income from sources within the United States cannot be treated as a credit for taxes but as a deduction from gross income (O. D. 317). The amount of income, war profits, and excess profit taxes paid to the Canadian Government is a credit against the income tax liability to the United States Government (O. D. 393). Any taxes on income paid by a citizen to a foreign country on income from sources therein is an allowable credit against taxes or income due to the United States, if his books are kept on the cash basis; if on the accrual basis, only that portion accruing within the taxable year (O. 987). The Cuban tax imposed on each bag of sugar produced by a corporation is a production tax and therefore is not a credit against income tax but a deduction from gross income (O. D. 372). The term "foreign country" (in Sec. 238 (a) and 234 (a) (3) of the Revenue Act of 1918) means the composite whole made up of all the subdivisions of a foreign country; therefore, neither British Columbia (O. D. 1050) nor Tasmania (S. M. 1614) are "foreign countries" and any income taxes paid therein are deductible only from gross income. Taxes imposed by a foreign government on dividends paid by corporations under its jurisdiction are taxes on the income of the stockholders, and any United States corporation receiving such dividends may credit its proportionate tax so paid against income tax due the United States. If the foreign tax is levied on the income of the corporation itself, no part of the tax is properly a credit (O. D. 147; 232). A foreign corporation controlled by a domestic corporation must have actually paid during the year the income taxes for which credit is to be taken by the domestic corporation (T. B. R. 36). A domestic corporation keeping its books on the accrual basis and deriving its entire income from operations in Cuba may file on Form 1118 a "claim for credit" on taxes on income accruing to the Cuban Government (O. D. 406). Where credit is claimed by an American bank for the amount of taxes withheld from the interest on bank deposits and paid to a foreign country by a foreign bank, there should be attached to and filed with Form 1118, an affidavit from the foreign withholding agent (O. D. 671). An income tax which really was a tax on expenditures, levied by a foreign country, could not be credited (I. T. 1444).

FISCAL AND PARTIAL YEARS

Where rates have changed during a fiscal year, the general rules for the tax computation are: the excess profits

tax, surtax, and normal taxes are computed twice in each case, assuming for the sake of the computation that the 12 months' income falls entirely within each calendar year. The ratio of the number of months actually falling within each year to 12 is then applied to the respective computations (Art. 951-5).

Returns for a fractional year arise from various causes. such as death, discharge of executor or administrator, departure from the United States, change of accounting period, and the formation or dissolution of a corporation. If the fractional year return is caused by a change in the accounting period, the income for such fractional year should be raised to an annual basis in the case of corporations, using the credits applicable and reducing the resulting tax to the fraction of the full year represented by the period in question (Art. 591). An individual changing his accounting period should deduct a pro rata portion of the credits to which he is entitled. But in a fractional-year return for a deceased person or for his estate during administration, the full credit may be claimed without averaging (Art. 431). If a corporation, after its formation, or as a result of dissolution, has a net income of $25,000 or more for a fractional year, the credit of $2,000 should be reduced to the proportion of the actual number of months to 12 (Art. 625).

Prior to 1924, the Department had required that all returns for fractional years be put on an annual basis, but the new rule has apparently been made retroactive over past years (Bankers' Trust Company v. Bowers, 292 Fed., 793; 295 Fed., 89; T. D. 3573; Mim. 3178; I. T. 2065).

IV

METHODS OF ACCOUNTING FOR INCOME

Methods and basis of accounting. Capital and revenue expenditures. Constructive receipt.

THE method of accounting followed by a taxpayer in recording his transactions should govern, in a general way, in calculating his taxable income. He must prepare his return on a fiscal year basis if his books are so kept. Changes from a fiscal to a calendar year or vice versa, or changes in the general accounting method must first be approved by the Commissioner, 30 days' notice prior to the close of the proposed new taxable year being required. Form 1128 should be used in making application for a change in the taxable year. An individual not keeping books cannot render a return on the basis of a fiscal year or on an accrual basis (Art. 22, 23(3), 25, and 26). No penalty is imposed for not keeping necessary records (I. T. 1929).

