CHAPTER XXV DEDUCTIONS FOR INTEREST The passage of the 1918 law greatly simplified the procedure for deducting interest paid. Previous laws had imposed restrictions upon corporation deductions for this purpose, making it necessary to distinguish interest payments very sharply from other payments.1 Deductions allowed to individuals.LAW. Section 214. (a) . (2) All interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917), the interest upon which is wholly exempt from taxation under this title as income to the taxpayer, or, in the case of a nonresident alien individual, the proportion of such interest which the amount of his gross income from sources within the United States bears to the amount of his gross income from all sources within and without the United States;2 Deductions allowed to corporations.3 LAW. Section 234. (a) . . . . (2) All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness The arbitrary restriction imposed by the 1913 and subsequent laws, its effect and the proper method of arranging the accounts in order to prevent unnecessary burdens are fully discussed in Income Tax Procedure, 1919, pages 454-463. See Chapter XXXIII, "Non-Resident Aliens." [Former Procedure] 1917 LAW. "Section 5. (a) . . . . Second. All interest paid within the year on his indebtedness except on indebtedness incurred for the purchase of obligations or securities the interest upon which is exempt from taxation as income under this title;" This restriction was introduced by the 1917 law. Before that time an interest deduction was not disallowed because incurred for the purchase of tax-exempt securities. It will be noted that the 1918 law introduces the words "or carry" in speaking of tax-exempt securities. 'For a discussion of the limitation which formerly applied in the case of corporations, see Chapter XV of Excess Profits Tax Procedure. incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917), the interest upon which is wholly exempt from taxation under this title as income to the taxpayer, or, in the case of a foreign corporation, the proportion of such interest which the amount of its gross income from sources within the United States bears to the amount of its gross income from all sources within and without the United States;* Interest which is deductible.-Under the 1918 law all interest paid on indebtedness by an individual or a corporation is deductible, except interest paid on money borrowed to purchase or carry certain securities the interest upon which is wholly exempt from taxation. United States obligations issued prior to September 24, 1917, including first or 32 per cent Liberty bonds, are exempt from taxation and interest on money borrowed to purchase or carry such obligations is not deductible. This date, September 24, 1917, marked a change in policy by the United States Government. The understanding was that after that date securities entirely exempt from taxation were not to be issued, and, consequently, the restriction on the deduction for interest was not applied to interest paid on money borrowed to carry obligations of the United States issued thereafter." However, a peculiar situation has developed. The 334 per cent Victory notes issued in 1919 were entirely free from taxation, but no change was made in sections 214 and 234 of the income tax law so that interest on money borrowed to pur 'See Chapter XXXIII, "Non-Resident Aliens." "[Former Procedure] The 1917 law did not allow as a deduction interest paid on indebtedness incurred for the purchase of obligations of the United States issued after September 24, 1917, to the extent to which any part of the interest from such obligations was tax-exempt. The 1917 law entirely omitted the reference to obligations of the United States, and it was therefore held that any interest paid on indebtedness in respect of the $5,000 of second Liberty bonds (the interest on which principal amount of bonds was exempt) was not deductible. This restriction was made effective by the following directions in section E, page 2 of income tax form 1040 (revised January, 1918): chase or carry the 334 per cent notes is at present fully deductible in income tax returns. When the campaign for their sale was being made one of the most potent arguments used was that a taxpayer who had a large income from other sources might borrow money to buy the tax-exempt Victory bonds and secure a net return on a margin of 10 per cent invested in the bonds of as much as 26 per cent per annum. In some cases banks loaned 100 per cent of the amount required to buy the bonds which enabled taxpayers to realize a large profit (through the reduction in taxes) without any investment. The size of the savings, of course, depended on several factors: (1) the market price of the bonds; (2) the margin required; (3) the rate of interest charged by banks on the loans, and (4) the size of the tax rate. As the inducement was made by Treasury and other government