For 1924 and subsequent years affiliated corporations may, at their option, file either a consolidated return or a separate return for each corporation, irrespective of the basis upon which returns were filed prior to 1924. However, once the option is exercised, returns must be made on the same basis thereafter, unless permission to change is obtained from the Commissioner. This option is similar to that contained in the 1921 law for a taxable period beginning on or after January 1, 1922. Prior to the passage of the 1921 law, there was no option. If corporations came within the definition of affiliated corporations, consolidated returns had to be filed. It is in marked contrast with the procedure for the excess profits tax years, 1917 to 1921.

LAW. Section 240. (a) Corporations which are affiliated within the meaning of this section may, for any taxable year, make separate returns or, under regulations prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income

1 [Former Procedure] No provision whatever for consolidated returns, either of corporations or partnerships, appeared in either the 1913 or 1916 laws. Every corporation was held to be a separate and distinct entity and the tax

for the purpose of this title, in which case the taxes thereunder shall be computed and determined upon the basis of such return. If return is made on either of such bases, all returns thereafter made shall be upon the same basis unless permission to change the basis is granted by the Commissioner.

If consolidated returns are made, intercompany transactions which involve profits or losses can be freely made without affecting the net taxable income. In addition to this, two important points should be considered in deciding how the option may be most advantageously exercised: (a) losses of affiliated companies and (b) loss of specific credits.

(a) The loss sustained by an affiliated company included in a consolidated return is applied against the net income of the other member or members of the group, thereby reducing the net taxable income. It is true that if a consolidated return is not rendered, the taxpayer may, under certain conditions prescribed in section 206, deduct losses sustained in one year from the net income of the succeeding year or years. However, a consolidation makes it possible to apply a loss against any net income in the current year. Since corporation earnings and losses do not run consistently from year to was imposed upon each separately. In the administration of the 1917 law, the Treasury permitted consolidated reurns by corporations for excess profits purposes but not for income tax purposes. No specific provision in the 1917 law required the filing of consolidated returns; but by regulation (Reg. 41, Arts. 77 and 78) the Treasury, under the general provision of section 201, required the filing of consolidated returns for excess profits tax in the case of corporations, when there was either substantial stock ownership, or close financial relationship or control. Partnerships, which in 1917 were subject to excess profits tax, were, under the original 1917 regulations, neither required nor permitted to make consolidated returns. In a specific case the Treasury refused to accept a consolidated return where a partnership was affiliated with a corporation.

Articles 77 and 78 of Regulations 41 were amended by T. D. 3389 (C. B. I-2, page 266; August 24, 1922) to include partnerships in consolidations. This is in accord with section 1331 of the 1921 law which was passed to validate the requirement of consolidated returns under the 1917 law.

LAW. Section 1331. (a) That Title II of the Revenue Act of 1917 shall be construed to impose the taxes therein mentioned upon the basis of consolidated returns of net income and invested capital in the case of domestic corporations and domestic partnerships that were affiliated during the calendar year 1917.

Under the 1918 law, consolidated returns were required for both income and profits taxes. See Excess Profits Tax Procedure, 1921, Chapter XIV. The 1918 law neither permitted nor required partnerships to make consolidated returns with corporations.

year, and since one corporation may lose year after year, it seems that consolidated returns are desirable.

A further reason in favor of the consolidated form of return is that a net loss, as defined in section 206 (a), must be reduced by the amount of dividends received. In a consolidated return intercompany dividends are eliminated. The net loss of any member of the group is, therefore, fully effective. If separate returns are filed by the affiliated companies, the net loss of any of them would have to be reduced by the amount of intercompany dividends received. It will thus be seen that where net losses are concerned, separate returns may have the effect of indirectly taxing intercompany dividends at the rate of 122 per cent. Furthermore, tax-exempt income must be added back in computing the net loss.

(b) The question of the specific credit also has a direct bearing on the advisability of consolidation.

LAW. Section 236. . . . (b) In the case of a domestic corporation the net income of which is $25,000 or less, a specific credit of $2,000; but if the net income is more than $25,000 the tax imposed by section 230 shall not exceed the tax which would be payable if the $2,000 credit were allowed, plus the amount of the net income in excess of $25,000..

A consolidation is entitled to but one specific credit of $2,000,2 whereas, if separate returns are rendered, each corporation in the group having a net income of less than $25,000 may claim a specific credit of $2,000, which, with a tax rate of 121⁄2 per cent, means a saving of $250 per corporation.

The fact that affiliated companies are in the hands of receivers cannot exclude them from consolidation.3

What constitutes an exercise of the “election.”—

The 1921 law granted affiliated corporations an election to file either separate or consolidated returns for any taxable year beginning on or after January 1, 1922. The 1924 law grants a similar option which apparently relates to the calendar year 1924 or any fiscal year ended in the year 1924. Both laws provide that corporations are. bound by this option for subsequent years unless permission to change

2 Section 240 (b).

C. B. I-1, page 296; A. R. R. 818.

the basis is received from the Commissioner. The following rulings. under the 1921 law would, therefore, be equally applicable under the 1924 law.

