author: Phillips:

text:
    Appeal of H. S. Crocker Co.
    Docket No. 4581.
    Decided November 16, 1926.
    1. Where two corporations are affiliated the consolidated net income is to be computed as for one corporation.
    2. Where the parent corporation acquires the stock of its subsidiary at its book value and subsequently sells it at its book value, no profit or loss to the affiliated group results.

      Robert N. Miller, Esq., Virgil Y. Moore, Esq., Andrew T. Smith, Esq., John E. MeClure, Esq., and N. L. McLaren, G. P. A., for the petitioner.

      George G. Witter, Esq., for the Commissioner.

      John W. Davis, Esq., and E. H. Mart, Esq., as amici curiae, on behalf of United States Rubber Co.
    Taxpayer appeals from the determination of a deficiency of $53,654.85 in income and profits taxes for the fiscal year ended March 31, 1919.
    PXN'DIN'GS OP PACT.
    1. The H. S. Crocker Co., of San Francisco, Calif., hereinafter sometimes called “ Crocker,” was incorporated in January, 1891, and was engaged in the business of stationers, printers, lithographers, bookbinders, copper-plate engravers, publishers, etc., from date of incorporation to March 31, 1919, when it sold all of its assets (except certain real estate, notes, Government certificates, and accounts receivable), for the sum of approximately $1,150,000.
    2. In 1912, Cunningham, Curtiss & Welch Co., hereinafter sometimes referred to as “ Cunningham,” had outstanding 288 shares of capital stock of a total authorized issue of 300 shares. From 1912 to March 31, 1919, the issued and outstanding stock of Cunningham remained unchanged. It operated a business in Los Angeles similar to that conducted by Crocker in San Francisco.
    3. In 1912, Crocker purchased for $133,500, 256 shares of the issued and outstanding stock of Cunningham. The purchase price of $133,500 was based on the then book value of the stock of Cunningham.
    4. Crocker continued to hold its original purchase of the stock of Cunningham until the close of its fiscal and reporting period, March 31, 1919. On that date it sold, for the sum of $234,000.96, the 256 shares of the stock of Cunningham theretofore acquired by it. This price was substantially equivalent to the then book value of the stock, the only adjustment made being that inventories were taken at cost or market, whichever was lower.
    5. Between the date of purchase in 1912 and March 31, 1919, Cunningham earned substantial profits. Part of these profits was allowed to accumulate as earned surplus. The difference between the purchase price of the stock of Cunningham in 1912 of $133,500 and the sale price in 1919 of $234,000.96 is equivalent to 256/288ths of such accumulated profits.
    6. The Commissioner held Crocker and Cunningham to be affiliated for the fiscal years ended March 31, 1918 and 1919, and computed the taxes on the basis of a consolidated return. He included in the consolidated income for 1919 an alleged profit of $100,500.96, claimed by him to have been realized by Crocker from the sale on March 31, 1919, of the shares of stock of Cunningham acquired in 1912.
    7. Federal taxes have been assessed against and paid by Cunningham from year to year on the basis of its income, between 1912 and March 81, 1919.
   OPINION.

Phillips:

This case arises under section 240 of the Revenue Act of 1918, and the issue before the Board is this: Does the purchase by the parent company of the stock of its subsidiary at the then book value of the stock, and the sale of the stock at a later date at its then book value, result in taxable income or deductible loss? It is admitted that the companies were affiliated during the taxable j^ear involved.

Section 240 (b) (1) of the Revenue Act of 1918 says, in part, that:

For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns directly or controls through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others.

Section 240 (a) says, in part:

That corporations which are affiliated within the meaning of this section shall, under regulations to be prescribed by the Commissioner with the approval of the Secretary, make a consolidated return of net income and invested capital for the purposes of this title and Title III, and the taxes thereunder shall be computed and determined upon the basis of such return.

And further:

In any ease in which a tax is assessed upon the basis of a consolidated return, the total tax shall be computed in the first instance as a unit.

The Commissioner found that the taxpayer and its subsidiary were affiliated within the meaning of section 240 and accordingly computed invested capital and net income on the basis of a consolidated return, including, however, as part of the consolidated income the sum of $100,500.96, the difference between the purchase price and the sale price of the stock of the subsidiary, which is likewise the pro rata portion of the undistributed profits attributable to the stock of the subsidiary owned by the taxpayer during the period of ownership. The Commissioner thus seeks to impose an income tax against the affiliated group upon an amount which has already been taxed to one of the affiliated group, in part under the Act of 1918 and in part under acts in effect prior thereto. It is his contention that the net income of each corporation in the group is to be computed, intercompany transactions wiped out, and that the result, without any further adjustments, is the consolidated income.

It is our conception of the law that, for purposes of taxation, the affiliated group must be considered as a single economic unit. The requirement with respect to computing the taxes of an affiliated group upon the basis of a consolidated return was first introduced into the law to prevent avoidance and resulting injustice, either to the Government or to the taxpayer, as the case might be, and not to create that situation. The normal treatment in the case of an affiliated group as a single economic unit, therefore, is to disregard the internal structure, to break down the separate legal existence of the constituent members, and to treat them in all respects, so far as taxation is concerned, as one.

