Tax Revision Studies, 1937


VOLUME IV: UNDISTRIBUTED PROFITS TAX

Table of Contents

Summary

Section I. Historical Background

Section II. Equitable Basis

Section III. Discussion of Principal Objections Raised Against the Undistributed Profits Tax

Section IV. Recommendations


To:       Mr. Magil    
FROM      Mr. Haas

Subject: TAX REVISION STUDIES, 1937 -- UNDISTRIBUTED PROFITS TAX

SUMMARY

The primary purpose of the undistributed profits tax is to make effective the rates of the individual income tax. To accomplish this, the tax should be sufficient over the major portion of its range to induce the distribution of corporate earnings to the equitable owners thereof, and over the remaining portion of its range should at least compensate the Treasury in part for the individual income taxes lost by the non-distribution of corporate earnings. While the theoretical need for a tax of this character has existed ever since the rates of the individual income tax diverged substantially on the up-side from those of the corporation normal tax, this need became acute for the first time in a decade with the high rates of the individual income tax imposed by the Revenue Act of 1932 and subsequent Acts. These rates -- at present amounting to as high as 79 percent on segments of income in excess of $5,000,000 and 62 percent, or higher, upon all segments of income in excess of $100,000 -- could not be made really effective as long as corporate profits could be retained and reinvested without the parent of the individual income tax. The undistributed profits tax, as at present upon the statute books, takes a long step toward making such rates effective. We believe that its efficacy in this direction can be further increased and that certain elements of harshness can be greatly diminished by the changes suggested in this memorandum. A careful canvass of the situation, on the other hand, has failed to reveal any practicable alternative device by which this could be accomplished.

Aside from its primary objective of reducing the inequity and increasing the revenue productivity of the income tar system, the undistributed profits tax has certain social and economic effects. The most important of these are (1) that the tax tends, on balance, to reduce somewhat the proportion of the national income which is saved arid to increase somewhat the proportion which is currently consumed, and (2) that it tends to "democratize" the process of capital formation by returning to stock-holders the function of deciding whether or not they are willing to reinvest in a particular corporate enterprise their pro rata share of its annual earnings. These effects are inseparable from the tax as such, except to the extent that corporate earnings may be distributed through the declaration of taxable dividends in the form of securities of the corporation itself, or are reinvested by the stockholders through the exercise of coercive rights. While we advocate the undistributed profits tax primarily as a revenue and equitable measure, we believe that these incidental and largely inseparable social and economic effects are, in themselves, desirable and tend to reinforce rather than detract from its revenue and equitable objectives.

In order to make the tax more equitable in its application, to remove certain hardships, and to increase its effectiveness in certain respects, the following changes are suggested:

(1) COORDINATION WITH THE PRIVILEGE TAX. It is recommended that adjusted net income should consist of privilege-tax net income -- that is, net income before the deduction of interest, rents and royalties -- less the privilege tax paid, and that undistributed net income should consist of adjusted net income less dividends, interest, rents and royalties.

(2) RATE SCHEDULE. The following rate schedule is recommended:

          Percent of adjusted                   Tax
       net income undistributed              (Percent)
       ________________________              _________

               0 -   5                           3
               5 -  15                          15
              15 -  50                          40
              50 - 100                          60

The rate in the initial bracket has been lowered as compared with the present law, principally in order to mate allowance for the margin of error of estimate in net income, while the rates in the last two brackets have been made sufficiently high to induce distribution of earnings in the vast majority of cases, including even those of closely held corporations. The narrowing of the first bracket is necessary to prevent a substantial loss in revenue in view of the change in the base for adjusted net income. It will have an effective width substantially greater than that of the present initial 10 percent bracket for corporations with large amounts of prior charges. These corporations cause little revenue loss, and are the most needful of and the most clamorous in demanding relief in any event, while some relief for them seems especially timely in view of the transitional burden to which they will be subjected by the new privilege tax.

(3) Small Corporations. It is not believed that the contention frequently made that the undistributed profits tax places small corporations at a disadvantage has merit, but the contrary is rather believed to be true. Nevertheless, in line with our consistent policy of granting preferential treatment to small corporations in any event, it is recommended that the specific credit provided in Section 14(c) of the Act be continued at $5,000, that the rate of tax thereon be lowered from 7 percent to 3 percent to conform with the lower rate suggested for the first bracket of the regular tax, and that it be extended in its application to corporations with adjusted net incomes of up to $100,000 (rather than $50,000) in view of the proposed change in the base of adjusted net income, It is further recommended, however, that whatever income remains undistributed beyond the amount included in the specific credit be taxed at the rates applicable if tie specific credit had not been granted.

(4) ALLOWANCE OF NET CAPITAL LOSSES. It is recommended that an unlimited offset of capital losses be permitted, for the purpose of the undistributed profits tax only, against other income.

(5) NET LOSS CARRY-OVER. It is recommended that a two-year carry-over should be allowed for all losses (including capital losses as merged with other losses by the preceding recommendation) for the purpose of the undistributed profits tax only.

It is believed that recommendations 4 and 5 taken in conjunction will meet the legitimate complaint that it is often necessary for a corporation incurring substantial capital losses, or engaged in a fluctuating business, to pay an undistributed profits tax, in order to RETAIN its capital intact; whereas, in the contemplation of the law, such a tax should be paid only when it is desired to INCREASE the capital employed in a business by the reinvestment of earnings free from the individual income tax.

