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INCOME FROM INTEREST-GENERAL

All interest, except on state, municipal and certain United States securities, is to be included in gross income, whether on notes, bank deposits, securities, bonds, mortgages or deeds of trust or other similar obligations of domestic corporations and insurance companies, bonds issued in foreign countries or upon foreign mortgages or likę, obligations (not payable in the United States). Interest upon the obligations of foreign corporations, associations and insurance companies engaged in business in foreign countries must also be included. Interest on tax-exempt securities is not to be reported as a part of gross income, but a statement showing the number and amount of such securities and the income therefrom must be submitted with the annual income tax return.'

Subject to the exceptions stated, not only is all interest received by residents and domestic corporations taxable, but interest received by non-resident aliens and foreign corporations arising from sources within this country is also taxable-a fact which raises an interesting question of international double taxation,

The law and procedure regarding interest derived from United States obligations including farm loans will be found in the following chapter. Interest from all other sources will be discussed in this chapter.

Interest Taxable and Exempt
Interest subject to tax.-

Law. Section 213. That for the purposes of this title .... the term “gross income"

'Formerly, interest which was entirely exempt from taxation did not have to be reported at all.

*For discussion of the principles involved in the taxation of nonresident aliens, see Chapter XXXIII.

(a) Includes gains, profits, and income derived from .... interest ....3

Interest exempt from tax. —

Law. Section 213. .... (b) .... the following items, which shall be exempt from taxation under this title: ....

(4) Interest upon (a) the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia ; or (b) securities issued under the provisions of the Federal Farm Loan Act of July 17, 1916; or (c) the obligations of the United States or its possessions; or (d) bonds issued by the War Finance Corporation: Provided, That every person owning any of the obligations, securities or bonds enumerated in clauses (a), (b), (c) and (d) shall, in the return required by this title, submit a statement showing the number and amount of such obligations, securities and bonds owned by him and the income received therefrom, in such form and with such information as the Commissioner may require. In the case of obligations of the United States issued after September 1, 1917, and in the case of bonds issued by the War Finance Corporation, the interest shall be exempt only if and to the extent provided in the respective Acts authorizing the issue thereof as amended and supplemented, and shall be excluded from gross income only if and to the extent it is wholly exempt from taxation to the taxpayer both under this title and under Title III ;5

If no return is otherwise required because a taxpayer has no net taxable income this section cannot be invoked to call for a return of exempt interest.

Interest accrued but not collected.—So far as possible taxpayers are expected to keep their accounts on an accrual basis and return as income all interest which accrues to them.

*[Former Procedure] The language of the 1917 law was the same.

Former Procedure] The interest allowed by the Treasury upon money paid into the Treasury in anticipation of income and excess profits taxes as provided in the 1917 law was originally held to be taxable (T. D. 2622, December 26, 1917) but this ruling was canceled by T. D. 2695 (April 11, 1918). The later decision does not cite any section of the law to justify the exemption but it is assumed that the item was not dealt with as a receipt at all but in effect was regarded as a deduction from or reduction of the tax.

'[Former Procedure] The language of the 1917 law was almost the same. The 1918 law adds the words "territory,” “District of Columbia," "bonds issued by the War Finance Corporation," and "or its possessions" after the words the “United States." The provisions for reporting the holdings of tax-exempt bonds and for requiring the interest to be included in gross income unless wholly exempt are new, REGULATION. Where interest coupons have matured, but have not been cashed, such interest payment, though not collected when due and payable, is nevertheless available to the taxpayer and should therefore be included in his gross income for the year during which the coupons matured. This is so if the coupons are exchanged for other property instead of eventually being cashed. ... . (Art. 54.)

Unless the foregoing regulation is intended to refer only to cases where payment can be secured upon presentation of the coupons, it is too optimistic. It states without reservation that when interest is due it “is nevertheless available to the taxpayer."

Owners of public utility bonds which have been made worthless, or nearly so, by the hostile action of municipal authorities as in New York City, or by confiscatory legislation in other places, will be surprised to learn that the interest on their bonds is "available.” In such cases, whether or not the accounts are kept on an accrual basis, the interest should not be accrued until there is a reasonable chance of collecting it. Of course, if the taxpayer could collect, but does not, there is no excuse for not reporting the amount accrued.

Accrued interest returned as income which is not subsequently collected.—Taxpayers reporting upon the accrual basis should report as taxable income accruals from real estate mortgages, loans and other obligations when there is a reasonable expectation that such 'interest will be received in due course. In cases where it develops that the debtor is unable to pay the interest previously entered as income, this interest should be charged off on the taxpayer's books as soon as it is known to be worthless, and proper credit should be taken therefor in making the next succeeding income tax return.

