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c. Effect of Tax Treatment on Liquidation of Securities: Curiously enough, the maximum rate of 12 1/2 percent on capital net gains, which in 1921 was urged as a stimulus to transfers of capital assets, was being widely charged in 1928 and 1929 with obstructing the liquidation of securities and thereby contributing to the high and rising level of stock prices. It is true, however, that the relative value of the 12 1/2 percent rate had been reduced by reductions in the surtax rates applicable to individual incomes. Thus, the maximum individual income-tax rate, which had been 73 percent between 1919 and 1921, inclusive, was reduced to 58 percent for the years 1922 and 1923 /4/; to 46 percent for 1924; and to 25 percent for the years 1925 to 1931 /5/, inclusive; reductions which were accompanied by downward revisions in most of the other surtax rates. In the later Twenties therefore, the 12 1/2 percent maximum rate on capital gains compared with a 25 percent maximum income tax rate (24 percent in 1929) on ordinary income.

The charge that the 12 1/2 percent tax on capital gains was obstructing liquidation was made despite the fact of the unprecedented volume of market transactions then taking place. In 1928 and 1929, the average monthly number of shares sold on the New York Stock Exchange constituted 11.2 percent and 9.9 percent, respectively, of the average number of shares listed, as compared with 8.3 percent in 1925, 7.0 percent in 1926, and 7.8 percent in 1927; and between 1925 and 1929 the average number of shares listed more than doubled.

Such a volume of trading could conceivably be reconciled with an underlying scarcity of securities if this volume were primarily a product of an enormous turnover in a small fraction of the volume of securities outstanding.

The evidence points in the other direction, however. Berle and Means, in "The Modern Corporation and Private Property" (page 56), cite an estimated increase of 50 percent in the number of book stockholders of American corporations between 1920 and 1928. Three of the largest American corporations, the American Telephone and Telegraph Company, the Pennsylvania Railroad, and the United States Steel Corporation, according to Berle and Means, increased the number of their book stockholders between 1920 and 1929 by 237 percent, 47 percent, and 26 percent, respectively.

The numbers of stockholders registered on the books of corporations contain considerable duplications of ownership. A single individual may be counted thirty times as the owner of stocks in thirty different corporations, and the same is true of holding companies and other institutions. Mr. N. R. Danielian, in Chapter 3 of a study by the Twentieth Century Fund, Inc., entitled "The Security Markets," presents estimates of the increases between 1927 and 1930 in the numbers of actual stockholders, based largely upon income-tax data published in Statistics of Income. The mid-point of Mr. Danielian's estimate of the number of actual stockholders in 1927 is 5.5 millions; for 1929, 8 millions; an increase of 45 percent.

Other evidence also exists to indicate that the taxes applicable to profits from the sale of capital assets did not prevent a very substantial volume of liquidation by those holding such assets in the late Twenties. The total amount of net profits from the sale of capital assets reported by individuals in the years 1928 and 1929 greatly exceeded the aggregate volume of such net profits reported during any of the preceding six years (comparable data are not available for the years prior to 1922). Further, there WERE substantial increases in 1928 and 1929 in the volume of capital net gains reported from the sale of assets held for more than two years by individuals who otherwise would have been subject to income taxes thereon of more than 12 1/2 percent. (Table VI)

Mr. George Buchan Robinson in an article in The Annalist of June 11, 1937, entitled "A Reply to Recent Criticism of Capital-Gains Tax: Implications of Repeal" cites the case of Mr. Pierre du Pont. The following is quoted from Mr. Robinson's article:

"On Monday, May 10, the New York World-Telegram published an interview with Arthur A. Ballantine, formerly Under-Secretary of the Treasury, dealing with the subject of taxing capital gains. Mr. Ballantine would either abolish capital-gains taxation entirely or substantially modify the present treatment of such profits. He noted that the method and rates which prevailed from 1921 to 1934 were much more 'favorable'.

"As luck would have it, Mr. Ballantine's views were published in the same issue of The World-Telegram which carried the first news story of Pierre du Pont's whopping capital gain of 1929. Mr. du Pont appears to have made a profit of some $35,000,000 in General Motors stock which he had held for more than two years, and to have paid a tax thereon of about $4,375,000. The incident provides a timely-offered vantage point from which to glance at Mr. Ballantine's views.

