B-25432, JUNE 9, 1942, 21 COMP. GEN. 1103

B-25432, JUNE 9, 1942, 21 COMP. GEN. 1103

CAPITAL STOCK TAX AS ELEMENT OF COST IN COST-PLUS AND "PROFIT RECAPTURE" CONTRACTS WHERE CONTRACTS WHICH EITHER CONTAIN A PROFIT RECAPTURE CLAUSE OR ARE EXECUTED ON A COST-PLUS-A-FIXED-FEE BASIS ARE MADE SUBJECT TO ADMINISTRATIVE REGULATIONS SPECIFICALLY PROVIDING THAT CAPITAL STOCK TAXES MAY BE "TAKEN INTO ACCOUNT" AS AN ELEMENT OF COST, BUT THAT EXCESSIVE OR UNREASONABLE PAYMENTS WILL NOT BE SO TAKEN INTO ACCOUNT, IT IS PROPER TO RESTRICT THE ALLOWABLE PORTION OF CAPITAL STOCK TAX TO THAT WHICH IS BASED ON THE ACTUAL NET WORTH OF THE CONTRACTOR OR ON A REASONABLE--- RATHER THAN INFLATED--- CAPITAL STOCK VALUATION.

COMPTROLLER GENERAL WARREN TO THE CHAIRMAN, UNITED STATES MARITIME COMMISSION, JUNE 9, 1942:

THERE HAS BEEN CONSIDERED YOUR LETTER OF APRIL 16, 1942, AS FOLLOWS: SUBJECT: CAPITAL STOCK TAX AS AN ELEMENT OF COST.

UNDER THE COMMISSION'S REGULATIONS PRESCRIBING METHOD OF DETERMINING SHIPBUILDER'S PROFIT, AND I UNDERSTAND ALSO UNDER T.D. 5000 WHICH GOVERNS SIMILAR DETERMINATIONS UNDER NAVY DEPARTMENT CONTRACTS, IT IS PROVIDED THAT INCOME AND EXCESS PROFIT TAXES MAY NOT BE TAKEN INTO ACCOUNT AS AN ELEMENT OF COST, BUT THAT FRANCHISE AND EXCISE TAXES AND CAPITAL STOCK TAXES MAY BE TAKEN INTO ACCOUNT. THE INCLUSION OF CAPITAL STOCK TAX AS AN ELEMENT OF COST IS UPON THE THEORY THAT IT IS IN EFFECT A FRANCHISE TAX FOR THE PRIVILEGE OF DOING BUSINESS, RATHER THAN A DISTRIBUTION OF PROFITS.

RECENTLY, IN CONNECTION WITH THE COMMISSION'S CURRENT AUDITS OF SHIPBUILDERS' COSTS, THERE HAVE COME TO ATTENTION A NUMBER OF INSTANCES IN WHICH THE CONTRACTOR, AS A BASIS FOR HIS CAPITAL STOCK TAX, HAS DECLARED HIS CAPITAL STOCK VALUE AT A FIGURE GREATLY IN EXCESS OF HIS ACTUAL NET WORTH. FOR EXAMPLE, ONE COMPANY WITH A PRESENT NET WORTH THAT CAN HARDLY BE IN EXCESS OF $500,000 HAS MADE HIS CAPITAL STOCK TAX RETURN UPON A BASIS OF NET WORTH OF SOME $75,000,000, AND ANOTHER COMPANY WITH A FINANCIAL HISTORY ON THE BASIS OF WHICH IT HAS PREVIOUSLY DECLARED CAPITAL STOCK VALUATION OF ABOUT $35,000,000 HAS SUDDENLY INCREASED ITS VALUATION TO ABOUT $160,000,000.

