DECISION. Except, however, in certain cases mentioned, and in cases of sales of real property, the statute only applies to such gains, profits and income as are strictly acquisitions made during the year preceding that in which the assessment is levied and collected. The mere fact that property has advanced in value between the date of its acquisition and sale does not authorize the imposition of the tax on the amount of the advance. Mere advance in value in no sense constitutes the gains, profits, or income specified by the statute. It constitutes and can be treated merely as increase of capital. The rule adopted by the officers of the revenue in the present case would justify them in treating as gains of one year the increase in value of property extending through any number of years, through even the entire century. . . . . We are satisfied that no such result was intended by the statute."

Surplus arising from reappraisals may be taxable income. -Increased valuations arising from the writing up of book values are not subject to income or excess profits taxes, unless the taxpayer has adopted the inventory method as prescribed by sections 202 (a-2) and 203. In certain cases it is customary and desirable for dealers in securities and similar property to inventory their assets annually. When securities, etc., are stock-in-trade, the best accounting practice requires inventories. But it is not good accounting practice to

[British Practice] It is held under the British Income Tax Act (16 & 17 Vict. Ch. 34) that appreciations in the value of capital assets, even after the realization of profits by sale, do not constitute taxable income if the taxpayer does not deal in such assets in the course of his trade or business. (Stevens v. Hudson Bay Co., 5 Income Tax Cases 424.) In the case of California Copper Syndicate v. Haines (6 Fraser 894), the court said:

"It is quite a well-settled principle in dealing with questions of assessment of income tax, that where the owner of an ordinary investment chooses to realize it, and obtains a greater price for it than he originally obtained it at, the enhanced price is not profit in the sense of the income tax law. But it is equally well settled that enhanced values obtained from realization or conversion of securities may be so assessable, where what is done is not merely a realization or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business."

And again in Assets Co. v. Inland Revenue (24 R. 578), the court said:

"So where a person buys a doubtful debt and recovers a larger sum than he paid for it, the gain is not profit in the sense of the income tax law, unless the purchaser is making a trade of buying such debts."

'See page 341.

consider that revaluations of capital assets are equivalent to inventories. This is demonstrated by the practice of accountants who refuse to credit the surplus arising from revaluations of capital assets to the current profit and loss or earnings account.

Revaluations as of March 1, 1913, should, however, be used as bases for depreciation and depletion charges, and this requires that the appraisals be entered in the books. Property accounts will be debited and "surplus arising from reappraisement of property" will be credited. The latter account is equivalent to a capital surplus account, excepting that part of the appreciation which may subsequently be realized and which should then be transferred to an account which on a balance sheet and for excess profits tax purposes would be called "earned surplus." In order to avoid its inclusion as income for the taxable year, the amount on the books should be credited to "surplus earned prior to March 1, 1913."

Danger of taxing unrealized profits.-The attempt to tax capital gains, desirable though it may be, involves serious possibilities. Unless the tax is imposed intelligently, it will become unpopular and methods of evading it on a grand scale will be devised. It is quite conceivable that the effort to evade the tax might revolutionize the free exchange of corporate securities. Any tax system becomes vicious when it encourages evasion or interferes with legitimate business practices.

The chief defect in the present procedure governing the taxation of these gains is the attempt to tax profits which are not definitely realized. The Treasury states that gains or profits will not be taxed until realized. Of course it so states; otherwise the levy would amount to a direct tax on property-not an income tax-and such a direct tax is unconstitutional unless apportioned according to population.

Having decided that gains or profits arising from capital transactions are taxable, the tendency of the Treasury is to "See page 259.

tax every such gain, both those actually realized and those which are merely apparent. This tendency is illustrated by the Treasury rulings dealing with the question as to whether or not the exchange of securities constitutes a closed transaction. As a matter of fact, most such exchanges do not result in realizations. It may be readily admitted that if a man buys a share of inactive stock for $10 and later exchanges it for a share of United States Steel stock which is selling at $100 there is so near a realization of $90 in cash that there can be little objection to assessment of the tax. The theory that a newly acquired security can always be sold at current market quotations is sometimes fallacious, however, even when applied to listed stocks or bonds. In the case of unlisted or closely held securities the lack of a free market usually makes it unfair if not impossible to consider an exchange a closed transaction.

