1. SELECTED PORTIONS OF THE INTERNAL REVENUE CODE AND REVENUE RULINGS.

Section 101(6), Internal Revenue Code of 1939 (corresponds with section 501(c)(3), Internal Revenue Code of 1954).-Section 101 (6) of the Internal Revenue Code exempts from taxation:

(6) Corporations, and any community chest, fund, or foundation, organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals, no part of the net earnings of which inures to the benefit of any private shareholder or individual and no substantial part of the activities of which is carrying on propaganda, or otherwise attempting, to influence legislation.

Section 422, Internal Revenue Code of 1939 (corresponds with section 512, Internal Revenue Code of 1954). Unrelated Business Net Income.

[Sec. 422(a)]

(a) Definition.-The term "unrelated business net income" means the gross income derived by any organization from any unrelated trade or business (as defined in subsection (b)) regularly carried on by it, less the deductions allowed by section 23 which are directly connected with the carrying on of such trade or business, subject to the following exceptions, additions, and limitations:

(1) There shall be excluded all dividends, interest, and annuities, and all deductions directly connected with such income.

(2) There shall be excluded all royalties (including overriding royalties) whether measured by production or by gross or net income from the property, and all deductions directly connected with such income.

(3) There shall be excluded all rents from real property (including personal property leased with the real property), and all deductions directly connected with such rents.

(4) Notwithstanding paragraph (3), in the case of a supplement U lease (as defined in section 423 (a)) there shall be included, as an item of gross income derived from an unrelated trade or business, the amount ascertained under section 423 (d) (1) and there shall be allowed, as a deduction, the amount ascertained under section 423 (d) (2).

(5) There shall be excluded all gains or losses from

the sale, exchange, or other disposition of property other than (A) stock in trade or other property of a kind which would properly be includible in inventory if on hand at the close of the taxable year, or (B) property held primarily for sale to customers in the ordinary course of the trade or business. This paragraph shall not apply with respect to the cutting of timber which is considered, upon the application of section 117 (k) (1), as a sale or exchange of such timber.

(6) The net operating loss deduction provided in section 23(s) shall be allowed, except that—

(A) the net operating loss for any taxable year, the amount of the net operating loss carry-back or carryover to any taxable year, and the net operating loss deduction for any taxable year shall be determined under section 122 without taking into account any amount of income or deduction which is excluded under this supplement in computing the unrelated business net income; and

(B) the terms "preceding taxable year" and "preceding taxable years" as used in section 122 shall not include any taxable year for which the organization was not subject to the provision of this supplement.

(7) There shall be excluded all income derived from research for (A) the United States, or any of its agencies or instrumentalities, or (B) any State or political subdivision thereof; and there shall be excluded all deductions directly connected with such income.

(8) (A) In the case of a college, university, or hospital, there shall be excluded all income derived from research performed for any person, and all deductions directly connected with such income.

(B) In the case of an organization operated primarily for the purposes of carrying on fundamental research the results of which are freely available to the general public, there shall be excluded all income derived from research performed for any person, and all deductions directly connected with such income.

(9) (A) In the case of any organization described in section 421(b) (1), the so-called "charitable contribution" deduction allowed by section 23 (q) shall be allowed (whether or not directly connected with the carrying on of the trade or business), but shall not exceed 5 per centum of the unrelated business net income computed without the benefit of this subparagraph.

(B) In the case of any trust described in section 421(b)(2), the so-called "charitable contribution" deduction allowed by section 23 (0) shall be allowed (whether or not directly connected with the carrying on of the trade or business), and for such purpose a distribution made by the trust to a beneficiary described in section 23 (0) shall be considered as a gift or contribution. The deduction allowed by this subparagraph shall not exceed 15 per centum of the unrelated busi

ness net income computed without the benefit of this subparagraph.

