any amount of premium already returned as income (or of the face value plus any amount of premium not yet returned as income) over the purchase price is gain or income for the taxable year.

(3) (a) If bonds are issued by a corporation at a discount, the net amount of such discount is deductible as interest and should be prorated or amortized over the life of the bonds. (b) If thereafter the corporation purchases and retires any of such bonds at a price in excess of the issuing price plus any amount of discount already deducted, the excess of the purchase price over the issuing price plus any amount of discount already deducted (or over the face value minus any amount of discount not yet deducted) is a deductible expense for the taxable year. (c) If, however, the corporation purchases and retires any of such bonds at a price less than the issuing price plus any amount of discount already deducted, the excess of the issuing price plus any amount of discount already deducted (or of the face value minus any amount of discount not yet deducted) over the purchase price is gain or income for the taxable year. (Art. 544.)

When bond discount has been capitalized at the time of issuance of the bonds (as was frequently done and approved by public service commissions not many years ago), and when such discount has not been otherwise amortized, it appears to be permissible for income tax purposes to write off annually the pro rata amount.

When bond discount was charged to profit and loss during the year in which the bonds were issued (if since 1909) or during subsequent years, in amounts greater than the proper proportion, it seems to be permissible to prepare and submit amended returns for such years, or upon any reopening of a corporation's books by the Treasury to make claim for adjustment.

Decisions under the 1909 law.-The foregoing regulations are those prescribed by the Treasury under its authority to permit and require accounts to be kept on a basis which properly reflects the true net income of taxpayers.

Under the 1909 law the Treasury's hands were more or less tied. The law as written required accounts to be kept strictly on a cash receipt and payment basis. Therefore the

decisions of the courts under the 1909 law are of interest only in connection with returns for periods prior to January 1, 1913.

BALDWIN LOCOMOTIVE Co. v. McCOACH.—

REGULATION. The decision of the United States Circuit Court of Appeals for the Third Circuit, in the case of the Baldwin Locomotive Works v. McCoach, Collector (221 Fed. 59), holds that if the loss sustained by selling its own bonds at a discount is an expense of the business of a corporation, the expense will not be paid until the maturity of the bonds, and should therefore be prorated over the life of the bonds. (T. D. 2185, April 1, 1915.)

SOUTHERN PACIFIC R. R. Co. v. MUENTER, CIRCUIT COURT OF APPEALS, 9TH CIRCUIT, OCTOBER 6, 1919.—

REGULATION. Where a corporation sold bonds at a discount during 1906, 1907 and 1908 no deduction from gross income for the years 1909, 1910 and 1911 of sums set aside by the corporation to pay such discount at the maturity of the bonds is permitted under the provisions of section 38, Act of August 5, 1909, authorizing corporations to deduct from gross income "(second) all losses actually sustained within the year . . . .” and “(third) interest actually paid within the year on its bonded or other indebtedness. . . . .' (T. D. 2944, November 8, 1919.)

It will be noted that the court strictly construed the terms "losses actually sustained within the year" and "interest actually paid within the year."

Loss on bonds sold or paid at maturity.-When the amount received from the sale or redemption of bonds is less than cost, or fair market value March 1, 1913, the difference is an allowable deduction as a loss.

It should be remembered that there has been a great decline in the price of bonds since March 1, 1913, so that practically all bonds purchased or otherwise acquired prior to that time would show a loss if sold at this time.

If bonds were purchased at a discount or premium and the taxpayer has amortized the difference between par and purchase price, the amount of the loss is based on the book values and not on original cost, except as the value at March I, 1913, may necessitate further adjustment,

Premium on capital stock redeemed not a deductible loss.— RULING. This office is in receipt of your letter of the 6th instant, in which you ask for information on the following question: "A corporation in 1912 issued preferred stock for par. It was provided on the certificates that said stock was redeemable at 110. The company exercised its option and redeemed the stock at 110 by calling it in. The difference appeared on the books as a reduction of undivided profits. Is this difference a lawful deduction?"

In reply you are informed that this office will hold that the redeeming of the stock at a price in excess of par represents a capital transaction in which there can be no gain or loss to the corporation, and therefore the difference between the selling price of the stock and the price at which it was redeemed will not be deductible in a return of annual net income. (Letter to a subscriber of The Corporation Trust Co., signed by Deputy Commissioner G. E. Fletcher, and dated April 11, 1917.)

