This regulation is sound because all so-called expenses in construction enterprises are proper capital expenditures, and the cost of demolition of an old building is a capital charge. This rests on the principle that there can be no operating loss or expense in a new business until after the business commences to operate.

Corporate Losses in Issuance and Redemption of

Securities

Discount on bonds sold a loss which may be prorated.When a corporation sells bonds at less than par, it is because the nominal rate of interest as expressed in the bonds is less than the market rate. If a corporation has a high credit and there is a favorable market for securities, it will secure the advantage of a low rate of interest. Its 5 per cent bonds may sell at 110. If, however, the market is not so favorable even though the credit of the company be unimpaired, its 5 per cent bonds may sell at 90. In both cases, if one assumes the credit of the company to remain constant, it is the market rate of interest current at the time which governs the price of the bonds. Proper accounting calls for a reflection of the actual interest cost spread evenly over the life of the bonds, and this is readily accomplished by adjusting the interest account.

The regulations consider such discounts as losses rather than interest but provide that (with the exception of discounts on bonds purchased prior to 1909 and charged off) they may be prorated equitably over the life of the bonds.

REGULATIONS. Discount on bonds issued and sold prior to the year 1909, if such discount was then charged against surplus or against the income of the year in which the bonds were sold, is held not to be deductible from the income of subsequent years, for the reason that the charging off prior to January 1, 1909, of the entire amount of the discount constitutes a closed transaction, and such transaction cannot be reopened for the purpose of reducing the taxable income of a corporation for subsequent years by deducting therefrom an aliquot part of the discount. (C. & A. R. R. v. U. S., Court of Claims.)

If, however, the bonds were sold subsequent to January 1, 1909, at a discount, and the amount of the discount was then charged off on the books, either against earnings or surplus, but not deducted in the corporation's return of net income, such discount as was not then deducted, may be spread over the life of the bonds, and an aliquot part of the discount may be deducted from the gross income of each year until the bonds mature or are redeemed.

In cases wherein a corporation sells its bonds at a discount plus 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 will, for the purpose of an income tax return, be prorated over the life of the bonds sold, and the amount thus apportioned to each year will be deductible from the gross income of each such year until the bonds shall have been redeemed.

If a corporation having sold its bonds at a discount, the discount having been deducted from gross income, later repurchases or redeems the bonds at a price less than par, the difference between the price at which they are redeemed and their par value will be returned as income. If bonds are sold at a premium, the premium must be returned as income. (Reg. No. 33, 1918, ¶¶ 461-464.)

So far as the question has been before them, the courts seem to take the position that bond discount is an expense or loss rather than interest.

REGULATION. The decision of the United States Circuit Court of Appeals for the Third Circuit, in the case of the Baldwin Locomotive Works v. McCoach, Collector (221 Fed. 59), holds that if the loss sustained by selling its own bonds at a discount is an expense of the business of a corporation, the expense will not be paid until the maturity of the bonds, and should therefore be prorated over the life of the bonds. (T. D. 2185, April 1, 1915.)

When bond discount has been capitalized at the time of issuance of the bonds (as was frequently done and approved by public service commissions not many years ago), and when such discount has not been otherwise amortized, it appears to be permissible for income tax purposes to write off annually the due pro-rata amount.

When bond discount was charged to profit and loss during the year in which the bonds were issued, or during subsequent years, in amounts greater than the proper pro-rata, it

seems to be permissible to prepare and submit amended returns for such years, or upon any re-opening of a corporation's books by the Department to make claim for adjustment.

Premium on bonds purchased a loss immediately deducti

ble.

REGULATION. In a case wherein a corporation, under the terms of its indenture, securing an issue of bonds is required annually or at certain specified periods to purchase and retire a certain number of its bonds and in doing so pays more than par for the bonds, the loss sustained is an allowable deduction from gross income for the year in which such purchase is made, under the following conditions: First. If the bonds were sold at par, then the loss is the difference between par and the price at which they were repurchased for retirement.

Second. If the bonds were sold at a premium and such premium was accounted for as income for the year in which issued, then the difference between par and the repurchase price may be deducted as loss, but if the premiums at which the bonds were issued had not been carried into the income account then the loss to be claimed should be the difference between the price at which the bonds were sold and the price at which they were repurchased.

