APPENDIX

INTEREST DEDUCTION BY CORPORATIONS UNDER

REVENUE ACT OF 1916.

Under the 1916 Law, as amended, a corporation might deduct the amount of interest paid within the year on its indebtedness (except indebtedness incurred for the purchase of obligations or securities, the interest upon which was exempt from taxation as income under the law) to an amount of such indebtedness not in excess of the sum of (a) the entire amount of the paid up capital stock outstanding at the close of the year, or, if no capital stock, the entire amount of capital employed in the business at the close of the year, and (b) one-half of its interest-bearing indebtedness then outstanding. In the case of interest paid on indebtedness wholly secured by property collateral, tangible or intangible, the subject of sale or hypothecation in the ordinary business of the corporation, as a dealer only in the property constituting such collateral, or in loaning the funds thereby procured, the total interest might be deducted as a part of the expense of doing business, on an amount of such indebtedness not in excess of the actual value of such property collateral. (Revenue Act of 1916, § 12.)

Reason for the Limitation. This arbitrary limitation upon the amount of interest deductible by a corporation was a survival of a provision of the 1909 Law, which imposed an excise tax on corporations measured by the amount of income. In construing the 1909 Law the Supreme Court held that it was not in any proper sense an income tax law, but was an excise tax upon the conduct of business in a corporate capacity, the tax being measured by reference to the income. In limiting the amount of interest which a corporation could deduct under that law Congress evidently had in view the fact that some corporations carry a current indebtedness exceeding the amount of paid up capital stock and with respect to such corporations intended to limit the interest deduction to so much of the indebtedness as did not exceed the capital. It appears that Congress deemed that where the indebtedness exceeded that capital it should no longer be treated as an incident, but should be considered as a principal object of the corporate activities, and that the operations of such a corporation were conducted more for the benefit of the creditors than of the stockholders. There is no question of the power of Congress to adopt such a basis of dis tinction. (Anderson v. 42 Broadway Co., 239 U. S. 69, reversing 213 Fed. 777.) While the reason for such arbitrary limitation was excellent in the case of a tax such as that imposed by the 1909 Law, which could otherwise have been avoided by the conversion of capital into indebtedness, the reason applies with

much less force to the 1916 Law where the income which was not taxed to the corporation became taxable to the bondholder. To the extent, therefore, that a corporation was not permitted to deduct all of the interest paid on its indebtedness such interest was subject to tax both to the corporation and to the bondholder. This did not throw a double burden on the bondholder, but threw an extra burden on the stockholders of the corporation who were deprived of earnings to the extent that interest paid to bondholders was taxed to the corporation. The arbitrary limitation resulted in the creation of a fictitions income on which the corporation was taxed, and since such fictitious income not only was subject to a heavy income tax but entered very materially into the computation of an extraordinarily heavy excess-profits tax, the provision operated with rank injustice in the case of corporations which had an indebtedness greatly in excess of their capital stock. In fact, it seems inevitable that real estate corporations such as the Forty-two Broadway Co., which raised the question under the 1909 Law, would, under the 1916 income tax and excessprofits tax laws, incur such heavy tax burdens as to place them in grave danger of insolvency.

