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This section is similar to sections appearing in all the revenue acts from 1918 to 1932, inclusive. Its avowed purpose was to "stimulate prospecting and exploration" with respect to mines, oil or gas properties (S. Rept. 617 - 65th Congress, 3rd Session, page 6). In 1933, the Ways and Means Subcommittee on Prevention of Tax Avoidance stated in its report that this provision was apparently inserted in the law "as a subsidy to encourage the development of new mines and oil wells." The Subcommittee went on to say that in the present state of over-production there is no need to continue the subsidy, and recommended the elimination of the entire section (p. 16). Accordingly, the section was omitted from the Revenue Acts of 1934 and 1935.

As originally proposed, the Revenue Bill of 1936 (H. R. 12395) contained no provision for preferential treatment of income from the sales of oil or gas properties. However, the Senate Finance Committee, in reporting the bill, inserted a provision which, in effect, reenacted the provisions found in the revenue acts prior to 1934. This section became Section 105 of the Revenue Act of 1936 above quoted. The reason for the reenactment of this provision is found in Report No. 2156, 74th Congress, 2nd Session (page 18), as follows:

"It was brought to the attention of the committee that the effect of the omission in the 1934 Act of a similar provision was, in many cases, to prevent the sale of such properties and thus a tax loss has resulted, and individuals have been discouraged from embarking upon or continuing such enterprises. The result was to throw the business into the hands of corporations which, being subject only to the corporation-tax rate, would pay less tax than individuals would. It is believed that the result of the proposed change will be to stimulate individuals to develop oil and gas properties and to sell, thus increasing the tax yield from this source."

In this connection, it should be pointed out that while it may be deemed desirable to accord special treatment in order to develop oil property at such times as is in the national interest, it is not believed that such a condition exists at the present time and that nothing short of a war or other national emergency, would merit special consideration to be given to these types of assets. Even in such instances, it would seem more desirable to grant them outright subsidies rather than to manipulate and create artificial tax bases for the accomplishment of the same end.

With respect to the argument that the oil and gas business would, but for the provisions of this section, be driven into the hands of corporations, it is no more convincing than any similar argument that could be made by the holders of any other type of saleable asset. The same disparity in the treatment of income from the sale of assets held by individuals as against corporations exists for any type of asset. There seems to be no case for the continuation of preferential treatment of income from sales of oil and gas properties at the present time. Accordingly, the repeal of Section 105 of the Revenue Act of 1936 is recommended.

7. Taxation Of (Personal) Holding Companies

It is proposed that the existing personal holding company provisions be repealed and that the undistributed net income (as defined in Section 14) of all corporations that derive 80 percent or more of their gross income from rents, royalties, interest, dividends, interest in a trust, gains from sale of commodity futures and gains from sale of securities, etc., be taxed on the basis of the number of individuals owning 50 percent or more of the capital stock of such corporations. Banks, insurance companies, and corporations now exempt from the income tax should be exempt from the proposed tax.

It should be pointed out that the income items to be included for the purpose of determining whether a corporation comes within the scope of the proposed tax can be made identical with those now included in personal holding company income as defined in the Revenue Act of 1937. Further, all the safeguards there employed with respect to determining the percentage of income derived from the specified sources and with respect to the definition of an individual would need to be transplanted to the proposal. It does not appear to be necessary to enter upon these details here but they are of paramount importance.

Section 102, imposing a surtax on corporations improperly accumulating surplus, had been on the statute books since 1913, but has not proven a fully effectual means of stopping tax avoidance. Recognition of this fact was taken by the Subcommittee on Tax Avoidance in 1933 with particular reference to personal holding companies, as a result of which a special tax was imposed on personal holding companies. This became Section 351 of the law. Although it succeeded in a measure to overcome the use of this device for tax avoidance, there remained therein two major defects.

First, a highly complicated and artificial tax base was devised there, which served only to nullify the effectiveness of the provisions relating to the personal holding companies. This point is so well known from data developed elsewhere, especially in connection with the passage of the Revenue Act of 1937, that it can serve no useful purpose here to dwell upon it. The provisions with respect to the personal holding company in the Revenue Act of 1937 were primarily directed at the loopholes that resulted from the defective tax base employed under the Revenue Acts of 1934-36.

