The CHAIRMAN. You reach that conclusion because you think the time for assessing the value of the property which constitutes the capital is the wrong time? Mr. REED. It is the wrong time. The property, in many cases, is assessed on the assessment made by other parties 30 years ago, with no relation to the investment made by the present owners in the last few years. The CHAIRMAN. Instead of the invested capital being ascertained by valuing the assets at the time of their acquisition, you insist that the assets ought to be valued as of the date the tax is levied? Mr. REED. That can not be done, of course, Senator. The CHAIRMAN. As of the date the bill passses? Mr. REED. I am opposing the capital percentage basis. You have got to value that property as nearly as you can as to the value placed upon it the preceding year- The CHAIRMAN. In other words, for this year you would think you should value the assets as of the 1st of July, 1917? Mr. REED. That would be a decided relief and work justice in a great many cases. The CHAIRMAN. Now, Mr. Reed, if that were done, if we were to ascertain now the invested capital for the purpose of applying this 8 or 10 per cent, as the case may be, as of the 30th day of June, 1917, do you not think by reason of the greatly inflated value on that date, under those rates, we would get a very small tax, relatively speaking, and that in order to get the amount that we are seeking to get from incomes and profits, that we would have to enormously increase these rates? Mr. REED. An 80 per cent tax is a pretty heavy rate, Senator. I would like to answer, if I may, by an illustration of a case that came to me. A man had invested some three or four hundred thousand dollars The CHAIRMAN. Just let me finish, now. For instance, take for illustration this: Suppose you have a steamboat company which owns half a dozen big vessels of the larger type, we will say. If you are going to value those vessels, which are that company's assets, if you are going to value them at the price they would have brought on June 30, 1917, their capitalization is perfectly enormous. Mr. REED. No more enormous, Senator, than the man who bought them at that price at that time The CHAIRMAN. Ten per cent of their capital stock would wipe out very largely their net income, and there would be nothing left to tax. If you are going to take mines, coal mines and iron mines, and value them for the purpose of this deduction at the enormous price at which they would sell now, would you not have a capitalization that would be so much that the 10 per cent upon it would wipe out very largely the profit and we would get no tax from these incomes, or if we got some, it would be relatively a very small tax? Mr. REED. I did not intend to find myself arguing as a direct proposition for a valuation in 1917—————— The CHAIRMAN. That is what you have been arguing. Mr. REED. NO; I have been arguing against the capital percentage basis, because it is unfair. Senator SMOOT. Entirely. Mr. REED. As long as you ask me, I will say this, Senator, that logically and fairly, with this enormous tax, honestly that is what you should do, and I will answer it with an illustration. It is a tax on the profits of 1917 or 1918, as the case may be. In the case I was going to mention a moment ago, a man invested $400,000 back in 1914, I think, or 1913, in the development of some new process for extracting gasoline, I think, from the oil fields. He bought up contracts at nominal prices. Incidentally, he had spent so many thousands of dollars before that in other forms in experimenting with that process, but he had only $400,000 invested in 1917. Those contracts he had obtained at low figures, and he was offered for that business two and one-half millions. I can not quite get it out of my own head that that man was worth two and a half millions at the end of 1916, just as much as the man would have been who paid him two and a half millions for it. Senator SMOOT. Of course, under that plan we would not collect any taxes. I am speaking of the general business of the country. The trouble with an excess profits tax and the trouble with a question of valuation of stock or capital, which is virtually the same thing, is that it is impossible to put into operation. Senator THOMAS. I think the illustration of the chairman shows that. Mr. REED. With that kind of a valuation, Senator, you would not have to have so high a percentage deduction. That is nigh because you know it is unjust in many cases. Even in the English law, Senator, the law values the present property at its cost, which is a very different thing from valuing the investment 30 years ago. It is much fairer. Senator SMOOT. Quite true. Mr. REED. In fact I think that would be a very decided advance over the present bill if that were done. The CHAIRMAN. I have been asked to state that Mr. H. C. Brent, of the Fidelity Trust Co. of Kansas City, has been asked to appear here for the Kansas League of Municipalities in protest against the direct tax against municipal issues and also against the tax I have mentioned, and that he has telegrams from a number of citiesAtchison, Kansas City, and others. He would like to take three or four minutes to present those protests. The CHAIRMAN. He wishes to appear for the bondholders? Mr. REED. No, sir; the Kansas League of Municipalities, Mr. Gwinn, the city treasurer of Baltimore, is present, and would like to address you briefly. The CHAIRMAN. For the purpose of discussing the tax on municipal bonds? Mr. REED. Yes. Those are the only two. The CHAIRMAN. How long do those gentlemen desire? Mr. REED. About three minutes each, I believe. That also includes Mr. Gwinn. Mr. Chairman, before I finish I desire to present a brief in the form of a memorandum which I wish to be made a part of my remarks. (The memorandum referred to above is as follows:) OUTLINE OF POINTS-EXCESS AND WAR PROFITS TAX. A. ANALYSIS AND CRITICISMS OF HOUSE BILL. 1. Definition of invested capital changed from present law. (b) "Paid in surplus" on tangible property omitted. 2. Principle of invested capital unsound. (a) Tax is on excess profits of present stockholders whose capital is (c) 80 per cent tax on excess above 10 per cent of original capital may (d) Gives relative immunity to watered capital and penalizes conservative capitalization. 