paid on indebtedness incurred for the purchase of obligations or securities the interest upon which is exempt from taxation as income under that law. The phrase "obligations or securities" means only such securities as bear interest which is exempt from the income tax. State and municipal bonds are securities which would fall into this class. National bonds issued prior to September 1, 1917, would also fall into this class. But the limitation applies only where the interest on the securities so purchased is wholly exempt. Interest on indebtedness incurred for the purchase of Liberty Bonds of the second issue (the interest on which is not exempt from the supertax) may be deducted regardless of this limitation.la

Interest Paid Within the Year. The 1909 Law provided for the deduction of "interest actually paid within the year" and it was contended by the Treasury Department that this provision required that the interest should be both accrued and paid within the same year. It was held by the Circuit Court of Appeals, however, that interest actually paid within the year although pre

la T. D. 2541.

viously accruing should be permitted as a deduction.2 The 1913 Law provided for the deduction of interest paid within the year by individuals, and "interest accrued and paid within the year" by corporations. In a ruling appearing under that law it was held that in the case of corporations the deduction should be limited to interest which had both accrued and been paid within the same year.3 The present law permits the deduction of interest paid within the year in all cases and it does not seem essential that the interest should have accrued or become payable in the year in which it is paid.

Interest Paid by Corporations. The limitations on the amount of interest which may be deducted by corporations is referred to in the chapters on corporations and foreign corporations respectively.

Interest Paid by Banks. Interest paid by banks, banking associations, loan or trust companies on deposits may be deducted in full. For a discussion of the rulings on this point see the chapters on corporations and foreign corporations respectively.

The

2 Anderson v. 42 Broadway Company, 213 Fed. 777. Supreme Court in reversing the court on another point did not pass on the question of deducting interest accrued in one year and paid in another.

3 T. D. 1960.