(6) OPTIONAL SETTLEMENT OF SUBSEQUENTLY FOUND DEFICIENCIES. It is recommended that if audit of a corporation return reveals that net income from a previous year should have been reported at a higher figure than that appearing upon the face of the return, and no question of bad faith is involved, the taxpayer should have the option of paying the undistributed profits tax liability thereby created, with interests or of paying a special tax of 5 percent of the undistributed profits newly determined by the Commissioner, and adding the remainder of such newly determined profits to adjusted net income in the current year. It is felt that this recommendation will restoreewly determined by the Commissioner, and adding the remainder of such newly determined profits to adjusted net income in the current year. It is felt that this recommendation will restore to the taxpaying corporation, as far as it is possible to do so, its original option either of paying the undistributed profits tax, in whole or in part, or of distributing its earnings, in whole or in part.

(7) SPECIAL TAX ON EARNINGS EXEMPTED FROM THE UNDISTRIBUTED PROFITS TAX BY REASON OF CONTRACTS PROHIBITING THE PAYMENT OF DIVIDENDS, ETC. It is recommended that a tax of 10 percent be levied upon earnings exempted from the undistributed profits tax under Section 26(c) of the Act, because of contracts prohibiting the payment of dividends, etc., and that such tax be levied in lieu of the lowest brackets of the undistributed profits tax in which the amounts so exempted would otherwise have fallen. This tax will take cognizance of the fact that income which remains undistributed as a result of prior contractual obligations both increases the equity of the stockholders and results in revenue loss to the Government in the same measure as though it had remained undistributed as the result of a currently made decision of the Board of Directors of the corporation.


TO        Mr. Magill

FROM      Mr. Haas

Subject: TAX REVISION STUDIES, 1937 -- UNDISTRIBUTED PROFITS TAX

I. HISTORICAL BACKGROUND

Throughout our experience with income tax legislation and administration, the most difficult problem that we have encountered next to the definition of income itself has been the problem of the proper tax treatment of Corporation income. There is one body of opinion that has held that business organizations generally, whether incorporated or not, may be properly subjected to special rates or forms of taxation. There is another body of opinion that has held that corporations, because of the valuable special priveleges granted to them by law, may be properly taxed more heavily than other forms of business organization. And there is a third body of opinion which has held that corporations, like other business organizations, are merely conduits through which income flows to individuals and that the taxation of corporation incomes as such is therefore unjustified, since it involves double taxation first, when the income taxes are paid by the Corporation, and second, when the stockholders pay individual income taxes on their dividend receipts.

In the Civil War income tax measures, no tax was levied directly upon the incomes of ordinary industrial and mercantile corporations; but railroad, insurance, banking, and similar corporations were subject to an income tax equal to the lowest rate imposed upon individuals first 3 percent, then 5 percent, and later 2-1/2 percent. In the Revenue Acts of 1913 and 1916, the rates of 1 and 2 percent, respectively, imposed upon corporation incomes were identical with the normal tax rates on individual incomes, from which, moreover, dividends received from corporations were deductible for normal tax purposes.

So long as the range of normal and surtax rates on individual incomes was narrow -- in the Revenue Act of 1913 the maximum surtax rate was 6 percent -- and so long as the rate on Corporation incomes approximated the normal rate on individual incomes, from which dividends were exempt, it could be said that the law treated incomes derived through corporations on roughly the same basis as incomes derived from unincorporated business and from personal services. In other words, corporation stockholders were neither favored nor penalized to any substantial degree by our income tax laws.

Beginning with the Revenue Act of 1917, however, the surtax rates applicable to individual incomes were increased very drastically, the minimum surtax rate rising from 13 percent in 1916 to 63 percent in 1917, and to 65 percent in 1918. The corporation income tax rate, on the other hand, was raised only to 6 percent in 1917, and to 12 percent in 1918. Although very high excess profits and war profits taxes were also enacted in 1917, they were modified in 1918 to apply only to corporations, and were dropped after 1921. In consequence of the sharp increase in the range and absolute rates of individual surtaxes, without any corresponding increase in corporation income tax rates, a very important disparity arose between the tax treatment of corporation stockholders and the tax treatment of individuals deriving their incomes from partnerships, individually owned enterprises, and personal services. This disparity resulted from the fact that the earnings applicable to the shareholders' interests in a corporation but not currently distributed in dividends escaped the current individual income surtaxes; whereas the earnings applicable to members of partnerships, whether distributed or not, and the earnings of individual business and professional men, whether reinvested or not, were subject in full to the schedule of individual income surtaxes.

The privilege offered to corporation stockholders of allowing their share of corporation earnings to be directly reinvested for them without the current payment of individual income surtaxes thereon aroused considerable debate from the beginning. As early as September 8, 1916, the late Thomas S. Adams, in discussing the proposed Revenue Act of 1917, declared that ". . . . . the undivided profits of a corporation should be taxed at the rates which would apply if such profits were distributed to the shareholders . . . ."

