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Form?. R. 131 BOARD OF GOVERNORS or THC F E D E R A L RESERVE SYSTEM Office C o r r e s p o n d e n c e To Hr# Krost Fraitt George Jaszi Date March i9ig Subject: Amendments to the Excess ^ J^ P r o f i t s Tax of 19lu0 A b i l l amending the Excess P r o f i t s Tax of 19U0, with the o f f i c i a l t i t l e of the Excess P r o f i t s Tax Amendments of 191+1, passed the House of Representatives on February 25 without opposition and with l i t t l e pertinent discussion. Only one amendment, having the approval of the Ways and Means Committee, was o f f e r e d , and accepted. The Senate Finance Committee took the B i l l under consideration and reported i t to the Senate on February 27* The pending l e g i s l a t i o n w i l l apply to the computation of excess p r o f i t s tax l i a b i l i t y on 19^0 incomes; but tax returns w i l l have t o be f i l e d without regard to i t s provisions and petitions f o r adjustment made later* The b i l l i s based upon the recommendations of the Treasury and of the Staff of the Joint Committee on Internal Revenue who have been studying the hardship cases that might arise under the Excess P r o f i t s Tax: of I9I4-O. I t i s a tax r e l i e f measure designed to remedy what are thought to be discriminations a f f e c t i n g mainly growing corporations and corporations with fluctuating incomes. In the f i e l d of taxation, a discrimination arises when Corporat i o n A i s substantially similar to Corporation B in net income and other respects and yet pays a higher tax than Corporation B. Such a discrimina- t i o n may be removed either by increasing the tax on Corporation B or by reducing the tax on Corporation A,* The current b i l l removes discrimina- tions by lightening the burden on corporations against whom the I9I4.O Law discriminates, rather than by imposing a heavier burden on those whom i t -2- favors. The resulting loss of revenue w i l l make the task of financing the defense program more d i f f i c u l t . Press reports of prospective revenue loss, although somewhat ambiguous, mention a sum of $100,000,000 f o r the year in which the provisions of the B i l l take f u l l e f f e c t . Because of the un- limited two-year excess p r o f i t s credit carryover, the f i r s t year in which the current changes w i l l have t h e i r f u l l e f f e c t upon accruals of tax l i a b i l i t y w i l l be 1$L\2 and the year in which they w i l l have t h e i r f u l l e f f e c t upon collections w i l l be I9I4.3. The figure of $100,000,000 should be related to a t o t a l y i e l d estimate f o r the unamended b i l l of more than $800,000,000 f o r that year. I t was emphasized in the House of Representatives that the B i l l covered only hardship cases that had so f a r come to l i g h t , and that further amendments to the Excess P r o f i t s Tax could be expected. No mention was made, however, of amendments designed to tighten up the Excess P r o f i t s Tax either by increasing rates of taxation applicable to excess p r o f i t s , or by reducing the "normal" base from which excessive p r o f i t s are measured. The base might be reduced by limiting the use of the average earnings base to an amount representing a reasonable rate of return on current capital and by modifying the present method of including; part of borrowed funds in invested c a p i t a l . Under present procedure high rates of return on equity capital escape the Excess P r o f i t s tax i f the r a t i o of borrowed to equity capital i s high. The b i l l extends the excess p r o f i t s credit carryover provisions of the 191+0 Law by providing that a l l corporations who have less than normal earnings in a given year may apply the s h o r t f a l l as a deduction from t h e i r earnings in the two succeeding years. I t establishes an addi- tional option f o r taxpayers electing the average earnings method of determining normal earnings, providing a method of computation that takes account of the f a c t that average base period earnings may not be a proper yardstick f o r the measurement of current normal earnings in the case of growing corporations. I t broadens and strengthens the clauses of the 19l|0 Law that allow adjustment of abnormal items a f f e c t i n g base period or current earnings when such items increase tax l i a b i l i t i e s . I t com- p l e t e l y rewrites the section of the 19^0 Law under which r e l i e f could be obtained in unforeseeable cases of inequity not covered by the s p e c i f i c r e l i e f provisions. This section was deemed to be too broad to be e f f e c t i v e . 'The new B i l l allows corporations, the nature .of whose business has changed during the base period, or whose operations were disturbed by abnormal events, to establish f o r purposes of computing normal earnings a hypothetical figure of base period earnings as they would have been in the absence of business changes or abnormal events. I t sets f o r t h conditions under which corporations may capitalize certain advertising and goodwill expenses charged to income during the base period, thus increasing their normal earnings whether based on past earnings or on invested c a p i t a l . In addition, i t deals with a number of minor matters mentioned i n the more detailed description that f o l l o w s . 1. Extension of Unused Excess P r o f i t s Credit Carryover The ISij-O Act provides that corporations having less than normal earnings in a year subject to the Excess P r o f i t s Tax shall deduct the s h o r t f a l l from t h e i r earnings in the succeeding year, provided that their net income as computed f o r corporation income tax i n that year i s not more than |25,C00. Section 2 of the present b i l l extends the carryover provi- sion to two years, and to a l l corporations irrespective of income, This w i l l benefit growing corporations and corporations with fluctuating i n comes. 