for distribution as dividends is capitalized and no longer so available. In England, on the other hand, bonus shares are considered an accretion of capital in the hands of the shareholders and so not subject to tax as income.1 Were this view taken in the United States, they would probably be taxed.

In addition to the constitutional restrictions on the meaning of the word "income" which have already been discussed, the United States Constitution makes it impossible to tax municipalities or employees of States or of municipalities. Interest on the bonds or other obligations of States or municipalities cannot, under the Constitution, be subjected to the Federal income tax. The Constitution has also been held to forbid the imposition of income tax on the salaries of the President of the United States and of Federal judges in office at the time of passage of an income tax Act. Income accrued on March 1, 1913, became capital as of that date, and this has had an important effect in connection with the taxation of dividends earned by a corporation before that date, of capital gains from the sale of property acquired before that date, and of interest accrued before that date as well as other items. The sanctity of March 1, 1913, has been continued by all United States income tax laws passed since the adoption of the Sixteenth Amendment. These matters are dealt with in other chapters.2

I.R. v. Blott, [1921] 2 A.C. 171.

See Chapters VI, IX and X.

CHAPTER IX

CAPITAL GAINS AND CASUAL PROFITS

CAPITAL gains are profits which arise as a result of the sale or other disposition of assets in the nature of capital. The simplest case is the purchase of an investment for cash and its sale for a greater amount of cash. If the selling price is less than the cost we have a capital loss. The term capital gain" is peculiar to the United States. In Great Britain such gains come under the more inclusive head of casual profits," unless the person selling the asset is engaged in the business of dealing in such assets. Casual profits also include other gains of a non-recurring nature which arise outside the regular business of the recipient. The British income tax law does not tax casual profits.

We have seen that the United States Supreme Court has defined "income" to include profit gained through a sale or conversion of capital assets, and that the term "gross income" under the United States law includes "gains, profits and income derived . . . from . . . sales, or dealings in property, whether real or personal, growing out of the ownership or use of or interest in such property." 2 It is further provided 3 that, upon the sale or exchange of property, the entire amount of the gain or loss will be recognized as taxable gain or deductible loss except where the law in subsequent sections specifically limits this general provision. Before setting out these limitations we should observe that the law provides rules for determining gain or loss from sales or exchanges of property. It is provided 4 that the gain from such dealings in property shall be the excess of the amount realized therefrom over the basis

I See p. 124.

3 Ibid., Section 203 (a).

• Revenue Act of 1926, Section 213 (a). ♦ Ibid., Section 202 (a).

provided in the Act, and the loss shall be the excess of such basis over the amount realized. In computing the amount of such gain or loss, proper adjustment must be made for any expenditure or item of loss properly chargeable to capital account, and the basis must be diminished by the amount of the deductions for exhaustion, wear-and-tear, obsolescence, amortization and depletion, which have, under the income tax laws, been allowable with respect to such property since its acquisition.1

The amount realized from the sale or exchange of property is the sum of any money received, plus the fair market value of the property (other than money) received.2

The basis, referred to above, varies in different cases. Το set out these bases in any complete or adequate way would be quite beyond the scope of this book. It is an exceedingly technical matter, and abounds in complexities. Nevertheless, it is essential to give some description of them, both because an adequate understanding of this part of the United States law is otherwise impossible, and also because it is necessary in a comparison of the United States law with the British to have a thorough understanding, if not of the United States law itself in this regard, at least of the fact that this feature of it does involve tremendous complications and difficulties.

It must be remembered that before March 1, 1913, it was unconstitutional for the United States Government to impose an income tax. Accordingly, any accretions of capital accrued before that date cannot be subjected to the tax.3 While the general basis for determining gain or loss from sales or exchanges of property is the cost of the property, in the case of property acquired before March 1, 1913, this basis may not always be used. The basis in such cases is cost (or such other basis as may be prescribed by the statute), or value as of March 1, 1913, whichever is greater.4

As has been said, the usual basis is the cost of the property.

In addition to cases of property acquired before March 1, 1913, there are, however, certain exceptions :--1

(1) If the property should have been included in the last inventory, the basis will be the last inventory value thereof;

(2) If the property was acquired by gift after December 31, 1920, the basis will be the same as it would be in the hands of the donor or the last preceding owner by whom it was not acquired by gift ;

2

(3) If the property was acquired after December 31, 1920, by a transfer in trust (other than by a transfer in trust by bequest or devise), the basis will be the same as it would be in the hands of the grantor, increased in the amount of gain or decreased in the amount of loss recognized to the grantor upon such transfer under the law applicable to the year in which the transfer was made; 3

(4) If the property was acquired by gift or transfer in trust on or before December 31, 1920, the basis will be the fair market value of such property at the time of such acquisition;

(5) If the property was acquired by bequest, devise, or inheritance, the basis will be the fair market value of such property at the time of acquisition;

(6) If the property was acquired by an exchange which involved no taxable gain or deductible loss, the basis will be the same as in the case of the property exchanged;

(7) If the property was acquired in an exchange involving the receipt of property as to which no gain or loss was recognized, and also of money and of other property as to which gain or loss was recognized, then the basis will be the same as in the case of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized upon such

With an exception as to property transferred in contemplation of death or by a power of appointment. See Revenue Act of 1926, Section 204.

The 1921 law abandoned, as of December 31, 1920, the previous basis of value as of date of acquisition in the case of property acquired by gift. 3 There are certain exceptions to this exception. See Revenue Act of 1926, Section 204 (a) (3).

I

exchange under the law applicable to the year in which the exchange was made.

The above seven cases do not by any means include all the various exceptions. They are set out as typical of the complications involved, and as the most important exceptions to the general basis of cost. In some cases the basis is the same as it would be in the hands of the previous owner; in other cases determination and computation of the basis involves an apportionment. Enough has been said to give a good general idea of the method employed and of the difficulties involved. The sections of the United States law dealing with the taxation of capital gains are given in full in Appendix II.

It will have been observed that a variation in the basis is frequently required because a prior sale or exchange of property has not resulted in any tax or has not resulted in tax on the full amount of the difference between the basis and the value of the property received in exchange. We must now note the exceptions or limitations to the general rule that a sale or exchange of property results in a taxable gain or deductible loss to the extent of the difference between the cost (or other appropriate basis) of the property and the selling price of the property or fair market value of the property received in exchange. The following paragraphs discuss the more important of these limitations:

(1) The first of these limitations is of a special nature and really has no bearing on the general rule. It is a limitation on the rate of tax applicable to capital gains and also provides a limitation on the deduction of capital losses.1 The normal tax and surtax on capital gains and capital losses is limited to a flat rate of 12%. A capital gain means a taxable gain from the sale or exchange of capital assets. Capital assets are defined as property held by the taxpayer for more than two years (whether or not connected with his trade or business), but the term does not include stock-in-trade or other property which would properly be included in the inventory, if on hand at the close of the taxable year, or property primarily for sale in the course of • See Revenue Act of 1926, Section 208.