The tax base in this proposal ties to the tax base employed for purposes of the undistributed profits tax, a base which every corporation subject to the special tax here proposed will already have established for the purpose of determining its tax liability under Section 14. This is the logical basis for the special tax here proposed since the objective of the special tax is identical with the objective of the surtax on undistributed profits, namely, to stop the avoidance of the high individual surtax rates through corporation retention of earnings. The surtax under Section 14 strikes at the average situation. Corporations owned by a few wealthy individuals could still avoid some of the high individual surtax rates unless some additional tax were to be imposed. That is the purpose of the present personal holding company provisions and that also is the purpose of the proposal -- it is to implement Section 14 in cases where the ownership of corporations is highly concentrated. For this reason, the bases for the two taxes should be identical.

Secondly, and more fundamentally, the personal holding company provisions of the Revenue Act of 1937, like Section 351, suffer from an overly precise definition of the term "personal holding company." It invites the potential taxpayers to crawl beyond the sharp line of demarcation between personal holding companies and others and thus to escape the surtax imposed. It is not possible to cure this second difficulty completely but the proposal would overcome most of it.

Recommended rates for the proposed tax are as follows:


If 50 percent of the value of the
capital stock outstanding at any             Rate on undistributed
time during the last half of the             net income as defined
taxable year is owned directly or            in Section 14:
indirectly by or for:

     1 to  5 individuals                               70%
     6 to 10      "                                    60
    11 to 20      "                                    50
    21 to 30      "                                    40
    31 to 40      "                                    30
    41 to 50      "                                    20
    51 and more   "                                    10

The treatment of the personal holding company problem proposed above is based on the assumption that it would prove to be too difficult to treat such companies in the manner of the British and Canadian income tax laws. Otherwise, it would be simpler to treat these companies as partnerships. By adopting this procedure the British and Canadians have not only solved the problem of the domestic personal holding company but have prevented income tax avoidance by transfers of property to foreign personal holding companies.

The Canadian law, beginning with the taxable year 1925, distinguishes "personal corporations" from others. Personal corporations are those (a) that derive one quarter or more of their gross revenue from one or more of the following sources:

(1) From the ownership of or the trading or dealing in bonds, stocks, etc.;

(2) From the lending of money with or without security or by way of rent, annuity, royalty, interest or dividends; or

(3) From title or interest in or to any estate or trust;

and (b) that are controlled directly or indirectly (by ownership of stock or in any other manner) by one individual (or family) who resides in Canada. It is of no moment where such corporations are created, where they do business, or where their assets are situated.

In general, such personal corporations are not themselves taxable in Canada. Their income, whether distributed or not, is deemed to be distributed on the last day of each year as a dividend to the shareholders and the shareholders are taxable each year as if the income of the personal corporation had been distributed. The personal corporation is required to pay the corporation income tax rate on only that portion of its income which is deemed to be distributed to nonresidents.

It is clear, therefore, that a resident of Canada cannot avoid taxes through the use of a domestic personal company or by transferring assets abroad to a foreign personal corporation. Even if such corporation does not distribute its income, the resident of Canada will be liable each year for the income tax on his pro rata share of the undistributed profits in the same way as if such profits had been distributed in dividends. Except for the portion of income allocable to nonresidents, the Canadian law fixes the liability for the income of the personal company (whether organized in Canada or abroad) directly on the individual or individuals (resident in Canada) that control the company. The Canadian problem would appear to be one primarily of administration. The individuals that fail to report their pro rata share in such income become criminally liable but the administrators must ferret out those that prefer to run the gauntlet of the law to paying high income taxes.

