Full text of Diaries of Henry Morgenthau, Jr. : Volume 222 : Part 2

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158

MEMORANDUM OF POSSIBLE CHANGES IN THE TAX
LAW WHICH WOULD INCREASE REVENUE BY THE

ELIMINATION OF DISCRIMINATIONS
INCOME TAX

1. Existing Law as to Personal Exemptions (Sec.
25

(b))

The Internal Revenue Code now allows personal exemp-

tion of $1,000 to a single person and to a married person not
living with husband or wife, and a personal exemption of
$2500 to the head of a family or a married person living with
husband or wife. A credit is also allowed for dependents
amounting to $400 for each person dependent upon the taxpayer.

This provision involves serious discrimination in favor of high bracket taxpayers. To a married
Discussion

person with a net income of less than $4,000 it means a tax

saving of 4% (the normal tax rate) of $2500, or $100. To a
married person with a net income in excess of $100,000 and not
in excess of $150,000 the provision means a tax saving of 62%

of $2500, or $1550, which is more than 15 times the saving to
the first low bracket person mentioned. To a married person
with a net income in excess of $5,000,000 the same exemption
means a tax saving of 79% of $2500 or $1975, which is almost
80% of the personal exemption.

Recommendation Section 25 (b) should be amended

so that the credit now allowed therein for both normal tax and

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199

surtax purposes is made a credit against tax under which equal
benefit is given by the exemption to taxpayers in the low

brackets and taxpayers in the high brackets. An alternative
remedy might be to limit the credit presently in the statute
by making it a credit for normal tax purposes only.

2. Existing Law as to Stock Dividends (Sec. 115 (f))
The statute since 1936 has contained an illuminating provision
that a "distribution made by a corporation to its shareholders

in its stock or in rights to acquire its stock shall not be
treated as a dividend to the extent that it does not constitute
income to the shareholder within the meaning of the Sixteenth
Amendment to the Constitution." This provision was drawn in the
1

2

light of such cases as Eisner V. Macomber, Koshland V. Helvering,
3

and Helvering V. Gowran.

In practice it means that stock divi-

dends of the type involved in Eisner V. Macomber (common upon

common with no other class of stock outstanding) are still
exempted from tax. Most other dividends, such as (1) preferred
upon common and (2) common upon preferred, are regarded as taxable.

Discussion As was prophesied by Mr. Justice Brandeis
in his dissenting opinion in Eisner V. Macomber, the existing
1. 252 U.S. 189 (1920).
2. 298 U.S. 441 (1936).

3. 302 U.S. 238 (1937).

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3

statutory provision, as administratively interpreted, constitutes a serious revenue leak. There are approximately
850 issuers of stock listed on the New York Stock Exchange,
the total issues of these issuers being approximately 1230.
Excluding common stock issues of railroad companies, there
are approximately 390 issues of common stock on the New York

Stock Exchange of 390 companies in which the capital is
represented by common stock, or which have a small senior

equity security ranking prior to the common stock. The
capitalization of these companies, including 33 preferred
stock issues, no one of which is of a $1,000,000 nominal
value, consolidate into approximately 625,000,000 common

shares having a nominal value in excess of $16,000,000,000.

These figures constitute a prima facie showing of the companies merely on the New York Stock Exchange which are now

in a position to issue tax-free stock dividends. Further investigation would no doubt show that many, if not the majority,
of these corporations have an earned surplus upon the basis
of which stock dividends may be distributed.
Recommendation

It is highly desirable to subject

all stock dividends to tax by an amendment either to the
statute or to existing regulations. Such an amendment either

of the statute or of the regulations would avoid difficulties
as to retroactive application which would arise from a judicial

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4

decision decreeing all stock dividends to be taxable under

the existing regulations. If there be any doubt as to the
possibility of securing a statutory amendment, some attempt
should be made through the courts to secure a reversal of
Eisner V. Macomber. In spite of the Supreme Court's decision
of November 6, 1939, in the Wilshire Oil case, the issue
1

of a regulation prospectively incorporating a new rule may
be advisable.

3. Existing Law as to Trust Income (Secs. 166, 167)
A number of years ago Sections 166 and 167 were placed in our

revenue act for the purpose of taxing the grantors of taxavoidance trusts which did not accomplish any transfer away

from the grantor of unfettered control over the corpus or income of the trust. These sections, according to Mr. Justice
Roberts, were designed to prevent "facile evasion of the law.'
2

The constitutionality of Section 167 was upheld in Burnet V.
3

Wells.

Discussion The purpose of these sections has been

very largely frustrated by court and Board decisions. The
4

sections, as interpreted by the courts, permit the accomplish1. Helvering V. Reynolds Tobacco Co., 306 U.S. 110 (1939)
2. Reinecke V. Smith, 289 U.S. 172, 178 (1933).
3. 289 U.S. 670 (1933) See Corliss V. Bowers, 281 U.S. 376 (1930)

4. See e.g., Clifford V. Helvering, 105 F (2d) 586 (CCA

8th, 1939); Corning V. Comm., 104 F (2d) 329 (CCA 6th, 1939);

John E. Rovensky, 37 BTA 702.

5

202

ment of the tax-avoidance purpose of the grantor in the
1

case of the income of short-term trusts. Thus, even
though the grantor-trustee has reserved broad powers of
sale and investment, the grantor has been held not tax-

able upon the income of a trust for the benefit of
his wife where the trust was to terminate at the end
of five years, or upon the death of the beneficiary or
the grantor during that period, and the remainder (in excess
of the undistributed income or the proceeds of the investment
2

thereof) was to go to the grantor. If it is certain that the
power to revest will come into being at a fixed point of time,
Section 166 will be applicable, but if the same substantial
result is accomplished by providing that the trust automatically
ceases to exist at the end of a fixed period, without any

affirmative act on the part of the grantor in exercise of a
3

power, then the grantor is not taxable under Section 166. This

1. Of course, the trust problem is much broader than here

indicated. The splitting of income by irrevocable multiple

trusts accomplishes tax avoidance on a large scale. But the
only remedy in this case of irrevocable trusts seems to be a
system of taxation on a family unit basis. Cf. Hoeper V. Wisconsin, 284 U.S. 206 (1931), which probably would be overruled
by the Supreme Court as now constituted.

2. Clifford V. Helvering, supra.
3. See Meredith Wood, 37 BTA 1065, aff'd per curiam 104 F
(2d) 1013 (CCA 2nd, 1939); Christopher L. Ward, 40 BTA 225.

203

means that the grantor in high brackets on account of other
income is able to transfer high-bracket income to a trust
which starts in the low brackets.
Recommendation Sections 166 and 167 should be

entirely revamped to prevent this type of tax avoidance. The
amendment necessary may be briefly described as an elimination

of the emphasis now placed in the statute upon the word "vested",
combined with an addition covering short-term trusts which are
to revert automatically.
1

4. Existing Law as to Unreasonable Accumulations

of Surplus (Sec. 102) Section 102 of the Internal Revenue
Code provides a special penalty tax upon corporations formed or

availed of for the purpose of preventing the imposition of the
surtax upon its shareholders (or the shareholders of any other
corporation) through the medium of permitting the accumulation

of earnings or profits. Although the constitutionality of
this statutory provision was recently sustained by the Supreme
Court in Helvering V. National Grocery Company, the section
2

3

has been a conspicuous failure. Up to a few weeks ago the

reports show only about 33 cases directly involving Section
102, most of which were decided after 1930. The score in
these cases is nominally 18 to 15 in favor of the government,

but the score is really against the government when it is

1. Clifford V. Helvering, 105 F (2d) 586 (CCA 8th, 1939);

Meredith Wood, 37 BTA 1065, aff'd per curiam 104 F (2d) 1013 (CCA

2nd, 1939).

2. 304 U.S. 282 (1938).
3. See Statement of Mr. Vinson, Hearings before the Joint Committee on Tax Evasion and Avoidance, 75th Cong., 1st Sess., p. 173
(1937).

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.7

remembered that in 13 of the government victories against
9 of its defeats, the taxpayer was one which would now be
classed as a personal service corporation.
Discussion What may be now done with impunity under

the existing statute is illustrated by the famous Cecil De
Mille case.
Mr. Cecil De Mille successfully advanced as a
reason for the large surplus accumulation in his corporation
the argument that his corporation was building up its surplus
1

to a point where it could some day achieve independent picture
2

production. Mr. Bud Fisher successfully maintained that his
corporation was building up a surplus so as to have capital
sufficient to effect the distribution of independent comic
strips in the contingent event that a syndicate through which
distribution was effected should refuse to renew outstanding
contracts. This sort of argument is like the argument made by
the White Knight who carried a bee hive around with him because some day he might want to keep bees.

Recommendation Section 102 should be strengthened

by adding to the section a clause similar to subdivision (b)

now therein providing that certain facts "shall be prima facie
evidence of a purpose to avoid surtax upon shareholders."
Among such facts constituting prima facie evidence may be
suggested the following:

1. 31 BTA 1161, aff'd 90 F (2d) 12 (CCA 9th, 1937), cert.

den. 302 U.S. 713 (1937).

2. Fisher & Fisher, Inc., 32 BTA 211, aff'd per curian 84

F (2d) 996 (CCA 2nd, 1936).

205

(a) The fact that less than a stated percentage of
income is distributed;

(b) The fact that more than a given percentage of income consists of dividends;

(c) The fact that the corporation is to a stated degree
1

closely held;

(d) The fact of any major change in distributive policy
resulting in a lower percentage of distribution;
(e) The existence of substantial loans to stockholders;
(f) The existence of substantial non-interest bearing
loans by stockholders; and

(g) The fact that the non-distribution of profits actually
had the effect of a substantial tax saving.
Another amendment which would strengthen Section 102

at one of its weakest points would be the insertion before the
word "business" in subdivision (c) of the word "existing", mak-

ing the "fact that the earnings or profits of a corporation
are permitted to accumulate beyond the reasonable needs of the

(existing) business" determinative of the purpose to avoid sur-

1. The addition of this factor as creating a rebuttable

presumption would be quite different from the so-called "third

basket provision as proposed in the House of Representatives
in 1938. (See House Bill, Revenue Act of 1938, Secs. 451 et

seq.; Ways and Means Committee Report No. 1860, 75th Cong.,

Sess. Thatfrom
imposed
a new tax which
that by Section

3rd was totally p. separate 53 (1938)) imposed proposal 102, and

which was the stockholding requirements were met.
would transfer some

Thefactors
ing present
inescapable
suggestion
if simply
from
the proposed
Section
451Section
into of the 102 determin- it-

self as an additional ground for raising a rebuttable presumption of intent to avoid tax.

9

206

tax upon shareholders unless there is a clear preponderance

of evidence to the contrary. This would mean that the term
#reasonable needs" of the business would be related to the
business in which the corporation is currently engaged and

would place a greater burden upon the corporation to justify
accumulations allegedly designed to permit the corporation to
enter some new business activity. This sort of amendment
would prevent tax avoidance of the De Mille type.

It may be that the statute of limitations should be
lengthened for Section 102 cases, as has been done with
1

respect to foreign personal holding company cases, corporate
2

distributions in liquidation, and where there is a 25% omission
3

from gross income.

An alternative remedy might be to adopt in some part the
This English statute
English counterpart of Section 102.
4

applies only to closely held corporations, and in effect ignores
the separate entity of such corporations. It taxes retained
income to the stockholders, a remedy which may be too drastic.

1. Internal Revenue Code, Sec. 275 (d).
2. Internal Revenue Code, Sec. 275 (e).
3. Internal Revenue Code, Sec. 275 (c).
4. Finance Act of 1922, Sec. 21, First Schedule as Amended

by Act of 1927.

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10

Perhaps also the rates of tax imposed by this

section should be increased. In relation to our present
surtax brackets the existing rates - 25% upon the undistributed Section 102 net income not in excess of $100,000,
and 35% upon such income in excess of $100,000 - render it

advisable for some corporations to pay the tax rather than
distribute.

5. Existing Law as to Charitable Gifts in Form of
Property (Sec. 23 (o)) The Internal Revenue Code now pro-

vides for a deduction on account of religious, charitable
scientific, literary, educational and other contributions.

Discussion This provision works satisfactorily
with respect to cash distributions, but it is wholly indefensible
as to contributions in the form of property. As the law now
stands, a taxpayer secures a deduction to the extent of the
1

value of the property transferred at the date of the gift.
For example, a taxpayer has purchased securities in 1932 for

$1,000 cash, and their value in 1939 is $5,000. This taxpayer

would have a taxable profit of $4,000 if he sold the securities
and made a gift of $5,000 cash; however, if the taxpayer is
well advised, he will donate the securities themselves without any sale thereof; the donee institution may then make
2

the sale as it pleases without any tax liability.
1. Reg. 101, Art. 23 (o)-1.
2. Paul, Selected Studies in Federal Taxation, Second
Series, p. 173, note 75 (1938).

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11

Recommendation Gifts not in money form to religious,

charitable, scientific, literary and educational institutions
should be allowed as a deduction only in the amount of the

adjusted cost basis of the property to the donor or its
value at the date of gift, whichever is lower. A middle alternative would be to allow no more than would be allowed if
the donor sold the property and contributed the cash proceeds
less the capital gains tax.

6. Existing Law as to Non-Business Casualty Losses
(Sec. 23 (e)(3)) The Internal Revenue Code now provides for
the deduction of losses on property not connected with the

trade or business if the loss arises from fire, storm, shipwreck, or other casualty, or from theft.

Discussion This provision results in substantial
deductions and difficulty of administration, particularly
in connection with losses of the type sustained on account
of the recent hurricane which devastated the eastern seaboard.

It is particularly availed of by taxpayers who have large estates; smaller taxpayers cannot afford the appraisal fees in1

volved in proving losses.
Recommendation The provision allowing non-business

casualty losses should be eliminated or restricted, like the
charitable deduction, to a fixed percentage of the taxpayer's
net income as computed without the benefit of this particular

1. Obici V. Helvering, 305 U.S. 468 (1939).

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209

deduction. Another appropriate limitation might be to treat
such losses as capital losses, thus limiting the tax effect
thereof.

7. Existing Law as to Interest on Non-Business
Loans (Sec. 23 (b)) The Internal Revenue Code now allows

the deduction of interest on non-business borrowings (see
item 8 below).

Discussion While it may be that a deduction should
be allowed on business borrowings, although we have here the

discrimination mentioned in item 8 below, the principal

justification for allowing a deduction of interest on personal
borrowings is a desire to promote small home ownership and

building. The deduction in its broader aspects is more or
less arbitrary, and often results in debatable questions as
to whether loans were contracted for any real purpose or a
1

mere tex-avoidance purpose.

Recommendation Section 23 (b) should be amended

by limiting the allowance for the deduction of interest on
non-business borrowings to a fixed maximum amount of, say,

$500, a sufficient amount to cover interest on mortgages upon
a personal home of limited value, and on small personal borrow-

ings to pay doctor and hospital bills or to hold title to small
investments.

1. Paul and Mertens, Law of Federal Income Taxation,

Sec. 24.06 (1934).

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210

8. Existing Law as to Deduction of Interest Paid
or Accrued (Sec. 23 (b)) Section 23 (b) of the Internal
Revenue Code now allows a deduction for all interest paid or
accrued within the taxable year on indebtedness (except indebtedness incurred or continued to purchase certain tax-exempt se-

curities). On the other hand, no deduction is allowed for purposes of the ordinary corporate income tax for dividends paid.
From the stockholders' standpoint dividends and interest are

treated alike; the provision formerly in the law allowing a
credit for normal tax on account of dividends received has
been eliminated.

Discussion The above provision is designed to encourage corporate financing by borrowing, rather than by
1

capital contributions. In the last few years a large number
of corporations have "recapitalized" without tax under
Section 112 (g) by retiring preferred stock and issuing bonds
in the place thereof. For instance, if a corporation has
outstanding a preferred stock issue of $10,000,000, upon

which it pays dividends at the rate of 6%, or $600,000, it
is at a disadvantage as compared with a corporation which owes

Tax
of
p.
36:
makes interest on
1. See Final Report of the Committee of the National

the federal income tax on

"Certainly Association present on Federal Taxation Corporations, corporations,

the deduction of interest on money

which but permits no allowance for imputed proprietor's borrowed

capital, sets up a marked discrimination against financing by
means of stock issues and in favor of financing by bonds."

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14

$10,000,000 to bondholders and pays out the same annual in-

terest of $600,000. The disadvantage consists of 18%
of $600,000 annually, or $102,000 in years beginning with
1940.

Recommendation Section 23 (b) should be amended

to eliminate this discrimination. The entire elimination of
this deduction would probably be too drastic a remedy, although it would be incentive taxation of an extreme character

and would definitely encourage equity financing. A less
drastic mechanism would be at least to disallow the deduction in all cases in which a tax-avoidance purpose colored
the incurring of the indebtedness. This may be covered, so
far as recapitalizations are concerned, by the doctrine of
Gregory V. Helvering, although this is by no means certain.
At the very least a regulation should be framed to cover
1

2

such situations.

1. 293 U.S. 465 (1935).
2. The Higgins V. Smith case, now pending in the Supreme
Court, may help to settle this question.

15

212

9. Existing Law as to Non-Business Bad Debts
(Sec. 25 (k) The Internal Revenue Code now allows a deduction for debts ascertained to be worthless and charged off

within the taxable year. This provision differs from the provision relating to losses in that generally speaking losses
(apart from casualty losses discussed in item 6 above) must be

incurred in trade or business, or in transactions entered into
for profit. Deductions are allowable to individuals for nonbusiness bad debts, including debts between relatives.

Discussion Few provisions of the statute have
been productive of so much litigation as the bad debt pro1

vision. A great many so-called debts are originally in fact
gifts because there is no intention to repay when the socalled indebtedness is incurred; from the creditor's side
2

there is no expectation of repayment.
Recommendation Section 23 (k) should be amended

by limiting the allowance for the deduction of non-business
bad debts. to a fixed small amount, say $1,000 in the case of
each debtor.

1. See Paul, Studies in Federal Taxation, p. 235 (1937).
2. Paul and Mertens, Law of Federal Income Taxation,

Sec. 28.15 (1934).

16

213

10. Existing Law as to Non-Business Taxes
(Sec. 23 (d)) The Internal Revenue Code allows as a deduc-

tion taxes paid or accrued within the taxable year except
income, profits, estate, inheritance, legacy and succession
taxes and taxes assessed against local benefits. State income taxes, sales taxes, local property taxes, and custom

duties are not within the exception. This deduction is allowed
without reference to whether the taxes in question are on business property or dealings.

Discussion This allowance involves a manifest
discrimination between taxpayers who own their own homes

and taxpayers who rent their homes. Taxpayers who own their

homes are enabled through this provision and the provision
for the deduction of interest on non-business borrowings (item
7 above) to deduct almost the equivalent of rent, an expenditure
which is regarded as a non-deductible personal expense in the
case of taxpayers who rent their homes.
Recommendation Section 23 (d) should be amended

by limiting the allowance for the deduction of taxes on nonbusiness property ordealings to taxes on small homes not exceed-

ing, say, $10,000 in cost or value. Possibly some exception
should be made in the case of state income taxes.

11. Existing Law as to Basis Where Optional Valuation Privilege is Chosen (Sec. 302 (1) of 1926 Act as Amended)

The 1935 law added to the estate tax provision Section 302 (j)

17

214

permitting the executors of a decedent to elect the date
a year after the death of the decedent for valuing the decedent's
assets. The remedial purpose was to avoid a heavy estate tax
where assets have shrunk greatly in value during the period
of administration. No corresponding provision has ever been
1

made, however, with respect to the cost basis to be used by
the distributees in computing gain or loss upon the sale of

the assets. The cost basis of such assets is still the value
at the date of acquisition, viz., the date of the decedent's
death.

Discussion Since executors never use the optional
valuation unless there has been a shrinkage of value, taxpayers

obviously get the benefit of a differential which was never
subjected to an estate tax. For example, a decedent may leave

assets having a value of $1,000,000 at the date of his death,
and drastic market fluctuations may have reduced the value of
these assets a year after the date of death to $100,000. In such
a case the executors may exercise the option accorded to them

by Section 302 (1), and the basis to the distributees for purposes of depreciation and purposes of computing gain on sale is,
nevertheless, $1,000,000, although only $100,000 has been subjected to an estate tax.

Recommendation The simplest solution is to insert
a new subdivision in Section 113 stating that where the optional
1. See H.R. Rep. No. 1681, 74th Cong., 1st Sess., p. 9
(1935) H. R. Rep. No. 1885, 74th Cong., 1st Sess. p. 9 (1935).

18

215

valuation privilege is exercised, the basis of such property
shall be the value as used in the estate tax return.
12. Existing Law as to Taxation of Husband and Wife

(Sec. 51 (b)) Husband and wife living together have an option,
as the law now stands, of filing separate returns or a single
joint return including their aggregate income.
Discussion This permission to husband and wife to
file separate returns results in unfair discrimination between
persons whose income is derived principally from property and

persons whose income is derived principally from personal ser-

vices. Property owners frequently convey part of their
property to their spouses, thus reducing income tax, whereas
individuals deriving income from personal services are not able
to secure a corresponding reduction in income tax, since an
assignment of income from personal services is not recognized
1

income tax purposes. On the other hand, in the community
property states income even from services is divided equally
for

between husband and wife, which gives the citizens of these

states a special substantial advantage over the income of citizens
from the other 40 states. This situation may become aggravated
by the fact that there is a tendency in some states to establish

an optional community property system. It is understood that
Oklahoma has recently passed such a statute. Furthermore, many

1. Corliss V. Bowers, 281 U.S. 376 (1930); Lucas V. Earl,
281 U.S. 111 (1930).

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216

family unit incomes must escape tax under existing law because the income of neither husband nor wife on a separate

basis is sufficient to require the filing of an information
return by the payor of the income. If the payor of income

were required to file an information return on all yearly payments of over $1,000, whether the recipient be single or
married, this method of escaping taxes would be curtailed.
Recommendation One thing which could be done

in this situation is to require husband and wife living together to file a joint return. If this recommendation is
adopted, a difficult differentiation should probably be made,
in the interests of the modern independent status of women,
between husbands and wives who are on an independent earnings

or property basis and husbands and wives who transfer property

to each other for the purpose of saving tax, the requirement being limited to the latter type of case. If the recommendation
is not adopted, the present permission, as distinguished from
requirement, of husband and wife to file a joint return might
be eliminated from the statute. Such a return is never filed
under existing circumstances unless it is to the advantage of
the spouses. Still another method might be to tax the income
of husband and wife on a combined basis. Or the method employ-

ed in the British statute might be adopted, - namely the assess-

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217

ment of the entire income of both spouses against the
1

husband at a rate determined by the combined total.
Still another method, which would come substantially
to the same result, is to assess husband and wife
separately at surtax rates based upon the combined income.

13. Existing Law as to Taxation of Interest
from Governmental Obligations (Sec. 22 (b) (4)) At the
present time the Internal Revenue Code excludes from gross

income (1) interest upon the obligations of a state,

territory or any political subdivision thereof, or the District of Columbia, (2) interest upon the obligations of a
corporation organized under act of Congress if it is an instrumentality of the United States (to the extent provided
in the acts authorizing the issue of such obligations), and
(3) interest upon obligations of the United States or its
possessions (to the extent provided in the acts authorizing
the issue of such obligations).
Discussion Extended discussion of this exemp-

tion is unnecessary. It results in a serious loss of revenue.
Recommendation Interest upon all bonds, state

and Federal, issued after the date of introduction into
Congress of a new act should be taxed directly and com-

1. See Paul, Five Years with Douglas V. Willcuts, 53

Harv. L. Rev. 1 (1939); Paul and Havens, Husband and Wife
under the Income Tax, 5 Bklyn L. Rev. 241 (1936).

21

pletely. This would of course mean that Congress would have
to refrain from authorizing any issue of tax-exempt bonds
by the Federal government or affiliated organizations, such
as the Federal Farm Loan Banks. Interest on future issues
of state bonds should be taxed directly and completely.

It would not be fair to tax the income from past
issues of state and municipal bonds even though it might be

constitutional to do so. In so far as Federal bonds have
been issued on a tax-exempt basis, the impairment of con-

tract clause would probably prevent their taxation.
Although it is not suggested that income on past issues
of state and municipal bonds or of tax-exempt Federal bonds

should be taxed, Senator Glass's proposal, that the surtax
on income from non-tax-exempt sources should take into account the existence of tax-exempt income ,should be adopted;

that is, a taxpayer with an income of $200,000, one-half of
which comes from existing tax-exempt securities, ought to pay

surtaxes on the non-exempt half at the rates applicable to incomes between $100,000 and $200,000. That would not be tax-

ing income from tax-exempt securities. If the court wished to
sustain the tax, it could do so by reasoning that this would
simply be denying the taxpayer the right to escape his proper
surtax on his non-tax-exempt income.

14. Existing Law as to Taxation of Capital Gains
(Sec. 117) The Internal Revenue Code now lays a tax on

capital gains, which in the case of long-term capital gains

218

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219

cannot exceed 15% of the gain on the sale of assets held
two years, and 20% of the gain on the sale of assets held

from 18 months to two years. Short-term capital gains,
which arise upon the sale of assets held less than 18
months, are subjected to the ordinary surtaxes.

Discussion This tax is extremely lenient, par-

ticularly as it will operate in an inflationary period. It
involves a serious discrimination against persons who derive
1

their income from personal services. The oft-repeated
criticism that the taxation of capital gains impedes the mo-

bility of capital, and discourages capital from venturing, is
exaggerated.

Recommendation The capital gain rate should be in-

creased, or, in lieu of a flat increase, tax should be imposed on capital gains by reference to the other non-capital
gain income of the taxpayer. If the taxpayer is in a bracket
between $200,000 and $300,000, he can afford to, and should,

pay a higher capital gains rate than a taxpayer in the bracket
just above the point at which it pays to elect to be taxed at

the flat rates contained in the existing statute. An additional
thought would be to give some favored treatment on account of

the reinvestment of the proceeds of capital gains in equity
risks in new enterprises.

1. Internal Revenue Code, Sec. 117. An individual with

an earned income of $100,000 (disregarding credits for earned

income and dependents, but allowing a $1,000 exemption) would
be taxed $33,354, whereas an individual realizing $100,000

from long-term capital gains would be taxed only $9,334.

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23

15. Existing Law as to Corporate Distributions
of March 1, 1913 Profits (Sec. 115 (b)) Every corporate distribution of earnings and profits accumulated, or increase in
value accrued before March 1, 1913, is exempt from income tax.

Such a distribution cannot be made so long as a corporation
has earnings or profits accumulated since February 28, 1913,

because there is a conclusive presumption in the statute that
every distribution is made out of most recently accumulated

earnings or profits. But the pre-March 1, 1913 profits, or
increase in value of property, may be distributed free from
tax if all more recently accumulated earnings or profits have
been distributed.

Discussion There is no constitutional reason why
earnings or profits accumulated, or increase in value of property
accrued before March 1, 1913, should not be taxed. Corporations have been given a reasonable opportunity (20 years) to
distribute pre-March 1, 1913 earnings and increase in value of
1

property without any tax.
Recommendation

You may wish to revive the attempt once

made to amend Section 115 (b) so as to eliminate the exemption

therein given to corporate distributions of earnings or profits
accumulated, or increase in value of property, accrued, before
2

March 1, 1913.

1. Lynch V. Hornby, 247 U.S. 339 (1918) ; Lynch V. Turrish,

247 U.S. 221 (1918).

2. Such an amendment at least once passed the Senate, but

did not survive in the final bill enacted.

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221

16. Existing Law as to Life Insurance Proceeds
Paid in Installments (Sec. 22 (b) (1)) The Internal Revenue
Code provides for an exemption for income tax purposes of

amounts received under a life insurance contract paid by

reason of the death of the insured. In Section 22 (b) (1)
there follows a parenthetical clause to the effect that
if life insurance proceeds are held by the insurer under
an agreement to pay interest thereon the interest payment
shall be included in gross income.

Discussion This provision does not work satisfactorily. A few years ago the General Counsel ruled that
1

this provision exempted only the principal sum or capital

value of the life insurance policy as of the date of the insured's death, and that all amounts which are added to such

principal sum when it is paid in installments by reason of
the running of time should be taxable. The Board has recently

held that this interpretation was incorrect, and that the
Congressional intent was to exempt amounts received by the

beneficiary of a policy paid by reason of the death of the
insured in installments or in annuities and not merely amounts
paid upon the death of the insured or payable at that time.
Putting this thought in another way, the exemption is construed
not to apply merely to the commuted value of the face of the
policy, but rather to the face amount of the policy whenever

1. G.C.M. 13,796, CB XIII-2, p. 41.

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222

its proceeds are paid. Only income from the retained face
amount of the policy, usually taking the form of excess interest dividends, is taxable, because such excess interest
dividends are not received solely by reason of death of the
insured, but are paid by reason of the withholding of the
future installments of the principal amount and are profitable
1

investments by the company.

Recommendation Section 22 (b) (1) should be amended

in such a way as plainly to incorporate the principles
announced in G.C.M. 13,796.

17. Existing Law as to Double Loss Deductions

(Secs. 23 (e). (f). 24 (b). 112 (b) (5). 113 (a) (8)) It is
possible under the law as it stands for an individual who owns
securities which have substantially decreased in value to
transfer these securities to a new corporation without the
recognition of loss under Section 112 (b) (5). The corporation under Section 113 (a) (8) takes over the high cost basis

of the individual transferor. It may then sell the securities
and obtain the benefit of the loss. If there is a mere expectation and not an agreement to liquidate the corporation at

the time of the transfer of the securities to it, a second or
1. See Sidney W. Winslow, Jr., 39 BTA 373; cf. United States
V. Heilbroner, 100 F (2d) 379 (CCA 2nd, 1938); Edith M. Kinnear,

20 BTA 718.

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223

double loss deduction may be secured upon the liquidation
1

of the corporation.
Discussion

Although double deductions are frowned
2

upon by the Supreme Court, this seems to be a wholly indefensible loophole. While several members of the Board
dissented in the W. & K. Holding case and the case may be

reversed on appeal, there is a substantial possibility that
it reflects a correct interpretation of the present statute.
Recommendation

The statute should be amended to

prevent this double loss deduction.

18. Existing Law as to Basis of Property Transmitted
by Death (Sec. 113 (a) (5) Under the Internal Revenue Code tax-

able gain and deductible loss on the sale or exchange of
property transmitted at death (acquired by bequest, devise
or inheritance or by decedent's estate from the decedent) is

the fair market value of the property at the time of acqui sition (death).

Discussion For example, if B acquires property
transmitted at death by A, and the property cost A $100,000

in his life time and is worth $500,000 at the date of death,
B when he sells the property is entitled to use $500,000 as
his basis. This means that $400,000 of appreciation in value
1. See W. & K. Holding Corp., 38 BTA 830, 839.
2. McLaughlin V. Pacific Lumber Co., 293 U.S. 351 (1934);
Ilfield Co. V. Hernandez, 292 U.S. 62 (1934).

27

224

has never been, and will never be, subject to income tax.
Tremendous loss of revenue must be involved in this rule, and
it must have a freezing market effect by discouraging sales
by persons late in life.
Recommendation Section 113 (a) (5) of the Internal
Revenue Code should be amended to provide that the basis

for gain or loss on the disposition of, or for purposes of
depreciation or depletion upon, property transmitted at
death is the adjusted cost basis in the hands of the decedent,
rather than value at the date of death. While this would
1

raise the basis where property has depreciated in value
between original acquisition by the decedent and the date

of death, it is perfectly fair to allow such a potential loss
to be carried over from the decedent; moreover, this aspect

of the change should not so greatly affect the revenue, since
losses are frequently consummated during life to save taxes,
whereas many gains for the same reason go deliberately un-

realized. In connection with this recommendation it should

be noted that it is fairer than the basis in the case of gifts
inter vivos established by Section 113 (a) (2) which establishes

as a gain basis of cost to the donor, but limits the donee to
a loss basis of cost to the donor, or value at the time of
gift, whichever is lower.
Another alternative remedy for this situation would be
to count death as a closed transaction, somewhat in the manner

established by Section 42 with respect to accrued income. This

1. It is realized that this change may involve problems of
distribution among legatees, the high donor cost basis property
being of greater value to a legatee, but problems of this sort

are hardly insuperable.

28

225

remedy, however, would be largely self-defeating under the

present scheme of estate tax deductions in that the additional tax imposed upon the decedent during the last taxable year of his life time would be increased and this
would automatically increase the estate tax deductions.
19. Existing Law as to Domestic Building and Loan
Associations (Sec. 101 (4)) The Internal Revenue Code
1

under certain conditions now allows a special exemption from
income tax to domestic building and loan associations, sub-

stantially all business of which is confined to making loans
to members.

Discussion This broad provision gives exemption
to building and loan associations the activities of which
are not related to financing home ownership, but go to the
length of owning and operating office buildings; also to associations which make loans to building contractors, as distinguished from persons who are purchasing or erecting their
homes for personal use; and also to building and loan asso-

ciations owned by small groups, which derive substantial income from their ownership of the association. It does not
destroy exemption that associations accept what are substan-

tially savings deposits, and thus compete with banks.
Recommendation Although the line of demarcation is

hard to draw, Section 101 (4) of the statute should be redrawn in such a way as to limit the exemption given to

1. See Reg. 80, Art. 37.

226
29

building and loan associations of a genuine cooperative

character, the activities of which are primarily related to
financing home ownership.