When the Senate finance Committee first reported the bill that became the Revenue Act of 1917, a provision was included imposing a 15 percent tax, in addition to the regular corporate income tax, on undivided earnings exceeding 20 percent of the total net income. As finally enacted, the 20 percent exemption was eliminated and the rate of additional tax was reduced to 10 percent, applicable to that portion of the total net income, after federal income taxes, remaining undistributed six months after the end of the calendar or fiscal year; but a broad new exemption was inserted that made the entire provision virtually ineffective. This exemption read in part, as follows:

"The tax imposed by this subdivision shall not apply to that portion of such undistributed net income which is actually invested and employed in the business, or is retained for employment in the reasonable requirements of the business, or is invested in obligations of the United States issued after September 1, 1917."

The broad character of the permission to retain earnings, without tax liability, if such earnings are employed "in the reasonable requirements of the business" made it extremely difficult to prove tax liability; and the entire provision was repealed by the Revenue Act of 1918.

It is interesting to note that in the Civil War income tax laws, Congress solved this problem, with respect to ordinary industrial and mercantile corporations (though not with respect to railroad, banking, and similar corporations which were then relatively more important), by providing that individuals were subject to income taxes on their share of the profits and gains in the corporations in which they held interests, whether these profits were divided or not. Such a provision today would probably prove more difficult of effective administration, barring questions of constitutionality. It is significant, however, that the problem met in this way by the Civil War revenue acts, so far as industrial and mercantile corporations are concerned, is, in substance, the same problem that confronted the Congress in 1916, and the very same problem that Congress again attacked through the Revenue Act of 1936.

Under the Revenue Acts of 1921, 1924, 1926, and 1928, apple cable to the ten years ended in 1931, the surtax rates on individual incomes were progressively and sharply reduced; so that from 1925 to 1931, inclusive, the maximum surtax rate was 20 percent; and the corporation income tax rate during this period ranged from 11 to 13- 1/2 percent. These reductions in the individual surtax rates, coupled with the maintenance of corporation income tax rates higher than the normal rates on individuals, moderated in part the preferential tax treatment of stockholders whose earnings were directly reinvested by their corporations, as compared with the reinvested earnings of individual business men and partnerships. But with the enactment of the Revenue Acts of 1932, 1934, and 1935, whereby individual income surtaxes were again increased substantially, this disparity once more became a serious problem.

II. EQUITABLE BASIS

1. Prior to the Revenue Act of 1936, when corporations distributed their earnings to their stockholders, the dividends were subject to the surtax rates named in our income-tax law. Then corporate earnings were not so distributed, the individual stockholders, while enjoying the benefit of these earnings in the form of more valuable investments, were enabled to avoid all payment of surtaxes thereon. Between 1923 and 1929, inclusive, more than 45 percent of the compiled net profits, after income and excess-profits taxes, of all corporations REPORTING NET INCOME was not distributed by the corporations and was therefore not subject to the individual income taxes, or their approximate equivalent, applicable to their stockholders. /*/

2. Very large proportions of the incomes accruing for the benefit of members of the upper income groups in the Univalent, applicable to their stockholders. /*/

2. Very large proportions of the incomes accruing for the benefit of members of the upper income groups in the United States had previously escaped the individual income surtaxes for long periods or forever in this fashion. Henry Ford, for example, has been liable for individual income surtaxes on only such portions of the profits of the Ford Motor Company as have actually been paid out to him. By allowing his profits to accumulate in and to be reinvested by the Ford Motor Company, he has been enabled to avoid individual income-tax liability for most of his share of such profits. The Federal Government need never get anything like the equivalent of the taxes avoided in this fashion by Mr. Ford (to continue the example), for at Mr. Ford's death his estate will pass to his heirs without any tax liability for the huge capital gains incorporated in this estate, part of which arose through the Ford Motor Company's retention of earnings, nor will the rated of tax applicable to the estate be at all higher than on estates of similar size that may have been created by individuals whose equitable incomes had been subject in rich greater measure to our individual income and capital gains taxes unless the latter tee of loophole is eliminated in some such manner as is recommended in a companion memorandum on Estates and Gifts Taxes.

3. Our high individual surtax rates were obviously ineffective in large part when their application could be postponed for long periods or avoided altogether through corporate retention of earnings. Further, even when corporate earnings were fully distributed over a period of years, there was unjust discrimination in tile distribution of the tax burden. The ability of corporations and of their controlling stockholders to choose the timing of dividend distributions, without any effect upon the corporation's tax liability and without reference to current earnings, often resulted in a loss of revenue to the Federal Government and an unjust avoidance of taxation by stockholders of large personal incomes. The current earnings withheld by a corporation would often, if distributed, have raised tile surtax brackets of many stockholders, thereby subjecting such earnings to the higher surtax rates. When withheld for a time and then paid out in years When the other income of important stockholders was smaller, such earnings escaped the higher rates to which they would have been subject. Individual businessmen and partnerships possessed no corresponding choice for the timing of the distribution of earnings for income-tax purposes. All of the income of individuals and members of partnerships is taxable in the year earned, whether saved and reinvested in the business or not.

FOOTNOTE

/*/ For the same years, 1923-29, all corporations (whether reporting net income or not) withheld 27 percent of their combined compiled net profits, after income and excess profits taxes.

END OF FOOTNOTE

Moreover, shareholders in corporations that pursued liberal dividend policies were discriminated against as compared with shareholders in corporations pursuing niggardly dividend policies; for the corporation taxes took no account of the differences in dividend policies, while the individual income-tax liabilities were greater for stockholders in corporations making liberal distributions. Stockholders receiving large dividends commonly re- invest much of these, but they are subject to individual income taxes thereon before such reinvestment Where the corporation made the reinvestment directly for stockholders, such investment took place tax free.