Under British law private companies may also become liable to tax on their distributive share but the British appear to have experienced some difficulty in fixing the tax liability onto the individual in instances where the income is not distributed by private companies. Thus, under Section 21 of the Finance Act of 1922 (as amended by Sections 31 and 32 of the Finance Act of 1927 and again by Sections 19 and 20 of the Finance Act of 1936) if companies under the control of five persons or less fail to distribute a reasonable portion of their annual income (as adjudged by the Special Commissioners in charge of administering this section) the income of the company at the direction of the Special Commissioners may be deemed to be the income of the members, and the individuals are assessed on their pro rata share at the top rates applicable to them in the name of the company. If they do not elect to pay the tax, then after twenty-eight days the company must pay but if the company does not pay within three months from service of the notice of the charge, then by Section 19 (5) of the Finance Act of 1936, the Revenue is given the right to recover it from the individual members. It remains to be seen whether much litigation will develop from these and the other provisions of the Finance Act of 1936 which attempt to stop up tax avoidance schemes by cutting through the corporate veil.

The British in Section 18 of the Finance Act of 1936 plugged the foreign personal company loophole for income tax avoidance. If an individual, ordinarily resident in the United Kingdom, transfers assets to nonresidents or persons not domiciled in the United Kingdom so that the income is payable to them while he nevertheless retains such control that some time it may inure in some way for his benefit, then the income is deemed to be his income for all the purposes of the income tax unless he can satisfy the Special Commissioners (who are given broad powers in administering this section) that the transfer and any associated operations were effected mainly for some purpose other than the purpose of avoiding liability to taxation. These provisions were made retroactive. They applied in relation to transfers of assets whether carried out before or after this enactment. Presumably to soften the blow on those that had acquired a vested interest in this tax avoidance practice, the standard rate was not to be charged the first year, 1935-36, on income from assets transferred abroad. Only the surtax rate was charged the first year. In subsequent years both the standard and surtax rates will be charged.

In the income tax law of the United States the taxation of shareholders on their pro rata shares of a corporate entity has always been optional. The individual's choice has been either to shoulder a pro rata share of the rates imposed on the corporate entity or to shoulder the individual income tax rates applicable to the undistributed income deemed to have been received by him. Under the Revenue Act of 1934, however, for purposes of determining whether certain percentages of outstanding stock are owned directly or indirectly by an individual, constructive ownership was taken into account. The principle of constructive ownership was broadened extensively under the Revenue Act of 1937. In addition, under this act, the income of foreign personal holding companies is treated as the income of the shareholders within the jurisdiction of the United States and such shareholders are required to report as their income the undistributed net income of foreign personal holding companies.

There is room for doubt whether the treatment of domestic personal holding companies as partnerships would not encounter insurmountable difficulties unless simultaneously additional discretionary powers were granted the Commissioner or some other administrative body. The granting of such additional power is likely to meet with substantial resistance in this country because it runs counter to our past practice. For this reason, even if legal obstacles to the treatment of personal holding companies as partnerships could be surmounted, it may be better to enact the proposal for domestic holding companies and to restrict the application of the partnership concept to foreign personal holding companies.

8. Treatment Of Charitable And Other Contributions

It is proposed:

a. With respect to estates and trusts, to amend Section 162(a) so as to limit the deduction for charitable and other contributions to an amount which in the combined specified cases does not exceed 15 percent of the net income of the estate or trust as computed without the benefit of the deduction for charitable contributions.

b. With respect to partnerships to amend Section 23(o) so as to limit the deduction for charitable and other contributions to an amount which added to the individual's pro rata share in partnership deductions for charitable and other contributions does not exceed 15 percent of the taxpayer's net income, including his pro rata share in partnership income computed without the benefit of partnership deductions for charitable and other contributions.

c. With respect to individuals, to amend subsection (a), (o) and (q) of Section 23 so as to limit the contribution charges to expense under (a) and the deductions under (o) and (q) to the amounts actually paid out in the taxable year and receipted for by a charitable, etc., organization in the United States and so as to make the 15 percent limitation in (o) and the 5 percent limitation in (q) applicable to the combined charges for charitable and other contributions under subsection (a) and the deduction for such charitable and other contributions under (o) and (q).

d. To repeal Section 120.

a. Estates And Trusts

Prior to 1917 no deduction for charitable contributions was allowed for purposes of computing the net income of an estate. The Revenue Act of 1917 allowed a 15 percent deduction, which was increased to an unlimited amount under the Revenue Act of 1918 and has since been so continued.

