The choice is available to the following classes of corporations: (1) A domestic corporation, the first taxable year of which begins in 1940, if it was in existence for at least 48 months prior to the beginning of such taxable year. (2) A domestic corporation, which, while not in existence for the period specified under (1), is deemed to have been in existence for a period of 48 months prior to the beginning of its first taxable year beginning in 1940, because it acquired, or resulted from the coalescing of, other corporations through certain tax-free exchanges or reorganizations, where such other corporations were in existence at the beginning of such 48-month period or had predecessors who were in existence at that time. In the opinion of your committee, the denial of the privilege of election to corporations in this category would be inequitable. The two methods of measuring excess profits are outlined below. First method-Based on income. If this method is chosen, the taxpayer measures its excess profits by a comparison of its earnings for the taxable year with its average earnings for the base period. For the purposes of the comparison, the average earnings for the base period are increased by 8 percent of the net additions to capital occurring after the beginning of the taxpayer's first taxable year under the bill, or decreased by 6 percent of the net reductions in capital during the same period. The amount so arrived at constitutes the taxpayer's excess-profits credit which, when deducted from the earnings for the taxable year, determines the excess profits, or the portion of the income which after the deduction of the specific exemption of $5,000 is subjected to excess-profits tax. Second method-based on income and invested capital. Under this method, the portion of the earnings for the taxable year to be considered as excess profits, to which the tax will apply, is ascertained by deducting from the earnings of the taxpayer for the taxable year an amount equal to the percentage of its invested capital for such year which its earnings during the base period bear to its invested capital for the base period. Such percentage may not be more than 10 or less than 5, except that with respect to the first $500,000 of invested capital for the taxable year the minimum percentage is 7 instead of 5. These minimum percentages establish a floor for corporations with low earnings during the base period, thus allowing such corporations a reasonable return on their invested capital before becoming subject to excess-profits tax. In addition, corporations, under this method, are allowed a 10 percent tax-free return on new capital, to the extent that it does not cause the invested capital to exceed $500,000, and 8 percent on new capital in excess of that figure. (b) Corporations in existence during only part of the base period.— Corporations in existence for only a part of the base period must measure their excess profits by the second method. For this purpose they are supplied an invested capital for the period during which they were not in existence equal to their invested capital at the beginning of their 1940 taxable year, and upon that hypothetical invested capital they are deemed to have earned 10 percent of the first $500,000 of such invested capital and 8 percent of the amount in excess of $500,000. For example, corporation A came into existence on January 1, 1938. It had an invested capital as of January 1, 1940, of $800,000 and keeps its books and accounts on a calendar-year basis. It had an average invested capital and excess-profits net income for the portion of the base period during which it was actually in existence as indicated. These factors for the portion of the base period during which it was not in existence are supplied as follows: The amounts marked by an asterisk (*) do not represent the actual experience of the corporation but have been supplied by the invested capital for 1940, upon which a yield of 10 percent for the first $500,000 and 8 percent on the balance is assumed. Thus, the portion of the earnings for the taxable year in excess of an amount equal to 8.7 percent of the invested capital for the taxable year is considered excess profits and, after being reduced by the specific exemption of $5,000, is subject to tax. (c) Corporations not in existence in the base period.-Corporations which come into existence after the close of the base period (other than those companies which are allowed the use of a substituted baseperiod experience because of certain tax-free exchanges and reorganizations) must measure their excess profits under the second method. For this purpose, they are allowed a credit equal to 10 percent of the first $500,000 of their invested capital for the taxable year and 8 percent of such capital in excess of $500,000. 5. COMPUTATION OF THE EXCESS-PROFITS CREDIT First method-Based on income. Under this method the excess-profits credit for the taxable year is the aggregate of earnings for all of its taxable years in the base period divided by the total number of those years. In the event of a deficit for 1 year in the base period, the aggregate earnings for the other years are not reduced thereby. If there are deficits in more than one year in the base period, the aggregate earnings for the other years are reduced by all such deficits except the one for the year in which the greatest deficit occurred. But in all cases the aggregate so determined is divided by the total number of years in the base period. For example, corporation X had earnings of $300,000 in 1936, and $200,000 in 1937. In 1938 it had a deficit (that is, an excess of deductions and net income credits over gross income) of $150,000 and in 1939 another of $100,000. Its aggregate earnings for the base period are $400,000; that is $300,000 plus $200,000 minus $100,000; the