rr-07-31.pdf

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Part I

Section 118.--Contributions to the Capital of a Corporation

26 CFR 1.118-1: Contributions to the capital of a corporation.

Rev. Rul. 2007-31

ISSUE
Is universal service support received by a corporation under the universal service
support mechanisms a nonshareholder contribution to capital under section 118(a) of
the Internal Revenue Code?
FACTS
The federal universal service support mechanisms are required by 47 U.S.C.
§ 254. The Federal Communication Commission (Commission) is required to establish
periodically the services to be supported by federal universal service support
mechanisms. 47 U.S.C. § 254(c)(1). The Commission has established that the
following services be supported by federal universal service support mechanisms:
(1) voice grade access to the public switched network; (2) local usage; (3) dual tone
multi-frequency signaling or its functional equivalent; (4) single-party service or its
functional equivalent; (5) access to emergency services; (6) access to operator
services; (7) access to interexchange service; (8) access to directory assistance; and

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(9) toll limitations for qualifying low-income consumers. 47 C.F.R. § 54.101(a). An
eligible telecommunications carrier must offer each of the services in order to receive
federal universal service support. 47 C.F.R. § 54.101(b).
The Universal Service Administrative Company (Administrator) administers the
federal universal service support mechanisms. 47 C.F.R. § 54.701. The Administrator
is responsible for administering the following federal universal support mechanisms:
(1) the high cost support mechanisms described in 47 C.F.R. part 54, subpart D; (2) the
low income support mechanisms described in 47 C.F.R. part 54, subpart E; (3) the
schools and libraries support mechanism described in 47 C.F.R. part 54, subpart F;
(4) the rural health care support mechanism described in 47 C.F.R. part 54, subpart G;
(5) the interstate access universal support mechanism described in 47 C.F.R. part 54,
subpart J; and (6) the interstate common line support mechanism described in 47
C.F.R. part 54, subpart K. 47 C.F.R. § 54.702(a). The Administrator is responsible for
billing contributors, collecting contributions to the universal service support
mechanisms, and disbursing universal service support funds. 47 C.F.R. § 54.702(b).
The federal universal service support mechanisms are funded by contributions
from telecommunications carriers. Every telecommunications carrier that provides
interstate telecommunications services must contribute, on an equitable and
nondiscriminatory basis, to the specific, predictable, and sufficient mechanisms
established by the Commission to preserve and advance universal service. 47 U.S.C.
§ 254(d). Entities that provide interstate telecommunications services to the public, or

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to such classes of users as to be effectively available to the public, for a fee will be
considered telecommunications carriers providing interstate telecommunications
services and must contribute to the universal service support mechanisms. 47 C.F.R.
§ 54.706(a). Federal universal service contribution costs may be recovered through
interstate telecommunications-related charges to end users. 47 C.F.R. § 54.712(a).
In order to receive support, an eligible telecommunications carrier first must
provide the supported services. The universal service support provided pursuant to 47
C.F.R. part 54, subparts D, J, and K (identified above) ensures that consumers in all
regions of the nation have access to and pay rates for telecommunication services that
are reasonably comparable to those in urban areas. The universal service support
provided by 47 C.F.R. part 54, subparts E, F, and G (identified above) allows carriers to
provide discounted, or reduced, rates to low income consumers, schools and libraries,
and rural health care providers. The amount of federal universal service support
received depends on either the discount offered to the targeted customers or the cost of
providing service (the carrier’s revenue requirement) in high cost areas. For financial
accounting purposes, the Commission requires all carriers to record their federal
universal service support receipts as revenue.
All carriers that receive universal service support must use that support only for
the provision, maintenance, and upgrading of facilities and services for which the
universal service support is intended. 47 U.S.C. § 254(e) and 47 C.F.R. § 54.7. This
includes, for example, the ability to use the funds to reduce intrastate rates, to cover

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operating expenses (billing and marketing expenses) associated with the supported
services, and to upgrade the facilities for the supported services. Annual certifications
are required to be filed with the Administrator and the Commission with respect to
universal service support from certain universal service support mechanisms stating
that all universal service support received from such mechanisms will be used only for
the provision, maintenance, and upgrading of facilities and services for which the
support is intended.
LAW AND ANALYSIS
Section 118(a) of the Code provides that in the case of a corporation, gross
income does not include any contribution to the capital of the taxpayer. The committee
reports accompanying the enactment of what is now section 118(a) indicate that the
provision was intended to codify the existing law that had developed through
administrative and court decisions on the subject. H.R. Rep. No. 1337, 83d Cong., 2d
Sess. 17 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 18 (1954).
Section 1.118-1 of the Income Tax Regulations includes within the meaning of a
contribution to capital, a contribution by a nonshareholder and cites as examples of
nonshareholder contributions to capital: the value of land and other property
contributed to a corporation by a governmental unit or by a civic group for the purpose
of inducing the corporation to locate its business in a particular community, or for the
purpose of enabling the corporation to expand its operating facilities. However, the
exclusion from gross income does not apply to any money or property transferred to the