If a trade or business regularly carried on by a partnership of which an organization is a member is an unrelated trade or business with respect to such organization, such organization in computing its unrelated business net income shall, subject to the exceptions, additions, and limitations contained in paragraph (1) through (9) above, include its share (whether or not distributed) of the gross income of the partnership from such unrelated trade or business and its share of the partnership deductions directly connected with such gross income. If the taxable year of the organization is different from that of the partnership, the amounts to be so included or deducted in computing the unrelated business net income shall be based upon the income and deductions of the partnership for any taxable year of the partnership (whether beginning on, before, or after January 1, 1951) ending within or with the taxable year of the organization. In the case of an organization described in section 3813(a) (2) which is a member of a partnership all of whose members are organizations described in section 3813 (a) (2), if a trade or business regularly carried on by such partnership is an unrelated trade or business with respect to such organization, such organization shall, for taxable years beginning before January 1, 1954, be allowed a deduction in an amount equal to the portion of the gross income of such partnership from such unrelated trade or business which such organization is required (by a provision of a written contract executed by such organization prior to January 1, 1950, which provision expressly deals with the disposition of the gross income of the partnership) to pay within the taxable year in discharge of indebtedness incurred by such organization in acquiring its share of such trade or business, or to irrevocably set aside within the taxable year for the discharge of such indebtedness (to the extent that such amount has been so paid or set aside) if (i) such partnership was formed prior to January 1, 1950, for the purpose of carrying on such trade or business, and (ii) substantially all the assets used in carrying on such trade or business were acquired by it or by its members prior to such date. As used in the preceding sentence, the word "indebtedness" does not include indebtedness incurred after January 1, 1950.

[Sec. 422 (b)]

(b) UNRELATED TRADE or BUSINESS.-The term "unrelated trade or business" means, in the case of any organization subject to the tax imposed by section 421 (a), any trade or business the conduct of which is not substantially related (aside from the need of such organization for income or funds or the use it makes of the profits derived) to the exercise or performance by such organization of its charitable, educational, or other purpose or function constituting the basis for its exemption under section 101 (or, in the case of an organization described in section 421(b) (1) (B), to the exercise or performance of any purpose or function described in section 101 (6)), except that such term shall not include any trade or business—

(1) in which substantially all the work in carrying on such trade or business is performed for the organization without compensation; or

(2) which is carried on, in the case of an organization described in section 101 (6), or in the case of a college or university described in section 421(b) (1) (B), by the organization primarily for the convenience of its members, students, patients, officers, or employees; or

(3) which is the selling of merchandise, substantially all of which has been received by the organization as gifts or contributions.

The term "unrelated trade or business" means, in the case of a trust computing its unrelated business net income under the section for the purpose of section 162 (g) (1), any trade or business regularly carried on by such trust by a partnership of which it is a member. If a publishing business carried on by an organization during a taxable year beginning before January 1, 1953, is, without regard to this sentence, an unrelated trade or business, but before the beginning of the third succeeding taxable year the business is carried on by it (or by a successor who acquired such business in a liquidation which would constitute a tax-free exchange under section 112(b)(6)) in such manner that the conduct thereof is substantially related to the exercise or performance by such organization (or such successor) of its educational or other purpose or function described in section 101 (6), such publishing business shall not be considered, for the taxable year, as an unrelated trade or business.

Section 1481, Internal Revenue Code of 1954 (corresponds with section 3806, Internal Revenue Code of 1939).

SEC. 1481.-Mitigation of Effect of Renegotiation of Government Contracts or Disallowance of Reimbursement. (a) Reduction for Prior Taxable Year.—(1) Excessive Profits Eliminated for Prior Taxable Year.-In the case of a contract with the United States or any agency thereof, or any subcontract thereunder, which is made by the taxpayer, if a renegotiation is made in respect of such contract or subcontract and an amount of excessive profits received or accrued under such contract or subcontract for a taxable year (referred to in this section as "prior taxable year") is eliminated and the taxpayer is required to pay or repay to the United States or any agency thereof the amount of excessive profits eliminated or the amount of excessive profits eliminated is applied as an offset against other amounts due the taxpayer, the part of the contract or subcontract price which was received or was accrued for the prior taxable year shall be reduced by the amount of excessive profits eliminated. For the purposes of this section—

(A) The term "renegotiation" includes any transaction which is a renegotiation within the meaning of the Federal renegotiation act applicable to such transaction, any modification of one or more contracts with the United States or any agency thereof, and any

agreement with the United States or any agency thereof in respect of one or more such contracts or subcontracts thereunder.

(B) The term "excessive profits" includes any amount which constitutes excessive profits within the meaning assigned to such term by the applicable Federal renegotiation act, any part of the contract price of a contract with the United States or any agency thereof, any part of the subcontract price of a subcontract under such a contract, and any profits derived from one or more such contracts or subcontracts.

(C) The term "subcontract" includes any purchase order or agreement which is a subcontract within the meaning assigned to such term by the applicable Federal renegotiation act.

(D) The term "Federal renegotiation act" includes section 403 of the Sixth Supplemental National Defense Appropriation Act (Public Law 528, 77th Cong., 2d Sess.), as amended or supplemented, the Renegotiation Act of 1948, as amended or supplemented, and the Renegotiation Act of 1951, as amended or supplemented.

