pating corporation, it seems to me proper to require that substantially all assets be transferred. The present 80-percent rule for stock acquisitions appears to me to be satisfactory.

2. Should voting stock be required? Despite the recommendations which have frequently been made that this requirement be dropped, I think it proper to continue it, strengthened with a requirement that except where preferred stock is issued in exchange for other preferred (in which case no vote is needed) the relative vote must be roughly proportionate to the relative value of the stock at the time of issuance. Part of the theory of a reorganization is that the participating stockholders retain an equity interest in the resulting corporation. Common stockholders of a participating corporation who end up with only a nonvoting preferred, which can be drafted to be the financial equivalent of a debenture, do not seem to me to have retained such an interest. Further, the common incidence of nonvoting stock and of tax-avoidance transactions, while far from universal, is high; the allowance of a vote is some assurance of a genuine business transaction.

3. May preferred stock be issued? The provisions of section 306 seem to me adequate protection against bailouts effected through preferred stock, and I would generally permit its use.

4. What proportion of the consideration may be property other than stock or (to the extent securities are surrendered) securities? A compromise between the present rule for the statutory merger or consolidation (about 50 percent) and the acquisition of assets or stock (either solely stock or 80-percent stock) seems desirable. Either 66% percent or 75 percent would seem reasonable to me, although possibly if the 75-percent figure is used a special provision would be necessary for certain dissenting stockholder situations.

The net effect of this review of the specific questions raised by a reconciliation of the reorganization methods is that such a reconciliation can be expected to yield a considerable simplification of the law, a real gain in consistency, but only a modest expansion of the tax base. D. Is there a fruitful new approach?

Mr. Justice Holmes' aphorism that the life of the law has not been logic but experience is never more accurately applied than to Federal income taxation. A partial answer to the dilemma of corporate combinations may perhaps be found in the experience of administering the consolidated return provisions.

One of the reasons, I believe, why the consolidated return provisions have worked well and without charges of "erosion" is that taxpayers have since 1942 been required to pay modestly for the benefit of consolidation. The additional 2-percent tax automatically discourages the filing of consolidated returns where the reasons are not compelling; yet it permits the filing where genuine need exists.

A gains tax of 7 to 10 percent imposed on what are now tax-free combination as a part of an overall broadening of the tax base might have a similar effect. Such a tax would presumably not result in stepping up the basis for depreciation and subsequent sale to fair market value; it would be a kind of nonrecoverable fee which, like the additional 2-percent tax on consolidated taxable income, is paid for the privilege of enjoying an exception to the tax base. Except

The amount of the tax itself might be added to the basis.

in acquisitions of stock, the tax would be paid by the surviving corporation, and be measured by gain on the assets of the smaller of the two participating corporations.

The tax should not be heavy enough to discourage a genuinely motivated business transaction, and a 7- to 10-percent rate would not often do so. It should be heavy enough to discourage use of the exception to the rate base where business considerations permit a taxable sale, and a 7- to 10-percent rate would frequently have that effect. Most selling stockholders consciously or unconsciously take account of the tax burden when fixing the price at which they will sell or exchange. Most of the tax, therefore, is ultimately borne by the buyer. Most well-financed corporate buyers, confronted by the choice between an acquisition of assets of a smaller business for stock, on which a 7- to 10-percent gains tax is payable, and an acquisition for cash, on which a 25-percent gains tax, much of it recoverable in depreciation and amortization at 52 percent, is payable, would select the cash transaction.

Thus the tax might tend to preserve the rate base without unduly discouraging desirable transactions. If it should in practice turn out to have this effect, the fact that the tax is theoretically unsound-because it is consistent with neither the sale nor the pooling theories, or because imposition of a tax on an exchange without increasing the basis to market value is new to our tax system, or because there is no theoretical reason for picking out the particular rate selected-seems to me to be quite irrelevant.

Tax losses. The present law curbs the use of existing and potential tax losses in three ways. It disallows them if their acquisition is motivated principally by a desire to obtain the tax benefit, rather than to obtain the business to which they relate. It disallows existing losses without proof of intent if the business is changed or discontinued in 1 to 2 years after a purchase of 50 percent of the loss company. And it partially disallows the loss to the extent it is held by a corporate participant in a combination less than 20 percent of the size of the resulting corporation.