WHILE VALUATIONS OF THIS CHARACTER ARE APPARENTLY IN ORDER FOR TAX PURPOSES UNDER THE INTERNAL REVENUE CODE AS IT PRESENTLY STANDS, THE EFFECT IS TO INCREASE THE AMOUNT OF CAPITAL STOCK TAX PAID AND TO DECREASE THE EXCESS PROFITS TAX. ACCORDINGLY, IF THE CAPITAL STOCK TAX BE INCLUDED AS AN ELEMENT OF COST WITHOUT LIMITATION, THE VOLUNTARY ACTION OF THE CONTRACTOR IN INCREASING HIS CAPITAL STOCK TAX WOULD INCREASE THE APPARENT BOOK COST OF PERFORMING HIS CONTRACTS WITH THE MARITIME COMMISSION AND WOULD THUS REDUCE RECAPTURE IN THE CASE OF CONTRACTS WHICH ARE SUBJECT TO RECAPTURE. IN THE CASE OF CONTRACTS WHICH ARE ON A BASIS OF COST PLUS A FEE, IT WOULD ACTUALLY HAVE THE EFFECT OF CAUSING THE COMMISSION TO PAY THE CONTRACTOR'S EXCESS PROFITS TAX OR AT LEAST SO MUCH THEREOF AS REPRESENTS THE REDUCTIONS IN THAT TAX EFFECTED BY REASON OF THE ARTIFICIAL INCREASE OF THE CAPITAL STOCK VALUATION.

SINCE IT APPEARS OBVIOUSLY CONTRARY TO THE INTEREST OF THE GOVERNMENT OR TO AN EQUITABLE ADMINISTRATION OF THE CONTRACTS TO PERMIT THE CONTRACTOR TO SHIFT TO THE GOVERNMENT THE PAYMENT OF WHAT MIGHT OTHERWISE BE HIS EXCESS PROFITS TAXES OR ANY PART THEREOF, THE COMMISSION'S AUDITORS AT THE VARIOUS SHIPYARDS HAVE BEEN INSTRUCTED TENTATIVELY TO DISALLOW AS AN ELEMENT OF COST OR FOR REIMBURSEMENT PURPOSES THE CAPITAL STOCK TAX PAYMENTS, PENDING THE ISSUANCE OF SPECIFIC INSTRUCTIONS WITH RESPECT THERETO.

THE COMMISSION IS ABOUT TO INSTRUCT ITS AUDITORS FURTHER TO ALLOW AS AN ELEMENT OF COST ONLY SO MUCH OF THE CAPITAL STOCK TAX AS IS BASED UPON A FIGURE NOT IN EXCESS OF ACTUAL NET WORTH OF THE CONTRACTOR, OR, WHERE THE CONTRACTOR HAS A CONSISTENT HISTORY OF A REASONABLE CAPITAL STOCK TAX VALUATION RETURN PRIOR TO THE EFFECTIVE DATE OF THE REVENUE ACT IMPOSING THE PRESENT EXCESS PROFITS TAXES, TO ALLOW SO MUCH OF THE CAPITAL STOCK TAX AS IS BASED UPON RETURNS MADE PRIOR TO THE PASSAGE OF THAT ACT, INCLUDING, OF COURSE, ALLOWABLE INCREASES OF SURPLUS.

WHILE THE COMMISSION WILL BASE ITS INSTRUCTIONS TO ITS AUDITORS UPON THE FURTHER PROVISION IN ITS REGULATIONS TO THE EFFECT THAT NO EXCESSIVE PAYMENTS MAY BE ALLOWED AS PART OF COST, THIS BEING AN OVERRIDING PROVISION WHICH LIMITS THE PROVISION RELATING TO THE INCLUSION OF CAPITAL STOCK TAX, IT DOES NOT NECESSARILY RELY SOLELY THEREON.

BEFORE ISSUING SUCH INSTRUCTIONS, HOWEVER, THE COMMISSION WILL APPRECIATE YOUR COMMENTS SINCE THE MATTER MAY HAVE COME TO YOUR ATTENTION THROUGH OTHER AGENCIES OF THE GOVERNMENT.

