Cooper, Walter A.

Law and Contemporary Problems : a Quarterly Published by the Duke University, School of Law

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Accounting Problems Under the Excess Profits Tax

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ACCOUNTING PROBLEMS UNDER THEEXCESS PROFITS TAXWALTE, A. CoopEr.*A prominent jurist has said that taxation is an eminently practical subject-towhich statement accountants add "Amen." Too often, however, our legislators,jurists and administrative authorities pay lip service to the ideal and promptly forgetit in practice. Perhaps that is too broad a statement. It may, in many cases, correctlydescribe the result but not the attempt, because often the accounting problems ordifficulties are neither visualized nor appreciated. It is understandable that such aresult may be reached by those who are not, in any way, acquainted with accountingdifficulties which arise in attempting to apply statutory concepts, ideal in nature, towhat might be termed "fluid" accounting principles and data.I use the term "fluid" not in the sense of uncertainty or lack of substance but todescribe an ever-changing panorama. Accounting science must keep, and has kept,pace with business and changing industry and commerce. What is correct today wasnot accceptable five years ago, and that, in turn, was not acceptable ten years earlier.Accounting principles and practices have had to change as business has changed,as industrial organizations have changed, as the requirements of accounting datahave changed, and as laws and administrative authorities have changed-as in thecase of the tax laws and the Securities and Exchange Commission requirements.The excess profits tax law focuses more attention on these problems and difficultiesthan any tax law we ever have had, because it involves a heavy tax on net income inexcess of certain statutory credits or exemptions, both of which are historical innature or, as in the case of Section 722 relief claims, fictional. A correct determinationnecessarily requires that the needed historical accounting and other factual data beavailable, or that the ultimate results which may now be reflected in the accountspresently appearing in the records of corporate taxpayers reflect the result of accu-mulated accounting in line with what is now required for tax purposes.In seeking to develop a taxing statute which produces what seems to be the idealresult, legislators frequently fail to take into account, probably because the difficultiesare not visualized, the inability of the taxpayer or his accountant to supply theanswers required. So also do our jurists, who sometimes reach what may well be a*B.C.S., 1923, New York University. Certified Public Accountant, New York State (1924), Okla-homa (x933), Pennsylvania (T937). Chairman of the Committee on Taxation of the New York StateSociety of Certified Public Accountants; Chairman of the Special Committee of the Tax Foundation onPost-War Reserves; formerly Chairman of the Committee on Federal Taxation of the American Instituteof Accountants.LAw AND CONTEMPORARY PROBLEMSpractical result in a given situation, but in the process lay down a principle that isimpractical in many other cases.Greater leeway is available to administrative officials who, being less rigid in theirapproach, can recognize these difficulties and give credence to records, statements,or even working papers, notes or other records *which, retained and presented in goodfaith, provide the only source for the development of data which is required bylegalistic concepts and historical bases but which cannot otherwise be established bynormal sources of evidence. We have yet to see whether or not that will be done, butas matters now stand it remains for the administrative officials to soften the impactof impractical legislative theory. Here are some of the specific problems we face:Invested Capital Paid InCongress has said that one of the norms for determining profits that are notexcessive shall be specified percentages of capital originally paid in to taxpayer cor-porations, and, where the capital that was paid in took the form of property otherthan cash, it is to be measured by the cost of the property, which is usually its valueat the date of acquisition.Take a simple case and disregard such frills as "property at its basis for determin-ing loss under the law applicable to the year in which it was disposed of" if it is nolonger on hand. Such property may have been paid in twenty, fifty or more yearsago. When such property consisted of what might be called consumable items, suchas depreciable plant assets, inventory, etc., all of which have long since been con-sumed in operations, we might expect to have no problem, because whatever istreated as paid-in capital somehow or other becomes a charge against accumulatedearnings or surplus, so that the one item of invested capital is reduced by the amountincluded in the other. However, that does not necessarily follow, because in dealingwith the determination of accumulated earnings one is required to reduce profitsactually realized by losses or deductions to the extent recognized for income taxpurposes, and the so-called mitigation of the Statute of Limitations (Section 734)requires that there be an adjustment of the prior-year income tax liability if it wasdetermined by treating any item entering into the determination of the investedcapital in a manner inconsistent with the treatment accorded it in such determination.Hence, in all such cases, it becomes necessary to ascertain when the consumableitem was consumed and should have been treated as a deduction in determining tax-able income (from 1913 on, only). If it has not been allowed as a deduction in theyear in which it should have been allowed, the taxpayer may be in position to invokethe benefits of Section 734 to obtain an adjustment of the prior year's tax liability, orelse force the Treasury to incorrectly determine the accumulated earnings for thecurrent-year invested capital computation in order to be consistently incorrect withthe prior treatment.Thus a correct determination might require a complete revaluation as of the dateof acquisition many years ago of plant assets, inventories, etc., as well as a determina-ACCOUNTiNG PROBLEMS UNDER THE ExcEss PROFITS TAxtion of when they were consumed, even though they no longer exist and are not partof the capital with which the taxpayer corporation is now operating.Similarly, when such permanent assets as goodwill are involved, a valuation,which may never have been made, may now be required. Furthermore, these prob-lems apply not merely to the existing taxpayer but may apply to a series of predeces-sors, all of whom have long since expired but whose basis carries forward to theexisting taxpayer.Lucky is the taxpayer who has the records now available to even attempt to