Rev. Rul. 54-534

Advice is requested whether a domestic corporation which commenced business after the first day of its base period and determined its average base period net income under the provisions of section 445 of the Internal Revenue Code of 1939 is required to make an adjustment to normal tax net income under the provisions of section 433(a)(1)(O) of the Code for interest on borrowed capital, in the computation of its excess profits net income.

Section 445 of the Code provides an alternative method for computing the average base period net income of a `new corporation' which is not ineligible under the provisions of subsection (g) thereof. A `new corporation,' as the term is used in section 445 of the Code, is a corporation which commenced business after the first day of its base period.

Section 433(a)(1) of the Code provides that certain adjustments shall be made to normal tax net income in the determination of excess profits net income. Subsection `O' thereof is as follows:

(O) Interest-Credit Based Upon Income.-If the excess profits credit for the taxable year is computed under section 435, the deduction for interest shall be reduced by an amount which bears the same ratio to the interest on the indebtedness included in the daily amounts of borrowed capital (determined under section 439(b) as the excess of the amount determined under section 435(g)(3)(C) over the aggregate, divided by the number of days in the taxable year, of the amount determined under section 435(g)(4)(E) for each day of the taxable year, bears to the average borrowed capital for the taxable year (as defined in section 439(a)).

Section 445 of the Code does not itself provide any excess profits credit and can become effective for the purposes of the excess profits tax imposed by Subchapter D of Chapter 1 of the Code only by bringing into play other provisions of that Subchapter for the determination of the excess profits credit. Section 434(a) provides that the excess profits credit for a domestic corporation shall be computed under section 435 or section 436, whichever results in the lesser tax. Section 435, relative to the excess profits credit based on income, provides in pertinent part as follows:

(a) AMOUNT OF EXCESS PROFITS CREDIT.-The excess profits credit for any taxable year, computed under this section, shall be-

(1) DOMESTIC CORPORATIONS.-In the case of a domestic corporation the sum of-

(A) * * * per centum of the average base period net income,

*

(c) AVERAGE BASE PERIOD NET INCOME.-DETERMINATION.-For the purposes of this section the average base period net income of the taxpayer shall be the amount determined under subsection (d), subject to the exception that if the taxpayer is entitled to the benefits of subsection (e) of this section, or sections 442, 443, 444, 445 or 446 or any subsection of section 459, then the average base period net income shall be the amount determined under subsection (d) or (e) or under such section or subsection, whichever results in the lesser tax under this subchapter for the taxable year for which the tax under this subchapter is being computed.

In other words, the function of section 445 of the Code is merely to provide an alternative method for the computation of average base period net income for the purposes of an excess profits credit computed under the provisions of section 435 of the Code. Except as otherwise expressly provided, the provisions generally applicable to the computation of an excess profits credit under section 435, including the provisions of section 433(a)(1)(O), are applicable even though the average base period net income of the taxpayer is determined under section 445 rather than under section 435(d) or another of the relief provisions of subchapter D.

It is the principal function of section 433(a)(1)(O) of the Code to require the elimination of the interest deduction to the extent attributable to interest on borrowed capital which is included in the taxpayer's `net capital addition,' determined under section 435(g)(3)(C), in order to eliminate a duplication of benefits from borrowed capital, since section 435(a)(1)(C) allows a 12 percent return on the net capital addition in the computation of the excess profits credit under the income method. Section 433(a)(1)(O) serves the same or a similar purpose where section 445 is used for the determination of average base period net income since the same return on the net capital addition is allowed under section 435(a)(1)(C) in such cases except for taxable years governed by section 445(d)(1), and for taxable years subject to section 445(b)(1) the taxpayer is allowed the average base period rate of return, for the taxpayer's industry classification, on an amount which includes 100 percent of the borrowed capital included in the net capital addition, under section 445(b)(1)(A) and 445(c)(2). The provisions of section 445(c)(1), denying any net capital addition or reduction in the computation of the excess profits credit for taxable years subject to section 445(b)(1), merely eliminate a further possibility of duplication of benefits in the excess profits credit for such years. See Regulations 130, section 40.445-2(c).

Accordingly, it is held that in the determination of the excess profits net income of a domestic corporation which commenced business after the first day of its base period and which determines its average base period net income under the provisions of section 445 of the Internal Revenue Code and its excess profits credit under section 435 of the Code, the normal tax net income must be adjusted for interest on borrowed capital to the extent provided in section 433(a)(1)(O) of the Code.