time (A. R. R. 2564, overruling A. R. R. 307) nor patents under either the 1917 or 1918 acts (A. R. R. 4123). Property was taken over in a consolidation in 1911 at the values appearing on the books of an old corporation; but an appraisal in 1912 showed that these assets were worth considerably more. The excess was permitted as an addition to invested capital in 1917 inasmuch as the value was determined near the time of purchase (A. R. R. 161). An appraisal in 1917 attempting to work back to and to justify 1913 values for the purpose of ascertaining paid-in surplus at the formation of a corporation in the earlier year, was not permitted to establish such values (A. R. R. 358); but retrospective appraisals are now recognized in full (A. R. R. 747; Mim. 3209), even where a corporation voluntarily wrote down the value of its assets in 1914 (A. R. R. 1276). The appraisal cannot be allowed, however, when it is impossible to verify it with the books, date of purchase, costs of installation, and so forth (A. R. R. 2406), nor where it is based on cost on the books of the vendor who accepted stock for them (S. M. 2284), or on values realized subsequently from their sale (A. R. R. 7932). Paid-in surplus cannot arise from the value of a plant bought from an owner who was compelled to sell nor from contracts to which the corporation is a party (A. R. R. 233). A cash account must be in the name of a corporation if it is to be regarded as an asset thereof (A. R. R. 2766). And property held in trust for a corporation, to be conveyed to it at the end of the trust period in case certain provisions were complied with, could not be included in paid-in surplus until actual conveyance had taken place (A. R. R. 2971).

XXII

INVESTED CAPITAL:

EARNED SURPLUS-INTANGIBLES

Earned surplus. Deductible and non-deductible reserves. Additions to earned surplus. Intangibles: limitation thereon.

AMONG items classified as earned surplus and properly included in invested capital are:

(a) Profits from operation (after proper allowances for depletion, depreciation, losses, and so forth) accrued to the beginning of the taxable year. Profits from one year must be applied in reduction of a deficit from previous years (Art. 838).

(b) "Non-deductible" reserves, such as sinking-fund reserves, reserves for bad debts (under the 1918 law), contingencies, Federal taxes, and other balance-sheet credits, additions to which are not allowable deductions in computing net income.1 "Deductible" reserves, such as the reserve for depreciation and a reserve representing the difference between the cost and market price of inventories, must be excluded from invested capital, unless the charges which compose the reserves could not be claimed as a deduction from gross income (Art. 839; 840(1); 841(1); 844; 845). Surplus from appreciation must also be excluded except as realized through depreciation charges.

2

(c) Equipment acquired and charged off prior to January 1, 1917, may be included in invested capital if still in use by the business. If restored, the value to be taken for invested capital purposes is the cost less

1 Payments from this class of reserves was required to be averaged. See Chapter XXIII. 2 See (e) on next page.

the proper depreciation (Art. 840 (2); 841 (1); 842).

(d) Intangibles charged off may be added back only if still existent and only if it can be proved that the corporation originally paid for such assets. Patents may have a definite value extending beyond their life; that is, they may become good-will. If a corporation has charged off patents for its own benefit (that is, has claimed depreciation or loss thereon as a deduction) in computing its net income since January 1, 1909, the amount written off cannot be restored to invested capital. But if the write-off of patents has not been deducted in tax returns, and the patent is still of value to the corporation, it may be restored to invested capital but not again deducted. Costs of developing and protecting patents previously written off cannot be restored (Art. 840(3); 841(2); 843).

(e) Realized appreciation. If assets are revalued as of March 1, 1913, and depreciation is deducted on such value, it is evident that, while depreciation of this kind is an allowable deduction for tax purposes, surplus would be understated if this charge, greater than cost, were permitted to decrease it. That is, depreciation on appreciation, if the appreciation refers to March 1, 1913, values, is a deductible expense but a proper charge for accounting purposes against the appreciation reserve rather than against surplus. Hence if the full depreciation charge has been carried to surplus, care should be taken that a proper portion of the appreciation surplus, otherwise not part of invested capital, is included in earned surplus.

(f) Cash surrender value of a life insurance policy (Art. 846).

Profits earned during the year were required to be excluded (Art. 850). But if an operating deficit (i. e. negative surplus) existed at the beginning of the year, paid-in capital need not be reduced thereby (Art. 860).