In the Appeal of American La Dentelle, Inc., 1 B. T. A. 575, we said:

Prom July 1, 1919, however, Congress has said that the generally recognized principle of corporate identity was to be overridden for the purpose of the income and profits tax and that a consolidated return should be filed “ if substantially all the stock of two or more corporations is owned or controlled by the same interests,” which is the situation here. Prom July 1, in other words, the separate existences ceased for tax purposes just as effectually as if under a State statute the corporations had been consolidated for all corporate purposes. A new tax status was created.

In the Appeal of Frank G. Shattuck Co., 2 B. T. A. 7, we said:

The law provides that affiliated corporations shall make a consolidated return. To consolidate is defined as “ to combine; to cause to become united; to merge.” The two corporations are to be regarded as one business unit.

We have said that the object of the law requiring the computation of the taxes of an affiliated group on the basis of consolidated returns was to prevent tax avoidance and resulting injustice. Certainly, if that was the object of the Congress — and there is no reasonable doubt that it was — then the purpose of the Congress is defeated by the Commissioner’s interpretation of the law. If the computation is made on the basis of a single economic unit, then the same tax — the invested capital and the income being the same — will be found for a parent and a subsidiary in a given year as that found for a corporation discharging through a branch like functions to those of the subsidiary. Under the Commissioner’s theory, however, that is by no means so.

The taxable group, if the Commissioner’s theory were followed, would have to account twice for the same profit or would be allowed a double deduction of the same loss. We do not believe the provision for a consolidated return intends any such result. We do not believe that through the medium of a subsidiary corporation it was possible, under the Revenue Act of 1918, for a corporation to cause its subsidiary to have losses so that its assets became depleted, and then W selling the stock of that subsidiary to have the deduction a second time, and the same rule necessarily follows as to profits. No such claim as is here made by the Commissioner could be made in the case of a company selling a corresponding unincorporated branch of its business. It was to avoid just such inequities in taxation between two business units differently organized, as well as to prevent tax evasion by intercompany transactions, that the provision for consolidation was enacted.

The effect of consolidation, in the language of congressional committees quoted in other decisions of the Board relating to affiliations, is to treat that as an economic unit which really is an economic unit. The statute should be so interpreted that consolidation can not be so carried out as to make evasion possible, or so carried out as to make accidental differences result in tax. This can only be done by disregarding corporate lines in computing the income and treating the affiliated group as one. corporation. When this is done it is clear that a transaction such as we have here results in no profit or loss to the affiliated group, being a change in form of a profit or loss previously realized and reflected in the assets or liabilities of one of the group.

There is the further consideration that, under the affiliation provisions of the statute, the acquisition by one company of the stock of another, thereby creating affiliation, creates no additional investment in the affiliated group. By the act which creates the affiliation the group acquires a part of its own capital stock. The affiliation continues its existence until the stock of the subsidiary is disposed of by the parent corporation. Considering the affiliated group as an entity, the sale is a disposition by it of a portion of its capital stock. We have heretofore held that dealings by a corporation in its own capital stock give rise to no profit or loss. Appeal of Simmons & Hammond Mfg. Co., 1 B. T. A. 803.

We are consequently of the opinion that no taxable profit resulted from the transaction here in question.

Order redetermining the amount of the deficiency will he entered on 15 days’ notice, under Rule 50.

Abundell, GREEN, Love, Teammell, and Teussell dissent.


source: Caselaw Access Project

author: Littleton:

license: Public Domain

text:
    Appeal of W. S. Bogle & Co., Inc., Essanbee Mines Co., Pine Ridge Mines Co., Retlaw Mines Co., and Crescent Coal & Mining Co.
    Docket No. 2208.
    Decided November 16, 1926.
    1. Certain coal leases paid in for stock held, to have had no actual cash value in excess of the stipulated royalties.

      2. The reduction of invested capital on account of insufficient depletion taken in prior years, and the reduction of surplus of the consolidated group in the amount of the deficit of certain subsidiaries, approved.
    3. The evidence is not sufficient to show that the Commissioner’s determination of reasonable compensation for the year 1917 was erroneous.

