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Law. Section 240. (a) That corporations which are affiliated within the meaning of this section shall, under regulations to be prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income and invested capital for the purposes of this title and Title III [war profits and excess profits tax], and the taxes thereunder shall be computed and determined upon the basis of such return: ....

CONSOLIDATED RETURNS OF NET INCOME.—Section 240 (a) of the law specifically provides that all taxes shall be computed and determined upon the basis of the consolidated return. It sometimes happens that earnings of a holding com- . pany and its subsidiaries are not sufficient within certain periods to cover the dividends paid during such periods. In computing invested capital such a contingency might result in the reduction of the invested capital of one of the group. By consolidating the net income of all affiliated corporations, there will be no reduction in the invested capital after the expiration of sixty days following the end of the taxable year, provided the combined earnings of the group are sufficient to pay the combined dividends.

From the standpoint of income tax it makes little difference whether or not the accounts of affiliated concerns are consolidated, unless one or more of a group should be losing money. In such a case under separate returns no credit could be taken for the loss. If, however, consolidated returns were not permitted (as was advocated so strenuously by Mr. Kitchin) it would require very little adjustment, in most cases, to shift enough profit to a losing subsidiary to correct the situation.

The subject of consolidated returns is more fully dealt with in the author's Excess Profits Tax Procedure.

REGULATION. "If subsidiary corporations exist in name only, or are mere agents or integral parts of the parent corporation and as such transact no business and have no income of and for their own account, and incur no expenses, all business being transacted, all income being received and all expenses being paid directly by the parent company, no separate accounts being kept by or for such subsidiaries, it will be considered that such subsidiary concerns do not have any taxable income within the meaning of this title, and so long as they are so operated no tax liability will be asserted against them.” (Reg. 33, 1918, Art. 208.)

REGULATION. The provision of the statute requiring affiliated corporations to file consolidated returns is based upon the principle of levying the tax according to the true net income and invested capital of a single business enterprise, even though the business is operated through more than one corporation. Where one corporation owns the capital stock of another corporation or other corporations, or where the stock of two or more corporations is owned by the same interests, a situation results which is closely analogous to that of a business maintaining one or more branch establishments. In the latter case, because of the direct ownership of the property, the invested capital and net income of the branch form a part of the invested capital and net income of the entire organization. Where such branches or units of a business are owned and controlled through the medium of separate corporations, it is necessary to require a consolidated return in order that the invested capital and net income of the entire group may be accurately determined. Otherwise opportunity would be afforded for the evasion of taxation by the shifting of income through price fixing, charges for services and other means by which income could be arbitrarily assigned to one or another unit of the group. In other cases without a consolidated return excessive taxation might be imposed as a result of purely artificial conditions existing between corporations within a controlled group. .... (Art. 631.)

FORM OF RETURN.

REGULATION. Affiliated corporations, as defined in the statute and in article 633,42 are required to file consolidated returns on form 1120.43 The consolidated return shall be filed by the parent or principal reporting corporation in the office of the collector of the district in which it has its principal office. Each of the other affiliated corporations shall file in the office of the collector of its district form 1122, along with the several schedules indicated thereon. The parent or principal corporation filing a consolidated return shall include in such return a statement specifically setting forth (a) the name and address of each of the subsidiary or affiliated corporations included in such return, (b) the par value of the total outstanding capital stock of each of such corporations at the beginning of the taxable year, (c) the par value of such capital stock held by the parent corporation or by the same interests at the beginning of the taxable year, (d) in the case of affiliated corporations owned by the same interests, a list of the individuals or partnerships constituting such interests, with the percentage of the total outstanding stock of each affiliated corporation held by each of such individuals or partnerships during

"See page 101.
"It is presumed that the same form will be used in 1920.

all of the taxable year, and (e) a schedule showing the proportionate amount of the total tax which it is agreed among them is to be assessed upon each affiliated corporation. Foreign corporations and personal service corporations need not file consolidated returns. .... (Art. 632.)

“AFFILIATED CORPORATIONS" DEFINED. —

Law. Section 240. .... (b) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns directly or controls 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 is owned or controlled by the same interests.

