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quently purchased and retired at a price in excess of the issuing price plus any amount of discount already deducted, the excess of the purchase price over the issuing price plus any amount of discount already deducted (or over the face value minus any amount of discount not yet deducted) is a deductible expense for the taxable year.51 It was held under the 1916 Law that in cases wherein a corporation sells its bonds at a discount and pays a commission for selling, the amount of such discount and commission, together with other expenses incidental to issuing the bonds, constitutes a loss, the aggregate amount of which loss should for the purpose of an income tax return, be prorated over the life of the bonds sold, the amount thus apportioned to each year being deductible from the gross income of each such year until the bonds shall have been redeemed.52 Under the later rulings it would seem that such amounts, while deductible, should be treated as expense.

Payments from Earnings of Public Utility Paid to State. In the case of a public utility acquired, constructed, operated or maintained by a taxpayer under contract with any State, Territory, or political subdivision thereof, or with the District of Columbia, containing an agreement that a portion of the net earnings of such public utility shall be paid to the State, Territory, or political subdivision thereof, or the District of Columbia, the amount so paid may be deducted by the taxpayer as a necessary expense in transacting business.53

Expense in Oil and Gas Industry. For purposes of the oil and gas industry it is ruled that expense includes all amounts paid out (exclusive of amounts paid for physical property and development charged to Capital Sum) incident to the development and operation of producing properties and the preparation of their product for market, such as costs of pumping, cleaning, reshooting (including cost of torpedoes), gauging, storing, treating, reducing, repairs and maintenance, transporting, refining, conserving, marketing, overhead expense, insurance, etc. The cost of repairs and replacements made necessary through

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51 Reg. 45, Art. 544. Such amounts were deductible as a loss prior to this later ruling. (Letter from Treasury Department dated March 23, 1915; I. T. S. 1918, ¶ 1437.) See p. 326.

52 Reg. 33 Rev., Art. 150.

53 Revenue Act of 1918, § 213 (b) 7; Reg. 45, Art. 84; T. D. 2090; see Revenue Act of 1916, § 11 (b).

deterioration of equipment may be charged off as expense, but if this is done the amount allowed as a depreciation deduction will be reduced. In all cases items of expense must be charged off as such for the year incurred and can neither be deducted from the income of subsequent years as expense nor added to Capital Sum.54

54 Manual for the Oil and Gas Industry, p. 15. See Chapter 29.

CHAPTER 23

DEDUCTION OF INTEREST

The Revenue Act of 1918 provides that citizens and residents and domestic corporations may deduct all interest paid or accrued within the taxable year on indebtedness, except on indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917), the interest upon which is wholly exempt from taxation as income to the taxpayer. Non-resident aliens and foreign corporations may deduct that proportion of such interest. which the amount of his or its gross income from sources within the United States bears to the amount of his or its gross income from all sources within and without the United States.1 But this deduction is allowed to a non-resident alien only if he files a true and accurate return of his total income from all sources, corporate or otherwise, in the manner prescribed 2 by the law. In all cases, interest upon indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917), the interest. upon which is wholly exempt from the income tax to the taxpayer, may not be deducted. Thus, a citizen or resident may, with the one exception above stated, deduct all interest paid or accrued within the taxable year on his indebtedness. This includes not only indebtedness incurred for business purposes, but indebtedness incurred for any purpose, such as for the purpose of buying dwelling houses or any articles or things of personal use.

Interest on Capital. Interest calculated as being a charge against income on account of capital or surplus invested in the business, but which does not represent a payment on an interestbearing obligation, is not an allowable deduction from gross in

1 Revenue Act of 1918, §§ 214 (a) 2, 234 (a) 2; Reg. 45, Art. 121. The limitations imposed by the 1916 law upon the amount of interest which might be deducted by corporations is discussed in the Appendix.