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corporation in consideration for goods or services rendered.
In Detroit Edison Co. v. Commissioner
, 319 U.S. 98 (1943), 1943 C.B. 1019, the
Supreme Court held that payments by prospective customers to an electric power
company that were used by the company to construct the facilities necessary to deliver
electricity to the customers were not nonshareholder contributions to capital. The Court
found that the motivation for the prospective customers' contributions was to obtain
electric services from the power company and, therefore, the contributions were
payment for services. 319 U.S. at 102, 1943 C.B. at 1021.
In contrast, Brown Shoe Co. v. Commissioner
, 339 U.S. 583 (1950), 1950-1 C.B.
38, held that money and property contributions by community groups to induce a shoe
company to locate or expand its factory operations in the contributing communities were
nonshareholder contributions to capital. The Court reasoned that when the motivation of
the contributors is to benefit the community at large and the contributors do not
anticipate any direct benefit from their contributions, the contributions are
nonshareholder contributions to capital. 339 U.S. at 591, 1950-1 C.B. at 41.
The Court again considered this issue in United States v. Chicago, Burlington &
Quincy R.R., 412 U.S. 401 (1973), 1973-2 C.B. 428. In that case, the Court set forth
the following five characteristics of a nonshareholder contribution to capital: (1) the
contribution must become a permanent part of transferee’s working capital structure;
(2) the contribution may not be compensation, such as a direct payment for a specific,
quantifiable service provided for the transferor by the transferee; (3) the contribution

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must be bargained for; (4) the asset transferred foreseeably must result in benefit to the
transferee in an amount commensurate with its value; and (5) the asset ordinarily, if not
always, will be employed in or contribute to the production of additional income and its
value assured in that respect. 412 U.S. at 413, 1973-2 C.B. at 432.
In reaching its conclusion that the improvements at issue did not qualify as
contributions to capital, the Court reasoned:
Although the assets were not payments for specific, quantifiable services
performed by CB&Q for the Government as a customer, other characteristics of
the transaction lead us to the conclusion that, despite this, the assets did not
qualify as contributions to capital. The facilities were not in any real sense
bargained for by CB&Q. Indeed, except for the orders by state commissions and
the government subsidies, the facilities would not have been constructed at all.

412 U.S. at 413-14, 1973-2 C.B. at 432.
In Texas & Pacific Railway Co. v. United States
, 286 U.S. 285 (1932), XI-1 C.B.
263, the Court held that payments received by a railroad company from the federal
government did not constitute a contribution to capital and thus were includible in
income. The Court noted the Transportation Act of 1920 provided for payments
representing a guarantee of minimum operating income to compensate the railroad
during the transition from federal control to private ownership. The Court reasoned that
the payments did not represent capital contributions:
Here they were to be measured by a deficiency in operating income, and might
be used for the payment of dividends, of operating expenses, of capital charges,
or for any other purpose .... The Government’s payments were not in their
nature bounties, but an addition to a depleted operating revenue consequent
upon a federal activity.

286 U.S. at 290, XI-1 C.B. at 265.

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In Deason v. Commissioner
, 590 F.2d 1377 (5th Cir. 1979), the Fifth Circuit held
that payments received from the Department of Labor for job training for unemployed
individuals were not a contribution to capital under section 118. The court affirmed the
opinion of the Tax Court, which concluded that irrespective of the public benefit of
reduced unemployment that occurred as a result of the payments, the payments
constituted direct compensation for training services and thus could not be considered a
contribution to capital.
As provided in section 1.118-1 and stated by the Supreme Court in Detroit
Edison and Chicago, Burlington & Quincy R.R., compensation in exchange for a specific
quantifiable service constitutes taxable income, not a capital contribution. Indeed, the
Court in Brown Shoe
premised its decision that inducement payments by community
groups to a private corporation for relocating and building a factory constituted a capital
contribution, based on the specific absence of customers and payment for services.
Conversely, these are precisely the factors that are present in the universal service
support. There is a clear nexus between the universal service support and the provision
of universal telecommunications services by the carriers. The motivation underlying the
universal service support is to compensate the carriers for the shortfall in operating
income for providing services at a discount to certain customers and/or providing
services to customers in high cost areas at below cost rates. The universal service
support is predicated on the carriers providing the mandated universal service and is an
integral part of the government’s mandate to insure that universal service is provided.

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In addition, the universal service support does not satisfy the five characteristics
of a nonshareholder contribution to capital set forth in Chicago, Burlington & Quincy
R.R., because the universal service support: (1) does not necessarily become a
permanent part of the carrier's working capital structure because the support is not
limited to the acquisition of capital assets and can be used to pay current expenses; (2)
is made for specific, quantifiable telecommunication services to telecommunication
customers of the carrier; (3) is not bargained for because the universal service support
mechanisms are a unilateral government program and the method of participation by
carriers is mandated (despite any certification requirements); (4) does not benefit the
carrier commensurate with the value of the support because the support payments
merely maintain the carrier’s viability; and (5) does not necessarily generate additional
income for the carrier because the support is not limited to the acquisition of capital
assets that will generate additional income for the carrier, but can be used to pay
current expenses or to replace capital assets.
The holdings in Texas Pacific
and Deason also are illustrative in this context. In
Texas Pacific
, the federal government provided payments to fulfill a statutory public
purpose and yet because of the inherent nature of the transaction as reimbursement for
deficiencies in operating income, the payments did not warrant capital contribution
treatment. In Deason
, the federal government made payments that served the public
goal of reducing unemployment. Despite the existence of a public benefit derived from
the payment, the court concluded that the payments were compensation for services

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and therefore ineligible as a capital contribution. Similarly, although a public purpose is
served by payment of the universal service support, and the payor is not the consumer
of the universal telecommunications services, the universal service support is
nonetheless compensation to the carriers for the provision of universal
telecommunications services.
HOLDING
Universal service support received by a corporation under the universal service
support mechanisms is not a nonshareholder contribution to capital under
section 118(a) of the Code.
DRAFTING INFORMATION
The principal author of this revenue ruling is David McDonnell of the Office of
Associate Chief Counsel (Passthroughs and Special Industries). For further information
regarding this revenue ruling, contact Mr. McDonnell at (202) 622-3040 (not a toll-free
call).