that when stocks, tax-free bonds or other inadmissible assets are purchased with the proceeds of borrowed money, it must be assumed that a proportion of the admissible assets also was acquired with the proceeds of borrowed money. D3.

: LAW. Section 326. . . . . (c) There shall be deducted from invested capital as above defined' a percentage thereof equal to the percentage which the amount of inadmissible assets is of the amount of admissible and inadmissible assets held during the taxable year.

A corporation has capital and surplus of $400,000 and indebtedness of $100,000. It has admissible assets of $420,000 and inadmissible assets of $80,000. Under the 1917 rulings as the indebtedness exceeded the amount of inadmissible assets there was no deduction from capital and surplus. Under the 1918 law [Section 326 (c)] it is assumed that all the assets were proportionately purchased from the proceeds of the indebtedness. That is, there must be deducted from the capital and surplus 80/500ths (16 per cent) of $400,000 or $64,000, making the invested capital of the concern $336,000. Or, to put it another way, after ascertaining invested capital by adding capital, surplus, etc., together, there will be deducted therefrom all inadmissible assets, unless there is indebtedness outstanding which might have been available for the purchase of all or part of the inadmissible assets. If there is such indebtedness, the capital will be reduced only by the proportion which the inadmissible assets are of the total assets (both admissible and inadmissible).

If the same concern had no indebtedness, but had $500,000 of capital and surplus, it would result in a deduction of $80,000, i.e., the total inadmissible assets, from the capital. The section therefore is not effective unless there is indebted

ness.

LAW. Section 325.

(a).... The term "borrowed capital" means money or other property borrowed, whether represented by bonds, notes, open accounts, or otherwise;

When gains have been realized on stocks, etc., or interest on borrowed money has not been deductible.-There is another exception to the rule that inadmissible assets must not be included.

where the

LAW. Section 325. (a) [Inadmissible assets] income derived from such assets consists in part of gain or profit derived from the sale or other disposition thereof, or where all or part of the interest derived from such assets is in effect included in the net income because of the limitation on the deduction of interest under paragraph (2) of subdivision (a) of section 234,' a corresponding part of the capital invested in such assets shall not be deemed to be inadmissible assets;

The phrase "a corresponding part of the capital invested in such assets" may be understood to mean that the part of inadmissible assets which shall be included will be "an amount which bears the same ratio to the total amount invested in such stocks or bonds as the amount of such gains or profits bears to the total amount of such income." This quotation is from the 1918 regulations.

REGULATION. Whenever income consists partly of gains or profits subject to the excess profits tax arising from trading in stocks, bonds, etc., the dividends or interest on which are not subject to such tax, and partly of such dividends or interest, then, subject to the limitations as to borrowed money, there shall be included in the invested capital an amount which bears the same ratio to the total amount invested in such stocks or bonds as the amount of such gains or profits bears to the total amount of such income. (Reg. No. 41, 1918, ¶ 101.)

The benefits of Section 325 are in addition to those of Section 326, which has already been referred to, but the aggregate of the inadmissible assets included in invested capital under the two sections must not, of course, exceed the total of the inadmissible assets.

Stock of foreign corporations may be included as invested capital. The law excludes from invested capital, stocks the

'Section 234 (a-2) covers limitation of interest paid on indebtedness incurred to purchase or carry tax-exempt securities.

dividends upon which are not included in computing net income. When a domestic corporation owns stock of a foreign corporation and the latter pays income tax upon the part of its net income realized in the United States, a corresponding part of the dividends received by the domestic corporation would not be included in income. But the dividends received by the domestic corporation presumably would include income from foreign sources upon which no income tax was paid to the United States. Such part of the dividend would be subject to income tax, and a proportionate part of the value of the stock should be included as invested capital.

REGULATION. In the case of domestic corporations or partnerships and of citizens or residents of the United States holding stock in a foreign corporation part of whose net income is subject to the income tax, there shall be included in invested capital such proportion of the value of the stock in such foreign corporation as the net income of such foreign corporation from sources outside the United States is of its entire net income. (Reg. No. 41, 1918, ¶ 102.)