3. No general or adequate power to deal with exceptional cases. (a) Sec. 327 limited to specific classes. (b) Simply applies a secondary arbitrary basis of tax. (c) This basis unsound and probably unconstitutional. (d) Measures C's tax by income of A and B. 4. Prohibition of consolidated returns invites evasion of tax. (See 336.) B. PROPOSALS. 1. War-profits tax, alternative or exclusive, should reach all profits above normal during the war year. (a) Normal profit determined prima facie by prewar standard. (b) Adjusted in exceptional cases. (c) What is normal profit in given case is business question which can be decided by administrative officer or board analogy to valuation of property by local assessors. (d) Principle to be recognized one of taxation, not of profits limitation. (e) It is constitutional and practical and also essential. 2. Capital (when used) should be present assets. (a) Determined by balance sheet adjusted to meet statute. lowance for purchase of stock representing appreciation should be (c) English valuation is cost or value when acquired, less depreciation; and indebtedness is deducted. (d) 1914 valuation should be allowed in any event to minimize inequalities. * ** * The House bill changes the present excess-profits tax in two vital respects. First, the rate of tax is made confiscatory of the so-called excess profits, and, second, although the House committee's report states in terms that the "definition of invested capital in the existing law has not been changed in any important particular," it has in fact been changed in its most important particular, that of the valuation of tangible property acquired for stock. Under the present law and regulations tangible property acquired for stock prior to January 1, 1914, is required to be valued as of that date, and any excess over the par value of the stock may be allowed as "paid-in surplus" (Regulations No. 41, art. 63), while under the pending House bill, section 326, there is allowed only "actual cash value of tangible property, other than cash, bona fide paid in for stock or shares at the time of such payment, but in no case to exceed the par value of the original stock or shares specifically issued therefor." The following illustrations of the operation of this provision with the greatly increased rates of tax speak for themselves: 1. A Co. was formed in 1905 and $10,000,000 stock was issued for properties which at that time were earning $800,000 and (probably) could have been bought for $4,000,000. Between 1905 and 1912 the company's earnings were high and it put $700,000 into surplus. Its average prewar net income was $900,000 and its stock was selling in 1914 on a valuation of $6,000,000. By 1918 its surplus had increased to $1,400,000. It is now earning $1,200,000. It values the original property at $10,000,000 on its excess profits return and puts its invested capital at $11,400,000. The Treasury can obtain no proof of actual values in 1905 except that shown on the company's books and supported by the subsequent earnings. On a war-profits basis it would be taxed 80 per cent on $300,000, its excess over $900,000, a tax of $240,000. By the 10 per cent limitation based on invested capital, its misnamed war-profits" tax is limited to 80 per cent of $60,000, the excess over $1,140,000, a tax of $80,000, a loss to the Government of $192,000. The actual tax under the graduated rates would be 35 per cent of $288,000, the excess over $912,000 (8 per cent of $1,140,000), a tax of $110,800, a net loss to the Treasury of $129,200. Its real, original invested value was $5,400,000, on which it is earning over 22 per cent and enjoying immunity up to 17 per cent ($912,000). 66 2. B Co. was formed by K. and L. in 1905 with $2,000,000 stock. They turned over to it for the stock a family partnership business for which the partners had just refused a cash offer of $5,000,000. They appraised the physical properties at $3,500,000, but thought that $1,000,000 each was enough stock. They had no reason except personal conservatism for undervaluing the properties. They have kept up the properties, but paid out their net earnings and would have under the House bill a present invested capital of just $2,000,000. In 1914 they refused $7,000,000 for the property. They have averaged $400,000 a year on the property since 1905, this also being their average prewar net income, and are in 1918 trying to avoid profiteering and doing necessary war work with a net income of $470,000. They are taxed under the 80 per cent over 10 per cent clause on the excess over $200,000, which is 4 per cent of the price they refused for the property in 1905, less than 3 per cent of what it was worth in 1916, a total tax of $216,000, leaving them (subject to corporation income and personal taxes) $254,000. Incidentally K. died in 1916, leaving his widow only a one-twentieth interest in his share, valued for inheritance tax at $159,000, and producing an income of $10,000 a year. Or possibly he has sold a one-fortieth interest or 250 shares to J. for $300 a share, paying an income of $5,000 a year. In either case the income is practically cut in half. All parties concerned will probably sell out the company to new owners who on a new valuation are relatively untaxed. A company in the position of A Co. (illustration 1) or E Co. (illustration 5) could take it over without incurring any additional taxation. 3. Corporation C was formed in 1915 by new parties and acquired the properties of either corporation A or corporation B, either for cash or stock, at a valuation, say, of $7,000,000. In either case they have an invested capital based on the actual 1915 valuation plus their surplus since 1915, say, $300,000. Earning $1,000,000 net (the same as A Company) they will be taxed 80 per cent on $470,000 (excess over $730,000) or $376,000. On an earning of $470,000 (same as company B) they would not be taxed at all. In each case the comparison of the recently formed company having a prewar valuation with a company formed in earlier years is very striking. 