20. Existing Law as to Mutual Casualty and Fire
Insurance Companies (Secs. 101 (11), 207 (c) (3) Section
101 (11) of the Internal Revenue Code exempts farmers' or

other mutual hail, cyclone, casualty or fire insurance companies or associations (including interinsurers and reciprocal
underwriters) the income of which is used or held for the
purpose of paying losses or expenses. Section 207 (c) (3)
gives a special allowance to mutual insurance companies (including interinsurers and reciprocal underwriters but not

including mutual life and marine companies) requiring their
members to make premium deposits to provide for losses and

expenses consisting of the amount of premium deposits re-

turned to their policy holders and the amount of premium
deposits retained for the payment of expenses, losses and
reinsurance reserves.

The effect of these provisions, as interpreted
by the Bureau rulings, practice and regulations, is that
1

316 V.

1. See Reg. 101. Art. 101 (11)-1; Reg. 101, Art. 207-6.

See also Comm. V. National Grange Mutual Liability Co., 80
of Houses
from
Loss byFire,
F(2d) Contributionship (CCA 1st, for 1935); Insurance
McLaughlin
Philadelphia

73 F(2d)582
(CCAcert
3rd, den.
1934)

294 U.S. 718 (1935);

Commercial Health & Accident Co. V. Pickering, 281 Fed. 539 (1922);

V.
United
3
290 U.S. 662 Mutual Assurance

Battercial Baltimore (Ct. Cls., Equitable 1933) cert. Society den. States, (1933); Fed. Supp. 427

Society of Virginia, 24 BTA 1102, acquiesced in CB XIII-1, p.11;
L.O. 1050, CB 3, p. 279; S.O. 156, CB III-1, p. 284; A.R.R. 7939,
CB III-1, p. 294.

30

227

practically all mutual insurance companies other than life
are exempted from income tax; those which fail to secure
exemption under Section 101 (11) escape tax in large part by

reason of Section 207 (c) (3) It is believed that virtually
no substantial tax is collected from such mutual companies, although a substantial tax is collected from stock insurance
companies of the same type.

Recommendation Section 101(11) and Section 207

(c)(3) should be modified so that exemption is limited to
companies of a purely local character, the phrase eliminated
by Section 1013 (b) of the Revenue Act of 1924. Further
protection should be introduced into the statute to prevent
undue deductions under Section 207 (c) (3). One method would

be to use the provisions of existing law applicable to the
taxation of stock insurance companies other than life. Other
possible methods should be canvassed.

21. Existing Law as to Employers' Contributions to
Pension Trusts (Secs. 23 (a). (p), 165) The Internal Revenue
Code allows a deduction on account of amounts transferred to

pension trusts. Although amounts transferred to stock bonus,

pension or profit-sharing plan trusts are deductible by the
employer, the amounts transferred to the trusts are not taxable to the employee until they are paid out of the trust
after retirement or otherwise, according to the pension plan.
The trust itself is not taxable with respect to income earned

31

228

upon the investment of the funds transferred to it.
Discussion These statutory provisions were undoubtedly intended to encourage pension and retirement plans
which would give a measure of old age security to employees. 1
They have been employed, however, to a large extent for the

purpose not of benefiting junior low-paid employees, but
rather for the purpose of laying aside for future lowerbracket taxation after retirement, large blocks of the
salaries payable to senior key men in the employer companies.
Recommendation
Sections 23 (b), (p) and 165

of the statute should be amended so as to limit the deduction
for payments made by employers to pension trusts to some
fixed amount (say $5,000) for any one employee.

22. Existing Law as to Discovery Value and Per-

centage Depletion (Sec. 114 (b)) Section 114 (b) of the Internal Revenue Code allows special depletion in the case of
mines (other than metal, coal or sulphur mines) discovered by

the taxpayer. The basis is the value of the property at the
date of discovery, or within 30 days thereafter; the depletion
allowance is limited to 50% of the net income of the taxpayer
from the property. In the case of oil and gas wells, the
allowance is 271% of the gross income from the property

(excluding rents and royalties), but the allowance may not

1. The purpose of these statutory provisions is stated

in part in Conference Report No. 486, 67th Cong., 1st Sess.,
p. 29, Nov. 19, 1921; Finance Committee Report No. 960, 70-

th Cong., 1st Sess., p. 29, May 1, 1928. See also Oscar A.

Olstad, 32 BTA 670.

32

229

exceed 50% of the net income of the taxpayer from the

property. In the case of coal mines, the percentage of
gross income is 5%; in the case of metal mines it is 15%;

in the case of sulphur mines it is 23%. These last three
allowances are limited to 50% of the net income. It should
be noted that these percentage allowances go on indefinitely
and not merely until a definite capital sum is exhausted.
Discussion The special depletion deductions

originated in discovery value deductions included in the
1

Revenue Act of 1918 which was during the World War. They
were designed to encourage metal resource development, par-

ticularly oil wild catting. In 1926, because of valuation
difficulties, percentage allowances were substituted in the
cases mentioned for discovery value allowances. The original
discovery value allowances were "favored industry" deduc-

tions, and involved the factor of incentive taxation. In
1937 the President and the Secretary of the Treasury re2

commended the elimination of these provisions, but the recommendation was not adopted.
Recommendation

You will no doubt wish to urge once

more the elimination of these special depletion allowances.
1. Paul and Mertens, Law of Federal Income Taxation, Sec.

21.53 (1934).

2. Letter of President Roosevelt, June 1, 1937, quoted
in
1Report
on1stofTax
Evasion
Avoidance,
75thCong.,
the
Joint
Committee
Morgenthau,
and
Sess., p. 1 (1937); Secretary

Hearings before the Joint Committee on Tax Evasion and Avoidance,

75th Cong., 1st Sess., p. 11 (1937).

230

33

of course, depletion on the basis of cost or value at March
1, 1913, should be retained in the statute.
23. Existing Law as to Development Expense
1

Under the regulations now outstanding the taxpayer is given

the option to charge to capital or expense intangible drilling and development costs, including expenditures for wages,

fuel, repairs, hauling supplies, etc., incident to the drilling of wells and the preparation of wells for the production
of oil or gas.

Discussion Expenditures of the type mentioned
result in a capital asset, which in the case of productive
properties continues to produce income throughout the

life of the property. The so-called option is only an
option in an artificial sense, since taxpayers generally take
2

the cash and let the credit go by availing themselves of the

privilege of deducting immediately the full cost of capital
assets, rather than postponing the deduction to years when it
may be recovered through the door of depreciation of a
capitalized item. The Treasury made a move about a year ago

in the direction of eliminating this so-called election, and
compelling capitalization, but abandoned the idea after industrial hearings.

1. Reg. 101, Art. 23 (m)-16.
2. See Government Brief in the Wilshire case, p. 9.

34

231

Recommendation This option has been granted by

the regulations for a long period of years, and may have
become embedded in the statute. Its elimination for the
1

future will not require a statutory provision.
It is worth consideration whether a further provision should not be enacted limiting depletion and depreciation deductions to amounts reported to stockholders in

annual reports. Conversely, listing applications to the
Security & Exchange Commission might be required to show

depletion and depreciation taken for income tax purposes.

24. Existing Law as to Taxation of Non-Resident
Alien Individuals and Foreign Corporations (Secs. 211-219;
Secs. 231-238) Under the Internal Revenue Code neither
non-resident individuals nor foreign corporations are now

taxable with respect to capital gains; and foreign corpora-

tions are given the benefit of a flat rate of 15% on their
taxable income, and 10% in the case of dividends (whi ch may

be reduced to 5% in the case of a corporation organized under
the laws of a contiguous country - Canada and Mexico - if so

provided by treaty with such country).
Discussion No sufficient reason appears why non-

resident aliens should have this distinct advantage over

1. Helvering V. Wilshire 011 Co.

U.S.

(1939); ;

cf. Helvering V. R. J. Reynolds Co., 306 U.S. 110 (1939).

35

232

citizens and residents of the United States, nor why foreign
corporations over domestic corporations should have any

advantage with respect to rates of tax or types of taxable

income. If anything, discriminations should operate in
the opposite direction.
Recommendation Sections 211 to 219 and 231 to
238 of the Internal Revenue Code should be amended to tax

non-resident aliens and foreign corporations upon income

from sources within the United States in such a way that

there is no discrimination in their favor. There appears
no reason why non-resident aliens and foreign corporations
should not be taxed upon capital gains consummated within
the United States even though they have no office or
place of business within this country.

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233
1

ESTATE TAX

25. Existing Law as to Estate Tax Exemptions (1932

Act, Sec. 401 (c). 1926 Act, Sec. 302 (g) The Internal
Revenue Code now grants a general estate tax exemption of $40,000,
and a special exemption of $40,000 of insurance upon policies

taken out by d ecedent upon his own life and payable to bene-

ficiaries other than the estate of the insured.
Discussion While a general estate tax exemption
2

should be allowed in the case of reasonably small estates, and
while a $40,000 special insurance estate tax exemption should
perhaps be allowed also in the case of small estates, these two
exemptions as t hey now operate confer an undue benefit upon
estates in high brackets. The $40,000 general exemption means

$400 to an estate of between $40,000 and $50,000. In the case

of a net estate in excess of $4,000,000 but not in excess of
$4,500,000, the exemption means $20,000 in tax. In the case
of an estate in excess of $50,000,000 the exemption means

$28,000 in tax. The same figures may be applied to the insur-

ance exemption. It is well known in insurance circles that
many persons with high brackets estates take out insurance

policies of $40,000 not because they are interested in insurance,

1 Section number references under the estate tax are to the

several revenue acts and not to the new Internal Revenue Code
with which latter section numbers most persons are not yet familiar.

2 Possibly an even greater exemption should be allowed in the

case of small estates.

37

but merely to secure a $40,000 exemption.

234

Recommendation As in the case of the personal exemption

and c redit for d ependents in connection with the income tax,
these $40,000 exemptions should be modified so that they are of

equal benefit to large and small estates; or perhaps they should
be eliminated altogether in the case of net estates in excess of
a given substantial figure. One mechanism for accomplishing this
change would be to insert normal and surtax structure in the estate
tax allowing the $40,000 exemption for normal estate tax p urposes.
The special insurance exemption should perhaps be eliminated in
the case of a 11 estates and an increase of the general exemption
allowed. to small estates.

26. Existing Law as to Taxation of Life Insurance
(1926 Act. Sec. 302 (g))

Apart from the contemplation of death

provision the proceeds of life insurance payable to beneficiaries

other than the estate of the insured are taxable only if the insured is vested at the date of eath with incidents of ownership
in the policy. Incidents of ownership are now defined as including:
(1)

The right of the insured or his estate to the

economic benefits of the policy;

(2) The power to change the beneficiary;

(3) The right to surrender or cancel the policy;
(4) The right to cancel the policy;
(5) The r ight to revoke an assignment;

(6) The right to pledge the policy for a loan; and
The right to obtain from the insurer a loan
against the surrender value of the policy.
(7)

1. Reg. 80, Art. 25, as amended by T.D. 4729, CB 1937-1,

p. 284.

235

38

If the insured irrevocably assigns the above incidents
of ownership to another person (usually his wife), there is no
estate tax upon the proceeds of the insurance, unless the transfer is held to be in contemplation of death. The more modern
form of avoidance in this field of the law is the issuance
of cross policies, one on the life of the husband taken out
and owned by the wife, and the other on the life of the wife
taken out and owned by the husband. This method avoids the

necessity of any assignment or irrevocable transfer of the
incidents of ownership.
Discussion

Large amounts of insurance proceeds

altogether escape tax under existing law. Insurance is sold
to large customers upon the basis of a tax-avoidance selling
appeal. It is believed that intra-company schools are main1

tained by the insurance companies in which salesmen are

instructed how to discuss possible tax savings with prospective
insurance buyers.

Insurance proceeds, in so far as they exceed cash

surrender value, are at the date of the death of the insured

enjoyable for the first time by the beneficiary. The death
of the insured creates an additional untaxed value and frees

it for the first time to the beneficiary's use. Such a
genuine enlargement of the beneficiary's rights has been enough,

without any shift of economic benefits from the estate, to
1.

See Wright and Lowe, Selling Life Insurance through

a Tax Approach.

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236

support the taxation (1) of interests held by joint tenants
and tenants by the entirety; (2) of property as to which
1

the decedent has retained for life the possession or enjoyment

of the income if transferred after the 1931 Joint Resolution
amending Section 302 (c); and (3) of property as to which
2

the decedent has retained nothing more than a veto right to

3

prevent a revocation of the trust by the beneficiaries alone.
Where it is necessary to prevent tax avoidance devised by
ingenious minds, there may be no denial of due process in
measuring the tax upon the transfer of insurance by reference
to what passes at death.
Recommendation We may be precluded from amending out4

Regulations 80, Article
standing regulations retroactively.
25, as amended, should be further amended at least for the
future. If necessary, the statute should be amended so as to
make inescapably clear the intention of Congress to subject to
tax the proceeds of all life insurance policies taken out by

1. Tyler V. United States, 281 U.S. 497 (1930).
2. Helvering V. Bullard, 303 U.S. 297 (1938).
3. Helvering V. City Bank Farmers Trust Co., 296 U.S.

85 (1935).

4. Helvering V. Reynolds Tobacco Co., 306 U.S. 110
(1939); cf. very recent opinion in the Wilshire oil case.

40

237

the decedent on his own life to the extent that he has paid
premiums thereon, or where he possessed at the time of death

some incident of owner ship over the policies. In the situation
involving cross-policies, commonly taken out and paid for by
spouses with their separate funds, there is lacking any substitute for testamentary disposition, and Congress might well
canvass the comparative merits of revamping the present income-

tax exemption of insurance proceeds, or of imposing a special

excise tax, wholly dissociated from the estate tax title,
upon the receipt by the beneficiary of life insurance proceeds
in excess of the aggregate premiums paid by him. However,

any amendment taxing the proceeds of policies, regardless of
incidents of ownership or regardless of the source of premium
payments, should be only prospective in application, to avoid
obvious unfairness against persons who have already procured

policies in reliance upon the Treasury's outstanding interpretation of the statute. It might be possible to apply
the amended statute to policies taken out before its passage,
but to exempt from ultimate estate tax the cash surrender value

of policies theretofore taken out, existing as of the passage
of the amendment, or to exempt an amount bearing the same ratio

to the total proceeds as the time between the issuance of the
policy and the passage of the amendment bears to the total
period until the date of death. This amendment involves the

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238

elimination from the statute of the c ompletely unsatisfactory language "policies taken out by the decedent upon
his own life."
1

27. Existing Law as to Property Passing under
Powers of Appointment (1926 Act, Sec. 302 (f)) The estate
tax statute now provides that there shall be included in
the g ross estate property passing under a general power of

appointment exercised by the decedent (1) by will, or (2)
by deed exercised in contemplation of or intended to take

effect in possession or enjoyment at or after death, or
(3) by deed under which the decedent has retained for his
life, or any period not ascertainable without reference to
his death, or for any period which does not in fact end before his death (A) the possession or enjoyment of, or the

right to the income from, the property, or (B) the right,
either alone or in conjunction with any person, to designate
the persons who shall possess or enjoy the property or the
income t herefrom.

Discussion The use of the word "passing" makes

it possible to escape all estate tax at the election of the
person for whom the power is exercised, if that person would

have taken the same property in default of appointment. For

instance, if a power is given to A, and in default of his
1. See Paul, Life Insurance and the Federal Estate Tax,
52 Harv. L. Rev. 1037 (1939); Bailey V. United States, very

recently decided by the Court of Claims.

42

239

exercise of the power by will the property is to pass to

A'S issue, or if no issue to A's heirs-at-law, A's heirs
may still elect to take under the will of the donor of the
power, rather than under the appointment itself, even
though A has expressly exercised the power in their favor.
The Board of Tax Appeals recently decided James Webster, Exec.
1

2

under authority of the Grinnell case. This case illustrates

a

simple estate t ax avoidance expedient. The rule stated is that
if the beneficiary-appointee receives no more because of the
exercise of the power by the donee than he already had under

the donor's will in default of the exercise, Section 302 (f) will
not apply. This rule is highly prejudicial to the revenue
3

because it will apply to numerous family testamentary dispositions.
So long as the statute covers only general powers,
there are ample means of avoiding tax deriving from technical
distinction between general and special powers. The outstanding r egulations S ay that a power is general if the donee
4

may appoint to himself, his estate or his creditors.

A

1. Helvering V. Grinnell, 294 U.S. 153 (1935)
2. 38 BTA 273.

3. Lewis Spencer Morris, Exec., 39 BTA 570 followed

the same rule.

4. Reg. 80, Art. 24.

43

240

special power may be used which in no way will affect the

desired purpose of the donee. Examples of such special
powers are:

(1) A power to appoint among natural persons and

charitable corporations in which the donee is deprived
of the right to appoint business corporations.
1

2

(2) A power exercisable with the consent of a trustee.
(3) Under Maryland law a power which on its face is
general becomes a special power because no appointment can

be made to creditors. In that state virtually no power of
appointment can be reached by Section 302 (f) as the sec3

tion now stands.
Recommendation

(1) The word "passing" should be eliminated from the
statute so as to preclude escape from tax when a general
appointment gives the beneficiary-appointee the same or less
than he would have received in default of the exercise.

(2) The words "alone or in conjunction with any person"
should be associated in the statute with the word "exercisable."

(3) The statute should include within its scope special
powers, as well as general powers, with a provision for the exception of some special powers to cover cases in which an appoint1. Waldemar R. Helmholz, Exec., 28 BTA 165.

2. Charles J. Hepburn, Exec., 37 BTA 459.

3. Leser V. Burnet, 46 F (2d) 756 (CCA 4th, 1931).

241
44

ment under a special power after a single life tenancy c an
be exercised only among the children of the donor or donee,
and where the property in default of appointment is to be
distributed among that class. This would not postpone the

tax "unduly," but would prevent such situations as exist in
Delaware, where an estate can escape t ax forever by giving a
son a life estate and a special power to appoint any of the
son's children; each generation can then repeat this process.

(4) There should be provision for a tax on powers,
whether they are exercised or not, except in the case of the
1

exception mentioned in (3).

If special powers were taxed regardless of the limitation suggested, testators would immediately turn to the

alternative of setting up life estates with vested remainders.
Therefore, if no such limitation were placed upon the taxation
of property passing under a Special power, Congress should can-

vass the possibilities of imposing a succession or
inheritance
(rather than an estate) tax whenever a re2

mainderman under a will succeeds to property upon the death

of

1. This whole subject is ably discussed in Griswold, Powers
Appointment And The Federal Estate Tax, 52 Harv. L. Rev.

929 (1939).

2. See letter of the President to Congress quoted in Ways

and Means Committee Report No. 1681, 75th Cong., 1st Sess.,

p. 1 (1935).

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242

of the preceding life tenant. This would not be an extreme
hardship, since life tenants are frequently given a power
of invading the trust corpus which gives them virtually
the same economic control over the remainder as is possessed

by the donee of a power of appointment. The rates of taxation
upon the remaindermen in such cases should be considerably

lower than those under the present estate tax law; and the
remainder should probably be exempted from the tax if the

life tenant dies within a period of five years after the death
of the original decedent. Any statutory amendment along this

line would have to cover the still further alternative of
buying an annuity for the wife (as distinguished from making
her a life tenant) and leaving the balance outright to the
children, perhaps with enjoyment postponed until a certain age.

28. Existing Law as to Reverter Interests (Sec. 302
(c) as Amended by the 1 932 Act. Sec. 803(a)) In Helvering V.
1

St. Louis Union Trust Co.

the Supreme Court decided by a vote

of 5 to 4 that there is no tax upon the estate of the grantor of
a trust where the only reservation in the trust instrument is

1. 296 U.S. 39 (1935). .

243

46

a possibility of reverter (as to income) if the beneficiary
(the grantor's daughter) should predecease the grantor. This

decision resulted in a revision of the estate tax regulations
and the insertion of the following language:
1

"On the other hand, if, as a result of the transfer,
title or interest in the transferred property, then no part
of the property is to be included in the gross estate merely
by reason of a provision in the instrument of transfer to
the effect that the property was to revert to the decedent
there remained in the decedent at the time of his death no

upon the predecease of some other person or persons or
the happening of some other event."

Discussion The existing statute, as so interpreted,
makes a highly artificial distinction. For instance, if the
decedent provides that the benefit of the property should pass
to A for life with a reservation of the fee to the grantor, but
with a remainder in fee to A contingent upon A's survival of

the g rantor, then the property is includible in the grantor's
estate. On the other hand if a technically vested fee title to
the property is given to A, but with a further provision that
the property should revert to the grantor if A predeceases him,

1. Reg. 80, Art. 17 (1937 Ed.)

47

244

no estate tax is imposed, although the net effect of the disposition is exactly the same as in the preceding case.
Recommendation There are, of course, all sorts of

variations of reverter interests, but certainly as to many of them
the dissenting opinion of Mr. Justice Stone, concurred in by
3 of his associates, reflects the rule that should be incorporated
1

into the statute. In net effect the rule is that the estate
tax should be imposed in all cases in which the decedent in

making disposition of his property retains any valuable interest
in the property by which he postpones final disposition of the
property until his death. The Supreme Court may, however, relieve

this difficulty in several pending cases in which an overruling
of the St. Louis doctrine is being requested by the government.

29. Existing Law as to Gifts in Contemplation of
Death (Sec. 302 (c) of 1926 Act)

The estate tax statute pro-

vides that there shall be included in the gross estate gifts and
transfers in trust made in contemplation of death.

1 Helvering V. St. Louis Union Trust Co., 296 U.S. 39 (1935).

245

48

Discussion The statute, by making taxability depend on the motive or purpose accompanying the gift, incorporates
1

a subjective test. Whether there is contemplation of death is
a question of fact which the courts tend to answer with extreme

liberality in favor of decedent estates. In United States V.
2

Wells the frankly admitted motive of the decedent in making the
gift was to reduce income taxes. The only motive connected with
life which prevented the gift from being subjected to an estate
tax was itself a tax-reduction motive. In many cases gifts made
by persons well over 60 years of age are held not to be in
contemplation of death; in one case a gift by a person over
3

90 years of age was held not in contemplation of death.
Recommendation Some provision should be made to show

Congressional intent to tax all gifts and transfers in trust
which serve as substitutes for testamentary disposition. The
1926 Act inserted a two-year conclusive presumption which was
4

held unconstitutional by a 6 to 2 decision in Heiner V. Donnan

1. Paul, Selected Studies in Federal Taxation, Second

Series, p. 285 (1938). .

2. 283 U.S. 102 (1931).
3. Rochester H. Rogers, 21 BTA 1124.
4. 285 U.S. 312 (1932).

49

While the present Supreme Court might sanction such a

provision, it would be extremely unfair in the case of
gifts by relatively young persons. A general provision
might perhaps be enacted establishing conclusive presumption

to cover cases in which the gift is made after the decedent
reaches 60 years of age, with the present rebuttable presumption covering cases in which someone under the age of

60 makes a gift and dies thereafter within a two-year period.

30 Existing Law as to Elimination of Estate Tax
Against Insurance Proceeds by Reason of Uncollectible
Under the Internal Revenue Code
Claims ( Sec. 303 (a)

claims against the estate which are allowed in the jurisdiction in which the estate is being administered, are deductible in determining the net estate, even though the
claims are not enforceable against some particular assets
of the estate.

Discussion In many states the proceeds of life
insurance payable to named beneficiaries a re not subject to
claims against the estate. Taxes are escaped altogether

if the claims against the estate exceed not only the net
estate, but also the statutory gross estate, including life

246

247
50

1

insurance proceeds. In one case an estate evaluated at
over $2,000,000 more than half of which consisted of the

proceeds of life insurance, had valid claims against it
amounting to some $6,000,000, none of which constituted

a charge against the proceeds of the policies. Since the
uncollectible claims exceeded the gross estate, there was

no estate tax liability.
Recommendation

Section 303 (a) of the Internal

Revenue Code should be amended to provide that claims a gainst

an estate are allowable d eductions only if collectible in
the particular jurisdiction.

1. Comm. V. Ames, 88 F(2d) 338 (CCA 7th, 1937).
See also Helvering V. Northwestern National Bank and Trust
Co., 89 F(2d) 553 (CCA 8th, 1937 ); Comm. V. Lyne, 90 F(2d)
745 (CCA 1st, 1937); Helvering V. O'Donnell, 94 F(2d) 852
(CCA 2nd, 1938); Comm. V. Strauss, 77 F(2d) 401 (CCA 7th,
1935) on rehearing aff'd 81 F(2d) 1016 ( CCA 7th, 1936); Comm.

V.

102175
F (2d)
1 (CCA
1939);Edna
Wainwright
et V.al.,
Ex'rs, Kyle,
22Hallock,
F. Supp.
(B.D.
Pa.,6th,
1937);
F. Hays

34 BTA 808. See the dissenting opinion of Member Harron in
Thomas DeC. Ruth, et al., Ex'rs, 36 BTA 191 which was however

aff'd by the Circuit Court of Appeals (appeal dismissed,

CCA 5th, 1938).

51

248
1

GIFT TAX

31. Existing Law as to Gift Tax Exemptions (Secs.
505 (a), 504(b) of the 1932 Act, as amended)

The exist-

ing gift tax allows a cumulative exemption of $40,000, and a
non-cumulative annual exemption of $4,000 per donee. This

last exemption is not applicable to transfers in trust.
Discussion This $4,000 exemption is much abused.
Many taxpayers spread large amounts of valuable gifts among
several persons and accomplish substantial transfers of property

without any gift tax. Furthermore, a donor who sufficiently
anticipates the future may over a span of years give away a

considerable amount of property free from tax. The principal
purpose of the exemption is merely to allow a reasonable latitude

for inter-family gifts.
Recommendation Section 504 (b) of the Revenue Act of
1932 should be further amended so as to restrict exempted gifts
at least to members of the donor's immediate family.

November 13, 1939

1 Section number references under the gift tax are to the
with which latter section numbers most persons are not yet familiar.
several revenue acts and not to the new Internal Revenue Code

249

MEMORANDUM A-1

QUESTIONS AS TO THE EFFECT ON THE REVENUE
OF THE POINTS MADE IN MEMORANDUM A

Referring to Mr. Paul's accompanying memorandum

marked "A", question arises as to how much additional tax
will be derived from the suggestions made as follows:
1. The making of some appropriate provision to
the end that the personal exemption and credit for dependents

will be changed from its present form to a credit against
tax, under which equal benefit would be given to taxpayers
in the low brackets and taxpayers in the high brackets.
This might be accomplished by an amendment to the statute

limiting the present personal exemption and credit for dependents to a credit for normal tax purposes only.

2. The taxation of all stock dividends not presently subjected to income tax and particularly common stock dividends upon common stock, there being no other class of stock

outstanding at the time of the declaration of the dividend.
3. The taxation of short-term and other trusts of a
character exempted from tax to the grantor in such cases as
1

the Meredith Wood case, in which title to the trust property

is transferred for a limited term to the trust, and the trust
becomes a taxpayer in a lower bracket than would be the

1. 37 BTA 1065, aff'd per curian 104 F (2d) 1013 (CCA
2nd, 1939), cert. granted, Oct. 9, 1939.

2

grantor if he were charged with the income of the trust.

4 (a). he strengthening of Section 102 by a
provision that the facts recited in Memorandum A, page 8,
shall be regarded as constituting prima facie evidence of
a purpose to avoid surtax upon shareholders.

(b). The strengthening of Section 102 by a
provision that the word "existing" be inserted before the
word "business" in subdivision (c) of Section 102 to prevent avoidance of the De Mille type described on pages 8 to
9 of Memorandum A.

(c). The lengthening of the statute of limitations as suggested in the same memorandum with respect to
Section 102 cases.

5 (a). A provision to the effect that deductible
religious, charitable, scientific, literary and educational
and other contributions of the type deductible under Section

23 (o) be limited, when paid in the form of property, to the
cost basis of the property to the donor or its value at the

date of gift, whichever is lower.
(b). An alternative provision allowing no
greater deduction than would be allowed if the donor sold the
property and contributed the proceeds less the capital gains
tax.

6 (a). An elimination of the deduction now contained in Section 23 (e)(3) applicable to losses arising from

250

251
3

fire, storm, shipwreck or other casualty, or from theft.
(b). Treatment of such deduction as a capital
loss instead of an ordinary loss.
7. A limitation of the allowance for the deduction of interest on non-business individual borrowings to
a fixed amount of $500.

8 (a). . An elimination of the deduction provided
in Section 23 (b) of the Internal Revenue Code for interest
paid or accrued on funded corporate indebtedness.

(b). A restriction of the reorganization provision so that it will not apply to recapitalizations having as their principal purpose the tax avoidance motive of

substituting borrowed capital for an equity contribution by
stockholders.

9. An elimination of the provision contained in
Section 23 (k) for the deduction of non-business bad debts
except bad debts when not exceeding $1,000 in the case of
each debtor.

10. A limitation upon the allowance of deductible
taxes as provided in Section 23 (d) in respect to property
held for the taxpayer's own use to taxes on small homes not
exceeding $10,000 in cost to the deducting owner, or value in
the taxable year of deduction.

4

252

11. A provision to the effect that where the
optional valuation privilege granted by Section 302 (j)
of the estate tax statute is used, the basis for the
property valued pursuant to this election shall be the same
for purposes of capital gains or losses as the value used
in the estate tax return.

12 (a). A provision denying to husband and wife

living together the privilege of filing joint returns.
(b). A provision generally adopting the British
method of taxation of husband and wife as outlined in Memorandum

A, assessing the joint income at surtax rates based upon the
combined income of both husband and wife.

13 (a). An amendment of existing law along the
lines suggested in item 13 of Memorandum A with particular

respect to taxing the interest on all state or Federal bonds
issued after the passage of a new Congressional amendment.

(b). An amendment of the existing law, as proposed by Sena tor Glass 20 years ago, which would measure the

surtaxes applicable to non-tax-exempt income in relation to
taxpayer's total income, including tax-exempt income.

14 (a). A flat increase in capital gain rates of
50% of the existing rates with a provision that capital gains
shall not be recognized to the extent that the gains are
reinvested within 12 months in risk-bearing equities in new
enterprises.

253
5

(b). An amendment of capital gains provisions so as to make capital gains taxable at the highest
rate (not exceeding 50%, however) applicable to taxpayer's
income, exclusive of capital gains, with a provision for
a credit against the tax to the extent that the gains are
reinvested within 12 months in risk bearing equities in
new enterprises.
15.

A provision revoking the exemption now

granted by Section 115 (b) of the Internal Revenue Code to

corporate distributions of earnings or profits or increase
in value of property accrued prior to March 1, 1913.

16. A provision in the statute incorporating
the general principles of G.C.M. 13,796, CB XIII-2, p. 41,
discussed under item 16 of Memorandum A.

17. A provision discountenancing the doctrine
of the W. & K. Holding case, 32 BTA 830.

18 (a). A provision that the basis for gain or
loss and depreciation and depletion shall be, in the case
of property transmitted at death, the adjusted cost basis
in the hands of the decedent, rather than the value at the
date of death.

(b). A provision along the lines of Section
42 of the Internal Revenue Code generally to the effect that
death shall constitute a closed transaction with respect to

254
6

property transmitted by the decedent at death.

19. A provision limiting the exemption now accorded to domestic building and loan associations along the
general lines indicated at page 28 of Memorandum A.

20. A provision limiting the exemption and deductions granted to mutual casualty and fire insurance companies along the lines indicated at page 29 of Memorandum
A.

21. A provision limiting the deduction for payments made by employers to pension trusts to a fixed amount
per annum of $5,000 for any one employee.

22. A provision eliminating the "bonus" deduction on account of discovery value and percentage depletion
now allowed to mine owners and oil and gas well owners, to

the general end that such taxpayers shall be limited to
cost depletion, or depletion on the basis of value at March
1, 1913.

23. A modification of the existing regulations
granting the option as to the expense deduction or capitalization of intangible drilling and development costs as outlined
at page 33 of Memorandum A.

24 (a) . The elimination of the exemption from
capital gains tax on sales consummated within the United States

255
7

now granted to non-resident aliens and foreign corporations having no office or place of business wi thin the
United States.

(b). A general provision placing foreign nonresident
corporations upon a basis of taxation similar to that employed with respect to domestic corporations.

25 (a). A modification of the $40,000 general
estate tax exemption (and also the $100,000 estate tax
exemption granted by the 1926 Act) so that an equal bene-

fit is derived from the exemption by both large and small
estates.

(b). An elimination of the $40,000 general estate tax exemption (and the $100,000 estate exemption) in the
case of estates exceeding $1,000,000 in net value excluding
the exemption.

(c). A redevelopment of the estate tax structure
so that the effect of the $40,000 general estate tax exemption (and the $100,000 exemption granted by the 1926 Act) is
limited to a normal estate tax not exceeding 20%.

(d). A provision similar to that mentioned in
(a), (b) and (c) above with respect to the insurance proceeds
exemption of $40,000 on policies payable to named beneficiaries.