Basis for Ascertaining Appreciation of Property Values

Determination of the taxable profit derived from the appreciation of property is made, of course, by a comparison of the value of the property at two points of time. This section discusses problems surrounding the establishment of the first valuation, the basis from which the appreciation is measured. Chapter XV considers the valuation at the second point of time, the end of the taxable period.

LAW. Section 202. (a) That for the purpose of ascertaining the gain derived or loss sustained from the sale or other disposition of property, real, personal, or mixed, the basis shall be

(1) In the case of property acquired before March 1, 1913, the fair market price or value of such property as of that date; and

(2) In the case of property acquired on or after that date, the cost thereof; or the inventory value, if the inventory is made in accordance with section 203.

The principle of cost, or March 1, 1913, value has been well established and is recognized throughout all recent reg

'See page 359.

ulations. Section 202 (a-2) places with the Commissioner additional discretion as to permitting the extension of the inventory method. It is probable, however, that the courts would construe section 203 as limiting the use of inventories to property used in the trade or business of a taxpayer.

The difficulties which have been experienced in this section of the field relate to the application of the principlesnot to the principles themselves. No trouble is experienced when an actual realization takes place. The trouble arises over the interpretation of "sale or other disposition of property," in conjunction with "gain derived or loss sustained."

Cost or fair market value March 1, 1913.-The measurement of gain in the case of property subject to inventory has been adequately discussed in the preceding chapter.10 As to other property, the law plainly designates cost as the base from which to measure appreciation in the case of property acquired on or after March 1, 1913, and the value on that date for property acquired previously. The general provision of the regulations governing this point reads as follows:

REGULATION. For the purpose of ascertaining the gain or loss from the sale or exchange of property the basis is (a) its fair market price or value as of March 1, 1913, if acquired prior thereto, or (b), if acquired on or after that date, its cost or its approved inventory value. In both cases proper adjustment must be made for any depreciation or depletion sustained. . . . . .. (Art. 1561.)

The words "or its approved inventory value" appear in the law as "or the inventory value, if the inventory is made in accordance with section 203."

The section of the law referred to grants to the Commissioner full authority to require taxpayers to inventory their assets, so long as the basis prescribed conforms "to the best accounting practice in the trade or business" and "as most clearly reflecting the income." It would seem that there is a very definite limitation upon the power of the Commissioner 10 See pages 295-308.

because it is not customary in any trade or business to inventory annually or periodically the capital assets. The inventory method is used only with trading assets. Although it might be highly desirable, no specific authority is given to prescribe inventories for those not engaged in trade or busi

ness.

No specified method of determining values.

REGULATION. . . . . What the fair market price or value of property was on March 1, 1913, is a question of fact to be established by any evidence which will reasonably and adequately make it appear. (Art. 1561.)

Realizations may not occur for many years and it is sometimes difficult because of the lapse of time to determine a fair value as of March 1, 1913. It is advisable, therefore, if sales are at all probable, to give consideration to the factors underlying valuations and to accumulate evidence to establish true values as of that date.

RULING. The fair market price or value of timber or timber lands, as of March 1, 1913, is the price at which the property in its then condition and with the circumstances then surrounding it, could have been sold, for cash or its equivalent. This value must not be speculative, but must be determined without taking into account any prospective profits that may result from the manufacture of the timber into lumber. It must be, as the law contemplates, a fair market value, and, once determined, must be set up on the books, and, as the measure of a stumpage deduction for income tax purposes must remain constant and cannot be increased. The value so set up as of March 1, 1913, will be subject to the approval of the Commissioner of Internal Revenue. (Letter to subscriber of The Corporation Trust Company from Deputy Commissioner L. F. Speer, March 10, 1917.)

Determination of fair market value as of March 1, 1913."— The cost of reproduction is rarely a satisfactory basis for the determination of fair market value as of any date. When applied to the present time we find that many properties are

"Definitions of value:

"The importance of a commodity measured by the amount of other commodities (commonly represented by money) for which it can be exchanged in open market; the ratio in which one thing exchanges against