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Published online by Cambridge University Press: 12 February 2016
The courts and the legislature in both Israel and Britain have recently been occupied with the problem of the valuation of investment property upon conversion to business use. The problem involves the whole complex of income tax and capital gains taxation and goes to the root of the income tax system. Different approaches to the basis of valuation in “converted property” cases have been taken by the American Internal Revenue Code, under the British Finance Act and according to the Israel Income Tax Ordinance. The main object of this study is to analyse and compare the similarities and differences of these tax systems and try to draw conclusions which will suggest the lege ferenda to be applied in Israel. I shall first examine the American practice, then deal with the British views and finally consider the approach adopted by the Israel courts.
1 Recently the Supreme Court of Israel dealt with the problem in Cohen v. Assessing Officer (1966) Vol. 3 20 P.D. 421.
2 Finance Act 1965, Sch. VII para. I. and Finance Act, 1962, Sch. IX, para. 7.
3 I.R.C. §§ 1001, 1002, 1011, 1012 and 1016. Regs. §§ 165–7, 1.165–9 and 1.167(g)–l.
4 I.R.C. §§ 61 and 1201.
5 I.R.C. § 1034. For exclusion from gross income of certain gains from the sale or exchange of the residence of a taxpayer who has attained the age of 65, see I.R.C. § 121. For gain derived on the sale of residence held for production of income, see § 1250.
6 I.R.C. §§ 1011, 1012 and 1016.
7 I.R.C. § 167(a)(2).
8 Regs. § 1.167(g)—1: “In the case of property which has not been used in the trade or business or held for the production of income and which is thereafter converted to such use, the fair market value on the date of such conversion, if less than the adjusted basis of the property at that time, is the basis for computing depreciation.” Compare Parsons v. U.S. 227 F.2d 437 (3rd. Cir. 1955), fixing the same basis for depreciation.
9 See I.T. 2533, IX–I Cum. Bull. 192 (1930), cited in Surrey, & Warren, , Federal Income Taxation Cases and Materials (1960 ed.) 349Google Scholar.
10 I.R.C. §§ 1011, 1012 and 1016 and Regs. § 1.167(g)–l quoted supra n. 8.
11 I.R.C. § 165(a) and Regs. § 1.165–9; I.R.C. § 62(4).
12 Regs. § 1.165–9(b), vide examples (1) and (2) ibid. Subsec. (c). See also Regs. § 1.165–7(a) (5), basis rule in cases where property is converted from personal use to business use, for computing casualty losses. From the original acquisition cost or fair market value on the conversion date, whichever is the lower, depreciation allowance is deductible, adjusting the basis under § 1016.
13 276 U.S. 582, 48 S.Ct. 326 (1928). See Parsons v. U.S., 227 F. 2 d. 437 (3rd. Cir. 1955), applying this rule in fixing the basis for depreciation. See also Regs. § 1.167(g)–1, quoted supra n. 8.
14 Per Justice Stone, ibid. p. 586. See also Surrey, & Warren, , “The Income Tax Project of the A.L.I.: Gross Income, Deductions, Accounting, Gains and Losses, Cancellation of Indebtedness” (1952–1953) 66 Har. L.R., 761, 805 note 53CrossRefGoogle Scholar.
15 DeCapriles, “Modern Financial Accounting” (1962) 37 N.Y.U.L.R. 1001, 1062. The writer deals broadly with the computation below cost of inventory. The same reasoning applies to computation below cost of investment property converted to business use. See discussion below.
16 I.R.C. § 471 and Regs. § 1.471–2(c). The basis of property included in inventory is prescribed in § 1013.
17 Regs. §§ 1.471–2(c) and 1.471–3.
18 Regs. §§ 1.471–2(c) and 1.471–4.
19 Regs. §§ 1.446–1(e) and 1.471–2(d).
20 I.R.C. § 1014.
21 I.R.C. § 1015. As to property acquired in part by way of gift and in part by way of sale, see Regs. § 1.1015–4.
22 See for instance I.R.C. §§ 362, 1031(d), 1033(c) and 1034(e).
23 See text to n. 10 above.
24 Finance Act, 1962, secs. 10 to 16 and Schs. 9 and 10. This Act was amended by the Finance Act 1965, secs. 17 and 18, Sch. 22 pt. III.
25 Finance Act 1965, secs. 19–45 and Schs. 6–10.
26 See Wheatcroft, Capital Gains Tax (London, 1965), 9.
27 London County Council v. Att. Gen. 4 T.C. 265 at 293; [1901] A.C. 26.
28 Income Tax Ordinance, sec. 88 as amended in 1965.
29 I.R.C. § 1222. See Bittker, , Federal Income, Estate and Gift Taxation (3rd. ed. 1964) 577Google Scholar. See also Surrey, & Warren, , Federal Income Taxation Cases and Materials (1960 ed.) 655Google Scholar.
