SECTION 215. INTEREST ON CERTAIN DEFERRED

PAYMENTS

A. "Unstated interest" provision

Present law. Under present law when an individual sells a capital asset on the installment basis and makes no provision for interest payments on the installments, the full difference between his cost (or other basis) for the property and the sales price is treated as a capital gain to the seller (unless under section 1245, part of the gain is treated as ordinary income). The buyer takes as his cost for the property the total sales price paid. This can be illustrated by an individual having a capital or depreciable asset with a basis and fair market value of $1,000 which he sells for $1,300 payable in equal installments over a 10-year period. In this case, if no part of the payments are designated as interest payments and the seller elects to report any gain on the installment basis, then each payment will be treated partly as a return of capital and partly as a capital gain. Over the 10-year period, the taxpayer would report $300 of capital gain rather than reporting this amount as ordinary income. The buyer would treat the $300 as a part of his cost for the property which means that in the case of depreciable property the $300 would be recoverable over the life of the property. (He might also be eligible for an investment credit with respect to this $300.) If the $300 had been specified as interest, the buyer would have received an interest deduction of $300 spread over the 10-year period.

General rule under House bill.-The House bill provides that where property is sold on an installment basis and part of the payments are due more than 1 year from the date of the sale or exchange, if no interest payments are specified (or if "too low" interest payments are specified), a part of each of these payments due after the first 6 months is to be treated as an "unstated interest" payment (rather than as a part of the sales price).

The amount of this "unstated interest" is to be determined by using an interest rate specified by the Secretary of the Treasury or his delegate by regulations. The House report indicates that this interest rate is to be the going rate of interest and is to be no higher than the rate at which a person in reasonably sound financial circumstances and with adequate security could be expected to borrow from a bank. It is suggested that a 5-percent rate appears appropriate under existing circumstances.

With this interest rate, the proportion of each of the installment payments in the case of a sale or exchange of property which is to be considered as interest is to be determined in the following manner: First, the present value of each installment payment is determined based upon the specified interest rate discounted semi-annually. Second, the total of these present values of the installment payments are deducted from the total of the installment payments. The amount remaining is the total "unstated interest." Third, this unstated interest then is assumed to be spread evenly over the total payments involved.

76

Thus, if a specified payment represents one-tenth of the total payments, it would be assumed to include one-tenth of the total unstated interest.

The method just described for computing the unstated interest in each installment, relates to the case where no interest payments are specified in the contract. Where interest payments are provided but at a rate more than 1 percent lower than the rate specified by the Secretary of the Treasury, the present values of these actual interest payments are determined along with the present values of the remainder of the payments. The unstated interest then is the total of the payments to be received under the contract minus the total present values, including the present values of the actual interest payments, reduced by the actual interest payments.

The House provision specifies that the regulations are to provide for the discounting of payments on a 6-month basis and are to ignore for this purpose any interest payments due within the first 6 months. Where an installment contract provides for the payment of some interest, no unstated interest is to be computed unless the actual interest payments represent interest computed at a rate more than 1 percent below the rate specified by the Secretary of the Treasury. Thus, if a 5-percent rate is specified by the Secretary, no unstated interest will be computed where the interest actually provided is 4 percent or more.

For purposes of the section payment for property in the form of a note or other evidence of indebtedness of the purchaser is not to be treated as a payment since otherwise it would be possible to exchange non interest bearing forms of indebtedness for the installment contract for the property. However, payments made on this indebtedness are treated as if they were payments made on the installment contract itself.

Where some or all of the payments are indefinite as to their sizefor example, where payments are in part at least, dependent upon future income derived from the property-the unstated interest is to be determined separately for each of these indefinite payments as if it were the only payment involved. Also, where there is a change in the amount due under a contract, the unstated interest is to be recomputed at the time of each change.

The House bill specifies five situations in which this provision is not to apply or is to be modified:

1. It is not to apply unless the sale price of the property is in excess of $3.000.

2. If any of the amounts involved under the installment contract are carrying charges which presently are treated as interest from the standpoint of the purchaser then, in the case of the purchaser, such amounts are to be treated as interest payments for purposes of this provision.

3. In the case of the seller this provision is to apply only if some part of the gain (if any) from the sale or exchange of the property would be considered as gain from a capital asset, or gain from depreciable property.

4. It is not to apply in the case of payments with respect to patents which are treated as resulting in capital gain under present law.

5. It is not to apply where the property involved is exchanged for annuity payments which depend in whole or in part on the life ex

pectancy of one or more individuals nor is it to apply to payments such as those for timber, coal, and iron ore (sec. 631). In this latter case, the provision does not apply because the transaction involved is not considered to be an installment contract.

Eample. The operation of this provision can be illustrated by assuming that an individual sells real property under a contract which provides that the purchaser is to make payments in three equal installments of $2,000 each, with the installments being due annually in the first 3 years after the date of sale. Assume further that no interest is provided under the contract, and that the Secretary of the Treasury has prescribed by regulations that 5 percent per annum compounded semiannually is to be the rate of interest to be used under this provision.

The present value of the first $2,000 payment discounted for 1 year at 5 percent (compounded semiannually) is $1,903.63. The present value of the second payment similarly computed but discounted for 2 years is $1,811.90. The present value of the third payment discounted for 3 years is $1,724.59. The sum of the three present values of these three installment payments is $5,440.12. Subtracting this amount from the total of the installment payments ($6,000) leaves $559.88 as the unstated interest. This unstated interest then is assumed to be attributable evenly to the three installment payments, $186.63 to each.

