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ing units to determine the basic values. A unit should be determined by the size of the average mill site (O. D. 43).

The deduction for depletion based on the value at discovery, or within 30 days thereafter, is allowed to parties acquiring rights to a lessor's royalty (T. D. 3089 and I. T. 1894) and to a lessee who subleases and retains a right in the oil produced (I. T. 1920). An unrestricted member of the Osage Indian tribe, as lessor, was allowed to deduct an allowance for depletion of the oil within the Osage Indian reservation according to his or her interest (I. T. 1478). In case a material error had been made in an estimate of the mineral content of a mine a new estimate could be made only by readjusting the rate of depletion on minerals subsequently extracted to the new estimate (A. R. R. 431, I. T. 1616). The value to the lessor of a lease on a coal mine was held to be the present worth of his royalties per ton. That is, the result obtained by multiplying the royalty per ton by the number of estimated tons to be extracted by the lessee was taken at its discounted present value, which, when divided by the tons to be extracted by the lessee, gives the unit rate of depletion to the lessor (Sol. Op. 80). Where a company charged exploration expenses to capital for 1917, it could not later amend its returns (O. D. 796). If the option to charge developmental and drilling expenditures to operating expenses was exercised, such items could not subsequently be treated as capital expenditures (A. R. M. 110). Where the parent company exercised its option to charge developmental expense to operations, a subsidiary to whom the leases were sold was required to follow the same practice (O. D. 1002). In case a lease and the improvements thereon cost less than the value of the improvements, the lease was considered worthless and no depletion could be taken, because the capital could be restored by a return through depreciation charges on improvements (A. R. R. 570). A fee owner was not permitted a deduction for depletion when minimum royalties were received but no ore extracted (A. R. R. 1147). Where a company contracted to convey to another company the merchantable lumber paid for and cut, it was held that the company purchasing the lumber acquired a lease rather than standing timber as a result of the sale, and depletion could not be deducted (A. R. M. 111).

XV

INTEREST AND TAXES

Interest on loans to purchase or to carry tax-free securities. Methods of computing non-taxable interest paid. Taxes. Items not deductible as taxes.

INTEREST, paid or accrued during the taxable year on any sort of obligation, is deductible. Interest paid on scrip dividends is deductible (Art. 564).

An exception is made of interest on loans to "purchase or carry" interest-bearing tax-free securities such as municipal bonds. Interest on loans to purchase or carry wholly tax-free obligations of the United States issued after September 24, 1917, is deductible, providing the taxpayer is an original subscriber. Hence, interest paid in connection with the First Loan (which was issued in the early part of 1917 and is entirely exempt from income taxes) is not deductible, while interest paid to purchase or carry holdings of all other issues excepting the Victory 334 Notes (also exempt but retired June 15, 1923) may be deducted whether or not the present holdings were originally subscribed for. A taxpayer must have been an original subscriber to the exempt Victory 334's which he still held at the time of making his return if interest paid in connection therewith was to be claimed as a deduction. In the 1918 act the deductibility of interest paid was not affected by the taxpayer not being an original subscriber to obligations of the United States (Sec. 214(a)(2); 234(a)(2); Art. 121).

The case of non-deductible interest arises most frequently in connection with individuals. Interest on loans with Liberty bonds of the first and fifth (334) issues (in the latter case not originally subscribed for) and municipal bonds as collateral, would not be deductible at all. Where there is

a mixed group of collateral the apportionment of interest paid may be made on the basis of ratios existing between interest received from taxable interest and interest received from non-taxable (including the one Liberty Loan) bonds, or on the basis of the averaged principals of each class at par or at market prices.

Where bank loans or other interest-bearing obligations are secured by tax-free bonds,' the problem of apportioning the interest paid thereon becomes a problem to the corporate enterprise. Possible methods are as follows:

(a) All interest paid is deductible despite the fact that collateral for loans consists of tax-free securities, the theory being that the loans are for the benefit of the business generally and not solely to "carry” such securities. This method should be followed unless the Department has ruled otherwise in a specific case.

