This appeal1 involves the proper income tax treatment of non-taxable subsidies granted under Act 224 of the Virgin Islands Sessions Laws (1957). The question presented is whether such subsidies (non-taxable when paid) reduce the basis of property acquired with the subsidy payment, os that upon liquidation and distribution of that property (from subsidiary to parent), the reduced property basis results in increased income and hence additional taxes to the parent. The answer to this question depends upon whether the non-taxable subsidies are to be considered as 'non-shareholder contributions to capital' subject to the provisions of 362(c)(2)2 of the Internal Revenue Code, or whether they retain their non-taxable character despite liquidation and distribution. The district court held3 that the subsidy payments made to Standard Time Corporation ('STC') did not constitute non-shareholder contributions to capital such as to require a reduction in asset basis. We agree.

The facts are undisputed. HMW, the taxpayer-petitioner, is a Pennsylvania corporation, formerly known as Hamilton Watch Co. Prior to August 4, 1969, all of the outstanding stock of STC, a Virgin Islands corporation engaged in the watch manufacturing business in St. Croix, was owned by petitioner. On August 4, 1969, STC was liquidated and its assets distributed to petitioner4 in a transaction qualifying under 332 of the Internal Revenue Code for non-recognition of gain or loss. Under 334(b)(1) of the Code, petitioner's tax basis in the assets received from STC was the same as STC's tax basis in those assets prior to the liquidation. HMW filed a Virgin Islands income tax return for the period August 5, 1969 through January 31, 1970, using STC's ending (or liquidation) inventory tax basis as its beginning inventory tax basis. Thereafter, respondent asserted a deficiency of $181,548.80 in petitioner's income taxes for fiscal 1970. The theory upon which the deficiency was assessed appears in the 'Explanation of Items' section of the assessment as follows:

Included in the cost of goods sold section was beginning inventory of $346,778.11. This was the same amount as the ending inventory on the subsidiary's (STC) return before liquidation. The question was raised as to whether the amount was correctly includable in cost of goods sold. Subsidy received or accrued during the period ending 8/4/69 was deemed to be in excess of $395,600.00. This is broken down into the following categories:

Examination revealed that during a time period before liquidation, the only property acquired by Standard Time was inventory. Since the subsidy exceeded the inventory at the time of liquidation, the basis of the inventory in the hands of the subsidiary was zero. When the inventory was transferred to the division (HMW), the same basis should have been used, which had a zero basis. This adjustment resulted in a substantial increase in income.5

The asserted deficiency is the result of the Commissioner's contention that the subsidies received by STC reduced STC's basis in its inventory, and consequently reduced HMW's carry-over inventory basis. This reduction in the basis of HMW's opening inventory had the effect of decreasing HMW's cost of goods sold, thereby increasing its taxable income for the fiscal year ended January 31, 1970. Thus, HMW is liable for the deficiency assessed only if the subsidies paid to STC are found to be non-shareholder contributions to capital.

Whether the subsidies paid here are non-shareholder contributions to capital as the Commissioner contends or a reduction in taxes without more, as is contended by the taxpayer, requires an examination of the history and purpose of the relevant tax laws. By the Naval Appropriation Act of July 12, 1921,

The income-tax laws in force in the United States of America and those which may hereafter be enacted shall be held to be likewise in force in the Virgin Islands of the United States, except that the proceeds of such taxes shall be paid into the treasuries of said islands.6

This provision was incorporated into the Virgin Islands Code and is the basis of the Virgin Islands income tax law. Thus, 33 V.I.C. 1931(15) provides:

'Virgin Islands income tax law' means so much of the United States Internal Revenue Code as was made applicable in the Virgin Islands by the Act of Congress entitled 'An Act making appropriations for the naval service for the fiscal year ending June 30, 1922, and for other purposes,' approved July 12, 1921 (48 U.S.C. 1397).

As we recognized in Dudley v. Commissioner of Internal Revenue, 258 F.2d 182 (3d Cir. 1958), the purpose behind the enactment of the Naval Appropriation Act was to impose 'upon the inhabitants of the Virgin Islands . . . a territorial income tax, payable directly into the Virgin Islands treasury, to assist the Islands in becoming self-supporting.' 258 F.2d at 185. Thus, the effect of the above quoted provisions was to create a separate taxing structure for the Virgin Islands 'mirroring' the provisions of the federal tax code except as to those provisions which are incompatitible with such a separate tax structure. Dudley, supra; cf. Chicago Bridge and Iron Co. v, Wheatley, 430 F.2d 973 (3d Cir. 1970) cert. denied, 401 U.S. 910, 91 S. Ct. 873, 27 L. Ed. 2d 809 (1971).

