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operating deficit or invested capital money lost still counted as though in the business, so you cannot always reconcile sound accounting and invested capital. Invested capital was a thing brought into the world by this statute without heritage, and I think most people hope it will have no posterity. But at least it is an artificial thing, and congress has not said that invested capital shall be ascertained according to the principles of sound accounting. It has written certain hard and fast rules and it is a question how much they violate your principles, because you must admit that those hard and fast rules in section 326, in their application, at least, do at times violate the very soundest and most hallowed principles of accounting. It is a question of degree.
Assume, for instance, that I am a minority stock-holder in a corporation with an operating deficit, and the majority stockholders, more than 95 per cent, want to sell. There are two purchasers in the field, Mr. Gore here who is in accounting practice and whose business is not a corporation. He would not have to consolidate if he bought. But Mr. Reckitt here, who we will assume is in some other corporation, having a 95 per cent interest in that corporation is also a potential buyer. The moment Mr. Reckitt buys that company he is confronted, and he knows he is confronted, with the obligation to consolidate. Mr. Gore knows that he can buy and not have to consolidate. Mr. Reckitt knows if he buys he is going to lose some invested capital, and that the property is going to carry a higher rate of tax in consequence of the loss of invested capital. He is therefore going to suffer. Mr. Gore knows he is going to lose no invested capital. Therefore the corporation of Mr. Reckitt can afford to offer more for the business, as his taxes will be less. You see this regulation by adhering to accounting principles does a collateral harm-it affects the market value of stock.
I say that this regulation, wonderful in its conception, magnificent in its intricacy, which works out beautifully in most cases, has in its essence certain unsound principles which ought to be eradicated. You might think that this is an unusual case. I assure you it is not.
A gentleman came up here from Cincinnati this morning and brought this very case into my office this morning, although I have had a similar situation before in another case. Unfortu
nately, some of these propositions I am not permitted to argue at Washington because other propositions are granted by the department, I get what I consider a fair tax and then quit. I am not in sympathy at all with any effort to reduce a tax to the very least sum. I feel that a prosperous corporation should pay large taxes, and that has been the spirit of my clients. Therefore when I reach a point where I think the tax is just, I stop, even though from a professional standpoint I may want to go on and argue other questions.
Perhaps you want me to tell you how I would ascertain invested capital? Ascertain the invested capital of my several units and add that together; and even though the principles of sound accounting are not observed by that simple process, I assert the principles of sound law are maintained.
Now what is the practical value of a proposition of this kind ? When you have such a case, if I may venture the suggestion, try my method and see if you have lost any invested capital as compared with the effect of consolidating according to sound accounting principles. If you find you have, maybe you have got a point that is worth using.
In other words, where the principles of sound accounting and sound law do not coincide, I assert that the principles of sound accounting must yield. Congress was a very determined parent. Congress made up its mind that the commissioner had to enter into a matrimonial alliance with somebody, and so it took Mr. Commissioner and Miss Law by the hand and led them to the altar, and the commissioner is married to sound law and has no right to flirt with Miss Accounting no matter how winsome her charms or radiant her beauty.
Before I leave that point I want to show you a single expression of congress which rather supports my view that congress meant that the simple layman-like method of adding these several units together is the way to compute consolidated invested capital. You will find it in section 240, which determines when there must be a consolidation of returns. Incidentally, there is an expression there with respect to consolidated invested capital, and in regulation 864 the commissioner does not mention it. This section provides that in the event of the consolidation of certain corporations, and if it is found in the examination of the return that
one of them a corporation organized after August 1, 1914, has derived more than 50 per cent of its income from gains, profits, commissions and so on, made on war contracts, in such case the corporation so organized which has made such profits shall be taken out and assessed on the basis of its own invested capital and net income, and the remainder of the affiliated group shall be assessed on the basis of the remaining consolidated invested capital and net income.
In other words, this section first provides something that is to come in, then something that is to go out and then that there is to be a remainder. Do you assume for a moment that congress thought one sum would go in and another sum would go out and a different sum would be left? I do not think so for a moment. I think that there is a clear although incidental expression by congress to the effect that you must determine the invested capital of each company and add these amounts together, and that that shall be your consolidated invested capital according to law, whatever it may be according to sound accounting.
