For a corporation to be a "mere holding or investment company" is "prima facie evidence of a purpose to escape surtax." Although cases have been presented to the Department, it is believed that no penalty has yet been invoked.

Whether a corporation is retaining profits for the reasonable requirements of the business or accumulating an unreasonable dividend depends upon what the corporation actually does with the profits (T. B. M. 2 and O. D. 106). The section relating to unreasonable profits cannot be used to force the distribution of unnecessary surplus accumulated in years prior to 1918 (0. D. 188), nor under the 1921 act does the provision affect accumulations prior to 1921 (I. T. 1572). Whether a surplus is an unreasonable accumulation of profits depends on facts and conditions such as the volume of business done and the principles of sound business management (S. 1117 overruling S. 153). If the corporation retires part of its common stock and allows the surplus to stand, it would be regarded as having an unreasonable surplus (O. D. 360). A corporation disposing of its property preparatory to winding up its affairs was permitted either to hold the profits from the sale of its assets until the final disposition of all assets or to distribute the profits immediately. If there was an accumulation for the purpose of preventing the imposition of surtaxes upon its stockholders, the profits would be taxed to the stockholders (O. D. 838). A corporation which is accumulating surplus according to the purposes outlined in its charter is not guilty of fraudulent action (A. R. R. 475). Reinvestment of profits by a manufacturing or trading enterprise for the reasonable needs of the business is not a violation of the act (I. T. 1289 and S. M. 2273). The provision to be taxed as a partnership prior to 1924 is dependent on both the unanimous consent of the stockholders and the approval of the Commissioner (I. T. 1668).

X

INTEREST-RENTALS-FOREIGN EXCHANGE

Liberty bond interest. Other interest; annuities. Rentals and leaseholds. Foreign exchange.

FIVE "Liberty Loan" bond authorization acts were passed by Congress commencing soon after the war in 1917 and continuing until 1919. In order that the bonds might be attractive investments to the public they were made entirely exempt from individual and corporation normal taxes and partially exempt from surtaxes and excess profits taxes. Each act carried with it a different exemption of its own and prior issues. The various issues may be summarized as follows:

From July 3, 1923, the total exemption on Liberty bonds and other obligations from surtax was as follows:

$5,000 in the aggregate of (2) to (8) inclusive, in the above tables, together with Treasury bonds, Treasury certificates of indebtedness, and War Savings certificates. This exemption has no time limitation.

$50,000 in the aggregate of (2) to (8) inclusive. This exemption was in force from July 3, 1923, to July 2, 1926.

Before July 2, 1926, therefore, the exemption from surtaxes was $55,000; thereafter, $5,000 (Sec. 1125; Art. 82). Interest from the following obligations of the United States is entirely exempt from income tax:

1. First 32's (No. 1 above); the Victory 334's (No. 9) were also exempt.

2. All obligations issued before September 1, 1917.

3. Postal Savings deposits.

4. Securities issued under the Federal Farm Loan Act of July 17, 1916, as amended March 4, 1923 (Sec. 213 (b) (4)).

Before January 1, 1921, the exemptions in force, which were divisible between the indicated issues in the manner most advantageous to the taxpayer, were:

(a) $5,000-applicable to all taxable issues throughout their life, except (1), (9), and (10).

(b) $5,000—applicable only to 5% War Finance Corporation bonds. These first two exemptions will continue through the life of the issues.

(c) $30,000-applicable only to

(7).

(d) $30,000-applicable only to (7) and (8).

(e) $45,000-applicable to (2) to (6), inclusive; the exemption could not exceed the sum indicated nor 11⁄2 times the amount of the Fourth Loan originally subscribed for and still held at the time of preparing the return. The last three exemptions were to apply until two years after the termination of the war.

(f) $30,000-applicable to (2) to (8), inclusive, until five years after the end of the war.

(g) $20,000-applicable to (2) to (8), inclusive, during the life of the Fifth Loan; the exemption in this case must not exceed the sum indicated nor three times the amount of the Fifth Loan originally subscribed for and still held.

Interest from the First Liberty Loan unconverted (31⁄2's) and from the Fifth (334's) is wholly tax-free. The Fifth (434's) was not subject to any exemption except that it was not subject to normal tax.

For the purpose of arriving at the taxability or non-taxability of Liberty bond interest during 1919 and 1920, the interest had to be separated by issues and capitalized according to the rates applicable to the various issues. The exemptions or any portion of them were subtracted from the capitalized principal; the taxable interest was then arrived at by applying the interest rate to the excess of capitalized interest over exemptions.

Sections 1328 of the 1921 act and 1028 of the 1924 act retained (a), (b), and (c) above mentioned but in lieu of (d), (e), (f), and (g), substituted an aggregate exemption of $125,000 until two years after the war (i. e., July 2, 1923) and a $50,000 aggregate exemption for three years more. The new rule was effective from January 1, 1921. The "subscribed for and still held" feature of the earlier act was eliminated, except in connection with non-deductible interest paid, which will be discussed in Chapter XV. Now holdings cannot be averaged as described in the preceding paragraph; the exemptions must be applied to the actual principal held (split if desired) and applied only once to the same period.

Corporations are not subject to tax upon Liberty bonds held in 1922 and years following because of the existence of only a normal tax on corporations.

An original subscriber is not a person who acquires Liberty bonds through inheritance, nor is his estate an original subscriber (O. D. 405, 742, 1000). A corporation whose assets were merged with those of another could not claim exemptions pertaining to the original subscriber; but a partner, to the extent of his equity, was held to be an original subscriber to Liberty bonds acquired from the partnership (O. D. 362). A corporation was formed from a partnership prior to July 1, 1919, and elected to be taxed as a corporation from January 1, 1918; it was looked upon as an original subscriber to bonds acquired in 1918, but a

partner purchasing bonds during the period from the same partnership was not (O. D. 211, 502). A bank which took over subscriptions for Liberty bonds upon default in payment by subscribers was not an original subscriber (T. B. R. 28 and O. D. 192). Changing the nature of, or the interest on, a bond within the same issue did not take away rights from the original subscriber (O. D. 718). Affiliated companies are each entitled to full exemption (T. B. R. 7).

The average principal basis could not be applied to 1921 and years following. If the principal varied but was always less or more than the exemption, a statement to that effect could be put in the return. However, if the principal at any time exceeded the exemption, a full statement and computation was called for (I. T. 1229). In 1923 the total exemptions decreased from $160,000 to $55,000. Interest accrued through July 2, where the books were on a cash basis, was subject to the larger exemption, although received thereafter (T. D. 3565).

OTHER INTEREST; ANNUITIES

All other interest received or accrued, except that coming from state, county, and municipal bonds, is taxable.1 Interest on a sinking fund created by a corporation for the benefit of creditors is taxable to the corporation even though not actually received (Art. 542). Annuities or interest paid by charitable corporations under annuity contracts are taxable when the total payments exceed the amounts set aside in consideration for the contract.

An annuity from a trust created under a will is taxable income (Irwin v. Gavit, 268 U. S., 161). This decision is of considerable significance, inasmuch as it had long been contended by attorneys that such payments were legacies. Likewise, annuities paid in connection with devised land are taxable income to the recipient without deduction. If the payment of the annuity or other sum is made by an insurer following the death of the insured, the receipts are not income, even though paid in instalments, unless they are payments of interest rather than principal (Sec. 213 (6) (1); Art. 72).

1 See page 154.