"There is, of course, nothing new in the broad view. There was quite as much complaint against the taxing of capital gains when the rate was a flat 12 1/2 percent and very reach the same arguments were presented against it.

* * * * *

"But Mr. du Pont appears not to have been discouraged from selling by the taxes which selling faced. If other persons were, at or about the same date (June, 1929), it may be hoped that they will read of Mr. du Pont's better judgement not merely with such regrets as they may have but with some determination never to be so deterred again. For the reading, there is a good lesson available to all less experienced investors and speculators in Mr. du Pont's action.

* * * *

"It is impossible from the published data to compute what the tax on such a profit would be under the present law, but it can be estimated roughly, if it be assumed that the stock has been owned for more than five years, but less than ten. In that case, of a $35,000,000 profit, 40 percent, or $14,000,000 would be taxed for normal tax and surtax. The sum of these on $14,000,000 would be not less than $10,901,000 (though possibly not more), or some $6,625,000 greater on $35,000,000 than under the 1929 law. But even at that figure, there would be no tax percentage whatever against 60 percent of the profit, which in itself is a considerable preferential."

It is extremely doubtful that the tax advantage of realizing losses in years when capital gains and other incomes are large has been of great practical importance, save in those cases, some of which have been widely publicized, where the realization of loss has been more nominal than real -- as in sales to and by related interests. The business and market conditions which favor large capital gains and a high level of income derived from other sources are precisely those which minimize the possibilities of realizing large capital losses. It will be noted in Table VI that the total losses from the sale of capital assets were relatively small in the years 1926, 1927, and 1928, when the volume of capital gains was very great. The drastic decline in the securities market in the fall of 1929 forced or enabled some individuals to realize a total of $1,039 millions of net losses from their transactions in capital assets as a whole in that year, as compared with total net gains, realized by other individuals on their capital transactions as a whole, of $4,685 millions. The heaviest losses were realized in the two years immediately following, when the market trend was substantially though irregularly downward, and when the level of income from other sources was likewise declining sharply.

Those who held during the late Twenties that a capital gains tax of 12 1/2 percent (less for individuals subject to maximum income taxes of less than 12 1/2 percent, and ranging up to 25 percent (24 percent in 1929) for gains on assets held for two years or less) constituted a major obstruction to adequate liquidation, and therefore fostered the stock market boom, are confronted with the fact that the period was one in which an unparalleled volume of securities trading took place and an unparalleled volume of gains was realized from the sale of capital assets. (Table VI)

On the other hand, those who argue that a drastic reduction in the tax rates applicable to capital gains from those now in effect is essential to encourage the liquidation needed to moderate a boom, are confronted with the fact that a maximum rate of 12 1/2 percent on assets held for more than two years, and rates ranging up to a maximum of 24 or 25 percent on assets held for two years or less, though substantially lower than those now existing, did not prevent the greatest stock market boom in our history.

d. Effect of Tax Treatment on Timing: Evidence available in the income tax returns, though not at all conclusive, does not indicate that the time differentials in the taxation of capital gains have been important in determining the timing of the transactions that have actually accounted for a very substantial proportion of the aggregate capital gains reported for income tax purposes. By reason of the varying normal and surtax rates in force during the period 1922-1933, the level of income at which it was profitable to report capital gains separately was not uniform throughout the period. Roughly, the breaking point ranged between $16,000 and something less than $50,000 between 1924 /6/ and 1933, inclusive; so that we are sure that all well-advised individuals with incomes from other sources of $50,000 or more took advantage in their-returns of the 12 1/2 percent option rate on capital gains throughout these years.

Virtually all of those with incomes, inclusive of profits on the sale of capital assets, of less than between $16,000 and about $32,000, varying in the different years, did not avail themselves of the option, and therefore included in their ordinary income the gains realized on assets held for more then two years. It is significant that not a single individual reporting a net income of $25,000 or less actually obtained any benefit from the 12 1/2 percent optional rate between 1922 and 1931, inclusive.