SECTION 600 OF THE INTERNAL REVENUE CODE, AS AMENDED, PROVIDES:

IF ANY CORPORATION IS TAXABLE UNDER SECTION 1200 WITH RESPECT TO ANY YEAR ENDING JUNE 30, THERE SHALL BE IMPOSED UPON ITS NET INCOME FOR THE INCOME- TAX TAXABLE YEAR ENDING AFTER THE CLOSE OF SUCH YEAR, A DECLARED VALUE EXCESS-PROFITS TAX EQUAL TO THE SUM OF THE FOLLOWING:

6 6/10 PERCENTUM OF SUCH PORTION OF ITS NET INCOME FOR SUCH INCOME TAX TAXABLE YEAR AS IS IN EXCESS OF 10 PERCENTUM AND NOT IN EXCESS OF 15 PERCENTUM OF THE ADJUSTED DECLARED VALUE;

13 2/10 PERCENTUM OF SUCH PORTION OF ITS NET INCOME FOR SUCH INCOME TAX TAXABLE YEAR AS IS IN EXCESS OF 15 PERCENTUM OF THE ADJUSTED DECLARED VALUE.

SECTION 1200 (A) OF THE INTERNAL REVENUE CODE, AS AMENDED, PROVIDES:

DOMESTIC CORPORATIONS.--- FOR EACH YEAR ENDING JUNE 30, BEGINNING WITH THE YEAR ENDING JUNE 30, 1939, THERE SHALL BE IMPOSED UPON EVERY DOMESTIC CORPORATION WITH RESPECT TO CARRYING ON OR DOING BUSINESS FOR ANY PART OF SUCH YEAR AN EXCISE TAX OF $1.25 FOR EACH $1,000 OF THE ADJUSTED DECLARED VALUE OF ITS CAPITAL STOCK.

THE CAPITAL STOCK TAX AND THE EXCESS PROFITS TAX ARE THUS CLOSELY RELATED, BOTH TAXES BEING BASED UPON THE "ADJUSTED DECLARED VALUE" OF THE CAPITAL STOCK OF A CORPORATION, AND THE CORPORATION IS GIVEN, UNDER THE LAW, AMPLE LATITUDE IN ASCRIBING TO ITS CAPITAL STOCK SUCH VALUE AS IT MAY DETERMINE FOR THE PURPOSE OF COMPUTING THESE TAXES. AS A RESULT SUCH VALUE NEED NOT CONFORM TO THE ACTUAL VALUE OF THE CORPORATION ( CHICAGO TELEPHONE SUPPLY COMPANY V. UNITED STATES, 35 FED.SUPP. 470) AND THE TAXPAYER MAY CHOOSE TO IGNORE ACTUALITIES AND BASE ITS COMPUTATION ON CONJECTURE. ISTHMIAN STEAMSHIP COMPANY V. UNITED STATES, 33 FED.SUPP. 1007. APPARENTLY THE CORPORATIONS HAVE TAKEN ADVANTAGE OF THIS SITUATION BY PLACING ON THE CAPITAL STOCK A VALUATION WHICH, WHEN USED AS A BASE FOR DETERMINING THESE TWO TAXES, WILL RESULT IN THE LOWEST COMBINED TAX POSSIBLE.

MANIFESTLY IF A CORPORATION DOING BUSINESS WITH THE GOVERNMENT BE ALLOWED TO INCLUDE AS AN ELEMENT OF COST UNDER EITHER OF THE TYPES OF CONTRACT MENTIONED IN YOUR LETTER THE FULL AMOUNT OF ITS CAPITAL STOCK TAX, THE RISK WHICH A CORPORATION ASSUMES IN ARTIFICIALLY INFLATING ITS CAPITAL STOCK VALUATION AND UPON WHICH THE CONGRESS DEPENDED AS A CONTROLLING FACTOR IN SUCH VALUATIONS WOULD BE REMOVED. THE UNDESIRABILITY OF SUCH PRACTICE APPEARS TOO CLEAR TO WARRANT ANY DISCUSSION.

