money, and you pay a tax on it because it is this year's income, and you pay this year's brackets on this amount of income.

If you have a piece of property that you hold 10 years and you sell that piece of property at a large profit because you have invested and held on to that with an expectation of profit, and you have held it for 10 years, and all your profit falls in 1 year, if you had to pay ordinary rates on that profit, the taxpayer receives a very unfair treatment.

He can say, "That profit arose over a 10-year period, and it is unfair to tax me in these very high brackets by lumping that profit in 1 year." But then, a rule of thumb has been fixed for taxing capital gains which will not stand up, as I see it. Probably, under perfect theory, you should spread that profit over the years that it was earned. But from an administrative standpoint, I do not think it can be handled

that way.

Mr. KEOGH. When you make a suggestion like that, are you not opening up an area that undoubtedly would contain many administrative problems?

Mr. GAMBILL. I am. That is right.

Mr. KEOGH. I might hold a piece of property for 15 years, and the depreciation in its value might have taken place last week. Mr. GAMBILL. That is possible, too.

As I point out, I do not think we can, from a practical standpoint, do much about it, because of the administrative difficulty.

Mr. KEOGH. If you concede that the basic, if not the principal motivation for the imposition of the tax is to gain revenues, then would you not agree that anything that is done that expedites the turnover of capital assets, rather than delaying the turnover, would be in consonance with that objective?

Mr. GAMBILL. Of course, you are absolutely correct there, because I am sure there is more trading going on under the 6-month than the 12-month holding period. There are more transactions.

Mr. KEOGH. And more would go in a 3-month period than a 6-month.

Mr. GAMBILL. It certainly would, and that is probably 1 of the things that was thought about when we fixed a 6-month period. Mr. KEOGH. Thank you very much, Mr. Chairman.

Mr. EBERHARTER. I just wanted to add, Mr. Gambill: It is contended, and particularly with reference to trading in securities, in stocks and bonds, that if it were lowered to a 3-month period instead of 6 months, there would be such an increase in volume in the trading that it would bring in more revenue.

Mr. GAMBILL. That is right.

Mr. EBERHARTER. I wonder whether that is true or not.

Mr. KEOGH. Will the gentleman yield to me before the answer is given?

Mr. EBERHARTER. If Mr. Gambill consents.

Mr. GAMBILL. Yes.

Mr. EBERHARTER. Go ahead.

Mr. KEOGH. I suppose nobody knows with mathematical accuracy. The only way to find out, I suggest, is to try it.

Mr. EBERHARTER. Do you want to add anything to that?

Mr. GAMBILL. I am not sure of my position, but I think I would agree, or would predict, at least, that if we had a holding period of 3 months instead of 6, there would be more turning over.

Mr. EBERHARTER. And more taxes?

Mr. GAMBILL. Yes; provided it was turning over gains all the time. But I think that would happen.

Mr. EBERHARTER. Thank you very much, Mr. Gambill.

Mr. GAMBILL. Thank you very much.

Mr. FORAND. We thank you very much, sir.

The committee will now stand adjourned until 2 o'clock, at which time our first witness will be Mr. James K. Hall.

(Thereupon, at 12: 15 p. m., the committee recessed, to reconvene at 2 p.m.)

AFTERNOON SESSION

Mr. FORAND. The committee will be in order.

Our first witness this afternoon is Mr. James K. Hall.

Mr. Hall, for the purpose of the record will you identify yourself, please?

STATEMENT OF JAMES K. HALL, PROFESSOR OF ECONOMICS, UNIVERSITY OF WASHINGTON, SEATTLE, WASH.

Mr. HALL. My name is James K. Hall, professor of economics, University of Washington, Seattle, Wash. I appear here at the invitation of the committee.

Mr. FORAND. Do you have a prepared statement, Mr. Hall?

Mr. HALL. I do.

Mr. FORAND. You may either read your statement or file it for the record and talk extemporaneously on it, whatever you want to do.

Mr. HALL. Mr. Chairman, may I have the prepared statement entered into the record? I have a brief synopsis of several pages which I will read.

Mr. FORAND. Without objection, your complete statement will be placed in the record.