Again, an individual who reinvests in his business the large profits of one year and subsequently experiences losses, is nevertheless subject in full to the income taxes on the profits of his good year; whereas the stockholders of a corporation that similarly reinvested the large earnings of one year and subsequently suffered equivalent losses, escaped individual income taxes on the profits of the good year.

4. It is clear that the most direct method of achieving equality of taxation of all income, corporate and other, would be to include in the taxable incomes of corporate stockholders their pro rata shares of the current earnings of corporations, whether distributed or not. This method, however, presents numerous administrative, economic and legal difficulties. An increase in the schedule of normal corporation income tax rates might produce the mathematical equivalents in revenue, but would be unfair to stockholders with small incomes and to stockholders of corporations pursuing liberal dividend policies. The President, therefore, proposed to meet these problems of tax avoidance and tax inequity by repealing altogether the normal corporation income, capital stock and excess profits taxes; and to substitute therefor very substantial rates of tax on the undistributed profits of corporations. The thought was that these rates of tax would encourage the distribution of the great mass of current earnings of corporations (no attempt was made to tax previously accumulated surpluses), thereby subjecting them to the individual income taxes; and that the taxes paid by corporations on the retained portions of their earnings would fully compensate the Treasury for the individual income taxes avoided through such retention.

The Congressional committees were disinclined to abolish the corporation income, capital stock, and excess profits taxes, partly because of the legal and economic advantages enjoyed by corporations over individuals and partnerships (particularly by large corporations), partly because such taxes were already well established and therefore reflected in the price of corporate securities, and partly because of the uncertainty attaching to revenue estimates for the new substitute tax. In consequence, the normal corporation income, capital stock, and excess profits taxes were retained in the Revenue Act of 1936, the two former at lower rates. Despite the retention of the normal tax on corporation incomes, the previous exemption of dividends from individual normal tax was eliminated.

5. Such evidence as we have to date supports the belief that the tax has shad a profound effect upon corporate dividend policies. During, the last quarter of 1936, the period most likely to reflect the influence of the tax, dividend declarations, as reported by the New York Times, amounted to $1,552 millions, compared with $857 millions during the last quarter of 1935. The great bulk of the additional dividends undoubtedly went to members of the higher income groups. Between 1927 and 1935, inclusive, 85.8 percent of the dividends reported by individuals subject to income tax were received by individuals reporting net incomes of $10,000 or more.

6. While the undistributed profits tax, viewed as a whole, results in removing major sources of tax avoidance and inequality, the present rate schedule introduces a new type of discrimination which to some extent offsets these advantages. When earnings are retained and tee tax is paid, the burden is borne equally by stock holders of all income groups. In effect, this raises the total tax burden on the portion of such corporation income going to stockholders in the lower brackets sharply above that which they would bear if the income has been distributed and taxed at the regular income tax rates. The only recourse which such stockholders have at present is to shift their investments into corporations distributing substantially their entire earnings.

This inequity, however, cab be substantially reduced by a realignment of the present rate schedule. It is greatest in the case of medium rates -- those which are not high enough to induce distribution, and yet are much higher than ought equitably to be borne by stockholders in the lower brackets. It is proposed, therefore, in the recommendations appearing in another part of this memorandum, that the rates of tax applying to the first segment of undistributed net income be made sufficiently low so as not to impose an undue hardship upon stockholders in the lower brackets, even if earnings are retained and the tax paid; and, on the other hand, that the rates applying to the larger percentages of undistributed net income be made sufficiently high to effect distribution and so permit stockholders in the lower income brackets to par only the rate of tax appropriate to their particular cases. It is believed that by such a revision the inequity in the present law can be reduced to minor proportions.

III. DISCUSSION OF PRINCIPAL OBJECTIONS AGAINST THE DISTRIBUTED PROFITS TAX

The principal objections which have been advanced against the undistributed profits tax are:

(1) The tax tends to divert current income from saving to consumption and thus to retard the process of capital accumulation.

(2) Corporations that use part or all of their earnings for the payment of short-or long-term debts are subjected to a tax penalty.

(3) Corporations are deprived of a necessary source of capital for expansion, except on payment of a tax penalty.

(4) The tax on undistributed earnings will discourage corporations from creating the corporate surpluses deemed necessary to maintain wages, employment, dividends, and business solvency, through periods of depression.

(5) The tax will prevent small corporations from growing- into big ones, and therefore operate to protect established corporations with accumulated surp (5) The tax will prevent small corporations from growing- into big ones, and therefore operate to protect established corporations with accumulated surpluses from new competition.

1. DIVERSION OF SAVINGS

It is objected that the tax tends to divert current in come from saving to consumption and thus to retard the process of capital accumulation. It is pointed out that, whether a corporation does or does not distribute its earnings, a vastly increased share of corporate income will go to the Government, from which it ordinarily enters the channels of consumption; and further that, to the extent that a corporation does distribute its earnings, it is unlikely that all or nearly all of the dividends will be reinvested by the receiving stockholders. The objection to the tax on this basis is founded on the orthodox theory of capital, which places no limits on toe progress obtainable through increased saving. However applicable this theory may have been to earlier stages of capitalistic society, its validity under our present economy has been sharply challenged by a number of reputable economists, including J.M. Keynes and Harold G. Moulton.