During the period 1922-1933, only. 37.9 percent of the aggregate net profits-from the sale of capital assets reported by individuals with net incomes received the benefit of the 12 1/2 percent maximum rate on capital gains. Even for individuals reporting net incomes of $50,000 to $100,000, the tax advantage obtainable by delaying liquidation until a capital asset had been held for more than two years, was not sufficient to bring about such delay in the case of transactions accounting for 50.9 percent of the aggregate net capital gains reported by members of this group during this period. On the other hand, individuals reporting net incomes of $100,000 and over realized only some 21 percent of their aggregate net capital gains from assets held for two years or less. (Table VII.)

It was only in the year 1929, that as much as one half of the aggregate profits from the sale of capital assets received the preferential tax treatment open to those with large incomes on gains from assets held for more than 2 years. In the years 1922 to 1928, inclusive, between 60.9 and 74.9 percent of the reported aggregate net profits from the sale of capital assets was reported by individuals who could not enjoy the preferential tax treatment of capital gains, either because the assets involved had been held for less than 2 years, or because their incomes from other sources were not large enough to subject their capital gains to a tax rate of more than 12 1/2 percent if included in ordinary income. (Table VII.)

The Revenue Act of 1934 incorporated the five-step system whereby varying percentages of capital gains were included in ordinary taxable income, and whereby a distinct tax advantage was given to those who held their assets for longer periods of time, up to just over ten years, before realizing gains thereon. This Act was preceded and accompanied by very pronounced increases in individual income-tax rates. If the tax treatment of capital gains exerted a very considerable influence upon transactions in capital assets, the joint effect of these two changes might have been expected to reduce sharply the proportion of total capital gains which was realized on assets held for two years or less.

Although it is impossible to obtain the relevant figures for the year 1934 in a form fully comparable with those of preceding years, the evidence provided by the individual income tax returns for 1934 is entirely consistent with that provided in preceding years. More than 50 percent of the total net gains from the sale of assets reported by individuals for 1934 was derived from assets held for two years or less. Likewise, about 51.7 percent of the total net gains incomes of $30,000 to $100,000 in 1934 was derived from assets held for two years or less. For individuals reporting net incomes of $100,000 and more in 1934, 22.3 percent of their total net capital gains was derived from assets held for two years or less. (Table VIII.)

2. 1935-1937

In March 1935, the average of the daily closing prices of the 30 stocks included in the Dow-Jones index of industrial stock prices was $99.8. By March, 1937, this average price had risen to $188.4, an increase of 69 percent. During this period, the volume of trading, though increasing, remained at relatively low levels. Thus, the ratio between the monthly average number of shares sold and the monthly average number of listed shares on the New York Stock Exchange was only 2.4 percent in 1935 and 3.1 percent in 1936, as compared with ratios more than twice as great in the years 1925 to 1929, inclusive. This measure of the volume of trading is far from perfect because additions to the list of relatively inactive securities previously traded only on other exchanges or over the counter have probably caused some downward bias in the ratio; but the effect of such bias is probably of relatively small proportions as compared with the substantial decline in the ratio.

There are some who contend that the rise of securities values since the spring of 1935, attended by a volume of stock market trading very substantially below that which obtained in the late Twenties, is conclusive evidence that the existing capital gains tax provisions are seriously retarding the liquidation of securities and thereby contributing to an unhealthy stock market boom. In view of numerous other factors that have operated to raise securities prices and to restrict the volume of stock market trading, this contention would seem to give undue weight to the restrictive influence of our capital gains tax provisions.

a. Improvement in Business and Profits: In the first place, the rising stock market of the last two years is much more obviously explained in terms of the enormous improvement that has take place in the volume of business activity and in the level of corporate profits. The aggregate statutory net income of corporations (excluding intercorporate dividends) increased from less than $3 billions in 1933 to about $4.3 billions in 1934, and to some $5.1 billions in 1935. The 1936 figure was estimated at $7.2 billions by the Treasury in a report to the House Ways and Means Committee.

The pronounced upward course of business activity between May 1935 and May 1937, was reflected by a rise of 39 percent in the adjusted index of industrial production of the Board of Governors of the Federal Reserve System.