This unlimited deduction for charitable and other contributions allowed for purposes of computing the net income of an estate or trust seems to be excessive and provides a substantial loophole for tax avoidance. Thus, a wealthy individual desiring to escape the 15 percent limitation on deductions for charitable contributions under Section 23(o) may create a trust for the incidental purpose of providing income for a beneficiary and the primary purpose of taking advantage of the unlimited deduction for charitable and other contributions allowed under Section 162(a). Also, by arrangement between the settler and the beneficiary, the settler can save the beneficiary substantial income tax liability by setting aside in the deed creating the trust an amount agreeable to the beneficiary for charitable purposes. Were the beneficiary to receive the entire income from the trust, he would be subject to the limitation under Section 23(o) when filing an individual income tax return. If, however, the entire income of the trust is split between the beneficiary per se and the several charitable, etc., organizations, then the beneficiary is favored by the unlimited deduction for charitable and other contributions allowed under Section 162(a).

The distinction between the two cases may be important from the legal viewpoint but appears to be altogether too formal for purposes of the income tax. The above considerations appear to be equally applicable in the case of an estate where part of the income is by the terms of the will allocated to the beneficiaries and part to the charitable and other contributions.

It is therefore proposed to limit the deduction allowed trusts and estates to 15 percent of their net income, computed without the benefit of this deduction. The chief argument against the proposed amendment is that the charitable organizations might suffer from a shrinkage of funds left to them pursuant to the terms of wills or deeds creating trusts. It cannot be denied that the proposed amendment would tend to diminish such charitable and other contributions but it can properly be doubted whether this would seriously embarrass the organizations since in substantial measure the beneficiary must choose between sharing his income with the Government or with the charities.

b. Partnerships

Previous to the Revenue Act of 1917, charitable contributions made by partnerships were not deductible. That Act, however, permitted a 15 percent deduction from net income for such purposes. Subsequently, under Section 218(d) of the Revenue Act of 1918, the deduction was disallowed, and it was not until 1934 that partnerships were again allowed a deduction for contributions made to charities.

Partnerships are at present allowed the deduction for charitable and other contributions not in excess of 15 percent of the net income computed without benefit of this deduction.

If the limitation under Section 23(o) is based on the net income of individuals including the income from partnerships, the deduction for charitable and other contributions is, in effect, not limited to 15 percent of the individual's net income before the deduction for such contributions. The limitation will be in excess of 15 percent of the individual's income from all sources, because on the income from partnership the deduction for charitable and other contributions will have been made twice, once in computing the income of the partnership and again when computing the income of the individual. This duplication of the deduction for charitable and other contributions should be avoided.

It is therefore recommended that the deduction allowed under Section 23(o) be limited to an amount which added to the individual's pro rata share in partnership deductions for charitable contributions does not exceed 15 percent of the taxpayer's net income, including in his pro rata share in such partnership income computed without the benefit of partnership deductions for charitable contributions.

An alternative procedure for the avoidance of the double deduction for charitable and other contributions would be to disallow the deduction in the case of partnerships. This procedure is not recommended because it probably would embarrass many of the charities by increasing their difficulties in obtaining contributions. For example, in the case of a partnership, it is much easier for the charity to obtain a collective contribution from a partnership than separately from the individual partners.

c. Individuals And Corporations

It should be pointed out that when charitable and other contributions are taken as a deduction from gross income, the individual in the high income bracket is given greater relief from the income tax than the individual in a low income bracket even though both individuals make equivalent contributions. Thus, if two individuals, one with surtax net income of $10,000 and the other with surtax net income of $1,000,000, each make a contribution of $10,000, the first individual, in effect, donates $8,640 of his own and $1,360 of the Government's, whereas the second individual donates $2,300 of his own and $7,700 of the Government's funds for if they had not made the donation the tax applicable to the $10,000 would have been $1,360 and $7,700, respectively. Examined superficially, it would appear more equitable to make the tax value of a donation of equivalent amounts the same, irrespective of the economic status of the donor, by allowing a tax credit to individuals, corporations, estates and trusts for contributions made in lieu of allowing such contributions as a deduction from gross income. This does not seem to be a desirable procedure for the following reasons:

First, many of the private charities have been established and have operated for many years under the type of shelter which the income tax provisions for the deduction of charitable and other contributions have provided. It is true that the deduction for corporations dates only from 1936 and that the deduction for partnerships only from the Revenue Act of 1934, but the deduction in the case of individuals dates from the Revenue Act of 1917 and the unlimited deduction in the case of estates and trusts from the Revenue Act of 1918. It must, however, be recognized that at least in part some of the charities have been established because of these unduly liberal provisions and so may be said to possess a vested interest in them.