These curbs have been variously criticized as inadequate, unworkable, and unfair; their strengthening and their elimination have each been advocated. Actually, much of the criticism of ineffectiveness is in my opinion due to court decisions which have interpreted the "purpose" curb literally. As I have already indicated, I do not think a purpose test is unworkable in tax-loss situations, and the uncertainty it creates is in my judgment a lesser evil than either untrammeled trafficking in losses or total prohibition of their carry forward to new entities or new ownership. Accordingly, in my judgment a sufficient broadening of the tax base in this area could be obtained by legislation making the "purpose" restriction applicable to indirect acquisitions of benefit.8

8 For instance, the "purpose" curb (sec. 269 of the code) could explicitly be made applicable where persons acquire control of a tax-loss corporation for the principal purpose of merging into it other profitable businesses which they own in order to eliminate tax on the income of those businesses. The most feasible alternative to the "purpose" rule may be a restriction of the loss to the same business in which it was incurred. This raises definitional problems, and would adversely, and I think improperly, strike at the profitable corporation which diversifies into a new and temporarily unprofitable business. The Canadian experience with this "same business" test might profitably be studied.

III. REALIZATION OF ACCUMULATED EARNINGS

Thus far I have examined two of the three principal ways in which corporate financial policy may contract the tax base, and the tentative conclusion which has emerged is that means are available, if desired, to broaden the base moderately in these two areas. Thus, while the present code treatment of the collapsible corporation issue is unsatisfactory, a solution which will embody the necessary objective standard is available. Similarly, a generous relative size test and a modest tax on "tax-free" reorganizations appear to be feasible means to include in the tax base, if it is thought to be desirable, a significant number of corporate combinations which now are not taxed at all; and a modest strengthening of present law should adequately control the use of tax loss carryforwards.

Satisfactory means to effect a comparable broadening of the base are more difficult to find when we turn to the third area of corporate financial policy—the realization of accumulated earnings at less than the progressive personal tax rate. The aspect of this problem which is directly within the scope of this paper is the tax treatment of corporate distributions and adjustments. But it is clear that there is no sense in having one set of rules applicable to sales of stock and another set to distributions which are the practical equivalent of sales, and it is therefore necessary at the outset to reach some conclusions with regard to the tax treatment of the realization of accumulated earnings through the more simple mechanism of a sale.

There is no doubt that where business considerations permit it is a common objective of corporate financial policy so to arrange an incorporated investment as to minimize the necessity for payment of dividends. On incorporation of a business, good tax planning requires incorporation "thin," so that operating profits are used for repayment of debt or for interest, rentals, and the like. Once a new business has become successful, paid its debts, and accumulated the maximum earnings permissible under the code, good tax planning not infrequently suggests that it be sold so that the appreciation in equity value resulting from payment of the debt will be taxed at capital gain rates. The process can then be repeated if the buyer is a new corporation, also incorporated "thin," which will again permit earnings to be used to increase equity values rather than to be paid out in dividends. Even in our largest businesses, heavy-frequently exclusive— reliance upon debt financing and retained earnings as sources of new capital are common.

There is room for reasonable difference of opinion whether the tax law should create as compelling an incentive as it does to these financing practices. It is rather shocking to me that the present tax law itself induces sales of business property which otherwise would be retained by their owners. Heavy reliance on debt renders business vulnerable to recession, and, perhaps more serious, increases the number of those in the economy who have a direct financial stake in continued inflation. Many authorities believe that the reliance on debt and accumulation of earnings is largely responsible for the fact that the supply of common stocks available to investors has lagged far behind the demand for them and has contributed to the steady rise in stock market prices. On the other hand, there is no doubt that the present incentive moderates the rigors of the two-tier tax system, particularly

for small business, and channels funds into speculative equity in

vestment.

On balance, I believe that the reduction of the present tax pressure toward accumulation of earnings and debt financing is desirable. It is doubtful, however, that this pressure can be reduced consistent with the objective of protecting the tax base. In my judgment there is no satisfactory way to remove the extraordinary incentive for debt financing and accumulation of earnings created by present law without a reduction in the aggregate yield of the corporate income tax. Since this conclusion is a premise to my conclusions with regard to the effect on the tax base of present law on distributions and liquidations, it is well to test it by considering for a moment the alternative ways of mitigating the existing incentive.