THE CAPITAL STOCK TAX HAS BEEN HELD TO BE AN EXCISE TAX LEVIED UPON THE PRIVILEGE OF DOING BUSINESS AS A CORPORATION. FLINT V. STONE TRACY COMPANY, 220 U.S. 107; U.S. STEEL PRODUCTS COMPANY V. UNITED STATES, 36 FED.SUPP. 368. HOWEVER, IN CONSIDERING WHETHER THE AMOUNT OF SUCH TAX SHOULD BE AN ALLOWABLE ITEM OF COST UNDER MARITIME COMMISSION SHIPBUILDING CONTRACTS, THE TAX APPEARS TO PRESENT A PROBLEM OF A DUAL NATURE. WHERE A CORPORATION CHOOSES ARTIFICIALLY TO INFLATE THE DECLARED VALUE OF ITS CAPITAL STOCK AND TO PAY THE INCREASED CAPITAL STOCK TAX THEREON RATHER THAN RISK PAYING AN EXCESS PROFITS TAX SHOULD ITS INCOME EXCEED THE EXCESS PROFITS CREDIT, IT IS IN EFFECT SUBSTITUTING PAYMENT OF AN EXCISE TAX--- THE CAPITAL STOCK TAX--- FOR A TAX ON EARNINGS--- THE EXCESS PROFITS TAX. CONSEQUENTLY, THAT PART OF THE CAPITAL STOCK TAX WHICH IS BASED ON AN ARTIFICIALLY INFLATED CAPITAL STOCK VALUATION APPEARS TO BE MORE IN THE NATURE OF A TAX ON EARNINGS THAN AN EXCISE TAX AND WOULD SEEM TO BE FOR CONSIDERATION AS SUCH UNDER CONTRACTS CONTAINING A PROFIT RECAPTURE CLAUSE AND THOSE EXECUTED ON A COST-PLUS-A-FIXED-FEE BASIS.

IN A DECISION BY A FORMER COMPTROLLER OF THE TREASURY UNDER DATE OF JUNE 28, 1918, REPORTED IN 24 COMP. DEC. 787, THERE WAS CONSIDERED THE QUESTION WHETHER THE SPECIAL EXCISE TAX IMPOSED BY SECTION 407 OF THE ACT OF SEPTEMBER 8, 1916, 39 STAT. 789, WAS AUTHORIZED AS AN ITEM OF COST UNDER COST-PLUS CONTRACTS. SAID SECTION PROVIDED, IN PART, AS FOLLOWS:

THAT ON AND AFTER JANUARY FIRST, NINETEEN HUNDRED AND SEVENTEEN, SPECIAL TAXES SHALL BE, AND HEREBY ARE, IMPOSED ANNUALLY, AS FOLLOWS, THAT IS TO SAY:

EVERY CORPORATION, JOINT-STOCK COMPANY OR ASSOCIATION, NOW OR HEREAFTER ORGANIZED IN THE UNITED STATES FOR PROFIT AND HAVING A CAPITAL STOCK REPRESENTED BY SHARES, AND EVERY INSURANCE COMPANY, NOW OR HEREAFTER ORGANIZED UNDER THE LAWS OF THE UNITED STATES, OR ANY STATE OR TERRITORY OF THE UNITED STATES, SHALL PAY ANNUALLY A SPECIAL EXCISE TAX WITH RESPECT TO THE CARRYING ON OR DOING BUSINESS BY SUCH CORPORATION, JOINT-STOCK COMPANY OR ASSOCIATION, OR INSURANCE COMPANY, EQUIVALENT TO 50 CENTS FOR EACH $1,000 OF THE FAIR VALUE OF ITS CAPITAL STOCK AND IN ESTIMATING THE VALUE OF CAPITAL STOCK THE SURPLUS AND UNDIVIDED PROFITS SHALL BE INCLUDED: * * * IT WAS HELD IN THAT DECISION THAT THIS TAX SHOULD NOT BE INCLUDED AS AN ELEMENT OF COST.