When the general business situation is undergoing solid and rapid improvement, there is a natural tendency, irrespective of the tax treatment of capital gains, for investors to retain their securities for higher prices, particularly in the case of common stocks, but only somewhat less so in the cases of speculative preferred stocks and defaulted and other speculative bonds. The very facts that securities prices and corporate earnings continue to rise provide the strongest possible inducement for investors to retain their securities pending a change in the outlook. Conditions such as these naturally reduce the disposition of investors to sell their holdings.

b. Low Interest Rates: In the second place, the low level of interest rates, both short- and long-term have operated powerfully to raise the market values of income-yielding securities. Stock prices averaging 12 or 14 times current earnings may well appear high when the yields obtainable on good bonds are 4 1/2 to 6 percent; but when no more than 3 to 4 percent can be obtained on good bonds, stock prices averaging 15 to 20 times earnings may well appear reasonable. The latter is apt to be particularly true if dividend distributions are in generous volume; and the most striking effect of the undistributed profits tax provisions of the Revenue Act of 1936 has been very greatly to increase the volume of dividend disbursements.

c. Foreign Purchases of American Securities: In the third place, the business revival in the United States and the continuing favorable outlook, as well as the existence of great uncertainties abroad, has made American securities extremely attractive to foreigners. Between January 2, 1935 and March 31, 1937, total foreign purchases of domestic securities amounted to $4,941 millions, and total sales to $3,$65 millions. The weekly figures of foreign purchases and sales of domestic securities as presented in the Treasury's third report on capital movements, /7/ and in the two previous reports, indicate a clear tendency for the amounts of net foreign purchases of domestic securities to vary directly with upward and downward movements in our stock markets. There can be no doubt that the foreign demand for American securities has helped to raise their prices.

d. New Government Restrictions on Trading: Thus far, we have explained the reluctance of investors to liquidate capital assets in terms of fundamental improvement in business conditions and in the business outlook; and we have explained the rise in securities prices both in these terms and in the terms of the declining interest rates and the addition to domestic demand created by foreign purchasers of American securities.

The decline in the aggregate volume of stock market trading during the past few years, as compared with the late Twenties, is to be explained partly in terms of the greatly different speculative temper of the times and partly in terms of the very substantial structural hangs in our stock markets effected by the Securities Exchange Act of 1934, and the subsequent regulations of the Securities and Exchange Commission and the Board of Governors of the Federal Reserve System, including the newly required publicity respecting corporate acts and the securities transactions of officers, directors, and principal stockholders of corporations.

The abnormal character of the stock market speculation of the late Twenties requires little more than mention; and there are few persons who would regard the volume of that period as a standard by which the adequacy of the present volume of activity should be gauged. Apart, however, from this difference, the chief explanation of the reduced volume of securities trading must be sought in the elimination, as the result of new legislation, of a very considerable fraction of the speculative activity which formerly constituted one of the mainsprings of the market. The more important of the new restrictive provisions which are operating to reduce the volume of stock market trading are below:

(1) Requirements for substantial margins have been established under rules and regulations prescribed by the Federal Reserve Board. The maximum loan value for a registered security is now set at 45 percent of its current market value, except in certain special instances. Banks, brokers, et cetera, cannot extend credit for the purchase or carrying of securities without collateral. Undermargined accounts are subject to trading restrictions and in all margin accounts no trading activities can be conducted which would undermargin such accounts.

(2) The sources of borrowing on securities by stock-exchange members, brokers and dealers are restricted to member banks, non-member banks which have filed with the Federal serve Board certain prescribed agreements, and other members, brokers, and dealers to a limited extent. At the present time, it is unlawful for a broker to allow his aggregate indebtedness to persons other than the foregoing to exceed 2,000 percent of the net capital employed in his business; and it is unlawful for a broker to lend securities carried for a customer without his consent, or to hypothecate such securities for a sum in excess of the customer's aggregate indebtedness in respect to such securities.

(3) Prohibitions have been set up against the manipulation of security prices. It is unlawful to create a false appearance of active trading in any security by effecting transactions involving no change in beneficial ownership; or by effecting transactions, knowing offsetting orders will be offered; or by inducing sales by circulation of rumors that certain operations are to be conducted affecting the price of a security; or by effecting transactions for the purpose of pegging or fixing prices in contravention of regulations prescribed by the Commission.

(4) Regulations have been prescribed covering transactions on over-the-counter markets, and providing for the registration of brokers and dealers. Activities of brokers and dealers on the over-the-counter market have been limited, except where full disclosure of the broker's position or activity is made to the customer, and, in certain cases, where the broker obtains the customer's written consent to each transaction.

