taxable year. When this method of deducting vacation pay was adopted, there may or may not have been a compressing of 2 years' deductions into 1 year, depending upon the circumstances. Some taxpayers under present law may not be permitted to deduct any amount for vacation pay in 1958 or 1959. This situation should be corrected by appropriate legislation, preferably by the reinstatement of section 462 or the enactment of a similar provision.

We would oppose, however, any proposal which would allow the taxpayer a deduction for estimated expenses to be incurred after the close of the taxable year only at the price of forgoing a deduction for estimated expenses attributable to prior taxable years incurred during the taxable year or subsequently.

21. STATUTE OF LIMITATIONS

The committee recommends that the statute of limitations should be the same for refunds as for deficiencies, insofar as dating the 3-year period from the date the return was filed (rather than the original due date) is concerned. Prepaid income tax should be deemed to have been paid no earlier than the date a timely completed return was filed where extensions of time for filing the return have been obtained.

22. STAMP TAXES ON ISSUANCE OF CAPITAL STOCK

Sections 4301 and 4302 of the 1954 code continue the tax on the issuance of capital stock previously imposed by section 1802 (a) of the 1939 code. Controversy has recently developed over the circumstances under which the tax ought to apply, however, and we believe some legislative clarification is desirable.

The tax has been interpreted by the Internal Revenue Service as applying to mere increases in the stated value of capital stock without the issuance of any shares. This view has been overruled in United States v. National Sugar Refining Co. (113 F. Supp. 157 (S. D. N. Y., 1953)); F. & M. Schaefer Brewing Company v. U. S. (130 F. Supp. 322 (E. D. N. Y., 1955)), on appeal to the second circuit; and Archer-Daniels-Midland Co. v. U. S. (— F. – (D. Minn., 1955)). We believe that the rule in these cases, viz, that the tax does not apply to increases in capital stock which are the result of mere book transfers to the capital account unaccompanied by the issuance of any shares, should be written into the code. As a matter of fact, the 1947 amendment of section 1802 (a) of the 1939 code dealing with recapitalizations (sec. 4302 of the 1954 code) indicates that the true test should be a dual one; actual issuance of shares plus dedication of the amount to capital for the first time. Unfortunately, as the law now stands, the dedication-to-capital branch of the test is limited to recapitalizations. But there is no reason why a reorganization involving more than one corporation should be treated differently from one which takes the form of the recapitalization of the same corporation. A conspicuous example of a transaction which is presently taxed, but which ought not to be, is one involving a mere change in the state of incorporation. We therefore also recommend that the stock issuance tax be made applicable to stock issued pursuant to a plan of reorganization as defined in section 368 only to the extent that an amount is dedicated to capital for the first time by such reorganization.

23. RESTRICTED STOCK OPTIONS

Section 421 of the code provides that restricted stock option treatment will be available only if an individual is an employee at the time the option is exercised or, if his employment has terminated, the option be exercised within 3 months of the date on which he has ceased to be an employee. H. R. 7064 changes the 3-month period to 6 months. There is apparently some question as to the status of retired employees for purposes of the application of this limitation. It is recommended that the statute be clarified on this point and that it be provided that employees who have retired because of disability or age be considered to be employees for all purposes of section 421.

A further point relating to restricted stock options arises from the fact that section 1014 (d) provides that the general rule contained in section 1014, to the effect that the basis of property acquired from a decedent shall be its fair market value at the date of the decedent's death (or optional valuation date), shall not apply to a restricted stock option which had not been exercised by the employee before his death.

This exception gives rise to an anomalous situation. If a restricted stock option is exercised before death, the stock will have a basis in the hands of the estate

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or beneficiary equal to its fair market value at date of death (or optional valuation date), whereas stock acquired by exercise of a restricted stock option after the employee's death will have as its basis only the option price, despite the fact that the value of the option (difference between fair market value at date of death and option price) is included in the gross estate for estate tax purposes. There is no apparent reason for this inequality of treatment and it is urged that the basis for income tax purposes of a restricted stock option unexercised at date of death be determined by application of the general rule prescribed by section 1014 (a) of the code.

24. AFFILIATED GROUPS (EMPLOYEE PENSION AND OTHER PLANS)

(a) Many pension plans cover more than one corporation and within a corporation may cover more than one group of employees having different coverages as required by union contracts or other agreements. Also union contracts may cover the employees of several affiliated companies. Because of longstanding methods of operation employees may be shifted between affiliated corporations because of changes in duties or products or business. In many instances it is impossible to determine actuarially the financial liability for pensions on an individual corporation basis. The liability for pensions may be decreased or increased several times for employees individually and by groups by changing laws and union contracts. These problems have been recognized by the Internal Revenue Bureau at various times. (See PS No. 14, 1944 P-H par. 66, 352; special ruling, October 23, 1944, 443 CCH par. 6632; PS No. 51-A, 1945 P-H par. 76,276; special ruling, 1945 P-H par. 76,281; special ruling, March 5, 1947, P-H par. 76,126; Frederick J. Wolfe, (8 T. C. 689 (1947)); PS No. 62, 1950 P-H par. 76,285, and 1954 code sec. 404 (a) (3) (B) re profit-sharing plans.)