Second, it does not seem advisable to replace the present charitable deduction with a tax credit because such a procedure would be interpreted to imply a complete change in the Government's attitude towards the charities. Instead of the Government, in effect, giving a bounty to each individual making a charitable contribution without any restriction on the individual's choice among the charities, such limitations, drastically curtailing private donations, would leave the Government with the responsibility of determining the pattern and the scope of the nation's organization for charitable purposes. In other words, a measure of inequity with respect to the deduction for charitable contributions may be the price that has to be paid if the charities are to operate on a private and not a publicly subsidized basis.

In this connection, it should be pointed out that while the British do not allow contributions to charitable organizations to be deducted for purposes of the income tax, they do allow charitable, etc., organizations to claim rebates for the amount of the income tax paid at source on such contributions provided that the contribution is shown to be in the nature of an annual charge against the taxpayer's income. Further, such contributions are allowed to be deducted for purposes of the surtax. In other words, the chief difference between the British procedure and our own appears to be that whereas we limit the deduction for charitable and other contributions to a certain percentage of net income, the British do not make such limitations but do not allow casual contributions to affect the income tax.

As the law stands at present, the taxpayer can render the limitation placed upon the deduction for charitable contributions ineffective by charging such contributions in whole or in part as a business expense allowable under Section 23(a). It is proposed to make the limitation unequivocably applicable to all charitable contributions, irrespective of whether taken by the taxpayer under Section 23(a), (o) or (q).

Further, it would seem proper to restrict the deduction for charitable contributions to those made to a charity organized in the United States. Such charities may, of course, contribute funds to alleviate distress in foreign countries. It does not seem practicable to restrict the deduction to those contributions that are ultimately used for strictly domestic purposes, but if the deduction were restricted to contributions to institutions organized in the United States certain of the contributions that are now made purely for the alleviation of distress abroad or for other "causes" would no longer be allowed to affect the yield of our income tax. It may be desirable to give the Commissioner full power to determine whether the deductions claimed for charitable contributions are in accordance with the intent of the statute and to disallow the deductions made to institutions though organized in the United States which operate primarily as foreign charities.

Section 120 of the Revenue Act permits an unlimited deduction for charitable and other contributions in such instances where the amount of contributions for the taxable year and for the ten preceding years exceeds 90 percent of the taxpayer's net income for each of those years. Although this section dates back to 1924, it should be repealed not only because it is applicable only to few individuals but also because if it should be effective it would operate inequitably as between an individual who for each of ten years preceding the taxable year had a record of contributions which together with certain taxes amounted to more than 90 percent of his income and a taxpayer who had a similar record for only eight or nine years preceding the taxable year. Also, it does not seem fair to make special provision for taxpayers that pay out amounts which together with certain taxes are equal to more than 90 percent of their net income and not to make somewhat similar provision for taxpayers that pay out other very substantial percentages such as more than 80 percent, 70 percent, etc. To give effect to the variations in the different percentages paid out as well as to the number of years over which the taxpayer had maintained a record of unusually large contributions to charities, would not only require very complex legislation but would be incompatible with the main objective of the income tax law.

9. Pension Trusts

It is proposed to amend Section 165 so as to exempt from income taxation only those employees' trusts which are irrevocable, the benefits of which trusts apply at least to (1) all persons having been employed for five or more years and earning $5,000 or less per year, and (2) to 75 percent of the total number of employees earning $5,000 or less per year.

