porations on account of "tax-free" bonds. Under the 1918 law the deduction is allowed in a different way (by a deduction from the tax as otherwise computed), but the effect is the same.

So far as the deduction is concerned no controversy has arisen, but in the second edition of Regulations 45 the Treasury for the first time took the position that taxpayers must enter as additional income an amount equivalent to the tax "withheld" by the debtor corporation.

RULING. Receipt is acknowledged of your letter of June 20, 1919, asking for advice in regard to the office ruling which authorizes increase of the income by the 2 per cent normal tax paid by the debtor corporation on bonds containing a tax-free covenant clause.

In reply you are informed that this office holds that the obligor, in pursuance of a contract voluntarily entered into, guaranteed to pay a direct liability of the taxpayer which consisted in paying a certain amount of normal tax for him to the government. The reduction of the payment of his tax liability under such a contract constitutes income to him by reducing his expenditures in that amount. The fact that the amount of the liability was paid direct to the government instead of to the taxpayer and by him to the government, does not preclude such an amount from constituting income to the taxpayer. (Letter to Hugh W. Martin, secretary, Northwestern Trust Company, St. Paul, Minn., signed by J. H. Callan, Assistant to the Commissioner, by George V. Newton, Head of Division, and dated September 13, 1919.)

RULING.

Reference is made to your letter of May 13, 1919, asking if the following provision in article 31 of Regulations 45 is retroactive in its application to returns already filed under the Revenue Act of 1918 and previous revenue acts:

"The amount of income tax paid for a bondholder by an obligor pursuant to a tax-free covenant in its bonds is in the nature of additional interest paid the bondholder and must be included in his gross income."

In reply you are advised that the provision quoted above is applicable to income tax returns for the years 1913-1918 inclusive, as well as for subsequent years. (Letter to Prentice-Hall, signed by P. S. Talbert, Head of Division, and dated August 1, 1919.)

The government cannot summarily assess additional tax in respect of 1913, 1914 and 1915 returns. After March 1, 1920, the same restriction applies to the 1916 returns. So

far as the additional tax above referred to is concerned, taxpayers should not sign waivers, but should require the government to bring suit, if it so elects (which is very doubtful).

Thousands of taxpayers are receiving notices of additional assessments in accordance with the foregoing ruling. The additional assessments call for payment not only of the full normal tax but also of surtax computed on the amount of the tax paid by the debtor corporation.

In one case a taxpayer in 1917 received $2,300 from "taxfree" bond interest. He claimed credit for $46, representing the 2 per cent tax paid for his account by the debtor corporations. In 1919 he received an additional assessment of $23, computed by adding to the 4 per cent normal tax a surtax of 46 per cent. In other words, on the $46 paid to the government by the corporations, the bondholder was taxed $23.

If the bondholder had received the $46, that would have been a different matter, but he did not receive it, even constructively, for Congress with full knowledge of the facts provided the method of reporting the specific income and taking credit for the specific tax in question. In view of the widespread criticism of the Treasury's position and probable litigation in connection therewith, it will be of interest to discuss the matter from various angles.

The tax can only be imposed on "net income" as defined in the law, and the law in turn must confine itself to the authority contained in the sixteenth amendment. A taxpayer who owns a $1,000, 6 per cent bond with a "tax-free" covenant receives $60 per annum. Under past practice he reported the $60 as income and unless exemption was claimed received credit for $1.20 against his total tax otherwise payable. The corporation was required to pay $1.20 to the government and was not permitted to claim credit for the pay

ment.

The question now arises, "Can the taxpayer be charged with additional income to the extent of $1.20?" He has en

tered as income all he has received, all that was due, and he cannot be required to enter any additional amount unless it can be shown that he had "constructive" income equal to the tax credit. If, however, the credit he has taken is in accordance with an express provision of the law there is no need to construe the credit as additional income merely because it benefits the taxpayer.

The law does not state that the amount to be included as income shall consist of the interest plus the tax. It specifically restricts the item of income to that amount upon which tax is required to be withheld. No tax is withheld upon the $1.20.