One possibility is to apply the fragmentation principle described above in connection with collapsible corporations, and provide that the amount of gain from the sale or exchange of stock which is attributable to increases in earned surplus while the stock is owned should be taxed at ordinary income rates, with a spreading device to mitigate the effect of progression. This solution presents formidable administrative difficulties in the case of listed stock, and would complicate the collapsible corporation problem by creating a tax penalty for realization of earnings by corporations. Even if these difficulties could be overcome, this possible solution will strike most people as excessively rigorous. The fragmentation principle is suitable for collapsible corporations because in that situation ordinary income otherwise might escape tax altogether. If applied here, the additional tax imposed on the sale of stock would enormously increase the "locking-in" effect of the present capital gains tax and would substantially deter investment in equity stock.

In some countries the tax system seeks to control the conversion of accumulated income into capital gain by treating the distribution of earned surplus in liquidation as a dividend. The fairness of this provision is open to question since it imposes the tax on a person who may not have profited from the liquidation, and, even if mitigated by a spreading device, concentrates income in a relatively short span of years. Further, it becomes a growing deterrent to liquidation, a sort of inverse sword of Damocles, which may have undesirable economic consequences. Finally, it seems open to ready avoidance, by sales in anticipation of liquidations, particularly to low-bracket or charitable entities.

Equal difficulties are encountered in attempting to control the accumulation of earnings. The penalty tax on unreasonable accumulations is to some degree effective, but it does not in practice reach accumulations by widely held "growth" companies, or accumulations to pay off debt, even where the debt was incurred by the purchaser in a transaction motivated by the seller's desire to escape the dilemma created by the penalty tax. The use of debt itself does not seem susceptible of control; the distinction between debt incurred for business reasons and debt incurred solely for tax planning is not one that can in practice be drawn.

Thus, it appears that there is no effective and feasible technical device to reduce the tax incentive for accumulation of earnings and

Canadian Income Tax Act, secs. 81 et seq.

debt financing. It follows that the incentive can be reduced only by adjustment of tax rates.10 I do not believe that the capital gains tax rate should be increased, and it therefore appears that the only way to reduce what seems to me to be the excessively severe pressure which the present tax system exerts toward accumulation of earnings and debt financing is by enlarging the tax concession to distributed earnings as compared with accumulated earnings. Because I believe that for compelling psychological reasons the Government should not take more than roughly one-half of corporate net income, I am brought finally to these conclusions:

1. There is no feasible means simultaneously to enlarge the tax base and reduce the tax incentive for accumulation of earnings and use of debt.

2. So long as fiscal policy requires that the yield of the corporate income tax not be reduced, it is better to continue the present system, despite the excessive pressure it creates for accumulation of earnings and creation of debt, than to adopt any of the alternatives that appear available.

3. When and if it becomes possible to reduce the yield of the corporate income tax, that reduction should be made in a way which will reduce that pressure.11

These conclusions establish the principal criterion by which the effect on the tax base of the present rules applicable to corporate distributions and liquidations should be appraised: Do they represent a contraction in the base significantly larger than the contraction resulting from allowing capital gain treatment to realization of accumulated earnings by sale? As I have already suggested, a complete liquidation should not be given less favorable tax treatment than a sale, because if the treatment differs the tax conscious and informed stockholder will arrange a sale before the liquidation takes place. The sale of common stock dividends should be taxed in the same manner as the sale of stock, for the practical reason that there is no significant difference between a stockholder selling the shares received in a 3-percent stock dividend and selling 3 percent of his stock were no dividend declared. Similarly, if a distribution of part of the assets of a business or of the stock of a subsidiary corporation is a means for a stockholder to realize accumulated earnings without disposition of a part of his underlying investment, it should be taxed as a dividend; if it is equivalent to a disposition it should be taxed as a sale.

Tested by this standard, there is, I believe, little to criticize in the present provisions of the code relating to corporate distributions and adjustments. Preferred stock dividends are generally adequately

10 This kind of control in fact works well in another comparable instance: the relationship between the capital gains tax and the 52 percent corporate tax is such that it is generally of marginal financial advantage for a corporation to sell to a stranger and lease back appreciated property, incurring an immediate capital gains tax for the benefit of ordinary income deductions spread out over a substantial period in the future. Whatever financial advantage arises frequently is offset by the business disadvantage of the loss of ultimate title to and control over the property.

"The most satisfactory means to reduce the tax pressure toward debt financing and accumulation of earnings, I believe, is to allow a deduction to the corporation for a percentage (perhaps on the order of 25 percent) of dividends paid. This is preferable to the credit-to-the-shareholder approach taken by present law because it is less vulnerable to the charge that it is a preference to investment rather than earned income and because it would more directly reduce, in the eyes of business management, the tax advantage of debt financing and accumulation of earnings.