(b) Another method is to compute, from the collateral record, the portion of tax-free interest securities up for collateral (as in the case of individuals).

(c) A third method is to apply to interest paid a fraction, the numerator of which is the yearly average of all municipals and the denominator the average of all securities, including municipals, held for trade, no matter whether or not used as collateral.

(d) A fourth method is similar to and applicable to the same conditions as the third except that the denominator is the average of all current assets commonly included in working capital. Considering funds and their application in this type of enterprise, it is axiomatic that a bank loan represents an equal investment in a dollar's worth of municipal bonds, a dollar's worth of cash, or any other current asset.

(e) The same principle as is used in computing the

1 Interest paid by a corporation to purchase or to carry stocks is deductible for the reason that dividends from other corporations are taxable income, although dividends from domestic corporations are allowable deductions. See page 121.

inadmissible 1 percentage for invested capital purposes may also be applied. This method resembles the third and fourth just described, the denominator being all assets and not merely the inadmissible or current assets. If the law regarded a capital liability as invested ratably in current and capital assets, a current liability must also be so invested.

The conclusion may be drawn, therefore, that the inadmissible percentage method should be followed by the taxpayer if he is forbidden to deduct all interest paid.

Penalty interest paid the Government in connection with additional taxes is deductible (O. D. 319 and O. 922) as well as interest on overdue Federal estate taxes (I. T. 1317). Other deductible interest has included:

1. Interest paid under a guaranty agreement (S. 1298). 2. Discount sustained by a contractor converting municipal certificates of indebtedness (O. D. 999).

3. Interest paid charged to construction, no option being allowed the taxpayer even under the authority of a state utility commission (S. 935, overruling S. 23).

4. Interest on loans carried to cover losses sustained on the sale of Liberty bonds and to pay city taxes, although Liberty bonds were used as collateral (I. T. 1213).

5. Dividends on certain forms of debenture stock where the principal, interest, or both, rank superior to the claims of unsecured creditors (A. R. R. 237), but not ordinary preferred stock dividends (3 B. T. A. 1129).

6. Interest on deferred dividends ordered paid by a court (O. D. 778).

7. Interest on subscriptions to capital stock, prior to the issue of certificates (I. T. 1334; see also page 213).

Deductible interest has not included a finance charge added to a purchase on the instalment plan (I. T. 1912), interest on bonds issued by a road improvement district included in a special

1 Inadmissible assets were assets (except obligations of the United States) the income from which was wholly or partially non-taxable and which, therefore, were excluded from invested capital to the extent the income was not subject to tax and to the extent that stockholders had an equity in them. In computing the equity no distinction was made between actual liabilities to outsiders and the 'liability' of net worth. See Chapter XXIII.

assessment (I. T. 2044), nor all interest paid by dealers in securities (I. T. 1987).

TAXES

Taxes are deductible, as a rule, by all individuals and corporations and are not limited to business property. They include the following:

(a) Local and state property taxes, including automobile license fees.

(b) Income taxes levied by states, and taxes levied by United States possessions and by foreign countries except that portion of the income taxes of the last named which are credits against the tax payable.1

(c) Import and export duties.

(d) Excise taxes (on so-called luxuries and semiluxuries, such as toilet articles) except those paid and deducted by the manufacturer.

(e) Taxes on transportation and other facilities. (f) Stamp taxes.

(g) Taxes on admissions and dues.

(h) Gift taxes imposed by Section 309 of the Revenue Act of 1924.

(i) The Federal estate tax is deductible from the income of the estate; state inheritance taxes, levied on the right of beneficiaries to inherit property, are deductible to the beneficiaries unless paid from funds not otherwise available to them. (Sec. 214(a) (3); Art. 131-2; 134). This rule was modified, however, before the appearance of Regulations 69 by U. S. v. Mitchell (271 U. S., 9), in which the Supreme Court makes deductibility depend on the incidence of the tax. In this case and in Keith v. Johnson (271 U. S., 1), the inheritance taxes of New York and Texas were held proper deductions from the income received by executors. Following similar

1 See pages 42-43.

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