RULINGS. When a corporation secured the ownership and control of another corporation for a negligible period of the year 1922, and separate returns were filed for such period, the filing of the separate returns will not operate as the exercise of the option of filing separate or consolidated returns within the meaning of section 240 of the Revenue Act of 1921 and thereby deny the corporation the right to file a consolidated return for the year 1923. (C. B. II-2, page 216; I. T. 1783.)

Two affiliated corporations filed a consolidated return for 1922 upon the advice of an accountant and in this way lost the right to take the specific credit of $2,000 for each corporation in computing their income tax. The taxpayers stated that they were unfamiliar with the provisions of the Revenue Act of 1921 at the time the consolidated return was filed and asked leave to file separate amended returns for 1922 in lieu of the consolidated return previously filed.

Held: In the instant case, the filing of a consolidated return for 1922 by the taxpayers was authorized by law. As a return in that form was made, this constituted an exercise of the election permitted by section 240 (a) of the Revenue Act of 1921, and separate amended returns for 1922 can not be filed, although the consolidated return may have been made in ignorance of the election conferred by that section of the law. The taxpayers, however, have a right to apply for permission to make a change in the basis of their returns for future years. (C. B. II-2, page 211; I. T. 1777.)

The foregoing ruling is not consistent with the recognized principle of law that there can be no valid election when the one who exercises the option is in ignorance of the alternatives which must always exist when an election is had.4

"Affiliated corporation" defined.-In order to file consolidated returns, the corporations involved must first meet the requirements of affiliation set forth in the law.

LAW. Section 240. (c) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns at least 95 per centum of the voting stock of the other or others, or (2) if at least 95 per centum of the voting stock of two or more corporations is owned by the same interests. A corporation organized under the China Trade Act, 1922, shall not be

4

For further discussion of options, see patent depreciation treated in Chapter XLI.

[Former Procedure] Under previous income tax laws (section 240 of the 1918 law and sections 240 and 1331 of the 1921 law) two or more domestic corporations were to be deemed affiliated for the purpose of making con

deemed to be affiliated with any other corporation within the meaning of this section.

solidated returns (1) if one corporation owned directly or controlled through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if substantially all the stock of two or more corporations was owned or controlled by the same interests.

Accordingly it was held that commercial or financial relations alone would not be sufficient grounds to warrant a consolidated return. (C. B. 2, page 225; A. R. R. 123.) Also where the control of the output and policies of a company by another company through agreement, without the ownership by one corporation of the stock of the other or the ownership of the stock of the two corporations by the same interests, it was held that such control did not entitle the two corporations to affiliate. (III-37-1785; S. M. 2452.)

In its recent rulings the Treasury has leaned toward a narrow construction of the meaning of the word "control" as used in the statutes. In S. M. 2001 (III-37-1784) the opinion is expressed that "control which is not based upon a right recognized in law and enforceable by legal means does not meet the test of the statute." In another case affiliation was denied when voting control was exercised through proxies. Control through the lease of capital stock (III-39-1807; I. T. 2084) C. B. III-1, page 305; I. T. 2032) was also rejected as a basis for affiliation.

The following rulings have also been issued under the 1917, 1918 and 1921 laws:

Ownership of 65 per cent of the stock of another company, together with a verbal option to purchase a further 24 per cent, the remaining 11 per cent being held by stockholders who were not active in the business, was not considered sufficient to permit affiliation. (III-28-1666; A. R. R. 8282.)

In another case affiliation was denied where 80 per cent of the stock was owned but where there was evidence of the closest inter-company relations. (III-39-1803; I. T. 2083.)

In the case of Temtor Corn & Fruit Products Co. (299 Fed. 326) it was held that "substantially all the stock of the other" means substantially all the voting stock only or such stock as carries control. This case is now on appeal.

A taxpayer recently received a letter from the Treasury reversing its ruling on an affiliation which had been decided more than two years previously. Such action was approved by the Solicitor. (III-39-1807; I. T. 2084.) Unless new facts have been brought to light or fraud is alleged such a proceeding would seem to be entirely unwarranted.

Where the affairs and operations of two corporations were actively conducted by and in the control of the male members of one family, the stock of one corporation which owned and leased various pieces of property in California was held by four of the male members, each in the proportion of five twentyfourths and a sister held the remaining one-sixth. The stock of the other corporation which owned and operated properties in the Hawaiian Islands was held by the members of the same family with the exception that one-sixth was held by each of the above four male members, one-sixth by the sister, and onesixth by the husband of a deceased sister. Held that the corporations should file separate returns. (Letter to the Corporation Trust Company signed by Commissioner Daniel C. Roper, and dated April 11, 1919.)

Affiliation was denied in the case of two companies in one of which 24.26 per cent of the stock was owned by individuals who held no stock in the second company, and more than 6 per cent of the stock of the second company was held by individuals who held no stock in the first company. (C. B. 1, page 236; T. B. R. 52.)

The interests of husband and wife in the State of Wisconsin are separate and distinct, and, in the absence of any ulterior motive, the holdings of husband