SECTION 326, ARTICLE 831: Meaning of invested capital. (See 7-21-1453; sec. 233, art. 541.) Rentals for company's own equipment used temporarily for construction purposes charged to capital account. SECTION 326, ARTICLE 831: Meaning of invested capital. (Also Section 214(a) 1, Article 109.) 7-21-1456 A. R. R. 384 The Committee has had under consideration the appeal of the M Company from the action of the Income Tax Unit in reducing an improvement account carried on the corporation's books to cover the cost of improving a leased property under the terms of a 10-year lease which expired April, 1915, through depreciation charges allocated over the term of such lease, and disallowing as invested capital any portion of such account for the taxable year 1917 and subsequent years. It appears from the records that the M Company, a corporation organized for the purpose of conducting a restaurant, leased certain portions of a building from A for a period of 10 years and 3 months. Under a memorandum of agreement which formed a part of the lease between A and the corporation, the latter obligated itself to pay a monthly rental of a dollars for the demised premises plus certain contingent charges and to expend 30x dollars or more in making certain specified permanent improvements to such premises. The amount expended in making these improvements was carried to an improvement account on the books of the corporation, which account is still maintained. It is this account which the Unit has disallowed as invested capital for the year 1917 and subsequent years, from which action the taxpayer now appeals for the reason that no depreciation on the improvements has ever been claimed and for the further reason that the premises with respect to which the improvements were made are still in the possession of the taxpayer, the original lease having been renewed. The taxpayer has filed with the Unit a certified copy of the memorandum of agreement which formed a part of the original lease dated November, 1904, together with certified copies of the agreements covering renewal leases dated March, 1915, and April, 1920. This memorandum of agreement specifically provides that the improvements therein provided for shall upon their installation by the lessee immediately become the property of the lessor. It contains no provision granting the lessee any right of renewal upon expiration of the lease and it is not shown nor claimed that the lessee had any such right under the lease itself. The lease was to run for a period of 10 years and 3 months beginning February, 1905, and ending April, 1915, on which latter date the lessee corporation was to surrender all right and title to the demised premises and the improvements which it was obligated to make. That the corporation did surrender all of such right and title is evidenced by the memorandum of agreement forming part of the renewal lease, dated March, 1915. Article 109 of Regulations 45 as amended by Treasury Decision 3062 (C. B. 3, p. 144), provides: Where a leasehold is acquired for business purposes for a specified sum, the purchaser may take as a deduction in his return an aliquot part of such sum each year, based on the number of years the lease has to run. * ** The cost borne by a lessee in erecting buildings or making permanent improvements on ground of which he is lessee is held to be a capital investment and not deductible as a business expense. In order to return to such taxpayer his investment of capital, an annual deduction may be made from gross income of an amount equal to the total cost of such improvements divided by the number of years remaining of the term of lease, and such deduction shall be in lieu of a deduction for depreciation. * Under the provisions of the above-quoted article the amount invested by the M Company in the said improvements, if paid for out of original capital or surplus, can be held to constitute invested capital for the taxable year during which expended, such invested capital to be reduced at the beginning of each subsequent year by an amount equal to the result obtained by dividing the total cost of such improvements by the number of years of the lease term. The lease under the terms of which the improvements were made expired in 1915, and subsequent to that year the taxpayer had no right nor title under the lease to any asset which constituted a part of such improvements, not even the right of usage. The amount expended for the improvements and their installation may be considered as a bonus paid to secure the execution of the lease, or as additional rental for the leased premises to be charged off as expense ratably over the term of the lease. Whether or not such amount was so charged off, any right or title which the taxpayer ever possessed in the investment was exhausted upon termination of the original lease in April, 1915, and subsequent to that date it possessed nothing therein which can be said to constitute invested capital for the purpose of computing excess profits tax under the provisions of the Revenue Act of 1917 or 1918. The Committee, therefore, recommends that the action of the Unit in disallowing as invested capital any portion of the amount expended for improvements by the M Company under the terms of the lease dated November, 1904, be sustained. SECTION 326, ARTICLE 831: Meaning of invested capital. (See 8-21-1468; sec. 233, art. 547.) Invested capital of a corporation in process of liquidation. SECTION 326, ARTICLE 831: Meaning of invested capital. (Also Section 331, Article 941.) REVENUE ACT OF 1917. 