In 1957, Act No. 224, Virgin Islands Sessions Laws was enacted to encourage new business enterprises in the Virgin Islands. Its preamble stated:

Whereas it is deemed of great benefit to the people of the Virgin Islands, as well as to the economy of the Virgin Islands, to establish as many self-sustaining enterprises in the Virgin Islands as is practical-- to attract additional investment capital-- to promote tourism-- to promote the building of hotels, guest houses, and housing projects-- to the end that the economic life of the Virgin Islands may be as diverse and stable as possible, and the people of the Virgin Islands trained and employed in investments, in finance, in modern techniques of production, mechanical skills, services and trades; and

Whereas it is deemed to be in the public interest to extend such inducements and render such aid as will encourage persons, firms and corporations to establish and develop new business enterprises; to make additional investment capital available to new and existing business; to promote tourism and the building of hotels, guests houses and housing projects.

Act No. 224's 'Declaration of Policy' provided among other things:

(d) To achieve this objective, exemptions from payment of certain taxes or fees and the granting of special subsidies shall be allowed to new business enterprises and to such other persons and corporations as hereinafter provided, and

(e) In order that the encouragement tendered by this Act in the form of subsidies for the promotion of the business and industrial development of the Islands may be an incentive, having a real and unmistakably sure basis, the Government of the Virgin Islands hereby declares that it considers all orders granting subsidies and tax exemptions made available under the provisions of this Act as being in the nature of a contract or agreement between the Government of the Virgin Islands and the persons or corporations receiving the benefit of the subsidies or tax exemptions, and that it will not adopt any legislation which may impair or limit such subsidies or tax exemptions granted hereunder or which may defeat the purpose of this Act.

To achieve the stated objectives and policy aims, the Act 6(b) among other things provided that each qualifying corporation 'shall also be entitled to receive a nontaxable subsidy in an amount equal to Seventy Five (75%) Per Cent of the Income Tax paid into the Treasury of the Virgin Islands . . ..'

In 1960, Congress amended Title 26 to include Section 934.7 It is apparent that Congress was concerned with the attempt by the Virgin Islands legislature to reduce the income tax liability of certain taxpayers 'with respect to the tax attributable both to income from sources within the Virgin Islands and from sources within the United States.' Both the Senate and House Reports indicate that Congress felt that Act No. 224 had achieved 'substantially the same effect' as a 'rebate' of income taxes but that the Act failed to limit the 'rebate' or reduction in tax to just Virgin Islands income. It, thus, enacted section 934(a) which provides that:

Tax liability incurred to the Virgin Islands pursuant to this subtitle . . . shall not be reduced or remitted in any way, directly or indirectly, whether by grant, subsidy, or other similar payment . . ..

However, recognizing that the purpose of Act No. 224 was the economic development of the virgin Islands, it did not find objectionable a properly limited reduction in income tax liability as an incentive for new businesses to locate there. Therefore, a number of exceptions to the general rule stated in section 934(a) were provided.

One of these exceptions is section 934(b) which provides:

(b) Exception for certain domestic and Virgin Islands corporations.-- In the case of a domestic corporation or a Virgin Islands corporation, subsection (a) shall not apply (if the information required by subsection (d) is supplied) to the extent such corporation derived its income from sources without the United States if the conditions of both paragraph (1) and paragraph (2) are satisfied:

(1) Three-year period.-- If 80 percent or more of the gross income of such corporation for the 3-year period immediately preceding the close of the taxable year (or for such part of such period immediately preceding the close of such taxable year as may be applicable) was derived from sources within the Virgin Islands; and

(2) Trade or business.-- If 50 percent or more of the gross income of such corporation for such period or such part thereof was derived from the active conduct of a trade or business within the Virgin Islands. For purposes of the preceding sentence, the gross income of a Virgin Islands corporation, and the sources from which the income of such corporation is derived, shall be determined as if such corporation were a domestic corporation. For the purposes of this subsection, all amounts received by such corporation within the United States, whether derived from sources within or without the United States, shall be considered as being derived from sources within the United States.

A corporation satisfying these conditions would be eligible for subsidies limited to Virgin Islands income, if appropriate subsidy legislation was enacted.

Accepting the 'invitation' extended by Section 934, the Virgin Islands legislature enacted the Industrial Incentive Program8 which was substantially the same as Act No. 224, except that it contained the limitations required by Section 934(b). See 33 V.I.C. 4071(a(2).

With this brief legislative history as a backdrop, we turn to the immediate issues before us.

STC, as a qualified corporation, had been granted Section 6(b) subsidies under Act No. 224 since the time such subsidies were authorized in 1959. The instant deficiency concerns only the last subsidy paid to STC prior to its liquidation.

Initially, the Commissioner argues that the Virgin Islands legislature did not have the authority to enact a tax law (Act No. 224) which conflicted with or modified any provision of the Internal Revenue Code and that Act No. 224 was just such a law because it purported to reduce the income tax liability of certain taxpayers.