26(a). A prospective provision generally to the
effect that the proceeds of life insurance shall be subjected

256
8

to estate tax to the extent that the decedent has paid
premiums on the insurance or in their full amount where he
possesses at the date of his death some incident of ownership over the policies.

(b). A provision as to cross-insurance policies
along the lines suggested in Memorandum A, page 39, subject-

ing the proceeds of such policies to income tax at the

regular rates, or to a special excise tax at a flat rate
of 10%

(c). A comparative statement showing the effect
of this amendment generally as compared with an amendment

modified on the basis of cash surrender value or ratio
on the time basis, as described on page 39 of Memorandum A.

27 (a). A provision limiting the tax exempting
effect now applicable in the case of special powers of
appointment as indicated on page 43 of Memorandum A with an

exception that special powers made thereunder can be exercised

free from estate tax only among the children of the donor or
donee and where the property in default of appointment is to
be distributed among that class.

(b). A provision imposing a succession or inheritance tax on the value of remainders under a will, to be
imposed at the death of the life tenant at rates equal to the
existing estate tax rates.

9

28. A provision subjecting reverter interests
to estate tax taxation where the decedent retains any
valuable interest in his property by which he postpones

final disposition thereof until his death, such as the
interest involved in the St. Louis case mentioned on page
43.

29. A provision that gifts by persons over 60
years of age shall be subject to an irrebuttable presumption that they were made in contemplation of death.

30. A provision precluding the estate tax
deductibility of uncollectible claims.

31. A provision limiting the $4,000 gift tax
exemption to gifts to members of the donor's immediate
family.

257

258

MEMORANDUM OF TRANSMITTAL OF
B AND B-1

TO:

Honorable Henry Morgenthau

Secretary of the Treasury

FROM:

The White House

I am enclosing herewith a second memorandum,

marked B, also prepared by Mr. Randolph E. Paul, listing
a number of situations in which the tax laws might possibly

be amended in the interest of taxpayers. I would like to
have from you an estimate of the loss in revenue, if any,
which would result from the adoption of Mr. Paul's suggestions.
For your convenience I enclose a memorandum of specific
questions keyed to Mr. Paul's memorandum, marked B-1.

As with respect to the accompanying memorandum, I

again realize the impossibility of answering these questions
with mathematical accuracy, but I would like in all cases
to have your best estimate.

259
MEMORANDUM B

MEMORANDUM OF POSSIBLE CHANGES IN THE TAX LAW

WHICH WOULD ELIMINATE CERTAIN INJUSTICES TO TAXPAYERS
TO SOME EXTENT RESULTING IN DECREASE OF REVENUE
INCOME TAX

1. Consolidated Returns

2. Intercorporate Dividends

3. Mitigation of the Statute of Limitations in Certain Cases

4. Mortgage Transactions

5. Taxation of Alimony
6. Cancellation of Indebtedness in Corporate Reorganizations
7. Ascertainment of Earnings or Profits Available for
Corporate Distributions

8. Taxation of Undistributed Profits Despite Impairment

of Capital
9. Personal Holding Company Tax Where Dividends Cannot Be
Distributed

10. Res Judicata

11. Credit for Dependents
12. Personal Medical Expenses
GIFT TAX

13. Gifts in Trust
14. Gift Tax on Tenancies by the Entirety
GENERAL

15. Interest on Deficiencies and Refunds

280

MEMORANDUM OF POSSIBLE CHANGES IN THE TAX LAW

WHICH WOULD ELIMINATE CERTAIN INJUSTICES TO
TAXPAYERS TO SOME EXTENT RESULTING IN DECREASE
OF REVENUE

INCOME TAX

1. Existing Law as to Consolidated Returns. The income

tax law since 1934 has abolished the privilege of filing consolidated corporate returns, except with reference to railroad
corporations.

Discussion It seems to be generally accepted good
accounting that the accounts of affiliated corporations should be
computed on a consolidated basis. Separate corporate returns
often mean multiple taxation of the same earnings, and put an

irresistible premium upon artificial intercompany transactions
to reduce the tax burden. Also, Internal Revenue Bureau decentralization
enormously complicates the problem of auditing unconsolidated

returns. What is really a single business unit should properly
be taxed as such. Although the older provisions on this
point were productive of considerable litigation as to the
existence of affiliation and the precise treatment of various
intercompany items, the use of consolidated returns would be

practical and feasible, especially in the light of previous

1. See Internal Revenue Code, Sec. 141.

261
2.

experience. Little or no loss of revenue would be involved, since
it is impossible to administer Section 45 with thoroughness.
Recommendation Affiliated companies should either

be required or permitted (if not required) to file consolidated
returns under the general method applicable to years prior to

1934. If the latter alternative is adopted, a higher rate of
tax and consent to various regulations might be required as a price

for the privilege of filing a consolidated return; such a
differential was provided in the 1932 Act.

2. Existing Law as to Intercorporate Dividends For
nearly twenty years the income tax statutes, until 1935, exempted
intercorporate dividends. Recipient corporations were required
for information purposes to report dividends from domestic
corporations, but were allowed to deduct such dividends to their

full extent in determining taxable net income. Section 26 (b)
of the Internal Revenue Code now has the effect of relieving
intercorporate dividends from double taxation only to the
1

extent of 85%, while tax is imposed upon such dividends to
the extent of the remaining 15% This means a normal tax
of 2.7% on intercorporate dividends under the 1940 rates
(18% of 15%).

1. This percentage was formerly 90%

282

3.

Discussion The purpose of the legislative change
of policy in 1935 resulting in partial taxation of intercorporate
1

dividends was partly a revenue purpose, and was also derived
from a desire to discourage complicated networks of holding
companies. This purpose has, of course, been partly achieved
in the case of management and holding companies by the WheelerRayburn Law. A Congressional purpose to discourage personal

holding companies has also been achieved by a very drastic

special provision applicable to personal holding companies

first inserted in the 1937 Act and now part of Title I A
and Supplement P. However, there still remains a necessity

of discouraging over-complicated corporate structures, particularly

structures involving the use of a triple tier of corporations.
On the other hand, there are undoubtedly many situations in
which subsidiaries are a legal necessity, as for example where

a railroad is compelled to incorporate in a number of states
2

as the price of doing business.

1. Apparently another purpose in 1936 was to prevent
avoidance of tax by dividing the income of a corporation among
several subsidiary corporate units. But see Twentieth Century
Fund, Facing the Tax Problem, p. 179 (1937): "However, substantial avoidance would be unpractical for a large corporation
since its business would have to be divided among numerous

small subsidiaries Furthermore, such avoidance could be pre-

vented by taxing aubsidiaries at the highest rate of taxation
applicable to the whole affiliated group.
2. Various useful and necessary purposes of holding
and subsidiary corporations are set forth in Berle & Means,

Modern Corporation and Private Property (1932).

263
4.

It would be a happy solution 1f we could
devise some method of taxing intercorporate dividends which,
in accomplishing desirable objects, did not penalize cases
where a minor degree of corporate complication is unavoidable.

It might also be advisable to eliminate from this double
taxation intercorporate dividends where the receiving
corporation has merely reasonably invested a surplus in the
stock of other corporations and has a small interest which
has no real controlling power in the corporation whose stock
is owned.

Recommendations Recommendations have to be vague

on this point, but certainly certain aspects of the problem
may be canvassed as follows:

(a) The possibility of the elimination of this
type of double taxation where a subsidiary corporation is a

matter of necessity or requirement, as in the railroad cases
mentioned.

(b) The possibility of the elimination of this
type of double taxation in cases in which a corporation has
merely more or less temporarily invested surplus as above.

(c) The possibility of stiffening the tax in cases
of inexcusably complicated corporate structures which have no
reasonable business purpose or foundation.

264
5.

3. Existing Law as to Mitigation of the Statute of
Limitations in Certain Cases Section 820 was added to the
income tax statutes by the Revenue Act of 1938 to prevent
the possibility of double deductions or double taxes based

upon the same items. Under this Section if there is a determination under the income tax laws subsequent to August 27, 1938,

resulting in an inconsistent treatment of a prior item - either
as to the 1dentification of the taxpayer or when an item is
taxable - then the item can be corrected by taxing the amount
correctly and allowing a deficiency assessment or refund,
except that no adjustment can be made for years previous to
1

1932.

Discussion Some of the worst types of inconsistency
are not covered by this Section. The statute treats of the
double allowance of a deduction, but does not affect the double
disallowance of a deduction. The chief examples of this
category are deductions for worthless securities or bed debts.
Neither taxpayers nor government officials are entirely

innocent of inconsistent footballing regarding such items. The
government often claims, and frequently with success, that
the stock or bad debt claimed as a deduction by the taxpayer

1. See generally Maguire, Surrey and Traynor, Section 820
of the Revenue Act of 1938, 48 Yale L.J. 509, 719 (1939).

265
6.

actually became worthless in a year prior to the taxable year
and also prior to the period within which refund claims are
possible.

The new statute thus 18 inconsistent in its condemnation
of inconsistencies. Stock losses may not be claimed by the
taxpayer because of reasonable doubt as to the facts, rather
than any culpable negligence on the taxpayer's part; and if
the debt or stock is finally held to have become worthless in

an outlawed year, then the error is irretrievably perpetuated.
The explanations offered informally for this incompleteness of

Section 820 are not wholly satisfactory. It is stated that if
an-adjustment were here permitted, the statute of limitations

would be virtually abolished. But at least some permissive
machinery might be set up to permit the Commissioner to do
justice in these excluded cases.
Recommendation

Section 820 should be extended so as

to give discretion to the Commissioner to allow adjustments
back to some appropriate date for amounts which would other-

wise be completely lost as deductions. Also, the requirement

in Section 23 (k) that a debt ascertained to be worthless
must be "charged off within the particular year" n should be
removed from the statute, and this elimination should be made
retroactive to the extent outlined above.

266
7.

4.

Existing Law as to Mortgage Transactions A great

number of opportunistic decisions made by a bewildering variety
of administrative and judicial officials has completely confused
the whole field of transactions involving mortgaged property.
This confusion involves questions both as to the recognizable
date of the loss suffered by the mortgagor or mortgagee and the
nature of such losses (whether capital or ordinary).
1

Discussion Where the mortgagee bids in mortgaged property at a price which happens to include interest accrued on
the mortgage, the Supreme Court has decided that the "interest"
is constructively received and constitutes taxable income to
the mortgagee, even though the fair market value of the property
at the time of the sale may have been far less than the bid
2

price and the mortgagee therefore had an actual loss.

On the

other hand, if the property is "voluntarily" conveyed by
the mortgagor to the mortgagee in satisfaction of the debt
without the formality of a foreclosure, the mortgagee 1s not
treated as having received taxable interest unless the fair
market value of the property transferred is equal to the principal debt plus interest.
3

1. See generally Paul, Federal Income Tax Problems of

Mortgagors and Mortgagees, 48 Yale L.J. 1315 (1939).

2. Helvering V. Midland Mutual Life Insurance Co., 300 U.S.

216 (1937).

3. Manhattan Mutual Life Ins. Co., 37 BTA 1041.

287
8.

The Board of Tax Appeals has held that the mortgagor's
loss on foreclosure is realized only when the redemption period
expires under local law.
In view of the comparative infre1

quency of redemptions, such a rule is decidedly arbitrary.
Moreover, it causes complicated questions where the period

of redemption is different with respect to different parties
in interest. It would be far more convenient, and certainly
more realistic, to provide that the loss 18 realized at least as
soon as the foreclosure sale occurs.

The nature of any loss suffered by the parties as to
whether an ordinary or capital loss for income tax purposes)
has also been a fertile field of disagreement. The Treasury
regulations permit the mortgagee to deduct as an ordinary bad
debt the uncollectible deficiency upon a foreclosure, to the
extent that the mortgage notes have not been applied on the bid
price. But the regulations go on to provide that where the
2

mortgagee bids in the property, he realizes a capital gain or
loss measured by the difference between the bid price and the

fair market value of the property. It is also ruled by the
Bureau and the Board of Tax Appeals that except as to de-

1. J. C. Hawkins, 34 BTA 918, aff'd 91 F(2d) 354 (CCA 5th,
1937): Derby Realty Co., 35 BTA 335, dismissed without opinion
92 F(2d) 999 (CCA 6th, 1937).

2. Reg. 101, Art. 23 (k)-3

268
9.

preciable property a capital loss occurs (as to both mortgagor
and mortgagee) where property is conveyed in satisfaction of
the debt without a foreclosure by a mortgagor personally
liable for the mortgage debt.
1

There should certainly be no taxable gain from the
purchase of property by the mortgagee. Nor should the loss
of the mortgagee upon a foreclosure, or the loss of either
party upon a "voluntary" conveyance of the mortgaged property,

be treated as a capital loss. Such a conveyance is not a
"sale or exchange" except in the most technical sense of the
term; the parties are in the position of debtor and creditor
rather than of seller and purchaser. It is a medieval play with
words to say that a foreclosure sale is involuntary but that a
conveyance under threat of foreclosure is voluntary. The
mortgagor's equity is usually wholly worthless in either case.
Calculations of gain or loss upon foreclosure raise
further problems 8.8 to the mortgagee's cost basis for gain or
loss upon a re-sale. The regulations now provide that the
mortgagee's basis is the fair market value at the time of foreclosure (which is taken to be the bid price in the absence of
clear contrary evidence). However, considerable doubt has been

1. See for example Betty Rogers, et al., 37 BTA 897, aff'd
103 F(2d) 790 (CCA 9th, 1939), cert. den. Oct. 9, 1939; but see

Bingham V. Comm.,

F(2d)

(CCA 2nd, July 26, 1939).

269
10.

cast on the validity of these regulations by the Midland Mutual
decision. The Supreme Court's refusal in that case to consider
fair market value on the question of interest income may mean

that the mortgagee's basis is the price which he bid at the
foreclosure, regardless of actual value.
Recommendation There should at least be added to
Section 117 (as was done in the case of redemptions of corporate

bonds) a provision that neither a foreclosure, nor a conveyance
in lieu thereof, is to be deemed a sale or exchange for
income tax purposes.

Such a provision might be merely part of a general

revision of Section 117, in so far as it relates to transfers
which are essentially involuntary, such as losses on corporate
liquidations.

5. Existing Law as to Taxation of Alimony The Supreme
Court several years ago committed itself to the view that
alimony does not constitute taxable income to the divorced wife.

1

This principle has been further extended to exempt from income

tax in the hands of the wife trust payments provided in lieu of
direct alimony payments; the income from such trusts remains

taxable to the husband on the ground that he is receiving its
economic benefit through the discharge of his legal obligation
2

of support.

1. Gould V. Gould, 245 U.S. 151 (1917).

2. Douglas V. Willcuts, 296 U.S. 1 (1935).

270
11.

Discussion

It does not seem constitutionally necessary

to continue granting divorced wives this freakish exemption from
income tax either upon direct alimony payments or upon distributions from an alimony trust set up by the husband. The theory
of the Supreme Court in the Gould case was that alimony was not

income, but rather a transfer to her of capital to take the place
of the support which the husband would have given her in future

years if the parties had continued living together. But while
it is true that the value of the support given by a husband to
his wife is not taxable to her while the parties are living
together, there seems no conclusive reason why the same exemption

should be granted to the pecuniary substitute which the law grants
to the wife upon her divorce, and which she is free to use for
any purpose she desires.

The existing treatment leads to endless complications
and controversies as to who shall be taxed on the trust income
under varying sets of facts, as where the husband dies before

the ex-wife but the alimony trust for her benefit continues, or
where the wife was the guilty party in the divorce proceeding

and was not legally entitled to alimony, or where the very creation
of the alimony trust completely relieves the husband under local
law from any further obligation to his ex-spouse. A typical case
in this field is now pending before the Supreme Court but is
1

1. Fitch V. Comm., 103 F(2d) 702 (CCA 8th, 1939) cert.

granted Oct. 9, 1939.

271
12.

unlikely to afford a complete solution. The liabilities of
the present system, in the form of uncertainty and of the heavy
burden of litigation which it throws upon the courts, more
than outweigh its assets, since taxing the wife rather than
the husband would cause little if any decline of revenue.
Recommendation The income tax statute should be amended

to tax the wife upon alimony payments or trust payments in lieu of
alimony, and the husband should be allowed to deduct such amounts

from his own taxable income. The revenues could be completely

protected by imposing a gift tax upon the creation of alimony

trusts; this could be accomplished by inserting into the gift
tax sections a provision that release of marital rights to
alimony should not be considered an adequate consideration in

money or money's worth for a transfer of property.

The alimony situation is, of course, only a segment of the
whole field of trusts set up by a husband for members of his family.
Where such a trust 1s set up for a child or wife living harmoniously with the husband, the existing cases are so confused

that one never knows when the grantor will be taxable upon the
income and when the beneficiary who receives the income. The

model of the English income tax law certainly deserves careful
consideration here; the grantor might be taxed by express

statutory provision on the income from any trust set up for a

wife living with him, or for a minor child, unless a full life
estate in the income is given in trust for the child rather than

272
13.

a

mere term of years. If deemed desirable, this new statutory
scheme could be made applicable only for the future, and the old

scheme could remain for cases in which alimony arrangements
have been based upon existing law.

6. Existing Law as to Cancellation of Indebtedness in
I

Corporate Reorganizations The Chandler Act, recently passed

to clarify and amend certain portions of the National Bankruptcy
Act, contains a provision that no income tax shall be levied
upon any release of indebtedness occurring when a company is
reorganized and returned to business under Section 77 B. A

large reduction of fixed indebtedness usually occurs, since that
18 the very purpose of a corporate reorganization. The Act,
however, goes on to provide in Section 270 that the cost basis
of the assets in the hands of the reorganized company shall be
reduced by the full amount of the indebtedness cancelled or
reduced. This sweeping income tax provision crept in almost

in the still of the night, through the Judiciary Committee
rather than the Ways and Means Committee.
Discussion

The above treatment, although seemingly

fair on it s face, leaves the situation worse than it was before
the attempted remedy. Independently of this statute, the corporation would be taxed as having received income only in the

1. Pub. No. 696, 75th Cong., 3rd Sess., c.575 (1938).

273
14.

1

amount by which it is left with an affirmative surplus. The
Chandler Act, however, appears to have the effect of imposing
a deferred income tax (through a basis reduction) on the whole
amount of indebtedness cancelled, even though only a part of
the cancellation would have been taxable to the corporation
under general income tax principles.

Thus, a corporation with a debt of $1,000,000 and assets
of $800,000 which secured a $500,000 reduction of its debt,
would, under general income tax principles, not be taxable upon

the first $200,000 of the cancellation, since that would merely
leave the assets and debts exactly equal. Only the remaining
$300,000 would be taxable. Under the Chandler Act, however,

the whole $500,000 goes to reduce the cost basis of the
company's assets for depreciation purposes and for computing gain
or loss upon subsequent disposition.

Recommendation The provisions of the Chandler Act

relating to income tax seem out of place, and might be transferred to the Revenue Code, with a clear provision that cost
basis should be reduced only to the extent that the corporation
would have received taxable income except for the statutory
exemption. Section 113(b)(3) of the Code affords a precedent

1. Lakeland Grocery Co., 36 BTA 289. Even this rule has its
qualifications. Several forms of release from indebtedness do not
constitute taxable income regardless of solvency. Thus the cancella-

a debt to one of its

isordinarily
tion of treated
owed not
by as
a income,
corporation
but as astockholders
contribution to the

capital of the corporation. Reg. 101, Art. 22(a)-14.

274
15.

here, although even that Section is somewh at ambiguous in its
phraseology.

There seems no reason why a similar treatment should not
be extended to individuals. Extension or re-adjustment agreements

with creditors, of the type here involved, are really adjustments
of capital rather than the creation of income in the ordinary
sense of the term.

7. Existing Law as to Ascertainment of Earnings or

Profits Available for Corporate Distributions The income tax
statute defines a dividend as any distribution out of "earnings or
profits. # The term "earnings or profits" includes many items
of non-taxable income, such as interest on government bonds
and dividends of domestic corporations. Numerous questions have

arisen as to whe ther particular receipts which would otherwise
be taxable income, but which have been accorded a statutory

exemption, are "earnings or profits" so that distribution therefrom to the shareholders would be taxable to them.
For example, property may be acquired by a cor-

poration in the course of a tax-free reorganization. Company A, having property for which it paid $1,000, but
which has risen in value to $1,000,000, may transfer the

property to Company B in return for the latter's stock.
A simil ar gain may, of course, arise on an exchange of stock

for stock. It has been held by the Board and the courts
that such a gain, though it is not recognized as taxable

275
16.

to the company due to the reorganization provisions, never-

theless, increases the earnings or profits of the transferring company available for taxable distribution.
Furthermore, at least one court has indicated
1

that a mere rise in value of property held by the same
2

company may constitute earnings or profits, although unrealized increment has never been considered taxable income.

Discussion Cases like F. J. Young Corporation
ignore the basic theory underlying the non-recognition of

gain in reorganization transactions. Section 111(c)
provides: "In the case of a sale or exchange, the extent
to which the gain or loss determined under this section
shall be recognized for the purposes of this title, shall
be determined under the provisions of section 112. #

The words "for the purposes of this title" seem to compel
the conclusion that the exemption from non-recognition for
income tax purposes applies equally to the determination of
earnings or profits. A correlation between these two con-

cepts is essential if we are to achieve the objective of the
reorganization sections, and if we are to avoid extremely

1. F. J. Young Corporation, 35 BTA 860, aff'd 103

F(2d) 137 (CCA 3rd, 1939); Susan T. Freshman, 33 BTA 394,
dismissed without opinion CCA 2nd, 3rd, 1936.

2. Binzel V. Comm., 75 F(2d) 989 (CCA 2nd, 1935) cert.

den. 296 U.S. 579 (1935).

276
17.

difficult problems of administration and of bookkeeping
for tax purposes. The decisions referred to are also con1

trary to the Treasury's own current income tax regulations.
Recommendation

The statute should be amended to

make it perfectly clear that "earnings or profits" are
not increased either by appreciation, or decreased by
depreciation in value, or increased by any receipts rendered
tax-free by the reorganization provisions.

8. Existing Law as to Taxation of Undistributed
Profits Despite Impairment of Capital Though expiring
at the end of the current year, the undistributed profits
tax still leaves a large number of controversies arising
with respect to earlier years since 1935. Relief from
this tax was accorded to insolvent companies and
to 0 ompanies in receivership. However, companies which

had an impaired capital structure, but which had somehow
managed to stay out of bankruptcy or receivership, were

given no similar relief, even though they were equally

unable under local law to distribute any dividends. The
charter of such a corporation was held not to be a contract

offor
these
or Prothe ofof
of .Corporate

1. Reg. 101, Art. 115-3. For a more complete criticism

fits" cases Purpose see Paul, Determining Ascertainment Taxability Earnings

Distributions, included in Selected Studies in Federal T axation, Second Series, p. 149 (1938).

277
18.
1

executed by the corporation, and the statute so interpreted
2

has been held constitutional.
Discussion

There is still no authoritative decision

upholding the right of Congress to tax as undistributed profits
earnings the distribution of which is forbidden by state
law. The right to tax in such cases will probably be upheld,
but such a conflict between national and local statutes is

certainly inexpedient. It was often not feasible, due to
limitations of time or to the unwillingness of preferred
creditors, for companies with impaired capital to write
down their capital structure in order to distribute the
current earnings. Therefore, such corporations are practically
in the same position as corporations in receivership or
bankruptcy, and should be given the same relief. Otherwise,
the very corporations least able to pay dividends are forced

to pay the greatest undistributed profits tax.
Recommendation If it is deemed inadvisable retroactively to exempt deficit corporations from the undistributed
profits surtax to the extent of their capital impairment,
then they should be least be given the favored treatment of a

flat tax at a rate substantially below the average effective
undistributed profits tax rate.
1. Reg. 94, Art. 26-2.
1939).

2. Crane-Johnson Co. V. Comm. 105 F(2d) 740 (CCA 8th,

278

19.

9. Existing Law as to Personal Holding Company Tax
Where Dividends Cannot Be Distributed Since 1934 Congress
has imposed upon "personal holding companies a tax now

amounting to 65% on the first $2,000 of undistributed income,
and A tax of 75% on the remaining undistributed income. Section 405(a) allows such companies the deduction of dividends
paid. The current act, however, denies to such companies

the benefit of the capital loss provisions which will
be available to other corporations beginning next year,
and also purports to deny them the benefit of the carry-over
of net losses.

Discussion As a result of the above provisions,
many personal holding companies are being spanked much more

seriously than Congress probably intended. This is especially
true in the case of corporations which have current taxable income but which have no earnings or profits available for dividend distribution, either from the current year or from past
years. This situation is possible where the corporation
has non-deductible capital losses, or other non-allowable
expenses or losses, which eliminate "earnings or profits"
within the technical meaning of that phrase but leave
1

current taxable income.

F(2d)
1. See Foley Securities Co. V. Comm.,
(CCA 8th, 1939). Here the personal holding company had a 1934

profit of $49,000. However, it had a deficit of about $23,000

(continued on following page)

279
20.

Under the existing law such a corporation may be

taxable at approximately 75% of its net income. It cannot escape this tax, since even if it distributes an amount
equal to the total current taxable income, that amount will
1

not be a taxable dividend because not out of "earnings or profits",
and therefore would not entitle the corporation to a dividendspaid credit. Nor can the tax be escaped through the mechanism
2

of a consent dividends credit; the intention of Congress,
as revealed in the legislative reports and in the current
regulations, was that such a credit could be obtained only to
the extent that a dividends paid credit would have been
possible if the actual cash had been distributed, which means
that the amount of the credit is limited by the amount of
(continued from previous page)

at the beginning of the same year. It distributed approximately

$42,000 to escape the personal holding company surtax.

Due to the prior deficit, it was held that the first $23,000

had to be used to make up that amount, and the distribution to
this extent was a return of capital, not taxable to the shareholders and not available for use as a dividends credit.
This problem does not exist under the acta since

out of or

1936, since Section defines "dividend" to a

distribution
either 115(a)
now earnings
profitsof
accumulated
mean
1913since
or current
earnings
or profits
the taxable

year without regard to the existence of accumulated earnings.
That
is,
since
current
would
when
even
there
is
and
taxable distributed, 1936 a dividend from though profa
deficit,
be
such a dividend would be deductible by the corporation. The
problem typified by the Foley case still may arise, however,

where the company has current taxable income but no earnings

or profits either from the current year or prior years since
1913.
1. See Internal Revenue Code, Sec. 115(a) defining a

dividend.

2. See Internal Revenue Code, Sec. 28.

280

21.
1

earnings or profits available.

Even complete liquidation would

possibly not serve to remove the strait jacket; even here the
dividends paid credit might be limited.
Recommendation If it is deemed inadvisable to
2

exempt from the personal holding company surtax corporations with

no current or past earnings or profits, then an alternative
mechanism would be to extend the consent dividends credit
to such personal holding companies for amounts which the share-

holders include in their individual returns, even though such
amounts would not have been taxable as dividends if actually
distributed.

10. Existing Law as to Res Judicata The general
judicial doctrine of res judicata, namely the principle
that issues of fact or of legal rights determined in one
suit cannot thereafter be re-litigated, is applied by the
3

courts in tax controversies.

The doctrine involves special

1. Ways and Means Committee Report No. 1860, 75th Cong.,

3rd Sess., pp. 24-25 (1938); Reg. 101, Art. 23(c)-1.

2. See Gaston & Co., 39 BTA 640, involving Section
351 of the 1934 Act and holding that a liquidation distribution,
not being taxable to the shareholders except to the extent
that it exceeded their basis, could not be deducted by the
corporation in computing the personal holding company
tax. Under present law, however, it is possible to obtain a
dividends paid credit for some liquidation distributions; Reg.

101, Art. 27(g)-1.

3. Tait V. Western Maryland Ry. Co., 289 U.S. 620 (1933),
discussed in Paul, Selected Studies in Federal Taxation, Second
Series, pp. 104, 106 (1938); Griswold, Res Judicata in Federal

Tax Cases, 46 Yale L.J. 1320 (1937).

281
22.

questions with relation to the income tax for the reason
that the income tax involves items such as trust income, depreciation and many others which recur annually year after

year, causing each year's tax liability to constitute a
different cause of action.

As applied to tax cases the doctrine is further complicated by the fact that tax suits may sometimes be brought
against the Collector of Internal Revenue and sometimes against
the Commissioner or against the United States. On this point
the law may be summarized by stating that decisions in the
cases involving the United States or the Commissioner as a

party may be res judicata as to later actions involving the
Collector, whereas the converse of this proposition is not
true.

Discussion The application of res judicata causes
some startling instances of martyrdom as tax law progresses
and changes. Consider the plight of the unhappy husband in Helvering V. Brooks.
The Second Circuit Court of Appeals in this
2

case held that a certain husband who had created an alimony

trust in behalf of his divorced wife was taxable on the trust
income upon the ground that the income operated to discharge

his legal obligation towards the ex-spouse. Several years

later (long after the time for any direct appeal in the Brooks
1. Cf. Bankers Pocahontas Coal Co. V. Burnet, 287 U.S.
308 (1932) and Tait V. Western Maryland Ry. Co., 289 U.S.

620 (1933).

2. 82 F(2d) 173 (CCA 2nd, 1936). .

282
23.

case had expired) the same Circuit Court of Appeals in a differ1

ent case, involving a substantially identical alimony trust
held that the husband was not taxable and expressly over-

ruled its prior decision in the Brooks case. Nevertheless, because of the operation of res judicata, Mr. Brooks
must apparently continue to pay income taxes upon the trust

income so long as the trust endures. An error has been perpetuated which neither the Court, nor the taxpayer, nor the
government can do anything to alleviate.

The doctrine has further complications in tax cases
due to the system of Supreme Court certiorari. The United
States Supreme Court rarely grants certiorari in tax cases unless the lower courts are in c onflict; but conflict may de-

velop only after it is too late for the original taxpayer to
petition for certiorari. The purposes of the doctrine of res
judicata, namely, to lessen litigation is, of course, a worthy
objective, but as applied to tax cases under our system of
courts, the objectives of the doctrine are defeated instead

of achieved. In cases decided adversely to the particular
litigant, whether government or taxpayer, every avenue of appeal
must be exhausted, however small the amount involved, since

otherwise the original decision will result in a binding adjudication which may be conclusive as to all future tax 11abilities relating to the same item.
1. Helvering V. Leonard, 105 F(2d) 900(CCA 2nd, 1939).

283

24.

Recommendation

The existing distinction between

suits involving the United States, the Commissioner and the

Collector is highly artificial, and there is no reason
why all tax suits and proceedings should not be required to
be brought against the United States, the real party in interest.

It also need not be too loose a remedy to authorize
the courts and the Board of Tax Appeals to relax the rule of
res judicata in meritorious cases upon a showing of additional
or different facts in the subsequent year or upon a showing
that the rules of law as announced by the courts have changed

since the prior determination. This can be accomplished
procedurally by permitting motions to strike out pleadings on
the ground that res judicata applies and permitting such mo-

tions to be defended on the ground of additional or different
facts or a new rule of law.
11. Existing Law as to Credit for Dependents. The
existing law granting a $400 credit for dependents has been
stated in the accompanying memorandum. This credit for dependents now provided by the statute ceases when the dependent

reaches the age of 18 years, unless the dependent is physically
incapable of self support.
Discussion The accompanying memorandum suggests

an elimination of the discrimination involved in the fact that
taxpayers in the high brackets receive more tax saving than

284
25.

those in the lower brackets. On the other hand, the credit
for dependents 18 inadequate in that it stops, as indicated
above, at the age of 18 years. This is about the college
entering age when in many families dependents become most expensive and the credit for dependents is most needed.
Recommendati on

Assuming the discrimination in-

volved in the credit is eliminated, it is worth serious consideration whether the maximum age of 18 should not be lifted

to 21 years, the standard age of attaining majority.
12. Existing Law as to Personal Medical Expenses

The present statute expressly disallows all personal living
1

expenses and this disallowance includes any amount expended
for medical services.

Discussion It would be wholly logical and fair to
allow taxpayers some deduction for expenses incurred in protect-

ing their own health - their chief income-producing capital

asset. It is plainly inconsistent to permit a farmer to
deduct the expense of veterinarian service to his cattle, but
not to deduct medical expenses made to protect the health of
himself and his family. A deduction here would encourage the
obtaining of adecuate medical attention by taxpayers in the
lower-middle income brackets. An experiment in permitting such
a deduction has worked successfully under some of the state income

1. Internal Revenue Code, Sec. 24(a)(1).

26.

tax laws.

Recommendation A maximum deduction of perhaps

$100 a year should be allowed for medical or dental expenses
paid by the taxpayer on behalf of himself or any member of
his family.
GIFT TAX

13. Existing Law as to Gifts in Trust Section 505(a)
of the 1938 law amended Section 504 (b) of the 1932 law by

providing that the $4,000 annual exclusion allowed generally

for gift tax purposes shall not apply to gifts in trust.
Discussion This amendment was inserted to remedy

the evil of creating a number of trusts for the same beneficiary in order to secure the benefit of more than one ex-

clusion. The calculation of the exclusion in this situation
has been the subject of a difference of opinion between the

Board of Tax Appeals and the courts; the courts have finally
held under the laws prior to 1938 that the beneficiaries
are the true donees rather than the trustees, and therefore
1

the tax avoidance which the 1938 amendment was assigned to

prevent has proven illusory. At any rate the remedy adopted
in the act amounts to burning down the house to destroy

the rats. Trusts for minor children and other members of the
family are a useful social device, and it seems unwise to
give them a virtual death blow by completely removing the
exemption.