(5) Reports of securities transactions are required each month of directors, officers and beneficial owners of more than 10 percent of any equity security. When new securities are registered, such owners, officers or directors must file statements of their beneficial interest at the time the registration becomes effective.

(6) Profits realized from any purchase and sale of a corporation's securities within any period of less than six months by its officers, directors, or beneficial owners of more than 10 percent of any of its equity securities inure to and are recoverable by the issuer of such securities. Arbitrage operations by such persons in such securities are unlawful unless the profits are accounted for to the issuing corporation.

(7) Certain limitations are placed upon the functions of persons who are both brokers and dealers, particularly in connection with transactions in securities which are a part of a new issue, in the distribution of which such persons participated as members of a selling syndicate.

VI. Corporations

The problem of the tax treatment of capital gains and losses has been of much more restricted significance for corporations than for individuals. The need for special treatment naturally did not arise so long as there was a relatively low flat corporation income tax; and even the enactment of graduated rates beginning in 1936 has created no practical problem, because the range of graduation is relatively narrow.

A. Market Effects

Most of the broader considerations involved in the relation between capital gains taxation and the securities markets apply to the securities transactions of corporations, trusts, and associations, no less than to those of individuals. So far as the securities markets are concerned, the chief effects of the existing capital gains provisions relating to corporations are exercised through their influence upon the actions of financial corporations and associations. Of these, investment trusts, which in this country characteristically employ their funds in speculative and semi-speculative investment, and other corporations which, though often ostensibly or actually engaged in other activities primarily, also maintain sizeable portfolios of speculative and semi-speculative securities, are most important in this connection.

In a general way, it may be said that professional managements of investment portfolios are less likely to allow irrational repugnance to the occurrence of avoidable or postponable tax liabilities to influence their decisions than is the case with many investors. Hence, tax considerations constitute only a minor deterrent to liquidation by such managements in all cases where the motive for liquidation is the desire to withdraw from a threatened or embarrassed industry or enterprise, or to reduce investments generally because of an anticipated decline in business and the securities markets. When substantial declines are anticipated -- and even secondary fluctuations in stock prices are often substantial --, the profits safeguarded and the losses avoided by properly-timed liquidation overshadow the tax liabilities incurred by the realization of gains.

The tax provisions exert a greater influence upon switching, as contrasted with liquidating operations. The management of a corporation's speculative-investment portfolio may become convinced that, although the market as a whole is going to continue to rise for some little time, certain groups of stocks in which it is interested are not likely to rise as much as certain other stocks in which it is less heavily, if at all, committed. To make the switch may involve the realization of very substantial capital gains in the securities to be liquidated, and a related substantial increase in tax liability. If safe and adequate provision is to be made for the increased tax liability, the funds available for the substitute investments may be sufficiently reduced to eliminate the superior attractiveness of the projected substitute investments.

This consideration was probably of importance to various personal holding companies in 1934, 1935, and 1936, because of the special surtaxes to which they were subject on their undistributed incomes. The owners of many such companies were subject to relatively high individual income surtaxes if the gains were distributed; and their personal holding companies were subject to relatively high surtaxes if the gains were not distributed. Hence, the certainty of substantial tax liabilities on realized capital gains, in such cases, provided a strong motive against undertaking ordinary switching operations designed to improve profit prospects rather than to avoid losses. In addition, it probably deterred real liquidation, as contrasted with switching operations, in some cases.

B. Effect Of Undistributed Profits Tax

So long as the tax applicable to capital gains was limited to 15 percent or less, the tax influence was minimized, especially for investment trusts and financial corporations. Imposition of the surtax on undistributed profits, however, made the tax consideration important to all corporations with substantial portfolios of speculative and semi-speculative securities, and particularly to those which shift their portfolios frequently. Unless it qualifies as a "mutual investment company", a corporation subjects itself to surtaxes (as well as normal taxes) on all capital gains that are not distributed in taxable dividends. This is of particular importance to investment trust corporations. If they plan to distribute all of the capital gains realized during periods of rising stock prices, they must contemplate a net shrinkage in their effective capital funds in periods of declining stock prices, unless (1) they time the liquidation of their stock holdings so well as to avoid depreciation in the market value of their portfolios; or (2) they recoup their capital gains distributions by additional stock issues.