There are other inconsistencies, benefits and penalties in the law. A taxpayer who owns his residence is permitted to deduct the taxes he pays although the taxpayer who rents his residence from an owner receives no equivalent benefit. The taxpayer who borrows money to buy an automobile for pleasure purposes is permitted to deduct the interest paid on the loan, although the taxpayer who rents an automobile receives no equivalent benefit. A stockholder receives credit for the 8 per cent normal tax paid by a corporation on the amount of dividends which he received, but the stockholder is not required to enter the tax as income. There are many other inequalities and seeming inequalities which need not be enumerated, and it is not probable that any revenue law will ever be free from them.

If the taxpayer can establish his right to the credit provided by section 221 (d) irrespective of anything else, he cannot be taxed on an additional amount of income unless he receives it or it accrues to him in some specific way. The corporation has fulfilled its contract with the taxpayer when it pays him $60 and when it pays the government $1.20 in accordance with its understanding to pay such amount for account of the taxpayer.

In the case of real estate taxes paid by a lessee for account of the lessor the latter is held to have received an equivalent

amount as additional rent.22 It makes no difference whether the lessor returns it or not, since, if entered as income, the amount is also an allowable deduction. It must be remembered that the lessor is legally liable for the real estate taxes, and the payment by the lessee discharges a legal obligation of the lessor. Such a transaction properly imputes "constructive" income to the lessor, but it does not result in his paying additional income tax.

It may be argued that the corporation when it pays $1.20 to the government is also paying the bondholder's obligation (to pay the normal tax); that the bondholder would have to pay the 2 per cent if the corporation did not, and that as the corporation discharges a legal obligation of the bondholder the latter, like the lessor, should be charged with constructive income of $1.20. If this were the whole case the author would not argue it. It would be fair enough if the law would provide that corporations need withhold nothing at all. That would free most of the corporations from any obligation to assume any normal tax whatever. If the provisions of a deed of trust were such as to require a corporation to pay a bondholder's normal tax, or any part of it, the corporation would (if it agreed to pay 2 per cent) have to pay the $60 interest plus $1.20, plus enough additional tax to pay the tax on the tax, all of which the bondholder would have to return as income. The taxpayer would then receive $60 net. Under the present and prior laws, while he is ostensibly entitled to something more than $60, because he has an enforceable contract against a corporation to receive $60 and in addition to receive or have paid for him his normal federal income tax thereon (provided the corporation is required to withhold it), he actually receives no more than if the contract provided that the corporation pay the bondholder's tax.

The intention of Congress seems to have confirmed this. claim of the bondholder that he is entitled to something more than $60 by giving him the right to deduct the 2 per cent,

22Reg. 45, Art. 109, page 445.

even though Congress recognized the fact that he did not pay it.

Nothing in the law as it stands supports the theory of "constructive" income of any additional amount. What the Treasury is now doing, when applied to a taxpayer subject to a high surtax, practically nullifies the credit. Instead of doing the thing carelessly Congress spent a tremendous amount of time enacting the present and former clauses permitting the credit. And it was intended that it should operate as a 100 per cent credit. Congress never intended that the taxpayer should report $61.20 as income. Otherwise section 221 (d) when it was being drafted would have so provided.

As above stated, if Congress had intended that the taxpayer should return his tax-free bond interest so that the net result would be as the Treasury now insists, an obviously important change in section 221 (d) would have been made. The only logical conclusion is that Congress intended to insure to the bondholder his $60, intended to make the corporation pay the 2 per cent and intended that the taxpayer should receive the benefit of the 2 per cent, notwithstanding the general provision that federal income taxes are not an allowable deduction. True, the bondholder gets more than $60 net out of it, but his contract called for that.

If it is claimed that the constructive income imputed to the taxpayer is additional interest, logically the corporation would be entitled to deduct it.

In a word, Congress deliberately permitted the transfer of a part of the income tax on a bondholder's income to the debtor corporation which had issued a tax-free covenant bond, and the Treasury cannot by administrative regulations change any provision of the law. The courts usually confirm the clear intent of a revenue measure, and if it is not clear the courts do not permit the government to decide doubts in its own favor. In the opinion of the author the additional assessments now being made should be paid under protest and claims should be filed for refund.