      M. F. Gallagher, Esq., and E. B. Wilkinson, Esq., for the petitioners.

      Benjamin H. Saunders, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency in income and profits taxes for the years 1917 and 1918 in the amount of $13,331.60.
    FINDINGS OF FACT.
    Petitioners were, during the years here involved, affiliated corporations, all of the stock, with the exception of a few shares, being held by Walter S. Bogle. Their principal office is located at 116 N. La Salle St., Chicago, Ill.
    The Essanbee Mines Co. was organized under the laws of Indiana in November, 1913, with authorized capital stock of $250,000 par value. With the exception of four qualifying shares this stock was issued to Walter S. Bogle for property having an actual cash value of $300,000. This property consisted of 1,390.5 acres of coal land, 39 acres of surface land, and certain mine equipment and supplies. It was located in the West Clinton coal field in Vermillion County, Ind., on the Chicago, Terre Haute & Southeastern Bailway, 160 miles from Chicago. It had the advantage of being nearer Chicago and the steel manufacturing district than any other property in the field. The land contained three seams of bituminous coal, graded as Nos. 3, 4, and 5. Grades 3 and 5 were steam coal, No. 5 being used to a certain extent for domestic purposes. The coal in No. 4 seam was of a better grade, and was used for more varied purposes than the coal from the other seams. At the time the property was acquired there was a completed mine to the No. 5 seam and a partially completed mine to No. 4. A switch from the railroad to the mouth of the mine had been previously constructed.
    Immediately after organization the Essanbee Mines Co. leased this proj>erty to Walter S. Bogle for a period of twenty years. The lease provided for the payment of a royalty of 5 cents for each ton of coal mined and a minimum royalty of $1,666.67 per month. The lessor was required to complete the mine to the No. 4 seam of coal. There was also a provision that if the lessor should at any time during the period of the lease desire to sell the premises, it should have the right to cancel the lease upon payment to the lessee of a sum not exceeding $50,000.
    On or about February 5, 1914, W. S. Bogle & Co. Inc., was organized for the purpose of taking over the lease above mentioned and operating the mines thereunder. This corporation was organized under the laws of Indiana and its authorized capital stock had a par value of $100,000. Stock was issued to Walter S. Bogle for the lease, which was entered on the books of the corporation at a value of ⅝$42,400. At the time this corporation was organized the coal business was, and for some time previous thereto had been, generally dull.
    In 1917, after the Fuel Administration had issued regulations permitting a profit of 15 cents per ton to companies engaged solely in the business of selling coal, it was mutually agreed between the parties that the lease mentioned should be canceled and that the Essanbee Mines Co. should operate the mines and W. S. Bogle & Co., Inc., should sell the output, thereby enabling the former to make a profit from operation and the latter the profit allowed to selling companies. The Essanbee Mines Co. purchased the mine equipment and supplies from W. S. Bogle & Co., Inc., at cost, but no payment was exacted for the cancellation of the lease.
    The Pine Bidge Mines Co., also an Indiana corporation, was organized July 25, 1917, with authorized capital stock of $50,000 par value. This stock was issued to Walter S. Bogle for an option to lease 800 acres of coal land and to purchase a mine and equipment located thereon, the lease to require payment of a royalty of 5 cents on each ton of coal mined and the purchase price of the mine and equipment to be $138,000. Bogle had procured this option from W. S. Bogle & Co., Inc., for a payment of $10. W. S. Bogle & Co., Inc., had previously leased 400 acres of the property at a royalty of 3 cents per ton from the Higgins Martin Coal Co. and had purchased the mine and equipment from the same company for $131,500. W. S. Bogle & Co., Inc., originally agreed to pay $175,000 for the mine and equipment, but because of certain contracts of the Higgins Martin Coal Co., which it was required to assume, tlie price was reduced. The remaining 400 acres had been obtained from J. J. Higgins under a lease likewise providing a royalty of 3 cents per ton. This tract was located adjacent to that procured from the Higgins Martin Coal Co. and could be reached through the mine located on that tract. The Pine Bidge Mines Co. exercised the option, thereby acquiring the lease and purchasing the mine and equipment for a payment of $138,000.
    The Pine Bidge property was located in Yigo County, Ind., about eight miles south of the holdings of the Essanbee Mines Co. The lease under which it was held provided that the mine could be used in developing adjoining acreage if the lessee so desired. At the time this property was acquired the coal market was very active.
    The Retlaw Mines Co. was incorporated under the laws of Indiana in February, 1910. Its capital stock was issued to Walter S. Bogle for a coal mine, 300 acres of surface and 800 acres of coal land located in Vigo County, Ind. The company assumed certain liabilities that were outstanding against the property at that time. The mine was operated for only a year or two before it was abandoned. Soon afterwards, in 1913, the ground works of the mine were partially destroyed by fire. They were not replaced and the mine has not been operated at any time since. On January 1, 1917, the company had capital stock outstanding in the amount of $30,000 and a deficit in the amount of $78,498.88. In 1919 the surface land and the buildings thereon were sold for $11,700. During the years 1914 to 1918, inclusive, interest on the bond issue of the Retlaw Mines Co. was paid by Walter S. Bogle.
    The Crescent Coal & Mining Co. was organized under the laws of Illinois. Its business was that of selling agent and jobber in bituminous coal. Active conduct of business was discontinued about 1912. On January 1, 1917, the company had capital stock outstanding in the amount of $38,300 and an accrued deficit of $15,-389.43. In 1917 the assets of the company as shown on the books were: Cash, $519.84; accounts receivable, $4,068.41; notes receivable, $15,202.47, and real estate, carried under the name of Walter S. Bogle, trustee, $6,592.17.
    In 1916 the Retlaw Mines Co. was indebted to the Crescent Coal & Mining Co. in the sum of $45,902.48, for cash advanced in previous years. In that year Walter S. Bogle assumed this indebtedness and surrendered to the Crescent Coal c% Mining Co. capital stock of that company in the amount of the debt. The amount of this indebtedness constituted a part of the deficit shown on the books of the Retlaw Mines Co. as of January 1, 1917.
    During the years 1915 and 1916 the Essanbee Mines Co. paid to Walter S. Bogle, its president, a salary of $3,500 a year. In 1917 a resolution was adopted by the board of directors increasing his salary to $10,000 a year and authorizing the payment of $7,000 as additional compensation for services rendered in 1915 and 1916. The full amount, $17,000, was paid in 1917 and deducted as an expense on the return of the corporation for that year.
    For the years 1917, 1918, 1919 and prior years, the Essanbee Mines Co. charged off depletion at the rate of 1.39 cents per ton. Its returns were filed on that basis. The parties agree that the correct rate of depletion on the Essanbee Mines Co. properties is 1.765 cents per ton. The Commissioner has used this rate in determining the deduction allowable for the taxable years on account of depletion and has adjusted invested capital by applying the same rate for prior ySars.
    W. S. Bogle & Co., Inc., has exhausted the lease to the Essanbee Mines Co. property at the rate of 10 per cent, on the ground that the coal would be exhausted at the end of ten years. In 1917, when the lease was canceled, it sought to charge off the remaining value shown on its books as a loss. This was refused by the Commissioner and the company has continued to take exhaustion at the rate of 10 per cent per annum.
    It is admitted on behalf of the Commissioner that, through clerical error, the invested capital of W. S. Bogle & Co., Inc., for 1917 was erroneously reduced in the amount of $7,600; that the correct amount of depreciation allowable to W. S. Bogle & Co., Inc., for 1917, on its physical assets, is $4,885.52; and that the proper allowance for the depletion for 1918 of certain coal lands owned in fee by W. S. Bogle & Co., Inc., and leased to the Pine Ridge Co., is $143.48.
    The return filed by W. S. Bogle & Co., Inc., for the year 1919 disclosed a net loss of $12,753.68. . The Commissioner has reduced this loss to $4,708.45, the amounts disallowed consisting of $4,240 representing deduction on account of exhaustion of the lease to the property of the Essanbee Mines Co., $3,537.23 paid as minimum royalties, and $268 representing cost of preparing abstracts on property owned by the company. The Pine Ridge Mines Co. reported a net loss for the same year of $2,491.51, of which amount $1,274.42 represented exhaustion claimed of its leasehold and $1,277.09 represented development charge. The petitioner has acquiesced in the disallowance of the latter amount. The Essanbee Mines Co. also reported a net loss for 1919, of which the Commissioner has disallowed $3,225 deducted on account of minimum royalties paid under leases to certain property being operated by the corporation.
   OPINION.