Interest-Bearing Indebtedness. The interest-bearing indebtedness referred to in this provision of the 1916 Law did not include preferred capital stock; interest or dividends paid upon such stock was not deductible from gross income. (Revenue Act of 1916, § 12.) It did not include indebtedness secured by collateral subject to sale. Under the 1909 Law, if a corporation took title to real property subject to a mortgage but did not assume the indebtedness secured thereby, the interest could be deducted in full, as this would not be a payment by the corporation owning the property subject to such lien on its own indebtedness, because the indebtedness was not its bonded or other indebtedness, but an indebtedness created by a third party and charged as a lien upon the land acquired, subject thereto, by the purchasing corporation. (28 Op. Atty. Gen. 198.) But the 1916 Law did not permit of this construction since it provided that "payments required to be made as a condition to the continued use or possession of property,' as the phrase appeared in the 1909 and 1913 Laws, must be with respect to property "to which the corporation has not taken or is not taking title or in which it has no equity." Where a corporation purchased property encumbered by a mortgage or other lien and the amount thereof was a part of and included in the purchase price, upon the payment of which the title vested absolute in the purchaser, the purchaser assumed the indebtedness on the property thus purchased and interest thereon partook in no degree of the nature of rental or franchise charges and its deduction was limited by the provisions of law. (T. D. 1865.) If a corporation had an equity in or was purchasing for its own use the real estate upon which a mortgage was a prior lien and the corporation assumed the payment of interest, the indebtedness was held to be indebtedness of the corporation and interest paid on such mortgage was deductible only within the limit fixed by the law. (Reg. 33, Art. 148.) A corporation, which did a brokerage business and bought securities for its customers, who paid only a part of the purchase price, paying interest on balances, the corporation also paying for the securities purchased only part of the purchase price and owing balances on which it paid interest, including in return of gross income the difference between the

interest received and the interest paid, was held to have made an incorrect return. The interest received by the corporation from its customers should have been included in gross income. In determining net income, interest could be deducted only to an amount not exceeding the paid-up capital stock outstanding at the close of the year. (Altheimer & Rawlings Investment Co. v. Allen, 246 Fed. 270, petition for a writ of certiorari denied November 18, 1918; Middlesex Banking Co. v. Eaton, 233 Fed. 87; T. D. 2441.)

Indebtedness Bearing Different Rates of Interest. Where a corporation had several classes of indebtedness bearing different rates of interest and the aggregate amount of indebtedness exceeded the limit allowed by law, the indebtedness bearing the highest rate might be first considered in computing the interest deduction, and the balance, if any, computed on the indebtedness bearing the next lower rate and so on until the interest on the maximum prin cipal allowed was computed. (Reg. 33, Art. 151.)

Indebtedness Outstanding at Close of the Year. From the amount of indebtedness to be reported as indebtedness outstanding at the close of the year was required to be eliminated all indebtedness incurred in the purchase of securities the income from which was not subject to the income tax. (Reg. 33 Rev., Art. 95.) Such amount should not include indebtedness which was not bearing interest. If no indebtedness was outstanding at the close of the year, the maximum deduction allowable on account of interest paid would be measured by an amount of indebtedness not exceeding at any time within the year the entire paid up capital stock outstanding at the close of the year; that is, in such case the capital stock outstanding at the close of the year measured the highest amount of indebtedness upon which deductible interest could be computed. (T. D. 1960.) Where the indebtedness of a corporation varied from month to month so that during portions of the year the interest-bearing indebtedness outstanding was greatly in excess of the maximum principal upon which interest could be calculated and in other portions of the year less than such maximum principal, the corporation was limited to a deduction which represented the amount of interest actually paid during the year but at all. times within the limitation fixed by law, and was not allowed to deduct the total amount of interest paid during the year, even though at the rate of interest paid (6%) such amount was less than 6% of the maximum principal. (Letter from Treasury Department dated April 29, 1918; I. T. S., 1918, ¶ 3344.) Paid Up Capital Stock Outstanding at the Close of the Year. (See Associated Pipe Line Co. v. U. S., 258 Fed. 800.) This phrase meant the par value of shares issued as reported in Item 1 of the return from and did not include the surplus carried by the corporation. The full amount of stock represented by the par value of the shares issued was regarded as the paid up capital stock, except when such stock was assessable on account of deferred payments, or payable in installments, in which case the amount aetually paid on such shares constituted the actual paid up capital stock. (T. D. 2090; Reg. 33, Art. 95.) Where the capital stock of the corporation was issued without par or nominal value, the law provided that the amount of capital stock as represented by such shares would be the amount of cash or its equivalent paid or transferred to the corporation as a consideration for such shares. If such shares were issued as a bonus in connection with shares

