Invested Capital from a Legal Standpoint as Applied to Excess and War Profits Taxation*

BY KEENE H. ADDINGTON

I dared to select this subject because it is vital, because it is alive, because it seems to afford the opportunity for a lawyer at least to supplement to some extent the vast amount of accounting knowledge which flows into the final reservoir.

I am going to speak almost wholly on the 1918 law. Of course I cannot say for the 1917 law, what I say in very truth of the 1918 law, that in many respects the 1918 law is one of the greatest laws ever placed upon our statute books. In draftsmanship it is masterly, and I have no sympathy with the man who hides his ignorance with the statement that he cannot understand its terms. It is a great law from other standpoints. From the standpoint of its great flexibility to meet the vast and varied questions which arise under it and go to questions of justice and equality in taxation, it is a great law. As this law is developed principally in your hands and partly in the hands of my profession, I think many of the objections to it will disappear, because in my experience I have yet to see an aggravated case which tended to an unjust and unequal tax, for which this law did not provide, if you were ingenious enough and diligent enough, substantial although perhaps not complete relief. I have been before the department in many cases, and it has been a sort of an obsession with me not to get into the courts. I have not one single case that is going to the courts that the department has not asked me to take there in order to settle some difficult and doubtful legal question.

This law is a great law from another point of view. It is great from the standpoint of the constructive opportunity which it affords to your profession and to mine-constructive opportunity in the organization of new enterprises, creating them on sound bases with the utmost of economy in taxation.

I say without any extravagance of praise that I think, when you measure the entire administration of both the 1917 and the

Taken from an address delivered at the regional meeting of the American Institute of Accountants, Chicago, November 19, 1920.

1918 laws by the officers at Washington, you will find that we have had an administration there that is quite as wise, quite as broad, quite as intelligent, quite as enlightened and quite as liberal as the law's opportunities will afford.

While I will not say the regulations (which represent the treasury department's interpretation of these laws) are a sacred book, they are at least a work which should command our highest respect. In the main they are sound. They have many errors, like all things human. They have many inadequacies and incompletenesses, like all things which are done by human minds; but in the main those regulations represent genius in constructive effort and are, I think, 95 per cent, the work of your profession rather than of mine. We started a little later than you did. We are pouring our thought only gradually into the development of this law, but I think we are beginning to diffuse new ideas upon the general principles which are now represented by the administration of these laws.

I am going to start tonight with one of the great pivotal sections of the law which relates to the ascertainment of invested capital: section 331 of the 1918 law.

This section, of course, must be construed with section 326, the great section definitive of invested capital; but that section, as you know, directs the manner of the ascertainment of the invested capital of a consolidated company-that is to say, one company organized in 1901, another in 1902, a third in 1903 and a fourth, which absorbed the first three, in 1904. The date to which you go for the purpose of ascertaining the values of your assets and of determining your invested capital is the 1904 date. You practically ignore the other three dates. That is settled. There is no question about that, as you all know.

But assume a corporation that reorganized in 1904, absorbing three previously existing units; assume that the spirit of conservatism prevailed intensely among the organizers of that 1904 corporation. They did the thing which created the right to revalue, but they did not have the power to draw aside the veil that hid the future and know what 1917 would bring in the way of laws, and therefore they did not revalue. I give you this question-it is unsettled today: May such a corporation now revalue and get the value of those assets as of 1904, predicating that re

valuation upon facts and conditions known to exist in 1904, and taking that revaluation in conjunction with what was the fact, that the officers of that corporation knew at the time they consolidated in 1904 that those assets were worth more than the sum of the stock which they issued against them?

Am I talking radicalism? Am I not suggesting a proposition of paid-in surplus upon a present day valuation as of that date, which is sound both under the law and the regulation? That question has not been decided. It is a question I expect to argue before another spring comes upon us.

Now suggesting another proposition which is the reverse, in a way we have three similar corporations; we have a similar consolidation; but we have not in this other consolidation of which I am now speaking the same spirit of conservatism. The directors of that company, when they issued the stock against the three original underlying companies' properties, went to the extreme limit in the matter of valuation; they poured all they could into their appraisement, which was the predicate of the stock issue, and did that both as to tangibles and intangibles. The directors, as you know, always value properties when they issue stock against them.