This consideration may well deter such companies from transferring funds from one group of stocks to another as promptly and to the same extent as might be the case if tax considerations were altogether neutral. On the other hand, as already cited, the tax factor loses much or all of its weight even for such enterprises when liquidation is contemplated because of actual or expected adverse developments in business and the markets as a whole, or in particular industries or enterprises.

Further, if capital gains off good years must be paid out currently to avoid surtaxes on undistributed earnings, but no carry forward off the capital losses of bad years is allowed, the tendency over a period off years will be to shrink the value off capital assets off corporations. The most practicable method off minimizing or eliminating this tendency would appear to be that off allowing net capital losses as a deduction in computing adjusted net income with the further provision that any excess of such net capital losses may be carried forward for purposes of determining adjusted net income off future years. Such a provision would permit corporations to repair the inroads made upon their capital funds by net capital losses.

VII. Recommendations

A. Individuals

In Section IV of this memorandum, a standard of equity was set up to judge the present tax treatment of the capital gains of individuals. It will be recalled that the standard was determined by dividing a capital gain by the number of years during which the asset had been held, adding the quotient to the individual's other income in the year of realization, determining the tax applicable to this added segment, and multiplying this tax by the number of years during which the asset had been held. The recommended plan for the treatment of the capital gains of individuals is based on the principle incorporated in the standard of equity.

In the standard of equity only a single capital gain is involved. The recommended plan -- called the average accrual method -- is designed to operate equally well where there are several transactions. while retaining the principles of the standard of equity.

1. Procedure For Individuals Reporting Capital Gains But No Capital Losses From Sales Or Exchanges

a. An average investment period is first determined by computing a weighted average (the years being weighted by the gains) of the years assets incorporating capital gains were held. In this computation, one-half of a year or more is considered a full year, and less than one-half of a year is disregarded. The resulting average investment period is likewise rounded off to an even number of years.

b. The average annual gain for this period is then determined by dividing total gains by the average investment period.

c. The tax on this average annual gain is then computed with reference to the surtax net income excluding capital gains; and the resulting tax is multiplied by the number of years in the average investment period to determine the total tax on capital gains.

d. In computing the tax on the average annual gain, no allowance is given for any portions of the personal exemption, credit for dependents, or minimum earned income credit not utilized in computing the ordinary income tax. If there is no surtax net income, the tax is computed on the average annual gain, assuming surtax net income to be zero rather than a negative quantity.

e. The same procedure as above is followed where an individual has capital losses but no capital gains. In such cases, a tax credit would be computed instead of a tax. This tax credit is carried forward for two years, to be allowed only as an offset against tax liability on capital gains realized in those years.

The following example illustrates the procedure for gains only:

Assume an individual with other surtax net income of $10,000 having a capital gain of $10,000 on an asset held 10 years and a capital gain of $10,000 on an asset held 5 years.


Computation of average investment period:

          $10,000 multiplied by 10                       $100,000
         10,000 multiplied by 5                           50,000

          Total weighted gains                           $150,000
          Divided by total gains of                        20,000
          Average investment period                   8 years /8/

Computation of average annual gain:

          Total gain                                      $20,000
          Divided by average investment period of               g
         Average annual gain                              $2,500

Computation of tax:

          Tax on $12,500 (other surtax net                   $980
          income plus average annual gain)

          Tax on $10,000 (other surtax net income)            700

          Tax on average annual gain                         $280
         Multiplied by average investment period of            g

         Total tax on capital net gain                    $2,240

The following example illustrates the procedure for losses only:

Assume an individual with other surtax net income of $10,000 having a capital loss of $10,000 on an asset held 10 years and a capital loss of $10,000 on an asset held 5 years.


Computation of average investment period:

          $10,000 multiplied by 10                       $100,000
          10,000 multiplied by 5                           50,000

         Total weighted losses                          $150,000
          Divided by total losses of                       20,000
          Average investment period                   8 years /8/

Computation of average annual loss:

          Total loss                                      $20,000
          Divided by average investment period off              g
          Average annual loss                              $2,500

Computation of tax credit:

          Tax on $7,500 (other surtax net income             $455
         minus average annual loss)

          Tax on $10,000 (other surtax net income)            700

          Tax credit on average annual loss                  $245
          Multiplied by average investment period of            g
         Total tax credit on capital net loss             $1,960