of preferred stock, the par value of the preferred stock would be the limit which might be claimed as paid up capital stock. If both common and preferred were issued for cash or other equivalent consideration, the amount would be the par value of the preferred stock plus the amount actually paid in on the shares issued without par value. (Letter from Treasury Department dated January 13, 1916; I. T. S. 1918, ¶ 1767.) Neither in the case of stock issued with a par value nor in the case of stock issued without par value could the amount of paid up capital stock be increased except as new capital was paid in and for which additional shares were issued. (Letter from Treasury Department dated January 13, 1916; I. T. S. 1918, ¶ 1767.)

Interest Paid by Banks on Deposits. In the case of a bank, banking association, loan or trust company, the interest paid on deposits or on moneys received for investment and secured by interest-bearing certificates of indebtedness issued by such banks, banking association, loan or trust company was permitted to be deducted in full. Where a corporation, chartered as a bank, was engaged in the business of selling debenture bonds and guaranteed real estate securities, by a method by which it both paid and received interest, it was held under the 1909 Law that the interest paid out could not be deducted in full as interest paid on deposits, the transaction in no way being a banking transaction. (Middlesex Banking Co. v. Eaton, 233 Fed. 87.) Such interest could probably be deducted as inteerst paid on indebtedness secured by collateral.

Car Trust Certificates. Railroad companies were permitted to include these trust certificates in the amount of their bonded or other indebtedness reported. (Reg. 33 Rev., Art. 188.)

Interest on Indebtedness Secured by Collateral. The deduction of such interest was permitted without limit provided (a) the indebtedness was wholly secured by property collateral, tangible or intangible, (b) the collateral was the subject of sale or hypothecation in the ordinary business of the corporation as a dealer in such property or in loaning the funds thereby produced and (c) the indebtedness did not exceed the actual value of such property collateral. Such interest was deductible not as interest paid, but as an expense of doing business. The deduction was required to be stated separately in the return of annual net income and was required to be segregated from indebtedness not so secured. Failure to segregate the two forms of indebtedness resulted in a suspension or disallowance of the amount claimed. (T. D. 1993.)

Collateral the Subject of Sale. This phrase as used in the law referred to tangible or intangible property bound for the performance of certain covenants or payment of certain obligations. Real estate owned and mortgaged by corporations organized for and engaged in the business of buying, selling and dealing in real estate, warehouse receipts representing property the subject of sale in the ordinary business of the corporations owning same, and which warehouse receipts were pledged as collateral for such corporations' own debt, were examples where the interest would be deductible without limit. (T. D. 2090.) If a corporation whose ordinary business was the purchase and sale of real estate had an office building under mortgage, which office building was not subject to sale in the ordinary business of the cor

portion, the interest paid on such mortgage might not be deducted without limit. (T. D. 2137.)

As a Dealer Only. The only corporations allowed under this proviso to deduct interest in full were those organized and operated for the purpose of buying, selling and dealing in the particular kind of property upon which the mortgage was given, and the particular property pledged for the debt upon which the interest was paid was required to be the subject of sale in the ordinary business of the corporation. (T. D. 1993.)

Ordinary Business of the Corporation. Where a corporation dealt in the property serving as collateral for the indebtedness as a matter of its ordinary business, deduction might be made in full, but where the property was held by it for the purpose of, or as an instrument in carrying on, its ordinary business such as the rights of way and other property of public utility companies, permanent office buildings and property of like character held or occupied for the particular use or purpose or the furtherance of the objects of the corporation, the property was held not to be the subject of sale in its ordinary business, but to be occupied or used as an instrument of carrying on the ordinary business for the transaction of which the corporation was organized. The fact that such property might be subject to sale under extraordinary or peculiar conditions did not qualify it as collateral. (T. D. 1993.)