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operatives on the profits derived from businesses unrelated to the cooperative's essential purposes. For example, the income of a marketing cooperative might be divided into two parts. The first part, consisting of its income from activities directly related to the marketing or incidental processing of members' products, would be offset by the amount of patronage dividends paid in cash or in short-term interest-bearing evidences of indebtedness. Its remaining income, derived from sources essentially unrelated to its cooperative character, would be subjected to the corporate income tax without any deduction for patronage dividends, allocated or paid.

This treatment of patronage dividends does not seriously conflict with the above analysis. To the extent that a cooperative's income is derived from activities not directly related to transactions with patrons, the distribution of patronage dividends more closely resembles à distribution of profits than a rebate. Therefore, they should not reduce the cooperative's taxable income. On the other hand, to the extent that a cooperative's income is derived from its transactions directly with its patrons, it would not seem unreasonable to permit patronage dividends to be treated as rebates. While this approach would present difficulties in defining "unrelated business” and determining the amount of income therefrom, these difficulties are not insurmountable. Similar problems, although less complex, have been met by Congress by arbitrary classification.

Thus, Congress has defined "unrelated business" for purposes of taxing the income of otherwise exempt charitable organizations. 31 Similarly, in the area of the manufacturers' excise tax, both Congress and the Treasury Department have defined the scope of "manufacturing” and the proceeds therefrom. 32

This approach would seem to provide the most equitable solution to the problem. Cooperatives would continue to enjoy their tax-free status to the extent that they fulfill their basic traditional purposes. Thus, a cooperative would not be taxed on the income from marketing its members' products if this income were immediately distributed on the basis of patronage. On the other hand, if a cooperative were to engage in "unrelated” activities, it would do so only on a taxpaying basis. Accordingly, cooperatives would no longer enjoy the substantial and unfair competitive advantage over ordinary corporations which exists today. In addition, Secretary Anderson's objective that all the income of a cooperative be taxed at least once in the year in which earned or the following year would be accomplished.

These three suggestions illustrate some of the approaches that could be taken if cooperatives were no longer to be granted tax exemption. Many different methods in taxing cooperatives have been utilized by other countries that have been faced with the same problems. These methods have ranged from complete exemption from tax to attempts to place cooperatives on a basis with ordinary business corporations.

Careful consideration of these methods would seem warranted. Any such evaluation must necessarily take into account the overall tax structure of the particular country, particularly from the stand

81 I.R.C., sec. 513.

82 See, e.g., I.R.C., secs. 4216-4219; Reg. sec. 330.1 and Temporary Rules, sec. 148.1; d. I.R.C., sec. 482.

point of the significance of the income tax; the scope of cooperatives' activities; the necessity of fostering cooperatives from the standpoint of national economic development; and, in some cases, constitutional limitations, 88

Obviously, it has not been possible for me to undertake a project of such magnitude in the short period of time available. I have however, examined secondary sources in this connection,34 and have reached the conclusion that the degree of preferential tax treatment of cooperatives tends to vary inversely with the degree of economic development of a country. As the economy of a country matures and becomes more competitive, there is less justification for granting cooperatives a preferred status. Accordingly, the more highly developed countries generally impose an equitable system of taxation on cooperatives. In general, it bears a fairly close resemblance to the taxation of other corporations. For example, in France, farmers' cooperatives are not allowed to deduct or exclude from taxable income amounts paid as patronage dividends.35 In Belgium, cooperatives are not allowed a deduction for “retains” credited to members' accounts.36 Denmark uses an approach similar to Canada's which has already been referred to.37

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Our tax laws presently grant special benefits to several classes of taxpayers. This naturally results in an inequitable distribution of our national tax burden and conflicts with fundamental objectives of Federal tax policy. In this era of high taxation, it is incumbent on Congress to reexamine these special benefits constantly to determine if they should be continued and if they have been abused. Thus, in 1950 Congress remedied the unfair situation which existed with respect to certain tax-exempt institutions which had been engaging in unrelated businesses at a substantial advantage over taxpaying competitors.

Many instances of special treatment now provided for in our tax laws would seem unwarranted in light of present-day conditions. While it is hoped that all such instances will be reexamined in the near future, it is essential that the situation with respect to cooperatives be acted upon immediately. Delay in this matter will cause irreparable harm to many business corporations now competing with cooperatives; it will also result in substantial revenue loss.

Cooperatives have been expanding their facilities with tax-free earnings at a rapid rate. Their taxpaying competitors have not been able to maintain this pace. Unless Congress faces up to this problem and places cooperatives on an equitable taxpaying basis with other corporations, cooperatives will soon be in a dominant position and control substantial portions of certain markets. Accordingly, it is urged that this committee study the suggestions made and take immediate action toward remedying the situation.

88 In passing, I should like to note that a substantial amount of research into the taxation of cooperatives by other countries has already been accomplished by William S. Barnes of the Harvard Law School.

34 See, e.g., Barnes, “Salient Comparisons. Between Cooperative Legislation in Europe and in the United States, American Cooperation” (1950); Valko, "International Handbook of Comparative Legislation” (1954); Harvard Law School, World Tax Series.

86 Barnes, supra, at 394.
* Id., at 395.
87 See note 27, supra.

A FUNCTIONAL APPROACH TO THE FEDERAL INCOME

TAXATION OF FARMERS' COOPERATIVES

Leo J. Raskind, associate professor of law, Vanderbilt University,

Nashville, Tenn.