greatest deficit, the $150,000 deficit, being disregarded. The average earnings for the base period are, therefore, $100,000, or $400,000 divided by the number of years in the period. Second method-Based on income and invested capital. This method involves the same procedure as the first for determining the average earnings of the base period. In determining the average invested capital, however, the invested capital for no year is eliminated. Additions to invested capital are allowed a tax-free return of 10 percent to the extent that they do not cause it to exceed $500,000; a tax-free return of 8 percent is allowed on new capital above that figure. For the purpose of distinguishing between old capital and new, all capital in excess of that for the beginning of the taxpayer's first taxable year under the bill is considered to be new. But, if the invested capital subsequently reaches a lower figure, that figure would become the measure of new capital. For example, a corporation on a calendar-year basis had on January 1, 1940, the beginning of its first taxable year under the excess-profits tax, an invested capital of $100,000. In 1941 its invested capital had increased to $150,000. This $50,000 increase would be considered as new capital and allowed a return of 10 percent. In 1942 its invested capital was $130,000, or $20,000 less than 1941, but still $30,000 more than in 1940. This $30,000 would still be regarded as new capital as it is in excess of the measure established by 1940. However, if in 1943 the invested capital were to be reduced to $75,000 this figure would replace the $100,000 figure for 1940 as the measurement of new capital. That is, for years subsequent to 1943 any invested capital in excess of $75,000 will be considered as new capital until a new low is established. The following tables prepared by the Treasury Department illustrate the effect of the tax under the first and second methods: TABLE I.-Illustrations of sample corporations, showing excess-profits taxes under (1) average base period earnings method and (2) percentage return on invested capital method 1 Normal tax net income: 2 Average for base period: Percent of invested Taxable year: Amount. Percent of invested Net income for excess-profits Average for base period. Cor- Cor- Cor pora- pora- pora- Corporation 4 Corpo- Corporation 5 ration 6 Corpo- Corpo ration 7 ration 8 $50,000 $50,000 $50,000 $1,000,000 $1,000,000 $1,000,000 $500,000 $1,250,000 $60,000 $60,000 $60,000 $1,200,000 $1,200,000 $1,200,000 $1,500, 000]$1, 500, 000 Taxable excess profits: 1 Except where otherwise indicated it is assumed that (1) invested capital remains unchanged; (2) for the base períod Federal income taxes amounted to 16 percent of net income; (3) the corporation derived no income from dividends from domestic corporations, interest on taxable United States securities, or capital gains; and (4) the corporation had no borrowed capital. Net income before deduction of normal tax. 3 Net income after deduction of normal tax. The amount for the taxable year is the "excess profits net income." Excess profits net income for the taxable year less the specific exemption of $5,000 and the excess profits credit. Flat rate tax of 4.1 percent is computed on normal tax net income. • Invested capital consists of the $3,500,000 equity capital and 33% percent of the $1,500,000 borrowed capital. It is assumed that this corporation (1) distributed all its net income in dividends; (2) derived no income from dividends from domestic corporations, interest on taxable United States securities or capital gains; and (3) had no borrowed capital. Normal income taxes are computed at rates effective in the several years Second method-Based on income and invested capital. This method involves the same procedure as the first for determining the average earnings of the base period. In determining the average invested capital, however, the invested capital for no year is eliminated. Additions to invested capital are allowed a tax-free return of 10 percent to the extent that they do not cause it to exceed $500,000; a tax-free return of 8 percent is allowed on new capital above that figure. For the purpose of distinguishing between old capital and new, all capital in excess of that for the beginning of the taxpayer's first taxable year under the bill is considered to be new. But, if the invested capital subsequently reaches a lower figure, that figure would become the measure of new capital. For example, a corporation on a calendar-year basis had on January 1, 1940, the beginning of its first taxable year under the excess-profits tax, an invested capital of $100,000. In 1941 its invested capital had increased to $150,000. This $50,000 increase would be considered as new capital and allowed a return of 10 percent. In 1942 its invested capital was $130,000, or $20,000 less than 1941, but still $30,000 more than in 1940. This $30,000 would still be regarded as new capital as it is in excess of the measure established by 1940. However, if in 1943 the invested capital were to be reduced to $75,000 this figure would replace the $100,000 figure for 1940 as the measurement of new capital. That is, for years subsequent to 1943 any invested capital in excess of $75,000 will be considered as new capital until a new low is established. The following tables prepared by the Treasury Department illustrate the effect of the tax under the first and second methods: TABLE I-Illustrations of sample corporations, showing excess-profits taxes under (1) average base period earnings method and (2) percentage return on invested capital method Normal tax net income: * Percent of invested Taxable year: Amount $50,000 $50,000 $50,000 $1,000,000 $1,000,000 $1,000,000 $500,000 $1,250,000 $60,000 $60,000 $60,000 $1,200,000 $1,200,000 $1,200,000 $1,500,000 $1,500,000 |