The dissenters from the orthodox theory assert that in an industrial society the tendency is for current savings to become too large for current absorption, thus resulting in unemployment and a depression of the standard of living. This occurs because the construction of new capital assets does not vary directly with the amount of savings available -- as the orthodox theory assumes -- but is largely dependent upon the markets for the final products. If the savings of the community absorb too large a part of current income, the consequent shrinkage of consumer demand destroys the profitability of investment. Therefore, as the wealth of the community increases, it may be increasingly necessary to reduce the potential savings of the wealthier members, among whom the propensity to save is greatest, and to direct such income to the poorer members.

There are good grounds for believing that there exists in this country a considerable stream of uninvested savings which prevent a full absorption of the potential products of industry. Aside from its equitable advantages, therefore, the tendency of the undistributed profits tax to prevent over-saving by the higher income groups may be considered to be a desirable contribution, particularly in view of the prospective diversion of consumption expenditures by the Social Security taxes.

2. ALLEGED UNFAIRNESS AND UNSOUNDNESS OF IMPOSING A SURTAX ON EARNINGS USED FOR DEBT RETIREMENT:

This objection is considered in its proper perspective only if the treatment of corporations is contrasted with that of individuals and partnerships. Individuals owing short-term debts contracted for consumption purposes or longer-term debts such as mortgage debts on their homes, are not released from income-tax liability for the portion of their incomes used for the payment of such debts. Nor are members of partnerships freed from individual income-tax liability on those portions of their partnership incomes employed for the retirement of partnership debts. The underlying assumption of this objection, therefore, is that corporate debts are of such special character as to merit exceptional treatment. This assumption does not withstand analysis.

Corporate indebtedness consists of two chief types commercial debts such as bank borrowings for inventory and other working capital purposes; and funded debt, usually represented by mortgage or debenture bonds.

With respect to the first type, that is, short-term loans for the purposes of acquiring inventories, paying wages, etc., it is not usually contemplated that such loans should be repaid out of EARNINGS. On the contrary, it is expected that such loans will be repaid out of the gross proceeds of the business. A department store which borrows $100,000 for the purchase off seasonal merchandise for its Christmas trade is expected to repay this loan out of the gross retail proceeds of perhaps $130,000, and not out of the $2,000 net profit remaining to it after all costs. It is for this reason that such loans are welcomed by banks as self-liquidating.

As class, moreover, such loans are never completely liquidated because new loan transactions are usually being entered into by the same or other business enterprises as past loans are being liquidated -- though not necessarily, of course, in off setting amounts. They constitute a revolving fund whose aggregate volume has normally exceeded the total statutory net income of American corporations. Their volume for any particular enterprise bears no necessary relationship to the amount of its net profits, and, is frequently several times the amount of the proprietors' capital.

It is true that exceptionally profitable enterprises sometimes reduce the average volume of their commercial borrowings by substituting capital funds derived from reinvested earnings. This, as stated above, is not the normal source of repayment of such borrowings. Other enterprises reduce or eliminate their commercial borrowings by the sale of additional securities to their stockholders and others. In general, however, the most economical utilization of the country's capital takes place when short-term needs are supplied by temporarily borrowed rather than by owed and permanent capital funds. Hence, no public purpose would be served by the extinguishment of short-term commercial debts.

Finally, it is obvious that the exemption from corporate surtaxes of earnings employed for the repayment of commercial debts would open wide an enormous door for tax avoidance: Debts could be contracted solely for the purpose of retiring them out of earnings and thereby indirectly reinvesting earnings and adding to the proprietorship capital tax-free.

With respect to bonded and other forms of longer-term indebtedness, somewhat different considerations apply. Much of the proceeds of such loans has normally been employed for plant, machinery, and other fixed assets. Is it fair or wise to place a surtax on earnings employed to retire such debts?

It should be observed in the first place that prudent lenders and prudent borrowers eject a fixed investment financed by such a loan at least to pay for itself during the life of the property. That is, funds for the complete retirement of the investment, if no replacement of the physical property is contemplated, will be provided by depreciation charges deducted from the gross receipts over a period of years. prudent lenders and prudent borrowers are not likely to contract for loans extending over a longer period than the economic life of the property to be constructed or acquired with the proceeds; though loans are often contracted, perhaps by reason of temporary money market stringency, for periods shorter than the economic life of the property, with the expectation that such loans will be subsequently refinanced. Depreciation charges should provide the necessary funds for the ultimate extinguishment of debts incurred for the acquisition of fixed assets not intended to be replaced; no net earnings should be necessary for this purpose.

It is more commonly true that physical properties financed by bond issues are continuously maintained or replaced. Where this is done by the use of funds allocated from gross receipts for depreciation and similar charges, the retirement of the indebtedness normally takes place in any one or more of three ways: (1) By refunding the debt at maturity or an earlier call period by means of a new issue of obligations (This is by far the most common method among railroad and public-utility companies, which account for about three-fourths of the aggregate funded debt of all non-financial corporations); (2) by funds raised through the sale of additional common or preferred stocks (a method commonly used by industrial corporations); and (3) by funds derived from the undistributed earnings of the corporation.

