year following a profitable year, but these and similar contingencies do not affect the government's claim to its share of the preceding year's net income. When payment is made it is immaterial whether the payment is charged one way or another on the taxpayer's books, or whether the cash to pay comes from current earnings, past earnings or from borrowed money. None of these factors can shift the tax liability of the previous year in such a way that it will be helpful to one taxpayer and injurious to another. Unpaid taxes are now included in invested capital and all corporations will be treated alike.

The only logical way in which to treat taxes of a prior year is to consider the cash (or Treasury certificates) required to meet the taxes a part of the capital of the taxpayer so long as it is in his possession. After he pays it out it can no longer be considered as part of his capital. Nevertheless so-called "accountants" have advised corporations which charged 1917 taxes against a reserve for taxes set up to meet such liability, or against surplus, that such entries should be corrected and that instead the payments should be charged as current expenses for 1918. Calling federal taxes current expenses does not make them so. Such advice can only get corporations into trouble. It is highly desirable that the so-called "accountants" should get into trouble also.

Deficit or loss accounts.-Surplus accounts are added to capital stock accounts to determine the correct amount of invested capital. The question therefore arises: "Should book accounts representing losses or accumulated deficits be deducted from capital stock accounts and thus decrease the amount of invested capital?" Good accounting practice requires that deficit accounts shall be shown on the liability side of a balance sheet and so stated as to be in effect a deduction from capital stock.

Of course, it is not claimed that a deficit account reduces

the par value of capital stock, but whenever the net worth of a corporation is less than the par value of its outstanding capital stock, it is obvious that the book value of the capital stock has been diminished.

The deficit is the explanation. As we have seen, however, the excess profits tax law does not pretend to adopt book values and it is fairly clear that it was intended that book losses should be ignored.

If the deficit account represents net operating losses or losses allowable for income tax purposes, there can be no question that the amount has been part of the paid-in capital. The law apparently continues to recognize it as capital.

If all or part of the deficit is made good out of subsequent earnings, invested capital will remain unchanged-that is, any part of the deficit will drop out of invested capital and the surplus (earned prior to the beginning of the taxable year) will take its place.

Adjustment of Assets

Unless there has been a sale or transfer of assets to a new owner, no appreciation in values can be used in stating invested capital. If there has been no sale to an outside interest, there has been no realization of the increases in values. Without a bona fide realization there can be no trustworthy measure of the alleged appreciation.

The disallowance of estimated appreciation does not work a comparative hardship in most cases, although many think that persons who have recapitalized or sold out have derived some special benefit therefrom as compared with those who have retained their pre-war status.

In the case of sale:

I.

There must have been an actual change of ownership or no possible benefit accrues.

2.

The sellers, if they sold out at prices substantially

greater than book values, must account for the excess realized and pay income taxes thereon.

3. The buyers having hazarded new capital in what to them is a new enterprise, are entitled to consider as invested capital the full amount of the new capital employed.

4. The amount of new capital automatically equalizes matters, because if by any chance the buyer pays an inflated price and thereby will receive exemption on an inflated amount of invested capital, the seller (who has realized the inflated price) must account for a like amount of profit.

5. It is true that there was no income tax burden on the sellers who sold out before March 1, 1913, and in a comparatively few cases a large benefit now accrues to such persons, but transactions which took place many years ago were not influenced by the imminence of income and excess profits taxes and they cannot be fairly penalized now for avoiding something which no one foresaw.

Furthermore the parties to the ancient transactions may have reinvested and lost the realizations of those times or may have reinvested in other enterprises now paying heavy taxes.

If all items properly classed as invested capital tangible and intangible could be reappraised as of March 1, 1913, or January 1, 1918, there would be such a great increase in values that the rates of tax would have to be greatly increased to raise the same amount of revenue.

Where assets charged off may be included as invested capital. When it is claimed that book values of assets do not reflect actual values the Department in some cases allows the restoration of assets charged off in past years. The permission, however, is greatly restricted.

