true once the basic question of fair limits of employer contributions to the retirement plans of tax-exempt educational organizations has been settled. We therefore wish to renew our request for such an extension of the 1954 provisions, and we are hopeful that this consideration will be given in further deliberations of Congress on H. R. 8381. The code provisions which are the subject of this statement are minor in the whole picture of tax benefits under retirement plans, and they involve little or perhaps no revenue loss. To the relatively small number of individual participants and beneficiaries affected, however, they may be of considerable importance. Because of these individual problems, the lesser tax aspects have become a source of annoyance and confusion under those retirement plans where deaths or other occurrences have forced individual situations to attention, and the number of these will undoubtedly continue to grow. We respectfully suggest that the best means of solving this problem is to extend consistent tax treatment under the new provisions of the 1954 code. This can be done within the same limits deemed proper under the proposed section 403 (b). Since the present section 403 (a) (1) is the provision having the major tax effect upon these retirement plans, we submit that the lesser provisions should naturally follow it, or any amendment that is made to it. We scarcely need to call attention to the problems which will be faced by the educational organizations in this country in the coming years, with the vastly increased importance of scientific knowledge, and with the growth of college populations. Our educational organizations need to attract and hold the best caliber of people for their staffs; and sound retirement plans play an important part in this. We therefore hope that this committee will see fit to continue the general tax situation as it existed prior to 1954, under which our retirement plans have grown strong, and to eliminate those present discriminations which give rise to dissatisfaction among a dedicated but relatively poorly paid group of scientists, teachers, and other academicians. STATEMENT OF INDEPENDENT NATURAL GAS ASSOCIATION OF AMERICA, SECTION 243-DIVIDENDS RECEIVED BY CORPORATIONS Historically, payments of intercorporate dividends have been treated for Federal income-tax purposes as nontaxable transfers of funds from one corporation to another. Prior to the Revenue Act of 1936, a corporation receiving dividends was allowed a reduction in the amount of 100 percent of such dividends and thus incurred no tax thereon. This deduction was allowed upon the theory that a corporate tax had already been paid upon the earnings out of which the dividends were distributed. Beginning with the enactment of the Revenue Act of 1936, 15 percent of intercompany dividends have been subject to tax. This is accomplished by including the entire amount of dividends in gross income and allowing a credit against net income for 85 percent of the amount of dividends received, such credit being limited to an amount not in excess of 85 percent of adjusted net income. In 1936, with a corporate income tax rate of only 15 percent, the effective tax rate on intercompany dividends was only 2.25 percent. Under the present 52 percent tax rate, the effective rate on intercompany dividends is 7.8 percent. Thus, the burden of this economically unsound tax has become much more serious than when first imposed. The only reason for and the only possible justification for taxing intercorporate dividends is contained in a message to Congress by the President of the United States dated June 19, 1935, in which the President recommended the substitution of a corporation income tax graduated according to the size of corporation income in place of the then uniform rate of 134 percent. The President followed this recommendation with the following: "Provision should, of course, be made to prevent evasion of such graduated tax on corporate incomes through the device of numerous subsidiaries or affiliates. each of which might technically qualify as a small concern even though all were in fact operated as a single organization. The most effective method of preventing such evasions would be a tax on dividends reecived by corporations. Bona fide investment trusts that submit to public regulation and perform the function of permitting small investors to obtain the benefit of diversification of risk may well be exempted from this tax." This reason should not be controlling as regards to taxation of a public utility company system. Under the Public Utility Holding Company Act of 1935, holding companies which are still in existence have established to the satisfaction of the Securities and Exchange Commission that they provide substantial economies for the benefit of the consumers and the group as a whole. Over the past few years many of the former subsidiaries have, where possible, been merged into their parent or into other operating subsidiaries. In other instances, a regulated public utility is required to furnish part of one or both of its services through the medium of subsidiaries. For example, some States require that a utility operating within their geographical limits shall be incorporated within the particular State, even though the separate corporation is a