resultant deferral of recognition of gain but would have been a continuity of basis had that then been the result of a reorganization. This would have meant that though the acquiring corporation had a fixed obligation in dollars given in exchange for the property, the basis of the property in its hands would have been entirely different from, and unrelated to, its investment in the property. As it happened, the basis statute did not then tie continuity of basis to the fact of reorganization as closely as it has for the past 20 years. But the unfortunate basis result which was rather fortuitously avoided in Pinellas and LeTulle has in fact been the result in closely analogous reorganization transactions during the past 20 years. In cases such as Nelson Co. v. Helvering (296 U.S. 374), the acquiring corporation gave not obligations but a fixed preferred stock, to be retired in accordance with sinking fund provisions. In that case the transaction was held a reorganization, and that would have been equally true at any time during the past 25 years had the preferred been voting stock. This means that the acquiring corporation's investment in the property is, or becomes, as fixed a sum as though it had given obligations, but the basis on which it computes depreciation, or gain or loss on subsequent sale, is unrelated to that investment.

The point in what I have written just above is that the basis provisions of the code, particularly as they relate to reorganizations and similar transactions, need a thorough restudy. The easy assumption that continuity of basis must or should accompany all reorganizations or other tax-free exchanges will not stand analysis here or in a number of other transactions.

As a further example of the significance of basis in tax-free exchanges, and the necessity that it be given careful restudy, I should like to point to some of the anomalies resulting from intercorporate liquidation, and to suggest a change. In 1935 Congress added section 112(b) (6) to the Revenue Act of 1934 and for the first time permitted a parent corporation to liquidate an 80-percent-owned subsidiary without recognition of gain or loss. This seemed, and seems, a wise provision, partaking of the nature of a reorganization though not technically a reorganization. Under the statute as originally enacted, the normal concomitant of a tax-free exchange followed: the parent's basis, or investment, in the stock of the subsidiary was applied to the assets it received in the tax-free liquidation.

The Revenue Act of 1936 changed this basis provision without benefit of committee or other explanation. It added section 113 (a) (15), which provided that upon a liquidation of a subsidiary under section 112(b) (6) the assets of the subsidiary should have the same basis in the hands of the parent that they had had in the hands of the subsidiary. Now this was entirely proper and reasonable in a case where the parent had acquired the stock of the subsidiary in exchange for the issue of its own stock, particularly in an exchange tax free to the prior stockholders. In such a case, the parent had no actual investment in the stock of the subsidiary, its basis in the subsidiary stock represented no outlay on its part, but the transferors' basis if the exchange had been tax free, and the liquidation of the subsidiary amounted to a two-step merger of the two corporations. In such a case, as in a simple merger, it was proper and reasonable that there be continuity in the basis of the assets.

But the situation was, and is, quite different when the parent had bought the stock of the subsidiary or otherwise acquired it by giving up property in which it had an investment representing outlay of its assets. The parent might have bought the stock of the subsidiary for $50,000 cash. Then, upon liquidation of the subsidiary, it would in one case, let us say, receive assets with a basis of $30,000, and in another, assets with a basis of $75,000. Remembering that in one case the $30,000 figure, and in the other case the $75,000 figure, would be the basis on which depreciation or gain or loss would subsequently be computed, it is apparent that in the first case the parent has suffered a real loss for which it never gets any deduction, and in the second case it has a very real gain on which it will never be taxed. It is apparent that income, as well as earnings and profits, constitutes a function of basis, as Judge Magruder pointed out in Bangor & Aroostook RR. v. Commr. (193 F. 2d 827). If this is so, and it is difficult to question it, such discontinuities between basis and investment, be they gaps or overlaps, seem difficult to defend.

The 1954 code carries this anomaly even further, at least in one respect. Let us assume, as above, that parent has paid $50,000 for the stock of subsidiary. Subsidiary's assets have an aggregate basis of $30,000, and subsidiary has $5,000 of earnings and profits. Subsidiary is liquidated under what is now section 332, and section 334 (b) (1), the successor of section 113 (a) (15), is applicable and gives to the subsidiary's assets, now in the hands of the parent, the continuing basis of $30,000. It is obvious that $20,000 of the parent's investment has disappeared, and that the aggregate basis of its assets is reduced by that amount. Yet section 381(a)(1) provides that the transaction by which the parent's assets are reduced by $20,000 results in an increase of $5,000 in its earnings and profits. Reconciliation of these provisions in the context of a rational system will tax the ingenuity of any analyst, be he accountant, lawyer, administrator, or judge. One should point out also that an equal but opposite anomaly will occur with respect to the subsidiary whose assets have a basis of $75,000, accentuated should that subsidiary have an operating deficit. The so-called Kimball-Diamond rule was a judicial device which softened the impact of section 113 (a) (15) in some cases. But it apparently operated only if liquidation followed soon after purchase. The 1954 code, in section 334 (b) (2), has given statutory recognition to the Kimball-Diamond rule, with wise provision for adjustments which are soundly spelled out in the regulations. But section 334 (b) (2) is hemmed in by a number of limitations to its applicability, and on its face is recognized as an exception.