2. Procedure For Individuals Reporting Both Capital Gains And Capital Losses From Sales Or Exchanges.

Where there are both gains and losses, the tax treatment is the same as that described above, except that the actual computation is somewhat more complex.

a. Capital gains are segregated from capital losses. An average investment period for gains and the average annual gain during this period are determined; and an average investment period for losses and the average annual loss during this period are determined.

b. The average annual gain and the average annual loss are combined to determine the net gain or loss applicable to the shorter of the two investment periods. The tax or tax credit on the resulting figure is computed with reference to the surtax net income excluding capital gains and losses, and this tax or tax credit is multiplied by the number of years in the shorter investment period to determine the tax or tax credit on capital gains and losses during this period.

c. The tax or tax credit on the average annual gain or the average annual loss, whichever accrued for the longer average investment period, is computed with reference to the surtax net income excluding capital gains and losses, and multiplied by the number of years by which the longer investment period exceeds the shorter, to determine the tax or tax credit applicable to that period.

d. The taxes or tax credits thus obtained are combined, and the result represents the total tax or tax credit on capital gains and losses.

The following example illustrates the procedure where there are both gains and losses.

Assume an individual with other surtax net income of $10,000 having a capital gain of $10,000 on an asset held 10 years and a capital loss of $15,000 on an asset held 5 years. It is not necessary to compute the average investment period for the gains and the average investment period for the losses in this illustration. If there were several transactions resulting in gain and several transactions resulting in loss, an average investment period for the gains and an average investment period for the losses would be computed in the same way as illustrated above.


Computation of average annual gain:

Total gain                                            $10,000
Divided by average investment period of              10 years
Average annual gain                                    $1,000

Computation of average annual loss:

Total loss                                            $15,000
Divided by average investment period of               5 years
Average annual loss                                    $3,000

Net average annual loss applicable to the shorter      $2,000
of the two investment periods ($3,000 minus
$1,000)

Computation of tax credit on the net loss applicable to the
shorter investment period:

Tax on $8,000 (other surtax net income minus             $500
net average annual loss)

Tax on $10,000 (other surtax net income)                  700
Tax credit on net average annual loss                    $200
Multiplied by average investment period of                  5
Total tax credit                                       $1,000

Computation of tax on average annual gain applicable to the number
of years by which the longer investment period exceeds the shorter:

Tax on $11,000 (other surtax net income plus
average annual gain)                                     $810

Tax on $10,000 (other surtax net income)                  700
Tax on average annual gain                               $110

Multiplied by number of years by which the                  5
longer investment period exceeds the
shorter

Tax total                                                $550

Combined tax and tax credit ($550 minus $1,000)          $450
or tax credit of

Proposed capital gain and loss schedules for individual income tax returns are presented in Appendix B, together with the computation of tax or tax credit for illustrated cases.

3. Treatment Of Capital Gains And Losses Of Partnerships And Fiduciaries

Fiduciaries and partnerships furnish each individual the figures for his pro rata share of total gains and total losses, and weighted gains and weighted losses, computed in the same way as described above for individuals; these figures are combined by the individual with the corresponding items respecting his other capital gains and losses.

4. Treatment Of Capital Gains And Losses In Property Donated To Charitable Institutions

a. If legally feasible all contributions to charitable and similar institutions should be regarded as occasioning the realization of capital gains and losses by the donor; and such capital gains and losses should be included with other capital gains and losses.

b. If this proposal is not deemed legally feasible, or if practical considerations seem to bar its adoption, it is recommended, for the purpose of determining the deduction for charitable contributions, that the value of such contributions in kind be fixed at the adjusted basis (Section 113) or market, whichever is lower.

5. Treatment Of Capital Gains And Losses In Property Transferred By Inter Vivos Gifts

a. If legally feasible, all transfers by INTER VIVOS gifts should be regarded as occasioning the realization of capital gains and losses by the donor and such capital gains and losses accorded the same tax treatment as other gains and losses realized by the donor.

b. If this proposal is not deemed legally feasible, it is suggested that a supplementary gift tax be levied, measured by the capital gains and losses incorporated in such transfers. This tax could be determined in a similar way to that applicable to capital gains in property transferred at death as described in the estate and gift tax memorandum.

c. If practical and legal considerations should likewise bar the adoption of the latter proposal, a part of the tax on capital gains avoided by inter vivos transfers of property could be recouped if Section 113(a)(2) were amended to provide that, for the purpose of determining both capital gains and losses, the basis for property acquired by gift were made either the base in the hands of the donor or market value at time of transfer, whichever. is lower.