2, Modification in Method of Computing Normal Earnings with Reference to Past Earnings Under the 19^0 Act corporations who e l e c t to determine t h e i r normal earnings on the basis of their earning experience during the base period 1936-1939* ®ust base t h e i r calculations on the average experience during the whole base period. This discriminates against growing corpora- tions, because their past earning experience, especially in the e a r l i e r base years, may be an inappropriate yardstick f o r what constitutes normal p r o f i t s to them currently. Section Ij. of the present b i l l provides f o r an optional calculation of base period earnings which makes them equal to average annual earnings i n the second half of the base period plus 50 per cent of the d i f f e r e n c e between average yearly earnings in the f i r s t and second half. The earnings so computed cannot, however, exceed the highest base year earnings. Provision i s also made, in the case of corporations whose base period extends beyond the f i r s t of June 19l±0, that high earnings due to the National Defense Program shall not influence the determination of what constitutes normal earnings. As amended in the House (Section 1 3 ) the b i l l allows corporations who underwent certain corporate reorganizations to determine normal earnings under t h i s new clause rather than under the special procedure established for such corporations in the 1914-0 Law, 3. Adjustments in Income and Capital a. Treatment of Abnormal Deductions i n Base Period and Abnormal Income in Current Years The 19k0 Act provides that in the calculation of base period earnings certain s p e c i f i c types of deductions shall be disallowed, and in the calculation of the earnings of the year subject to Excess P r o f i t s Tax certain s p e c i f i c types of income shall be re-allocated to previous or future years provided that they are of a type which i s not normal to the taxpayer 1 s business or that they are grossly disproportionate in amount. Both these measures serve to diminish tax l i a b i l i t y , the one increasing normal earnings from which excessive p r o f i t s are measured, and the other by diminishing actual current earnings. The present b i l l ( i n sections 3 and 5) provides f o r the extension of this treatment to a l l types of deduct i o n and income under rules established by the Commissioner of Internal Hevenue. I t provides a quantitative test of what constitutes gross d i s - proportionality and i t establishes other conditions under which the benef i t s of this section may be claimed. b. Calculation of Hypothetical Base Period Earnings of Certain Corporations The I9I4.O Act, in section 722, gave broad powers to the Commissioner of Internal Revenue "to make such adjustments as may be necessary to adjust abnormalities a f f e c t i n g income or capital"• too broad to be e f f e c t i v e . This provision was considered Section 6 of the B i l l rewrites Section 722 so as to confine i t to adjustments i n the base period earnings of taxpayers -6- whose f i r s t taxable year begins in 19^0 and who choose to determine normal earnings on the basis of past earning experience rather than invested capital. In order to claim benefit under t h i s section, the taxpayer must establish that the character of his business has changed, or that normal operations were interrupted or diminished because of the occurrence of abnormal events, in one or more years of the base period. A difference in the products or services furnished, in productive capacity, in the r a t i o of borrowed to t o t a l capital, existence during part only of the base period, and acquisition of assets of a competitor which limited or eliminated competition constitute a change in the character of the business; the impact of the business cycle does not constitute an abnormal event within the meaning of the B i l l . Fires, floods, arid strikes would presumably do so. A taxpayer who can establish any of these conditions may estimate base period earnings as they would have been in t h e i r absence and determine his normal earnings with reference to this hypothetical f i g u r e . Restrictions are placed on the applications that can be made under this section and the amount of tax r e l i e f that can be claimed, ibtxfcsxy*^ Section 9 regulates the review by the Board of Tax Appeals of the decisions of the Commissioner of Internal Revenue under the abnormality provisions just reviewed. The decision of the Board of Tax Appeals i s f i n a l in the case of any question arising s o l e l y from the abnormality provisions of the B i l l , c. Capitalization of Advertising and Goodv/ill Expenditures Section 10 of the B i l l specifies conditions under which a tax- payer may c a p i t a l i z e advertising and goodwill expenses charged to income during the base period. He must pay normal corporation income taxes with accrued interest on these expenses. This e l e c t i o n increases normal earn- ings whether they are based on past earnings or on invested c a p i t a l . d. Reopening of Income Tax Returns Closed by the Operation of Some Provision of the Law Section 11 prescribes conditions under which income tax returns that are closed by the operation of some provision of the law, such as the statute of limitations, may be re-opened, and back taxes or refunds paid in cases where an item or transaction in Excess P r o f i t s Tax return i s treated in a manner inconsistent with i t s treatment i n the closed return. I4.. Other Provisions of the B i l l The B i l l (Section 7) allows corporations that have insurance company a f f i l i a t e s (other than l i f e or mutual insurance) to include such a f f i l i a t e s in a consolidated return; i t permits corporations growing from partnerships or sole proprietorships in tax f r e e exchanges to use the earning experience of those partnerships or proprietorships in the computation of base period earnings (Section 8 ) ; and i t provides f o r the special t r e a t ment of corporate stock and dividends when such stock i s held by dealers of securities f o r sale to the public (Section 12).
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