8-21-1470 A. R. R. 393 Held, that values claimed for "contracts, brands, and good will" can not be allowed as invested capital when it is not conclusively shown that such values represent paid-in capital of a partnership, and that in reorganization no greater value can be given to corporate assets than existed before reorganization, the interest in the corporation being substantially the same as that in the partnership. The Committee has had under consideration the appeal of the M partnership, and the N corporation, from the action of the Income Tax Unit in disallowing certain items as invested capital. The action of the Income Tax Unit in disallowing, in the taxable year 1917, 7x dollars as invested capital of the M partnership is explained in the following language: This decrease is due to the disallowance of 7x dollars claimed as the value of contracts and good will not shown on the books of the partnership. No evidence has been submitted as to the value of these intangible assets, the methods of acquiring them, and the cost. (See Regulations 41, articles 57-60, 64.) The action of the Income Tax Unit in disallowing as invested capital for the N corporation an item of 10x dollars is explained in the following language: The amount at which these intangible assets were included in the invested capital of the M partnership, in its return for the five-months' period ended May 31, 1917, has been excluded from the invested capital of the partnership in a letter addressed to it by this office. The corporation succeeded the partnership as of June 1, 1917. The excess profits tax return filed by the corporation shows that an interest of 50 per cent or more remained in control of the same persons. In such case no asset transferred from the partnership will be allowed to be included in the invested capital of the corporation, at a value greater than would have been allowed in computing the invested capital of the partnership if no transfer of assets had taken place, unless such asset is specifically paid for in cash or tangible property. (See Regulations 41, article 50.) The facts on which the appeal has been taken may, therefore, be said to be definitely stated in the exceptions above quoted. The partnership was of more than 40 years' standing and on June 1, 1917, its affairs were incorporated as the N Corporation with capital stock of 40 dollars. In the year 1917, just prior to this reorganization, there was set up on the books of the partnership an item of 7 dollars for "contracts, brands, and good will," but in the reorganization by incorporation the said account "contracts, brands, and good will" was set up on the books of the corporation as of the value of 10 dollars. It is contended that two contracts, recorded in this accounting, were worth at least 10 dollars, but it is noted these contracts dated as far back as the year 1908. It is further contended that as the result of an examination and audit of the books of the M partnership, for the years 1908 to 1912, inclusive, the average net earnings on invested capital of said partnership were more than 52 per cent. It is noted, however, that at December 31, 1916, the financial statement of the partnership showed a deficit of dollars. It is not in evidence that the value of "contracts, brands, and good will," either in the amount claimed as set up on the partnership books or in the amount claimed as set up on the corporation books, was actually paid into the partnership or corporation. Article 42 of Regulations 41 provides, in part, as follows: The basis, or starting point, in the computation of invested capital is found in the amount of cash and other property paid in, the original values of such other property being determined in accordance with the rules laid down in these regulations. *** If value appreciation of a kind not subject to income tax (other than that allowed under article 55) has been taken up in the accounts, a deduction must be made in respect of such appreciation so taken up. This Committee, in its Recommendation 17 (C. B. 2, p. 280) said, in part, as follows: The fact remains, however, that the law expressly provides what may be regarded as the invested capital of a corporation or partnership, and that is, as affects the question now at issue, the amount of cash or tangible property paid in to the corporation or partnership for stock or shares, the share evidently referring to the member's interest in the paid-in capital of the partnership. The law and the decisions issued thereon by the Department have consistently stated that the basis or starting point in the computation of invested capital is the amount of cash or other property actually paid in, the original values of such other property being determined in accordance with the statute and regulations. It is contended that the partnership was one of long standing and that the right to include this additional capital is entirely justified from figures and detailed statements of earnings as reflected by two contracts alone. The Committee can not concur in this contention. It can not recognize going concern value or appreciation growing out of the development and expansion of a business. There is no justification in the law or in the regulations for doing so. Furthermore, it has been conclusively pointed out by the Income Tax Unit, that under article 50 of Regulations 41: If an interest or control in such trade or business of 50 per cent or more remains in control