2 Revenue Act of 1918, § 217.

come; that is to say, the interest which the money might earn if otherwise invested is not a deductible charge against income.3

Indebtedness Incurred or Continued to Purchase or Carry TaxExempt Securities. The Revenue Act of 1918 does not permit the deduction of interest paid or accrued on "indebtedness incurred or continued to purchase or carry obligations or securities (other than obligations of the United States issued after September 24, 1917) the interest upon which is wholly exempt from taxation under this title as income to the taxpayer."4 State and municipal bonds are obligations or securities falling within this class, as well as National bonds issued prior to September 1, 1917. Interest on indebtedness incurred for the purchase of Liberty bonds of the second issue (the interest on which is not entirely exempt from the surtax) was held deductible regardless of the limitation contained in the 1917 Law.5 By the parenthetical clause of the 1918 provision taking obligations of the United States issued after September 24, 1917, out of the exception to the deductibility of interest, the Revenue Act of 1918 makes it clear that interest on indebtedness incurred or continued to purchase or carry Liberty bonds of the second and subsequent loans will be allowed as a deduction. The extension of the exception to the deductibility

3 Reg. 45, Art. 122.

4 Revenue Act of 1918, §§ 214 (a) 2, 234 (a) 2. Prior to its amendment by the Revenue Act of 1917, it was held under the 1916 Law that interest paid on indebtedness might be deducted, whether or not the indebtedness was incurred for the purchase of bonds, the interest upon which was exempt from taxation. This ruling in effect permitted a double deduction, that is, the interest on the money so borrowed could be deducted and the income derived from the money so borrowed and invested could also be deducted. The 1917 Law did not permit the deduction of interest paid on "indebtedness incurred for the purchase of obligations or securities the interest upon which is exempt from taxation as income under this title." (Revenue Act of 1916, §§ 5 (a), 12 (a), as amended by the Revenue Act of 1917.)

5 Reg. 45, Art. 121; T. D. 2511.

6 Reg. 45, Art. 121. The provision of the statute permitting the deduction of all interest paid or accrued within the taxable year is the subject of some criticism on the ground that it permits a reduction of the income tax by the purchase of non-taxable securities with borrowed money. The remedy pro posed is that the interest deduction be limited to an amount bearing the same proportion to the total interest paid upon indebtedness which the taxpayer's income derived from taxable sources bears to his income from all sources. The provision of the 1918 Law as it now stands permits the deduction of interest paid or accrued on indebtedness incurred or continued to purchase or carry

of interest to indebtedness "continued" as well as incurred, and incurred or continued to "carry" as well as to purchase taxexempt securities should be noted.

Interest Paid or Accrued Within the Year. The 1909 Law provided for the deduction of "interest actually paid within the year" and it was contended by the Treasury Department that this provision required that the interest should be both accrued and paid within the same year. It was held, however, that interest actually paid within the year although previously accruing should be permitted as a deduction.7 The 1913 Law provided for the deduction of interest paid within the year by individuals, and "interest accrued and paid within the year" by corporations. In a ruling under that law it was held that in the case of corporations the deduction should be limited to interest which had both accrued and been paid within the same year.8 The 1916 Law permitted the deduction of interest "paid within the year.' 119 The Revenue Act of 1918 permits the deduction of interest "paid or accrued within the taxable year." 10 It does not seem essential

obligations of the United States issued after September 24, 1917. The parenthetical exception to the general restriction upon the deduction of interest was designed to stimulate the sale of Liberty Bonds. It will be remembered that the Victory or Fifth Liberty Loan consisted of two kinds of notes; that is, (1) 4-4% three/four year convertible gold notes exempt from state and local taxes except estate and inheritance taxes and from normal Federal taxes, (2) 3-4% three/four year convertible gold notes exempt from all Federal, state and local taxes except estate and inheritance taxes. It could hardly have been contemplated at the time §§ 214 (a) 2 and 234 (a) 2 (a) were drawn that the Victory Loan would include any wholly exempt notes or bonds. This section of the law should be amended to guard against the evasion of the surtax by the heavy purchase of the above 3-4% notes with borrowed money. 7 Anderson v. 42 Broadway Co., 213 Fed. 777. The Supreme Court in reversing the lower court (239 U. S. 69) did not pass on the question of deducting interest accrued in one year and paid in another.

8 T. D. 1960.

9 Revenue Act of 1916, §§ 5 (a), 12 (a), as amended by the Revenue Act of 1917.

10 Revenue Act of 1918, §§ 214 (a), 2, 234 (a) 2. The term "paid or accrued' is to be construed according to the method of accounting upon the basis of which the net income of the taxpayer is computed. (Revenue Act of 1918, § 200.) Under the 1916 Law, corporations keeping books of account on an accrual basis were permitted to deduct interest for the year whether paid or not, when such interest was shown as a charge against accrued income upon the books of account (T. D. 2625).

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