1. Welch V. Davidson, 102 F(2d) 100 (CCA 1st, 1939);

Rheinstrom V. Comm., 105 F(2d) 642 (CCA 8th, 1939).

285

286
27.

Recommendation The $4,000 gift tax exclusion

should be restored to gifts made by way of trust, with the
limitation that only one trust should be recognized for each
beneficiary in computing the tax. The exclusion, in other
words, should be in all cases determined according to the
number of beneficiaries rather than the number of trusts. If
one exclusion is claimed with respect to a gift in trust
for a certain beneficiary, no additional exclusion should be
allowed in the same year for a gift made directly to the same
beneficiary.

14. Existing Law as to Gift Tax on Tenancies by the
Entirety.
The existing regulations under the gift tax provide that 1f a husband purchases property and causes title to
be conveyed to himself and his wife as tenants by the entirety,
then the transaction amounts to a taxable gift to the wife,

consisting of the value of her interest in the property.
1

This position has been upheld by the courts. However, the
estate tax law provides that upon the death of the husband in
such a situation, the whole value of the property is includible in his estate for estate tax purposes.
2

Discussion The above treatment means that the
government inconsistently treats such a conveyance as a com-

1. Lilly V. Smith, 96 F(2d) 341 (CCA 7th, 1938) cert.

den. 305 U.S. 604 (1938).

2. Sec. 302 (e).

287
28.

pleted transfer to the wife for gift tax purposes, but disregards the transfer for estate tax purposes. The gift tax
rule, moreover, involves considerable difficulties of valuing the wife's right to the joint use of the property for life
and her contingent right to become sole owner of the property
in case she survives the husband; and it is possible that refined distinctions may have to be drawn according to the

exact legal rights which the law of the particular locality
gives to the wife as one of the joint owners.
Since the estate tax and gift tax were clearly de- the gift tax should
signed as supplementary to one another,
1

not be interpreted as covering transfers which are explicitly
covered by the estate tax. The more significant shift of
economic interests occurs at the husband's death; and here,

as elsewhere, the imposition of tax should be laid upon

economic realities rather than artificial legal technicalities.
The gift tax upon the type of transfer in question would, of
course, be an allowable deduction in computing the estate tax;
but due to the methods of computing such a credit, this is an
inadequate protection. Moreover, the husband may not consciously have intended to make a gift to the wife in the sort

of transaction here involved, and imposing a gift tax traps the
unsuspecting taxpayer.

1. The precise extent to which this is true will be further

11 luminated by the decision in Sanford Estate V. Comm., U.S.
(1939) aff'g 103 F(2d) 81 (CCA 3rd, 1939).

288
29.

Recommendation Assuming, as we apparently must, that

Lilly V. Smith 18 a correct interpretation of the statute, the
gift tax law should be amended to provide that no transfer (except gifts ultimately determined to have been made in contem-

plation of death) should be subjected to gift taxation where the
same property would be included in the transferor's taxable
estate upon his death.
GENERAL

15. Existing Law as to Interest on Deficiencies and
Refunds. The present law allows interest of 6% upon the amount

of any deficiencies, and also allows the same rate of interest
upon any refunds found to be due the taxpayer.

Discussion These percentages are out of line with
present interest rates and should be reduced. Such a reduction
would benefit taxpayers since the amount of deficiencies collected
by the government must considerably exceed the amount of refunds
collected by taxpayers.
Recommendation

The interest rate on both deficiencies

and refunds should be lowered to 4%.
November 13, 1939

Note: Section number references under the gift and estate
taxes are to the several acts and not to the new Internal

Revenue Code with which latter section numbers most persons

are not yet familiar.

289

MEMORANDUM B-1

QUESTIONS AS TO THE EFFECT ON THE REVENUE
OF THE POINTS MADE IN MEMORANDUM B

Referring to Mr. Paul's accompanying memorandum

marked "B", question arises as to how much loss of

revenue will result from the suggestions made as follows:

1 (a). A provision requiring affiliated corporations (defining those terms as they were defined in the
income tax acts immediately prior to 1934) to file consolidated
returns, the rates of taxation to remain unchanged.

(b). A provision granting permission to file
consolidated returns (1) upon condition that under a consolidated return there should be added an additional rate of 1%

to the tax generally provided with respect to corporations,
and (2) without such a 1% differential.

2. A provision modifying the present taxation on
15% of the amount received as intercorporate dividends in
the following respects:

(a). An elimination of this tax where the dividends
were received from a subsidiary company the formation of

which was necessary to carry on business activities in a
particular state.

(b). Eliminating the tax completely where the corporation has reasonably invested surplus in another corpora-

2

290

tion without acquiring a controlling interest.
(c). Raising the tax (by imposing it upon
25% instead of 15% of the dividends received) in the case

of complicated corporate structures involving a sub-subsidiary.
3 (a). A provision amending Section 820 added
by the Revenue Act of 1938 and giving the Commissioner discretion to allow adjustments back to 1932 for worthless
stock or bad debts when there has been a determination re-

sulting in a double disallowance of such a deduction.

(b). A provision eliminating from the statute
(retroactively to 1932) the requirement that bad debts ascertained to be worthless during the taxable year must be
charged off on the books of the taxpayer.
4. A provision amending Section 117 of the Internal Revenue Code to provide that neither a mortgage

foreclosure nor any conveyance in lieu of a foreclosure
should be regarded as a sale or exchange within the meaning

of Section 117 and that the loss of either party upon such
transactions should be ordinary, rather than capital, losses.

5 (a). A provision which would prospectively
amend the income tax statute by rejecting the Supreme Court
cases of Gould V. Gould and Douglas V. Willcuts and which
would impose income tax upon a divorced wife with respect to
amounts hereafter received by way of alimony or trust pay-

291
3

ments in lieu of alimony, allowing the husband to deduct
such amounts from his gross income.

(b). A provision which would subject to existing gift tax rates the creation by a husband of an alimony
trust which completely discharged the husband's obligation
of support towards his divorced wife.

6. A provision amending the Chandler Act to provide that the cost basis of assets in the hands of a corporation reorganized under Section 77 B should be reduced only
by the amount of the debt cancellation which would have con-

stituted taxable income except for the statutory exemption
in the same Act.

7. A provision that the earnings or profits of
corporations available for dividend distribution shall not be
affected by any increase or decrease in the value of assets,

or on account of a tax-free reorganization, which are not
recognized for income tax purposes.

8. A provision retroactively reducing the undistributed profits tax in the case of corporations which
were unable to make legal distribution of dividends under local

law because of capital deficits, to a flat tax of 5%.
9 (a). A provision removing the 65% or 75% tax on
the undistributed income of personal holding companies where

the company has no earnings or profits available for the dis-

4

292

tribution of a dividend.
(b). A provision imposing the personal holding company surtax upon taxable income without regard to the

existence of earnings or profits, but extending the consent
dividends credit provided in Section 28 to permit shareholders to consent to the taxation of undistributed income
even though such amounts would not have been taxed to them

as a dividend if actually distributed.
10. A procedural provision requiring all tax
suits or proceedings to be instituted against the United
States rather than the Collector or Commissioner and conferring upon the Board of Tax Appeals and the courts a broad dis-

cretion in tax cases to disregard the principle of res judicata,
where the facts or the law as announced by the courts is
changed in the subsequent year.

11. A provision allowing the $400 credit for dependents to be claimed with respect to children of the taxpayer until the children reach the age of 21, instead of 18.
12. A provision allowing a maximum deduction of
$100 for medical or dental expenses per year paid on behalf
of the taxpayer or any of his dependents.

13. A provision once more granting the $4,000 gift

tax exclusion to gifts in trust, but with a limitation that
only one such exclusion should be recognized in any year with

293
5

respect to gifts in trust for the same beneficiary.
14. A provision amending the gift tax law to
the effect that conveyances by way of tenancies of the

entirety of the type involved in Lilly V. Smith should not be
subjected to gift tax where the same property will later
be taxed for estate tax purposes.

15. A provision reducing the interest on deficiencies
and refunds to 4%, rather than 6%.

OPT:FE:MHP)

No. 15

294

AMERICAN CONSULATE

Hanoi, Indochina, November 14, 1939

Subject: Movement of Cargo from Haiphong

by Lighters.

The Honorable

The Secretary of State,
Washington.
Sir:

rea

not

I have the honor to refer to my despatch no. 5 of October
13, 1939. in which mention is made of the plan of a British concern to
establish a lighterage service from Haiphong to the nearest port in
China in order to assist in clearing the congestion of cargo awaiting
transit to China. This plan has been definitely abandoned but a
lighterage service has been inaugurated between Haiphong and Phu Lang
Thuong, a point about half way between Hanoi and Dong Dang. The

British company has already put two lighters in service and is
attempting to establish a schedule which will enable the movement of
approximately 700 tons a month. This amount is, of course, relatively

small but it will relieve to a certain extent the over-taxed capacity

of the railway to Dong Dang.
To date, however, the British company hasnot had much success

in securing cargo for its lighters. The representative of the

company has expressed his confidential opinion that the "transitaires"
at Haiphong and presumably the railway company are not anxious to

see even this small amount of lucrative business go into otherhands.
This may be a correct interpretation of an anomalous situation - the
French express great concern over the congestion of cargo at Haiphong,
they are constantly urging that something be done to clear the
congestion, and yet they do not take advantage of an opportunity to
assist this clearing.
Curiously enough, I am told that even the Chinese shippers
have shown no great enthusiasm for this plan.
Respectfully yours,
CHARLES S. REED

Charles S. Reed II,
American Consul.

Original and 2 copies to the Department
Copies to Embassy, Chungking and Peiping
Copy to Consulate General, Hongkong,
Copy to Consulate, Saigon
815.4

295

PLAIN

HSM

London

Dated November 14, 1939

Rec'd 10:34 a. m.

Secretary of State,
Washington.

2350, November 14, 4 p. m.
FOR TREASURY.

Today's press quotes a stock Exchange notice clari-

fying the existing regulations affecting the sale by
non-residents of securities subject to regulation of the
defence (finance) regulations. Briefly the notice makes
it clear that securities subject to the restrictions cannot be sold by a non-resident EXCEPT to another non-resi-

dent; an EXCEPTION to this rule allows residents of British
dominions including India, the colonies and protectorates
(excluding Canada, Newfoundland and Hong Kong) and resi-

dents of British mandates, Egypt, Anglo-Egyptian Sudan and

Iraq to sell restricted securities to a United Kingdom
resident but not (repeat not) to purchase such securities
from a United Kingdom resident.
KENNEDY

DDM

Y

74(e)

296

FEDERATORESERVE

OF NEW YORK

FICE CORRESPONDENCE
CONFIDENTIAL FILES

L. W. Knoke

DATE November 14, 1939.
SUBJECT TELEPHONE CONVERSATION WITH
BANK OF ENGLAND.

I called the Bank of England at 10:58 a.m. and in
Mr. Bolton's absence I spoke to Mr. Siepmann. In discussing
yesterday's sterling market, I stated that it had been about
as thin on the up-swing as it had been on the downward movement.

Foreign buying orders seemed to have exceeded foreign selling

orders. Selling orders from Japan appeared to have dried up.
Siepmann confirmed my statement about Japanese orders. They had

had £900,000, he thought, and very little of that was left by now.
referred to the International Tel. & Tel. business and Siepmann

1

replied that the International Tel. & Tel. people would have to
decide by tomorrow night. He confirmed that the British subsidiary had been permitted to cover £150,000, that is the first
maturity, in the open market. The total was $4,000,000 and he had
told them that he would not deal with them at any other than the

official rate and that he expected them to deal with him in London.
If they did not comply with his request, he would reek his vengeance

on the British subsidiary. As a result he hoped that the transaction would be concluded at the 4.02 rate. If the International
Tel. & Tel. had gone in at the rate of a week ago, they figure
it would have cost them a loss of 60,000 and they had not wanted
to get stung for that. Siepmann had spoken to them this morning

and was trying to get them to deal with the control. If the subsidiary chose to go the other way, he could not help it.

29

FEDERAL RESERVE BANK
OF NEW YORK

ICE CORRESPONDENCE

DATE November 14, 1939.

CONFIDENTIAL FILES

SUBJECT: TELEPHONE CONVERSATION WITH

L. W. Knoke

BANK OF ENGLAND.
2

I suggested that the Rumanians seemed to be through

with their selling. Siepmann stated that he had spoken to them
severely and told them that they were doing damage to themselves

as well as to the British. I asked where did the Rumanians get
their sterling
and he replied that it was the result of
shifting the whole of their European assets.
With regard to today's market, I mentioned that we had
been up to 3.96, following Amsterdam, which seemed to be the

principal buyer here. The local demand for sterling, I thought,
was just about satisfied and a further upward movement of the rate,

if any, was likely to be less abrupt than in the last few days.
Siepmann asked whether Brazil had been a seller of sterling and I

repeated what I had told Bolton a few days ago, namely, that all
the information which we had been able to gather seemed to deny that.

I asked whether he would venture a guess as to foreign

balances left in England. He replied that it was really difficult
to say but there was very little left that was not Empire money.

To what extent do foreigners hold sterling securities," I asked,
and his answer was "A great deal." The thought that foreigners

could build up their sterling balances as a result of security sales
was one that would disturb him. At the moment he was not troubling

about our free market but if foreigners should begin selling sterling
securities the situation would be difficult.

FEDERAL RESERVE BANK
OF NEW YORK

298
DATE November 14, 1939.

FICE CORRESPONDENCE

SUBJECT TELEPHONE CONVERSATION WITH

CONFIDENTIAL FILES

BANK OF ENGLAND.

L. W. Knoke
3

I referred to his lengthy cable No. 1067 of November 8

and told him that we would cable him tonight about certain difficulties which we were experiencing. Meanwhile would he please
have somebody send us by airmail copies of these certificates.

That, I said, would probably make it unnecessary for us in future
to send a cable similar to the one we were dispatching tonight.
Siepmann promised that he would see to that.

LWK:KW

eeel

of

VOV

ADDRESS THE COMMANDANT.

AND REFER TO NA OP-71

TREASURY DEPARTMENT

650
63

UNITED STATES COAST GUARD
HEADQUARTERS

WASHINGTON

14 November, 1939.

MEMORANDUM FOR: The Secretary of the Treasury.

The attached self-explanatory letter from Admiral
Harold R. Stark, Chief of Naval Operations, U. S. Navy, dated
9 November, 1939, is forwarded for your information.

annual
R. R. WAESCHE,

Rear Admiral, U. S. Coast Guard,

Commandant.

"
STORTARD

BIRTHIN

299

300
NAVY DEPARTMENT

OFFICE OF THE CHIEF OF NAVAL OPERATIONS
WASHINGTON

9 November 1939

Dear Admiral Waesches

Shortly after arrival of the IROQUOIS in New York I
received a letter from Captain L. E. Denfeld, U. 3. Navy, who at that
time was commanding the Grand Banks Patrol. In this letter be
stated:

"I cannot comment too favorably in regard to
the performance of the CAMPBELL and her commanding

officer, Commander Greensyun. He contacted the
IROQUOIS under very difficult circumstances as the
visibility was not good and the IROQUOIS was not

using her radio due to fear of being found by a

possible enemy. The CAMPBELL performed her duties

in the innor anti-submarine screen faultlessly. It
certainly is a pleasure having coast guard cutters,
so ably commanded under my command."

It was my intention to forward this information to you
immediately but the letter in which this statement was made was

given to one of the officers in my office who mislaid it and it

has only now been returned to me. I wish, even though belatedly,
to forward to you these comments on the excellent relationships
between Naval and Coast Guard Forces.

with kindest personal regards
Yours sincerely,

/a/ H. R. STARK
Rear Admiral R. R. Waesche,
Commandant, U.S.Coast Guard,
Washington, D.C.

00-0-P-T*

Farm
FEDERAL RESERVE BANK
OF NEW YORK
Hilline Whither was B. *. decision

the

November 14, 1939

Dear Mr. Secretary:

For your information I enclose an excerpt from

a strictly confidential letter received by me from
Mr. Ivar Rooth, Governor, Sveriges Riksbank, which I think

you will be interested in reading.
Sincerely yours,

George L. Harrison,
President.

Hon. Henry Morgenthau, Jr.,
Secretary of the Treasury,
Washington, D. C.

301

MISC 140-B 5M 12.35

SVERIGES RIKSBANK

Stockholm, 25th October, 1939

Strictly Confidential

302

Mr. George L. Harrison,
President,
Federal Reserve Bank of New York,

NewYork,N.Y.

Dear Mr. President,

As I told you in my letter of April 12th regarding

our foreign exchange policy we were increasing our holdings
of gold. Up to now there has during this year been an increase in our gold holdings by about 160 million kr. The

gold is held as follows /figures in millions of Swedish
kronor at actual gold price/:
24/10 1939

Gold in Sweden
" England
" U.S.A.

1.030
96

"

375

"

1.501

Since the outbreak of the war there has been a heavy

drain on our dollar and sterling balances. Owing to the fact
that Swedish importers have been buying dollars partly for payments of goods already delivered and partly for anticipated
payments of imports, and that foreign banks have withdrawn
their balances in Sweden, our dollar assets have been reduced

from 143 million dollars at about the 20th of August to 87,5
million dollars yesterday. That is the reason, why we asked
your Bank to sell part of our gold against dollars in order
to increase our dollar holdings.
We are now sending some gold from Sweden to U.S.A.

With kind regards,

I remain, dear Mr. President,

Faithfully yours,
(signed) Ivar Rooth

303
November 17. 1939

My dear Mr. Harrison:

This will acknowledge re-

ceipt of your letter to Secretary

Morgenthau, dated November 14th,

with its enclosure.

I shall be glad to bring

this to his attention as soon as
he returns to the office. We are
expecting him back on Monday.

Sincerely yours,

(Signed) H. S. Klotz
H. S. Klotz
Private Secretary
Mr. George L. Harrison,
President, Federal Reserve
Bank of New York,
New York, New York.

304
GRAY

JI

Paris

Dated November 14, 1939

Rec'd 4:55 p.m.

Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION ONE)
FOR THE TREASURY.

After an absence of SEVERAL months due in part

to illness Frederic Jenny, LE TEEPS' well known and

influential collaborator, has returned to that journal
with a timely article in the November 13 issue entitled
"War Finances". It is an Error, he says, to think that
financial and Economic problems are of SECOnd place

importance in war time: on the contrary the SUCCESS
of modern warfare depends on immense financial re-

sources. The primary question is to find these resources rather than to adjust "public Expenditure to
permanent receipts". HE then reviews the year's
Expenditures as follows: The total 1939 budget voted

by Parlingent carried Expenditures of the State (not
including those of local governments nor the budget of
the amortization fund) of a little over 100,000,000,000
francs of which 66,500,000,000 constitutes the ordinary
budget

305

-2-2753, November 14, 7 p.m. (SECTION ONE) from Paris

budget balanced by revenues and the other 35,000,000,000

consisting largely of national defense Expenditures
were to be COVERED by borrowing.
(END OF SECTION ONE)
BULLITT

EMB

306
JI

GRAY

Paris

Dated November 14, 1939

Rec'd 7:05 p.
Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION TWO)

After the Germans marched into Prague in March, these

Expenditures were materially increased bringing the
total to between 110 and 115,000,000,000 francs. In
the var session of September 2, Perlinement voted
additional credits of 69,000,000,000 of which
approximately 45,000,000,000 were "payment credits"

and 24,000,000,000 authorizations (our telegram No.
1742, September 2, 7 p.m.). Reynoud (who is due

to present his budget to the Finance Commission of the

Chamber Friday) will set forth his Estimates for the
coming year (it will be recalled from our telegram No.
2215, September 27, 8 p. that war Expenditures will
be voted only by quarters in view of the 1 possibility
of estimating needs for a year ahend). The question
arises, continues Jenny, as to how these expenditures
are to be COVERED.
BULLITT
NK:EMB

307
JI

GRAY

Paris

Dated November 14, 1939

Rec'd 7:10 p.m.

Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION THREE)

HE urges that the revenue from taxation should bE

as large as possible (given the adverse Effects on
revenue of mobilization on
/the country's Economy) to facilitate the managing
of the money market and to safeguard the stability
of the currency. Additional sacrifices should be
asked of tax payers and consumers and at the same

time the maintenance of productive Economic acts

should be stimulated to prevent the drying up of
sources which feed the Treasury. HE admits that,

"It is a delicate problem in the first place to
strengthen the tax system sufficiently to permit a
satisfactory flow of revenues without EXCEEDING the

point where the spirit of enterprise becomes discouraged

and losses are registered rather than the desired
increases"; on the other hand to bring about possible
Economics and to fight censelessly against waste and

thirdly

308

-2-2753, November 14, 7 p.m. (SECTION THREE) from Paris

thirdly to reconcils the maintenance of an Economic

life as active as possible to military necessities.
BULLITT

EMB

309

GRAY

JI

Paris

Dated November 14, 1939

Rec'd 5:36 p.m.

Secretary of State
Washington

2753, November 14, 7 p. (SECTION FOUR)
Turning to EXCEPTIONAL resources, he says they

are two: inflation and borrowing. Inflation is the
Easier, but its abuse inevitably hns repercussions
on the currency and on prices. It should therefore
be avoided as far as possible. There must, however,
be SOME recourse to the creation of money, given the

rapidity with which massive war needs materialize.
It was for this reason that the Bank of France opened

the Treasury's 25,000,000,000 credit. In this connec-

tion, he says it is worth noting that the State's
authorized advance up to November 2 was drawn on only
to the EXTENT of 7300 millions and that "apparently

this noney was utilized less for current EXPENSE

Expenditures than to permit the Treasury to cover
advances which it was obliged to make to the stabiliza-

tion fund for gold purchases. In the last analysis,
therefore,

310

-2-2753, November 14, 7 p.m. (SECTION FOUR) from Paris

therefore, this inflation, so moderate under the
circumstances, is guaranteed at least in part by
metallic money (gold)"
BULLITT
NK:EMB

311

GRAY

JI

Paris

Dated November 14, 1939

Rec'd 5:20 p.m.
Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION FIVE)

Turning to borrowing, he says that borrowing
will be called upon to provide the Government with

the greater part of its war resources which is why
a policy of borrowing designed to safeguard the credit
of the state is of such importance. HE points out that
French rentes today are higher in spite of the war than
in 1938 and EXPRESSES the belief that the present

policy of catering "to the public preference for
short term loans" is sound. Consolidation operations
will COME later from time to time "to EASE the short
term money market and reconstitute circulating funds"
.

BULLITT

EMB:NK

312
JI

GRAY

PARIS

Dated November 14, 1939

Rec'd 8:16 p.m.

Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION SIX)

In the monstary field, he says, it is important
in war time (firstly) to prevent the outflow of gold
EXCEPT for the Government's arms purchases abroad;

(secondly) to prevent Exchange rates "which are no

longer !regularized by gold movements from losing

their stability and finally to assure that all
national and foreign Exchange resources are placed

at the disposition of the country. HENCE complete

control of Exchange, of foreign trade and the requirement for declarations of holdings abroad. HE concludes:
"Behind the barriers of Exchange control, that
Expedient so abhorrent in time of PEACE but a measure

of precaution so necessary in time of war there is
established a capital circuit strongly primed by the
return of funds, largely maintained by savings placed

at the service of the country in peril, a circuit
which

313

-2-2753, November 14, 7 p.m. (SECTION SIX) from Paris

which brings to the coffers of the Treasury under the
form of loan subscriptions a large part of the sums
EXPENDED by the State. For this reason borrowing
takes in Effect, among the immense resources which

the financing of a war necessitates, the predominant
place which it must occury.
BULLITT
EMB

314
REB
GRAY

Paris

Dated November 14, 1939

Rec'd 8:22 p. m.

Secretary of State,
Washington.

2753, November 14, 7 p. m. (SECTION SEVEN)

WE have reported in past telegrams (for example
telegram No. 2632, November 1, 7 p. m. and 2707, November

9, 7 p. m.) the natural emphasis being placed here on
the need to Export and the difficulties and obstacles in
the way of Exports -- concerning the progress or lack

thereof no statistics are available. The press is
beginning to discuss the question more freely and last
night's LE TEMPS contained a leading article on the

subject. It pointed out that export enterprises need
labor, row materials, and plants; that it is useless to
invite them to Export if in the first place they cannot
produce. Doubtless the necessities of national defense
writes LE TEMPS take precedence OVER EVERYTHING but

exportation is one of these necessities. "WE must not
forget that our Exports are composed largely of luxury

articles, the creation of which requires that our artists
and our artisans work in an atmosphere that it is difficult
to

315

REB -2- 2753, From Paris, Nov. 14, 7 P. m. (Section SEVEN)

to maintain in war. It is all the more necessary that
the population lead a life as approaching normal as
military necessities will permit." To Export, LE TEMPS
continues, both a seller and a buyer are necessary and

unfortunately the difficulty of communications is
seriously hindering French Exporters.
BULLITT
LMS
EMB

GRAY

JI

Paris

Dated November 14, 1939

Rec'd 8:29 p.m.

Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION EIGHT)

Neutrals complaining of French delays in Export
authorizations and communications report on the other
hand that relations with Germany are much quicker and

easier. "The necessity for controlling correspondence
with the outside world is easily understandable. The
Enemy must be prevented from receiving information

which is precious to him; against this disadvantage
must bE placed those which result in the stopping of
our Exports. In order to blockade Germany must WE
go to the EXTREME of blockading oursElves? If that
is the CASE it is necessary to choose between postal
control and Export, but WE do not bEliEVE WE are

condemmed to this alternativé. Is it really impossible
to organize control so that urgent communications with

neutrals are not subject to delays? Such is the problem it is urgent to solve if one bEliEVES that Export
is in war time, EVEN more than in PEACE time, a vital
necessity for the country".
BULLITT
PG:EMB

316

317

REB

GRAY

Paris

Dated November 14, 1939

Rec'd 8:35 p. m.
Secretary of State,
Washington.

2753, November 14, 7 p. M. (SECTION NINE)

This is the first somewhat timid following in France of
the more outspoken complaints appearing in the British
press on war time controls and restrictions there and

it is probable that the French press responding to the
complaints which in spite of the more disciplined
attitude of C country schooled by universal military
service may become more vocal as time goes on. Both
LE TEMPS for Example and LA JOURNEE INDUSTRIELLE sound

warnings at the "danger" of increased Government controls
as EVIDENCED by the proposed departmental groups to

assure supplies of foodstuffs and agricultural products
(please SEE our telegrams Nos. 2632, November 1, 7 p. m.

and 2644, November 2, 6 p. m.) the latter journal protests
that while producers beg for more "liberty" the State
threatens more and more control and predicts that the

State will pass away from "regulated liberty" to "controlled Economy".
BULLITT
EMB

318

GRAY

PAP

PARIS

Dated November 14, 1939

Rec'd 8:50 p.m.

Secretary of State
Washington

2753, November 14, 7 p.m. (SECTION TEN).

The securities market showed a firmer tone yesterday

and this tendency continued on an increasing scale today.

Practically all along the line gains were registered and
rentes advanced on the average over one half a franc. The
two exchange guaranty issues of 1925 and 1937 gained 1.70

and 4.10 respectively. The improved tone of the markets

the past two sessions is largely due to the public belief
that the danger of a German invasion of Holland and-Belgilium
is somewhat lessened.

The Journal Officiel today carries a decree increasing
cigarette prices by the tobacco monopoly on the average
about one franc twentyfive per package.
The Belgian National Bank statement for the week ending
November 8 shows gold holdings at 18,029,000,000 up 8,900,000;
foreign exchange holdings down 167,000,000 to 3,925,000,000,
Belgian commercial advances up 519,000,000 to 3,296,000,000
and commercial advances abroad up 39,000 to 18,539,000
Advances

319

PAP -2- 2753, November 14, 7 p.m. (SECTION TEN) from Paris
Advances on public funds are down 276,000,000 to 761,000,000.

Note circulation is up 51,000,000 to 27,195,000,000. The
treasury account is down 1,500,000 to 7,200,000. Gold
coverage is 64.20 as against 64.24%
BULLITT
REP:EMB

320

REB

GRAY

Paris

Dated November 14, 1939

Rec'd 8:11 p. m.

Secretary of State,
Washington.

2753, November 14, 7 p. m. (SECTION EL EVEN)

The Belgian Treasury has issued 40,000,000 francs of

three months Treasury bills at an average rate of 2.75%
per annum against 2.74% previous.

The Belgian Finance Ministry has issued a statement
concerning proposed new taxes. EXCESS profits tax will be

70% and the remaining 30% will be subject to the "taxe
mobiliere". There WERE likewise increases in a number of
indirect taxes designed to produce 1,443,000,000 francs
additional revenue while maintaining approximately the
present proportion between indirect taxes, consumption

taxes, and stamp taxes. The statement Estimates the cost

of Belian mobilization at 8,500,000,000 francs of which
4,500,000,000 is actual mobilization costs from October
19, 1939 to December 31, 1940 and 1,500,000,000 the
revenues. The Extraordinary budget
for 1940 is EXPECTED to total 2,500,000,000.

French financial press takes pleasure in announc-

int the Esteblishment of the agency of the Societe
Generale ct NEW York.
(END OF MESSAGE)
EMB

BULLITT

321

TREASURY DEPARTMENT
INTER OFFICE COMMUNICATION

DATE November 14, 1939
Secretary Morgenthan

TO

Mr. Cochran

FROM

The foreign exchange market was thin with rates moving in an erratic manner.
In Amsterdam this morning, sterling was quoted at 3.92-13/16 and, prior to the
beginning of business here, it was 3.93-7/8. In New York the opening quotation
was 3.94-3/8 and at that time the Chase Bank reported that it was purchasing
sterling in Amsterdam. The Irving Trust Company received an order from Sweden

to sell 150,000 which was not offered in the market but taken by the Irving into
its own position. The Guaranty Trust Company reported that it had received both
buy and sell orders for sterling in small amounts from banks in Paris. About midmorning, sterling was quoted at 3.96. It then began to recode and shortly after
noontime reached the low of 3.93-1/8. It subsequently recovered to 3.94-3/8 and
closed at 3.93-3/4. The market in sterling was so small that at times the rate
moved a penny per pound on small orders, either way.

The discount for one month's sterling widened to 1-1/24 per pound, equal to
4-9/16% per annum. For three months, the discount was 4-3/84 per pound, equal to
4-7/16% per annum.

Sales of sterling by the four reporting banks in New York totaled 2449,000
from the following sources:
By commercial concerns

By foreign banks (Far East, Europe and South America)
Total

L 206,000
L 243,000
L 449,000

Purchases of sterling amounted to $505,000, as indicated below:
By commercial concerns
By foreign banks (Europe and South America)

I 289,000
L 216,000

Total L 505,000

The banks also reported that the British Control purchased sterling amounting

to 177,000 at the official rate of 4.02. All of this sterling represented cotton

bills.

The other important currencies fluctuated rather widely and closed as follows:
French francs
Guilders
Swiss francs

.0223-1/2
.5309-1/2
.2247-1/2

Belgas

.1633

Canadian dollar

12-2/46 discount

--

322

The discount on the Cuban peso continues to increase and was today quoted at
14-7/8%

The Dow Jones ticker carried an Associated Press despatch from Madrid stating

that the Spanish government again has corrected the peseta rate to conform to the

decline of the British pound and the French franc in relation to the U. S. dollar.
In the future, U. S. dollars resulting from Spanish exports will be worth 10.05
pesetas ($.0995 per peseta). Dollars which are voluntarily returned to Spain will
be worth 12.56 pesetas ($.0796 per peseta). The former rates were 9.90 pesetas
($.1010 per peseta) and 12.37 pesetas ($.0808 per peseta) which were in effect for
the last two months.

We purchased the following amounts in gold from the earmarked accounts of the

banks indicated:

$8,000,000 from the Netherlands Bank
993,000 from the National Bank of Belgium
350,000 from the Bank of the Republic, Colombia (consummated late on November 13)

$9,343,000 Total

The Federal Reserve Bank reported to us the following shipments of gold:
$1,663,000 from Canada, shipped by the Bank of Canada, Ottawa, consigned to the

Federal Reserve Bank of New York, for sale to the U. S. Assay Office at

New York.

1,130,000 from Switzerland, shipped by the National Bank of Switzerland for the
account of the BIS, consigned to the Federal Reserve Bank of New York

for the account of the BIS, the disposition of which is unknown to us
at the present time.

22,000 from England, shipped by Samuel Montagu & Co., consigned to the Bankers

Trust Company, New York, for sale to the U. S. Assay Office at New York.