of the same persons, corporations, associations, partnerships, or any of them, then in ascertaining the invested capital of the trade or business no asset transferred or received from the prior trade or business shall be allowed a greater value than would have been allowed under these regulations in computing the invested capital of such prior trade or business if such asset had not been so transferred or received, unless such asset was paid for specifically as such, in cash or tangible property, and then not to exceed the actual cash or actual cash value of the tangible property paid therefor at the time of such payment. In this article no distinction is made between tangible and intangible assets so transferred. The Committee accordingly recommends that the action of the Income Tax Unit in disallowing these items as invested capital of the partnership and of the corporation be sustained. SECTION 326, ARTICLE 831: Meaning of invested capital. REVENUE ACT OF 1917. 8-21-1471 A. R. R. 396 Held, that the value of certain patents for which stock of the M Company was issued must be measured by the cash consideration paid therefor by certain incorporators of the company just prior to incorporation. The Committee has had under consideration the appeal of the M Company from the action of the Income Tax Unit in disallowing as invested capital the par value of shares of stock of the said corporation issued specifically for patents at date of incorporation. The M Company was incorporated in 1914, with capital common stock of 250 dollars. The articles of incorporation read, in part, as follows: The amount of the capital stock of said corporation shall be 250 dollars divided into 25y shares. It appears that in September, 1913, A assigned an undivided onehalf interest in two patents to B in consideration of 11 dollars in cash, and in June, 1914, A assigned his remaining one-half interest in said patents to C, D, E, and F, in consideration of 5x dollars cash 61360°-21- -24 and in further consideration of the said assignees assuming the liability of A in all the debts and outstanding obligations of the A Company, a partnership, which debts and obligations amounted to 33 dollars. The Income Tax Unit, based on the report of an examining revenue agent, allowed 6 dollars as the value of the patents acquired for 225 dollars of the total issue of capital stock of the corporation organized immediately thereafter. In addition thereto, there was allowed as invested capital 11x dollars, the said amount being the cash paid in at par ($100) for 1y shares. There was also allowed as invested capital 11 dollars, the actual cost of patents subsequently acquired, making a total invested capital of 19 dollars. Because the income of the corporation was disproportionate to the amount of invested capital, the tax was subsequently adjusted under section 210 of the Revenue Act. The taxpayer contends that the full par value, namely, 225x dollars, should be allowed for the two patents first mentioned, and that on this basis of invested capital the tax should be assessed under section 207 of the Revenue Act. As above stated, the Income Tax Unit has rested its decision on the purchase price of the patents, as evidenced by sale when acquired by certain individuals, five of whom subsequently became incorporators of the M Company. No evidence has been submitted by the taxpayer to show the value of similar patents, if indeed such evidence could be produced, but the record shows that for the fractional part of the year 1914 (the year in which the company was incorporated) there was a profit of r dollars from operations; in 1915 a profit of 27 dollars; in 1916 a profit of 44x dollars, and in 1917 a profit of 43 dollars. In this latter year the corporation claimed a depreciation based on the life of the patents which, if disallowed, would leave a net income of 70.r dollars. It is also a matter of record that the 1y shares of stock were sold at par to about 25 individual subscribers in various proportions and an affidavit has been submitted by a broker who says that he has been engaged in the brokerage business for several years and that in the course of his business he has sold a good deal of the stock of the M Company during the three years just prior to May, 1919, at a price uniformly something near par, the sales ranging between $85 and $105 per share. The Committee has given careful consideration to the above facts, but it can not fail to recognize that the A Company, a partnership, which conveyed the patents immediately prior to the organization of the M Company, a corporation, to the principal incorporators for a cash consideration definitely known, was not successful in developing these patents. What efforts were made to do so are not recorded in the files before the Committee, but the fact is that after final sale. of the patent rights to a group of successful business men there was immediately put forth an active, progressive, commercial plan which gave general recognition to the practical use of the patents. It was this development of an idea in a systematic, corporate way without the necessity of large financial investment by any one of the incorporators of the M Company that gave substantial return to the stockholders. The Revenue Act does not recognize as paid-in capital a value rising from development of an idea after incorporation. It may be said this value is reflected in the earned surplus and, as such, it is a part of the invested capital of the corporation. |