Effective date. This provision applies to payments made after December 31, 1963, on account of sales or exchanges of property occurring after June 30, 1963.

Revenue effect. This provision is expected to result in a negligible increase in revenues.

B. Carrying charges

Present law. Among the itemized deductions allowed taxpayers under present law is the deduction for interest payments. Administrative practice has long allowed as an interest deduction the portion of any carrying charges on installment purchases to the extent the interest element is stated separately. In 1954, Congress also provided that an interest deduction is to be available in case of carrying charges stated separately even though the interest charge cannot be ascertained directly. In these cases, the statute provides that the carrying charges are to be considered as interest up to an amount equal to a 6-percent interest charge computed on the average unpaid balance under the contract. This provision applies, however, only in the case of "personal property" purchased under an installment contract.

House bill provision.The House bill amends the provision of present law which treats as an interest deduction carrying charges to the extent of 6 percent of the average unpaid balance under the contract, to extend this provision to cover payments for services sold under an installment contract. This would include, for example, such payments for services as college tuition.

This provision applies to taxable years beginning after December 31, 1963.

This provision is expected to result in a negligible loss of revenue.

SECTION 216. PERSONAL HOLDING COMPANIES

The individual income tax rates are steeply progressive up to 91 percent. On the other hand, the corporate rate on investment income generally does not exceed 52 percent and, in addition, because of the dividends received deduction the effective rate for a corporation on dividend income is less than 8 percent. For this reason if there were no special statutory provisions an individual owning stock and other valuable investments could save a large amount of income tax by placing all these investments in a corporation so that the income produced by them would be subject to tax only at the substantially lower rates. The personal holding company sections of the code (secs. 541-565) are intended to prevent the savings of income tax in this manner. Those sections apply only to corporations which are closely held and which have mostly personal holding company income. "Personal holding company income" generally includes dividend and interest income and in addition includes rents and royalties under certain conditions.

The bill makes numerous amendments in the personal holding company sections. Most of these amendments are intended to make avoidance of individual income tax through the use of a personal holding company more difficult than under present law. In view of the length of this section it will be discussed by separate topics.

New rate

The present rate of tax on "undistributed personal holding company income" is 75 percent on the first $2,000 and 85 percent on the balance. Subsection 216(a) of the bill diminishes this rate to 70 percent on the entire amount. The rate is reduced because the individual income tax rates are also reduced by the bill. The 70-percent rate will be the new top individual rate under the bill in 1965 and thereafter. New definition of personal holding companies

Under existing law a corporation is a personal holding company if at least 80 percent of its gross income is personal holding company income. The bill amends this definition to provide that a corporation is a personal holding company if at least 60 percent of its "adjusted ordinary gross income" is personal holding company income. It is important to note that the base, on which the percentage is computed, is changed.

Under the amendments made by the bill "ordinary gross income" is gross income minus the gains on capital assets and 1231 assets (depreciable business property). "Adjusted ordinary gross income" is ordinary gross income minus certain deductions to the extent attributable to rent income or to income from mineral oil and gas royalties or from working interests in oil and gas wells. These deductions are those for depreciation or depletion, property taxes and severance taxes, interest, and rent. Under the new rules many corporations, not now so classified, will become personal holding

79

69-108 0-66-pt. 2 -22

1723

companies. To illustrate this, let us assume we have a corporation which has $60,000 income from dividends and $40,000 income from a working interest in an oil well. The fixed charges above described incurred in connection with the oil well (depreciation, depletion, property taxes, severance taxes, interest, and rent) total $10,000. Under existing law the corporation is not a personal holding company because only 60 percent (not 80 percent) of its gross income

is personal holding company income. Under the bill amendments; however, the corporation is a personal holding company. The total "adjusted ordinary gross income" is $60,000 plus $40,000 minust $10,000 or $90,000. Accordingly, the percentage of this income

$60,000

which is personal holding company income is 66% percent $90,000/

which is more than 60 percent.

Excluded corporations-finance companies

The bill excludes from the application of the personal holding company sections certain domestic building and loan associations even though these associations may fail to qualify for the special income tax treatment afforded building and loan associations by the code.

Present law provides that certain classes of corporations are not to be treated as personal holding companies. Among the types of corporations so excluded are four different kinds of finance companies which are in general as follows: (1) Licensed personal finance companies classified as "small loan companies" by State law ("Russell Sage"); (2) other lending companies engaged in the small loan or consumer finance business; (3) a loan or investment company (such as a Morris Plan Bank) whose business consists substantially of receiving funds not subject to check and evidenced by certificates of indebtedness; (4) a finance company actively engaged in purchasing or discounting accounts or notes receivable or installment obligations or in making loans secured by any of these or by tangible personal property, This last class relates to business or factoring type loans.

The four sections excluding these special corporations contain various restrictions and limitations to prevent tax avoidance. The bill has eliminated all these four subsections and substituted a single subsection excluding all types of lending or finance companies in general terms. The requirements a finance company must meet to avoid classification as a personal holding company are as follows:

(1) 60 percent or more of its ordinary gross income must be derived directly from the active and regular conduct of a lending or finance business. The term "lending or finance business" for this purpose does not include dealing in obligations with a remaining maturity in excess of 60 months or dealing in bonds (income received from an 80-percent-owned subsidiary in the lending or finance business is also considered income from the lending or finance business);