$2,815,000 Total

On the report of November 8 received from the Federal Reserve Bank of New York,

giving the foreign exchange position of banks and bankers in its district, the total
position of all currencies was short the equivalent of $16,934,000. a decrease of
$1,780,000 in the short position for the week. The net changes in position are as
follows:

SHORT POSITION
COUNTRY

England
Europe
Canada

Latin America
Far East

All Others
Total

NOVEMBER 1

$5,049,000
8,345,000
932,000
291,000
4,056,000

SHORT POSITION
NOVEMBER 8

$ 4,190,000
8,898,000

DECREASE IN
SHORT POSITION

$ 859,000
553,000

41,000

515,000
363,000
2,937,000
31,000

417,000
72,000
1,119,000
10,000

$18,714,000

$16,934,000

$1,780,000

(Increase)
(Increase)

-3-

323

The equivalent of today's London spot silver price was 41.23# and the forward
price 40.97 The price paid by Handy and Harman for foreign silver was unchanged
at 34-3/4 The Treasury's price was also unchanged at 35$ In New York, we made
five purchases of silver totaling 375,000 ounces under the Silver Purchase Act.
We also purchased 350,000 ounces of silver from Canada making a total of 495,000
ounces purchased during November under our agreement to buy 1,200,000 ounces monthly.

Mr. Knoke told me at 11:15 this morning that he had just spoken with Mr. Siepmann

of the Bank of England, and had told Siepmann about the New York exchange market.

Siepmann thought the Japanese were practically through selling sterling. Siepmann
had talked with the Rumanians and had hinted to them that sales of sterling such as
they had been making had not been in their own interest. The Rumanians indicated,
in reply to Siepmann's query, that the sterling which they had sold represented
foreign exchange balances. In reply to Knoke's question as to the extent of foreign
balances in England, Siepmann replied that these were very small outside of British
Empire balances. Continuing the question as to the foreign-held British securities
that could be liquidated, Knoke was informed by Siepmann that this was an entirely
different question, and that the volume might be substantial. Siepmann hinted that

if signs of important liquidation of British securities developed, they might be

called to take some action. Siepmann stated that a decision would be taken by
tomorrow with respect to the 11,000,000 maturity of the I.T.T. which has been mentioned in earlier conversations between the Federal Reserve Bank and the Bank of
England. Siepmann said that 165,000 would probably be acquired on the New York

market and the remainder would be given by him in London at the official rate. In
closing his talk with me, Knoke expressed the opinion that the New York sterling
market was a little tired, having absorbed about all the sterling it could, and
that either buying or selling might have a marked effect on the rate.
Leroy-Beaulieu telephoned me yesterday from New York, He stated that the French

Consul General had that day endeavored to sell to the Chase Bank a sight draft drawn
by the Consul General on the Ministry of Foreign Affairs of France to cover salaries
and running expenses of the French Consulate General. The Chase Bank had refused to

buy the draft, stating that the Bank would have to communicate with the State Department at Washington to see whether such a transaction would be permissible under the

Neutrality Act. Leroy-Beaulieu told me that Pinsent was in his office and was much
interested in this case, since the British Embassy and consular officers in this
country would have the same problem. I let Leroy-Beaulieu know that this was not
a Treasury matter. I tried, without success, to learn from the State Department
who was handling this matter. I called Leroy-Beaulieu back and told him that if he
learned when, and to whom, and how, the Chase had referred this matter, I would see

if anything could be done to expedite a decision.

Mr. Knoke spoke with me at 4:45 yesterday evening. He mentioned that Pinsent

had telephoned him in regard to the question above described as raised by LeroyBeaulieu, and that Knoke had advised contact with the State Department.

Mr. Leroy-Beaulieu telephoned me at 3:30 this afternoon to the effect that
Pinsent had telephoned him today that the British Consul General in New York had
experienced the same difficulty as the French Consul General when endeavoring to

sell a draft to the Chase Bank. Leroy-Beaulieu told me that two lawyers represent-

ing the Chase Bank, Messrs. Millbank and Sargent, will come to Washington on

324

Thursday to see the Department of State, and will call on no. I explained to
Ieroy-Beaulieu that with both him and Pinsent in New York, I had done what I could

yesterday to find how the matter stood, but that since the Treasury itself is not
handling this matter, the lawyers should look to the State Department for advice, or
for reference by the State Department to the competent authorities in Washington.
Knoke gave me the following item with respect to the Reichabank account with
the Federal Reserve Bank. He said that between October 21 and 27. $3,975,000 had

been drawn out of this account with the Federal and paid to the Chase Bank. The

Chase Bank had then transferred $3,230,000 to the Stockholm's Enskilda Bank for
the Reichabank. The Swedish Bank had then credited about the same amount to the
Russian State Bank account with the Chase. The German funds thus proceeded in this
roundabout channel to the Russian State Bank,

325

TREASURY DEPARTMENT
INTER OFFICE COMMUNICATION
DATE November 15. 1939

Secretary Morgenthan

TO

FROM

Mr. Cochran

The foreign exchange market was quiet. Sterling opened in New York at 3.93-1/2
and declined to 3.92-1/2 on small selling orders from abroad received by the New
York banks. After absorption of this sterling by the market, good commercial buying appeared and the rate gradually strengthened to the high of 3.94-5/8 shortly
before noon. Thereafter the quotation moved in a narrow range and closed at 3.94.
The discount on forward sterling widened to 2-1/8 per pound for one month
and 5-1/2 per pound for three months. The Chase Bank received orders from London

this morning to sell forward sterling but, as there was no demand for forwards at
that time, it returned the orders to London unexecuted. During the course of the
afternoon, it was reported that the Japanese were offering forward sterling in
small amounts for three months at 5-1/24 per pound discount. The yield on one

month's sterling is 6-1/2% per annum and three month's, 5-9/16% per annum.

Sales of sterling by the four reporting banks in New York and the Federal
Reserve Bank of New York totaled 533,000 from the following sources:
By commercial concerns

By foreign banks (Europe, Far East and South America)
By Federal Reserve Bank of New York (For Norway)

Total

L 302,000
L 181,000

L 50,000
& 533,000

Purchases of sterling amounted to 1680,000, as indicated below:
By commercial concerns

By foreign banks (Europe, South America and Far East)

Total

L 525,000
L 155,000
680,000

Of the four reporting banks, the Guaranty Trust Co. was the only one that sold

sterling to the British Control. It sold a total of 45,000 at the official rate
of 4.02. All of this sterling represented cotton bills.
The Federal Reserve Bank purchased 65,000 belgas for the Bank of Latvia.

The other important currencies closed as follows:
French france
Guilders
Swiss francs
Belgas

.0223-1/2
.5310
.2246
.1638

Canadian dollar 12-1/4% discount

CONFIDENTIAL

-2-

326

We sold $2,357,000 in gold to the National Bank of Rumania, This makes a total
of $11,545,000 in gold sold to the Rumanian bank and completes their request to buy
gold valued at approximately $11,000,000, which request was mentioned in a previous
report.

We purchased the following amounts of gold from the earmarked accounts of the

banks indicated:

$10,000,000 from the Bank of France
4,200,000 from the Netherlands Bank
727,000 from the National Bank of Belgium
$14,927,000 Total

The Federal Reserve Bank reported to us the following gold shipments:
2,974,000 from England, shipped by the Bank of England, consigned to the Federal

Reserve Bank of New York for account of the Netherlands Bank, the disposition of which is unknown at the present time.

980,000 from England, shipped by Samuel Montagu and Co., consigned to the Chase

National Bank of New York for account of the Rotterdam Bank, for sale to
the U. S. Assay Office at New York.

249,000 from England, shipped by the Midland Bank to the Guaranty Trust Company

of New York for the account of a Canadian resident, for sale to the U. S.

Assay Office at New York.
33,000 from England, shipped by the Banque Belge pour 1'Stranger, consigned to

the Banque Belge pour l'Etranger of New York, for sale to the U. S. Assay

Office at New York.
$4,236,000 Total

Ye have received a cable advice from the American Consul at Bombay, India, that
he had invoiced for shipment to this country $630,000 in gold, shipped by the National
Bank of India to the Guaranty Trust Company of New York at San Francisco. It is
assumed that the gold will be sold to the U. S. Mint at San Francisco.
The equivalent of today's London spot silver price was 41.39 and the forward
price, 41.194. Handy and Harman's price for foreign silver remained unchanged at
34-3/44. The Treasury's price was also unchanged at 35
In New York we made four purchases of silver totaling 175,000 ounces under the

Silver Purchase Act.

Mr. Johnson, Manager of the Foreign Department of the Chemical Bank, telephoned

no from New York this morning in regard to the desire of one of the bank's customers
to export tin. Mr. Johnson inquired as to whether the bank should endeavor to discourage the export of such an essential commodity. I told him that I know of no
restrictions imposed by the Customs authorities of the United States upon such export, and I told him that the Treasury Department would not take the responsibility
of stating that such an export should be discouraged as a matter of national policy.

I told him that if he wished to pursue the matter further, he should speak directly

with Mr. Green of the Department of State.

CONFIDENTIAL

-3-

327

Mr. Pinsent telephoned me from Washington this afternoon. He had just returned
from New York. Before leaving that city he had learned through Mr. Loree that the
lawyers of the Guaranty Trust inclined to the opinion that British banks authorized
to deal in foreign exchange under the British regulations must be considered agents
of the British Government as a consequence, with the further result that they are
not free to participate in the private credit operations allowable under our Neutrality Act. Pinsent said this would be a much more serious matter than that of the
pay drafts which Leroy-Besulieu had mentioned to me. At the suggestion which I
made, after consulting with Mr. Bernstein, Mr. Pinsent stated that he would talk
with either Mr. Green Hackworth of Mr. Bert Hunt in the legal division of the Department of State.

Chairman Ida Pruitt of the Hong Kong Promotion Committee, Chinese Industrial

Co-operatives, called on me this afternoon. I learned subsequently from Mr. Penfield
of the Department of State that she had called at that Department, being personally
acquainted with several of the officers who had served in China, and had been referred to me when she sought the name of someone in the Treasury Department who

might consider her request for possible financial assistance to the organization
which she represents. The visitor hoped to be able to tell Secretary Morgenthan
her impressions of China, having resided there many years and having returned only
recently. I told her that the Secretary was kept up to date on China. When I
sought the exact purpose of her visit, and found that it was with the idea that
she might get some financial assistance for business enterprises in China, I told
her that the Export-Import Bank was the only government institution which might at
the present time give any consideration to her request. I gave her Mr. Pierson's
name and address. Since she was interested in talking with Mr. Arthur N. Young,
I gave her his address, the Mayflower Hotel, after learning from the State Department that he had returned today from Washington. She had Mr. Archie Lochhead's
name, and said that she was to see him in New York next week.

AMR

CONFIDENTIAL

328
GRAY

MA

Paris

Dated November 15,1939

Rec'd 4:47 p.m.

Secretary of State
Washington

2765, November 15, 7 p.m.
FOR THE TREASURY.

Today's Journal Official carries a decree postponing
from November 15 to December 31, 1939 the date on which

the required declarations of holdings abroad are to be
based and postponing from DECEMBER 1, 1939 to January 15,

1940 the date on which such declarations are to be filed.
(Embassy's telegrams numbers 2028, SEptEmbEr 18, 1 p.m. and

2394, October 9, 7 p.m.) the accompanying explanatory MEMO-

randum states that repatriation of capital has been so
substantial since SEptEmbEr 10 that it has been possible
" to MEET the first Expenditures abroad which the country's
requirements have made necessary" while foreign Exchange

reserves have continued to increase.
(END OF SECTION ONE)
BULLITT
EMB

329
JI

GRAY

Paris

Dated November 15, 1939

REC'd 3:34 p.m.

Secretary of State
Washington

2765, November 15, 7 D.M. (SECTION TV.O)

The menorandum adds that there are signs that this

return flow of capital is likely to continue and that
therefore the Government does not wish to stop such

repotriction y the November 15 dendline Especially
as delays in transportation, Etc., under existing
circumstances may have hindered the return of

holdings abroad where already decided upon. You will
recall (for example, our telegram No. 2635, November

2, 3 p.m.) that the attitude of the French financial
authorities is that while much of this capital would
sooner or later be made available to the Government

anyway, it is MORE satisfactory to obtain as much as

possible voluntarily.
BULLITT

E1B

330

JI

GRAY

Paris

Dated November 15, 1939

Rec'd 4:22 p.m.

Secretary of State
Washington

2765, November 15, 7 p.m. (SECTION THREE)

On the other hand the postponement of the date for

filing declaration means a delay in reaching an
approximate Estimate of the Extent of French holdings
abroad.

WE learn that a recent confidential instruction
has been issued the "approved intermediaries" by the
Foreign Exchange Office permitting them to grant,
with reference to the Foreign Exchange Office,

authorization for non-resident foreigners to carry
with them on leaving France the sum of 25,000 francs

or its Equivalent in foreign currencies, travellers
checks Etc. instead of the previous maximum of 5000

francs. For sums above that amount approval of the
Foreign Exchange Office was formerly necessary.
BULLITT

ENB

331

JI

GRAY

Paris

Dated November 15, 1939

Rec'd 4:40 p.m.

Secretary of State
Washington

2765, November 15, 7 pell. (SECTION FOUR)

To bring existing practice into conformity
with the cash and carry provisions of our Neutrality
Act WE understand that dollar Exchange to COVER

imports from the United States for which licenses
have been approved may be cabled through an "approved

intermediary" to its correspondent in the United
States. Thus payment may bE made to the American

Exporter at the time of transfer of the title of
the goods in question in the United States. On the
other hand for imports from a number of other coun-

tries payment is not approved until the goods have
actually arrived in France or documents presented.
Finance Minister Reynaud returned from his
London conversations this morning.
(END SECTION FOUR)
BULLITT

NPL

332
JI

GRAY

Paris

Dated November 15, 1939

Rec'd 4:55 p.M.

Secretary of State
Washington

2765, November 15, 7 p.m. (SECTION FIVE)

A joint British and French comunique has just
been issued here that reads as follows in translation
from the French:

"On the invitation of the Chancellor of the
Exchequer, Monsieur Paul Reynoud CAME to London on

the 13th and 14th of November accompanied by repre-

sentatives of the Ministry of Finance. The two
ministers recognized the necessity for a close and
constant cooperation in the Economic and financial
spheres. They Examined the arrangements which have

Existed for SOME time to assure this cooperation.
They decided to mointain it and Extend it EVEN further.
Different questions SOME of which concern general

financial and Economic policy and other of which
present a more technical character WERE discussed and
on all these questions the EXISTENCE of a common point
c

of ViEW was Evident.
(END SECTION FIVE)
BULLITT
NPL

333

GRAY

MA

Paris

Dated November 15, 1939

Rec'd 6:35 p.m.

Secretary of State
Washington

2765, November 15,7pm (SECTION SIX)

When these consultations WERE finished Monsieur Paul

Reynaud proposed further meetings of a similar nature in
order to maintain permanent contact between the two
treasuries. The Chancellor of the Exchequer gave his
complete assent to this suggestion".
On the securities market today variable revenue
issues WERE firm particularly internationals Suez advancing
455 francs. Most rentes advanced fractionally the 1937
Exchange guaranty issue gaining 70 centimes. The fortnightly
liquidation passed off easily with carryover money again

at one-half per cent.

(END SECTION SIX).
BULLITT

NPL

334

GRAY

MA

Paris
Dated NOVEMBER 15, 1939

Rec'd 6:40 p.m.

Secretary of State
Washington

2765, November 15, 7 p.m. (SECTION SEVEN). Exchange

rates have undergone no change since our telegram Number 2707,
November 9, 7 p.m. last paragraph with the EXCEPTION of

the belga which dropped to 718 - 724 during last WEEK'S

crisis and has remained at that figure.
The Netherlands Bank statement for the WEEK
ending November 13 shows a reduction in gold reserves

from 1,104,000,000 florins to 1,059,000,000. Total
liabilities are 1,357,000,000 as against 1,387,000,000.
Gold coverage dropped from 79.60 to 78.05 %.
(END OF MESSAGE)
BULLITT
NPL

TRUSARIT

adj to will

ISSUED - of - -

335
PLAIN

JR

London

Dated November 15, 1939

Rec'd 12:53 p.m.

Secretary of State,
Washington.

2363, November 15, 6 p.m.
FOR TREASURY.

In view of the comments on the necessity for
curtailing wage Earners' consumption and the mention of
compulsory saving as a method on page 13 of the Embassy's

memorandum of October 7 on the British ver budget, it is

of interest that two articles in the TIMES of yesterday
and today by Keynes advocate and outline a scheme for forced
savings.

Keynes argues that through longer working hours,

dilution of labor and wage increases (the letter tendency
having already appeared, SEE my No. 2167 of October 25)

"on increase in the purchasing power of wage Earners by

at least pounds 500 million a year must be Expected" and
when maximum Effort is reached a larger increase will be

inevitable; that if the government policy of holding down
prices of certain goods succeeds working class purchasing
power will corrand more goods; and that if wages are

allowed to rise the situation will be further aggrevated
and

336

-2- #2363, November 15, 6 p.m., from London.

and the vicious spiral of inflation induced.
Keynes EXAMINES alternative remedies:

(1) rationing though desirable for other reasons
is no remedy against a general increase of purchasing
power as it merely diverts demand from the rationed to

the unretioned article.
(2) Antiprofiteering measures "Excult into undue
prominence the least significant CAUSE of rising prices."
These two methods he characterizes C.S "psuedo

remedies." Three genuine remedies he considers must all

be applied but the degree is important:

(1) : rise in prices which he argues is desirable
insofar as the rise represents increases in costs, rise
in world prices and depreciation of Exchange. "It is
unlikely that WE can avoid SOME further rise up to (say)
20 per cent above pre-wer", but while a price rise
sufficient to restore Equilibrium between purchasing power
and the supply of goods would Enhance the yield of the
EXCESS profits duty it "would be beyond all reason and

Endurance and the vicious spiral of rising prices and
wages could not be avoided. The control of consumption

by a rise in prices would be "lergely futile unless WE
re-cast our wages system. The rise in prices helps only
to

337

-3- #2363, November 15, 6 p.m., from London.

to the EXTENT that it is greater than the rise in
wages".

(2) Taxation would have to be direct on the working
classes who consume three fifths of net consumption and
whos E incomes are likely to rise by upwards of 15 per cent.
A turnover tax on non-EsSEntials he considers dESERVES

closer attention but like a rise in prices this would
fall in Equal proportion on all levels of income and would
also have administrative difficulties, HE suggests that
the government might resell at a price yielding a profit
SOME of the staple goods of which it is monopolizing the

distribution. This would produce benefit to the treasury
with the least addition to Existing machinery. But the
price and taxation remedy both deprive the working class

of benefits from their increased earnings which largely
represent increased Effort on their part.
(3) HE therefore strongly advocates a system of
forced saving which would in Effect give wage Earners the

benefit of their increased Earnings at a deferred time, that
is when the war is over. Though the individual may dislike
postponing his own consumption, immediate expenditure of

increased earnings will not benefit the individual if
prices rise disproportionately or if his increased
Earnings are taxed away.
Keynes

338

-4- #2363, November 15, 6 p.m., from London.

Keynes therefore suggests that a percentage of all
incomes OVER a stipulated minimum should be paid to the

government, partly as compulsory savings and partly as

direct taxes. The total percentage taken would rise
steeply as the level of income increased. HE would
take 20 per cent of incomes of pounds 150 per annum and

by rising proportions up to 80 per cent of incomes OVER
pounds 200,000. Th lower ranges.would SEE the whole

amount taken put into a savings account not to be released

during the war while the higher ranges would first have
deducted their liabilities for income and surtax which
would represent an increasing proportion the higher
the income. The forced saving proportion would be credited

to the individual as a deposit in the post office savings
bank to carry 2 1/2 per cent interest and would not be
available for current expenditure or as security against
loans. The blocked savings might be used to meet pre-war
capital commitments such as installments on house purchase

or other hire purchase or insurance premiums, or with
special permission for unavoidable EXPENSES arising from
illness and unemployment. The blocked sums would be made

available after the var by a series of installments which
would greatly help the transition from war to a PEACE
Economy.

Keynes states he is unable to Estimate accurately the
amount

339

-5- #2363, November 15, 6 p.m., from London.
amount of compulsory savings which would result but

suggests at least pounds 400 million over and above

income and surtax. While a stiffer schedule might
bring in a correspondingly larger return. HE Emphasizes
that the proposal would only be supplementary to other
remedies but it would be "more Efficacious than any
conceivable increase in taxation, and nearly as good as

a 10 per cent fall in real wages while doing no lasting
injury to working class consumption." HE also Emphasizes
that the scheme would not obviate normal borrowing of
voluntary savings since resources would accrue in the

hands of banks, insurance offices Etc. and that
government loans could bE subscribed from company reserves,

sinking funds and capital released by the sale of foreign
investments Etc. "No more can be claimed for it than
it would appreciably EASE the Treasury's task."

Though this is the first proposal for compulsory
savings to be made public, the problems of reduction
of consumption and the tapping of potential savings

and tax liabilities before the purchasing power is spent
on consumption have been widely discussed since the
comments on the budget which were attached to the
memorandum on the budget referred to above. For Example
on October 23 the financial Editors of the DAILY TELEGRAPH
urged

340

-6- #2363, November 15, 6 p.m., from London.

urged the importance of tapping the increasing purchasing
power resulting from heavy government Expenditure by
a savings campaign and also through the sale of bonds
on tap, a method successfully used in the war of 1914-18.
On November 7 the FINANCIAL NEWS published an Editorial

urging a tax system which would collect income tax on

salaries at source from the Employer, other types of

direct taxation by installments at short intervals and
SOME method of taxing thos E below the direct taxation

level. The basic aim in borrowing as in taxation, the
Editorial urged, should be "to Entrap purchasing power

before it gets into general circulation" and the widest
possible propaganda for thrift and reliance on the tap
sales of securities of widely divergent types should be
used to reduce the margin of bank financing of national
loans.

Since the publication of the increase in the cost
of living index reported in my 2167 of October 25 and
the subsequent rises in wages there has been increasing

interest in the whole question of prices and wages in
relation to the fiscal policy of the government and a

growing feeling that, as Keynes puts it, "the central
problem of the home Economic front, a problem which requires

for its solution the coordination of price policy, budget
policy,

341

-7- #2363, November 15, 6 p.m., from London.

policy, and wages policy--has not yet been faced".

The TIMES lending Editorial today dealing with
Keynes articles offers one criticism on the grounds that
Keynes assumes that all productive resources are now

fully occupied. "WhatEver may be the case in a few
months time this condition does not now prevail" as
is proved by the 1,400,000 unemployed whos E number would

be increased by an immediate restriction on consumption.

But the Editorial continues, this condition will not
Endur E as the war Effort gains in momentum and "the
scheme deserves to be welcomed precisely because it takes

the long view, the absence of which was the outstanding

defect of the last budget".
KENNEDY
CSB

342
HSM

PLAIN

London

Dated November 1s, 1939

Rec'd 11:40 a. m.

Secretary of State,
Washington.

2373, November 13, 5 p. m.
FOR TREASURY.

The press reaction to Keynes' forced saving scheme

reported in my 2363, November 15, 6 p. M., is significant.
The writer of the DAILY EXPRESS leading Editorial EVI-

dently does not appreciate Keynes' concern that this war

should not, like the 1914-18 war, be financed by inflation.
HE characterizes Keynes "an Enemy of liberty" because he

insults the public with a proposal for compulsion when an
appeal to patriotism would have the desired result, and
asks whether Mr. Keynes has forgotten the response to the

war loans of the last war.
The DAILY MAIL financial Editor, while admitting the
soundness of Keynes' argument that the standard of living

cannot be Expected to improve in war time and that rising
prices would deprive increased wages of much of their value,
adds "but compulsory methods do not appeal to the city"
and suggests a savings drive among wage Earners.
The

343

hsm -2- No. 2373, November 16, 5 p. m., from London

The DAILY HERALD financial Editor, admitting that

Keynes' plan is preferable to a sales tax contends that
his argument rests on the assumption that the output of
goods consumed by the working class must actually be reduced
)

while the war Effort continues. "This cannot be proved

until this doubtful point is absolutely Established," this
writer thinks incomes under 65 per WEEK should not be

affected, while for persons above working class level
"there is much to be said for Mr. Keynes' plan," but the
"bribe of interest" should not be offered to holders of
big fortunes who should be subject to an annual capital tax.
The NEWS CHRONICLE financial Editor reports city opinion

as being not unfavorable but uncertain as to whether Labor
or the Government would accept a proposal so revolutionary
and adds "and that SEEMS to show that EVEN in the city there

is as yet insufficient realization of the fact that the
financial methods of the last war are going to prove completely inadequate to COPE with the present war".
The MANCHESTER GUARDIAN financial Editor's comment is:

"There are serious objections to the particular scheme drawn

up by Mr. Keynes, to which WE shall return, But the general
idea of paying out Extra Earnings during the war in the form
of deferred claims on goods and amenities is undoubtedly
sound."
The

344

ham -3- No. 2373, November 16, 5 D. M., from London
The TIMES city Editor agrees that special measures

are ESSEntial to prevent much of the Extra purchasing
power implicit in government war Expenditure Escaping into
Extra consumption but criticizes the scheme on the grounds

that it would work inequitably as between salaried officials
and wage Earners. HE characterizes the scheme as an amalgamation of two considerations (1) the need to draw off EXCESS

purchasing power, and (2) the difficulty of extending direct
taxation to the working classes. "In a SENSE it may be
conceived as an alternative to such an extension but it is
not such an Extension in fact and Mr. Keynes treats it as
if it were". HE also asks whether repayment of the forced
saving is to be raised by a post-war inflation and notes
that this would render negligible the inducement to voluntary
subscriptions to war loans which might fall in value while
compulsory savings WERE to receive 2-1/2 percent and to be

repaid at par shortly after the End of the war. "If usual
slump supervenes upon this war as it did upon the last

'reflation' need not necessarily involve a depreciation of
gilt-EdgEd".
The two financial dailies and the DAILY TELEGRAPH have
not yet commented on the scheme.
KENNEDY
KLP

345
PARAPHRASE OF TELEGRAM RECEIVED
FROM:

American Embassy, Paris

NO.:

2769

DATE:

November 16, 1939, 5 p.m.
FOR THE TREASURY

This morning we were informed confidentially by
Couve de Murville that (as was indicated in the last
sentence of the third paragraph of our telegram no.
2707 dated November 9, 7 p.m.) there were brought to

France yesterday Belgian gold reserves. At the request
of the Belgians these reserves have been sent to

Bordeaux, he said. He stated that it was his opinion
the Netherlands still had some gold in its own country
but he did not know how much. He said he thought it was

foolhardy of them to keep it there at this time. It is
safe to say, incidentally, that neither Couve de Murville
nor any other person in France 18 in possession of any

really well founded information today regarding the
question of whether or not the Netherlands and/or Belgium
will be invaded by Germany. That this will happen sooner

or later is, however, the opinion of the majority.
BULLITT

EA:EB

346
PARAPHRASE OF TELEGRAM RECEIVED

FROM: American Embassy, Paris

NO.: 2769
DATE: November 16, 1939, 5 p.m.
FOR THE TREASURY

This morning we were informed confidentially by

Couve de Nurville that (as was indicated in the last
sentence of the third paragraph of our telegram no.
2707 dated November 9, 7 p.m.) there were brought to

France yesterday Belgian gold reserves. At the request
of the Belgians these reserves have been sent to

Bordsaux, he said. He stated that it was his opinion
the Netherlands still had some gold in its own country
but he did not know how much. He said he thought it was

foolhardy of then to keep it there at this time. It is
safe to say, incidentally, that neither Couve de Murville
nor any other person in France is in possession of any

really well founded information today regarding the
question of whether OF not the Netherlands and/or Belgium
will be invaded by Germany. That this will happen sooner

or later is, however, the opinion ofmembraged
the sajerity.
V1088871

EA:EB

N
TRUSTRAY 1. TRUSANT

BULLITT

to a

dosessoR gratecold

347
PLAIN
HSM

London

Dated November 16, 1939

Rec'd 12:54 p. m.

Secretary of State,
Washington.

2378, November 16, 6 p. m.
FOR TREASURY.

1. The stock Exchange is quiet with little business
but gilt-Edged securities maintain their prices, war loan
closing today at 92-1/2. The loans of local authorities
are also working free of minimum prices, the margins between buying and selling quotations being reduced and SOME

of the minima being raised.
2. The appreciation of the Portuguese Escudo from
109 1/2-111 to 107 3/4-108 1/2 yesterday reflects the
Portuguese Government's decision to leave the sterling area

and tie its currency to the dollar. This rate was unchanged
today. Officially fixed rates have remained unchanged this
WEEK with the EXCEPTION of the belga which after appreciating

on Tuesday to 24.30-60 was fixed today at 24.35-65. The
Finnish Exchange fixed yesterday at 197 buyers was unchanged
today.

3.

348

hsm -2- No.2378, November 16, 6 p. m., from London

3. A small decrease in the note circulation of
$728,000 is recorded in today's Bank of England return.

This togEthEr with the decline in public deposits of
63.4 million and in other accounts of 6877,000 and a

small net increase in securities in the banking department (government securities having increased by 6950,000
and other securities decreased by 6821,000) resulted in

an increase in bankers' deposits of 65.2 million bringing
the total to 6107 million.
4. Today's FINANCIAL NEWS prints a story that as a

result of statements by a high official of the Czechoslovak
National Bank who has managed to reach Basle, that the
order to surrender the gold to Germany was made under

threat and intimidation, the Bank of International SEttlements has agreed to hold back 1600,000 of Czech gold not

yet actually delivered to Germany.
KENNEDY

RR

2011
TAJATMA
responsible

YOURANT

349
PARAPHRASE OF TELEGRAM RECEIVED

FROM: American Embassy, Paris

NO.: 2768
DATE: November 16, 1939, 4 p.m.
SECTIONS ONE, TWO, THREE, FOUR.
FOR TREASURY

This morning we dropped in on Couve de Murville for

a chat. He returned to Paris yesterday evening after
having gone with Reynaud to London. Couve de Murville

said that they had had two "very friendly talks with
Sir John Simon and officials of the British Treasury.
He said that the nature of these conversations was
completely preliminary and general and the participants
did not try to come to any definite agreement. He said
that naturally there was some marchandage (in other words,

horse trading) in connection with the matter of the

relative participation of France and Great Britain in
the granting of credits to Turkey and to other countries

friendly to the Allies. He said, however, that the differences between the British and the French should not
be exaggerated.

Payments for the large amounts being expended for

the maintenance of the British expeditionary force in
France was the other important question discussed in
London

350
-2-

London. Further discussions will be had between the
British and the French experts with reference to these
two big questions as well as regarding other matters
which are pending. It was mutually agreed that it was
important to maintain close contact.
The grave preoccupation which the British exhibited
with reference to their foreign exchange problem impressed

Couve de Murville particularly. He stated that although
they are making every effort to buy everything possible

in sterling, they are worried over the arrival of the
time when acute difficulties will be presented by having

to pay for vital war supplies in dollars. During the
World War, he said, it had been possible for France and
Great Britain to take care of their own purchases up

until 1917 (sio without loans from the United States
Government presumably) but he questioned whether this

time they would be able to continue on their own resources

for as long a period due to different circumstances and

the change in the nature of the warfare. He said that
frankly he did not know what could then be done. (As
time goes on we shall undoubtedly hear a great deal more

about this.)
Couve de Murville was not optimistic regarding the

possibility of increasing French exports to any great
extent

351

extent since these go principally to Great Britain and
are largely articles classed as luxuries, importation
of which the British Government is of course anxious to

discourage at this time. (British restrictions on
French imports have been criticized here.)
(END OF SECTION THREE)

EA:EB

352
PARAPHRASE OF SECTION FOUR OF TELEGRAM NO. 2768 OF

NOVEMBER 16, 1939, 4 P.M., FROM THE AMERICAN EMBASSY, PARIS:

Concerning the budget which will be presented tomorrow
to the Finance Commission of the Chamber, he stated the

total of the ordinary budget as approximately 68,000,000, 000
francs, which would be only for civil expenditures. He
added that they would balance this budget. Regarding military expenditures, he wasn't certain yet of the estimates

for the first quarter. In view of the heavy existing tax
burden in France, tax levies will not be greatly increased,
he reiterated; in this connection see Embassy's no. 2635
of November 2, 1939, 3 p.m.

EA:MSG

353

GRAY :

CJ

PARIS

Dated November 16, 1939

Rec'd 3:17 p.m.

Secretary of State,
Washington.

2768, November 16, 4 p.m. (SECTION FIVE).

This morning!s Journal Official carries a decree which
lays down the policy which the government proposes to

follow during the period of hostilities regarding wages
and Existing collective labor agreements. Brisfly, it
provides that for Enterprises not Engaged in supplying

material or services for national defense, revision of
collective labor contracts may be undertaken by mutual agreement of Employers' and Employees' organizations or by a

simple and rapid arbitral procedure if desired by Either
party. In Either case, the approval of the Ministry of
Labor is requested. The Government under the blanket

law of July 11, 1938 covering war time powers will fix
wages and working conditions directly for national defense
industries.
BULLITT
CSB

354

GRAY

CJ

PARIS

Dated November 16, 1939

Rec'd 5 p.m.

Secretary of State,
Washington.

