property must be replaced by a new invention, or where an increase in the cost of or other change in the manufacture of any product makes it necessary to abandon such manufacture, to which special machinery is exclusively devoted, or where new legislation directly or indirectly makes the continued profitable use of the property impossible. This exception does not extend to a case where the useful life of property terminates solely as a result of those gradual processes for which depreciation allowances are authorized. It does not apply to inventories or to other than capital assets. The exception applies to buildings only when they are permanently abandoned or permanently devoted to a radically different use, and to machinery only when its use as such is permanently abandoned. Any loss to be deductible. under this exception must be charged off on the books and fully explained in returns of income.35

Cost of Drawings, Models and Patterns. Expenditures made for designs, drawings, patterns or models representing work of an experimental nature should be treated as a capital disbursement and not as an expenditure if the designs, drawings, patterns or models prove to be satisfactory and result in the production of salable goods. If, however, they prove to be unsatisfactory and have no asset value, the expenditure may be charged off as a loss incident to running the business and as such deducted from gross income, provided that the taxpayer taking credit for such expenditures in the income tax return. makes a full and complete explanation with respect to the same.36 If designs, drawings, patterns, or models result in the production of goods which prove to be salable for a certain length of time

35 Reg. 45, Art. 143. Under the Hawaiian Law, which does not make any provision for a deduction to cover obsolescence, it has been held that no deduction may be taken to cover the value of mills, buildings, and a railroad discarded on account of the erection of a larger mill at a different location and the construction of a different railroad connected therewith. This transaction was held not to be deductible either as a loss or an expense and it was also held that the provision that "no deduction shall be made for any amount paid out for new buildings, permanent improvements or betterments made to increase the value of any property or estate," did not imply that deduction might be made for all amounts so paid out which did not in fact increase the value of the property. (Haw. Commercial, etc., Co. v. Tax Assessor, 14 Haw. 601, 687.)

36 Reg. 33 Rev., Arts. 175, 176.

and then become obsolete and can not be sold, the amount expended for such designs, drawings, patterns, or models, less any amounts previously claimed as depreciation with respect to the same or as a return of capital, may when charged off, be included in, and deducted as a loss incident to running the business, provided full and complete information is reported in a manner satisfactory to the Commissioner.37

Amounts Paid to Make Up Profits of Another Corporation Under Agreement. Contracts guaranteeing the payment of dividends or interest of one corporation by another are frequently made between corporations having close business relations. Whether or not amounts paid under such contracts or guarantees may be deducted, as a loss or as an expense of doing business, by the paying corporation has not been determined by the courts in this country. In England such payments have been held properly deductible as sums expended for the purpose of trade.38 If the payment is made under an enforceable contract, there seems to be no reason why the amount should not be deducted either as loss or expense. This question would seem under the present law to be covered in many cases by the provision for the making of a consolidated return by affiliated corporations.39

Shrinkage in Securities and Stocks. A person possessing securities such as stocks and bonds, can not deduct from gross income any amount claimed as a loss on account of the shrinkage in value of such securities through fluctuation of the market or otherwise. The loss allowable in such cases is that actually suffered when the securities mature or are disposed of. In the case of banks or other corporations which are subject to supervision by State or federal authorities, and which in obedience

37 Reg. 33 Rev., Art. 177.

38 Moore v. Stewarts & Lloyds (1906), 8 Fraser 1129. In this case it was observed that the question was one of fact rather than of law. One company entered into agreement with another whereby in return for the right to nominate a majority of directors of the second company the first undertook to pay to the second such sums each half year as might be necessary to make up any deficit in the dividends on the latter's preferred shares. The court said, “If the agreement was entered into with a view to profit, as I think it was then the annual charge to the respondent company is in my view a part of their business outlay or expenditure and is not subject to assessment."

*

*

39 See Chapter 10.

to the orders o. such supervisory officers charge off as losses amounts representing an alleged shrinkage in the value of property, the amounts so charged off do not constitute allowable deductions. The foregoing applies only to owners and investors, and not to dealers in securities. However, if stock of a corporation becomes worthless, its cost or its fair market value as of March 1, 1913, if acquired prior thereto, may be deducted by the owner in the taxable year in which the stock was ascertained to be worthless and charged off, provided a satisfactory showing of its worthlessness be made as in the case of bad debts.40

Worthless Stock. If stock of a corporation becomes worthless its cost, or its fair market value as of March 1, 1913, may be deducted by the owner in the taxable year in which the stock was ascertained to be worthless and charged off. The worthlessness must be satisfactorily shown as in the case of bad debts.41

Sale of Capital Stock. Where the capital stock of a corporation is issued for less than par, the amount of discount is not an allowable deduction to the corporation. Such a transaction is purely a capital transaction and the income of the corporation is not directly decreased by reason of the sale of the stock at a price less than its par value. Neither is any loss or gain realized from the purchase of its own stock.42