I am going to pass section 330 and discuss for a moment with you an important point with regard to tangibles and intangibles.
The question of what is a tangible and what is an intangible of course is important when you have a proposition of wiping out the excess of intangibles over 25 per cent under the 1918 law and 20 per cent under the 1917 law; and the more tangibles you can sustain as being in your capital stock issue, the better you are off. Likewise, this question becomes important under the present rulings of the department with regard to paid-in surplus. Under the present rulings paid-in or earned surplus may not be predicated upon intangibles. I do not think that is correct, although it is the present ruling, and I understand that there may be handed down shortly a decision to the contrary effect.
I have had occasion to go into this question fully and have found an interesting situation in the law as laid down by the supreme court of the United States in various cases. When you sum up the result of all those cases, you find practically that, before section 325 was enacted, tangible property consisted principally of physical assets. Everything else was intangible. Yet the supreme court of the United States in one case said that when you combine various properties into one company, you thereby
create a new asset, intangible in character, but perhaps worth more than all the properties standing alone before the consolidation. However, the definition of "intangible” before section 325 was very narrow. Congress saw that it was too narrow a definition, and I believe meant to give us a broad definition and defined the term "intangible property" as patents, copyrights and so forth and so on. In 1917 patents were tangibles, and curious questions arose as the result. Questions of paid-in surplus and all sorts of questions came up and the incongruous situation exists that the commissioner has to administer patents as tangibles for 1917 and intangibles for 1918. Today we have the following definition:
"The term 'intangible property' means patents, copyrights, secret processes and formulæ, goodwill, trade-marks, tradebrands, franchises, and other like property."
“The term 'tangible property' means stocks, bonds, notes and other evidences of indebtednesses, bills and accounts receivable, leaseholds and other property other than intangible property.”
I simply mention this point because it took one of my assistants a month to go through all the cases and to get down to the proposition of what was a tangible and what was an intangible. The conclusion from that investigation is that practically everything except those things specifically named in section 325 as intangibles are in reality tangibles.
I pass now to the last section I shall discuss, namely, 326, which is the great yard-measure for the determination of invested capital.
Again I want to suggest a question which affords an idea of some of the vast number of constructive opportunities afforded by this law. We all know that before a corporation is organized it frequently happens that the incorporators do much work, and by that work produce things of value. In the old days we would capitalize freely the result of that work and the assets acquired. We are not, however, quite so free to do that now because of the danger of imposing a personal income tax on the incorporators. And if we do not capitalize such assets we know at the same time we are losing what would be valuable for that new corporation in the way of invested capital.
Now, how can you secure the invested capital and not the personal income tax? The answer is simple in most cases. You
can organize your corporation and have your incorporators pay for their stock in cash, or in such manner as may be provided, and then, preserving to these incorporators what they have done as individuals, have them transmit it to the organization as a gift, thus creating a paid-in surplus, non-taxable as personal income. 1 simply throw that out as a suggestion.
It frequently happens that field examiners go out and find some poor, old corporation, organized in the days before the flood, whose invested capital, because of the accident of time or form of organization is low enough. Then they start in and apply rates of depreciation to the assets which were turned in at the time of the incorporation and, when they are through, what has the poor corporation left?
Section 326 does not say a word about the right of the department to reduce the value of an asset which has originally been paid in as payment for stock—not one single word, and the department recognizes that it does not say so. It recognizes also that it has no right under section 326 to make any deduction. The reason for holding that an operating deficit is still invested capital is that very reason, as I understand it. In other words, there is no provision that in the event of a loss of original and invested capital, the amount of the loss can be deducted.
I am a great friend of the excess-profits tax law. I am sorry we have to have so much money, but if we must have it I do not know any better way of raising it than this way; and I think that law will become more popular as it is better understood and better applied. The great harm that is being done in this country by taxation does not come so much from the excess-profits tax which, as I have observed it, corporations have been able to pay and still go on in prosperous ways, but it arises more from the large surtaxes, because they reduce the initiative of men of means who usually are men of brains, who frequently are our captains of industry. When such men realize that if they make a profit it is largely to be taken from them and turned in to the government, they hesitate to chance their capital upon an enterprise in part speculative.
It seems to me from what I have heard in Washington that the tendency is—and certainly it would seem to be sound economics—to have the excess-profits tax stand and the income tax