In our disposition of this case we need not reach the issues of whether the Virgin Islands legislature had the authority to adopt Act No. 224 and whether Act No. 224 conflicted with other provisions of Title 26 at the time it was enacted. It is clear that Congress has the power to ratify territorial legislation, even if that legislation was unauthorized when enacted. See Swayne & Hoyt Ltd. v. United States, 300 U.S. 297, 57 S. Ct. 478, 81 L. Ed. 659 (1937); Rafferty v. Smith, Bell & Co., 257 U.S. 226, 42 S. Ct. 71, 66 L. Ed. 208 (1921); see also Ex Parte Endo, 323 U.S. 283, 303 n. 24, 65 S. Ct. 208, 89 L. Ed. 243 (1944).

Rationally encompassed within this broad power is the authority to ratify questionably valid enactments. In our view such ratification occurred when Congress enacted Section 934 of the Internal Revenue Code. The subsequent passage of the Industrial Incentive Program conforming with the mandate of Section 934, removed any question of the validity of the Virgin Islands tax subsidy program.9

What then is the effect of subsidy payments made under an appropriately authorized subsidy statute? The issue is whether the particular subsidies granted STC were non-taxable for all purposes, and did not reduce the basis of HMW's opening inventory.

The Commissioner argues that Act No. 224 exempted only those taxes which local (Virgin Islands) legislation had authority to impose, such as gross receipts and excise taxes. The Commissioner claims that the subsidy in question cannot be termed 'non-taxable' because under Section 6(b) of the Act, the subsidy is equal in amount to only 75% Of the income taxes paid, and is further restricted to income taxes generated from activities for which the Certificate of Tax Exemption was granted.10 In addition, the Commissioner argues that the subsidies are paid as long as 18 months after the payment of the income tax on which they are based and no interest is paid on a subsidy. The Commissioner contrasts this with a refund of income tax which requires the payment of interest. In effect, the Commissioner takes the position that the statutes, relied on by the taxpayer as providing outright exemptions or reductions of tax liability, provide only for deferral or postponement of tax payment.

The taxpayer argues that the thrust of the legislation is to make the subsidies tax exempt for all purposes and at all times.11 The taxpayer claims that a permanent tax reduction was contemplated by Act No. 224 and the Industrial Incentive Legislation. In support of its argument, HMW refers to the intent and content of the legislation; the internal consistency of the statutes; the legislative history underlying the enactment of 934 of the Internal Revenue Code; and, a Revenue Ruling involving a similar subsidy.

As previously noted 33 V.I.C. 4071 provides that a Certificate Holder (such as STC) under the Industrial Incentive Program is entitled to certain 'subsidy' payments. One such subsidy is equal to 75% Of the amount of Virgin Islands income taxes paid. 33 U.S.C. 4071(a)(2). 75% Of the income taxes paid by such a taxpayer are placed in a separate fund known as the 'Industrial Incentive Fund' and it is out of this fund that 'subsidy payments' are made. 33 V.I.C. 4108(a) and (b). Significantly, 4108(b) refers to the subsidy payments as tax refunds, e.g., . . . 'The proper officers are authorized, with further legislation, to make refunds of such taxes authorized under the provisions of this subtitle from money in such special account.'

Section 4071(a)(2) of Title 33, among other things, provides that in the case of a subchapter S corporation (the income of which is taxed directly to its stockholders rather than at the corporate level), the stockholders rather than the corporation are entitled to receive the subsidy. HMW argues persuasively that a subsidy paid to stockholders can hardly be characterized as a contribution to corporate capital but rather must be regarded as a tax refund. Hence, HMW contends, the entire pattern of the Industrial Incentive Program requires that subsidies be treated as tax refunds and not as contributions to capital.

In our view, the legislative history underlying the enactment of 934 of the Internal Revenue Code demonstrates the intent of Congress to provide for income tax exemptions as distinct from income tax deferral or postponement.12 Reference is made to the Senate Finance Committee Report which recognized that subsidies, such as STC's, were 'substantially the same' as a rebate of income taxes. The Report states:

Although the Revised Organic Act provided the Virgin Islands no authority to rebate income taxes paid to it . . . nevertheless the (virgin Islands) legislature achieved substantially the same effect in Act No. 224 by providing subsidies ranging from 50 to 75 percent of the income taxes paid by corporations and residents with respect to certain specified types of new investment . . ..

For these reasons both the House and your committee in the first section of this bill, with two specified exceptions noted below, deny the right to the Virgin Islands to make any grant, subsidy, or other payment which has the effect either directly or indirectly of reducing tax liability incurred to the Virgin Islands.

. . . S.Rep.No.1767, 86th Cong., 2d Sess. 3-4 (1960), 1960-2 Cum.Bull. 829, 830-31. See also H.R.Rep.No.1131, 86th Cong., 1st Sess. 4-5 (1959), 1960-2 Cum.Bull. 811, 813-14.