REGULATIONS. The proceeds from the original sale by a corporation of its shares of capital stock, whether such proceeds are in excess of or less than the par value of the stock issued, constitute the capital of the company. If the stock is sold at a premium, the premium is not income. Likewise, if the stock is sold at a discount, the amount of the discount is not a loss deductible from gross income. . . . . (Art. 542.)

A corporation sustains no deductible loss from the sale of its capital stock. . . . . (Art. 563.)

....

The purchase or redemption by a corporation of its own capital stock is an operation of a nature entirely different from that involved in the retirement of bonds. The purchase or retirement of bonds at a premium involves a payment to a creditor. As explained above, the premium is nothing but a net expense spread over the life of the bonds. Payments to stockholders, on the other hand, must be out of profits (unless liquilation is in progress). Such payments are usually in the form of dividends, but in the numerous instances when corporations purchase their own shares at a premium, this premium in effect is a payment to a stockholder. Most states forbid a corporation to buy its own stock except out of surplus. As the payment of a premium on shares is the equivalent of a dividend, there is no ground whatever for a claim that such premiums should be allowable deductions in

an income tax return. In no sense of the word is such a payment capital. Although not an allowable deduction from net income, premiums on stock can only be paid from profits and that is the method always followed.

Consequently the author cannot agree with the Treasury when it says that the payment of the premium in redeeming stock is "a capital transaction in which there can be no gain or loss to the corporation." He does agree, however, with the conclusion that such payments are not deductible. As such payments are not allowable deductions to the corporation, and must, therefore, be charged direct to surplus, it can be claimed that a distribution of profits, equivalent to a dividend, has been made. The corporation will have paid the normal income tax thereon and should notify its stockholders of that fact so that they may enter the receipt of the premiums as a dividend and thus avoid the normal tax.

Losses of Holding Companies—Accounting

Procedure

The interests owned by holding companies in affiliated or subsidiary companies are usually represented by holdings of capital stock, bonds or other forms of indebtedness such as promissory notes, open book accounts, etc. When a holding company desires to reflect on its books the profits or losses of its subsidiaries, it does so by the accrual and reserve method, or by writing up or down the book valuations of the stocks or obligations owned.

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Under existing rulings, a mere writing down of valuations is not an allowable deduction. But many transactions ordinarily reflected by a change in valuations are more properly recorded as "losses which are immediately deductible." If a subsidiary loses money and the holding company advances funds, which in effect are used to make good the deficit, and

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20 Auditing, Theory and Practice (2nd edition), by R. H. Montgomery, page 514 et seq.

it is not likely that the subsidiary can repay the advance, it becomes a bad debt on the books of the holding company and

should be charged off as a loss. Transactions of this kind are sometimes improperly handled. For example, the advance from the holding company to the subsidiary is often treated as a gift from one to the other. If this were really so, the holding company could not claim it as an allowable deduction (because gifts are not deductible); but in fact this is not a gift. It is on the part of the holding company one of the necessary expenses incurred in its business or a loss of similar nature. Holding companies are formed to make money. When they lose in transactions from which profits were expected to arise, it is a trade loss-not a gift in the nature of a beneficence or anything of that sort. Therefore at the time when such transactions are entered, the true state of affairs should be disclosed and inadvertent mention of a gift should be avoided.31

The 1918 law provides for consolidated returns in all cases in which one corporation controls another or an individual controls two or more corporations. Therefore, when consolidated returns are made, the loss of one subsidiary operates as a credit against the profit of another and no adjustments need be made in the books.

But it would not be wise to depend on a continuance of the privilege of rendering consolidated returns. Representative Kitchin bitterly opposed the provision.

Furthermore, state income tax returns will require accurate reports from subsidiaries and in many cases no report at all will be required from the parent company or an affiliated

company.

"[Former Procedure] Article 115 of Regulations 33, 1918, required that earnings of subsidiaries taken up on the books of the holding company be returned as income. If the regulations were sound, then the converse must be good practice: that is, where losses of subsidiaries are taken up each month on the books of the holding company, they could be claimed as allowable deductions. As the author questioned the soundness of the ruling as it affects income, the same criticism applies where there is a loss.