INTRODUCTION

The extended and often acrimonious postwar debate concerning the appropriate mode of Federal income taxation for agricultural cooperative associations has been a controversy addressed to ever narrowing issues. The 1951 amendment to the Revenue Code has virtually foreclosed the question of full exemption for the cooperative by moving it within the ambit of tax treatment of the proprietary corporation while still recognizing certain differences in the nature of the receipts, distributions, and retained funds of the cooperative.

The remaining issues are vigorously contested. Broadly stated, there are two main areas of dispute. One issue involves the basic justification of the present tax treatment of the cooperative, which is alternatively characterized as an issue of erosion of the tax base or as a valid recognition of cooperative principles. The second issue is concerned with the adequacy of the present sections 521 and 522 of the code ? to achieve an effective mode of cooperative taxation. This paper seeks to provide some criteria for assessing the competing claims surrounding these two broad problems.

Insofar as questions of tax policy are inevitably complex, involving inferences from disputed facts enmeshed with judgments of value and statements of preference, and manifesting the attributes of "* * * group contest Tof) powerful interests ***s an impartial and ana

] lytical approach is warranted. Accordingly, the debate about the erosion question is examined in terms of a model for the functional characterization of the money-flows with which the cooperative is concerned. The utility of such an approach is that it supplants the forensic balancing of random characteristics. To be sure, no formal proof emerges from this perspective; the advantage lies in being able analytically to frame the relevant variables and to provide a mode of inquiry wherein material functional relationships are isolated and judgments of value are explicitly stated. The second topic concerning the technical adequacy of the existing statute draws upon the criteria and conclusions of the first topic.

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I. THE EROSION ISSUE

The principal area of conflict over the appropriate mode of Federal taxation for cooperatives involves the validity of sections 521 and 522 or the present code. In pamphlet 4 and in legislative proposal, the issue is raised by the allegation that full parity of taxation with the proprietary business association is the only tenable solution to the problem. The theory of this position is that the present tax treatment constitutes an erosion of the tax base. The remainder of this section is concerned with the question of erosion.

1 1.R.C., sec. 101 (12), as amended, 65 Stat. 491 (1951). * 1.R.C., secs. 521 and 522 (1954). • Adams, “Ideals and Idealism in Taxation," 18 Am. Econ. Rev. 1 (1928).

Although taxation of cooperatives is not ordinarily included in the general discussions of rate and base erosion, there are persistent references to leakages on this account. Most of the discussions about taxing cooperatives revert to the erosion issue. The magnitudes of revenue involved here are not large, but at present rates, any colorable allegation of a substantial “loophole” merits inquiry. But the path of inquiry is not without obstacles.

The paramount difficulty with the extensive literature on taxation of cooperatives is that it is unduly concerned with disputing this point in terms of the distributive functions and the legal structure of the cooperative business association. As for the distributive function, the evidence is in equipoise. Arguments in such terms about an appropriate mode of taxation are necessarily inconclusive. Insofar as the cooperative is an adjunct to the existing channels of distribution, it is deemed to merit equal tax treatment with proprietary units. Similarly, it is argued that the same functions of risk-taking and selling of identical products in the same market move the cooperative clearly on the side of a proprietary business unit; 10 while it is asserted with equal plausibility on the other side that the cooperative operates at cost in and that social utility of the cooperative merits special treatment insofar as exemption from income tax has been traditionally granted to * * * organizations which make an important contribution to the well-being of society and which do not operate for the purpose of making a profit for themselves.12

The tax consequences of the differences in legal structure of the cooperative are also in dispute. The marketing agreement is cited as authority for the position that the cooperative ought not be taxed

• National Tax Equality Association, "How Cooperative and Mutual Businesses Escape the Federal Income Tax” (1959); American Asssociation of Small Business, Inc., “Facts About Cooperative Taxation” (1959).

6 H.R. 198, 86th Cong., 1st sess. (1959); H.R. 3848, 86th Cong., 1st sess. (1959).

* Hearings Before the Subcommittee on Tax Policy of the Joint Committee on the Economic Report, Federal Tax Policy for Economic Growth and Stability, 84th Cong., 1st sess., 268–70 (1956); Adcock, “Patronage Dividends : Income Distribution or Price Adjustment," 13 Law & Contemp. Prob. 505, 520–5 (1948).

7 According to the most recent statistics available, taxable net income for 1953 for all reporting farmers? cooperatives was $15 million ; the reported tax was $9.8 million. See Treas. Dept., Statistics of Income, Farmers' Cooperative Income Tax Returns for 1953, 1 (1957). À crude estimate of these magnitudes for the period 1956-57 would indicate they would be about double the 1953 figure, based on the increase in total gross business volume reflected in Department of Agriculture, Farmer Cooperative Service, Statistics of Farmer Cooperatives, 1956–57, 14 (1959).

8 Sowards, “Should Co-ops Pay Federal Income Taxes ?" 19 Tennessee Law Review 908 (1947); Magill and Merrill, "The Taxable Income of Cooperatives,” 49 Michigan Law Review 167 (1950).

9 Hulbert and Mischler, Legal Phases of Farmer Cooperatives, Department of Agrt culture, Farmer Co-op Service Bulletin 10, 1 (1958). Packel, The Law of the Organt zation and Operation of Cooperatives, 2d ed., 5 (1947).

10 Statt, “The Effects of Cooperation on the Profit Economy." 13 Law & Contemp. Prob. 431 (1948).

11 Bradley, “Taxation of Cooperatives,” 25 Harvard Business Review 576 (1947); see S. Rept. 781, 820 Cong., 1st sess., 21 (1951).

12 Paul, “The Justifiability of the Policy of Exempting Farmers' Marketing and Purchasing Cooperative Organizations from Federal. Income Taxes,” 29 Minnesota Law Review 343, 361 (1945).

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