Littleton:

The issue presented for determination by this appeal grew out of alleged errors of the Commissioner — (1) in determining the value for invested capital and depreciation purposes of the lease acquired by W. S. Bogle & Co., Inc., in exchange for its capital stock; (2) in determining the value for invested capital purposes of an option to lease the Pine Ridge Coal properties and to purchase the mine and equipment thereon, procured by the Pine Ridge Mines Co. in exchange for its capital stock; also the cost of the lease acquired by the exercise of the option for the purpose of computing the deduction for the exhaustion thereof; (3) in excluding from consolidated invested capital amounts representing the outstanding capital stock of the Crescent Coal & Mining Co. and of the Eetlaw Mines Co.; (4) in reducing consolidated invested capital by applying the deficits of the Crescent Coal & Mining Co. and the Eetlaw Mines Co. against the surplus of the consolidated group; also in determining the amount of the deficit of the Eetlaw Mines Co.; (5) in reducing invested capital by adjustment of depletion of the Essanbee Mines Co. for prior years; (6) in disallowing the deduction for 1917 for salary paid in that year by the Essanbee Mines Co. on account of services rendered in 1915 and 1916, and in excluding that amount from invested capital for 1917; (7) in excluding from invested capital as of January 1, 1918, the amount of income and excess-profits taxes for the year 1917 assessed and collected subsequent to 1918; (8) in reducing the net loss for 1919 by disallowing deductions made by W. S. Bogle & Co., Inc., and Essanbee Mines Co. for minimum royalties paid during that year, deductions made on account of the exhaustion of the W. S. Bogle & Co. lease, and the lease of the Pine Eidge Mines Co.; also deductions made representing the cost of preparing abstracts on land owned by W. S. Bogle & Co., Inc.

There are other items which, on agreement of counsel at the hearing, are not now in dispute or which have been determined as facts and need only to be mentioned here. It has been admitted on behalf of the Commissioner that through clerical error the invested capital of W. S. Bogle <& Co., Inc., was erronously reduced in the amount of $7,600. It is agreed that, with the exception of the leasehold, the proper allowance for depreciation of assets to that corporation for 1917 is $4,885.52. It is also entitled to a deduction in the amount of $143.43 for depletion of certain coal lands owned by it in fee and leased to the Pine Eidge Mines Co. It is also agreed between counsel that thé proper rate of depletion allowable to the Essanbee Mines Co. on its coal mining property is 1.765 cents per ton, instead of 1.39 cents per ton as used by the petitioner in computing the deduction therefor on its 1917,1918 and 1919 returns. The deductions for those years should be increased accordingly.