2768, November 16, 4 p.m. (SECTION SIX)

Employers paying less than minimum fixed wages or more

than maximum will be subject to fines to be paid into the
solidarity fund (Embassy's despatch No. 4939 of SEPTEMBER

6, 1939). The decree further provides that where paid
vacations were not possible owing to war conditions this
year, an indemnity Equal to the period of unutilized
vacation shall be paid by Employers within a period of three
months to workers entitled to such indemnity whether mobiliZED or not. In commenting on this decree, the TEMPS says:

"The financial conduct of the war requires that an increase

in prices be prevented. Prices in principle have been
fixed at the level reached on September 1, last.
BULLITT
NK:NPL

355
CJ

GRAY

PARIS

Dated November 16, 1939

Rec'd 4:20 p.m.

3ecretary of State,
Washington.

2768, November 16, 4 p.m. (SECTION SEVEN)

But in spite of all regulations different reasons may
cause them to rise and increased wages is one of the causes
of which it would be impossible to prevent the consequences.

The stabilization of wages on the contrary will greatly

help to stabilize prices".
The Bank of France statement dated November 9 published

today shows a further increase of 1,400,000,000 francs in
the provisional advance account of the Treasury making the
total drawn so far since the war 8,700,000,000. Commercial
advances decreased 349,000,000 to a total of 6,500,000,000.

Thirty day advances decreased 140 millions.
BULLITT
CSB

356
CJ

GRAY

PARIS

Dated November 16, 1939

Rec'd 4:27 p.m.

Secretary of State,
Washington.

2768, November 16, 4 p.m. (SECTION EIGHT).

Circulation increased 129,000,000 to a total of
146,721,000,000 . Ratio of gold COVER to demand liabilities decreased slightly from 59.80% to 59.75%
Profit taking on an inactive securities market led to
moderate losses all through the first hour with the EXCEPtion of certain rentes which remained steady. The 1925 and
1937 Exchange guarantee issues lost 1.95 francs and 1.25

francs respectively.
Official Exchange rates are again unchanged with the
Exception of the belga which weakened today to 714-720.
(END MESSAGE).
BULLITT
CSB

03V13038
COTTON
TRANSTRATION TRUSABET

THAT mod 241 to salito

minus all at

357

in

file
DEPARTMENT OF STATE

NOVEMBER 16, 1939

FOR THE PRESS

No. 597

CONFIDENTIAL

FUTURE RELEASE
NOTE DATE
CONFIDENTIAL RELEASE FOR PUBLICATION AT 9 P.M., EASTERN STANDARD
TIME, THURSDAY, NOVEMBER 16, 1939. NOT TO BE PREVIOUSLY
PUBLISHED, QUOTED FROM OR USED IN ANY WAY.

ANALYSIS OF REQUIREMENTS OF SECTION 2 OF THE
NEUTRALITY ACT OF 1939

(Commerce with States Engaged in War)

I. American vessels (including aircraft) are prohibited from carrying passengers or any articles or materials to any state named
as a belligerent in a proclamation issued by the President.
A. Exceptions:
1. Transportation of any passengers or any articles or
materials by American vessels (including aircraft)
on or over lande, lakes, rivers, and inland waters
bordering on the United States.
2. Transportation by American vessels, other than aircraft, of mail, passengers, or any articles or
materials, except arms, ammunition, or implements of
war, to any port
a. in the Western Hemisphere north of 35° north
latitude and west of 66° west longitude;
b. in the Western Hemisphere south of 350 north

latitude;
south of 30 north latitude; or

C. on the Atlantic Ocean or its dependent waters
d. on the Pacific or Indian Oceans or their dependent
provided, waters; that no such port is included within a
combat area.
3.

Transportation by aircraft of mail, passengers, ammunition, or

any articles of materials, except arms,
or implements of war, to any port

in the Western Hemisphere; or
a. b. on the Pacific or Indian Oceans or their dependent

provided, waters; that no such port is included within a
4.

combat Transportation, area. as described in (1), (2) and of (3)
above, of arms, ammunition, and implements American vessels, war, if

to be used exclusively by their

aircraft, they are or other vehicles in connection-with

operation and maintenance.

II.

358
-2-

II. All right, title, and interest in any articles or materials (except copyrighted articles or materials) to be exported or
transported to a belligerent country must be transferred to
foreign ownership at the port of lading in the United States,
before the articles or materials are 80 exported or transported, or attempted to be so exported or transported, or
caused to be 80 exported or transported.
A. Exceptions:

1. Transportation of articles or materials, other than
arms, ammunition, or implements of war, by American
vessels (including aircraft) on or over lakes, rivers,
and inland waters bordering on the United States, or
by vehicles or aircraft on or over lands bordering on
the United States.
2. Transportation by American vessels, other than air-

craft, of mail or any articles or materials, except

arms, ammunition, or implements of war, to any port
a. in the Western Hemisphere north of 35° north
latitude and west of 660 west longitude;
b. in the Western Hemisphere south of 350 north

latitude;
south of 30° north latitude; or
d. on the Pacific or Indian Oceans or their

C. on the Atlantic Ocean or its dependent waters
dependent waters;

provided, that no such port is included within a
combat area.
3. Transportation by aircraft of mail or any articles or
materials, except arms, ammunition, or implements of
war, to any port
R. in the Western Hemisphere; or
b. on the Pacific or Indian Oceans or their dependent waters;

provided, that no such port is included within a
combat area.
4. Transportation by a neutral vessel to any port
referred to in (2) above, of any articles or materials,
other than arms, ammunition, or implements of war,
provided, such port is not included in a combat area.
5. Transportation, as described in (1), (2) and (3)
above, of arms, ammunition, and implements of war,
if they are to be used exclusively by American
vessels, aircraft, or other vehicles in connection
with their operation and maintenance.
(Note: There is no exception in the case of transportation
by a vessel of a belligerent state.)
B. Issuance of bill of lading under which title passes unconditionally to foreign purchaser upon delivery of the

articles or materials to a carrier constitutes transfer

of right, title, and interest.

C. The shipper of such articles or materials is required to
file with the collector of customs at the port of lading
a declaration under oath that he has complied with the
requirements of law regarding transfer of right, title,
and interest, and that he will comply with such rules and
regulations as shall be promulgated from time to time.
III. In the event of transportation by American vessels (including
aircraft) as described in IA (2) and (3), and II A (2) and
(3), and by neutral vessels (including aircraft) as described
in II A (4), every such vessel or aircraft shall, before
departing from the jurisdiction of the United States, file
with

-3-

359

with the collector of customs of the port of departure, or,
if no collector at such port, with the nearest collector of
customs, a sworn statement containing
A. a complete list of all articles or materials carried as
cargo, and the names and addresses of the consignees of
all such articles and materials; and
B. a statement of the ports at which such articles and
materials
the vessel.are to be unloaded and of the ports of call of

NOTE: Section 7 of the Neutrality Act forbids the extension of
credit to the government of any belligerent state or

political subdivision thereof or to any person acting for or
on behalf of such government or political subdivision. It
does not forbid the extension of credit to any person in
belligerent state who is not acting for or on behalf of a
belligerent government or any political subdivision thereof,
a

except that no credit of any kind may be extended to any
person whatsoever in a belligerent state in connection with
the sale of arms, ammunition, and implements of war as
defined in the President's Proclamation of May 1, 1937.
Articles and materials other than arms, Ammunition, and
implements of war may, therefore, be sold on credit to
private persons or firms in belligerent states, provided
those persons or firms are not acting for or on behalf of
a belligerent government or a political subdivision thereof.
It may be added that section 7 of the Act does not apply to
the extension of credit to the governments of neutral states
or to persons or firms in those states, unless those persons
or firms should be acting for or on behalf of the government

of a belligerent state or a political subdivision thereof.
***

360

TREASURY DEPARTMENT
INTER OFFICE COMMUNICATION
DATE November 16, 1939
TO

FROM

Secretary Morgenthau
Mr. Coohran

The foreign exchange market was very quiet. Sterling opened in New York
at 3.94 and fluctuated within a narrow range to close at 3.93-1/8.

Sales of sterling by the four reporting banks in New York and the Federal
Reserve Bank of New York totaled 1443,000 from the following sources:
By commercial concerns

By foreign banks (Europe, Far East and South America)
By Federal Reserve Bank of New York (For Norway)
Total

L 219,000
L 174,000

L 50,000
L 443,000

Purchases of sterling amounted to 4379,000, as indicated below:
By commercial concerns

By foreign banks (Europe and Far East)
Total

L 244,000
L 135,000
L 379,000

Of the four reporting banks, the following sold sterling to the British

Control at 4.02:

110,000 by the Bank of Manhattan
111,000 by the Guaranty Trust Company

120,000 by the National City Bank
141,000 Total

All of this sterling represented cotton bills.
The National City Bank of New York reported that 4300,000 were sold to the
I.T. & T. by the British Control at 4.04 through the National City Bank of London.
This transaction is one of special negotiation by the I.T. & T. with the British
Control. We understand that the I.T. & T. needs approximately 11,000,000 to
cover maturing obligations. of this amount, it has covered 1150,000 in the
market and the 4300,000 mentioned above making a total of 1450,000.
The Federal Reserve Bank purchased 105,000 belgas for the Bank of Latvia.

The other important currencies were fairly steady.

CONFIDENTIAL

-2-

361

We purchased the following amounts of gold from the earmarked accounts
of the Banks indicated:
$ 1,600,000 from the Netherlands Bank
1,010,000 from the National Bank of Belgium
$ 2,610,000 Total

The Federal Reserve Bank reported to us the following shipments of gold:
$ 2,450,000 from Holland, shipped by the Netherlands Bank, consigned to the
Federal Reserve Bank of New York to be earmarked for account of
the Netherlands Bank.
1,184,000 from Japan, shipped by the Yokohama Specie Bank, consigned to the

Yokohama Specie Bank, San Francisco. for sale to the U.S. Mint at

San Francisco.

$ 3,634,000 Total

The equivalent of today's London spot silver price was 41.334. Handy and
Harman's price for foreign silver remained unchanged at 34-3/44. The Treasury's

price was also unchanged at 35$

In New York we made four purchases of silver totaling 175,000 ounces under
the Silver Purchase Act.
Mr. Grosvenor Jones of the Department of Commerce asked, in behalf of a

banking inquirer from the Pacific Coast, about the arrangements for carrying
accounts of foreign purchasing commissions with the Federal Reserve Bank of

New York. I told him that the arrangements had not yet been completed and that
there had not yet been any official release on this subject.

Dr. Arthur N. Young, Financial Advisor in China, called this afternoon.
He told me that he had talked with Mesers. Hanes, White, Stewart, Viner and

Cotton since I last saw him in the Secretary's office. He is leaving for
California (1725 Chelsea Read, San Marino) on Saturday, but will fly back if the
Secretary desires to see him next week.

16.
CONFIDENTIAL

362

November 16,1939

Jesse Jones' ltr to HM,Jr re conference with Mr. Jaramilld
in which Jones stated his opinion was overdue interest

should be refunded at 3% instead of coupon rate of 61%;
bonds should extended at 3% for 10 years and 4% thereafter,
sinking fund of not less than $600,000 a year should be set

up with which to buy bonds annually on tender; desirable to
have some such arrangement as would permit individual bondholders to convert their bonds into milreis that could be
used in Colombia for purchase of things to export, having
in mind that this would result in increasing Colombian exports.

THIS LTR OF JONES IS FILED AS OF 11/22/39 as attachment

to meeting held in HM,Jr's office that date at 10 am

363

CJ

GRAY

GUATEMALA CITY

Dated November 16, 1939

Rec'd 4:06 p.m.

Secretary of State,
Washington.

51, November 16, 1 p.m.
FOR THE ACTING SECRETARY OF THE TREASURY FROM GASTON.

The CONFERENCE opened formally at a session open to

the public Tuesday morning followed by a business SESSi on

in the afternoon to which press representatives WERE admit-

tEd. At the afternoon session I made a general statement
of a noncomittal character which has apparently been well
received, the atmosphere of the Conference to date being

friendly and harmonious so far as I can judge. I shall
send you a copy of the statement by air mail.
The Conference has now resolved itself into committee

procedure to be followed by a plenary public session at the
End which I anticipate at the Earliest the beginning of
next WEEK. Following the general lines of the agenda
three com-ittees, monstary, banking and Exchange have been

created. I am on the Exchange committee but procedure is
informal and other members of the delegation are attending
sessions of the other committees. In the committees WE
are

364

-2- #51, November 16, 1 p.m. to Guatemala City

are now in the process of analyzing projects and suggestions
advanced for consideration by the various delegates.
Numerous countries have indicated an interest in working
toward uniform customs nomenclature and procedure, coopera-

tion against smuggling, uniformity of fiscal statistics and
exchange of financial information and publications. In
connection with customs procedure WE are going to circulate
Thursday the Tariff Commission document (Legation's 49,
November 13, 4 p.m. and Department's 50, November 15, 3 p.m.)

A number of other countries have circulated similar documents
In the Exchange committee WE have already agreed to

draft resolutions bearing on these subjects. WE have also
Engaged in SOME preliminary discussions of direct Exchange

problems but will take up the broad subject formally on
Thursday.

All three committees have devoted considerable attention to proposals of Mexico and Nicaragua which would create
SOME form of inter-American financial institution.
The Mexican proposal contemplates the creation of an

institution to plan and direct all new foreign capital
investment in the other American Republica the source of

such capital not being specified. The institution would also
act as agent for the several central banks and would assist
them in Exchange matters. In the Exchange committee

considerable

365

-3- #51, November 16, 1 p.m. to Guatemala City
considerable doubt was Expressed by all members as to the

practicability of the proposal and in the banking committee
it was decided that it should be referred to the Washington
Committee. The proposal is still under discussion in the
monetary committee which is considering a brief draft resolution recommending careful planning and direction of
new capital investment.
The Nicaraguan proposal envisages the EVENTUAL adoption

of an inter-American monstary standard and the creation of
an inter-American clearing house in NEW York to regulate
and stabilize Exchanges and carry out Economic studies.

The proposal is being considered chiefly in the monetary

committee, which will discuss it further on Friday. A
general opinion has been expressed that credits are ap-

propriate only for the Elimination of seasonal and similar
fluctuations, and that the only solution as .opposed to
palliative for Exchange difficulties is to be found in long
term development of industry and agriculture.
Several delegates have brought up the question of

reducing tariffs and Brazil has presented an informal
suggeotion for inter-American tariff preferences, but it
has been decided informally that such topics are not within
the competence of the meeting. Almost all of the delegates
have EVINCED interest in adequate shipping facilities and
lower

366

-4- #51, November 16, 1 p.m., to Guatemala City

lower rates, but again it has been decided that this
matter is not within the competence of the meeting. WE

have indicated a willingness to transmit informally to the
Maritime Commission and other appropriate agencies any

written comments which any of the delegates may wish to
prepare.

The Mexican proposal included incidentally a suggestion

urging the greater USE of silver but no interest in the
matter has been displayed by any other delegates.

I should appreciate information as to the progress
of the Washington Committee Especially as regards overlapping

study of any of the above subjects.
DESPORTES
CSB

Insurance

367
16

November 17, 1939

To:

The Files

From: Mr. Hanes

Cabinet meeting today at 2 p.m. Present were: The President,
Messrs. Welles, Hanes, Murphy, Woodring, Edison, Farley, Wallace, Ickes,
Noble and Madam Perkins.

The President opened the meeting by stating that he had been hard

at work on next year's budget, that he had made drastic and severe curtailment all along the line, and that he wanted each Cabinet member to
have a survey made immediately of the personnel situation in his department. The President said that he felt sure the regular departments of
Government had become over-manned, and he wanted all department heads

to cease filling the places of those employees who have resigned, and to

stop adding all personnel to their rolls. The President was specific
in his request that members of the Cabinet do everything within their
power to cut down the expense of running their departments.

Under Secretary Welles took up with the President several departmental matters, but had nothing to report on the foreign situation.
The President was interested in the Treasury report on markets, which
had been relatively strong during the week following the last Cabinet
meeting. I reported that Treasury bonds were now selling at the highest

point of their recovery levels since the start of the war. I also

reported that the Federal Reserve Board had sold approximately $22 million
in bonds in the last three days. most of which were guaranteed issues:

also, that the Treasury had sold approximately $3 million. I reported
that the New York Times Index for the week of November 11 was up 1.8

from the previous week, caused largely by excessive car loadings.
The President said that he appointed me a committee of one to try
to get away from Jesse Jones his surplus cash to the extent of $300 million.

He said, smilingly. that if I could perform this miracle he would indeed
be grateful.

The President talked at length about the price level for commodities
and industrial products, stating that he was very well satisfied with the
way the price level had behaved since the start of the war. The President
said he felt that industry had done a good job in keeping prices down.
and that unless some isolated cases came to view, such as might happen in
the aluminum industry, the Government would not have to take any action.

The President re-stated his belief that there would not be any material
slump in business during the first three months of 1940.
Secretary Woodring had nothing to report, but requested an audience

with the President after Cabinet meeting.

-2368
Attorney General Murphy reported that he had made a complete

survey of the files in his department and had gotten all back files

boxed up and put away. thereby making additional space available in
the Department of Justice. The President told the Attorney General that
he had received several complaints about conflict between the Treasury
and the Department of Justice on tax cases, resulting in costly delay
both to the Government and to taxpayers. He instructed the Attorney
General to take this matter up immediately with the Treasury. make a
thorough investigation, and report on what was causing these conflicts
and delays.

The only other interesting discussion took place between the
President and Secretary Wallace, who again made a plea for processing

taxes. Secretary Wallace was somewhat critical of the Treasury attitude
toward his farm solution. He almost persuaded the President that his
certificate plan would do the trick. The President asked me what I thought

of the certificate plan, and I told him that the Secretary of the Treasury
and I both felt that it was just another kind of processing tax, just as
vicious in its result as the direct processing tax. The President was
then told by Secretary Wallace that the certificate plan would collect
the revenue without its appearance in the budget. I pointed out to the

President that the Secretary's objection to this was based upon the
fact that it would create outside of the Treasury a second tax collecting
agency, and that we felt this would be bad procedure. The President then
instructed Secretary Wallace to get in touch with the Treasury and try

to iron out the differences of opinion on this subject.
The Cabinet meeting adjourned at 3:45 p.m.

TwH.

Treasury Department

Office of the Under Secretary
Date:
To:

11-21-39

Miss Chauncey

From: JR

I gave original to Mr. Kieley to place
on Secy's desk - 10:00 a.m.

16

November 17. 1939

To:

309

The Files

Front Mr. Hanes

Cabinet meeting today at 2 p.m. Present were: The President,
Mesers. Welles. Hanes, Murphy, Woodring, Edison Farley, Vallace Ickee,
Noble and Madam Perkins.

The President opened the meeting by stating that he had been hard
at work on next year's budget. that he had made drastic and severe ourtailment all along the line, and that he wanted each Cabinet member to
have a survey made immediately of the personnel situation in his department. The President said that he felt sure the regular departments of
Government had become over-manned. and he wanted all department heads

to cease filling the places of those employees who have resigned. and to

stop adding all personnel to their rolls. The President was appelific
in his request that members of the Cabinet do everything within their

power to cut down the expense of running their departments.

Under Secretary Velles took up with the President several departmental matters, but had nothing to report on the foreign situation.
The President was interested in the Treasury report on markets. which
had been relatively strong during the week following the last Cabinet
meeting. I reported that Treasury bonds were now selling at the highest

point of their recovery levels since the start of the war. I also

reported that the Federal Reserve Board had sold approximately $22 million
in bonds in the last three days, most of which were guaranteed issues:

also, that the Treasury had sold approximately $3 million. I reported
that the New York Times Index for the week of November 11 was up 1.8

from the previous week, caused largely by excessive car loadings.
The President said that he appointed me a committee of one to try
to get away from Jesse Jones his surplus cash to the extent of 300 million.
He said. smilingly. that if I could perform this miracle he would indeed
be grateful.

The President talked at length about the price level for commodities
and industrial products. stating that he was very well satisfied with the
way the price level had behaved since the start of the war. The President
said he felt that industry had done a good job in keeping prices down.
and that unless some isolated cases came to view, such as might happen in
the aluminum industry. the Government would not have to take any action.

The President re-stated his belief that there would not be any material
slump in business during the first three months of 1940.

Secretary Woodring had nothing to report, but requested an audience
with the President after Cabinet meeting.

2-

370
Attorney General Hurphy reported that he had made a complete

survey of the files in his department and had gotten all back files

boxed up and put away. thereby making additional space available in
the Department of Justice. The President told the Attorney General that
he had received several complaints about conflict between the Treasury
and the Department of Justice on tax cases, resulting in costly delay
both to the Government and to taxpayers. He instructed the Attorney
General to take this matter up immediately with the Treasury. make a
thorough investigation, and report on what was causing these conflicts
and delays.

The only other interesting discussion took place between the
President and Secretary Wallace. who again made a plea for processing
taxes. Secretary Wallace was somewhat critical of the Treasury attitude
toward his farm solution. He almost persuaded the President that his
certificate plan would do the trick. The President asked me what I thought

of the certificate plan, and I told him that the Secretary of the Treasury
and I both felt that it was just another kind of processing tax, just as
vicious in its result as the direct processing tax, The President was
then told by Secretary Vallace that the certificate plan would collect
the revenue without its appearance in the budget. I pointed out to the
President that the Secretary's objection to this was based upon the
fact that 18 would create outside of the Treasury a second tax collecting
agency, and that we felt this would be bad procedure. The President then
instructed Secretary Wallace to get in touch with the Treasury and try

to iron out the differences of opinion on this subject.
The Cabinet meeting adjourned at 3:45 p.m.

371
REPORT OF UNDER SECRETARY HANES' PRESS

CONFERENCE, NOVEMBER 16, 1939.

Hanes:

I wanted to get ready for this press conference to see

if I could find any news for you, but I'll be damned

if I had time. I don't think I've got any news.
Q.

You don't think you've got any?

A.

I will have to ask the boys here.

Q.

The impression has gotten out that possibly somebody
at the Federal Reserve System who made a speech out at

St. Louis might be representing the views of the
Administration. We don't know who he is.
A.

Mr. Eccles, I take it you are talking about. Well, I will
say on Mr. Eccles' subject of taxation that I don't think
he spoke for the Administration, I doubt seriously if he
spoke for the Congress, and I am absolutely positive he
did not speak for the Treasury.

Q.

A.

c.

Mr. Secretary, you said you doubted he spoke for what?
The Congress.

What was the last?

Definitely he did not speak for the Treasury.
If he was speaking for the Treasury what would he have said?
A.

That is one I can't answer.

Duffield: That's what the President calls an 'iffey' question.
Schwarz: Why don't they ask what the Treasury has to say!

-2-

372

Q.

What were your objections to the speech? You only said
you doubted he spoke for the Administration.
A.

No, I doubt if he spoke for the Congress. If you want
to publish it, you can say, I am damned certain he didn't
speak for the Treasury, but I don't think that's good

business to be quite so strong about it as that. As I say,
off the record, or for background purposes, we have made

a real sincere and conscientious effort here to find out
from people all over the country what they thought-these
people who were paying the taxes-what were the difficulties
in the system and it seems to me that having made that

earnest attempt to get that information this would indicate,
to the public mind at any rate, what was the use of going
down there and spending all that time and money to go tell

the Treasury and talk to then about this situation if their
minds were already made up. Our minds were not made up at

all-they are absolutely open, and we want to keep them
open, but to have somebody go out with a preconceived

program, which program incidentally (again I say off the

record) I don't subscribe to at all. I think it would be
the worst thing in the world we could do to have the
Administration go up and say we are going to just raise

taxes here and sock the little follow and sock the
undistributed earnings-that's what he said, put back the

undistributed profits tax.
e.

What did he call it?

-A.

Rainy-day reserves.

S.

You could see he didn't have a good press agent.

373

A.

Yes, that would be as popular as hell with the country!

a

Mr. Secretary, the one statement that your mind is open
on this thing, we may have that on the record?

A.

Yes, I don't mind saying that because that is the
absolute truth. The Administration has no definite program
in mind at all. We have an absolutely open mind and we are
not making any commitments of any kind, not making any

statements about it.
Q.

Well, I think the erroneous impression, if any, created by
that speech might be that since the Treasury didn't announce
its program this man, as an authority of the Government,
speaking the way he did, the reason that you haven't announced

the program is what you just stated-that you are saving your
judgment until you have studied all the facts.
A.

Another thing, again talking off the record, we would be

absolutely foolish and silly at this stage of the game if
we did have a program or would say we either will ask for
more taxes or not ask for more taxes. Nobody can say what

even the indicated return will be and this business situation
is going forward so steadily that nobody but a danned fool
can say I can tell you right now what revenue will be next
year. We don't know whether it will be $500,000,000 more

revenue or a billion dollars more revenue with the present

374

-

tax system. It would be foolish, looking all the way to
'41, 18 months ahead, to say we know now just what we are

going to require in revenue. That doesn't make sense.
I don't see how any sensible person could make such
a statement.

Can we say for the record that you say that it is far
too early to decide on any definite tax program for next
year, to hook it up with this open-mind thing?
I said a moment ago, I thought for the record, that we had
an absolutely open mind and that we had made no recommendations

and that our minds hadn't crystallized, and, under the
circumstances, could not be crystallized.
Mr. Secretary, Mr. Eccles' speech received favorable comment

in certain sections of the press. For example, the question

of financing further armster expenditures, plus relief, etc.
They pointed out that higher taxes is a sound way of offsetting these deficits rather than borrowing, and in some
sections of the press that received favorable comment.
Would you make some statement about that? His idea, he

was projecting also into the future-1941 and 1942--and
taking into consideration the huge armament expenditures,

plus relief and other general costs of the Government.
A.

I won't make any statement for the record about that for

the simple reason it gets into a subject entirely out of
my province. I only have one phase of it. I 321 not
charged with making Administration policy as to how much

we are going to spend or save. Our job, as appropriations

-5- -

375

are made, is to find as much revenue as we can without
distorting economy from the revenue system.

Don't you think it is sound to finance expenditures from

Q.

higher taxes?

I say, off the record, that I think it is sound to finance

A.

all expenditures of the Government through taxation as you

go on. In other words, I don't believe you can go on ad
infinitum spending $4,000,000,000 more than you collect.
That may be an old-fashioned viewpoint that you should

pay your bills, but I can't get it out of my head.
Q.

Your old argument with Mr. Eccles is - - ?

A.

My argument is he butted into the tax problem and he hasn't

got a God-danned thing to do with it. He can holler about

spending as much as he likes-that's his business. That's
his viewpoint and every man is entitled to his viewpoint.

I've got mine, he's got his. They don't go along parallel
lines.
Q.

Then you won't make any comment on the two subjects?

A.

No, you understand why I can't. As I say, that is none
of my damned business and he can be as critical of me when

I talk about the spending program, whoever's baby that is.

I try to mind my own business and all I ask him to do is
mind his.
Q.

Can we quote you on that? (Laughter)

A.

No.

&.

He's in bad shape; he's got a bad shoulder (Mr. Hanes).
I thought maybe you meant Eccles.

-6 A.

He's not here; that's the only excuse I've got.

Q.

Have you had any report yet from Guatemala as to whether

376

Mr. Gaston's pockets have been picked?

The only report I have had is the press reports-no direct

A.

reports.
Q.

What about this central bank institution they're talking
about down there? I see it was projected.

A.

They are talking about a tripartite situation or something

like that. It would be a 21-partite, but that I don't know
anything about and I don't want to say anything about it
until Herbert gets back because I as just as ignorant as
I can be about what they are doing down there.
Q.

Apropos of that situation how are your conferences coming
along with the State Department and Mr. Jones on the

Latin-American credit situation?
A.

I haven't attended any of those conferences. The Secretary

of the Treasury, Mr. Jones and Mr. Welles are, I think the
final committee on whatever may be done in South America,

but I laven't attended any of those meetings so I am not
up-to-date on them.
&.

There won't be any financing until the Secretary gets
back?

A.

No.

Q.

Mr. Hanes, is there anything you can say for the record
as to how you think general business is going along?

-7 -

377

I don't know if I an prepared to give you anything very
concrete at this moment.
Haven't you had some reports from your experts apropos

of the forecest you have to make on business conditions
next year?

Yes, I will say the Treasury forecast for business is
extremely optimistic.
Are you at all concerned about the inventory situation?

No, I an not concerned about it; I don't see any
tremendous accumulation at the moment.

Mr. Secretary, when you said the forecast HES extremely

optimistic, does that mean over, say, the next year?

Well, we don't try to go that far. ..e are just looking
now at the next six months. I would say, off the record,
under normal circumstances, what I would look for (this is

just purely my own percorlviespointcon't charge this
to the Treasury); I would look for 5 normal slackening in
business which we generally have around the first of

January, after the Christmas buying. I know every other
citizen in the United States does the same thing I CO.

I call my family together and say, 'Look here! he spent
a lot more money than we've got this Christmas, so we

are not going to eat so good in January.' And I think in
general there is a normal slackening in business, but

I don't subscribe to the viewpoint, and haven't right

-8-

378

along, of the economists who have been talking about

a real slump in January, February and March. I just
can't see that.
a.

Is that on the record?

A.

No.

Q.

How about the part you saying you personally look for

a normal slackening in business right after Christmas?
A.

Unless you followed it up, Sandy, that would put me in

the category I don't want to be put in and that is
I believe there is going to be a real slump in business
in January, February and March. You see the Federal
Reserve Board index is probably going to be around 123

to 125. The great weight in that average is the steel
operations have moved that up tremendously. Steel is

going like a house afire. I would expect some normal
slackening in that level but a slackening to 118 or 115
would still be a real move forward since we have been
operating around a level of 92 to 98, so whatever happens
you have had a tremendous impetus given to the steel

industry but this rush of orders to the automobile industry
and it is quite natural-anybody in the automobile business
using steel products, after the Germans marched into Poland

it would be quite obvious to anybody that our steel
manufacturers were going to have big business from abroad

when neutrality was changed. So I think it is perfectly

- -9 -

379

obvious that the prudent manufacturer would go out and
supply himself with materials, knowing that the demand

was just bound to come from abroad-there isn't any
other way about it.
You don't want to say for the record that you disagree
with the forecasters of doom?

Q.

A.

No, I don't want to be controversial about this.

Q.

You have already said that the Treasury view for six
months is extremely optimistic about business. Wouldn't

you want to say that your personal opinion is that after
the slackening in January business would resume?
A.

Do you think that is too far?

Schwarz:

I wouldn't use the term-anything so specific.

Hanes:

If you take out the extremely optimistic-because my
optimism is tempered and it must be by changing events.
What can we say?

Q.

A.

The Treasury is optimistic about business.

Q.

That is what your forecasts show?

A.

Yes.

Q.

How will we phrase that again? The way you just said it is
the Treasury is optimistic about business conditions and

then you said that applied only to the next six months.
A.

Yes, we are not making any effort to look too far in the
crystal.

- 10 380
Can we say on the record that your personal viewpoint

Q.

is that there is likely to be a moderate slackening after
the first of the year, seasonal slackening, but that you
don't look for any serious --?
A.

No sustained downturn in business.

Schwarz:

That relates to tax production.

Hanes:

Yes.

Q.

of course, the Treasury is following the situation very
closely; they've got very good contacts.

A.

They are in the process of following it every day because
we have got to make the estimates for the yield of this

tax system and I will say again, off the record, that if
you go back and look up the Treasury history of this group
of follows doing this forecasting I have been amazed by

the way they have hit it on the nose; they haven't missed

that thing hardly at all. I have forgotten what the figures
are but they haven't been more than 1 or 2% off. I have
got great confidence in them; they just haven't been wrong.
Q.

Mr. Secretary, couldn't we tie these two things up and say
that one reason for your optimism is that you want to see
what the revenue from the existing tax structure will be?

A.

And you can say that the outlook for increased yield from

the present tax system is bright. That is about all I've
got on my mind.
Q.

Thank you, Mr. Secretary.

381

November 16. 1939

My dear Rr. Chens

I sincerely appreciate your letter of
November 15th. and I will be glad to pass

this information on to the Secretary.
with every good wish,
Sincerely yours.

(Standed) John 11. Hands

Kr. Kwang Pa Chen
Room 1918

630 Fifth Avenue
New York. New York

jr

382
KWANG PU CHEN
BOOM 1018

630 FIFTH AVENUE
NEW YORK

November 15, 1939

CONFIDENTIAL

Mr. John W. Hanes
Treasury Department
Washington, D. C.
Dear Mr. Hanes:

In a recent conversation which I had with
Secretary Morgenthau he inquired whether Mr. Litvinov
had recently been in Chungking. He also understood that
Mr. Litvinov's mission had not been a success. The
Secretary asked me to wire back to Chungking for

clarification.

I cabled an inquiry to Dr. H. H. Kung
regarding this question, and have today received his
reply. He informs me that there is absolutely no
foundation for the information about Mr. Litvinov's
visit to Chungking. He considers this another example
of Japenese propaganda. I have also made a personal

inquiry with a Chinese official recently arrived from

Chungking, and he told me that he never heard of Mr.

Litvinov's visit to Chungking, but there has been a
Russian Trade Mission there discussing some business

matters with the Government. That might have given
rise to such rumors.

I shall feel thankful if you will kindly
pass the above information, at your convenience, to
The Secretary.