The character and importance of the third method is the one at issue in this connection. It is clear that this third method differs from the second only in form. In both cases, stockholders' capital is used to retire the debt. In the one case, there is a formal issue of securities to recognize the increased equity of the stockholders in the capital assets. In the other case, the increased equity of the stockholders is recognized by a commensurate addition to the corporate surplus account. The essential identity of the two methods may be seen by contrasting a corporation which refrains from dividend payments for five years and employs the $25 per share of earnings accumulated during that period for the retirement of debt, with another corporation that pays out the $5 per share earnings annually, but which, through an issue of stock rights at the end of that period, obtains $25 per share from its stockholder to retire indebtedness. The fundamental fact is that the use of corporate earnings to retire corporate indebtedness adds to the equity of the stockholders.

It has been suggested that all corporate earnings that are employed for debt retirement be exempted from the application of the surtax. Such proposals possess an emotional appeal because the supporting argument usually runs in terms of a debt-ridden individual -- although, as noted above, the law makes no concession to such an individual. The fundamental fact that corporate debts are parts of corporate capital structures and that the debt element in these structures is voluntary, for the most part, is ignored. Corporations of similar size in the same industry -- competitor structures and that the debt element in these structures is voluntary, for the most part, is ignored. Corporations of similar size in the same industry -- competitors -- vary greatly in the character of their corporate structures. Shall one company, because its stockholders desired to increase their own earnings by obtaining part of the corporate capital through the issue of fixed- interest securities, be given a tax advantage over the stockholders of another corporation in the same line of business who chose to supply all the capital through common stock?

We have already called attention to the fact that railroads and other public utility enterprises, which account for about three- fourths of the long-term debt of all non-financial corporations of the United States, commonly regard such debt as a permanent element in their capital structures, meeting the maturities of particular obligations by refunding issues. Such corporations and industrial corporations as well that desire to reduce their long-term debt may employ new capital funds obtained by the sale to stockholders and others of additional equity securities. Under the Revenue Act of 1936, moreover, a corporation need not distribute its current earnings in cash in order to avoid liability for the surtax on undistributed earnings. It may retain the cash and employ it for debt retirement, and nevertheless avoid the surtax by the distribution of taxable dividends consisting of securities, such as preferred and common stocks, where the effect of the distribution is to change the pro rata interest of the shareholders. There would appear to be no logical or practical ground therefore for exempting from the surtax on undistributed earnings such portions of corporate earnings as are used for debt retirement.

The possible effects upon the tax revenues of any substantial exemption from the corporate surtax of earnings used for debt retirement, apart from the possibilities of tax avoidance by the creation of new debts, should full utilization of the privilege take place, may be indicated by the following figures, which show the aggregate indebtedness of all corporations submitting balance sheets with their income-tax returns in 1928 and 1933:

                                             1928           1933
                                             ____           ____
                                            (Billions of dollars)

          Notes and accounts payable         27.4       19.3
          Bonded debt and mortgages          42.9       45.9
                                             ____       ____
            Total                            70.3       65.2   

3. THE ALLEGED UNSOUNDNESS OF DEPRIVING CORPORATIONS OF A NECESSARY SOURCE OF CAPITAL FOR EXPANSION, EXCEPT ON PAYMENT OF A TAX PENALTY:

It is frequently contended that the direct reinvestment of a large fraction of corporate earnings is essential to the expansion of corporate enterprise; and that the surtaxes imposed under the Revenue Act of 1936 will therefore operate to prevent or seriously to restrict such expansion. This argument is not well founded since ample means for expansion on the part of corporations which command the confidence of their stockholders are available in the form of taxable stock dividends and preferential rights to subscribe to additional securities.

(a) STOCK DIVIDENDS

In the first place, dividends may be paid in the form of securities constituting taxable income to the stockholders, such as preferred and common stocks (provided such distribution changes the proportionate interests of the various classes of stockholders), and various classes of debt instruments.

That the corporate structure is sufficiently flexible to make wide and effective use of this method of earnings retention is indicated by the similar adjustment made by many corporations following the Supreme Court decision in Eisner v. Macomber, in 1920. This decision, permitting the declaration of nontaxable stock dividends, resulted in an enormous increase in such dividends. In 1922 more than $3.3 billions of stock dividends were declared, and about $5.2 billions in the following seven years. The use of such dividends, therefore, for the purpose of making non-cash taxable distributions will involve no major innovation in corporate dividend policies.

(b) STOCK RIGHTS

In addition, for many decades, growing and successful corporations have been able to call upon their stockholders and others for additional capital through the offering of rights to the stockholders to subscribe for additional securities. Through the issuance of such rights, corporations may obtain the reinvestment in their business of capital equal to all or any desired proportion of the current earnings that have been distributed in dividends; and, if need be, more.

Assume a corporation that desired to reinvest in its business its entire earnings of $5 a share, but that, nevertheless, decided to pay out the whole amount in dividends in order to avoid the corporate surtax. Such a corporation could usually obtain the reinvestment in its business of this $5 per share by offering to its stockholders rights to purchase additional capital stock at prices below the prevailing market values. The rights themselves would constitute a valuable marketable instrument which could be sold by any shareholder who was not disposed to reinvest his dividend check. It is equally apparent, of course, that the amount of money which can be obtained in this way is by no means limited to the amount of the earnings of the corporation, but that any reasonable increase in total capitalization can be effected by this means.