(The statement is as follows:)

THE ACCUMULATED EARNINGS TAX

The accumulated earnings tax, code sections 531 to 537 inclusive, of the 1954 Internal Revenue Code, is the statutory successor to code section 102 of the Internal Revenue Code of 1939. The purpose of the predecessor, as well as the successor, statute is to protect the public revenues by the prevention of personal income-tax avoidance through the improper and unreasonable containment of corporate earnings within the corporation rather than their distribution as dividends to the shareholders. To the extent the earned surplus of a corporation is unreasonably increased at the expense of dividend distributions, the base of the personal income tax is diminished for application of the progressive schedule of rates and the public revenues suffer. The heavy dependence upon the personal income tax by the Federal Treasury to provide the requisite revenues strongly suggests the need for alertness by the Treasury and the Congress to prevent erosion of the tax base, as well as the inequity in the distribution of the burden of the personal tax, through the unreasonable retention of corporate earnings as a tax-avoidance device available to those who own and control corporations. The accumulated earnings tax is the only tax instrument of general application which stands in support of the progressive tax rate structure of the personal tax and the avoidance of these rates by the unreasonable accumulation of corporate earnings. Thus the measure of the effectiveness of the schedule of progressive rates of personal tax to a significant extent is determined by the operation of the accumulated earnings tax as a meaningful and effective instrument in preventing tax avoidance through the corporate device. In this connection it should be emphasized that the revenue obtained directly through the application of this

penalty tax is no indication of its importance; rather, it is the extent to which the revenue from the personal income tax is maintained and protected.

It is important to note that Congress consistently endeavored to strengthen the statute from its adoption in 1913 to 1954 by positive amendments, as well as by rebuffing efforts designed to create weakness in statute application and enforcement. A major factor contributing to the ineffectiveness of the statute prior to 1938 was the necessity of proving intent or purpose to avoid the personal tax through corporate surplus accumulations by the Treasury. The insertion of subsection 102 (c) in the Revenue Act of 1938 was intended to strengthen the statute by making unreasonable corporate accumulation determinative of the purpose to avoid the personal tax, and by placing on the taxpayer the burden of proving by the clear preponderance of the evidence that the purpose of avoidance was not present. As a result of this amendment, the statute acquired an enforcibility which it did not have during the prior period. It would appear that the strengthening of the statute came none too soon, with the substantial increase in the rates of the personal tax in the Revenue Act of 1942, which has been maintained at a high level since. In the Internal Revenue Code of 1954 Congress reversed its policy of prior years and instituted changes in the renamed and renumbered statute, which may have serious implications as to statute enforcibility. The more important changes singly and in the aggregate appear to accomplish one purpose only, namely, to weaken the statute. The more significant changes in the statute are (1) the shift in the burden of proof-which may not have been accomplished to the extent implied in the statute, (2) the elimination of the "immediacy test,"3 (3) the requirement that the tax is to apply only to that portion of the retained earnings unreasonably accumulated,* and (4) the provision of a $60,000 accumulated earnings credit.

1

BURDEN OF PROOF

As requirements precedent to the application of the accumulated earnings tax, there must be (1) an intent or purpose to prevent the imposition of the personal income tax on the shareholders of the corporation, and (2) the accomplishment of the purpose by the corporate retention of earnings. The basic issue of whether there is liability arises only when corporations do accumulate earnings, with the question then to be confronted as to the existence of the interdicted purpose, namely, a purpose or intent to avoid the personal tax.

The experience of the Treasury in its endeavor to apply effectively section 102 and its predecessor sections prior to the Revenue Act of 1938 constitutes most convincing evidence that, for the tax to have any real effectiveness, the burden of proof must be placed upon the taxpayer corporation to show by the clear preponderance of the evidence that the purpose of personal tax avoidance was not present, when the Treasury finds that unreasonable corporate retention of earnings has occurred. This was recognized by the Congress in its insertion of subsection (c) in section 102 in the Revenue Act of 1938. In its report on the Revenue Act of 1936, the Ways and Means Committee of the House took occasion to declare

"It is true that, if the Government can prove a corporation is formed or availed of for the purpose of preventing the imposition of surtaxes upon its shareholders, a special surtax can be collected from the corporation under section 102 of the existing law. The difficulty of proving such purpose, however, has rendered section 102 more or less ineffective." " (Italic ours.)

The Senate Finance Committee in its report on the Revenue Act of 1938 stated:

"Your committee is dealing with this problem [that much tax avoidance occurs through the unreasonable accumulation of corporate earnings and profits * * * in the case of operating companies] where it should be dealt withnamely, in section 102, relating to corporations improperly accumulating surplus

1 Other changes include the allowance of dividends paid within 2 months subsequent to the close of the taxpayer's fiscal year as a reduction in the base of the tax (sec. 535 (a), sec. 535 (c) (4), and sec. 563 (a)), and certain technical changes in tax base computation (sec. 535).