Interest accrued prior to March 1, 1913, not taxable.—The Treasury has held that interest which fell due on or before March 1, 1913, and was subsequently collected, is not taxable.

'Letter to the Central Trust and Safe Deposit Company of Cincinnati, dated March 16, 1915, embodying a decision by Commissioner W. H. Osborn, signed by A. C. Silligan, collector,

REGULATION. Property held by the taxpayer on March 1, 1913, is capital. Included in this capital are all claims, whether evidenced by writing or not, and all interest which had accrued thereon before that date. Interest accruing on or after that date is taxable income. Where an interest-bearing claim contracted prior to March 1, 1913, is paid in whole or in part after that date, any gain derived from the conversion of the claim into money is taxable. The amount of such gain is the excess of the proceeds of the claim (both principal and interest), exclusive of any interest accrued since February 28, 1913, already returned as income, over the fair market value of the claim as of March 1, 1913 (both principal and interest then accrued.) .... A claim for the purpose of this article means a right existing unconditionally on March 1, 1913, and then assignable, whether presently payable or not. Interest does not, of course, include dividends on corporate stock. ....? (Art. 87.)

Assume a taxpayer had a claim at March 1, 1913, for:

Principal .......

.................. $500.00 Interest accrued prior to March 1, 1913....

.............. 30.00 Interest accrued after March 1, 1913..........

.. 60.00

Fair market value March 1, 1913, was............ $200.00
Settlement was made for.........

............ 400.00 Proceeds to be reported. .......... :.................... Less: Interest already returned as income......... $ 60.00

Fair market value of claim March 1, 1913.... 200.00

$400.00

260.00

Net gain to be reported....

..... $140.00

Interest on Obligations of States and Political

Subdivisions It will be recalled that the law exempts interest upon "the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia.” [Section 213 (6-4).]

[Former Procedure] It was held that interest which became due and payable after March 1, 1913, was all taxable even though part accrued prior to March 1, 1913. The instance mentioned concerned an interest coupon due April 1, 1913, covering six months' interest to that date. There was an attempt to tax five months' interest which accrued prior to March 1, 1913. The proposed assessment could not be supported by the law and was not insisted upon,

'See Chapter XX.

Definition of a political subdivision.—The interpretation of the phrase "interest upon the obligations of a state . . . . or any political subdivision thereof” has raised the question as to whether certain special assessment districts are political subdivisions. The present regulation, quoted in full below, in addition to defining obligations of a state, gives a broad, inclusive definition of a political subdivision which results in the exemption of interest on the securities of special assessment districts generally. 8

REGULATION. Among income exempt from tax is interest upon the obligations of a State, Territory, or any political subdivision thereof, or the District of Columbia Obligations issued for a public purpose by or on behalf of the State or Territory or a duly organized political subdivision acting by constituted authorities duly empowered to issue such obligations are the obligations of a State or Territory or a political subdivision thereof. The term "political subdivision” denotes any division of the State or Territory made by the proper authorities thereof acting within their constitutional powers for the purpose of carrying out a portion of those functions of the State or Territory which by long usage and the inherent necessities of government have always been regarded as public. Political subdivisions of a State or Territory, within the meaning of

'[Former Procedure] T. D. 1946, issued February 10, 1914, interpreted the phrase substantially as does the present regulation. But in the 1918 edition of Reg. 33 it was held (Art. 83) that:

"A political subdivision as here used is held to mean a district, division, or community created by proper state authority and which, by virtue of such authority is vested with power to exercise certain governmental functions, such as prescribing regulations for its government, the exercise of certain police powers, the assessment and collection of taxes, etc."

It was held further (Art. 84) that "a district without power to exercise any governmental function, created for the purpose of making some improvement, primarily beneficial to the property located in and comprising the district, is not, within the meaning of these acts, a political subdivision of the state. Obligations issued in payment for such improvement, although guaranteed by a county, municipality or other political subdivision of the state, are not the obligations of the state or of any political subdivision thereof; but are rather the obligations of the benefited property upon which they constitute a lien. Hence, the income derived from obligations, which are a direct charge against or lien upon benefited property, is not exempt from these taxes, and must be returned as income of the recipient.” (T. D. 1946.)

These regulations issued early in 1918 were overruled by T. D. 2715 issued May 20, 1918. Article 74, quoted in the text above, is almost verbatim the same as this decision.

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