With reference to the first of the issues enumerated above, we are of the opinion that the Commissioner properly excluded from invested capital the amount purporting to be the value of the lease acquired by W. S. Bogle & Co., Inc., from Walter S. Bogle, in exchange for its capital stock. The petitioners contend that the lease had a value of at least $50,000 and that the Commissioner erred in eliminating from invested capital $42,400, the amount at which the lease was carried on the books of the corporation. This lease was acquired by Walter S. Bogle from the Essanbee Mines Co. without cost and was assigned without change to W. S. Bogle & Co., Inc., for stock. In support of their contention as to the value of the leasehold, the petitioners presented three witnesses who expressed as their opinion that the lease was worth $50,000 or more. Two of the witnesses had been employed in connection with the development of the properties, one having been engaged in gathering together the acreage prior to the time it was acquired by the Essanbee Mines Co. The third witness owned coal lands a few miles south of the property in question and for a number of years operated these properties. Testimony was given to' the efiect that the property was conveniently located with reference to market, that the coal was excellent both as to the quality and quantity, that a mine to one coal seam had been completed and another had been partially completed, and finally that the equipment was of high grade and new.

There is no question that such features as those enumerated tend to make the lease attractive, but there is nothing to show that all of these features were not fully considered and covered .when the lease was negotiated, and that the royalty of 5 cents per ton and the minimum royalty did not fully cover all of these items. There is nothing in the record which indicates that Walter S. Bogle procured, by way of the lease, more than he was obligated to pay as royalties, or that his prospects for profits could be based on anything other than operation of the mines. Furthermore, granting' that the lease, under ordinary circumstances, was very attractive, all conditions existing at the time must be considered in determining the value, and it appears that the coal business was and for some time had been very dull. On the evidence before us, we are not justified in saying that the lease in question had the value claimed by the petitioners or that it in fact had any value over and above the amounts paid annually by way of royalties.

Our conclusions in respect of the value, for invested capital purposes, of the lease mentioned will also dispose of the question as to whether or not the deductions claimed on account of the exhaustion of the lease should be allowed. Since nothing of value was gNen for the stock, the corporation had nothing on account of which exhaustion could be claimed. The same reasoning also disposes of the petitioner’s claim for deduction as a loss of the remaining value of the lease as shown by the books of the corporation at the time it was canceled. With reference to the last item, however, there is some question as to whether or not such a deduction would be allowable, even though it be conceded that the lease, at the time it was paid in for stock, had the value contended for by the petitioner. It is stated that it was mutually advantageous to both parties to cancel the lease. It is also well to note that under its provisions the lease could be canceled only in case the lessor desired to sell, and then only upon payment of $50,000 to the lessee. This payment was not exacted. Taking all these facts into consideration, it would be very strange reasoning which would permit a deduction on account of loss when it is admitted by the parties themselves that it was mutually advantageous to cancel the lease. Furthermore, if there was a loss on the part of the lessee, it had only to enforce the provisions of its contract in order to be fully indemnified against such loss.

In the case of the Pine Eidge Mines Co., the value of the option received for stock, or of the lease procured by exercise of the option, is immaterial so far as the determination of invested capital is concerned. This transaction falls within the provisions of section 208 of the Eevenue Act of 1911 and section 331 of the Eevenue Act of 1918, which provide that if property is paid in for stock after March 3, 1917, such property shall have, for invested capital purposes, no greater value than would have been allowed in computing the invested capital of the grantor, provided the same party or interests controlled 50 per cent or more of the stock of the corporation. In this case the option was paid in for all of the capital stock of the corporation in July, 1917, and inasmuch as the option was originally obtained by Walter S. Bogle for a payment of $10, it can have no greater value for invested capital purposes in the case of the Pine Eidge Mines Co. than it would have had if Walter S. Bogle had retained it.

The option acquired by the Pine Eidge Mines Co. in exchange for its capital stock was entered on the books of the corporation at a value of $50,000, which value was also attributed to the lease acquired by exercise of the option. The petitioner contends that this amount is the cost of the lease to the company, in that it represents the true value of the option received for stock and also represents the value of the lease at the time it was acquired. On that basis the petitioner claims that it should be allowed a proper deduction from income for the exhaustion of the said lease. W. S. Bogle & Co., Inc., from which Walter S. Bogle procured the option, and the Pine Eidge Mines Co. later acquired the lease, obtained the property by way of lease at a royalty of 3 cents per ton, and paid $131,500 for the mine and equipment. The lease to the Pine Eidge Mines Co. called for a payment of 5 cents per ton royalty and $138,000 for the mine and equipment. Three hundred of the 800 acres of coal had been removed. There was, however, this feature— that other property could be reached through the mine on the property covered by the lease and a provision permitting such operation was inserted in the lease. Testimony was also offered to the effect that, within a very short time after the lease was acquired, the Pine Eidge Mines Co. received an offer of $250,000 for the lease, mine and equipment. The witness testifying with reference to this offer stated that he understood it to be a cash offer. Another fact which might tend to support the position of the petitioner is that, at the time the lease was acquired, the coal business was in a very prosperous condition. None of the witnesses could recall a case in which a lease in that territory had ever been sold for cash. Before giving too much consideration and weight to the offer mentioned above, it is well to note that the offer did not cover the lease alone but also included the mine and its equipment. There is nothing to show how much, if any, of the price offered was or was intended to be allocated to the lease itself; neither is there anything in the record to indicate whether or not the contracts of the Higgins-Martin Coal Co. were to be assumed by the purchaser. Under these circumstances, we do not feel that this offer alone is a sufficient basis for determining the value of the lease for exhaustion.purposes, even though it be conceded that the offer was hona -fide for cash and an indication of the value of the whole property.

