Rev. Rul. 56-523

Advice is requested whether subsidiary corporations, which compute their separate excess profits credit under the income credit method, may include in borrowed capital their indebtedness to the parent corporation in the computation of net capital additions under section 435(g) of the Internal Revenue Code of 1939.

The parent corporation owns all of the controlling capital stock of several subsidiary corporations, each of which filed separate income tax returns for the taxable year here under consideration. The parent corporation computed its excess profits credit under section 436 of the Internal Revenue Code of 1939 and the subsidiary corporations computed their excess profits credits under section 435 of such Code.

For many years prior to the year under consideration, the parent corporation borrowed substantial amounts from financial organizations on its account which it, in turn, advanced to its subsidiary corporations. The amounts advanced, which were used by the subsidiary corporations for acquisition and development of properties, or for working capital, were recorded on the books of the corporations involved through inter-company accounts which reflected not only the advances made to the subsidiary corporations but also amounts receivable and payable which arise through normal inter-company transactions. In addition to this type of financing the parent corporation made available to the subsidiary corporations, on open account, funds sufficient to meet their bonded indebtednesses as they became due and payable. Since 1936 the subsidiary corporations have paid to the parent corporation interest at a stipulated rate per annum on the open account balances, but not in excess of available current earnings.

Early in 1951, and shortly after the enactment of the Excess Profits Act of 1950, it having become apparent that a considerable portion of the subsidiary corporations' open account indebtedness could not be repaid in the immediate future, the parent corporation requested the subsidiary corporations to issue promissory notes, payable on demand, for the major portion of the outstanding indebtedness owed by the subsidiaries. The promissory notes thus issued, which contained the same provisions with respect to interest as those previously applicable to the open account indebtedness which they replaced, were recorded on the books of the subsidiary corporations as notes payable. Inter-company accounts payable were reduced accordingly. The notes were also recorded on the books of the parent corporation as notes receivable and inter-company accounts receivable were decreased accordingly. From time to time, amounts were paid by the various subsidiary corporations in reduction of the outstanding notes payable when such corporations no longer had need for the full amount of the borrowings.

Section 435(g)(3)(C) of the Code provides that, in determining the daily capital addition of a taxpayer computing its excess profits credit based on income, there shall be included in computing such daily capital addition 75 percent of the amount by which the average borrowed capital for the taxable year exceeds the daily borrowed capital for the first day of the taxpayer's first taxable year subject to the excess profits tax.

Section 439(b)(1) of the Code provides, in part, that, for excess profits tax purposes, the daily borrowed capital for any day of any taxable year shall be the sum of the amount of the outstanding indebtedness (not including interest) of the taxpayer, incurred in good faith for the purposes of the business, which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, deed of trust, bank loan agreement, or conditional sales contract.

It is evident from the record that the indebtedness reflected in the inter-company open accounts and notes of the subsidiary corporations was incurred in good faith and for business purposes. Furthermore, the evidence discloses that the indebtedness of the subsidiary corporations to the parent corporation incurred subsequent to the date of conversion in 1951 was made the subject of a promissory note at that time. Therefore, the notes are valid obligations of the subsidiary corporations, even though issued for the sole purpose of permitting the subsidiary corporations to obtain the benefits of the amounts thereof as borrowed capital for excess profits tax purposes. See Adams Brothers Co. v. Commissioner , 22 Fed.(2d) 501. The promissory notes issued by the subsidiary corporations were `notes' within the meaning of section 439(b)(1) of the Internal Revenue Code of 1939.

Accordingly, it is held that the inter-company promissory notes payable by the subsidiary corporations to the parent corporation, under the circumstances stated above, which represent advances made by the parent corporation in good faith, and used by the subsidiary corporation for business purposes, constitute borrowed capital within the meaning of section 439(b) of the Internal Revenue Code of 1939 and should be taken into consideration in the computation of net capital additions under section 435(g) of the Code.