CHAPTER 44

TAX ON UNDISTRIBUTED INCOME OF CORPORATIONS

The provisions which imposed this tax were contained in the 1916 Law as amended. No similar tax is imposed by the Revenue Act of 1918. The purpose of the tax was to counteract the tendency of corporations to permit their earnings to accumulate as surplus, which action, although not taken with the intent of evading the surtaxes, would, nevertheless, operate to reduce the surtaxes paid by individual stockholders. Under this provision of the law a corporation could retain any part or all of its earnings for the year 1917, provided it was willing to pay a tax of 10% upon such portion thereof as was not (a) actually invested and employed in the business, (b) retained for employment in the reasonable requirements of the business or (c) invested in obligations of the United States issued after September 1, 1917. If the earnings of the corporation were accumulated with a fraudulent purpose or intent of preventing the imposition of the surtaxes on the stockholders, such stockholders could be taxed under the 1916 Law as though the earnings had been distributed.2 The tax on undistributed income of corporations was not intended to take the place of this provision, but was intended to operate in cases where the annual net income was retained beyond the reasonable requirements of the business of the corporation and yet not with fraudulent

1 Revenue Act of 1916, § 10 (b), added by Revenue Act of 1917. 2 Revenue Act of 1916, § 3, corresponding to Revenue Act of 1918, § 220.

intent to avoid the imposition of the surtaxes on the stockholders of the corporation.

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Tax Repealed by Present Law. The provision of the 1916 Law imposing the tax on undistributed income of corporations is repealed by the 1918 Law, except to the extent that it "shall remain in force for the assessment and collection of all taxes which have accrued thereunder." It is also expressly provided that "except as otherwise provided in this Act, no taxes shall be collected under Title I of the Revenue Act of 1916 as amended in respect to any period after December 31, 1917."3 seems clear that no tax can be imposed with respect to any income received in 1918. If the phrase "any period after December 31, 1917," has reference to the point of time six months after the close of the taxable year, at which time the status of the income for the purpose of this tax was to be determined, then the repealer amounts to practically a complete nullification of the tax, since in the great majority of cases that point of time fell after December 31, 1917. A reasonable view, however, seems to be that this tax will be held to apply to all incomes earned in 1917, and in the case of corporations whose fiscal years ended in 1918, the undistributed income should be apportioned as was provided in the case of corporations whose fiscal years ended in 1917. As to the 15% tax imposed in cases where the Secretary of the Treasury should find that any 'amount so retained at any time for employment in the business is not so employed or is not reasonably required in the business" it seems that such tax does not accrue until the finding of the Secretary has been made, and if the tax did not accrue before the date of repeal of the law no tax can be assessed under the law.

Corporations Subject to the Tax. The law provided that the tax should apply to "every corporation, jointstock company or association or insurance company."4

3 Revenue Act of 1918, § 1400.

4 See T. D. 2736.

F. T.-44

The tax, undoubtedly, applied to every domestic corporation and to such foreign corporations as had their principal office or place of business in the United States, that is, the class of corporations, somewhat indefinitely referred to in the 1916 Law as "resident corporations." It was ruled in the case of an English corporation whose total net income from sources within the United States was less than half of the entire income from all sources, and whose sole American stockholder held less than onefifth of one per cent., the tax applied to the undistributed earnings of the taxable year derived from sources within the United States. It was also ruled that corporations with fiscal years ending in 1917 were subject to the tax on that proportion of their net income allocated to the year 1917.6 Corporations or organizations exempt from the income tax were exempt from the undistributed profits tax.7

FOREIGN CORPORATIONS. A foreign corporation was held not to be relieved from this tax because it remitted to its home office within six months after the close of its taxable year the full amount of net income derived from business transactions from sources within the United States, such remittances not being a distribution of net earnings of the taxable year within the meaning of the law. Any part of the net income of a foreign corporation derived from sources within the United States which remained undistributed six months after the close of the taxable year, even though remitted to the home office, were considered taxable unless it was disposed of as specified in the law. Any disposition of the net earnings derived 5 Telegram from Treasury Department dated July 6, 1918; I. T. ' S. 1918, 3591. 6 T. D. 2736. An earlier informal ruling (Telegram from Treasury Department dated July 5, 1918; I. T. S. 1918, ¶ 3590), seemed to indicate that only corporations whose fiscal years ended within six months prior to October 3, 1917, were taxable, and that such corporations were taxable on their entire net income for the fiscal year without apportionment.

7 T. D. 2736.

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from sources within the United States which could not be exactly allocated, might be determined on a proportionate basis, that is, on the same proportion as the income from within the United States bore to the entire income of the corporation from the entire business transacted by it, both within and without the United States.8

Undistributed Net Income. The undistributed net income referred to in this provision of the law was the income for the taxable year, either the calendar year or the fiscal year accordingly as the corporation reported on the basis of the calendar or a fiscal year. The first year for which the tax was imposed was the calendar year 1917 or, if the corporation had elected to report its net income for the fiscal year, the fiscal year ending in 1917; in the latter case, however, the tax was held to apply only to the proportion of the taxable undistributed net income for such fiscal year as the period between January 1, 1917, and the end of the fiscal year was to the whole of such fiscal year. For example, if the fiscal year of a corporation ended on June 30, 1917, and its taxable undistributed income for that fiscal year was $50,000 only onehalf thereof or $25,000 was held to be taxable, since only one-half of the fiscal year was in the calendar year 1917. This provision of the law had no reference to the income, profits or surplus earned or accumulated by the corporation prior to January 1, 1917, whether or not such income, profits or surplus was employed in the business. The fact that surplus accumulated prior to January 1, 1917, might not have been employed in the business, or retained for the reasonable requirements of the business, might, however, bear upon the taxability of the income for the current year, since it was difficult to earmark the current income and employ it in business while surplus previously accrued was not so employed. Within the

8 Letter from Treasury Department dated July 23, 1918; I. T. S. 1918, 3615. The application of these rulings to foreign corporations which had no office or place of business in the United States was doubtful.

meaning of this provision of the law the net income, whether represented by liquid assets or otherwise, for the current year was distributed only when paid to the stockholders as dividends. Another provision of the 1916 Law, respecting dividends,10 deemed such dividends to have been paid out of the most recently accumulated undivided profits or surplus. The burden was upon the corporation seeking to establish a distribution in the current year of profits of the preceding taxable year to show that all the earnings of the current year had been first distributed. In determining the source of earnings from which a particular distribution was made, a corporation was, however, permitted to treat the earnings of the current year as reduced by payments for income and excessprofits taxes, or, if keeping its accounts upon an accrued basis, by proper reserves for such taxes, although such payments or reserves were not deductible in computing the income of the corporation for income and excess-profits taxes.1 11 The difference between the amount of net income shown in its return of annual net income and the amount thereof distributed by the corporation at any time before the expiration of six months after the end of its fiscal or calendar year, were held to constitute the undistributed net income which this provision of the law taxed. From such amount of undistributed net income the following items might be deducted: (a) the amount of any income taxes imposed by authority of the United States, paid by the corporation within the taxable year from income of that year; (b) that portion of such undistributed net income which was actually invested and employed in the business or; (c) retained for employment in the reasonable requirements of the business, or (d) invested in obligations of the United States issued after September 1, 1917. If the taxable year began on January 1, 1917, the remainder was the amount upon which the tax was assessed.

9 T. D. 2736.

10 Revenue Act of 1916, § 31 (b) added by Revenue Act of 1917. 11 T. D. 2736; T. D. 2678; T. D. 2659.