The alleged error enumerated above is that the Commissioner erroneously excluded from invested capital amounts representing the outstanding capital stock of the Crescent Coal & Mining Co. and of the Retlaw Mines Co. The Retlaw Mines Co. was organized in 1910, its capital stock being issued to Walter S. Bogle for a coal mine, 300 acres of surface, and 800 acres of coal land. The operation of the mine apparently was not profitable, for it was abandoned within two or three years. Soon afterwards the top works of the mine were burned. In 1919 the surf ace land and remaining buildings were sold for $11,700. On January 1, 1917, this company had outstanding $30,000 capital stock, and at the same time its books disclosed a deficit of $78,498.88. The facts concerning the Crescent Coal & Mining Co. are practically the same, except that the record fails to disclose the exact date of incorporation or the nature of the property received for its capital stock. It does appear that the capital stock outstanding on January 1, 1917, was $38,300 par value and that the total assets amounted to $26,382.89. The accrued deficit on the same date was $15,389.43.

On these facts the action of the Commissioner in excluding from invested capital amounts representing the capital stock of the Crescent Coal & Mining Co. and the Retlaw Mines Co. must be approved. Section 207 of the Revenue Act of 1917 and section 326 of the Revenue Act of 1918 specifically state the items that may be included in invested capital. They include actual value of property, with certain limitations, paid in for stock, paid-in surplus, and earned surplus and undivided profits. The amounts in question can not be included as earned surplus and undivided profits because the facts show that there were accrued deficits in the case of both corporations. There is no evidence to show that the amounts claimed represent amounts paid in for stock, paid-in surplus, or the value of property-paid in for stock. The record does show that the stock of the Eetlaw Mines Co. was issued for certain property, but there is no evidence which discloses the value, if any, of such property at the time it was paid in. It appears that the surface land and the buildings thereon were sold in 1919 for $11,700, but this sale can not be used as a basis for determining the value of the property in 1910, the year in which it was paid in for stock. With reference to the Crescent Coal & Mining Co., we are unable to say from the record before us that anything of value was paid in for stock of that corporation.

The petitioners also contend that the Commissioner erred in his determination of the amount of the deficit of the Eetlaw Mines Co. From the facts it appears that the Eetlaw Mines Co. was indebted in 1916 to the Crescent Coal & Mining Co. in the amount of $45,902.48 for cash previously advanced. Walter S. Bogle assumed the indebtedness and surrendered to the Crescent Coal & Mining Co. stock of that corporation in an amount sufficient to cancel the indebtedness. One of the witnesses testified that it was intended that the Eetlaw Mines Co. should be relieved of the debt and that the payment thereof by Walter S. Bogle should operate as a gift made in behalf of the debtor comi^any. No entry was made on the books of the corporation to that effect and, so far as its records are concerned, that amount is still carried as an obligation of the company. If Walter S. Bogle had any intention of relieving the company of that amount of indebtedness, it would have been a very simple matter to have made an entry to that effect on the books. In view of these facts, we are of the opinion that little weight should be given to the assertion of third parties, made at the present time, to the effect that a gift to the Eetlaw Mines Co. was intended.

In determining consolidated invested capital, the Commissioner has applied the deficits of the companies last mentioned against the surplus of the remaining corporations of the consolidated gro'up, thereby reducing invested capital. The petitioners contend that such procedure is improper in that it ignores corporate entities and that the invested capital of the respective corporations should be determined separately and then combined for purposes of computing the tax. The petitioners also attempt to distinguish between affiliations where the stock of one corporation is held by another corporation and affiliations where the stock of the several corporations is held by common interests.

The action of the Commissioner in reducing the surplus of the consolidated group in the amount of the deficits of the Retlaw Mines Co. and the Crescent Coal & Mining Co. (subsidiary corporations) is approved. Appeals of Gould Coupler Co., 5 B. T. A. 499; Farmers Deposit National Bank, 5 B. T. A. 520; Interurban Construction Co., 5 B. T. A. 529; Risdon Tool & Machine Co., 5 B. T. A. 530; Ruckman Coal Co., 5 B. T. A. 534; H. S. Crocker Co., 5 B. T. A. 537. See also Appeal of Valdosta Grocery Co., 2 B. T. A. 727.

With reference to the argument of the petitioners that a distinction should be made between consolidations where the stock of one corporation is held by another and where the stock of two or more corporations is held by common interests, it is well to note that there is nothing in section 240 of the Revenue Act of 1918 on which such argument could be based. The two classes of affiliations are set forth in that section, but there is no language which in any way intimates that Congress intended that a distinction was to be made between these two groups for the purpose of computing the tax or determining the invested capital.