Similarly, the Conference Committee Report states:

The first exception (Section 934(b), the requirements of which were satisfied by STC) relates to United States and Virgin Islands corporations and, in general, provides that subsidies can be paid to these corporations under much the same conditions as those under which income tax exemptions are presently available in the case of U.S. corporations carrying on a trade or business in most other U.S. possessions (sec. 931 of the code).

H.R.Conf.Rep.No.2214, 86th Cong., 2d Sess. 5 (1960), 1960-2 Cum.Bull. 859, 862, U.S.Code Cong. & Admin.News, p. 3766.13

Our attention has also been called to Revenue Ruling 69-433, 1969-2 Cum.Bull. 15314 holding that subsidies received under the Virgin Islands Industrial Incentive Program are considered to be a reduction in the amount of taxes paid to the Virgin Islands for purposes of the indirect foreign tax credit provisions of Internal Revenue Code 902. It is argued by HMW that inasmuch as the cited ruling is the official interpretation of the United States Internal Revenue Service, it should control the Commissioner's construction of the Code as made applicable to the Virgin Islands under 48 U.S.C. 1397 and 1642.15 The construction which taxpayer urges upon the Commissioner is that subsidies received under the Incentive Program constitute tax refunds and not contributions to capital.

Finally, HMW points to the closing agreement executed by STC and the Department of Finance of March 14, 1968. That agreement resolved the accumulated earnings tax liability of STC for its fiscal years ending 1964 through 1966. In paragraph 6(d) of that agreement, it is provided: 'Surplus resulting from subsidy payments . . . will not be considered in determining whether or not its (STC's) earnings have been permitted to accumulate beyond the reasonable needs of its business.' It is argued that this resolution implicitly recognizes that if subsidy payments could be considered for accumulation purposes, the effect would be to render the subsidies taxable, in contrast to the intent and terms of the closing agreement.

We agree with the district court that the subsidy legislation enacted by the Virgin Islands was designed to reduce the income tax liability of Certificate holders and reduce income taxes by refunding a portion of tax paid. See 33 V.I.C. 4108(b), 4071(a)(2). Nothing appears in any of the legislative enactments to indicate that a deferment of tax liability was intended rather than an exemption from tax liability. We do not believe that Congress has provided otherwise. If a subsidy is treated as the Commissioner contends, (that is, as a non-shareholder contribution to capital which must be applied in reduction of basis) the subsidy would in effect be rendered taxable, albeit at a later date. Yet, 33 V.I.C. 4071 specifically states that all of the subsidies are to be nontaxable.

The promise of tax reductions has been an important incentive for new businesses to locate in the Virgin Islands. In order to assure companies that this favorable treatment would not be subject to withdrawal at the whim of the legislature, it was provided that the arrangement was 'in the nature of a contract' between the government and the company. Act No. 224 1(e); 33 V.I.C. 4001(b). Congress understood that the Virgin Islands had made these firm commitments (and would make others in the future) when it enacted Section 934(b). To deny taxpayers who were induced to establish new businesses in the Virgin Islands the benefits they reasonably anticipated receiving would do immeasurable harm to the economy of the territory and render uncertain indeed its prospects of attracting any additional investment. I feel that a holding that subsidies designed to refund income taxes are non-shareholder contributions to capital, often causing an immediate increase in taxable income in the amount of the subsidy, would constitute such a denial of promised benefits.

368 F.Supp. at 919-920. To hold the subsidies which were paid to STC taxable under 26 U.S.C. 362(c)(2) would be contrary to both the letter and spirit of the Industrial Incentive Program Legislation and would frustrate the legislative intent so clearly expressed by the Virgin Islands Legislature commencing with Act No. 224. Such a holding would also deny taxpayers the benefits they reasonably anticipated receiving.16 It is our view that 934(b) was intended to ratify the subsidy payments made to qualified Virgin Islands taxpayers, and that these subsidies were of a non-taxable character rather than a non-shareholder contribution to capital.

Having concluded that we should not treat these subsidies as a postponement or a deferment of tax but rather as non-taxable, and recognizing that 934(b) was in effect17 at the time the subsidy in question was paid, we hold that the subsidy received by STC in the year prior to its liquidation was non-taxable, rather than a non-shareholder contribution to capital. Accordingly, the basis of STC's assets was not reduced in the amount of the subsidy and the district court did not err in concluding that HMW could include as beginning inventory for the period in question STC's closing inventory without reducing that inventory by the amount of the subsidy. See Joseph Lupowitz Sons, Inc., et al. v. Commissioner of Internal Revenue, 497 F.2d 862 (3d Cir. 1974).

The judgment of the district court will be affirmed.