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FVrm F. R. 131

BOARD OF G O V E R N O R S
OF THE

FEDERAL RESERVE

SYSTEM

^Office Correspondence
To

Chairman Eccles

From

Lauc




uurrie

Date—December 25, 1956
Subject:

Tax

Mr. Bryan and I have gone over the proposed amendments and, in
addition, Mr. Bryan has conferred with the head of the technical
staff of the Bureau of Internal Revenue, a personal friend, and
we both feel, for the reasons set forth In the accompanying
memorandum, that any relaxation of the law in respect to debtburdened corporations, or corporations with impaired capital,
should be carefully safeguarded.
If I might make a suggestion concerning tactics, it is this. I
think it is safer for us to appear to be prepared to make concessions
rather than appear to advocate amendments. We can rely on the opponents of the tax to do the advocating.
Mr. Bryan is prepared to attend the meeting if this is satisfactory
to you.

x m m F. R. 131

BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM

.Dffice Correspondence
To

r/hpi-rmpm f e / aa
tri

From

Date Becflmhgrr g 3
..

Malfifilmft-ryanand L?ni ah linCurT*! a




^ P n

,

Subject: — T h e Uaflistributed Earnings Tax.
6 P 0

16—852

The problems arising from (l) the present necessity of guessing
at earnings before the taxable year is closed, (2) of additional income
arising because of Bureau assessments, (3) small corporations, and (4)
losses, seem to be fairly satisfactorily adjustable. The present
notations deal simply with the problem of debt and capital impairment,
on which the whole structure and purpose of the law may be defeated.
It is suggested that for the following reasons exemption of earnings from the undistributed earnings tax in the case of debt-burdened
corporations and corporations with impaired capital should be approached
most cautiously:
1. It should be appreciated that the payment of debt or the reduction of capital impairment through earnings operates to increase
the assets behind ownership shares .quite as much as if new funds were
subscribed by the owners.
a. Ho general case in equity can at the moment be made for
permitting the tax-free payment of debt, since in thousands of
instances the present owners have secured control of corporations,
or the ownership of corporation stock, at prices that discount the
capital position of the companies involved. If owners who have
held properties all through the depression are permitted to repair
their capital position free of the undistributed earnings tax,
other owners who have no claim on tax relief would secure it; and
the balance of equities involved is certainly not clear on this
score.
b.
payment of
tions, the
the lender

There seems no equitable ground for permitting the
debt in cases in which, through bankruptcy or negotiaindebtedness has been pared down. In such instances,
has already taken the rap.

c. An exemption of earnings for the purpose of debt repayment would result in injustice between corporations having a debt
and those that are unindebted. Owners of indebted corporations
would be allowed to increase capital from tax-free earnings;
owners of corporations unencumbered by debt would be penalized
for increasing capital from earnings. This would be at one with
an exemption from the personal income tax in order that the taxpayer
could reduce the mortgage on his house.

-2-

2. In addition to the foregoing points, exemption of earnings
because of capital impairment would, according to expert opinion
secured from the Bureau of Internal Revenue, seriously embarrass
the administration of the tax* It is pointed out that book values
would be unacceptable, and that the appraisal of assets by professional
appraising companies would harrass the Bureau. All of the capitaldetermination problems that are to be expected in an excess profits
tax would immediately arise.
3. The rapid upturn in business activity and in profits improves
the position of indebted corporations by peimitting them to strengthen
their current position through the issue of stock or bask borrowing.
If the payment of debt were permitted as a credit against adjusted
net income for the purposes of the undistributed earnings tax, a
premium would be placed on the improvement of the corporations1 position
through the retention of earnings rather than through resort to the
capital markets, which is contrary to the non-fiscal purposes of the
law.
Conclusion
In view of these considerations, it is believed that any alteration
of the law in regard to debt and capital impairment should be narrowly
restricted. Probably some liberalization of law or rulings is indicated
in cases in which bond indentures, other covenants, or state laws compel
the debt payments before dividends. Even so, an optional tax in lieu
of the undistributed earnings tax should be provided for such an increase of owners* assets through earnings. Probably arrearages of
interest could properly be freed from the tax.