2 Section 534: For discussions of the burden of proof see Andrew Kopperud and J. Bruce Donaldson, "The Burden of Proof in Accumulated Surplus Cases" (35 Taxes 827 (November 1957), and Richard B. Barker, "Penalty Tax on Corporations Improperly Accumulating Surplus" (35 Taxes 949 (December 1957)).

3 Sec. 537.

4 Sec. 535 (c) (1).

Sec. 535 (c) (2).

74th Cong., 2d sess., H. Rept. 2475, p. 5.

The proposal is to strengthen this section by requiring the taxpayer by a clear preponderance of the evidence to prove the absence of any purpose to avoid surtaxes upon shareholders after it has been determined that the earnings and profits have been unreasonably accumulated. This will clearly shift the burden of proof to the taxpayer in such cases. The committee believes that substantial revenue will result from this change although no exact estimate of such revenue has been made by the Treasury Department. A reasonable enforcement of this revised section will reduce tax avoidance to a minimum and increase the revenues from sources where there is ability to pay."

7

Further "This subsection of the bill provides that the fact that the earnings or profits are accumulated beyond the reasonable needs of the business shall be determinative of the purpose to avoid surtax upon shareholders unless the corportation by the clear preponderance of the evidence shall prove to the contrary. Under existing law, an unreasonable accumulation is merely prima facie evidence of purpose to avoid surtax upon shareholders. Consequently, it has been argued that the only effect of an unreasonable accumulation is to shift to the taxpayer the burden of going forward with the evidence relating to purpose. Under the amendment, however, it is clear that an unreasonable accumulation puts upon the taxpayer the burden of proving by the clear preponderance of all the evidence submitted that it did not have the purpose of avoidance.” *

Section 533 (a) of the accumulated earnings tax, as in the case of section 102 (c), places the burden of proof upon the taxpayer corporation by providing— "Unreasonable accumulation determinative of purpose.-For purposes of section 532, the fact that the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business shall be determinative of the purpose to avoid the income tax with respect to shareholders, unless the corporation by the preponderance of the evidence shall prove to the contrary.” However, section 534 of the Internal Revenue Code of 1954 is a new provision with reference to the burden of proof. It is as follows:

"SEC. 534. BURDEN OF PROOF

"(a) GENERAL RULE.-In any proceeding before the Tax Court involving a notice of deficiency based in whole or in part on the allegation that all or any part of the earnings and profits have been permitted to accumulate beyond the reasonable needs of the business, the burden of proof with respect to such allegation shall

(1) if notification has not been sent in accordance with subsection (b), be on the Secretary or his delegate, or

"(2) if the taxpayer has submitted the statement described in subsection (c), be on the Secretary or his delegate with respect to the grounds set forth in such statement in accordance with the provisions of such subsection. The procedure established by section 534 is that the Secretary, i. e., Commissioner, may notify the taxpayer of the proposed issuance of a deficiency assessment under the accumulated-earnings tax. Upon receipt of this notification of an impending deficiency assessment, the taxpayer "may submit a statement of the grounds (together with facts sufficient to show the basis thereof) on which the taxpayer relies to establish that all or any part of the earnings and profits have not been permitted to accumulate beyond the reasonable needs of the business."" Should the Commissioner fail to notify the taxpayer of the impending deficiency assessment, or should the taxpayer, upon notification, fail to submit a statement of grounds, the burden of proof as to whether the retained earnings represent an accumulation beyond the reasonable needs of the business rests upon the party failing to go forward. Should the Commissioner follow the procedure of notification specified in section 534 and the taxpayer respond with a statement of grounds, the burden of proof with respect to the allegation of the existence of an unreasonable accumulation of earnings resides with the Commissioner.10

Section 534 of the 1954 code was apparently a congressional response to its dissatisfaction with the administration of section 102 of the 1939 code by the

775th Cong., 3d sess., S. Rept. 1567, pp. 4-5.

8 Ibid., p. 16.

1954 code, sec. 534 (c).

10 An amendment to sec. 534 by Public Law 367, secs. 4 and 5, 84th Cong., 1st sess. August 11, 1955, made retroactive the application of sec. 534 of the Internal Revenue Code of 1954 to proceedings pending, tried on their merits, under sec. 102 of the 1939 code subsequent to August 11, 1955.