This provision would restrict the scope of tax-exempt employees' pension trusts to those which are irrevocable only, thereby insuring that all payments made into such trusts could not be returned to the employer at some future date. Such a provision would eliminate the loophole in the 1936 law whereby an employer may use the pension trust as a device to reduce his taxable income in one year and receive back this same income in a subsequent year when his tax on this income may be less. Moreover, the proposed limitation would restrict such pension trusts to those designed to benefit the rank and file of employees rather than a limited number of executives who, by virtue of receiving a large part of their compensation through a pension trust, would avoid the high surtax rates.

Further, as a qualification for the exemption privilege, employees' trusts should be required to provide a plan for the distribution of their funds to the employees upon liquidation of the employer's business.

Such provision would insure the irrevocable nature of employees' trusts by requiring such trusts to provide a plan of distributing their funds to employees in the event of the failure and dissolution of the employer's business. Thus the possibility of the employer or any of his creditors receiving the trust funds through dissolution proceedings would be eliminated.

10. Treatment Of Worthless Stock As A Capital Loss

It is proposed to:

Disallow the deduction for worthless stock and in lieu thereof in all instances where the market value of the stock at the end of the taxable year is less than 3 percent of its cost or other basis as determined and adjusted under Section 113, allow the taxpayer to take a capital loss, provided that if such loss is taken the basis for such stock for the determination of future capital gain or loss shall become the market value used in the determination of the capital loss.

The deduction for worthless stock has been allowed as a deduction from gross income under all the revenue acts since 1913 and in effect enables the taxpayer to offset other income with capital losses. This procedure is not consistent with the treatment of capital losses in the event of sale of stocks. Losses on such stocks are subject to the five-step scale system, which accounts different percentages of the capital loss according to the period that the asset was held and are rigidly limited to capital gains plus $2,000. The present procedure of allowing the deduction for worthless stock would be no more tenable under the plan for treating capital gains and losses, as proposed in a separate memorandum on that subject, for similar reasons: (a) Because no effect would be given to the time element as it is proposed to do in the computation of the tax on capital gains and the credit on capital losses, and (b) because the proposed segregation of capital losses would be violated in general as well as for purposes of the carry-forward.

The recommended change surmounts these difficulties by accounting the loss in the case of worthless stock under the capital loss provisions, and it would surmount the difficulty with respect to an unexpected subsequent appreciation in value of "worthless" stock, since the basis of the stock for the determination of future gain or loss would become the "market" value used in the determination of the capital loss.

The proposal does not, however, surmount one of the difficulties now encountered. The worthlessness of a stock when it falls to low levels is in large part a matter of fiat and depends upon the ability of the taxpayer to make a "satisfactory showing." The distinction between stock that is worthless and stock that has fallen to very low levels is not altogether a marked one; hence the proposal is to select some arbitrary point of division between stocks that are in the twilight zone of worth and others. The distinction between stock that has fallen to 4 or 5 percent of its basis and one that has fallen to 3 percent is admittedly illogical. Some point of division is necessary, however, and it seems better to make the arbitrary division than to adhere to the present division between "worthless" and other stocks. The proposal that the deduction for worthless stocks be treated as a capital loss would seem to be acceptable irrespective of whether the division is made between worthless and other stocks as at present, or between stocks that meet some arbitrary test of approximate worthlessness and others, as is suggested.

The deductions allowable under Section 23(e)(3) dealing with losses of property by fire, storm, shipwreck, etc., while involving capital items, do not fall into the same category as the deduction for worthless stock allowable under Section 23(e)(2). On strictly logical grounds, perhaps some case can be made for the treatment of such losses as capital losses, but there does not appear to be the same opportunity for the taxpayer to devise schemes for tax avoidance with respect to fires, storms, shipwrecks, thefts, etc., as there may be with respect to worthless stock. Also, to view the deductions allowable under Section 23(e)(3) as capital items would seem to make of the income tax a more heartless instrument for the extraction of the Government's due from the taxpayer than the Government in its wisdom can afford to take.

11. Earned Income Of Nonresident Americans

It is proposed to repeal Section 116(a) of the Revenue Act of 1936 dealing with the exclusion from gross income of earned income from sources without the United States in the case of an individual citizen of the United States who is a bona fide nonresident of the United States for more than six months during the taxable year.