Changes in invested capital during taxable year may be averaged.

LAW. Section 326. . (d) The invested capital for any period shall be the average invested capital for such period, but in the case of a corporation making a return for a fractional part of a year, it shall (except for the purpose of paragraph (2) of subdivision (a) of section 311)1 be the same fractional part of such average invested capital. . . . .

REGULATION. If there has been any change made during the taxable year in the amount of the invested capital, the monthly average shall be taken (article 43), but in no case may the invested capital include any surplus or undivided profits earned during the taxable year. (Reg. No. 41, 1918, ¶ 130).

United States bonds are included as invested capital.Section 325 (a) provides that assets the income from which is not subject to the excess profits tax shall not be treated as invested capital, but obligations of the United States are expressly excluded from the prohibition.

'Section 311 (a-2) covers the war profits credit.

As to 4 per cent Liberty bonds (except the first issue) and certificates of indebtedness, the section makes little difference, because the interest on these obligations is subject to the excess profits tax (except as to the interest on a restricted amount of each issue), but a substantial advantage may be secured through the ownership of 32 per cent Liberty bonds. The interest on the 32 per cent and all other United States bonds issued prior to September 1, 1917, is entirely tax-exempt. Nevertheless, the cost price of such bonds need not be deducted from the assets of the corporation in computing invested capital. It will be noted that the bonds which must be deducted are tax-exempt bonds (such as municipals), not socalled tax-free bonds (such as corporate bonds).

As stated on page 718, a good test of the aggregate of allowable invested capital can be made by basing the calculation on the capital and surplus accounts rather than on the asset accounts. It is true that all United States bonds are admissible assets but so are cash and other items. United States bonds are not in themselves an admissible item of invested capital if purchased during a taxable year, nor is any other asset admissible unless during the year new capital is contributed to the business.

RULING. In October, 1917, a corporation invested $200,000 of its current earnings in Liberty bonds. May this amount be included in the invested capital for 1917?

No. Although the Liberty bonds are "admissible" assets, their acquisition did not affect the invested capital for 1917. Profits of a taxable year, even though carried to surplus account, cannot be included in invested capital for that year. (Excess Profits Tax Primer, 1918, question 77.)

Invested Capital of Insurance Companies

REGULATION. (a) The invested capital of a mutual insurance company will be deemed to consist of the sum of (1) any surplus or contingent reserves maintained for the general use of the business, plus (2) any legal reserves the net additions to which are included

in the net income subject to the tax-subject to the restrictive provisions of article 44 requiring the exclusion of tax-free assets other than obligations of the United States.

(b) The invested capital of a stock insurance company will be deemed to consist of its capital stock, paid-in or earned surplus and undivided profits (subject to the same restrictive provision of art. 44), computed in accordance with the provisions of article 53. (Reg. No. 41, 1918, ¶¶ 156, 157.)

Invested Capital of Foreign Corporations

REGULATION. When used with reference to a foreign corporation ...: the term "invested capital" means that proportion of the entire invested capital as defined and limited by these regulations which the net income from sources within the United States is of the entire net income. (Reg. No. 41, 1918, ¶ 105.)

Adjustments of Invested Capital as Shown by the Books

The liability side of the balance sheet will be analyzed first.

Capital stock. The aggregate capital stock outstanding in the hands of the public, including all issues of common and preferred stock, is prima facie fully allowable as an item of invested capital.

If issued for goodwill or other assets which are subject to adjustment, the deductions, if any, will be made when the asset side of the balance sheet is analyzed.

An increase in capital stock during the taxable year will take effect as of the date or dates when cash or other assets are received in payment for the stock.1

STOCK WITHOUT PAR VALUE.—

LAW. Section 325. ... (b) For the purposes of this title, the par value of stock or shares shall, in the case of stock or shares issued at a nominal value or having no par value, be deemed to be the fair market value as of the date or dates of issue of such stock or shares.

In most cases shares having no par value are placed upon

'Reg. No. 41, 1918, ¶ 96.