representatives it would be unjust to curtail the privilege without ample notice to those who acted upon the representations and purchased the bonds. There is a decided menace in the increasing volume of securities wholly taxexempt, but taxpayers are not responsible for the exemptions granted. If the 1918 law is amended in respect of the provision allowing as a deduction interest paid to carry 334 per cent Victory bonds the amendment should not become effective until January 1, 1921. INTEREST ON SCRIP DIVIDENDS DEDUCTIBLE. REGULATION. Interest paid by a corporation on scrip dividends is an allowable deduction. INTEREST ON CERTIFICATES OF DEPOSIT DEDUCTIBLE. In the case of banks and loan or trust companies interest paid INTEREST ON BONDS AND OTHER OBLIGATIONS OF THE UNITED STATES ISSUED SINCE SEPTEMBER I, 1917.— Interest paid. "If indebtedness has been incurred for the purchase of such obligations, find what percentage the amount of such obligations held in excess of $5,000 is of the total amount of such obligations held, and enter in column 5 the same percentage of the interest paid on the indebtedness." 'See page 657. within the year on deposits or on moneys received for investment and secured by interest-bearing certificates of indebtedness issued by such bank or loan or trust company may be deducted from gross income. (Art. 564.) INTEREST ON REAL ESTATE MORTGAGE DEDUCTIBLE. REGULATION. . . . . Interest paid by the taxpayer on a mortgage upon real estate of which he is the legal or equitable owner, even though the taxpayer is not directly liable upon the bond or note secured by such mortgage, may be deducted as interest on his indebtedness. .... (Art. 121.) SHOULD DISCOUNT ON BONDS BE TREATED AS PAYMENT OF INTEREST?-Bonds usually sell at a discount because the interest is fixed at a lower rate than the purchasers of the bonds. think the debtor corporation should pay. Under proper accounting methods the discount is distributed ratably over the life of the bonds. The annual interest paid plus the annual proportion of discount together form the true cost. The Treasury has treated the discount as a loss; therefore the discussion of bond discounts as a deduction will be found in Chapter XXVII, "Losses." 996 BANK OF DEPOSIT MAY DEDUCT INTEREST PAID ON DEPOSITS EVEN THOUGH MOST OF THE ASSETS CONSIST OF TAX EXEMPT BONDS.-An interesting question arises in the case of a bank which pays interest on deposits and invests most of its assets in tax-exempt bonds. A bank had capital and surplus of $1,000,000 and deposits of $10,000,000. Its funds were so invested that the income was as follows: From tax-exempt sources (chiefly municipals).. $300,000 350,000 The interest from tax-exempt bonds not being returnable the bank was not subject to the federal income tax. RULING. Reference is made to the following inquiry: "Is interest paid by a banking firm at the rate of two per cent on deposits subject to check received as a matter of convenience to clients held to be 'interest on indebtedness incurred or continued to purchase or carry obligations, the interest of which is wholly exempt' in case such firm owned only such obligations?" Subdivision (2) of section 234 (a) of the Revenue Act of 1918 provides that a corporation in computing its net income subject to the tax imposed by section 230 of the act shall be allowed to deduct from its gross income among other items "All interest paid or accrued within the taxable year on its indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917), the interest upon which is wholly exempt from taxation under this title as income to the taxpayer, or, in the case of a foreign corporation, the proportion of such interest which the amount of its gross income from sources within the United States bears to the amount of its gross income from all sources within and without the United States; . . . ." It is the ruling of this office that a bank doing a commercial business and receiving deposits upon which it pays interest is entitled to deduct from its gross income shown upon its annual tax return the full amount of interest paid to its depositors. The payment of such interest is one of the ordinary and necessary expenses in the carrying on of its banking business. Although the deposits constitute indebtedness of the bank, such indebtedness was not incurred and is not continued for the purpose of purchasing or carrying obligations, even though the deposits are invested in bonds or other obligations the interest upon which is wholly exempt from income and excess profits tax. (Letter to Lybrand, Ross Bros. & Montgomery, signed by Commissioner Roper, June 24, 1919.) STATE TAXES DEDUCTIBLE AS INTEREST-WHEN?-Notwithstanding the phrase "or any other tax paid pursuant to the contract" a regulation has been issued stating that a corporation paying a state tax or any other than a federal tax for someone else pursuant to its agreement may deduct such 'Section 234 (a-3). |