With kindest personal regards,

them

Very sincerely yours,

KPC:GT

Descursed at meeting

LORD, DAY & LORD
LUOUS

25 BROADWAY

BEERS

FOREST BALDWIN

LORD

NEW YORK

BRADLEY

KLEN EVARTS POSTER

CUNARO BUILDING

DEORGE OF FOREST LORD

PURKER COLLESTER
PAUL

office 11/30/39
CABLE ADDRESS

LORDATTY

-

NEW YORK

WASHINGTON OFFICE
VINCENT

SOUTHERN BUILDING

HEMINGWAY

BROWNELL.JR

November 16, 1939

The President,

The White House

Washington, D. c.

My dear Mr. President:
I enclose herewith a memorandum which attempts

to implement your ideas upon an excess profits tax. The
memorandum discusses some of the principal problems which

the drafting of a statute would involve and suggests a
number of problems which need further consideration. The

subject is a difficult one and requires more study than

could be given to it in the limited time available, but I
hope the enclosed memorandum will expedite a clarification

of the subject.
Generally speaking, the memorandum adopt's two

of the basic factors you have suggested, namely, (1)

net cost of assets, and (2) capitalized earnings. For
reasons given at pages 19 and 34 appraised value and book

value are not taken, but the two factors employed in

383

384

The president
2

ascertaining invested capital are to a large degree a duplication of the discarded factors. In other words, net cost
of assets amounts to a duplication of correct book values,
and capitalized earnings approximates correct appraised

value. Thus, we preserve your essential thought of compensating for inaccuracies inherent in the use of one formula

for the computation of invested capital or excess taxable
earnings.

In a nutshell, the tax discussed is a graduated
tax upon excess earnings. Excess taxable earnings are de-

fined as earnings in excess of the earnings of a representative
standard period, 1935 to 1938 inclusive, but they may not be
taken at less than 8% or more than 12% of the invested capital.
This minimum allowance is to protect corporations with low
earnings during the representative period. The maximum allow-

ance is to insure the collection of tax from corporations
which had large earnings during the representative period, and

which should be in the best position to pay.

In order to forestall criticism of the type directed
against the World War excess profits tax, the device is adopted
of ignoring cost of assets acquired before March 1, 1913, and

385

The President
3

taking that value. This scheme is favorable to taxpayers;

its virtue is that almost all assets can be taken at their
net cost basis for purposes of income tax depletion or
depreciation. This enormously simplifies the tax by using
to advantage computations now available to taxpayers and
the Bureau of Internal Revenue. We thus eliminate one of

the greatest difficulties and irritations incident to the
World War excess profits tax.

Naturally, all figures used by way of suggesting
rates and exemptions are tentative and illustrative.
If I have not made the subject clear in the enclosed memorandum, I shall be very glad to give any further
explanations that may be necessary.
Respectfully yours,

386
MEMORANDUM ON EXCESS PROFITS TAX
Page No.

Introduction
1

I. General Description of Tax

(a) Example of Computation of Tax
(b) Necessity of Graduated Rates

3

5

(c) Application of Tax

(1) Exempt Corporations

(2) Personal Service Corporations
(3) Small Corporations
(4) New Corporations

(5) Foreign Corporations

(6) Personal Holding Companies
(7) Successor Corporations

(8) Individuals and Partnerships
(d) Duration of Tax

II. Use of Invested Capital
(a) The Necessity of Using Invested Capital
(b) Criticism of Earlier Excess Profits Taxes
(c) The Influence of Depreciated Cost
III. The Calculation of Invested Capital
(a) In General
(b) Intangibles
(c) Capitalized Earnings of Taxable Year

7

9

10

10
10

11
11
11

12

13
14

15
16
20
24

27
27

28
30

(d) Assets Not Employed in the Business
32
(e) Borrowed Capital
(f) Stock of Other Corporations and Tax-Exempt Bonds 34
34
(g) Possible Use of Appraised Value Alternative
31

IV. Determination of Standard Profits
(a) The Choice of a Representative Period
(b) Adjustment of Standard Profits to Invested
Capital of Taxable Year
(c) New Corporations Organized After the Representative or Standard Period

(d) The Effect of Fiscal Period Differing from
the Calendar Year

V. Determination of Profits Subject to Tax
(a) Deduction of Income Tax
(b) Additional Losses

(c) Inventories
(a) Amortization
(e) Dividends Paid Credit

VI. Administrative Problems
(a) Assessment and Collection
(b) Possible Avoidance
(c) Special Assessment

36
38

40

41

41

43
45
45

46
48
50

52
52

52
53

387
-1INTRODUCTION

The purpose of this memorandum is to summarize

a general plan for the taxation of excess profits expected
to be forthcoming as part of the impact of the war upon
The memorandum will first S et
the American economy.
1

forth the fundamental proposal in broad outline; it will
then attempt a slightly more detailed exposition of some
of the necessary provisions of a statute imposing such
a tax. The description of the tax is not intended to be
complete, but a number of suggestions are offered in the
hope t hat they may serve as a basis for the framing of

a statute that will be fair and workable.

1. No attempt will be made to draft any precise

statutory provisions.

388

-2-

The advisability of once more imposing a true
1

excess profits tax has frequently been stated by impartial
2

commentators, often with the further thought that such a
tax, if administratively successful, might be retained as a
permanent part of the tax system.

1. The earliest instance of such a tax in the United

States, a 121% tax on manufacturers of munitions, was imposed

by the 1916 Act. A profits tax was imposed by the Act of
before it was ever applied by the excess profits tax of

March 3, 1917, (30 Stat. at Large 1000) which was replaced
October 3, 1917 (Revenue Act of 1917, Secs. 201-210), both of
which reappeared in revamped form in the Revenue Act of 1918.
This 1918 Act was a combination of two taxes:

one, the excess profits tax proper, and the other, a so-called
war profits tax. The first was theoretically on the excess

of profits over pre-war average earnings. The two normal rates
of return were deducted from actual profits to get the income
subject to tax. The normal rate of return under the excess
profits tax was 8% of the capital invested in the business
during the taxable year. The tax was imposed on the difference
between actual profits and normal profits plus an arbitrary
allowance of $3,000. The normal r ate of return under the
war profits tax was the average profit for the period 1911 to
1913, plus or minus 10% of the increase or decrease in invested
capital. The excess profits tax, in other words, assumed an

8% return on capital to be normal. The war profits tax

assumed that pre-war earnings were normal, and that 10%
profit during war time was normal. The method giving the higher
tax was the computation to be used.
2.
See, e.g., Twentieth Century Fund, Facing the Tax
Problem (1937); Godfrey Nelson, War Profits Taxes and Their
Records, 17 Taxes 569 (1939).

-3-

389

I. GENERAL DESCRIPTION OF TAX

The proposal has been made that a tax be enacted

along the following general lines:
(1) Allow a return free from the tax of normal
profits of the corporation.
(2) Tax any profits above the normal profits or
normal return at graduated rates increasing as the profits
realized in the taxable year exceeded the normal return.
1

(3) Profits would be defined, generally speaking,
in terms of "net income" for purposes of the existing income

tax, thus simplifying administration by taking full advantage
of work which has to be done independently of the new statute.
(4) The normal rate of return would be measured by

the following factors: (a) equity capital invested in the
2

corporation as of the beginning of the taxable year, which would

1. Variations are indicated at p. 43 below.
2. Possibly this invested capital should be increased on

account of stock dividends paid during the year. See p. 30.
The 1918 excess profits tax used the "average" of
the taxable year; 1918 Act, Sec. 326 (d). The "average" of

the year referred to capital paid in; no earnings of the year
were permitted to be included in invested capital This
rule furnishes a reasonable precedent for the present act.

390
-41

reflect assets at cost, or depleted or depreciated cost as
determined by the Bureau of Internal Revenue for income tax
purposes; (b) the average profits over some standard representative period, such as the period from 1935 to 1938, inclusive.
(5) There would then be allowed as normal profits

or normal return the average profits of the standard or repre2

sentative period with the limitation that these profits taken
3

as normal and used as an excess profits tax credit, might
not exceed 8% of the invested capital, plus 50%, which amounts

to 12% And 8 % of the invested capital would be taken as
normal profits even if the corporation had average profits
for the standard period of less than that amount.
4

For example:

(a) If a corporation has average standard period
profits of $200,000, current profits of $250,000 and an
invested capital of only $200, 000, there would be normal earnings of only $24,000, consisting of $16,000, being 8% of

1. As to value at March 1, 1913, see p. 25.
2. This period is sometimes referred to below as the

"standard period".

3. 1918, 1921 Acts, Sec. 312.
4. There are some who feel that these percentages of 8%

and 12% should be 5% and 15% making for a bigger spread and tak-

ing in more corporations. This is a matter which, of course,
requires complete study before it is decided. The recent

Canadian statute uses an optional rate of 5%.

391

-5-

1

invested capital plus an increase of 50%, or $8,000,
leaving taxable profits of $226,000.
(b) If a corporation has average standard period

profits of $200,000, current profits of $250,000 and an invested capital of $8,000,000, there would be normal earnings
of $240,000 consisting of 8% of $3,000,000, and the lower
average earnings of $200,000 would be disregarded, leaving

only $10,000 in the taxable class.
I. (a) Example of Computation of Tax

Before commenting on the above factors entering

into the computation of the tax it may clarify discussion
to set forth an example of a hypothetical tax liability as
follows:2

1. As an alternative method there might be used as

normal profits an average of the earnings of the For repre-

sentative period and 8% of the invested capital.

example, if a company had representative earnings of $200,000 its

and a capital cost of $200,000, 8% of which is $16,000,
normal profits would be 1/2 of $216,000, or $108,000.
2. The rates used in this example are merely illustrative.

392

-6-

Invested Capital
8% of above

50% of this percentage

$10,000,000

$800,000
400,000

1,200,000
2,000,000
1,200,000

Average standard profits - 1935 to 1938
Statutory normal return
Actual net income, Sec. 21,

3,000,000

Internal Revenue Code

540,000

Income tax liability @ 18% (approx.)

$ 2,460,000

Net income after ordinary corporate tax
Amount of
Net Income
Each Bracket

Not over 15% of

invested capital 1,500,000

Over 15% but not
over 18% of

invested capital

Statutory

Balance

turn(excess

To

Normal Re-

Rate

Subject of

Profits Tax

Tax

Tax

Amount
of
Tax

Credit

1,200,000 300,000 10%

300,000

Over 18% of

invested capital 660,000

30,000

300,000

25% 75,000

660,000

50% 330,000

$435,000

Total Excess Profits Tax
Average percentage of excess profits
tax on excess income

-

341%

Average percentage of aggregate ex-

cess profits and income tax

liability on total net income
There is attached hereto, as Exhibit A, a computation
in another case in which the taxpayer's average standard profits
are insufficient to give exemption greater than 8% of invested
capital.

-7-

393

I. (b) Necessity of Graduated Rates
Naturally the exigencies of revenue needs would be the
1

primary factor in determining the precise rates to be used. The
suggested proposal involves the use of a graduated rate scale, -

in this respect it 18 unlike the current British Act, but like the
Canadian Act and the American 1918 Act.

Excess profits taxation is grounded on the assumption that
extraordinary profits can be regarded as windfall gains. This assump-

tion seems to be the more justified the higher the profits are above

the "normal". Profits only a little bit higher than the "hormal"
may be due to windfalls from war or may be due to other reasons;

therefore, it seems justified to leave a large portion of profits
which only slightly surpass the "normal" in the hands of business,

but to increase the tax rates with increasing profit ratio under
the assumption that the higher the profitability the greater the
probability that they must be attributed to factors other than
special skill of management.

The general rule that the ability to pay principle does
not justify a graduation of corporate taxes does not hold true for
the excess profits taxes. The general rule is based upon the
1. For example, the legislative history of the 1918 Act shows
that that act was expected to yield $6,000,000,000, of which the

excess profits tax was expected to yield $2,400,000,000. (Senate

Finance Committee Report No. 617 (1919).

It is estimated that the 1917 excess profits tax absorbed about
44% of the increase in annual profit from $4,123,000,000 to
$9,500,000,000. A group of the largest manufacturing and mining
companies in the country paid in taxes (including both the normal
income taxes and the excess or war profits taxes) about 25% of their
net taxable income for 1917 and about 35% of the same income for 1918.
For refinements of these percentages, see Report of Special Committee on Investigation of Munitions Industry, No. 944, Part 2,
74th Cong., lst Sess., p. 14 (1935).

2. It is impossible to determine which profits are due to

management and which are attributable to economic conditions or
semi-monopolistic advantages.

-8-

394

assumption that corporate taxes are ultimately borne by the stock-

holder. If there should be any graduation it should be in
correspondence to the income bracket to which the stockholder be-

longs, which of course can be done only through the individual

income tax. Excess profits taxation is based on the theory
that these profits should be taxed irrespective of whether they
would otherwise accrue to a person in the lower or in the higher
brackets.

This tax is not based on the principle of the individual

ability to pay, but on the theory that gains attributable to extraneous factors be absorbed as much as possible by taxation. It

is a tax on the corporation per se and not a tax on individuals
through the means of collection at the source.
There are some arguments against graduated rates. All

excess profits taxation implies a certain crudeness in the determina-

tion of "normal" profits. If a uniform standard ratio is the
criterion of "normal" profits, then corporations with a normally
high ratio (for instance, because of high risk in the specific
branch) would fall into a higher bracket under the principle of
graduation. The necessary crudeness of the criterion thereby would
be aggravated.

If standard earnings in a base period are chosen as a criterion, then corporations which happen to have extraordinarily low

profits in the base period are penalized by a high bracket tax, if
graduation is applied.
If an excess profits tax 18 proposed for a neutral country

in a period of war, the rates cannot be too drastic. In such a sit-

-9-

395

uation business is not predominantly determined by the impact of

the war, so that all high profits could be regarded as war profits.
If the progression, therefore, should not reach very high percentages it may be more advisable to enact a flat rate with a
degression for profits just above the criterion of "normal" profits.
Such a degression is advisable in order to avoid a too sudden jump
from the non-taxable to the taxable profits.

A flat rate tax is more easily administered than a progressive tax.

I. (c) Application of the Tax

The Act should cover virtually all corporations; segregation of war profits industries in the conventional sense of
the term would be impractical, since all increased profits
will be partly attributable to war activities and to the attend-

ant rise in price levels. It is noteworthy that in the first
war act of 1916 munition makers were singled out as the sole

object of the tax. But other profits soared at the same time,
and all industries were soon drawn within the net of subse1

quent acts. Specific types of corporations should probably
be treated as follows:

1. It is true that a universal application of the tax

might lead to harsh consequences in particular cases. For
example, in the case of gold mining it was found under the
earlier acts that while gold brought the same price regardless
of the war, nevertheless the cost of labor and materials went
un. Therefore, such mining was exempted by special provisions
in the Act of 1918 (Revenue Act of 1918, Sec. 304). There
would probably be pressure at the present time for similar
special exemptions wherever the prices in the industry in
question are regulated by law, as for example, in the case
of railroads. But in view of the allowance of a minimum return
of 8% before the tax becomes operative, the need of such exemptions is far from clear.

396

-101

(1) Corporations exempt from the income tax should

also be exempt from this tax in order to simplify administration and avoid complaint.

(2) Personal service corporations, in which capital
is not a material income-producing factor, might be exempted
from the excess profits tax, but might reasonably be taxed as
2

partnerships, as was done under the 1918 and 1921 Acts.

(3) Some favored treatment might be shown to very

small corporations, which are not affiliated or subsidiary units
of large corporations. Average statistics under the earlier acts
covering profit-earning corporations show that the ratio of
net income to capital varied, roughly speaking, in inverse proportion to the size of the company. Larger concerns seldom

realize such a high percentage of profit as do successful
concerns of moderate or small size. Therefore, to avoid an undue discrimination against small corporations, there might be
3

exempted corporations with a net income of less than $25,000
or some other appropriate minimum amount.

1. Internal Revenue Code, Sec. 101.
2. This would be constitutionally more acceptable now than
in 1918. See Helvering V. National Grocery Co., 304 U.S. 282

(1938). Moreover, it might be better statutory technique to

give such corporations an option to be taxed as partnerships
upon consent to certain regulations issued by the Commissioner.
This technique might be especially valuable in the case of corporations engaged partly in personal service activities, where
allocations of income would be necessary.

3. This was the dividing line under the undistributed profits

surtax, as amended by the 1938 Act, Sec. 14(a).

-11-

397

(4) New corporations would also have to be treated

somewhat differently, as will be discussed more in detail

below. Here the reference to pre-war activities would have
to fall away, and an a priori normal return of some figure
between 8 and 12% of invested capital would have to be taken.

(5) Foreign corporations might be taxed under a
provision similar to the special assessment provisions of the
1918 and 1921 Acts discussed below, or they might be given
an option to use the general method of computing normal return
1

as to any capital actually employed within the United States.
(6) Personal holding companies and foreign personal
holding companies should be exempted; they are now subjected
2

to taxes calculated to compel their disintegration.

1. Compare Canadian Excess Profits Tax Act, Sec. 2(c).

2. Titles IA, Supplement P.

398

-12-

(7)

Successor Corporations The reorganization
sections, which have been embodied in the income tax statute

since 1918, render the treatment of reorganizations prior
to or after the enactment of the tax much less perplexing
than under the old acts. The 1918 and 1921 Acts drew the
1

line at a 50% change in interest or control in determining
whether assets should be stepped up for invested capital
purposes when there had been a reorganization, con-

solidation or change in ownership of a trade or business.
In computing invested capital for the current taxable year after
the imposition of the tax for any corporation reorganized or consolidated within the meaning of the tax-free reorganization
sections of the income tax statute, assets transferred to a new corpora2

tion may under the proposed tax be regarded, as for income tax purposes

as if still in the hands of the predecessor corporate owner or at

1. 1918, 1921 Acts, Sec. 331
2. Internal Revenue Code, Sec. 112, 113.

399
-13-

the cost to such previous owner, if the previous owner was

not a corporation. Generally speaking, the reorganizationbasis provisions would be applicable. Proper adjustment
would, of course, have to be made for any cash or property

actually paid in as part of the transaction.
(8) Individuals and Partnerships No attempt need

be made to apply the excess profits tax to individuals or to
partnerships as under the recently-enacted British statute
(except as to professions dependent mainly upon personal

qualifications) and under our 1917, but not the 1918, Act.
While it may be somewhat illogical to exempt individuals,

1

2

corporations make up the g reat body of American business,

and the individual surtaxes will take good care of the problem

of excess profits so far as individuals and partnerships are
concerned. Individual capital gains are another matter; if
we have a substantial rise in price levels, capital gains will
be war or excess profits in every true sense of the term. But
the better road to the taxation of such profits seems to be
1. The excess profits tax of 1917 caused great discontent

and was barely endured even as a war measure.

2. Kennedy, Dividends to Pay, p. 1(1939), stating that
385,000 corporations a S of 1925 increased to 456,000 in 1939.

-14-

400

through the raising of capital gain rates in the Income Tax
Title.
1

The individual surtaxes will similarly prevent any
gross inequality between the tax on corporate and non-corporate

business such as might raise an issue of constitutionality on
the grounds of arbitrary classification.

I.(d) Duration of Tax
It might be desirable to retain such a tax as a
permanent part of the revenue system. Bookkeeping devices

might avoid part of the incidence of any temporary excess

profits tax. And it may further be said that corporations
earning a very large return on their invested capital are
able to bear a larger part of the tax burden than other
corporations.
One technical problem which would become accentuated

with a continued duration of the tax would involve the standard
period of earnings to be employed. As time passed on and
economic changes occurred, the use of the 1935 to 1938 period
would grow more and more antiquated and out of proper comparison

with present facts. The use of a moving basis (in other words,
the use of the year immediately prior to the taxable year as
1. Sec. 117.

401
-15-

a part of the standard period) is a possible solution;
this method, however, would give corporations a vested

interest in one year's excess profits by permitting them
to reduce their subsequent tax accordingly. Potential
errancy in the use of a moving basis would be less serious
if, as has been suggested, standard profits (or excess profits
tax credit) are deemed to be not less than 8% and not more

than 12% of the invested capital. An alternative, and perhaps
preferable, solution would be to change the 1935 to 1938
period to some different span of years after industry had
passed through a fairly normal period.
II. USE OF INVESTED CAPITAL

While average profits during the standard period
would be the criterion usually employed under the suggested

proposal, the invested capital would be referred to for the
purpose of a minimum and maximum allowance. There is a
vital reason for these minimum and maximum allowances which

should be set forth at this point. Contrary to popular
impression, it appears incontrovertible that a great many of
the leading concerns have realized very substantial profits
1

in the so-called depression. A tax which merely reached

1. See Kennedy, Dividends to Pay, Ch. 1 (1939).

402

-16-

profits above these large depression-period profits would
permit the escape of large sources of revenue by those
best able to bear their share of the tax burdens. On the
other hand, there are many concerns which, either because

of their position in the industry or because of the nature
of the industry in which they are engaged, had low profits
in the depression period. Such concerns, the very concerns
which should be permitted a reasonable opportunity to recoup losses, would be heavily penalized if excess profits

were defined as profits of these low profit years. The
only protection which can be reasonably afforded for such
concerns is measurement of normal or standard profits by

reference to invested capital, which in turn measured by
reference to the depreciated or depleted cost of assets employed
in the business.

II. (a) The Necessity of Using Invested Capital
The suggested proposal, it will be noticed, combines

the concept of standard profits with that of a normal rate of
1

return upon invested capital.

From one viewpoint, the value of

1. In this respect it is somewhat similar to the recently
enacted British excess profits tax effective April 1, 1939,
This tax is fixed at 60% of the amount by which the profits
of the taxable year exceed the pre-war standard of profits.
The standard profit is determined with reference to the profits
of a standard period prescribed according to when the trade or
business was commenced. If the business was commenced before

January 1, 1935, the standard period as optional to the taxpayer
18 as follows: either 1935 or 1936, the years 1935 and 1937, or
the years 1936 and 1937. In the case of a business started

after July 1, 1936, the standard profits are the "statutory

percentage" which 1a 8% of the invested capital in the case of
corporations and 10% in relation to non-corporate organizations.
Minimum allowances are made in lieu of standard profits. It 18
also provided that referees may make special allowances for lines

of business involving particular risks or other conditions.

403

-17-

the assumed invested capital necessarily depends upon the standard earnings; from another viewpoint the exempted profits depend

upon the invested capital. The construction of an "invested
capital" based on earnings alone would involve a logical circle.
If it were proposed to tax all excess profits on an abstract

"invested capital," which itself would be found by capitalizing
earnings at a certain percentage, and if that same percentage

of return were then permitted to be received free from tax, we
would be indulging in circular reasoning. There should obviously
1

1. It is true that the use of capitalized earnings would be
one method of valuing invested capital for purpose of an excess
profits tax. One difficulty in this connection, however, would
be the selection of the capitalization rate for each industry,

considering how some businesses involve little and others a very
great hazard, as well as how the earnings of some industries
fluctuate widely while the profits of others are relatively stable.
There would be no yardstick here except the vague general principle

that high risk industries should be capitalized on the basis of a
higher rate of return than more stable low isk industries. But
refined differentiation would complicate administration, and it
would probably be necessary to adopt a liberal capitalization rate
which would be applicable to all industries. This would f avor the
high risk industries, which is economically desirable. However, in
the interest of consistency it would then be necessary to take the

same rate of capitalization in determining how much net income should

be exempt from tax altogether. Thus, if it were decided to leave a
6% return free from the tax, average net income during the standard
period might be capitalized by multiplying them by 16 2/3 which would

certainly be a reasonably liberal rate of capitalization. The

same result, however, can be reached more directly and more simply

by merely using the average standard profits as the norm without
any attempt at capitalization.
It is a serious question whether the old concepts of
comparative risk factors are any longer valid. For instances, extra-

the old idea was that the oil and mining industries are
hazardous. Are they today? These industries are usually
organized a large scale which averages out dry holes and

unprofitable on mines; moreover, modern methods of exploration of the and

discovery have greatly minimized old hazards. The man
(cont'd p. 18)

-18-

404

be some contributing measure of capital independent of

standard profits. Moreover, as indicated above, the use
of the factor of earnings alone would discriminate in favor
of corporations which profited materially during the depression years, and would be especially unfair in the case
of new and speculative industries. It might also over-accent
the factor of good will. A very costly mine shaft may never
have produced a single ton of coal during the standard period,
and the corporations which achieved good will peaks in the
representative period would pay no tax.

Therefore, whatever its difficulties the use of an
invested capital concept similar in many respects to that of the
1918 Act seems desirable. As to most assets the invested capital
computed would be related directly to the cost basis originally
1

arrived at for depreciation or depletion purposes under the income

tax. The use of such a basis is better adapted to a permanent tax
than any exemption related in every case only to average

(1 cont'd from p. 17)

street certainly no longer thinks of the stock of the Texas 011
Company as being stock of a hazardous enterprise. He may be

up-to-date in his thinking and the old recapitalization formulae

may be what are obsolete. On the other hand, perhaps a comparatively new company engaged in a reputedly stable industry

should be regarded as subject to a high risk. The man of the
street may be up-to-date in his thinking and the old recapitalization formulae may be what are obsolete.

1. See however p. 27, note 5, as to percentage depletion.

405

-191

earnings. It is a more responsible figure than book value and

is readily a vailable for use, since most of its underlying

2

material has already been computed for income tax purposes.

This would perhaps be the most arbitrary possible
basis of value. In the case of most well-conducted corporations
book values originate in cost, but many corporations even today
carry assets at book values completely out of line, up and down,
with depreciated costs and current values. Many assets of great
value never et on the books at all; on the other hand, many
assets of small value appear on the books at inflated values.
Even in the case of corporations whose book values started with
genuine cost there would be variances originating in differing
ideas and estimates of depreciation, obsolescence, etc. Since
a high book value would raise e employed capital, the use of this
factor would tend to penalize conservative bookkeeping, and there
would be high-sounding talk of conflict between New Deal agencies.
The answer may be made that crudities inherent in the
use of book values might be compensated by using book value
1.

as only one of several factors. This is true, and it is

also true t hat book or asset values are often taken in evidence
of value in the absence of other evidence. (See Paul, Selected

Studies in Federal Taxation, p. 211 (1937). But this reply is
only a partial answer, and any tax which was referable to book
values, so often stated by the courts to be merely evidentiary,
(see e.g., Doyle V. Mitchell Bros., 247 U.S. 179 (1918)) would
be subjected to some justifiable criticism, and much additional

unjustifiable criticism as well.

2. True, the use of value at March 1, 1913, for income
tion need not trouble us. See p. 24

tax purposes somewhat complicates the point, but this complica-

-20-

406

II.(b) Criticism of Earlier Excess Profits Taxes
Before defining invested capital in more explicit
terms, it may be well briefly to dispose of the criticisms
made of the World War excess profits taxes. Lack of ad1

ministrative experience, deficiencies in bookkeeping records

and unival lability of detailed factual information made invested capital under the old acts an unpopular institution.
The computation of invested capital was irritating and costly
to taxpayers and delayed the collection of revenue under a
procedural system which put a premium on under-payment of tax

in the original return. However, the Government and taxpayers were just beginning to understand the statute and its
application when Congress repealed t he tax, thus throwing
away the knowledge we had gained. The old tax had a sound

principle underlying it. If we had left it in the revenue laws,

1. Invested capital under our earlier excess profits
acts was defined as (a) cash paid in, (b) the actual cash
value of tangible property paid in, and (c) paid-in or earned

surplus employed in the business. (1918, 1921 Acts, Sec. 326)
Patents, trademarks, good will, copyrights and other intangible
assets were included up to an amount not exceeding the actual
value of such property when paid in, the par value of the stock
issued therefor, or 25% of the total par value of the corporation's
shares, whichever was the lowest.

407

-21-

its administration would have become relatively simple by
this time. Moreover, its graduated rates might have diminished
the incentive for tax avoidance by corporate surplus accumulation.
W1thout attempting at the moment any discussion of such
1

technical problems as the exclusion of borrowed capital, the

2

limitations to be put upon the inclusion of intangible property,
3

4

and inadmissible assets, and the treatment of reorgani zations,
reference may be briefly made to the troublesome problem of valua-

tion for purposes of invested capital. There was no special
difficulty under the old acts with respect to cash paid in, but
corporate stock is frequently issued for property, both tangible
and intangible. The method of computing invested capital used under

the e arlier acts therefore involved a valuation of property paid
in to the corporations at the time paid in. Such a valuation, as

1. Holmes, Federal Taxes, p. 1275 (1923 Ed.); see p. 32

2. Holmes, Federal Taxes, p. 1257 (1923 Ed.); see p. 28
3. Holmes, Federal Taxes, p. 1255 (1923 Ed.); see p. 34
4. Holmes, Federal Taxes, p. 1291 (1923 Ed.), See also
discussion of the old Dominion case, Report of Special Committee
on Investigation of Munitions Industry No. 944, Part 2, 74th
Cong., 1st Sess., pp. 19, 21 (1935).

-22-

408

of the time paid in, even though previous to March 1, 1913,
was presumably once made by the Treasury for corporations

old enough to have been subject to the tax imposed by the
1918 and 1921 Acts (except corporations granted special
assessments), though it may be a question to what extent de-

tails of the valuations so made could now be recovered from

old files. There would not be the same problem in the case
of newer corporations since the Bureau of Internal Revenue

presumably has sufficient cost records. But for reasons
indicated below, these difficulties may be avoided by ignoring acquisition cost before March 1, 1913.
Unless we do so, the violent, and often bitter,

criticism of the old excess profits tax, particularly in its
use of invested capital as a base for the exemption and,

again, particularly in connection with the difficulties involved in valuations, made by such experts as Mr. Arthur

Ballantine, former Assistant Secretary of the Treasury, the
late Dr. Thomas S. Adams, former Advisor to the

1. Another more theoretical problem under this method of
computation would be the determination of a basic theory of value.
The 1918 and 1921 Acts used the term "actual cash value"
(Sec. 326 (a)), and perhaps this term is as good as any that may
be found, for in the end value is a question of fact the answer
to which can never be determined with mathematical accuracy;
the question must always be determined by a process of compromise

with practical reference to a composite of complex circumstances,

and the basic terms used in the statute are a generality of little

practical consequence. (Paul, Selected Studies in Federal
Taxation, p. 168 (1937)).

409

-23-

1

Treasury, and others would no doubt be repeated. This criticism
seems to have been considerably exaggerated, but it was suffi-

ciently telling to accomplish the repeal of the old excess
profits tax. The t ask of government and taxpayers under a
new act would not be as difficult as it was under the 1918 and
1921

Acts for several reasons, among which are:
(a)

Corporate records are in better shape than they
were in the last war;

(b)

The Bureau is more adequately manned and more

experienced than it was in the last war; corporate advisors in the legal and accounting

fields are also more competent and experienced;

(c) It should be possible to re-utilize considerable
old valuation work; and

(d) The Bureau of Internal Revenue is in the po-

session of much data which would be useful, and
so perhaps are other b ranches of the government,
such as the S.E.C.

See Report of Special Committee on Investigation of
Munitions Industry No. 944, Part 2, 74th Cong., 1st Sess.,
1.

p. 19 (1935).

-24-

II.(c) The Influence of Depreciated Cost

110

There is a further and more fundamental reason why

the determination of invested capital will be easier today
than it was in the World War years. The capital (including
paid-in surplus) and earned surplus of a corporation, or its
net worth, consist, when all is said and done, of nothing
else but the difference between (a) the cost of the corporate
1

2

non-depreciable and non-depletable assets plus (b) the net
cost of the corporate depletable and depreciable assets after

depletion and depreciation and (c) the borrowed capital of the
corporation, both funded and current. The conventional approach is
from the liability side of the balance sheet. But there is another
1. Of course, adjustment of earned surplus has to be made
for reserves which are mere subdivisions of the surplus account.
Reserves for contingencies, reserves for self insurance and
reserves for Federal income and profits taxes are properly to

be considered parts of surplus. This is not generally true of
any reserves the additions to which may be deducted in computing
net income. Among such latter type of reserves are reserves for
depreciation (which are presumed to offset the loss in value
of assets) and reserves for state or local taxes where the corporation reports on the accrual basis and the amounts carried
to such reserves have been deducted. (See generally on this
subject Reg. 45, Art. 839).
2. The "net worth" of a corporation consists of the excess

of assets over liabilities (to creditors, as distinguished from

the proprietorship account). See Kohler and Morrison, Principles
of Accounting (1931) p. 33; Kester, Accounting (1925) Vol. II,
pp. 398, 412; Kester, Advanced Accounting, 3rd Ed. (1933) Ch. 21.
In its broadest sense, "surplus" represents the excess of net
worth over the capital stock of the corporation, with certain
exceptions (as where the capital stock was originally issued at
a dis count). Hatfield, Accounting (1931) p. 296; Kester, Accounting (1925) Vol. II, p. 439. See also Kester, Advanced Accounting,
3rd Ed. (1933) Ch. 25.

