Rev. Rul. 72-221

Advice has been requested concerning the Federal income tax consequences arising from an early disposition of "section 38 property" under the circumstances described below.

A taxpayer placed in service various items of "section 38 property" during the taxable years 1963, 1964, and 1966. The "section 38 property" placed in service in 1963 was disposed of in 1966 and a determination of the increase in tax resulting from the disposition is required under section 47 of the Internal Revenue Code of 1954. The taxpayer's income tax liability, investment credit earned, investment credit used, unused investment credit and carryover of unused investment credit for the years involved before consideration of the effect of the disposal of the property is as follows:

 --------------------------------------------------------------------

 --------------------------------------------------------------------

Section 47(a)(1) of the Code provides that upon an early disposition of "section 38 property" the tax for the year of recapture will be increased by an amount equal to the aggregate decrease in the credits allowed for all prior taxable years which would have resulted solely from substituting, in determining qualified investment, for such useful life the period beginning with the time the property was placed in service and ending with the time the property ceased to be "section 38 property."

Section 47(a)(3) of the Code provides that in the case of a cessation described in section 47(a)(1) of the Code, the carrybacks and carryovers under section 46(b) of the Code will be adjusted by reason of the cessation.

Section 1.47-1(a)(1)(i) of the Income Tax Regulations provides for the recomputation under the principles of sections 1.46-1 and 1.46-2 of the regulations of the credit allowed for the credit year and for any other taxable year affected by reason of the reduction in credit earned for the credit year, giving effect to such reduction in the computation of carryovers or carrybacks of unused credit.

Section 47(c) of the Code and section 1.47-1(b)(2) of the regulations provide, in effect, that any increase in income tax under section 47(a) due to the recapture shall not be treated as a tax for the purposes of determining the amount of the allowable investment credit.

Section 47(a) of the Code is designed to place the taxpayer in the same position at the close of the recapture year as he would have been in had he claimed the actual life of the "section 38 property" disposed of initially in computing the amount of investment credit earned in the credit year. To accomplish this result the actual useful life must be substituted in place of the useful life claimed initially, and the tax liabilities of all prior years affected by the substitution must be recomputed.

If no investment credit had been claimed in 1963, the $300 investment credit earned but unused in 1966 would have been added to the investment credit allowable in 1963 in accordance with the provisions of section 46(b) of the Code. Since there would have been an income tax liability in that year against which the 1966 investment credit could have been applied, the investment credit would have been treated as an investment credit allowed in 1963 and a claim for refund would have been allowable. Thus, the $300 unused investment credit earned in 1966 must be treated as an increase in the credits allowed under section 38 for prior taxable years that result solely from substituting the actual useful life of the section 38 property acquired in 1963 and disposed of in 1966 in place of the useful life claimed initially, and this increase must be taken into account in computing the aggregate decrease in credits under section 47(a).

Section 47(c) does not preclude the carryback of the $300 investment credit from 1966 to 1963 for purposes of recomputing the tax liability for all prior years. Section 47(c) only applies after the recapture tax liability has been computed to preclude an offset of the recapture tax against any carryovers or carrybacks available at that time.

In the instant case the use of the carryback of the investment credit earned in 1966 results solely from the substitution of the actual life of the "section 38 property" acquired in 1963 and disposed of in 1966.

Accordingly, it is held that under the facts of this case the recapture tax liability is $340. This is the aggregate of decreases in credits of $1,040 ($840 in 1963 and $200 in 1965) and increases of $700 ($400 in 1964 and $300 in 1966).