The phrases "substantially all the stock” and “the same interests” are interpreted by the Treasury in the following manner:

REGULATION. .... The words, "substantially all the stock” cannot be interpreted as meaning any particular percentage, but must be construed according to the facts of the particular case. The owning or controlling of 95 per cent or more of the outstanding voting capital stock (not including stock in the treasury) at the beginning of and during the taxable year will be deemed to constitute an affiliation within the meaning of the statute. Consolidated returns may, however, be required even though the stock ownership is less than 95 per cent. When the stock ownership is less than 95 per cent, but in excess of 50 per cent, a full disclosure of affiliations should be made, showing all pertinent facts, including the stock owned in each subsidiary or affiliated corporation and the percentage of such stock owned to the total stock outstanding. Such statement should preferably be made in advance of filing the return, with a request for instructions as to whether a consolidated return should be made. In any event such a statement should be filed as a part of the return. The words "the same interests” shall be deemed to mean the same individual or partnership or the same individuals or partnerships, but when the stock of two or more corporations is owned by two or more individuals or by two or more partnerships a consolidated return is not required unless the percentage of stock held by each individual or each partnership is substantially the same in each of the affiliated corporations. (Art. 633.)

The foregoing regulations refer to consolidated returns as covering theoretically the operations of a single business enterprise. It should be kept in mind that the law requires that corporations which are affiliated shall make consolidated returns without any regard whatever to the character of business conducted by the various corporations which are owned by the same interests. Therefore, if a holding company owns the stock of a street railway and also owns the stock of an oil company, or if corporations conducting any such dissimilar businesses are controlled by the same interest, section 240 (a) requires that consolidated returns be made.

It will be noted that the holding or principal corporation makes return on form 1120 and each of the other affiliated corporations uses form 1122. It should also be noted that when stock ownership is below 95 per cent but in excess of 50 per cent, a disclosure of affiliations must be made. After such disclosure the regulations would seem to indicate that a consolidated return will or will not be required, based on the decision of the Commissioner. The Commissioner must be guided by a reasonable interpretation of the phrase in the law "owns or controls substantially all the stock.” The ownership of 51 per cent of the stock of a subsidiary might be sufficient to control the subsidiary, but if the remaining 49 per cent were held by entirely different interests, it is not likely that income or expenses could be shifted to the detriment of the government.

RULING. It appears that there are two corporations, one owning and operating properties in the Hawaiian Islands and the other owning and leasing various pieces of property in California. The stock of the California corporation is held by the members of one family, four male members of the family each owning five-twenty-fourths and a sister one-sixth of the entire stock. The Hawaiian corporation is held by the same family principally, with the exception that onesixth of the stock is held by each of the four male members aforementioned, one-sixth by the sister aforementioned and one-sixth by the husband of a deceased sister to the other stockholders. The affairs and operations of the two corporations have in the past been, and are now being, actively conducted by and in the control of the male members of the family. The two corporations, it is stated, are in purpose and effect only one enterprise. In accordance with Regulations 45, where substantially all of the stock of two or more corporations is held by the same interests, such holdings must be in

substantially the same proportions in order to require a consolidated return. It is therefore held that these corporations should file separate returns. (Letter to The Corporation Trust Company, signed by Commissioner Daniel C. Roper, and dated April 11, 1919.)

THE CONSOLIDATION OF NET INCOME.

REGULATION. Subject to the provisions covering the determination of taxable net income of separate corporations, and subject further to the elimination of intercompany transactions, the consolidated taxable net income shall be the combined net income of the several corporations consolidated, except that the net income of corporations coming within the provisions of article 63544 shall be taken out. In respect of the statement of gross income and deductions and the several schedules required under form 1120, a corporation filing a consolidated return is required to prepare and file such statements and schedules in columnar form to the end that the details of the items of gross income and deductions for each corporation included in the consolidation may be readily audited. (Art. 637.)

The latter requirement automatically calls for a schedule which will show the elimination of intercompany items. 45

WHEN DOMESTIC AND FOREIGN CORPORATIONS ARE AFFILIATED.

REGULATION. A domestic corporation which owns a majority of the stock of a foreign corporation shall not be permitted or required to include the net income or invested capital of such foreign corporation in a consolidated return.46 .... (Art. 636.)

RULING. Receipt is acknowledged of your letter dated. April 11, 1919, in which you state: “A client of mine, a New Jersey corporation, owns all of the outstanding stock in a foreign corporation, which in turn owns all of the outstanding stock in a New York corporation. Although under article 636 of Regulations 45 relating to the income tax a domestic corporation is not required or permitted to file a consolidated return with a foreign corporation, it seems to me that the New Jersey and New York corporations above mentioned are affiliated as that term is defined in article 633, and that, on that account the New Jersey corporation should file a consolidated return for both, under the provisions of section 240 of the Revenue Act....."

“Refers to corporation deriving chief income from government contract.

*For an illustration of such schedule, see Appendix.

*But credit may be claimed for taxes paid by the foreign corporation, see Chapter XXVI.

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