A corporation which expended amounts for capital purposes was allowed to include its own labor used in the work in years prior to 1917 and thus capitalize it (I. T. 1347). Earned surplus credited to stockholders' accounts at stock ownership ratios was allowed to be included in invested capital, as the stockholders did not rank with the general creditors under the state law (A. R. M. 71); generally, it has been held that such credits must be excluded from invested capital (1 B. T. A. 1154, 1215; 3 B. T. A. 1333; 4 B. T. A. 401). There was no authority for reducing earned surplus because of an alleged failure to charge off sufficient depreciation in the past, unless the depreciable assets of the corporation were valued on its books at the beginning of the taxable year at an amount in excess of their actual value at that time (A. R. M. 106, 106 explained, O. D. 1104; A. R. R. 6040, 6127). This principle has been further defined by the Board of Tax Appeals: that adjustments of reserves prior to January 1, 1918, should not be made merely because depreciation had been provided for irregularly in the past; adjustments are warranted only where positive evidence exists that depreciation sustained had not been written off (1 B. T. A. 87, 194, 228; 2 B. T. A. 623). The general rule now observed by the Board is that no adjustment for depreciation is required where equivalent amounts, which might have been capitalized, have been written off to expense (4 B. T. A. 264), in one case over a 4-year period prior to 1918 (4 B. T. A. 697). Appreciation could not be included in earned surplus by using it as an offset to depreciation (A. R. R. 71), nor could appreciation realized through depreciation or depletion charges during the year be called invested capital (A. R. M. 51, I. T. 1791; S. R. 6141; compare with valuation for inventory purposes on page 227. Actual depletion sustained must be excluded from invested capital despite offsets in the way of appreciation and despite the limited deductions allowed under the 1913 act and the rule outlined in Stratton's Independence v. Hawbert, 231 U. S., 399 (A. R. R. 517). Disallowed depletion from 1909 to 1913 must also be excluded (O. D. 833). Write-offs in 1912 and 1913 in anticipation of estimated obsolescence may be restored (less subsequent depreciation) to surplus upon proof that the obsolescence has not occurred (T. B. R. 6). Amortization allowances for the purpose of computing "net profits" subject to the munition manufacture's tax of 1916 were not permissible deductions for net income purposes and hence did not reduce invested capital beyond the normal depreciation allowance (T. B. M. 56); when actually deducted in tax returns of 1916 and 1917 the taxpayer

should file amended returns excluding the deduction and increasing invested capital for 1917 (A. R. R. 349). Assessment of the excess profits tax for the fiscal year ending October 31, 1917, upon the basis of the full year, and excluding from invested capital net earnings for the fractional part of the year falling in 1916 was held to be proper (A. R. R. 853). Accrual of Federal taxes did not affect invested capital, except to the extent that the accrual of such taxes would cause dividend payments to draw on surplus at the beginning of the year (O. D. 85). Paid-in capital need not be reduced by Federal income taxes if a deficit stands on the books (I. T. 1599). A reserve for taxes owing by a preceding partnership was invested capital of a successor corporation until paid (A. R. R. 2190, revoking I. T. 1582). Taxes paid on bank stock by a bank under the 1918 act were in effect the same as dividends paid and were to be handled as such (I. T. 1279). Taxes withheld at the source cannot be included in invested capital (O. D. 202). A reserve for bad debts carried December 31, 1920, should be included in invested capital for 1921 subject to reduction to the extent utilized during the year (I. T. 1524). This ruling is obviously incorrect. Bad debts written off in 1921, applicable to prior years, were an allowable deduction in 1921. Any reserve at the beginning of the year should be permitted to stand as invested capital during the entire period, as was the rule in previous years.

A utility cannot include in invested capital interest charged on construction (O. D. 246 and 811). A national bank declared dividends and invested them, with the consent of the stockholders, in certain deals, a stockholders' liability account in the name of the trustee holding the funds being credited with the amount. Although technically a liability, the reserve was owned by the same interests and was required to be consolidated with earned surplus, income therefrom to be included with the bank's income (A. R. M. 43, overruling O. D. 260). The excess of insurance received over the cost of the asset where a replacement fund has been established cannot be included in invested capital as long as it remains unreported as income (O. D. 417). Goodwill cannot be created to offset an impairment of capital (O. D. 82). Unearned and unreported interest or discount cannot be included in earned surplus (O. D. 91), nor unearned income on instalment sales (O. D. 92).

The capitalization of costs of increasing the circulation of a newspaper prior to 1909 cannot now be permitted when the option to do so was not exercised by the corporation in those years and