30 See Wheatcroft, ibid. § 7–14, p. 136.
31 See Wheatcroft, ibid. § 7–19, p. 138.
32 Finance Act 1965, Sch. VII, para. 1 provides: “1 (1) Subject to sub-paragraph (3) below, where an asset acquired by a person otherwise than as trading stock of a trade carried on by him is appropriated by him for the purpose of the trade as trading stock … and if he had sold the asset for its fair market value, a gain or loss would have accrued to him, he shall be treated as having thereby disposed of the asset by selling it for its then market value.”
See Wheatcroft, ibid. §§. 8–06 and 5–12, discussing the same rule applied by the Finance Act, 1962, Sch. IX, para. 7(1) to short term capital gains and losses. See also Simon's, Income Tax (1966 ed.) vol. 2A, § 25, p. 19 and § 302, p. 147Google Scholar.
34 In order to limit gains and losses on assets acquired before the enactment of the Finance Act 1965, which introduces the long term capital gains tax in England, there is a special set of basis rules in Part 2 of Sch. VI. These rules endeavour to ascertain the amount of gain or loss which has accrued since the enactment of the long term capital gains tax and to limit the chargeable gain or allowance loss to that amount.
35 Finance Act 1965, sec. 19(1).
36 Finance Act 1965, sec. 22(4). The same rule applies to short term capital gain or loss: Finance Act 1962, sec. 12(3). Cf. Wheatcroft, ibid, §§ 4–25 and 7–10 discussing this rule.
37 36 T.C. 275; [1956] A.C. 58. See discussion in Wheatcroft, , The Law of Income Tax, Surtax and Profit Tax (1962) § 1–583Google Scholar.
38 Finance Act 1962, Seh. IX, para. 7(2) and Finance Act 1965, Sch. VIII, para. 1(2).
39 The decision was a majority decision, Lord Oaksey alone dissenting. The Court of Appeal had held unanimously the opposite opinion. The adverse rule applies under American law. The cost, and not the fair market value, of products consumed must be added to income, Jacob v. Commissioner (1950) 9 T.C.M. 415, involving whiskey and food consumed by a restaurant owner. See also Morris v. Commissioner (1928) 9 B.T.A. 1273 (A). For comprehensive discussion see Marsh, , “The Taxation of Imputed Income” (1943) 58 Pol. Sci. Quart. 514CrossRefGoogle Scholar and Vickrey, , Agenda for Progressive Taxation (1947) 26, 44–50Google Scholar.
40 See dictum loc. cit. (n. 37 above) at 298.
41 Watson Bros. v. Hornby 24 T.C. 506; [1942] 2 All E. R. 506, involving a transfer of an asset from one trading activity to another.
42 See n. 14 above.
43 Whimster v. I.R.C. (1926) 12 T.C. 813.
44 Cf. Plunkett, , Property Taxation (1963) 23–24Google Scholar; George, , Taxation and Property Transactions (1963) 51Google Scholar; Pinson, , Revenue Law (2nd ed. 1965) 40Google Scholar.
45 Pilkington v. Randall, Leaflets, T.C. (1965)Google Scholar No. 2157, 5. See also Coraddock v. Zevo Finance Co. Ltd. (1946) 27 T.C. 267 at 279, involving property acquired by gift. The market value basis was also applied in West v. Phillips (1958) 38 T.C. 203 at 210.
46 Para. 20(6)(a).
47 F.D. Reade, 64 D.T.C. 95; 34 Tax A.B.C. 313. See also C Bar C Ranch Ltd., 63 D.T.C. 872; 33 Tax A.B.C. 345. These cases are also quoted in MacDonald, , Canadian Income Tax, 1966, Supp. para. 26, 4(a) 133Google Scholar. An adverse view was expressed by Farano, , “Capital Into Inventory—Valuation Base” (1965) 13 Canadian Tax Journal, 254Google Scholar.
The original cost of acquisition is the basis rule applied under South African Jaw in converted property cases. See Silke, , South African Income Tax (3rd ed. 1963) para. 135, 171–172Google Scholar. “Thus if a taxpayer originally acquired an asset for the purpose of investment and during a subsequent tax year changes his intention and converts his capital asset into trading stock, the value of the stock…must be its cost price irrespective of its market value at the date of conversion of the asset from fixed capital into floating capital.”
However, a different basis valuation rule applies under Indian law. In C.I.T. Bombay v. Bai Shirinbai Kooka (1956) 30 I.T.R. 753, it was held by the Indian Supreme Court that the valuation basis of the property converted from investment into stock is the fair market value on the conversion date and not the original acquisition cost. This view seems strange since the same Court two years earlier refused to apply the Sharkey v. Wernher valuation rule at fair market value of property converted from business use to non-business use. See Kikabhai v. C.I.T. Bombay (1954) S.C.R. 219. Likewise, under Swedish law the basis of converted property, from investment into stock, is the fair market value at the conversion date. See Mutén (1966) British Tax Rev. 82 at 83–84.