Section 213(b)(14) of the Revenue Act of 1926 provided for the exclusion from gross income in the case of an individual citizen of the United States who is a bona fide nonresident of the United States for more than six months during the taxable year, of amounts received from sources without the United States if such amounts constitute earned income as defined in Section 209. Similar provisions have been continued in all the revenue acts subsequent to the 1926 Act.

In the Hearings before the Committee on Ways and Means in 1925, and in congressional debate, it was pointed out that the United States was the only country which imposed a tax on the foreign income of its non-resident citizens; that while a tax credit is granted with respect to taxes paid by American citizens to foreign countries, this credit is allowed only with respect to income or excess-profits taxes of foreign countries; that there are a multitude of other taxes paid by Americans abroad which cannot be taken as a tax credit; that these Americans abroad promote the foreign trade of the United States, and unless some relief were granted them from taxes upon income earned in foreign countries, it would tend to hamper and restrict American salesmanship and enterprise abroad. In view of the fact that the exemption was sought only for Americans who are bona fide foreign residents engaged in the pursuit of some legitimate business, profession or other occupation, the exemption granted was limited to earned income of such individuals.

In general, the policy of the United States is to tax American citizens on their income wheresoever it may have been derived. American citizens are required to include in their income tax returns all income from sources both within and without the United States. In order to eliminate double taxation, a tax credit is granted with respect to income or excess-profits taxes paid abroad. The treatment of earned income of bona fide nonresident citizens of the United States under Section 116(a) of the Revenue Act of 1936 is an exception to the general procedure. The exemption does not apply with respect to their unearned income.

The concession was granted in recognition of the fact that for the most part those citizens who are bona fide nonresidents of the United States for more than six months during the year or those who are more or less permanently established abroad whose chief sources of income are abroad are taxed as residents by the various foreign countries. It is clear that a substantial tax saving may be realized by an individual earning income abroad if he remains abroad one day more than six months rather than one day less than six months. Aside from such considerations, however, if it is to be the policy of the United States to tax individuals on the basis of citizenship, then on strictly logical grounds, there seems to be no basis for the arbitrary exclusion of this segment of income for a special group of citizens.

It is admitted that the repeal of Section 116(a) is likely to cause a measure of inequity and discrimination to this group of nonresident citizens due to the fact that they may be required to pay taxes abroad which are not deductible in the form of tax credit. This inequity it is believed, however, is in no wise proportionate to the inequity to the Government which now exists through the arbitrary exclusion of this source of income. It would seem proper to require nonresidents to file returns on the basis of their total income and to allow them tax credit for amounts of tax paid abroad. It is recommended, therefore, that Section 116(a) of the Revenue Act of 1936 be repealed.

12. Building And Loan Associations

It is proposed to amend Section 101(4) of the Revenue Act of 1936 so as to limit the exempt building and loan associations to those types operating on a mutual basis.

The types of corporations that are exempt from the Federal income tax are enumerated in Section 101 of the Revenue Act of 1936. Subsection (4), relating to building and loan associations, reads as follows:

"Domestic building and loan associations, substantially all the business of which is confined to making loans to members; and cooperative banks without capital stock organized and operated for mutual purposes and without profit."

This provision appears in all the revenue acts since 1913. The inclusion of building and loan associations with the exempt corporations enumerated in Section 101 implies that the exemption of building and loan associations derives from the theory that they are non-profit organizations. To the extent to which that theory is inapplicable the case for the exemption is weakened.

Many State laws allow building and loan associations to accept deposits, to pay interest thereon, and in general to conduct a regular banking business, thereby competing in effect with regular banking institutions. To the extent they do so, it would seem proper for the purposes of the Federal income tax to place them in the same category as banks and trust companies. Exemption from the income tax should be granted only to those building and loan associations which operate on a mutual basis with respect to all parties that advance money to the association.

It seems evident that the mutual basis is violated as soon as the building and loan association accepts substantial deposits and obligates itself to pay interest to depositors. Such obligation differs fundamentally from one to pay a return on the investment of the proprietary group. The very act of accepting deposits with an obligation to pay a fixed return of interest sets the shareholders up as a proprietary group as against the depositors. Furthermore, the payment on founders', organization, or preferred shares of a return higher than the return on the ordinary shares is in violation of the principles of mutuality and constitutes sufficient ground for confiscating the tax-exempt privilege granted under Section 101(4).