B. Corporations

The capital gains and losses of corporations are included in ordinary income in full, except that for purposes of determining the normal-tax net income, capital losses are allowed only to the extent of capital gains. Any excess of capital losses not allowed in the current year is carried forward for two years to be credited against the capital gains of those years.

In determining adjusted net income, the excess of capital losses over capital gains not allowed for purposes of determining the normal-tax net income is allowed in full against income from other sources. Any portion of capital losses not so utilized is carried forward for two years for use as a deduction in determining adjusted net income of those years.

VIII. Alternative Tax Treatments Of Capital Gains And Losses Of Individuals

A. Proposals Designed Primarily In The Interests Of Expediency

1. Complete Exclusion Of Capital Gains And Losses From The Income-Tax Base

The objections to this proposal have already been covered: Capital gains constitute taxpaying ability; they are not sharply distinguishable from other types of income; the bulk of them are realized in connection with transactions entered into for profits; and their exemption from income taxes would be extremely inequitable.

The case for the complete exclusion of capital gains and losses from the income-tax base is believed by some, including Mr. L. H. Parker, Chief of the Staff of the Joint Committee on Internal Revenue Taxation, to have been strengthened by the enactment of the surtax on undistributed profits in 1936. Mr. Parker maintains that if the undistributed profits tax is continued in substantially its present form, "the question of capital gains will become comparatively unimportant in the long run as a revenue producer." His argument is summarized in the statement that: "The increased value of corporate stock comes about largely, of course, because a considerable portion of the net earnings are retained in surplus and used in increasing the earning power of the corporation." (See address before the Institute of Public Affairs, July 9, 1936.)

Mr. Parker's argument, while applicable to one important source of capital gains, is by no means applicable to many others; and his simple generalization seems to be in conflict with some of the facts of common observation.

(i) If reinvested earnings constitute the chief explanation of increases in the values of corporate stock, a high degree of correlation should tend to exist between the book and market values of securities. The absence of any high degree of such relationship is, however, notorious. To illustrate the prevailing absence of any such close relationship, there is presented in Table XII a comparison of the book values and market values per share as of December 31, 1936 of the fifteen common stocks that were traded in the largest volume on the New York Stock Exchange on this date.

(ii) Anyone who makes an even casual study of the stock market averages over a period of years notices that wide swings in these averages take place cyclically. Mr. Parker's argument and conclusion would appear to rest upon the assumption, which is contrary to the facts, that no important capital gains (or losses) are realised as a result of these cyclical fluctuations.

For example, many investors and speculators have purchased iron and steel and railroad equipment common stocks since the beginning of 1933. There are presented in Table XIII comparisons of the changes between December 31, 1932 and December 31, 1936, in the market and book values of the common stocks of all the railroad equipment and iron and steel companies included in the Standard Statistics Company's indexes for these industrial groups. It will be observed that, whereas only one of the ten railroad equipment stocks increased in book value during this period (and by only 1.1 percent), the smallest percentage appreciation in the market value of the common stocks of any of the ten companies was 111 percent; and the average of the rates of appreciation, unweighted, of all ten stocks was 454 percent. In the case of the eleven steel companies, only four showed increases (and relatively small ones) in the book value of their common stocks between these two dates; but the appreciation in the market values of these stocks ranged from 113 to 914 percent; the average of the rates of appreciation, unweighted, of the eleven stocks was 444 percent. In the case of some of these companies, though by no means all, special write downs in the balance sheet values assigned to various assets, and charged directly against the surplus accounts, as well as operating losses, accounted for reductions in the book value of the stocks. The figures nevertheless provide vivid illustrations of the fact that, in appraising the changed earning power and outlook for these stock, the market did not wait upon commensurate additions to their book values through reinvested earnings. Speculators and investors who purchased these stocks in 1932 or 1933 have therefore enjoyed very substantial capital gains, realized or open to realization, primarily as a result of the cyclical recovery in the heavy industries, and not because of significant additions to their book values through the retention of earnings.

 
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