An analysis of the anomalies created by the basis provisions of section 334 (b) (1) demonstrates, I believe, that if and to the extent that a parent has purchased or otherwise acquired stock of a subsidiary for money or property, section 334 (b) (2) should provide the general rule and not the exception; if, and only to the extent that, the parent corporation has acquired the stock of the subsidiary by the issuance of its own stock, section 334 (b) (1) should control. A single, and relatively simple, provision for a tax-free exchange controls, but fair and sound results, here as elsewhere, require the application of differentiated basis provisions.

III. LOSS CARRYOVERS

The loss carryover is a useful averaging device for leveling out the peaks and valleys of income and loss which an annual system of accounting and taxation is likely to create. I presume that there is little likelihood that this device will be abandoned. It has proved difficult, however, to allow the loss carryover to survive corporate reorganizations and at the same time prevent abuse. The threat has been that empty shells of loss corporations would be merged into profitable corporations, and the income of the latter thereby immunized from taxation. This threat was removed by the Supreme Court decision in New Colonial Ice Co. v. Helvering (292 U.S. 435), limiting the carryover to the specific corporate taxpayer which had suffered the loss. This decision, while preventing one form of abuse, had the unfortunate effect of wiping out what all would concede were legitimate loss carryovers simply because the corporations suffering the losses subsequently participated in a reorganization involving a formal change of corporate identity. At the same time, it did not prevent feeding new assets, by capital contribution or otherwise, into the empty shell of the loss corporation which could thereafter carry over its prior losses to offset the subsequent income of its newly acquired business, benefiting, in most cases, a newly acquired set of stockholders as well. Until a very recent court of appeals decision this practice has gone unchecked for the years controlled by the 1939 code.

The 1954 code has attempted to deal with these problems in sections 381 and 382. The resulting difficultise may be suggested by the fact that the Treasury has been unable to formulate regulations under these sections during the 5 years which have passed since the enactment of the 1954 code. But one need not rely upon the suggestion of difficulty resulting from the prolonged absence of regulations. The difficulties, not to mention the anomalies and inequities, of existing law have been well if briefly summarized in the revised report of the Subchapter C Advisory Group in their comment on their proposed amendments to section 382.

The Advisory Group's proposal would be an improvement on existing law. The proposal, however, seems unfortunate in depending upon percentage point changes in stock ownership, linked as those are and apparently must be with intricate attribution rules, often fortuitous and even whimsical in application, and upon the price paid, actually or constructively, for the stock of the loss corporation. When one adds to these formulations the fact that in many cases the proposed section 382(d) is an invitation to disputes and litigation turning upon the elusive fact of corporate valuation, improvement over the existing law seems to come principally from the partial removal of existing anomalies.

Two recent decisions (Newmarket Mfg. Co. v. U.S., 233 F. 2d 493; F. C. Donovan, Inc., v. U.S., 261 F. 2d 460) of the Court of Appeals of the First Circuit supply the genesis of a simpler, and, I believe, effective method of dealing with the problem. In each of those cases a corporation suffered a net operating loss and clearly would have been entitled to carry it over to apply against profits of a different year but for the fact that in the interval the loss corporation participated in a reorganization resulting in a change of its corporate

identity. In each case the business enterprise continued unchanged. The court's decision was that the loss carryover should not be denied where it was demonstrable that the loss-producing enterprise had profits in the other years and the loss could have been used to offset those profits had there been no reorganization. The results in those cases seem sound analytically (cf. the Supreme Court's opinion in the converse situation in Libson Shops, Inc. v. Koehler, 353 U.S. 382), and produce a result which seems unquestionably wise as a matter of legislative policy.