(2) REDUCTION OF REIMBURSEMENT FOR PRIOR TAXABLE YEAR. In the case of a cost-plus-a-fixed-fee contract between the United States or any agency thereof and the taxpayer, if an item for which the taxpayer has been reimbursed is disallowed as an item of cost chargeable to such contract and the taxpayer is required to repay the United States or any agency thereof the amount disallowed or the amount disallowed is applied as an offset against other amounts due the taxpayer, the amount of the reimbursement of the taxpayer under the contract for the taxable year in which the reimbursement for such item was received or was accrued shall be reduced by the amount disallowed.

(3) DEDUCTION DISALLOWED.-The amount of the payment, repayment, or offset described in paragraph (1) or paragraph (2) shall not constitute a deduction for the year in which paid or incurred.

(4) EXCEPTION.-The foregoing provisions of this subsection shall not apply in respect of any contract if the taxpayer shows to the satisfaction of the Secretary of his delegate that a different method of accounting for the amount of the payment, repayment, or disallowance clearly reflects income, and in such case the payment, repayment, or disallowance shall be accounted for with respect to the taxable year provided for under such method, which for the purposes of subsections (b) and (c) shall be considered a prior taxable year.

(b) CREDIT AGAINST REPAYMENT ON ACCOUNT OF RENEGOTIATION OR ALLOWANCE.-(1) GENERAL RULE.There shall be credited against the amount of excessive profits eliminated the amount by which the tax for the prior taxable year under this subtitle is decreased by reason of the application of paragraph (1) of subsection (a); and there shall be credited against the amount disallowed the amount by which the tax for the prior taxable year under this subtitle is decreased by reason of the application of paragraph (2) of subsection (a).

(2) CREDIT FOR BARRED YEAR.-If at the time of the payment, repayment, or offset described in paragraph

(1) or paragraph (2) of subsection (a), refund or credit of tax under this subtitle for the prior taxable year is prevented (except for the provisions of section 1311) by any provision of the internal revenue laws other than section 7122, or by rule of law, the amount by which the tax for such year under this subtitle is decreased by the application of paragraph (1) or paragraph (2) of subsection (a) shall be computed under this paragraph. There shall first be ascertained the tax previously determined for the prior taxable year. The amount of the tax previously determined shall be the excess of

(A) the sum of (i) the amount shown as the tax by the taxpayer on his return (determined as provided in section 6211(b) (1), (3), and (4), if a return was made by the taxpayer and an amount was shown as the tax by the taxpayer thereon, plus (ii) the amounts previously assessed (or collected without assessment) as a deficiency, over

(B) the amount of rebates, as defined in section 6211(b) (2), made.

There shall then be ascertained the decrease in tax previously determined which results solely from the application of paragraph (1) or paragraph (2) of subsection (a) to the prior taxable year. The amount so ascertained, together with any amounts collected as additions to the tax or interest, as a result of paragraph (1) or paragraph (2) of subsection (a) not having been applied to the prior taxable year, shall be the amount by which such tax is decreased.

(3) INTEREST.-In determining the amount of the credit under this subsection no interest shall be allowed with respect to the amount ascertained under paragraph (1); except that if interest is charged by the United States or the agency thereof on account of the disallowance for any period before the date of the payment, repayment, or offset, the credit shall be increased by an amount equal to interest on the amount ascertained under such paragraph at the same rate and for the period (prior to the date of the payment, repayment, or offset) as interest is so charged.

(c) CREDIT IN LIEU OF OTHER CREDIT OR REFUND.-If a credit is allowed under subsection (b) with respect to a prior taxable year no other credit or refund under the internal revenue laws founded on the applicable of subsection (a) shall be made on account of the amount allowed with respect to such taxable year. If the amount allowable as a credit under subsection (b) exceeds the amount allowed under such subsection, the excess shall, for purposes of the internal revenue laws relating to credit or refund of tax, be treated as an overpayment for the prior taxable year which was made at the time the payment, repayment, or offset was made.

(d) RENEGOTIATION OF GOVERNMENT CONTRACTS AFFECTING TAXABLE YEARS PRIOR TO 1954.-If a recovery of excessive profits through renegotiation as described in this section relates to profits of a taxable year subject to the Internal Revenue Code of 1939, the adjustments in respect of such renegotiation shall be made under section 3806 of such code.

Bureau of Internal Revenue I.T. 3671.Section 3806: Mitigation of Effect of Renegotiation of War Contracts or Disallowance of Reimbursement.

INTERNAL REVENUE CODE

The term "renegotiation," for the purposes of section 3806 of the Internal Revenue Code, as amended, is not limited to a renegotiation within the meaning of section 403 of the Sixth Supplemental National Defense Appropriation Act, 1942 (56 Stat. 226), as amended.