THE TAX THERE CONSIDERED WAS OF THE SAME GENERAL NATURE AS THE CAPITAL STOCK TAX HERE INVOLVED, EXCEPT THAT BY ALLOWING THE TAXPAYER TO PLACE ITS OWN VALUE ON ITS CAPITAL STOCK WITH RESPECT TO THE PRESENT TAX CONGRESS AVOIDED THE NECESSITY OF PRESCRIBING A FORMULA FOR ARRIVING AT THE ACTUAL VALUE OF THE CAPITAL--- A PROBLEM WHICH HAD BEEN FOUND PRODUCTIVE OF MUCH LITIGATION UNDER THE EARLIER ACT--- AND AT THE SAME TIME PROVIDED PROPER SAFEGUARDS AGAINST LOSS OF REVENUE TO THE GOVERNMENT THROUGH UNDERSTATEMENTS OF CAPITAL. HAGGAR COMPANY V. HELVERING, 308 U.S. 389, 394.

IT WILL BE NOTED THAT THE ABOVE-MENTIONED DECISION OF JUNE 28, 1918, WAS RENDERED WITHOUT REFERENCE TO ANY PARTICULAR CONTRACT OR CLAIM BUT ON A WHOLLY ABSTRACT QUESTION. SUBSEQUENTLY, HOWEVER, THE COURT OF CLAIMS IN THE CASE OF CRAMP AND SONS SHIP CO. V. UNITED STATES (72 CT.1CLS. 146) CONSIDERED THE QUESTION WHETHER THIS SPECIAL EXCISE TAX SHOULD BE INCLUDED AS AN ITEM OF COST UNDER A NAVAL SHIPBUILDING CONTRACT EXECUTED ON A COST- PLUS-PROFIT BASIS CONTAINING THE FOLLOWING PROVISIONS:

THE ACTUAL COST SHALL INCLUDE THE FOLLOWING, AND ITEMS SIMILAR THERETO IN PRINCIPLE:

(D) A PROPER PROPORTION OF TAXES OF ALL KINDS ACCRUED DURING THE TAXABLE YEAR WITH RESPECT TO THE BUSINESS OR PROPERTY.

THE COURT HELD THAT THE TAX WAS A PROPER ITEM OF COST SINCE, BEING AN EXCISE TAX, IT WAS WITHIN THE EXPRESS TERMS OF THE CONTRACT. THE COURT STATED IN PART,"IT WAS IN FACT AND IN TRUTH A COST OF DOING BUSINESS AND THERE IS NO LEGAL OBSTACLE IN THE WAY OF THE GOVERNMENT TAKING THE SAME INTO CONSIDERATION IN DETERMINING THE AMOUNT TO BE PAID TO A CONTRACTOR FOR ARTICLES MANUFACTURED FOR THE GOVERNMENT.'

PRESUMABLY THE REGULATIONS TO WHICH YOUR LETTER REFERS ARE THOSE ENTITLED " REGULATIONS PRESCRIBING METHOD OF DETERMINING PROFIT" APPROVED MAY 4, 1939, BY THE UNITED STATES MARITIME COMMISSION.

SECTION 7, SUBSECTION 7.48, THEREOF PROVIDES:

TAXES.--- INCOME AND EXCESS PROFITS TAXES AND SURTAXES WHETHER FEDERAL, STATE OR OTHER MAY NOT BE TAKEN INTO ACCOUNT. FRANCHISE AND EXCISE TAXES, PROPERTY TAXES (EXCEPT TAXES ON PROPERTY HELD IN RESERVE OR FOR INVESTMENT, OR FOR OTHER EXTRANEOUS PURPOSES), SOCIAL SECURITY TAXES AND THE LIKE (NOT INCLUDING PAYMENTS DEDUCTED FROM OR CHARGEABLE TO EMPLOYEES OR OFFICERS) AND CAPITAL STOCK TAXES OTHER THAN TAXES UPON THE ISSUE OR TRANSFER OF SECURITIES MAY BE TAKEN INTO ACCOUNT. IN THE CASE OF STATE INCOME TAXES PAYABLE UPON ALTERNATIVE BASES, THE PORTION THEREOF, IF ANY, DEEMED TO BE FRANCHISE OR EXCISE TAX SHALL BE DETERMINED TO THE SATISFACTION OF THE COMMISSION.