4. D Company was formed in 1900 by M. and N. on an investment of $100,000. Its properties have been kept up and developed and have appreciated greatly in value, but it has not an "earned surplus." O. and P. bought the company from M. and N. in 1914 for $500,000, paying that price for the stock. The company is taxed on its excess over $8,000 or $10,000; that is to say, 8 per cent, or 10 per cent on its invested capital. O. and P., its owners, are taxed on the excess over 1 per cent, or 2 per cent of their investment. 5. M. and N. formed corporation E in 1900 with investment of $1,000,000. The properties have been kept up, but the company's earning power has been poor and the actual value of the property had depreciated in 1914, when the stock was bought by O. and P. for $500,000. In this case O. and P. have immunity from tax up to 16 per cent, or 20 per cent of their investment. 6. Restating 4 and 5, O. and P. in 1914 bought two corporations for each of which they paid $500,000. The properties were substantially equivalent in value and earning power, and one, to all intents and appearances, was the same as the other. In 1918 they are told that 80 per cent of the excess of the profits of D Company over $10,000 and 80 per cent of the excess of the profits of E Company over $100,000 are to be taken in tax-in the one case 2 per cent of their investment, in the other 20 per cent is the "war-profits" credit. They ask for a reason for the very wide divergence and are told that it is because M. and N. only put $100,000 in B Company, while they put $1,000,000 in E Company. They ask if there is any other reason, and the reply is none. None of the cases cited above are in character exceptional (except perhaps that of C Company, though some of them may be more extreme than the average case). Company A is typical of the watered stock companies; Company B of the undercapitalized companies; and Company C of newly formed companies; while O. and P. are typical of the great body of stockholders who have invested their capital in corporate enterprises at actual values and who will be taxed under this bill according to the accident of the original investment and not in any way according to the present or even prewar value of the actual properties which they acquired by their purchase of stock. A great many concerns whose values a few years ago were and now are in fact far below the original investment are practically immune from tax, while stockholders who have paid for the appreciated values of successful developments, will find their income. whether large or small, confiscated. The point is that there is no necessary relation in fact between the original investment of the original promoter and the values and actual investments of the present stockholders. It is the present stockholder and not the original promoters who are taxed. No such unsound and accidental foundation can support an 80 per cent tax. Under the bill, the Government would practically confiscate the income of one class of stockholders and then with equal lack of intent given to the other class what it has taken unjustly from the first class. Although no figures are available it is believed, that, especially in the immunity given to watered-stock concerns and to concerns whose original values have appreciated, the Government would lose as much as it took unjustly from the other class of stockholders. By using a fair basis the Government, we believe, can get an equal amount of revenue. Certainly if the basis is fair it can and will get all that it can safely take from the business profits of the corporations of the country. We very respectfully urge that the 1914 valuation provision of the present law be retained, and that in any event where the taxpayer can prove an actual value paid in in excess of the stock issued, such value be allowed as "paid-in surplus," which in fact it is. The suggestion has been made that one reason for refusing to allow " 'paid-in surplus in this case is that the stockholders may have undervalued their property for the purpose of keeping down the State organization tax. Assuming this to be so in some cases-and this is we believe permitted by the laws of most States-we are sure that so small a consideration could not be taken by the members of your committee to justify so punitive and unjust a penalty or undercapitalized concerns. It would be very much like shooting a soldier on learning that he had stolen jam from his grandmother as a small boy. The discrimination which the bill makes in favor of overcapitalized concerns is a much more serious matter, and the proposed confiscatory profits tax on the excess over fixed percentages of "invested capital as defined in the bill is so serious that it would be difficult to overestimate its effect, if enacted, at this very critical time. 2. Principle of invested capital unsound.-There are also, of course, serious objections to the principle of invested capital and to the allowance of original cash investment where the original property has disappeared or become valueless and new property has taken its place. The present properties represent the investment of the present stockholders, and assuming that inflated war values are to be avoided and that some adjustment is necessary to meet prevailing views as to this our suggestion would be that the capital be taken to be the present assets at cost or value when acquired, or if acquired prior to 1914 at their value on January 1, 1914. Borrowed money or indebtedness could, of course, be deducted, if this is desired, and the corporation balance sheet adjusted to meet the law would form the basis of the capital determination. This would accord substantially with the English law, except as to the . 1914 valuation. The 1914 valuation substantially minimizes the evil inherent in the principle of "invested capital." With this allowance-and without any limitation by the par value of the stock-prewar concerns are put on a generally equal basis. And there is no express advantage given to watered capital. We expect to urge the English plan of the valuation of present assets as opposed to that of original investment (but with some aliowances for appreciation), the capital percentage standard applying, of course, only to new businesses and new capital and as a limitation on the war-profits standard. |