Pennsylvania Statute 51-A makes an approach to the problem by allowing contributions to be made to a trust covering 2 or more corporations in relation to eligible payroll of employees covered by the trust but this solves only 1 small problem.

We recommend a revision providing where more than one corporation is covered by a plan or trust, or both, that the plan shall be considered as the plan of one employer for the various limitations contained in section 404 unless by reasonable actuarial methods the various limitations can be applied on a separate corporation basis and that the taxpayer shall be allowed to choose whichever method suits his situation best.

In addition, the consolidated return provisions of chapter 6 should provide that deductions applicable to such plans shall be allowed on a consolidated basis in a manner similar to the treatment of contributions.

(b) In 1954 the Federal Internal Revenue Code was amended (sec. 404 (a) (3) (B)) to permit other members of an affiliated group participating in a profitsharing plan to contribute proportionately the amount an affiliate would have contributed during the tax year had it not been prevented from doing so by the absence of current or accumulated earnings or profits. Each member of the affiliated group making such contribution on behalf of a loss member is allowed to deduct the contribution in determining its own taxable income for the year.

This salutary amendment should be carried a step further to permit a trust indenture establishing a profit-sharing plan for any group of affiliated corporations whether or not technically affiliated within the meaning of section 1504, to provide for the allocation of contributions in a tax year to participants of all members of the group, including those of a loss member which contributed nothing and for which nothing was contributed by the other members of the group. This would accomplish an equitable result for all participants and over a long period should work to the benefit of the employee participants of each member even though in a given year a member, because of its absence of current earnings and accumulated profits, was unable to make any contribution. Of course, a profit-sharing plan covering an affiliated or nonaffiliated group would have to state clearly that contributions in each year would be allocated among the participants of all members, including a loss member, and this would have to be made entirely clear in advance to each participant of every member in the group. By accepting the plan every participant would thus be contracting at the outset for the contributions to be allocated among the participants of all members regardless of a loss year or years by any member.

25. TAXATION OF INCOME FROM FOREIGN SOURCES

The following amendments to the present code are suggested:

(a) Section 902 (b) should be amended so as to change the requirement of stock ownership from 50 percent to the lesser of 50 percent or the maximum amount permitted in the foreign country. The purpose of this change is to make allowance for the fact that certain countries limit stock ownership by foreign nationals.

(b) In lieu of the present provisions of section 904 limiting the foreign tax credit on a country-by-country basis, taxpayers should be allowed an annual election between the overall and per country limitations on the foreign tax credit. (c) We favor the principles of H. R. 6628, of the 84th Congress, which provides for the carryover and back of excess foreign tax credits.

(d) We urge enactment into law of the proposals of the President to encourage foreign trade by providing substantial measures of relief from taxation of foreign income in the United States, if this country is not the source of that income. (e) We favor the principles of H. R. 128, 85th Congress, which provides a more reasonable basis for the determination of income from sources outside the United States with respect to qualification as Western Hemisphere income.

26. PROHIBITED TRANSACTIONS (SEC. 503 (C))

The requirements of the Internal Revenue Service with reference to the matter of prohibited transactions are very severe. The Treasury Department has granted an extension to June 30, 1958, with reference to this matter of disposal of certain securities. If exempt organizations are required to dispose of securities they have invested their money in, it may well cause a disruption of the bond market. Section 25 of H. R. 8381 provides what we believe to be a fair and equitable solution of this problem, and we favor its enactment into law.

The CHAIRMAN. The next witness is Mr. Fleming Bomar. Mr. Bomar, will you come forward and identify yourself for the record by giving your name, address, and the capacity in which you

appear.

STATEMENT OF FLEMING BOMAR, AMERICAN AUTOMOBILE ASSOCIATION, ACCOMPANIED BY RUSSELL SINGER, EXECUTIVE VICE PRESIDENT, AAA; AND NORMAN THOMPSON, SOUTHERN CALIFORNIA AUTOMOBILE ASSOCIATION

Mr. BOMAR. My name is Fleming Bomar. I am an attorney with offices in the Southern Building in the city of Washington. I have with me today Mr. Russell Singer, the executive vice president of the American Automobile Association, and Mr. Norman Thompson of the Southern California Automobile Association.

My appearance before your committee is in behalf of the American Automobile Association and a number of its affiliated clubs.

The CHAIRMAN. Mr. Bomar, can you complete your statement within 20 minutes?

Mr. BOMAR. Within 15.

The CHAIRMAN. You are recognized.

Mr. BOMAR. The reason for my appearance before your committee is that the American Automobile Association and also a number of its affiliated clubs have paid Federal income taxes for the past few years in an amount exceeding their entire net income, despite the fact that the maximum rate applicable to the net income of corporations is intended to be 52 percent.

During the calendar year 1956, for example, the net income of the American Automobile Association before taxes as certified by the accounting firm of Ernst & Ernst was $181,097. However, the

Federal income taxes paid by the association for 1956 totaled $209,861, or 115.7 percent of its net income. The American Automobile Association, in other words, earned a profit before taxes of $181,097 but after taxes operated at a loss of $28,764.