The difficulty in projecting the Newmarket and Donovan decisions forward in their exact form is that after a merger or other form of reorganization involving more than one enterprise it is rarely possible to demonstrate that a constituent element which suffered a net operating loss prior to the reorganization had subsequent profits against which the loss could properly and appropriately be applied. The purpose of a reorganization involving two or more enterprises is to unite them into one. The tax law does not contemplate several and separate income and loss computations thereafter, and the reorganization may have so reoriented the conduct of the constituent elements that continuing separate income computations would be unreal. Even if the separate components of the reorganized corporation are run as separate divisions of the single company, problems such as the allocation of overhead would make it difficult to demonstrate with any exactitude that the component which had suffered a prior operating loss had produced a postreorganization profit against which that loss could properly be applied.

The idea of the Newmarket and Donovan decisions requires some adaptation if it is to be generally useful, some conversion into an operating hypothesis. Like other acceptable operating hypotheses, this need not guarantee minutely accurate correlation with facts which happen to be unascertainable so long as it produces results of a generally acceptable nature. In this case the operating hypothesis, very simply converted into a statutory rule, would be that after the reorganization the subsequent income should be attributed to the component corporations (for loss carryover purposes) in the ratio of their contribution of assets to the reorganized corporation at the time of the reorganization. This would turn not on value always subject to dispute and difficult to prove-but upon the relative amounts of the net basis of the assets contributed. (This concept of net basis is at present employed and defined in regulations, sec. 1.312-10.) The rule would be that the loss carryover from a constituent corporation after a reorganization could be used to offset no more than a fraction of the resulting corporation's subsequent income. The fraction of income subject to offset would be the fraction that was formed with the net basis of the loss corporation's assets as the numerator, and the net basis of the combined corporations' assets as the denominator, the figures being taken as of the time of the reorganization.

As an example, let us suppose that X corporation has a loss carryover. The net basis of its assets is $100,000. It is merged with Y corporation, which has assets with a net basis of $900,000. The aggregate net basis of the reorganized corporation is $1 million. Thereafter, the loss carryover attributable to X corporation could be used for the period otherwise allowable, but to offset no more than 10 per

cent of the net income of the reorganized corporation for any year or other taxable period.

It will be seen, I believe, that this plan will largely limit the danger of using shells of loss corporations, since by definition their assets will be so small as to make their loss carryover of negligible value. At the same time the plan is fairly generous to stockholders of operating corporations with a loss carryover, for its operating hypothesis is that after a reorganization the assets of such a corporation contribute pro rata to the subsequent profits. If this were thought too generous a hypothesis upon which to operate, it would be possible, within the same general plan, to reduce it by providing that the fraction of income subject to offset should be, say, only two-thirds or one-half of the fraction of assets contributed by the loss corporation.

The same working hypothesis and plan could be used, and in order to supplement the reorganization provisions, would almost necessarily be used to deal with the so-called Alprosa Watch problem of feeding assets into a loss corporation. It would follow that in the event of a contribution to capital, a section 351 transaction, or any transaction in which a loss corporation received assets for the issuance of its stock, provisions similar to those dealing with reorganizations and loss corporations would require a fraction to be formed by comparing the net basis of assets before with the net basis of assets after the transfer to the loss corporation. Thereafter the carryover could be used only against the fraction of income which previous assets were of all assets immediately after the contribution to capital, etc. A series of transfers to the corporation would of course result in a series of reductions of this fraction.

For purposes of this plan, a corporate liquidation to which section 332 was applicable would be treated as a reorganization if the basis provisions of section 334(b) (1) were applicable. If the provisions of section 334 (b) (2) were applicable, no loss carryover would be allowed. (It would be hoped that the previously suggested changes with respect to these provisions would have been enacted.) In the latter case, the rule is that of existing law. In the former case, apparently existing law imposes no limitation on the use of the loss

carryover.

The plan proposed does not purport to be a precision instrument. But the facts make a precision instrument impossible. It does appear to provide a method of handling the problem which is fairly simple to administer, based upon facts or information available from properly maintained corporate records. It may be thought to provide a reasonably efficient guard against abuse, while allowing the utilization of loss carryovers under circumstances which would usually be deemed within a reasonable statutory purpose. It will be noted that by employing the net basis of assets as the significant factor, borrowing or buying assets on credit prior to a reorganization will not increase the potential utilization of the loss carryover. It will also be noted that this eliminates as significant factors changes in stock ownership and related attribution rules, as well as other difficult concepts which assist in the creation of a number of anomalies existing under present law.