part of an integrated utility system operating in several States. The result is that a separate utility corporation must be set up within the limiting State. In other cases, the use of a subsidiary to supply part of the service, or some of the facilities through which the service is supplied, is required because of joint ownership of property, franchise requirements, or similar causes over which the regulated public utility has no control. The situations outlined above have prevented many utility companies from merging into one single corporation. The same considerations, plus the stock ownership requirements of section 1504, may prevent the filing of a consolidated return. In these cases, the utility must, under the present provision of the Internal Revenue Code, pay tax at the rate of 7.8 percent on dividends received from its subsidiaries. This is an obvious inequity, since the utility is forced to pay a Federal tax penalty because of the requirements of State or local law, or other conditions over which the utility has no control. The following example will illustrate the imposition of tax as corporate earnings pass through the hands of other corporations before distribution to the beneficial owners. Corporation P (parent company) owns 79 percent of the voting stock of Corporation S which, in turn, owns 75 percent of the voting stock of Corporation A. Because of the lack of 80 percent stock ownership, none of the corporations can be included in a consolidated return. Thus, the full impact of the tax on intercompany dividends must be borne under the present law. Here is what hap pens: Corporation A with a net income before tax of $1,000,000 pays a tax of $520,000 and out of its net income after tax pays $480,000 in dividends to Corporation S. Corporation S pays a tax of 7.8 percent of its dividends from Corpora tion A, or a tax of.. and pays a dividend of $442,560 to Corporation P. Corporation P pays a tax of 7.8 percent on its dividends from Corporation S, or a tax of... 37, 440 34, 520 Thus, the total tax paid is______ 591, 960 In the above example, an effective tax rate of more than 59 percent has been paid. Yet the difference between an affiliated group of utilities and a utility which has been able to consolidate all of its operations into a single corporation is only a matter of form. This obvious inequity should be corrected by eliminating the present tax on dividends from one domestic corporation to another. WASHINGTON, D. C., January 29, 1958. Hon. WILBUR D. MILLS, Chairman, House Ways and Means Committee, Washington D. C. DEAR CONGRESSMAN MILLS: There are enclosed herewith copies of a memorandum dealing with the funding of employer's obligations under a deferred compensation contract. We respectfully request that the enclosed memorandum be made part of the record of the hearings on tax revision being conducted before your Committee. Respectfully submitted. GARDNER, MORRISON & ROGERS, By THOMAS J. BEDDOW. FUNDING OF EMPLOYER'S OBLIGATIONS UNDER A DEFERRED COMPENSATION CONTRACT Employee deferred compensation contracts have come into widespread use in the United States. The usual type of employee deferred compensation contract is one under which the employer promises to make compensation payments to the employee at specified times in the future (normally after retirement), or, in the event of the employee's death, to his heirs. In the typical situation the right to receive the future payments is subject to substantial conditions, such as the employee's making himself available for consultation after retirement, and the employee's not entering into a business competitive with that of his employer. Under existing law, it is well established that the usual type of deferred compensation contract is productive of taxable income to the employee (or his heirs) only when, as and if the future compensation is paid by the employer to the employee, and it is clear that the employer gets a deduction not when the potential liability to make future compensation payments to the employee comes into existence but only when such payments are, in fact, made by the employer. But suppose the employer were to fund his potential liability to pay deferred compensation by paying over the amount of such potential liability to a trustee for disbursement by the trustee to the employee in accordance with the terms of the contract. Under such circumstances, there is danger under existing law that the employee might be held to realize taxable income in the full amount of the funded potential liability even though the employee's right to receive anything is in futuro and conditional, or that the employer might be held to get no deduction in respect of the deferred compensation either at the time that actual payments thereof are made to the employee or at any other time. To allow the mere act of funding of deferred compensation obligations to produce income tax liability to an employee or to negate the right of the employer to a deduction is obviously unfair and unreasonable. Instead of perinitting uncertainties to exist that discriminate against the funding of deferred compensation agreements, our tax laws should specifically sanction such funding in order to give employees a more solid base for their future security than the mere unsecured promise of the employer to pay. The