Voluntary Payment by Stockholders of Loss of Corporation. Assessments made by a corporation on its capital stock are regarded as an investment of capital and the amounts paid do not constitute allowable deductions to the stockholders. This rule was held to apply in a case where a corporation showed a deficit at the close of the year and the stockholders agreed to make it good by the payment of voluntary contributions.44

40 Reg. 45, Art. 144; Letter from Treasury Department dated August 14, 1914; I. T. S. 1918, ¶ 1344; N. Y. Life Ins. Co. v. Anderson, 257 Fed. 576. The Act of June 30, 1864, as amended by the Act of July 13, 1866, seems to have permitted the deduction from earnings of depreciation in investments in bonds and depreciation in stock in order to arrive at the amount of the taxpayer's profits. (Miami, etc., R. R. Co. v. U. S., 108 U. S. 277.) 41 Reg. 45, Art. 144; T. D. 2135.

tion of bad debts.

See p. 383 for a discussion of the deduc

42 Reg. 45, Arts. 563, 542; T. D. 2090.

43 T. D. 2090.

44 Letter from Treasury Department dated February 21, 1916; I. T. S. 1918,

7

Shrinkage or Deterioration in Storage. Loss due to shrinkage or deterioration of produce in storage is not allowed as a deduction. Such shrinkage or deterioration is reflected in the selling price when the goods are sold and correspondingly reduces the net income at that time.45

District Irrigation Bonds. District irrigation bonds as a rule, if not always, are a lien upon the real estate affected by the irrigation project and until the corporation has taken such steps as are necessary to protect its rights and enforce the collection of the bonds, it does not appear that the corporation would be warranted in writing out of its assets and deducting from gross income, as a loss, the face value, or any other arbitrarily ascertained amount, representing a loss or shrinkage in the value of such bonds.46

Losses of Oil and Gas. Losses of oil and gas are of two kinds: (a) Those which are unforeseen or unavoidable, such as losses sustained through fire or accident; and (b) losses that are anticipated and recognized as unavoidable under operating conditions, such as evaporation of oil in storage, ordinary leakage, refinery losses, etc. Usually the latter class are indeterminate as to amount and are absorbed either implicitly or explicitly in current operating expenses or in cost of the oil or gas. Indeterminate losses may not be deducted from gross income.47

Reserves for Losses. Reserves to take care of anticipated or probable losses are not a proper deduction.48 On the other hand, losses sustained during the year may be deducted although made good out of a fund which has been accumulated as an insurance `reserve by the taxpayer.49

Worthless Debts. The Revenue Act of 1918 provides that individuals and corporations may deduct debts ascertained to be worthless and charged off within the taxable year.50 For the purpose of deduction as losses, debts are divided into two classes, (a)

45 Reg. 45, Art. 145; T. D. 2153.

46 T. D. 2152.

47 Manual for Oil and Gas Industry, p. 18.

48 Reg. 33 Rev., Art. 166; T. D. 2161. Reserves to take care of the depreciation or obsolescence of property used in the trade or business of the taxpayer are permitted as deductions as set forth in Chapter 26.

49 Reg. 33, Art. 122.

50 Revenue Act of 1918, §§ 214 (a) 7 and 234 (a) 5.

those which represent to the creditor a return of capital and (b) those which represent unpaid income. The former may be deducted regardless of when the debt became due and payable, but the latter, such as uncollected wages, salaries, rents, interest and similar items of taxable income, may not be deducted, if the debt became due on or after March 1, 1913, unless the amount thereof has been reported as income; but if the debt became due and payable prior to March 1, 1913, it may be deducted in any event.51 The losses which may be deducted are losses of capital; income on which the tax has been assessed assumes the status of capital, and income which became due and payable before the incidence of the tax is capital to the taxpayer, although it may be received thereafter. The mere failure to receive income does not warrant a deduction, as the omission of such amounts operates, in itself, as a reduction of tax. If a taxpayer computes his income upon the basis of valuing his notes or accounts receivable at their fair market value when received, which may be less than their face value, the amount deductible for bad debts in any case is limited to such original valuation. In the case of debts existing prior to March 1, 1913, only their value on that date may be deducted upon subsequently ascertaining them to be worthless. An account merely written down or a debt recognized as worthless prior to the beginning of the taxable year is not deductible.52 Only the difference between the amount received in distribution of the assets of a bankrupt and the amount of the claim may be deducted as a bad debt. The difference between the amount received by a creditor of a decedent in distribution of the assets of the decedent's estate and the amount of his claim may be considered a worthless debt. A purchaser of accounts receivable which can not be collected and are consequently charged off the books as bad debts is entitled to deduct them, the amount of deduction to be based upon the price he paid for them and not upon their face value.53

MUST BE CHARGED OFF ON BOOKS. The Revenue Act of 1918 expressly provides that in the case of both individuals and corpora

51 T. D. 2224.

52 Reg. 45, Art. 151. 53 Reg. 45, Art. 152.