SUBSECTION 7.23 OF SAID SECTION PROVIDES IN PART:

UNREASONABLE CHARGES.---EXCESSIVE OR UNREASONABLE PAYMENTS, WHETHER IN CASH, STOCK, OR OTHER PROPERTY SHALL NOT BE TAKEN INTO ACCOUNT. * * *

THUS, ALTHOUGH IT IS SPECIFICALLY PROVIDED THAT CAPITAL STOCK TAXES "MAY BE TAKEN INTO ACCOUNT," THE EXTENT TO WHICH THIS IS TO BE DONE IS LIMITED BY VIRTUE OF THE LAST QUOTED PROVISION TO THAT PART OF THE PAYMENT WHICH MEETS THE TEST OF REASONABLENESS. CERTAINLY THAT PART OF THE CAPITAL STOCK TAX PAYMENT AS MAY BE BASED ON A FIGURE IN EXCESS OF THE ACTUAL VALUE OF THE CAPITAL STOCK IS "EXCESSIVE OR UNREASONABLE," ESPECIALLY WHEN VIEWED AS BEING ONLY A SUBSTITUTE FOR A TAX ON EARNINGS WHICH IS SPECIFICALLY EXCLUDED AS A COST ITEM BY THE ABOVE-QUOTED REGULATIONS.

IT IS STATED IN YOUR LETTER THAT THE COMMISSION CONTEMPLATES INSTRUCTING ITS AUDITORS THAT IN CASES WHERE A CORPORATION HAS A CONSISTENT HISTORY OF A REASONABLE CAPITAL STOCK VALUATION "PRIOR TO THE EFFECTIVE DATE OF THE REVENUE ACT IMPOSING THE PRESENT EXCESS PROFITS TAXES" THAT SUCH VALUATION MAY BE USED IN COMPUTING THE ALLOWABLE PORTION OF THE CAPITAL STOCK TAX PAYMENT. IT IS ASSUMED YOU HAVE REFERENCE NOT TO THE "EXCESS PROFITS TAX" IMPOSED BY SECTION 710 OF THE INTERNAL REVENUE CODE, AS AMENDED ( SECOND REVENUE ACT OF 1940, 54 STAT. 975) BUT TO THE "DECLARED VALUE EXCESS- PROFITS TAX" PROVIDED FOR IN SECTION 600 OF SAID CODE, SUPRA. SEE IN THIS CONNECTION THE ACTS OF OCTOBER 8, 1940, 54 STAT. 1008, AND SEPTEMBER 20, 1941, 55 STAT. 703. BASED UPON SUCH ASSUMPTION THERE WOULD APPEAR TO BE NO REASON WHY THE AUDITORS OF THE MARITIME COMMISSION SHOULD NOT BE INSTRUCTED AS YOU SUGGEST WITH RESPECT TO CONTRACTS OF THE COMMISSION, GOVERNED BY THE REGULATIONS ABOVE QUOTED WHEREIN EXPRESS PROVISION IS MADE FOR CAPITAL STOCK TAXES AS AN ITEM OF COST. IN THIS CONNECTION THERE IS ENCLOSED FOR YOUR INFORMATION AND REFERENCE A COPY OF A RECENT DECISION OF THIS OFFICE DATED JUNE 2, 1942, B-25554, 21 COMP. GEN. 1082, INVOLVING THE QUESTION OF CAPITAL STOCK TAXES UNDER A CONTRACT PROVIDING FOR THE DETERMINATION OF COSTS IN ACCORDANCE WITH T.D. 5000.