Since building and loan associations have been tax-exempt, it might be advisable to give them a period of grace within which to make the necessary adjustments that would enable them to retain this privilege. Otherwise it is recommended that the tax-exempt privilege be granted only those building and loan associations that operate on a mutual basis, meaning that all classes of the proprietary group, "depositors" and stockholders, are paid interest or dividends at the same rate and on the same basis. Unless this definition of mutuality is drafted into the law, the proposed amendment would lack force. In substance then, it is recommended that in those instances in which building and loan associations disqualify as non-profit organizations they should be deprived of the privilege of tax exemption.

13. Dividends Paid Credit In Connection With Tax-Free Distributions

It is proposed to repeal Section 27(f) dealing with distributions in liquidation; to amend Section 27(h) dealing with nontaxable distributions so as to make an exception in the case of distributions in liquidation by allowing such distributions for the purposes of determining the dividends paid credit.

Thus, the law will be clear to the effect that a corporation in liquidation cannot claim a dividends paid credit for distributions made if such distributions are not taxable in the hands of the recipient except that distributions made in liquidation by a subsidiary corporation to a parent corporation may be claimed as a dividends paid credit to the extent that the earnings and profits of the subsidiary are in turn paid out as taxable dividends by the parent corporation. (Article 27(f)-1-(c) Regulations 94).

Section 27(f) of the Revenue Act of 1936 provides that "in the case of amounts distributed in liquidation the part of such distribution which is properly chargeable to the earnings or profits accumulated after February 28, 1913, shall, for the purposes of computing the dividends paid credit under this section, be treated as a taxable dividend paid." On the fact of it, this section would appear to allow distribution of the entire accumulated profits and earnings of a corporation in liquidation for the purposes of the dividends paid credit and leave such corporation no undistributed profits tax liability provided that the accumulated earnings or profits exceeded the adjusted net income. If, however, reference is made to Section 112(b)(6) wherein it is provided that "no gain or loss shall be recognized upon the receipt by a corporation of property distributed in complete liquidation of another corporation" and to Section 27(h) which provides that "if any part of a distribution is not a taxable dividend in the hands of such of the shareholders as are subject to taxation under this title for the period in which the distribution is made, no dividends paid credit shall be allowed with respect to such part," it seems clear that Section 27(f) is nullified and a corporation in liquidation is subject to the undistributed profits tax on its entire adjusted net income.

The Bureau has taken the position that a strict interpretation of Section 27(h) would impose an undue hardship in the case of complete liquidation of a subsidiary. Such a subsidiary would be liable to the severest of the undistributed profits tax rates on the full amount of its adjusted net income accounted for the portion of its taxable year up to the date of liquidation. In interpreting Section 27(f) it has, therefore, ruled (Article 27(f)-1-(c) of Regulations 94) that, subject to certain limitations, the portion of a distribution of earnings made by a corporation which has just received the total assets of another corporation representing earnings and profits of the liquidated corporation, may be allocated for the purpose of the dividends paid credit to the liquidated corporation.

As the statute now stands, Sections 27(f) and (h) appear to conflict; further conflict seems to exist between the statute and the regulations. In order to clarify the procedure, it is suggested that Section 27(f) be repealed and Section 27(h) be amended to read:

"(h) Nontaxable Distributions. -- If any part of a distribution (including stock dividends and stock rights) is not a taxable dividend in the hands of such of the shareholders as are subject to taxation under this title for the period in which the distribution is made, no dividends paid credit shall be allowed with respect to such part; EXCEPT THAT DISTRIBUTIONS IN LIQUIDATION SHALL BE ALLOWED FOR THE PURPOSES OF DETERMINING THE DIVIDENDS PAID CREDIT SUBJECT TO THE LIMITATIONS OF SECTION 115(B) AND TO THE EXTENT AND IN ACCORDANCE WITH REGULATIONS THAT SHALL BE PRESCRIBED BY THE COMMISSIONER, WITH THE APPROVAL OF THE SECRETARY."