Internal Revenue Service." Evidence and testimony were presented to congressional committees to the effect that cases were initiated by the Service on inadequate grounds and under circumstances of insufficient screening, that the expense and difficulty of litigating a section 102 case caused some taxpayers to submit to proposed deficiencies, that to proceed with the burden of proof in attempting to justify an accumulation of earnings as reasonable was an expensive undertaking for taxpayers, and that revenue agents resorted on occasion to taxpayer coercion for settlement of other issues by suggestions of deficiency assessments under section 102. As a means of alleviating these unsatisfactory aspects of section 102 administration, Congress endeavored to place the burden of proof on the Treasury under circumstances of taxpayer compliance with statement submission as provided in section 534 (c).

It appears, however, that section 534 of the 1954 code may not serve the purpose for which it was designed. It may, instead, create more uncertainties and risks for taxpayers than section 102 of the 1939 code. The Commissioner's present tactics with respect to section 534, which has received substantial support from the Tax Court, is that the ultimate burden of proof rests with the taxpayer despite section 534 and taxpayer submission of a statement of grounds in justification of his accumulation. In this respect, the position of the Commissioner is in sharp contrast with that of a predecessor in office, T. Coleman Andrews, who stated shortly after assuming his post as Commissioner of the Internal Revenue Service that "the Government should assume the burden of proof" in section 102 cases and that "as Commissioner of Internal Revenue I'm willing to accept that burden."1 Apparently, the Service has realized that to proceed with litigation on pending section 102 cases or on cases involving section 532 corporations, and to accept the burden of proof as specified in section 534, is to place the Service in a most difficult, if not impossible, situation in which efforts to enforce the statute are attended with almost insuperable difficulties.

12

The position of the Commissioner, as stated by the Tax Court in the Pelton Steel Casting Co. case," decided April 25, 1957, was that the respondent "contends, essentially (1) that while section 534 of the 1954 code has established a new procedure in accumulated-earnings tax cases, it does not necessarily apply to all such cases; (2) that, even where applicable, the critical factor in each is the purpose of the accumulations; and (3) to that end the burden of proof, or the risk of nonpersuasion, as it existed under prior law, has remained unchanged. Thus, respondent argues that it was not necessary for him to have made the determination stressed by petitioner and, further, that, even if respondent is unsuccessful in disproving one or all of the grounds relied upon by petitioner with regard to whether the questioned accumulation exceeded the reasonable needs of its business, respondent can still prevail on the ultimate and controlling issue of purpose as the same can be established entirely apart from reasonable business needs." [Italic ours.]

In support of the Commissioner's position, the Tax Court declared that there "is no expression of intent in the applicable 1954 code sections or in the legislative history to alter or reverse the existing law relative to burden of proof except with respect to accumulation of profits beyond the reasonable needs of the corporation, and then only if the requirements of section 534 are met, and, of course, if the issue is essential to decision."

Further: "To avoid the tax on undistributed section 102 net income, the burden remained with petitioner to prove the absence of a purpose to avoid the imposition of surtax upon its shareholders by the failure to distribute, in whole or in part, earnings or profits accumulated during the taxable year.

"The question of whether or not petitioner's earnings and profits were permitted to accumulate beyond the reasonable needs of the business is not essential to a decision in this case, as petitioner has failed to sustain its burden of proving the absence of the interdicted purpose."

11 See H. Rept. 1337, 83d Cong., 2d sess., pp. 51-54, and S. Rept. 1622, 83d Cong., 2d sess., pp. 68-72.

12 Interview with T. Coleman Andrews, United States Commissioner of Internal Revenue, Square Deal for Taxpayer, U. S. News & World Report, May 8, 1953, p. 39.

13 Docket No. 50,455, par. 28.20. P-H T. C. 1957. This case involved a deficiency assessment under sec. 102 of the 1939 code for the petitioner's tax year ending November 30, 1946. The petition of taxpayer was filed on September 8, 1954, in response to a notice of deficiency mailed to petitioner August 24, 1953. On August 11, 1955, sec. 534 of the 1954 Internal Revenue Code was amended by Public Law 367, ch. 805, secs. 4 and 5. Thereafter, on September 7, 1955, a notification was mailed to petitioner in the proper manner, and on October 6, 1955, petitioner timely submitted its statement to respondent. The case was heard on December 1 and 2, 1955.