REGULATION. Such additions will be accepted only to the extent and under the conditions stated below:

(1) Amounts which have been expended in the past for the acquisition of plant, equipment, tools, patterns, furniture, fixtures, or like tangible property, having a useful life extending substantially

beyond the year in which the expenditure was made, and which have been charged as current expense, may (less proper reduction for depreciation or obsolescence) be added to the surplus account in computing invested capital when such assets are still owned and in active use by the taxpayer during the taxable year. Special tools, patterns, and similar assets shall not be assigned any value if their cost has been recovered through having been included in the price of goods. If their cost has not been so recovered and they are held for only occasional use, they shall not be assigned a value in excess of the fair value based upon the earnings actually arising from their current use. Assets of this kind not in current use shall not be valued at more than their nominal or scrap value.

(2) Amounts expended in the past for goodwill, trade-marks, trade-brands, franchises, and other intangible assets of a like character, are controlled by the language of the statute which provides that such assets "shall be included in invested capital if the corporation or partnership made payment bona fide therefor specifically as such in cash, or tangible property." The Commissioner of Internal Revenue will recognize additions to invested capital on account of intangible assets only if such assets have been explicitly paid for in the manner prescribed by the statute. Where expenditures have been made for the general development of intangible assets, and charged as current expense, no readjustment thereof will be allowed.

(3) Amounts under (1) and (2) above, expended on or after March 1, 1913, will, in the case of a corporation, be limited strictly to items which have not been deducted in computing taxable income upon its income tax return. Whenever a corporation has claimed and the department has allowed a deduction in respect to its income tax, the item upon which the deduction is based shall not be restored to the surplus account nor included in the invested capital.

(4) The taxpayer shall in his return to the Commissioner of Internal Revenue make a statement of the proposed additions, specifying the kinds and amounts of property involved, the years in which the expenditures were made, and the method followed in distinguishing between capital outlays and current expenses.

(5) The taxpayer shall also show that adequate provision has been made for the depletion, depreciation, or obsolesence of such of the assets so acquired as are, under the rulings of the Department, subject to recognized depreciation. (Reg. No. 41, 1918, ¶¶ 151-155.)

Assets must be reduced to actual values.-The provision in the law that invested capital includes all cash and tangible assets "paid in"" has given rise to some misapprehension of the

'Section 326.

1

status (a) of property which has depreciated from normal use or has diminished in value for other reasons which can or should be adjusted by charges to surplus account; (b) of property which has become of less value and the shrinkage or loss of which cannot be adjusted by charges to surplus account because the corporation has no surplus.

WHEN NO PROVISION HAS BEEN MADE FOR DEPRECIATION. -If depreciation has taken place and is not provided for on the books it is necessary to reduce the assets affected to actual value and to reduce surplus accordingly.

REGULATION. The term "invested capital" as used in the excess profits tax law means the invested capital of the present owner. The basis, or starting point, in the computations of invested capital is found in the amount of cash and other property paid in, the original values of such other property being determined in accordance with the rules laid down in these regulations. But the computation does not stop with such original entries or amounts; it must take properly into account the surplus and undivided profits. In the computation of surplus and undivided profits, however, full recognition must first be given to expenses incurred and losses sustained from the original organization of the business concern down to the taxable year, including among such expenses and losses a reasonable allowance for depletion, depreciation, or obsolescence of property originally acquired for cash or for stock or shares or in any other manner. If value appreciation of a kind not subject to income tax (other than that allowed under article 55) has been taken up in the accounts, a deduction must be made in respect of such appreciation so taken up. In the computation of the invested capital for any year full effect must also be given to any liquidation of the original capital. No. 41, 1918, ¶ 93.)

(Reg.

WHEN APPRECIATION BECOMES PART OF INVESTED CAPITAL. -The foregoing regulation is sound except as to the deduction required for "value appreciation." It is true that if the appreciation is of a kind specifically excluded from invested capital, such as increases in valuation as shown by reappraisals, etc., the deduction from book values is proper. But if the appreciation is of the kind referred to in the following ruling the deduction may not be warranted.