Third. If the bonds were sold at a discount and the discount was charged against the earnings of the year in which issued, the difference between par and the repurchase price may be deducted as a loss, but if the discount on the bonds was prorated over the life of the bonds and the annual proportion charged against the yearly. income, the amount to be charged off as a loss for the year in which the bonds are repurchased for retirement should be the difference between the price at which the bonds were sold and the repurchase price minus an allowance for the sum that had been charged off annually on account of the prorated discount on such bonds. (Reg. No. 33, 1918, ¶¶ 467-470.)1

Premium on capital stock redeemed not a deductible loss.RULING. This office is in receipt of your letter of the 6th instant, in which you ask for information on the following question: "A corporation in 1912 issued preferred stock for par. It was provided on the certificates that said stock was redeemable at 110. The company exercised its option and redeemed the stock at 110 by calling it in. The difference appeared on the books as a reduction of undivided profits. Is this difference a lawful deduction?"

'T. D. 2137.

In reply you are informed that this office will hold that the redeeming of the stock at a price in excess of par represents a capital transaction in which there can be no gain or loss to the corporation, and therefore the difference between the selling price of the stock and the price at which it was redeemed will not be deductible in a return of annual net income. (Letter to a subscriber of The Corporation Trust Co., signed by Deputy Commissioner G. E. Fletcher and dated April 11, 1917.)

The purchase or redemption by a corporation of its own capital stock is an operation of a nature entirely different from that involved in the retirement of bonds. The purchase or retirement of bonds at a premium involves a payment to a creditor. As explained above, the premium is nothing else than a net expense spread over the life of the bonds. Payments to stockholders, on the other hand, must be out of profits (unless liquidation is in progress). Such payments

are usually in the form of dividends, but in the numerous instances where corporations purchase their own shares at a premium, this premium in effect is a payment to a stockholder. Most states forbid a corporation to buy its own stock except out of surplus. As the payment of a premium on shares is the equivalent of a dividend, there is no ground whatever for a claim that such premiums should be allowable deductions in an income tax return. In no sense of the word is such a payment capital. State laws say that it must be out of profits and that is the method always followed.

Consequently the author cannot agree with the Treasury Department when it says that the payment of the premium in redeeming stock is "a capital transaction in which there can be no gain or loss to the corporation." He does agree, however, with the conclusion that such payments are not deductible. As such payments are not allowable deductions to the corporation, and must, therefore, be charged direct to surplus, it can be claimed that a distribution of profits, equivalent to a dividend, has been made. The corporation will have paid the normal income tax thereon and should notify its stockholders

of that fact so that they may enter the receipt of the premiums as a dividend and thus avoid the normal tax.

Losses of Holding Companies—Accounting

Procedure

The interests owned by holding companies in affiliated or subsidiary companies are usually represented by holdings of capital stock, bonds and other forms of indebtedness such as promissory notes, open book accounts, etc. Where a holding company desires to reflect on its books the profits or losses of its subsidiaries, it does so by the accrual and reserve method,' or by writing up or down the book valuations of the stocks or obligations owned.

Under existing rulings, a mere writing down of valuations is not an allowable deduction. But many transactions ordinarily reflected by a change in valuations are more properly recorded as "losses which are immediately deductible." If a subsidiary loses money and the holding company advances funds, which in effect are used to make good the deficit, and it is not likely that the subsidiary can repay the advance, it becomes a bad debt on the books of the holding company and should be charged off as a loss. Transactions of this kind are sometimes improperly handled. For example, the advance from the holding company to the subsidiary is often treated as a gift from one to the other. If this were really so, the holding company could not claim it as an allowable deduction (because gifts are not deductible); but in fact this is not a gift. It is on the part of the holding company one of the necessary expenses incurred in its business, or a loss of similar nature. Holding companies are formed to make money. When they lose in transactions out of which profits were expected to arise, it is a trade-not a gift in the nature of a benevolence or anything of that sort. Therefore at the time

Auditing, Theory and Practice (2nd edition), by R. H. Montgomery, page 514 et seq.