The West German law seems to take a compromising approach. The valuation basis is market value at the conversion date. But if the property converted was purchased within three years before the commencement of the trade, then the basis must not exceed original cost. Another exception is when the contribution consisted of shares in a corporation in which the taxpayer holds a “substantial investment”, then the lower of cost or market value is used as basis, even if the acquisition took place more than three years before the appropriation. See World Tax Series, Taxation in the Federal Republic of Germany (1963) 313.
48 The authorities applying the fair market valuation basis deal specifically with investment converted into stock and not with investment converted to a capital asset of the business. See nn. 44 and 45 above. In the case of property remaining a capital asset in business use, there is no provision in the Finance Act, 1962, or the Finance Act 1965, changing the basis upon conversion.
49 Cf. Chabas v. Assessing Officer (1960) 14 P.D. 2568; Leather Merchant v. Assessing Officer, 9 Roeh Haheshbon (Auditors' Journal) 259. See also Witkon, , Tax Law (3rd. ed. 1966) 103 (in Hebrew)Google Scholar.
50 (1963) 17 P.D. 1963.
51 Supra, n. 37.
52 See sec. 2(3) (net annual value of residence) and sec. 2(8) (farmers’ self-consumption), cf. Lapidoth, “On the Question of the Net Annual Value For Income Tax” (1966) 22 HaPraklit 232.
53 (1966) 20 P.D., vol. 2, p. 421.
54 Landau J. and Berinson J. concurring.
55 Ibid., end of sec. 11 (Translation by the writer.)
56 Agranat J. (President) concurring.
57 Ibid., Sussman J., para. 12.
58 Sec. 50 of the Land Appreciation Tax Law (17 L.S.I. 211) provides:
a. “The sale of real estate rights or an association act, the profits from which are assessable under the Income Tax Ordinance shall be exempt from tax.
b. .…
c. Exemption under subsection (a) shall not apply where the appreciation exceeds the amount arrived at by multiplying four per cent of the acquisition value by the number of months elapsed from the date of acquisition to the date of sale.”
If the appreciation exceeds this amount a special deduction totalling that amount is provided under sec. 41.
59 
× 72 × 30,000 = 86,400. See supra n. 58 providing the formula under secs. 50(c) and 41.
60 Sec. 88 provides that the original cost is the amount spent to acquire the asset. This computation does not take into consideration—to simplify the example—depreciation allowance.
61 Amount received on sale (IL.2,500) less original cost (IL.2,250). This computation does not take into consideration—to simplify the example—depreciation allowance.
Compare a similar example under present British law, Wheatcroft, , Capital Gains Tax (1965) § 8–06, 162, Example 50.Google Scholar
62 Witkon J. delivering the judgment, Deputy President (then) Agranat and Cohn J. concurring.
63 Sussman J. delivering the majority judgment, Landau and Berinson JJ. concurring. Witkon J. expressed the minority view, President Agranat concurring.
64 See discussion supra nn. 30 and 31.
65 I.R.C. § 1239.
66 See Wheatcroft, op. cit., § 7–18, 137.
67 Sec. 24 provides that an asset transferred to related persons without transfer of control, retains its original basis for depreciation allowance computation. This provision applies only where the capital tax is not paid upon such transfer, see sec. 24(c), as amended in 1965. However, the Commissioner may disregard the transfer, applying sec. 86 provisions that the transfer is a mere sham and artificial, executed for the purpose of avoiding or minimizing tax liability.
68 The present Israel statutory framework does not include any stock valuation method.
69 Provided the property is a “capital asset” attracting capital gain (or loss) treatment. See definition of “capital asset” in sec. 88; cf. Klimowsky, “The Fallacy of the ‘Capital Asset’” (1966) British Tax. Rev. 79.
70 This rule corresponds with the present statutory provisions, see sec. 88 and p. 59 above.
71 Under the present law depreciation allowance is computed on the basis of original cost (sec. 21). There is no special provision for depreciation allowance basis in conversion cases. The rationale of the proposed rule is based on the American practice, disallowing depreciation allowance for the period prior to conversion, if there is a decline in market value, see supra p. 48.
72 Special treatment may be provided for assets that are not “capital assets” prior to conversion, for instance, assets acquired for personal use, converted into capital assets of the business. To prevent retrospective taxation upon subsequent sale, attributed to the period when the asset was not a capital asset, the taxpayer may elect to realize gain by transferring the asset to a related person, thereby maintaining a stepped-up basis. On the other hand the taxpayer may prefer to refrain from a transfer to a related company in order to retain the original holding period which entitles him to larger deductions for computation of future capital gain, see sec. 91. However, these cases are rare and exceptional.
73 The Courts Law, 1957, sec. 33 (11 L.S.I. 157).