During the period between 1921 and 1930, inclusive, the American Telephone and Telegraph Company paid regular dividends at the rate of $9 per share, the dividends aggregating about $850 millions during the ten years. But, during this same ten- year period, the corporation offered rights to purchase additional stock to its stockholders in 1921, 1922, 1922, 1926, 1928, and 1930, and in the aggregate raised about $950 millions of capital from its stockholders through the sale of such additional stock to them -- or about $100 millions more than the aggregate dividends paid to them during the period.

The Travelers Insurance Company of Hartford, Connecticut, by successive offering of rights to shareholders to subscribe to new stock at par in 1908, 1910, 1913, 1916, 1920, 1923, 1925, 1926, 1928, and 1929, multiplied its outstanding amount of capital stock twenty times, from $1 million to $20 millions.

One of the many recent illustrations of this obvious means of adjustment to the undistributed profits tax is offered by Montgomery Ward and Company, whose president, Mr. Sewell L. Avery, vigorously criticized the tax for compelling the company to distribute virtually all of its $20 millions of earnings in 1936. This company paid cash dividends of $~ per share during the past year as against nothing in the previous year, but recouped the entire distribution and more by obtaining $25 millions through an offering of additional common stock to its stockholders.

Referring to Mr. Avery's disclosure that the company is now in need of further capital because of its record-breaking volume of sales, the New York Times reported Mr. Avery as saying that the company has three alternative methods by which it can obtain the new capital it needs: First, issuance of new convertible preferred stock with a rate of about 4 percent; second, issuance of convertible debentures; and third, sale of additional common stock such as was sold last year to provide $25 millions.

The Bureau of business Research of the University of Illinois has estimated that more than $3 billions of capital was raised by corporations in 1929 through offerings of securities to their stockholders. In discussing such stock offerings, Dewing, in his Financial Policy of Corporations, a standard work on this subject, says, "They occurred almost as frequently in 1922 and 1923 as they did in 1928 and 1929". The number of corporations, relatively small and unknown as well as large and well-known, that have been using this means of raising capital funds during the past twelve months is substantial.

Medium-size corporations with scattered stockholders are less advantageously situated to recapture earnings from their stockholders than either small or large corporations. On the one hand, they are less able than small corporations to secure the informal and ready assent of their stockholders to the reinvestment of dividends; and on the other hand, they lack the ready access to the general capital markets that obtains for large corporations. Nevertheless, their managements possess in addition to the device of table stock dividends a highly coercive power to recapture, through rights to additional securities, a large portion of the earnings distributed in dividends.

The fact that this practice has been legs employed by most moderate-size corporations than by large corporations is not attributable to any inherent and decisive difficulty. So long as new capital funds could be obtained by direct reinvestment of earnings, most moderate-size corporations, whose dividend policies were less sive difficulty. So long as new capital funds could be obtained by direct reinvestment of earnings, most moderate-size corporations, whose dividend policies were less subject to tile critical appraisal of a large body of stockholders, found no special advantage in raising funds through rights to their stockholders. Now that the undistributed profits tax provided such an advantage, the coercion applied to stockholders by the preferential offering of new securities at very attractive prices may be ejected to be employed more extensively by moderate-size corporations than in the past, with effective results.

In addition to the funds which may thus be raised by nearly all profitable corporatIons, large and small, through the offering of new stock to their stockholders, large corporations, in particular, will continue to possess, as they always have, access to the organized capital markets for the direct flotation of securities to persons other than their existing security holders and so will be able to raise such additional funds as they nay need through the offering of stocks and bonds for public subscription.

Nevertheless, there are some who argue as if capital funds obtained by direct reinvestment of earnings, and therefore credited to an account called surplus, have a special magic about them that makes them more valuable to a corporation than capital funds obtained through the sale of equity securities. Thus, it is contended that corporations with large accumulated surpluses arc in a stronger competitive position than corporations with smaller or i&o surpluses. This contention does not stand examination. The item of surplus occurs on the liability side of a corporation's balance sheet and does not necessarily represent cash or marketable securities or inventories or any other type of liquid asset. In many cases, a corporation is born with a surplus as a result of the expedient of undervaluing its capital stock on its books and calling the rest of its paid-in capital surplus". In other cases, the surplus is the result of giving a large and sometimes fictitious value to such intangible assets as good will or patent rights. In no case can it be truly stated that a non-financial corporation with an accumulated book surplus is in a better competitive position than another corporation with equal assets and similar liabilities and equally good management that has no book surplus. The latter corporation could create a book surplus at any time by a reduction in the par or book value of its capital stock.

It is sometimes argued that these considerations are more applicable to corporations engaged in stable than to those engaged in highly fluctuating industries because the latter corporations experience frequent and prolonged period during which low earnings or actual deficits preclude successful appeals to stockholders for additional capital funds. However, such corporations were previously able to obtain substantial amounts of capital funds through reinvested earnings only during prosperous years, and under the new law, they may continue to utilize prosperous years to accumulate capital funds by the sale of additional securities to their stockholders.