code should accordingly be amended to provide that, not withstanding payment by the employer of deferred compensation to a trustee for disbursement by the trustee to the employee in accordance with the applicable contract, the employee shall be taxable only when and as he actually receives the deferred compensation and the employer shall be entitled to a deduction in the amount of and at the time of the actual payment of the deferred compensation to the employee. This would not permit employees to escape any tax liabilities, nor give employers unintended deductions, nor result in any loss of tax revenues to the Government. Its only effects would be to eliminate the possibility that employees might incur substantial tax liabilities before they are in receipt of spendable income, and to make certain that employers get appropriate deductions for compensation paid. The bill which became the Revenue Act of 1954 (H. R. 8300, 84th Cong.), as passed by the House, contained provisions (sec. 401 (c), 402 (b), and 403 (a)5) which would have largely eliminated the defects in existing law and permitted an employer to fund a deferred compensation obligation without tax incidence to the employee and without loss of a compensation deduction to the employer. These provisions were, however, eliminated from the bill by the Senate Finance Committee without comment. It is respectfully submitted that provisions of this sort should now be incorporated in the code. Hon. WILBUR D. MILLS, WASHINGTON, D. C., January 6, 1958. Chairman, Committee on Ways and Means, United States House of Representatives, Washington, D. C. DEAR SIR: In response to the late Chairman Cooper's announcement on September 11, 1957 on the general tax revision hearings which are being held by the Committee on Ways and Means, we respectfully suggest that the problem described in the following paragraphs and the attached technical memorandum merits the serious consideration of your committee. Taxpayers who purchase or otherwise acquire in a taxable transaction the assets of other businesses find themselves in an unfavorable tax position since the purchase price which is attributable to goodwill and other intangibles becomes frozen capital. Under current law no depreciation or amortization deduction is allowed for the purchase price attributable to such assets. This treatment of the cost of goodwill and other intangibles is inequitable for the reason that it discriminates against a taxpayer who purchases goodwill as compared with the taxpayer who, through deducting currently the costs of advertising, promotion, research, and similar expenses, creates goodwill. We therefore suggest that your committee give serious consideration to amending the 1954 code retroactively to permit the amortization of purchased goodwill and other intangibles. Attached to this letter is a memorandum setting forth at greater length the principles upon which we base this suggestion. Very truly yours, LYBRAND, ROSS BROS. & MONTGOMERY. INTERNAL REVENUE CODE SHOULD BE AMENDED TO PERMIT AMORTIZATION OF PURCHASED GOODWILL AND OTHER INTANGIBLES The code presently contains no provision dealing specifically with the writeoff of purchased goodwill, trademarks, trade names, secret processes and formulas, and other like intangibles. However, the following long-standing Treasury regulation effectively bars any current writeoff, requiring proof of complete abandonment or termination before any recovery of capital outlay is deductible: "Intangibles. If an intangible asset is known from experience or other factors to be of use in the business or in the production of income for only a limited period, the length of which can be estimated with reasonable accuracy, such an intangible asset may be the subject of a depreciation allowance. Examples are patents and copyrights. An intangible asset, the useful life of which is not limited, is not subject to the allowance for depreciation. allowance will be permitted merely because, in the unsupported opinion of the taxpayer, the intangible asset has a limited useful life. No deduction for depreciation is allowable with respect to goodwill. For rules with respect to organizational expenditures, see section 248 and the regulations thereunder." The reasons why the code should be amended to permit current recovery through amortization of purchased goodwill and other intangibles are twofold: No (1) The amendment is desirable to conform tax accounting with generally accepted principles of accounting. (2) The amendment is necessary to end the existing highly discriminatory treatment under the Internal Revenue Code of taxpayers making nonrecoverable capital outlays for intangibles. AMENDMENT WOULD CONFORM TAX LAW WITH ACCOUNTING PRINCIPLES The amortization of goodwill and other intangibles is discussed in the American Institute of Accountants, Accounting Research Bulletin No. 43, chapter 5, paragraphs 5 to 7. Two general classifications are made: Type (a)-includes, together with other intangibles, goodwill as to which there is evidence of limited duration; and Type (b)-includes, together with other intangibles, goodwill generally and going value having no such limited term of existence and, at time of acquisition, no indication of limited life. Paragraph 5 provides for amortization of type (a) intangibles and paragraph 6 permits amortization where type (b) becomes type (a). Amortization is made by systematic charges in the income statement. Goodwill, going value, trademarks, trade names, secret processes and formulas, and like intangibles acquired by purchase constitute type (b). As stated in paragraph 7 of the bulletin: "When a corporation decides that a type (b) intangible may not continue to have value during the entire life of the enterprise it may amortize the cost of such intangible by systematic charges against income despite the fact that there are no present indications of limited existence or loss of value which would indicate that it has become type (a), and despite the fact that expenditures are being 1 Sec. 1.167 (a)-3. 