Advice is requested whether the term "renegotiation," for the purposes of section 3806 of the Internal Revenue Code, as amended, is limited to a renegotiation within the meaning of section 403 of the Sixth Supplemental National Defense Appropriation Act, 1942 (56 Stat., 226), as amended, or whether any Government contractor, acting upon his own initiative and desirous of refunding direct to the United States profits he has realized under a Government contract, or a subcontract thereunder, may effect a repayment of such profits in a manner coming within the provisions of section 3806 of the Code, as amended. Section 3806 (a)(1)(A) of the Code provides as follows:

"The term 'renegotiation' includes any transaction which is a renegotiation within the meaning of section 403 of the Sixth Supplemental National Defense Appropriation Act (Public 528, 77th Cong., 2d sess.) or such section, as amended, any modification of one or more contracts with the United States or any agency thereof, and any agreement with the United States or any agency thereof in respect of one or more such contracts or subcontracts thereunder."

It will be noted that the above-quoted provision of the Code includes within the term "renegotiation""any modification of one or more contracts with the United States or any agency thereof, and any agreement with the United States or any agency thereof in respect of one or more such contracts or subcontracts thereunder."

It is held that the term "renegotiation," for the purposes of section 3806 of the Internal Revenue Code, as amended, is not limited to a renegotiation within the meaning of section 403 of the Sixth Supplemental National Defense Appropriation Act, 1942, as amended, supra (which section is cited as the Renegotiation Act). It includes an agreement in writing made in respect of one or more Government contracts or subcontracts thereunder, and may be effected by an exchange of correspondence which embodies a binding agreement by both parties as to the amount repaid or to be repaid and the year to which the repayment relates. A Government contractor, acting upon his own initiative and desirous of refunding direct to the United States, profits he has realized under a Government contract, or a subcontract thereunder, should, however, get in touch with the renegotiating agency as to the form of agreement in writing which may be employed.

Internal Revenue Service: Rev. Rul. 144.Section 187: Partnership returns.

Advice is requested respecting the effect on a partnership, for Federal income tax purposes, of the death, withdrawal, substitution, or addition of a partner.

As defined in section 3797(a)(2) of the Internal Revenue Code, the term "partnership" for tax purposes is broader than the term under common law, the Uniform Partnership Act, or individual State laws. Accordingly, the Federal tax consequences of transactions involving partnerships and interests in partnerships will be determined upon the basis of their substance and in accordance with the Federal tax laws without regard to the technical refinements of State laws. (See Commissioner v. Francis E. Tower, 327 U.S. 280; Ct. D. 1670, C.B. 1946-1, 11, and Heiner v. Mellon, 304 U.S. 271; Ct. D. 1345, C. B. 1938-1, 349.)

Sections 187 and 188 of the Code, which refers to the "taxable year" of the partnership, recognizes a partnership as a unit for the purpose of filing returns. These sections do not contemplate that a partnership may terminate its taxable year and thus change its accounting period by the mere act of admitting or retiring a partner, nor that the Commissioner may force a change of accounting period under such circumstances.

Accordingly, it is held that a change in the membership of a partnership resulting from the death, withdrawal, substitution, or addition of a partner, or a shift of interests among existing partners does not, in itself, effect a termination of a partnership for Federal income tax purposes. Ordinarily, a partnership will be treated as continuing where the business of the partnership, or a substantial portion thereof, is continued. The returns of a continuing partnership should continue to be filed on the basis of the annual accounting period previously established by the partnership.

Internal Revenue Service: Rev. Rul. 5482.-Section 3806: Mitigation of Effect of Renegotiation of War Contracts or Disallowance of Reimbursement.

INTERNAL REVENUE CODE

The provisions of section 3806 of the Internal Revenue Code will not apply to a subcontractor, who, at the direction of the Government agency that was the issuing office for the prime contract, makes a refund to the prime contractor, unless such payment to the prime contractor is made under circumstances which meet the conditions of that section requiring payment to the United States.

Where the provisions of section 3806 of the Code are applicable to a prime or a subcontractor and the excessive profits, applicable to the prior as well as the current year, are repaid, such repayment of excessive profits to the United States Government shall be allocated to the applicable years in the absence of the application of section 3806 (a) ( 4 ) of the Code. In the event that excessive profits have been repaid without benefit of a tax credit, where such credit is allow

able under section 3806(b) of the Code, the credit shall be treated as an overpayment of tax for the prior taxable year. Such overpayment is considered made at the time the payment, repayment or offset was made, for the purpose of computing interest under section 3771(b) of the Code.