It is further objected by some that stockholders may be reluctant or even unwilling to reinvest in any given enterprise any large fraction of the earnings distributed to the in dividends. But this argument assumes that corporate managements may justly reinvest earnings in a particular enterprise against the desire of the stockholders. In the last analysis, however, the earnings of a corporation belong to its stockholders; and stockholders are entitled to exercise a choice, which, under the present corporate practices they do not always possess, with respect to the disposition of these earnings. Insofar as one effect of the undistributed profits tax will be to encourage corporate managements to obtain the consent of their stockholders for capital expansion, and to give to stockholders -- the real owners of the corporation -- a greater control over the disposition of their earnings, this effect is altogether desirable. It has often been remarked that corporate managements are far more prudent in the use of capital funds obtained through formal financing with the aid of investment bankers than in the use of capital funds arising out of reinvested earnings. A more disciplined use of the latter source of capital is no less desirable.

4. THE CONTENTION THAT THE TAX ON UNDISTRIBUTED EARNINGS WILL DISCOURAGE AND IMPEDE THE CREATION OF CORPORATE SURPLUSES NECESSARY TO MAINTAIN WAGES, EMPLOYMENT, DIVIDENDS, AND BUSINESS SOLVENCY THROUGH PERIODS OF DEPRESSION:

Critics of all forms of undistributed profits taxation have attempted to rest much or most of their case on this contention. It has been widely charged that one of the principal results of the tax will be to make future depressions far more severe because the accumulated corporate surpluses that in the past have cushioned corporations, their creditors, their stockholders, and their employees from the full effects of a declining or low level of industrial activity, will, by reason of the new tax, be available in much smaller volume. Such contentions possess a surface plausibility, but they do not withstand analysis.

In the first place, much of the plausibility of these contentions arises out of a very widespread misapprehension of the nature of corporate surpluses. A corporate surplus appears on the liability side of a corporate balance sheet and not on the asset side. The account does not represent a pool of liquid assets, cash and the like, which corporations keep available for use in emergencies. It very commonly represents fixed assets in large part, such as plant and machinery; or intangible assets, such as good will, patent rights, contracts, etc., none of which can be "spent" to meet depression needs or to repair damages caused by floods, or for any other emergency. Corporations with capital deficits are quite frequently far better situated, so far as liquid assets are concerned, than corporations that publish balance sheets containing large, surplus figures.

In recent years particularly, the size and character of corporate surpluses, as the expression is used in corporate accounting, have been profoundly influenced by considerations of convenience, taxation, and financing; and the size of a corporate surplus today bears no necessary relationship to the aunt of accumulated earnings nor to the liquid resources of a corporation. Stock transfer and similar taxes, for example, often make it advantageous for a new corporation to place a small book or par value on its stocks, or for an established corporation to revalue its existing capital stocks in this direction, and in both cases to transfer the remainder of the stockholders' equity to the surplus account. Aside from the taxation and similar advantages involved, this chant is purely one of bookkeeping. It does not affect the corporation's ability to withstand depressions or to undertake new expenditures.

The case is not such different for a corporation whose surplus account actually represents accumulated earnings. If these earnings have been invested in the construction or purchase of additional plants and machinery, the large surplus account offers no measure of the corporation's ability to meet financial difficulties. If an investment banker or an investor examines the balance sheet of a corporation to determine whether the stockholders' equity provides an adequate margin of safety for a bond issue, he looks to the whole stockholders' equity, part of which will be found in the capital stock account and the rest of which wall be found in the surplus account. It makes very little, if any difference to him whether the surplus account is large and the capital stock account is small or vice versa, provided only that the book figures accurately measure the real value of the stockholders' equity.

It is not the size of a bookkeeping figure called "surplus" that determines the ability of a corporation to meet a depression or other contingency. It is the amount of the total assets of the corporation as compared with its obligations (particularly its short-term obligations), and the proportion of its assets which it keeps in liquid form, that are significant in this connection. Corporations with relatively large amounts of liquid assets, whether derived from previous earnings or from previous issues of securities, are in a position to meet unusual financial needs, irrespective of the size of the balance sheet item called "surplus".

There is no doubt that a corporation may increase the volume of its liquid resources by withholding current earnings from its stockholders. Then it does so, however, it is obtaining new capital funds from them. It could equally increase its liquid resources by distributing all of its current earnings in dividends and offering its stockholders rights to purchase additional stock with a portion or all of their dividend receipts. The undistributed profits tax places no limit upon the aggregate volume of a corporation's resources nor upon the proportion of these resources that it may keep in relatively liquid form.

There are some who defend the previous system of corporate taxation on the ground that the corporate surpluses that are built up free from surtaxes serve a public function by enabling corporations to maintain employment at a higher level than would otherwise be possible in periods of depression.

This view has been forcefully expressed by Colonel Leonard Ayres of the Cleveland Trust Company, /*/ Citing figures of the Depae in periods of depression.

This view has been forcefully expressed by Colonel Leonard Ayres of the Cleveland Trust Company, /*/ Citing figures of the Department of Commerce to the effect that the national income paid out exceeded the national income produced by a total of $26.6 billions between 1930 and 1934, inclusive, Colonel Ayres concludes: "That sum represents the contribution that business savings made to emergency relief during five depression years. These payments, in excess of income, were made possible because surpluses had been accumulated".

FOOTNOTE

/*/ Cleveland Trust Company Business bulletin, March 15, 1936

END OF FOOTNOTE


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