20675-58-pt. 239 made to maintain its value. The plan of amortization should be reasonable; it should be based on all the surrounding circumstances, including the basic nature of the intangible and the expenditures currently being made for development, experimentation, and sales promotion. Where the intangible is an important income-producing factor and is currently being maintained by advertising or otherwise, the period of amortization should be reasonably long." The proposal that intangibles be treated as a deferred expense is based on the nature of the intangibles involved. Goodwill, trademarks, trade names, secret processes and formulas are valuable to a purchaser only if, in the foreseeable future, they will provide a means of earning profits (called superprofits) in excess of a normal or average rate of return on investment. Going value represents the initial advantage in acquiring a functioning business organization rather than expending time and effort to reach that stage. The purchaser has no guaranty that superprofits will be earned at all but, based on appraisal of the circumstances, is willing to pay for an amount expected to be earned for a limited period from the carryover of customers, products, names, etc. Going value is an advantage which is based primarily on the time factor and varies with the size of the purchased business and the skill and enterprise of the purchaser. The purchaser cannot expect to realize superprofits indefinitely because sooner or later the retention of customers and realization of profits will be based upon the ability, effort, policies, and good fortune of the purchaser. Under the principle of matching costs with revenues, the cost of possible temporary advantage from goodwill purchased should be prorated against expected revenues and profits. The efforts of the purchaser to earn superprofits in the future will be through expenditures for development, experimentation, sales promotion, advertising, attraction of superior management by adequate compensation plans and incentives, etc. Profitable managerial policies must be continued and improved. Favorable circumstances and good fortune must be present, over which no control may be exercised. General or industry-wide conditions may prevail over any factors and thus eliminate superprofits. It is reasonable, therefore, that the cost of such purchased intangibles be written off during the most likely period of benefit from carryover. The contention that some elements may be present permanently appears to be unsound and unrealistic. The intangibles involved are not static but must be constantly renewed; they may be compared to a continuously burning fire. It is illogical to deduct the future cost of advertising and research currently and maintain as permanent capital outlay the price evaluated for advertising, research, etc., expended in the past. Modern competitive conditions, means of mass advertising, and accelerated pace of technological change also indicate a realistic need for early writeoff of such purchased intangibles. Changes in processes and products are more commonplace because of increased emphasis on research. The goodwill attached to existing products may vanish with the product because of better products. Even the customers may change because of greater mobility in transportation and communication. These factors also affect trade customers, employees, and the consuming public. Mere passage of time and ordinary rate of human mortality result in expiration of goodwill and need for its continual rebirth. The value of a going concern is not a permanent and exclusive advantage nor based on superior earnings. It is only the lag in developing a going business and should be amortized accordingly. The Securities and Exchange Commission has approved financial statements showing the writeoff of purchased goodwill by charges to earnings and it endorses the principles of amortizing intangibles as stated in Accounting Research Bulletin No. 43. In past years the commission has raised inquiries as to propriety of accounting where registrants have included goodwill indefinitely in the financial statements. As a result, numerous companies have amortized goodwill in the financial statements. AMMENDMENT WOULD END PRESENT DISCRIMINATION AGAINST The Internal Revenue Code of 1954 added two significant new sections to the law relating to: Research and experimental expenditures (sec. 174) and corporate organization expenditures (sec. 248). In each case the expenditures may, 2 Rappaport SEC Accounting Practice and Procedure, p. 61 (Ronald Press Co., 1956). |