showits correct position. Valuations may have to be made "sight unseen" by persons whoat the time had no idea of the existence of the assets they now are required to value,and will have to do that on the basis of cold, statistical data. And all too often thosedata are no longer available.In the writer's own practice a number of situations have arisen in which suchitems as goodwill are required to be valued as of some early date and the records orother information of either the taxpayer or the predecessor are no longer available.A common method of evaluating goodwill is to predicate it on a capitalization ofearnings for a period prior to acquisition. In many cases, particularly where thepredecessor owner was a partnership or an individual proprietorship, records, if theywere maintained at the time, cannot now be located. Sometimes old handwrittenstatements of net income written at the time are found at the bottom of musty oldfiles. Such meager information attorneys may say is inadmissible evidence. In othercases the early earnings history of the present taxpayer, subsequent to the determina-tive date, must be used as the basis to which some yardstick of valuation must beapplied to ascertain the extent to which such assets contribute to the invested capitalcurrently in use. If a reasonable attitude in the acceptance of such data as are avail-able is not adopted by administrative authorities, some taxpayers are going to sufferinequitable taxation.Accumulated EarningsSimilar problems arise in connection with the determination of that portion ofinvested capital represented by what is described in the statute as the accumulatedearnings and profits. No one as yet has attempted to define fully the term "accu-mulated earnings and profits," and even the statute goes no further than to indicatethe treatment of certain items that enter into its determination. Where an accumula-tion of earnings exists, some of our problems disappear in the sense that one neednot distinguish between the effect on capital and earnings-of items that offset eachother, as both constitute part of invested capital. Where a deficit exists, however, theproblem becomes much more acute, for what enters into a deficit account is not con-sidered in determining invested capital; but what affects paid-in capital is includedin invested capital.LAw AND CONTEMPORARY PROBLEMSBase-Period IncomeSome of the problems relating to the determination of invested capital, which isone of the measures of normal profits, have been described. Equally difficult prob-lems have arisen in connection with the determination of the average base-period netincome, which is the other measure of normal profits. Here the law permits orrequires the adjustment of the income correctly reflected on tax returns for itemsrecognized as abnormal, but taxpayers were not keeping their accounts in those daysin anticipation of an excess profits tax law which would call for the adjustment ofabnormal items. Accountants find, therefore, that some detailed analyses, theoret-ically required, cannot now be made with exactness.As an illustration, consider the case of a taxpayer who suffered a strike during thebase period. A strike usually involves the incurrence of abnormal expenses, possiblyin the form of additional wages, the expenses of those who attempt to work, extracosts for trucking or transportation of workers and merchandise, losses throughdefective work or destruction of properties or merchandise, expenses of guards andcompensation paid when work cannot be performed. All such items are usually ab-normal in nature and, under the law, may be added back to the actual net income,determined after deducting such charges. Very often the costs have been absorbedthrough general expense charges including items that are not abnormal. The wagesmay appear in the wages account along with normal wages; merchandise losses maybe absorbed in material costs of production; and lost, non-productive time may havebeen absorbed in either of those classifications or through overhead. How to extractthe amounts representing the abnormal expenses or losses is often a problem and,when it is impossible to develop the amounts with exactness, we must resort to esti-mates or apportionments. Unless administrative authorities are prepared to acceptsuch methods, some taxpayers will be denied justice in the determination of their taxliabilities.Relief under Section 722Finally, we come to what may be termed the fictional feature of our excess profitstax law, that is, the determination of relief from burdensome taxation and unduehardship which is available under the provisions of Section 722 of the InternalRevenue Code. Here the taxpayer must reconstruct and redetermine what its incomewould have been during the base period if the abnormal circumstances or conditions,specified in the law as entitling a taxpayer to relief, had not existed.To use the statutory language, the benefits of this relief are available if "the tax-payer establishes what would be a fair and just amount representing normal earn-ings." The word "establish" is defined in standard dictionaries as: "to fix firmly,""prove legally," or with similarly strong synonyms. If that statutory language istaken literally, how will the taxpayer ever be able to "prove legally" results or earn-ings which, in fact, never materialized? Obviously, such a reconstruction of earningsmust be largely a matter of estimate or opinion, or even guesswork. Unless adminis-ACCOUNTING PROBLEMS UNDER THE ExcEss PROFITS TAx 107trative authorities approach these determinations with an open mind and with fullrecognition of the difficulties involved, fair results will not be obtained.This publication will contain discussions dealing with principles of taxation inthe development of tax laws or legal interpretations of what we have on our statutebooks. Ultimately, these technical matters will be settled by the enactment of taxlegislation and the interpretation thereof by our courts. We shall be left with theproblem of applying practically the resulting rules to the admissible data. The ac-countant can work only with what is in the records that are available to him. Unlessboth our courts and our administrative authorities deal with these difficulties asreasonable men-not seeking the last ounce of legal proof or evidence-no law willever produce equitable taxation. It is heartening to note an expansion of this reason-able approach in both legislative and administrative policies. At the present writing,it must go much further, and it is the accountants' hope that as the wisdom andknowledge of the administrative organizations develop through greater experience indealing with these problems, this tendency will continue.

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Accounting Problems Under the Excess Profits Tax

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