Advice is requested as to the application of Rev. Rul. 53, C.B. 1953-1,479, to price redetermination cases under the following sets of circumstances:

(A) A subcontractor to a prime Government contractor, had a subcontract prime redetermination made by the Government agency that was the issuing office for the prime contract, and, at its direction, made a contract price readjustment refund to the prime contractor. A refund was made in 1951, the year in which the applicable subcontract income was accrued. Under the same circumstances a refund was made in 1952, but such refund to the prime contractor covered subcontract income which was accrued in 1951 and 1952.

(B) The prime contractor had a price redetermination made in 1952 and made refund to the Government agency in 1952. Income under the prime contract was accrued in 1951 and 1952. The prime contractor treated such refund, in 1952, as a reduction of sales for such year. No tax credits have been allowed under section 3806 of the Code since the refunds paid were in the amount of the determination.

With respect to (A), above, section 3806 (a)(1) states in part as follows:

In the case of a contract with the United States or any agency thereof, or any subcontract thereunder, which is made by the taxpayer, if a renegotiation is made in respect of such contract or subcontract and an amount of excessive profits for a taxable year* ** is eliminated, and *** the taxpayer is required to pay or repay to the United States or any agency thereof ***. [Italics supplied.]

Since section 3806 (a) deals only with payments or repayments required to be made to the United States or any agency thereof, payments made directly to a prime contractor by a subcontractor at the direction of the Government agency do not fall within the provisions of section 3806 of the Code or Rev. Rul. 53, supra, unless the payment is made to the prime contractor as an agent of the subcontractor to transmit the payment to the United States and the payment is actually transmitted to the United States by the prime contractor, or unless the payment is made under circumstances which make the prime contractor a trustee of the payment for the benefit of the United States. It is not sufficient, for the purpose of treating such repayments under section 3806 of the Code, that the refund is made to the prime contractor with the understanding that such refund will be taken into consideration when a price redetermination or renegotiation is made in the case of the prime contractor.

With respect to (B), above, since the repayment of excessive profits was made by the prime contractor to the United States Government, the provisions of section 3806 of the Code are applicable to the prime contractor. In the absence of the application of sec

tion 3806 (a) (4) of the Code to the case, the excessive profits should be properly allocated between 1951 and 1952 in order to comply with the provisions of section 3806 (a)(3) of the Code which reads:

(3) DEDUCTIONS DISALLOWED.-The amount of payment, repayment, or offset described in paragraph (1) or paragraph (2) shall not constitute a deduction for the year in which paid or incurred.

If the excessive profits have been repaid without the benefit of a tax credit, where such credit is allowable under 3806 (b), section 3806 (c) of the Code provides in part as follows:

(c) CREDIT IN LIEU OF OTHER CREDIT OR REFUND.— * * If the amount allowable as a credit under subsection (b) exceeds the amount allowed under such subsection, the excess shall, for the purposes of the internal revenue laws relating to credit or refund of tax, be treated as an overpayment for the prior taxable year which was made at the time payment, repayment, or offset was made. [Italics supplied.]

Accordingly, the provisions of section 3806 of the Internal Revenue Code will not apply to a subcontractor, who, at the direction of the Government agency that was the issuing office for the prime contract, makes a refund to the prime contractor, unless such payment is actually transmitted in full to the United States by the prime contractor as agent for the subcontractor, or unless the prime contractor becomes a trustee of the payment for the benefit of the United States.

Where the provisions of section 3806 of the Code are applicable to a prime or a subcontractor and the excessive profits, applicable to the prior as well as the current year, are repaid, such repayment of excessive profits to the United States Government shall be allocated to the applicable years in the absence of the application of section 3806 (a) (4) of the Code. In the event that excessive profits have been repaid without benefit of a tax credit, where such credit is allowable under section 3806(b) of the Code, the credit shall be treated as an overpayment of tax for the prior taxable year. Such overpayment is considered as made at the time the payment, repayment, or offset was made, for the purpose of computing interest under section 3771 (b) of the Code.

Internal Revenue Service: Rev. Rul. 71415.-Renegotiation of Government contracts. -Mitigation of: Refunds under price redeterminations: Repayment of excessive profits.Tax effect of the renegotiation of Government contracts or subcontracts resulting in a determination of excessive profits is outlined.I. T.'s 3577 and 3611 superseded.

The purpose of this Revenue Ruling is to update and restate, under the current statute and regulations, the portion of I. T. 3577, C. B. 1942-2, 163, and I. T. 3611, C. B. 1943, 978, that is currently applicable.

The question has been presented as to the