Books may be kept on a "paid" or on an "accrual" basis. The distinction is not clear, from either the accounting or legal standpoint (Sec. 200(d); Art. 1523). Strictly speaking, the "paid" basis would seem to involve merely the collecting together of cash receipts and disbursements relating to income, but among the minimum requirements laid down by the Department for either method are (Art. 24):

(a) That where merchandise is dealt in, opening and closing inventories must be taken;

(b) That capital and revenue expenditures must be properly differentiated; and

(c) That where depreciation is claimed as a deduction, replacements must be charged to a reserve therefor. Technically, this means that the cost of the asset

replaced must be charged against the reserve and current profit and loss while the cost of the new asset is capitalized.

Perhaps no set of books exists in which all accounts are handled on a strictly accrual basis. Small items will invariably be found which, properly speaking, are not expenses, although recorded as such, and while their theoretically correct treatment might increase taxes payable by a small amount, the Department seems to have recognized that slight variations of method are bound to exist. Consistency, however, is necessary in the handling of all items, and the fundamental rule laid down is that "the computation shall be made in such a manner as clearly reflects the taxpayer's income" (Art. 22).

In general, income should be included in the year received or accrued (Art. 50) and expenses deducted in the year accrued or paid (Art. 112). In the case of income the test is the availability thereof, as illustrated more fully under "Constructive Receipt," on page 54. Judgments, for example, ordinarily give rise to income in the year rendered or otherwise definitely determinable. Losses not discovered until a later year may justify the preparation of an amended return of a prior year. A loss from embezzlement can be deducted only in the year of the occurrence. Additions to a depositor's guaranty fund in the case of a bank are expenses only if a corresponding amount of funds is no longer an asset (Art. 567).

If a taxpayer wishes to deduct an expense or loss in some year other than the year in which the loss was incurred or paid, he must first conform to the general rule; but he may attach to his return a request for inclusion under some other year, with his reasons (Sec. 200(d); Art. 1523).

Permission to change the accounting period was denied where request was made following the close of the period (T. D. 3044 and A. R. R. 391). If a change is authorized, it must be followed (Mim. 2738). A new corporation does not need to secure permission to file on a fiscal year basis (O. D. 404). A sole

proprietor could not report his business income on one basis and his remaining income on another (O. D. 491). In general, permission to change the accounting period should be accompanied by good business reasons (T. B. R. 37). An action to compel the acceptance of a calendar year basis was denied (Greylock Mills v. Blair, 264 U. S., 587; T. D. 3542).

The accrual basis cannot be followed unless books of account are kept; hence if a partnership adopts the accrual method, a partner (O. D. 977) or other employee (O. D. 696) cannot, unless he keeps personal books. Deductions for notes covering payment of expenses, where the cash basis is followed, cannot be made until the year of payment, although the recipient must in any case report their fair value as income when he receives them (A. R. M. 201). Retroactive salary allowances after the books were closed were not allowed as a deduction (A. R. R. 493) until the year in which payment was made (A. R. R. 519); but in a later case, additional salaries for 1917, voted in February, 1918, were not deductible in either year, although the salaries for 1917 were nominal (A. R. R. 2658). On the other hand, where past methods of accounting have been improper, retroactive changes have been permitted and even required; thus, national and state banks which had charged off additions to furniture and fixtures as an expense were required to build up and keep supplemental records apart from the regular books of account so that they might be put on a proper accrual basis (A. R. R. 377 and A. R. M. 172). National banks should be required to file their returns from 1918 to 1921 on a cash or accrual basis, in accordance with the methods then in use (A. R. M. 220); they must accrue all items or none (S. R. 6; see also I. T. 2080). Adjustments of railroad accounts, ordered by the Interstate Commerce Commission, were required to be given retroactive effect in amended returns (O. D. 9). Where accounts receivable resulting from sales are present, the accrual method must be followed (A. R. R. 217); if resulting from services, the amount of the bill being subject to clients' approval, as in the case of a law partnership, the cash basis was permitted (A. R. R. 702 and 6158). The discounted value of notes received for commissions was income when received; but if they had no discounted value, income resulted when they were liquidated (I. T. 2046). Interest receivable, accrued in the past, must be continued even though the collection of such interest, because of changed trade conditions, is doubtful (A. R. R. 737). A business was held to have kept its accounts on an accrual basis where the books had been held open monthly to record payments of liabilities pertaining to that month (A. R. R. 4802).