The Commissioner made a further reduction of invested capital because the Essanbee Mines Co. failed to take sufficient depletion for the years prior to 1917. The petitioners contend that such an adjustment for prior years ¿s improper because of the fact that no deduction was taken by that corporation and that it has at no time received the benefit of such an adjustment. The petitioners have admitted, however, that depletion was charged off during those years at the rate of 1.39 cents per ton, whereas the proper rate is 1.765 cents per ton. In the Appeal of Cleveland Home Brewing Co., 1 B. T. A. 87, we held that depreciation of tangible property charged off the books of the corporation for prior years -would not be disturbed for invested capital purposes without positive evidence that depreciation actually sustained was not written off by the taxpayer. The decisions in the Appeals of Russell Milling Co., 1 B. T. A. 194, and Rub-No-More Co., 1 B. T. A. 228, were to the same effect. In this case, however, the facts are quite different, inasmuch as the petitioners have admitted that the depletion actually sustained was not written off on the books. Under these circumstances, there can be no question that the surplus of the petitioners should be reduced on account of inadequate depletion for the years prior to the taxable years.

The action of the Commissioner in disallowing the deduction for 1917, for salary paid by Essanbee Mines Co. to Walter S. Bogle in that year, on account of services rendered in 1915 and 1916, is approved. This case is slightly different from most of the cases that have been before us with reference to the payment of salaries on account of service rendered in prior years. We have repeatedly held that salaries voted and paid in a subsequent year are not deductible for the years in which the services were rendered. Sharpsville Boiler Works Co., 3 B. T. A. 568; W. F. Severa Co., 3 B. T. A. 664; Green Oil Soap Co., 3 B. T. A. 467. Since the petitioner claims the deduction in this case for the year in which the additional salary was voted and paid, it must come within the ordinary provisions governing such deductions if it is to be allowed. The petitioner has not shown that the services actually rendered during the year 1917 were such as to make the payment of the full amount, including the amount paid on account of services rendered for prior years, reasonable compensation for the year in which the salary was paid.

It is equally clear that the action of the Commissioner in reducing the invested capital of the Essanbee Mines Co. as of January 1, 1917, on account of the amount paid during 1917 for services rendered in prior years, is erroneous. There was no obligation on the part of the company to pay such an amount and no liability in regard thereto had been incurred.

The question as to whether or not income and excess-profits taxes payable for the year 1917, but assessed and collected subsequent to 1918, should be excluded from invested capital as of January 1, 1918, is governed by our opinion in the Appeal of Russel Wheel & Foundry Co., 3 B. T. A. 1168, wherein we held that, under section 1207 of the Bevenue Act of 1926, the action of the Commissioner in adjusting invested capital as of the beginning of the taxable year, on account of amounts payable for the preceding taxable year, should be approved. The same reasoning applies in this case.

The only question remaining for consideration is the determination of the net loss of the petitioners for the year 1919. This determination involves a consideration of three points; first, the disallowance of deductions claimed for the exhaustion of the leaseholds held by W. S. Bogle & Co., Inc., and the Pine Eidge Mines Co.; second, whether or not minimum royalties paid by the Essanbee Mines Co. and W. S. Bogle & Co., Inc., are deductible as expenses or should be carried in the capital expense account; and third, whether or not the cost of preparing abstracts on property owned by W. S. Bogle & Co., Inc., constituted capital expenditures. With reference to the first of these items, the action of the Commissioner in disallowing the deductions on account of exhaustion of the leaseholds is approved on the same basis on which the deductions claimed for the years 1917 and 1918 were disallowed. With reference to the minirrmm royalties, we are of the opinion that they constitute rent and are allowable deductions. It is well settled that royalties paid under the provisions of mining leases constitute rents. Appeal of Estate of Mary E. McCahill, 2 B. T. A. 875; Lynch v. Alworth-Stephens Co. 267 U. S. 364; Von Baumbach v. Sargent Land Co., 242 U. S. 503; and United States v. Biwabik Mining Co., 247 U. S. 116. The mere fact that the basis of computing such rents is at a rate of so touch per ton, provided a certain quantity of ore or coal is removed, or is iixed at a certain, specified amount if the required quantity is not mined, does not in any way affect the nature of the payment. The cost of preparing abstracts constitutes a part of the cost of the property for which the abstracts were prepared and are not allowable deductions.

Order of redetermination in accordance with the foregoing -findings of fact and opinion will be entered on 15 days’ notice, under Bule 50.


author: Tkussell:

text:
    Appeal of Burke Electric Co.
    Docket No. 1697.
    Decided November 16, 1926.
    1. Patents and good will. — Tbe value of patents and good will acquired for stock at tbe time of organization determined on tbe basis of stipulation between parties.
    2. Paid-in surplus. — A paid-in surplus, resulting from tbe acquirement from its stockholders of tbe stock of another corporation, and this resulting in an affiliation of tbe two companies, cannot affect invested capital of tbe affiliated group.
    3. Taxes oe 1916.- — Income taxes paid for a period ended in 1916 may properly reduce invested capital for 1917 in accordance with Bureau regulations and section 1207 of the Revenue Act of 1926.
    4. Capital value of patents, March 1, 1913. — The capital value of patents and inventions owned by tbe petitioner on March 1,
    1913, determined from a consideration of profits produced prior to that time, opinion evidence and a comparison with profits produced subsequent thereto.
    5. Exhaustion op patents, deduction. — In a proceeding before this Board a petitioner may claim and be allowed a deduction for tbe exhaustion of capital value of patents although the same was not made in its original return for tbe taxable year under consideration. Following Union Metal Mfg. Go., 1 B. T. A. 395.

