XXI

INVESTED CAPITAL:

CAPITAL STOCK-PAID-IN SURPLUS

Theory of invested capital. Present importance. Effect on tax payable, 191921. Illustrations. Capital stock. Status of unpaid subscriptions. Values in excess of par value of stock; paid-in surplus recorded and not recorded in books.

It has already been stated that invested capital consisted, for the most part, of paid-in capital and earned surplus at the beginning of the year. This tax-law conception of business investment implied that nothing could be included therein which did not represent values actually received by the corporation. Intangibles purchased with stock were limited to a percentage of the par value of capital stock. A proportionate deduction must be made for assets the income from which was not taxable. Changes during the year in the way of stock sold or retired, and payments from surplus must also be given expression to. No changes relating to invested capital were made in the 1921 law as compared with the act of 1918 except that certain provisions were eliminated in connection with the war profits tax which were applicable to the year 1918 only. No references are made in the following paragraphs to pre-war invested capital and pre-war income the computation of which were preliminaries in computing the war profits tax under the 1918 act. It will be found in most cases that the necessary details have already been accurately determined in returns filed for the war years.

Invested capital, as a factor in the computation of surtaxes on corporations, was first introduced into the Revenue Act passed March 3, 1917 (later supplanted by the act of October 3, 1917). Previous to 1917 the highest income tax that had been assessed against corporations was a normal

TABLE SHOWING EFFECT OF INCREASES OR DECREASES IN INVESTED CAPITAL ON CORPORATE INCOME AND EXCESS PROFITS TAXES-YEARS 1919, 1920, AND 1921

tax of 2% in 1916. With the advent of the World War it was believed a fairer supertax could be levied on business if a reasonable return on the investment were first permitted, only the excess above such fair return being subjected to the high tax rates. The term "war excess profits tax" was used in the 1917 act and a fair return on the investment was conceived to be the average return for the pre-war period (defined as the calendar years 1911, 1912, and

1913), not to exceed 9% of the invested capital for the year. In 1918 there were both a "war profits" tax and an "excess profits" tax, and the fair return on the investment was the average pre-war income (not to be less than 10% of the invested capital for the year plus $3,000), and 8% plus $3,000, respectively.

Invested capital was also used in determining the applicability of the higher bracket or brackets of the supertax levied on corporations during the entire period in which the corporate supertax was in force.

EFFECT OF INVESTED CAPITAL

Reference to the table on page 240 indicates that where invested capital played any part in the computation of the taxes for 1919-21 it reduced the tax payable by a percentage not exceeding 5.04%.

Examples: (a) A corporation's net income for 1920 was $50,000, and invested capital, $100,000. What tax refund should be applied for upon discovering that the invested capital for 1920 should have been $110,000? Answer: The size of the invested capital makes case 1, 2, 4, or 6 apparently applicable, but since the net income is greater than 20% of the invested capital, only case 6 actually applies. Hence, a tax refund of 5.04% of $10,000, or $504, is apparently in order.

(b) The 1921 invested capital of another corporation was increased from $50,000 to $60,000, the net income of $40,000 remaining unchanged. What is the effect on the tax payable? Answer: No effect; case 8 applies and invested capital does not enter into the computation.

The importance of invested capital still remains in connection with amended returns of past years. Furthermore its discussion is of importance in understanding the theory of income developed by Congress and the Department, as reflected in the law and in the regulations.

CAPITAL STOCK

The starting point in the computation of invested capital for tax purposes is capital stock outstanding. If the par value of the outstanding stock represents the cash price originally paid by stockholders in acquiring the stock, such par value is paid-in capital and may be included in its entirety in invested capital. If the par value appearing on the books was not the cash value realized at the time the stock was issued, the cash value (or fair value of the property received) will govern, even if greater than the par value, as will be further noted in paragraphs following (Art. 831).1

It has been held that stock issued as a bonus in connection with the sale of bonds is invested capital to the extent that the selling price of the bonds with the stock was higher than the selling price if sold without the stock. In such case the excess should be charged to "Discount on Bonds" (Art. 832).

Discount on stock sold must be deducted from the par value thereof and the amortization of such discount is not an allowable deduction. If, however, the discount has been charged against surplus, no adjustment need be made, since, in effect, a portion of earned surplus has been transferred to capital stock account.

Among the items in addition to cash which are regarded as paid-in capital are the following:

(a) Unpaid subscriptions from stockholders. Notes given by stockholders in payment of their subscriptions are proper inclusions in invested capital to the extent of their cash value when received. Such notes must be legal and their payment must not rest on some contingency. Contingent subscriptions, as, for example, employees' subscriptions to be paid for out of dividends received, cannot be included in invested cap

1 References in Part V are to Regulations 62 and to the Revenue Act of 1921, unless otherwise designated.