-25-

411

approach - namely, from the asset side of the balance sheet.
The capital and earned surplus may more easily be determined
today than in the World War years, because we are dealing in
the main with assets purchased or acquired during a period

in which cost depreciation affected net income. For most
corporations the Bureau and taxpayers must be in the possession
1

of data fixing the cost of assets, including assets purchased
with stock. Valuation problems are therefore reduced, and
we have available a current depreciated cost of assets on the

asset side which fixes the surplus on the liability side.
Where property was acquired before the advent of the income tax,
the basis used should be the 1913 value (unlike the treatment

under the old act which took original acquisition cost in the
case of assets acquired prior to March 1, 1913) rather than

attempting any retrospective appraisal as of the date contributed.
No similar net cost basis may be currently available as to non-

1. In some cases the basis may be the March 1, 1913 value.

412
-26-

depreciable assets, such as non-mineral lands and stocks re-

presenting the assets of subsidiary or other corporations. But
undepreciated cost is a safe enough basis for such lands, and

gross cost will usually be available, particularly where there
1

has been a reorganization.

Where such cost was not available,

the figure at which non-mineral land is carried on corporate
books is usually not unrepresentative of its current value;
and in the interest of simplicity the book value of the

land at the date of the introduction of the bill into Congress
might be used for this purpose, although this would work occasional
injustice where a company had rigorously scaled down its book

value without obtaining any income tax benefit from the reduction.
If we disregard cost of assets acquired prior to March 1, 1913,
an asset-side amount is therefore reasonably available as to a

large proportion of corporate assets, which establishes a firmer
surplus account than was available at the time of administration of the earlier acts and thus minimizes to a remarkable
degree the difficulties of computing invested capital which
made these earlier acts so unpopular.

1. See Reg. 101, Art. 112(g)-6.

2. Stocks, or inadmissible assets, will be dealt with

separately below.

2

413
27

III.

THE CALCULATION OF INVESTED CAPITAL

(a) In General

Reference has been made to the simplicity of

determining the first element of invested capital, - cash
paid in. Apart from intangibles the paid-in and earned
surplus accounts are plainly referable to the assets of
the corporation; if these assets are correctly valued,
surplus 16 a balancing figure. For purposes of computing
the correct surplus such assets as cash, and notes and
1

2

accounts receivable, could be taken at their face value;
inventories might be valued, as for income tax purposes
and as for purposes of invested capital under the old
3

excess profits tax, at cost, or cost or market, whichever is
lower. All depletable and depreciable property, including the
4

5

fixed property account, could be taken at the net original cost

1. See authorities cited in note 2, page 24.
2. There should perhaps be some discount for accounts
and notes receivable which were not worth face value, but

this is a matter of detail.

3. Holmes, Federal Taxes, p. 1268 (1923 Ed. )

4. Variations might be allowed where some other
inventory basis is allowed to the taxpayer.
5. A special problem is presented by the percentage
depletion deduction allowed to oil and gas producers and certain
mining companies. (Sec.114 (b)). It is a question to be decided
whether the excess of percentage depletion over cost or March 1,
1913, value depletion should be allowed as part of invested
capital. The same question arises as to discovery depletion.

414

28

1

for income tax purposes, or net value at March 1, 1913,
a figure already generally available to the Bureau of
Internal Revenue and taxpayers. This would leave such nondepreciable and non-depletable assets as land (except mineral

lands) to be taken at book value. Any assets, such as taxexempt bonds, the income from which is exempt, should, of
2

course, be inadmissible as part of invested capital.

III(b) Intangibles
The question of including intangible assets, such

as patents, good will, etc., also needs special consideration.
Intangibles, as well as tangibles, may contribute materially
in some industries to the profits of a corporation. Where
intangible values are in large part the result of deductible
advertising and promotional expense, then inclusion beyond

the recognition they obtain through the profits formula is hardly
justified by considerations of equity. A better case can be made
out for the inclusion of intangibles purchased for cash or stock,
the value of which the taxpayer has not built up by deductible expenses. Such intangibles should be to some extent included in invested

1. This alternative basis for property acquired prior
to that date is not a significant complication. It helps
corporations organized prior to that date, but simplifies

administration enormously.

2. This was done under the 1918 Act.

-29-

415

capital, perhaps to a greater extent than is recognized in
the standard earnings formula. This may lead to some
1

discrimination between a corporation which acquires such

assets by outright purchase, securing a substantial allowance therefor, and a corporation which has built up similar
good will gradually by enterprise and activity; and with a
heavy tax such discrimination,may, of course, cause serious
inequity. But it must be remembered that most intangibles
(such as patents, copyrights or franchises) purchased for
cash or stock have a depreciable basis for Income tax pur-

poses. To fail to allow the inclusion of such intangibles
would make for a departure from income tax practice.
Intangible values are to some extent recognized

through the use of standard profits in the cases of corporations which have had earnings attributable to intangibles in

the years prior to the incidence of the tax. But there are
many instances in which a corporation did not own, or had

not sufficiently developed intangible assets to produce earnings in the representative period. There are also cases in
which intangibles might have been dormant in the standard or re-

1. If standard earnings reflect earnings on intangibles,
as they will in the case of many corporations, the result under
the proposed tax approaches the inclusion of intangibles

pro tanto in invested capital.

416

30

presentative period. It seems desirable, therefore, to
give greater recognition to intangibles than is afforded
by the use of the standard profits formula. On the other
hand, the arbitrary par value formula for the recognition of intangibles contained in the 1918 Act seems
highly undesirable. A compromise would be the allowance

of the entire amount of intangibles acquired for cash

and the partial inclusion of intangibles acquired for stock.
The inclusion of intangibles acquired for stock might be
limited to the actual value of any stock given in exchange
or by a provision that the figure used as their cost basis
should not exceed 20%, or some other proportion, of the total
cost basis.

III (c) Capitalized Earnings ofTaxable Year

As an incentive to equity financing, and the distribution of stock dividends, earnings capitalized during the

1

current taxable year, at least up to the middle of the year,
might be included in invested capital by an express statutory
provision, though this was not done under the earlier acts.
Such a provision would recognize, to the extent of capita liza2

1. See page 3

2. Reg. 45, Art. 850.

-31-

417

tion, the indubitable fact that undivided profits of the
early part of a taxable year contribute to the production

of the profits of the later part of the year. The addition
would contemplate the addition only of earnings of the current
year, since the earnings of past years are already in invested
capital. It must be admitted, however, that this mechanism

involves difficulties of proof as to the amount of earnings,
which difficulties might be excessive in comparison with what

could be achieved. The inclusion of earnings capitalized during
the first 6 months of the year should be limited to cases in
which the capitalizing stock dividend was taxable to stockholders.

III. (d) Assets Not Employed in the Business
A further question arises as to whether there should

be included in invested capital only assets which are actually
employed in the business, which might in many cases be far

from equal to the totality of assets. It may be plausibly
argued that in a tax intended to fall upon the excess profits
of business, only business assets should be considered. Also,
a corporation with large accumulations of surplus would otherwise have an undue advantage, since it could invest that sur-

plus in bonds yielding only a small but safe percentage of
return and offset the high returns from its business operations with the relatively low return from investments. However, previous acts attempted no such differentiation and the
attempt should be avoided due to the insurmountable practical

difficulties which it would entail.

32

418

III (e) Borrowed Capital
Borrowed capital should be excluded from invested
1

capital as under the earlier acts, since the bondholders
are not the equity owners or the distributees of the corpora-

tion. It is true that if borrowed capital is excluded,
there is likely to be a considerable number of corporations
with no invested capital or not more than a relatively
nominal capital - for example, concerns with large intangible
assets built up by deductible expenses, or those whose tan-

gible property has appreciated hugely since the original
investment. However, to permit the inclusion of borrowed
capital would confer an unmerited advantage upon corporations

deriving large profits from funds borrowed at a low rate
of interest, which would be deductible in computing the
taxable income.
Moreover, from the incentive standpoint
2

1. Section 209 of the 1917 Act provided that where the
corporation had no invested capital or only a nominal capital,
the net income in excess of a stated exemption should be

taxed at 8%. Using this provision was jumping out of the

frying pan into (not the fire) relative immunity. A rate

of 8% would be much too low in many instances. The 1918 Act
provided that where the amount of borrowed capital was abnormal, the taxpayer might apply for special assessment under

Section 328.

2. This deduction would, however, be paralleled in the
case of other corporations if a dividends paid credit is allowed
in computing income subject to the excess profits tax. See
page 50

33

19

it is desirable to encourage equity financing, and a
corporation with a large funded debt should be tempted to

retire the debt in favor of a stock issue. Therefore,
borrowed capital should be excluded.

The exclusion of borrowed capital would be only
of the actual amount borrowed, including both funded debt
and current indebtedness; any assets purchased out of pro-

fits from borrowed capital would be included in invested
capital. Any so-called "preferred stock" should be treated
as borrowed capital if the holders rank either with or prior

to general creditors as to either "dividend" payments or principal amount; this involves esentially the same considerations
as the frequently-litigated question whether the annual payments on such securities are to be treated as dividends or
deductible interest. The hard cases of corporations with an
abnormally high borrowed capital would have to be handled

under a special assessment section, or by a provision giving
a corporation the option of including borrowed capital as

part of its invested capital provided that its standard
profits should then not be permitted to exceed a lesser percentage of invested capital (such as 5%).

34

420

III (f) Stock of Other Corporations and Tax-Exempt Bonds
Under the 1918 Act stock in other corporations
owned by the taxpayer was inadmissible in computing invested

capital on the theory that the dividends on such stock
were deductible in computing the net income of the corporation. Today, however, since 15% of the dividends received
1

from other corporations are taxable, a corresponding portion
of the capital investment in such shares should be recognized
2

in determining invested capital. Other inadmissibles, including bonds the interest upon which is not required to be
3

included in computing net income, may be excluded as under
the 1918 Act.

III (g). Possible Use of Appraised Value Alternative
The alternative use of standard profits or of a
percentage of invested capital would greatly reduce the

possible number of erratic instances in the operation of

the statute. Isolated unfairness, however, might still
result for the reason, among others, that the suggested pro-

posal, like the old excess profits tax, would not take any
1. Internal Revenue Code, Sec. 25(b). See, however,
following note.
2. Minor complications in connection with Supplement a

may be left for detailed consideration later.
815.

3. - See Revenue Act of 1918, Sec. 325; Reg. 45, Art.
Corporations engaged in buying and selling securities

(dealers in securities) present a special problem here for
further consideration.

421

-35-

1

consideration of appreciation of value, except as
appreciation in value is implicitly recognized by the allowance of an increase over 8% of invested capital if the
standard or representative earnings permit. Therefore,
a third possible alternative of measuring invested capital
may be offered as a suggestion, consisting of the appraised
value of the corporate assets at the beginning of the taxable year.

The alternative would, however, be impractical

as a compulsory provision. Even if the data relevant

to a current valuation were readily available, which is to
be doubted, appraisal would necessitate fixing upon some general

principles of valuation; and the use of this factor, to some
extent justifiably and to a perhaps greater extent because
of wide-spread taxpayer pejudice against valuation necessities,
would be an unpopular provision if made compulsory. Moreover,
the Government would have its problems; counter-proof in

valuation cases is expensive and beyond the ordinary facilities
of administration. Again, we would have the factor of delay in
1. La Belle Iron Works V. United States, 256 U.S. 377
(1921)

-36-

422

the collection of revenues. Taxpayers would claim high values
and the inevitable process of horse-trading would have to

be endured. It should also be noted that the use of appraised value is to some extent a duplication of the use
of average earnings, for one of the principal methods of
appraisal is to capitalize earnings.
For these reasons I would advise against the use of

appraised value as an invested capital factor. If this alternative is used, its use should be optional to the taxpayer.
This would certainly diminish criticism, since any taxpayer
which then chose to use this method would be doing so in order

to diminish tax liability. Moreover, if the alternative is
adopted, appraised value should be operative onlyby way of
refunds, and should not be permitted to be employed in com-

puting original tax liability payable in theyear of filing
returns.
IV DETERMINATION OF STANDARD PROFITS

As set forth above, many of our largest business

units were making substantial profits during the period from
1935 to 1938, inclusive, and to use average earnings as an

exclusive test of tax liability would mean virtual exemption
for many of our largest corporations. A similar situation was
the very reason why Congress, in passing the 1917 Act, did not

use the principle of pre-war profits as standard profits. A

37

423

ceiling limitation, based upon some percentage of invested
capital, seems necessary to prevent a serious loss of
revenue on account of the escape from the operation of the

tax by the very corporations the tax should most fairly
reach, and a cellar limitation is necessary to prevent an
excessive burden being placed upon corporations making

less than a fair return on their capital during the re1

presentative period.

As has been noted, it is proposed

1. Such a treatment would be very similar to the 1917
law in computing excess profits. That tax took the excess
over a so-called normal amount consisting of a fixed sum
($3,000 for domestic corporations or $6,000 for partnerships, citizens or residents) together with an amount equal
to the percentage of the invested capital represented by the
average annual income during the pre-war period, provided
that in no case should this percentage be less than 7% nor
more than 9% of capital. The years 1911 to 1914 were
used as the pre-war - period. If the business was not in
existence during those years, the deduction was fixed at
8% instead of 7% to 9%. If there was no income or a very
low income during the pre-war period, the criterion was the

percentage of capital earned by similar or representative
business. (Sec. 209).

An alternative possible limitation would be that the

normal rate of return might not exceed the amount necessary

to pay 6% dividends on the paid-up capital stock of the corporation (or in the case of no-par stock to pay the rate of
dividends paid in some representative year). Cf. part III,
Sec. 13 (7) of the English Excess profits Tax. This alternative
would be simpler, but less satisfactory, since it would unduly
favor over-capitalized corporations.

424
38

that standard profits, which are exempted from the operation
of the proposed excess profits tax by the mechanism of an
excess profits tax credit, be computed on an alternate basis.

They may consist of (a) 8% of the invested capital, or (b)
the standard profits of the representative period up to 8%
of the invested capital plus 50% thereof, or in other words,
12% Stating this thought in positive form, there would be an
excess profits tax credit consisting of the standard average
profits, but this credit would not be less than 8%, or more than
12% of the invested capital for the taxable year. Thus, a
corporation is always entitled to an exemption of profits up
to 8% of its invested capital, and may be entitled to an
exemption of a greater amount if the standard profits of the
representative period exceed 8% of the invested capital.
But the exemption is limited to 12% of invested capital.
The determination of standard profits involves the
further problems indicated in succeeding paragraphs.

IV (a) The Choice of R Representative Period
The cardinal problem in the use of average earnings
over a representative period as the basic measure of standard

profits is to choose some fairly representative period. For
this purpose the years 1935, 1936, 1937 and 1938 are per-

haps the best available, since the use of earlier years would

lead back to the pit of the depression. At least one of the
above years would be a high income year for many industries,
and more than one would be a high income year for some industries.

39

425

Criticism of this period as unrepresentative may
be anticipated, particularly from corporations which

found the period one of lean earnings. This criticism is
answered by the fact that a corporation is in all cases
entitled to a minimum earnings exemption of 8% of its in-

vested capital. There is the further possible expedient
in this connection of allowing the taxpayer the use of
some other fairly representative consecutive period upon
a showing that the years 1935 to 1938, inclusive, were

in its particular case not a fair period. This expedient
has been used in connection with the Agricultural Adjustment
1

Program and the Sugar Act.
Taxpayers which commenced operation too recently

to have had existence during the full standard period could

be given the option of taking the average of the last two
years, or merely of the single year, prior to the enactment
of the tax. Here the minimum return based upon the percentage of invested capital would afford an adequate protection against unfairness in most cases. The same protection
would apply where the net result of operations during the
whole standard period was a loss. Here, however, any part

of the current profits applied to the extinction of losses
suffered during the standard period might well be an allowable
deduction for purposes of computing the excess profits tax.

1. The taxpayer might be given the option of using 3 out of
years in certain exceptional cases where one particular
year was not representative.
4

426
40

IV (b) Adjustment of Standard Profits to
Invested Capital of Taxable Year

It would, of course, be an over-simplification to
average the profits of the representative period and to
ignore the average invested capital employed in producing
such earnings. Such a procedure would be unfair to concerns

which had increased their invested capital in the period,
and would unduly favor concerns which had decreased their

invested capital. It is, therefore, suggested that the
average invested capital be taken into the equation by increasing or decreasing standard profits for the representative
period in the proportion which the invested capital at the
beginning of the taxable year bears to the average invested
capital during the standard or representative period. Thus,
if the invested capital at the beginning of the taxable year
was double the average invested capital in the standard
or representative period, ,the normal or standard profits of the
taxable year to be free from the tax for the period would be
double the standard profits of the representative period, but the
standard profits to be used as an excess profits credit could not
exceed 12% of the invested capital for the taxable year.
The formula involves the reasonable assumption that

capital added during the standard or representative
period would have earned ordinary profits at the same ratio

as did the original capital. However, as to additional

41

27

capital investments after the enactment of the tax, a
some what higher percentage might be used, due to the reason-

able assumption that fair profits during a war period would
be somewhat higher than fair profits during the standard
or representative period.
IV (c) New Corporations Organized after the Representative or Standard Period
New corporations organized after the representative

or standard period present a peculiar problem. In their
case no standard profits are available to be taken into the
equation, and it seems necessary to rely wholly upon the

8% invested capital formula. The only alternative is perhaps
to increase this formula in such cases by an arbitrary percentage, say 25% (which is halfway between the straight invested capital formula and the highest standard profits available to other companies) making the percentage 10%. This

arbitrary increase is justified by the consideration that most
of these new corporations would be in a relatively unsafe
economic position and should be favored from a tax standpoint as compared with older established corporations.

IV (d) The Effect of Fiscal Periods Differing from
the Calendar Year

Another complication arises from the fact that many

corporations keep their books on a basis of fiscal periods
differing from the calendar year. In such cases the calendar

428

-42-

years of the standard period will not actually have been
used as an accounting year by the taxpayer. There is
some an omaly in treating corporations otherwise similar

differently simply because of accidental differences in

fiscal periods. Theoretically all profits should be subject to the same tax irrespective of past accounting period.
It would be possible to accomplish this by providing for an
apportionment of profits or losses to translate the profits
of a fiscal year into the years used, either in computing
the standard profits or in computing the excess profits
tax. Such an apportionment, if used, would normally be on
a time basis.
It might, however, involve complications and
1

additional expense to taxpayers, and I am inclined to prefer

the more practical expedient of resorting instead to those
established fiscal years which most closely coincide with

the calendar years specified in the statute.

1. Cf. Part III, Sec. 14 (1) of the British Act and

Sec. 335 of the Revenue Act of 1918.

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V. DETERMINATION OF PROFITS SUBJECT TO TAX

In determining what profits should be subject to
the excess profits tax, net income for income tax purposes
1

would be the natural and efficient starting point. For
example, investment income, as pointed out above, should be
2

included. The statute should perhaps expressly incorporate by reference methods of determining net income stated

in the income tax regulations to cover instances in which
methods are not expressly provided for in the income tax

1. There probably should be no special provision as in
the 1918 Act with respect to Government contracts; the income
from such contracts should be kept at the level of other profits.
Of course, many such contracts are treated specially by the

Vinson Act. An excess profits tax would in fact be illusory
here, since the excess profits tax would itself be taken into
account in arriving at the contract price. In other words,
the manufacturer would strive to obtain a price which would
leave him after paying the tax in about the same profit position
as he would have achieved had the tax not been in existence.

The Government would itself be creating with one hand the excess

profits which it would be taxing with the other.
2. But compare British Excess Profits Tax, Seventh
Schedule, Sec. 6; see also Canadian Excess Profits Tax, Sec.
4(1) (e), exempting from the Canadian tax any dividends received
from domestic Canadian corporations.

-44-

430
1

statute itself. For example, the income tax regulations
have a special provision - not appearing in the statute
itself - as to apportioning income from long-term contracts,
permitting the income from such contracts (a) to be taxed
when received or (b) apportioned over the life of the contract.
Consolidated returns would be very desirable in the case of

subsidiary or affiliated companies, since the duplication of
tax upon the same e arnings which otherwise ensues is
especially burdensome when the rates of tax reach the brackets
2

suggested in this proposal. However, the use of consolidated
returns for this purpose would not be desirable unless the
income tax statute were also amended to permit the general
use of such returns.
3

Some variations from net income for income tax

purposes W ould, however, be necessary to conform to the

peculiar characteristics of an excess profits t ax. Most of
these modifications would take the form of additional deductions.

1. Reg. 101, Art. 42-4.
2. Decentralization of the Bureau of Internal Revenue
emphasizes the necessity of consolidated returns.
3. They are now used only by railroad corporations;
Internal Revenue Code, Sec. 141.

-45V.

431

(a) Deduction of Income Tax

Clearly the ordinary income tax of the corporation
should be a proper deduction. This was not done under the
1918 Act; that act conversely allowed the excess profits
tax as a credit in arriving at the amount subject to income
1

tax.

V. (b) Additional Losses
The act should also be liberal as to the deduction
of losses. Deduction for amounts used to restore previous
losses during the standard period might be desirable. The

importance of such a relief provision is obvious; it would
help in hard cases and silence complaints. Also, losses
occurring in a year after the enactment of the excess profits
tax should be carried forward as under Section 211 of the Revenue

Act of 1939. The 1918 law, in Section 204, had a special relief provision somewhat along this line to take care of losses
2

ensuing from a termination of the war. That act provided
that net losses for 1919 could be charged back to 1918 and

forward to 1919, if the taxable year chanced to begin between
certain dates. Such a relief provision should be repeated and
extended in any present law.

1. 1918 Act, Sec. 236 (b). This method would be an acceptable substitute.

2. Sec. 204 (b).

-46-

432

v.(c) Inventories
Inventories present a special problem in connection

with an excess profits tax, since one should be prepared for

a large fall in value following the war. The increased value
of inventories a t the present time may thus eventually prove
1

illusory. The Revenue Act of 1918 permitted rebates in
case of inventory shrinkages under certain narrowly-defined

restrictions, but did not go far toward a complete solution of
this problem.

If inventory losses are allowed to offset the gains
of a prior year, grounds for complaint are greatly reduced.
Under the 1918 treatment the loss could not be claimed in the
subsequent return itself, but had to be obtained by way of a
refund claim, and the t axpayer's money was therefore with-

held from the time of collection of the tax until t he ultimate
refund. But this is a relatively unimportant procedural item,
and is probably necessary to preserve the orderly audit of
returns. The allowance of an offset against the inventory
gains of a prior year should be combined with a carry-over of
the loss to subsequent years as under Section 211 of the

1. Sec. 214 (a) (12) and Sec. 234 (a) (14); Reg. 45, Art. 261-8.

-47-

433

1939 Act. As an alternative, corporations might be permitted
to set up a reserve allowance of some percentage to guard

against a possible fall in values.
The last-in - first-out inventory principle, allowed
for a few industries by the 1938 Act and extended by the
1939 Act, might be enough to cover the case of goods actually

taken out of inventory during the taxable year. In an in-

flationary period this provision generally has the effect of
adding to the actual cost of goods sold during the year the
higher-price goods purchased later, and thus would be a shock-

absorber of a useful character, because it would relate high

costs to high gross income with a tapering off of costs as
the income tapers off in the deflation period. Such a provision, however, should be coupled with the net-loss provision

mentioned above. It might not be enough alone, since its
operation would be somewhat haphazard, depending on when goods

were purchased and when prices happened to change. Standing

alone, it might also have the undesirable effect of encouraging
taxpayers to engage in a scramble of end-of-the year sales,
thus intensifying any possible deflationary movement.

-48-

434

v.(d) Amortization
The 1918 Act-contained an amortization provision,

supplementary to the general provision for the deduction of
the depreciation and obsolescence, which provided that:

(a) in the case of buildings, machinery, and equipment or

other facilities constructed, erected, installed, or acquired
on or after April 6, 1917, for the production of articles
contributing to the prosecution of the War with Germany, and

(b) in the case of vessels constructed or acquired on or after

April 6, 1917, for the transportation of articles or men contributing to the prosecution of the War, there should be
1

allowed a reasonable deduction for the amortization for such

part of the cost of such facilities as had been borne by the
2

taxpayer.

This provision, founded in the idea that equity

required a recognition of the substantial risk involved in war

1. This feature of amortization is obviously inapplicable
to the present situation.
2. 1918 Act, Sec. 214(a)9, 234(a) 8. See Holmes, Federal
Taxes, 1923 Edition, p. 852, for a discussion of this provision.

435

-491

time construction, proved very difficult of administration.
Perhaps a substitute for the word "amortization" should be
found. The amortization allowed under the 1918 Act was nothing
more than extraordinary depreciation or obsolescence, and the

essential problem is to relate that depreciation or obsolescence,

chiefly the latter, to a short period of earning capacity.
Wha t really happens is that certain facilities lose their
earning power as soon as the war has ended; all that an amorti-

zation provision means is that certain war facilities may be
depreciated over the period of their extraordinarily short
useful life with proper allowance for subsequent non-war usefulness, which is really salvage value.
It should be noted that amortization may be thought
of in terms of a deduction for both income tax purposes and
war tax purposes, or it may be regarded as a special deduction

for war tax purposes. The old amortization provision was for
both purposes.

If it is practicable, some more flexible amortization
provision than was contained in the 1918 Act should be devised;

its virtue would be that it would be adaptable to incentive
taxation and an encouragement of capital investment in
industries where expansion is thought desirable.

1. Report of Special Committee on Investigation of the
Munitions Industry, No. 944, Part 2, 74th Cong., 1st Sess.,
p. 30 (1935).

36
-50-

V.(e) Dividends Paid Credit
1

One of the principal functions of the tax under
consideration is to tax e xcess profits in corporations
because of our knowledge that such corporate profits vill not
be sufficiently distributed to permit them to be subjected,
as they should be, to the individual surtaxes. The suggestion
may, therefore, be made of the advisability of permitting a
2

limited dividend paid credit of the kind now allowed for purposes
3

of the domestic personal holding company provisions and for

purposes of gection 102. Such a credit would tend to encourage
the distribution of corporate earnings to stockholders, some
of whom would be taxable at reasonably high brackets, and the
remainder of whom would enjoy increased spending power. The

extent to which this credit would be availed of would, of
course, depend upon the rates adopted in the excess profits tax.

1. True, the tax would also have some non-revenue, regulatory,

effects in connection with price control. See Report No. 944,
Special Committee on Investigation of The Munitions Industry,
pp. 8, 55, 74th Cong., 1st Sess. (1935).

2. The personal holding company provisions do not reach the

majority of corp orations, and Section 102, applicable to im-

proper surplus accumulations by corporations generally, has been
a conspicuous failure.
credit was also
Internal Revenue Code, Sec. 405. Such a
allowed 3. for purposes of the discarded undistributed profits tax.

Id., Sec. 27.

51

437

The credit might, perhaps, depending upon the amortization
provision adopted, discourage new construction, but any such

effect might be obviated by allowing a credit in respect
to taxable stock dividends. The credit might also be allowed
only as against the 50% surtax on income in excess of 18%

of the invested capital. So limiting the credit would obviate
the objection that the tax in effect required a corporation
to distribute funds needed in the business. For no corporation
which can earn and retain more than 18% of its invested capital
in any one year can complain if a tax induces it to distribute
the balance.

If any such provision is made a part of the law,
it should allow a reasonable period (say 21 months) after
the close of the year for the declaration of dividends, and
perhaps also a deficiency dividends paid credit. This would
obviate much criticism of the type leveled with justice and

effect against the undistributed profits tax. It would,
of course, mean some revenue lag, since stockholders would

report dividends paid after the close of the corporate fiscal
year in a later taxable year. Permission might also be granted
to obtain the credit through the mechanism of a consent

dividends credit without actual distribution.

438

-52-

VI. ADMINISTRATIVE PROBLEMS

VI. (a) Assessment and Collection
The provisions as to assessment, collection, and

refund should be the same as those existing in the ordinary

income tax field, probably including the privilege of appealing to the Board of Tax Appeals or the courts even from the
1

special assessments suggested below.

VI. (b) Possible Avoidance

Methods of attempting to avoid an excess profits tax

would undoubtedly be as limitless as the infinite ingenuity
of taxpayers and their advisors; they would vary all the way
from the petty device of putting relatives of the officers on
2

the payroll of small corporations at exorbitant salaries, or
the postponement of profitable activities in the hope that the
tax might disappear, to spending excess profits (otherwise

subject to the tax) for excessive advertising and every other
imaginable purpose which could conceivably be justified as a
business expense. However, it is unlikely that any great amount
of wasteful expenditures would result, or that avoidance would
be effective enough to hamper administration very seriously.
1. One additional suggestion with respect to the administration of the tax would be a lengthening of the statute of limi-

tations upon assessment and collection and possibly also upon
2. See Paul. The Background of the Revenue Act of
1937, 5 Univ. of Chicago L.R. 41, 44 (1937).

refunds.

439
-53-

Salaries present no very grave problems where the

tax is not made applicable to individuals or partnerships.
Exorbitant salaries could be treated under the limitation
as to reasonableness laid down in the income tax provisions

without any further statutory provisions. Many of the devices
common under the older acts were designed to postpone pro1

fits until the abolition of the tax; if the statute were
passed as a permanent part of the tax system, the efficacy
of such methods would largely disappear. Moreover, avoidance

and evasion are less likely to be rampant if the rates of tax
are kept fairly moderate.
VI.(c) Special Assessment in Cases of Peculiar
Hardship (Secs. 327 - 328 of the 1918 Act)
The Revenue Acts of 1918 and 1921 contained the
famous Sections 327 and 328 which the framers of the 1918 Act

wisely inserted in the statute to cover peculiar cases which
would not fit into the general pattern of the act without undue

hardship. These sections gave to the Commissioner of Internal
Revenue a wide discretion to adjust profits tax on a special
1. See, e.g., Report of Special Committee on Investigation
of Munitions Industry No. 944, Part 2, 74th Cong., 1st Sess.,

p. 34 (1935).

40

-54-

basis in cases in which invested capital could not be satisfactorily determined and in cases in which abnormal conditions

affected the capital or income of the corporation. In such
cases the Commissioner had the task of fixing the tax of the
corporation affected by such conditions by reference to the
taxes paid by representative corporations engaged in a like or
similar business.
1

The administration of these provisions put a great
burden upon the Commissioner. Many taxpayers in the course

of the war paid tax without protest in accordance with the conventional standards of invested capital set up in the act.
These same taxpayers later, with some abatement of patriotic

fervor, made application for revision and reduction of the taxes
they originally computed on the ground of alleged abnormal

conditions affecting capital or income. If the Commissioner
decided that such conditions existed, he was faced with the
problem of assessing a fair tax. He was handicapped in this

task by the fact that in the first few years after the war
the taxes of "representative" corporations computed in the
ordinary way had not yet been finally determined. Moreover,
from time to time rumored scandals were rife in connection
1. For a consideration of these sections by the Supreme
Court, see Williamsport Wire Rope Co. V. United States, 277 U.S.
551 (1928); Blair V. Osterlein Machine Company, 275 U.S. 220 (1927).

441
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with the special assessment section which handled these cases,

and there is no doubt that many corporations not entitled thereto received the benefit of the provisions.
However, there seems to be no escape from the necessity

of some such relief provision, perhaps somewhat more circumscribed

than that contained in the 1918 and 1921 Acts. The wisdom of

too much inflexibility is dubious, and in the end the legislative
branch will probably have to trust the administrative authorities
1

once more.

It is literally impossible to frame a broad compre- hensive statute such as the one under consideration without
working undue hardship in many meritorious cases. No reasonable

1. It would theoretically be very desirable to exclude the
possibility of a judicial review regarding such assessments. But
our greater reluctance to permit administrative finality, as
compared with the English practice, would make such an attempt
very unpopular. Moreover, it is at least conceivable that some of
our Supreme Court cases might b e interpreted to impose a constitutional requirement of judicial review regarding income tax
valuation questions. See Ohio Valley Water Co. V. Ben Avon, 253
U.S. 287; Crowell V. Benson, 285 U.S. 22; cf. Anniston Manufacturing Co. V. Davis, 301 U.S. 3 37 (1937).

442

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1

person expects a statute of universal application to be perfect,
and occasional hardship must be disregarded. But the door should
be left open to prevent irreparable damage in extreme situations.
Difficulties arise from the fact that in 80 many businesses the
profits may fluctuate very widely from year to year. Also, the
profits of 1940 may be merely the fruit of expensive activities
2

long antedating that year. Therefore, as under the 1918 Act,
some safety-valve must be provided for cases in which taxable

income is seriously disproportionate to capital as well as
cases in which invested capital is for some reason difficult to
determine.

November 16, 1939.

1. See e.g. Purity Extract & Tonic Co. V. Lynch 226 U.S.

201, 204 (1912); Tyler V. United States, 281 U.S. 497, 505 (1930);
Milliken V. United States, 283 U.S. 15, 20 (1931).
2. Cardozo, The Paradoxes of Legal Science, p. 69 (1927).

443

Exhibit A
Computation Based Upon
8% Normal Return

rackets

Amount of
Net Income
Each Bracket

Tax

Amount
of
Tax

700,000

10%

70,000.

300,000

300,000

25%

75,000

660,000

660,000

50%

330,000

over 15% of

vested capital 1,500,000

Statutory
Normal

Return
800,000

Balance

Subject
to Tax

Rate
of

r 15% but not
er 18% of

vested capital
r 18% of

vested capital

al Excess Profits Tax

$475,000