Evening star., 1936-03-23
TAX ON SURPRISES
FACES COURT TEST
Present Contracts May Be
Impaired by Roosevelt'S
Proposed Levy.
RY DAVID LAWRENCE.


that if the tax on undistributed sur
pluses is enacted by Congress. 1t may
not be collected into the Treasury
next wear but into the custody OF the
courts.
AS a substitute for processing taxes,
declared illegal, there is possibility
that the tax on undivided earnings
NAV likewise be declared unconstitu-
tional. Also, since the enforced COL
lection of the tax may drive certain
companies into receivership or bank
ruptcy, there will probably be applics-
ton by those companies to the courts
to restrain the collection of the new
taxes Just as there was with respect TO
processing taxes.
The legal situation can arise out of
number of concrete developments.
Thus many a corporation has issued
bonds and has entered into a contract
with the bondholders known generally
as an "indenture." In such docu-
ment, it is usually stipulated that the
company must set aside certain
amounts for the retirement OF the
dends shall not be paid unless there is
maintained a specified ratio between
current assets and current liabilities.
Devised for Safety.
These arrangements have been re-
ouired for many years as a method of
inSuring that there would be certain
cushion or safety for the investors.
The officers or directors or stockhold-
ers of a corporation are bound by the
''indenture" just as they are by any
ather contract lawfully entered into
by them Yet if they obey the demand
of the Government that earnings be
distributed, they will be violating or
impairing a contract. If they, on the
other hand, attempt to withhold the
surplus, the company then pays pro-
hibitive tax in the form of penalty
for doing that which the ";ndenture'
pre-emptorily requires them to do.
If an indenture is violated. the
bondholders have right to foreclose
Just as is the case with any mortgage
in which the provisions are in any
way impaired Many "indentures' de-
clare that the entire debt of the bond
issue becomes due and payable the
moment any provision is violated.
Take the case of a corporation with
an outstanding bond issue of S5.000,-
900, payable at the rate of S250,000 O
year. Such a company might be
ordinarily earning from $500000 tc
S75o,oO0 a year, but it so happens
that in the year 1886 it will have
earned only 100000 If the Fedora
tax on undivided earnings is about
33ls per cent it would mean thai
100000 would have to be paid tC
the Federal Government and 100000
would be left to meet sinking funC
requirement of $250,000.
Default Might Ensue.
Unless the corporation happened tC
have a surplus from past years OF
possessed borrowing power, it might
find itself in default and the bond
holders might apply for receiver
ship and take over the property. In
the same instance, however, let us
suppose that the sinking fund OIL
annual retirement is not fixed sum
amount to be used for paying off the
debt annually is expressed in per-
centages of earnings. Whose rights
have priority-the bondholders who
made contract before the new tax
was passed or the Federal Govern
ment. which comes in and to all
intents and purposes brushes aside
or impairs the contract?
1t has been held by the Supreme
Court that the tax authorities may
not be arbitrary in their application
of tax. 1t has been held that
certain steps by the Federal Govern
ment in pursuance supposedly of the
taxing authority cannot conflict with
other provisions of the Constitution
that require "due process" II prop
erty is to be taken by the Govern
ment. The query naturally arises
whether the undistributed surplus tax
by impairing contracts entered into
in good faith by bondholders might
be a taking of property belonging to
bondholders without adequately COM
pensating them for it.
Another Difficulty.
But there is still another legal diff
Guilty Many States by their laws for
bid the payment Of dividends unless
corporations have q certain credit
position Companies that are on the
edge might find themselves in hot
water in obeying the Federal COM
mand to pay out their earnings in
the form of dividends, especially if
the cash resources of a company which
has most of its capital in plant are
10 be drained for the purpose of meet
Ing the tax collectors demands.
The proposed tax on "undistributed"
surpluses or earnings is vuInerab BILE
from another constitutional aspect. A
tax on income or on net profits is
measurable. This form of fat tax
has been upheld. But the tax on
''undistributed" earnings is a tax on
discretion or rather a tax on the
judgment of management, so that in
effect the Federal Government uses
the taxing power to control the act
OF management with respect to earn
ings.
Present Law Solution.
What the Federal Government now
saws in effect is that it can control
the disposition of profits by giving one
corporation which is we'll heeled finan-
cially an exemption from taxes because
that institution is in a position to
pay out its earnings in dividends and
by putting a penalty on another cor
poratiOn in the same line of business
perhaps a competitor, which is not
well heeled financially. but must meet
the requirements of an indenture un-
der an outstanding bond issue.
Since TO pay out the tax money in
dividends might mean hardship and
possible legal steps of a foreclosure
nature, the corporation would doubt
less petition for an order TO restrain
collection of the tax by the Internal
leo iton 1n