We find the department looking through the stock to determine whether it was fully paid or not. We find possibly-not probably in the field an examiner at work in an effort to reduce those values to smaller sums. Your records are in poor shape. Your means of proof are difficult. Is there another answer?

I frankly say there are two sides to the proposition. But, is not the resolution of the board of directors, which fixed that value, binding and conclusive upon the treasury department? How can it possibly be? someone may say. I answer you that where the courts of this country have had to do with such resolutions and such valuations in cases brought by creditors to enforce stock liability, the uniform holding has been that if the valuation has been made in good faith, if it has not been fraudulent, if the valuation has not been grossly and excessively made with knowledge of the excess, it is binding upon the courts and the stock issue is held to be fully paid and non-assessable. That is held in cases in which the litigant is a creditor, a wage claimer. Such litigants are favored in law. The construction is always

liberal in their favor and against the stockholder defending. Why, all the more, might not the same principle apply in a case in which the government is enforcing a tax law, when the construction of the law must be strict against the government, liberal in favor of the taxpayer, and all doubts must be resolved against the government and in favor of the taxpayer?

Thus far I have spoken of section 331 with the idea in mind, although what I have said may apply as well to the second subdivision of 331, that we have to draw a line through the center of the section, because you know there is a date there, March 3, 1917, and in order for your invested capital to be different from that of the underlying companies, if the reorganization has taken place after March 3, 1917, there must be a 50 per cent change of ownership.

Assume your same three companies, one organized in 1901, one in 1902 and one in 1903, each of them having a small invested capital, at least very much below the present day values; each of them of equal size; all of them susceptible of being joined together in one harmonious whole. Now, what can you do? Consolidate them and then revalue all their assets. A simple proposition effecting, not only the economies which flow from consolidation, but a vast economy in the matter of taxation.

Now-along the same lines, a matter of finance-assume a corporation which has a large bonded debt and some floating indebtedness. It is pretty wise financial policy to refund that debt. The invested capital of this company is small, and its tax is large, for its profits are large. Transform that bonded debt and that floating indebtedness into a preferred stock issue and sell enough additional stock, if it is necessary, so that the preferred stock issue represents more than 50 per cent of the whole. Now you have your 50 per cent change of ownership. Now you have your reorganization and now you have created the right, under section 331, to get an up-to-date valuation of your assets and your invested capital is repaired.

I am going to pass section 331 and I am proceeding warily and cautiously, because I am a lawyer and you are accountants, to talk on the question of consolidated invested capital-that is to say, the invested capital of a group of corporations required to consolidate under section 240, which have not been merged in a

single corporation so as to come within the provisions of section 331.

Of course, we must ascertain our invested capital according to the different regulations governing that matter. In order to ascertain the consolidated invested capital of such a group you go to the regulations, principally regulations 864 to 868 both inclusive.

Regulation 864 I believe you will grant is at once the most complicated, the most difficult and the most important single regulation in the book. It is a wonderful regulation; and I want to say that I do not doubt for a moment that it represents sound accounting. Practical experience has shown me that the application of article 864 and the succeeding regulations in at least nineteen cases out of twenty reaches the same result that is reached by the method of ascertaining invested capital which I say is the legal way, the sound accounting method to the contrary notwithstanding.

I want to cite a few illustrations to show you some strange results that take place in following that regulation in ascertaining consolidated invested capital.

Under the regulations, article 860, an operating deficit is none the less invested capital. Money which has been lost was originally paid in and is still invested capital, but a company with an operating deficit, the moment it consolidates with a company having an earned surplus at least as much as the operating deficit. loses its invested capital represented by that operating deficit.

Let us see now what can be done. I am a minority stockholder in the corporation which loses that invested capital, and I do not think it is quite fair to require, because of that consolida tion, an increase in my tax, and I complain. I think I have a right to complain, a substantial legal right. But someone may assert that section 240 says these two corporations can apportion the tax among themselves, and it may be that by apportioning the tax my complaint is removed. All right. Let us grant it. The moment you do that you are increasing the tax of the other corporation, and some other Mr. Minority-man steps up with the right of complaint.

From an accounting standpoint you must have held up your hands in holy horror when the treasury department said that an