Similarly, for the calendar year 1955, the net income of the association before taxes as certified by Ernst & Ernst was $134,919, but the Federal income taxes paid for the year totaled $197,072, or 146.4 percent of its net income. After taxes the American Automobile Association in 1955 operated at a loss of $62,053.

A number of motor clubs affiliated with the American Automobile Association have had similar experiences.

The net income of the Automobile Club of Virginia in 1956 was $13,205, which under normal circumstances would be taxed at the 30 percent corporate income tax rate. However, this Virginia club paid income taxes of $15,353, or 116.3 percent of its net income. In 1955 this club had net income of $3,486; yet its Federal income tax bill was $10,696, more than three times greater than its entire net income.

The Automobile Club of Harford, Conn., operated at a net loss of $2,751 in the fiscal year ended March 31, 1957, but was required to pay Federal income taxes of $4,671. The same was true of the New Jersey Automobile Club at Newark, which sustained a net loss of $5,714 in 1956, yet had to pay $777 in Federal income taxes.

The California State Automobile Association at San Francisco paid Federal income taxes in 1956 equal to 96.6 percent of its net income, and in 1955 the percentage was 120 percent.

The reason for these incongruous results is that automobile clubs are compelled to pay Federal income taxes on a basis which is entirely different from that on which the accounting profession requires them to keep their books and records and to compute their true net income. The difference is in the treatment for Federal income tax purposes of membership dues, which constitute the principal source of income of an automobile club. The problem arises because dues are paid by members in advance for 1 year.

Since the American Automobile Association and its affiliated clubs are organized and operated as nonprofit corporations, the dues payable by a member are set at a rate intended to equal the expenses of serving the member, plus a small reserve for contingencies. Since dues are prepaid for 1 year, it cannot be determined whether a profit will be earned or a loss will be incurred on a given membership until the term of the membership expires. Because of this fact, the method of accounting recommended by auditors for automobile clubs requires that membership dues be taken into account, or spread, ratably over the term of a membership rather than reflected as income at the time of receipt.

A simple illustration of the problem may prove helpful:

Let us assume that a new automobile club which keeps its books and records on a calendar year basis was organized in November 1957. For the sake of simplicity, let us assume that 1,000 members join the club on December 1, 1957, and that each pays $12 annual dues in advance for services to be rendered over the ensuing 12-month period. The club expects to incur expenses of 95 cents per month per member on the average, $950 per month for the 1,000 members, or total expenses of $11,400 for the 12-month period.

A total taxable income of $600 would be realized out of the $12,000 collected of dues income from the members who joined in December 1957, or a profit of $50 per month.

The recommended method of accounting for this automobile club would be to report as 1957 income $1,000, one-twelfth of $12,000. After deducting expenses of $950 incurred in December, it would have a 1957 net income of $50 subject to tax. In 1958, the remaining $11,000 would be reported as income from which expenses of $950 per month would be deducted, and the additional $550 of income would be earned and taxed.

But under the method of accounting required by the Commissioner, the new club is compelled to report the entire $12,000 as 1957 income, and since only $950 of expenses have been incurred, the club has a fictitious profit of $11,050 which is subject to full Federal corporation income taxes. The $12,000 dues minus the $950 expense equals $11,050 net income.

After paying its tax on March 15, 1958, the club obviously will not have enough money left to pay the monthly expenses of $950 as they are incurred in rendering services to its 1,000 members.

Stated another way, the Commissioner compels an automobile club to pay an income tax in part on gross receipts rather than on net income, in the case of dues received from members who join the club late in the taxable year.

A method of accounting involving the same principle as that described in the illustration is no win use by the American Automobile Association and has been in effect for many, many years. Its clear objective is to reflect as income the dues received from a member over the same period of time that expenses will be incurred in serving the member. It was adopted by the association long before it was required to pay any Federal income tax. It has been accepted and approved by the Internal Revenue Service for Federal income tax purposes from the year the American Automobile Association was first required to pay Federal income taxes; i. e., the calendar year 1954, until the enactment of the Internal Revenue Code of 1954.

Experts in the accounting field advise that the method of accounting followed by the American Automobile Association is the best available in order to reflect its correct net income. Its method of accounting was approved under section 452 of the Internal Revenue Code of 1954, but the repeal of that section focused the attention of the Internal Revenue Service on the accounting methods employed by automobile club and brought the issue into litigation.

On April 22 of last year the Supreme Court of the United States rendered an adverse decision on the precise problem, in a case litigated by the Automobile Club of Michigan. In a 5-to-3 decision the Supreme Court held that under existing law the Commissioner of Internal Revenue has the power to force an automobile club to abandon its long-standing method of accounting, even though reasonable and accurate, simply because it does not reflect advance dues as income in the year of receipt.

Mr. Justice Harlan filed a strong dissent, a copy of which is attached to my statement, and which I would like to have included in the record, as I do not intend to read it.

The CHAIRMAN. Without objection, that may be done.