      Edward B. Burling, Esq., for the petitioner.

      J. Harry Byrne, Esq., for the Commissioner.
    Under date of November 28, 1924, the Commissioner served upon the Burke Electric Co., of Erie, Pa., notice of a deficiency in income and profits taxes for the fiscal year ended April 30,1917, in the a mount of $5,755.05. From this notice the petitioner appealed, and the issues presented for determination are:
    1. Value of patents acquired for stock on May 1, 1906.
    2. Value of good will acquired for stock on May 1, 1906.

      3. Whether in 1916 upon the acquirement of stock of the Duntley Products Co. the petitioner acquired a paid-in surplus.
    4. Whether the amount of income taxes paid for the fiscal year ended April 30, 1916, are properly deducted from invested capital for the period ended April 30, 1917.
    5. Value of patents owned by the petitioner on March 1, 1913.
    6. Whether the petitioner may now claim a deduction based upon the exhaustion of patent values which was not claimed in its original income-tax return.
    FINDINGS OF FACT.
    Petitioner is a Pennsylvania corporation with its principal office at Erie. It was organized on or about May 1, 1906, with an authorized capital stock of $1,250,000 par value — consisting of 2,500 shares of preferred and 10,000 shares of common, shares of both classes having a par value of $100 each — for the purpose of engaging in the business of' manufacturing and selling electrical devices, machinery and equipment.
    The original Burke Electric Co. was organized early in 1904, under the laws of the State of New Jersey, for the purpose of taking over and exploiting certain patents then owned by James Burke. In the middle of 1904 this company leased the plant of the Keystone Electric Co. and operated said plant until on or about May 1, 1906. During the period of operation of this leased plant the company’s earnings were not sufficient to provide a return of 8 per cent on the tangible assets.
    The Keystone Electric Co. had been organized some time prior to the original Burke Electric Co. and was engaged in manufacturing and selling electrical devices, machinery and equipment at its plant in Erie, Pa., until at or about the middle of 1904, when it leased its plant to the original Burke Electric Co. The business was not a success. The company’s earnings were not sufficient to provide a return of 8 per cent on the tangible assets, and at the time of leasing its plant it was experiencing serious financial difficulties.
    On May 1, 1906, the petitioner acquired all the assets and business of the Burke Electric Co. of New Jersey, hereinafter referred to as the New Jersey Company, for $642,000 par value of its own common capital stock. Among the assets thus acquired were tangible assets of a cash value of $30,000, good will, patents, and patent applications. The serial numbers of the patents, the dates the patents were issued, and the remaining life of the patents from the date acquired by the petitioner are set out as follows:

    The average remaining life of the above patents at the date acquired by the petitioner was 14.1613 years.
    Prior to the beginning of the taxable year under consideration, three of the eight patents acquired from the New Jersey Company, to wit, Nos. 706,017, 712,257, and 768,843, had been disposed of in some manner by the petitioner.
    The patent applications acquired from the New Jersey Company, the serial numbers of the patents issued, the dates applied for, and the dates the patents were issued, are set out below:

    Likewise, on May 1,1906, the petitioner acquired all the assets and business of the Keystone Electric Co. hereinafter referred to as the Keystone Company, for $358,000 par value of its own common capital stock. Among the assets thus acquired were tangible assets of a cash value of $139,856.53, good will, and patents. The serial numbers of the patents, the dates the patents were issued, and the remaining life of the patents from the date acquired by the petitioner, are set out below:

      The average remaining life of the above patents at the date acquired by the petitioner was 7.7321 years.
    Prior to the beginning of the taxable year under consideration, six of the nine patents acquired from the Keystone Company, to wit, Nos. 415,487, 470,158, 510,596, 513,626, 562,179, and 608,711, had expired, and the other three patents had been disposed of in some manner by the petitioner.
    Upon acquisition of the above-enumerated properties from the New Jersey Company and the Keystone Company, they were recorded on the books of the petitioner in the following amounts:
    Tangible assets_ $169, 856. 53
    Patents and good will_ 830,143.47
    Total assets acquired- 1, 000, 000. 00
    The corresponding credit entry was made to common capital stock.
    All of the petitioner’s preferred capital stock, consisting of 2,500 shares of the par value of $100 each, was sold on or about the date of organization for cash at par.
    In or about the month of November, 1906, a date approximately six months after the organization of the petitioner, James Burke, president of petitioner, entered into negotiations with George Westinghouse, president of the Westinghouse Electric & Manufacturing Co., with a view to the purchase by the latter individual and the Westinghouse Company of the petitioner’s entire outstanding common and preferred capital stock. It appears that at the outset of the negotiations both parties met on the proposition that the preferred stock was to be paid for at par. Burke offered to sell the common stock at $75 per share, but Westinghouse offered $60 per share. In the final conference a compromise figure of $65 per share for the common was fixed.
    Under the arrangement for the sale and purchase of this stock, the Westinghouse Company was to pay the purchase price in cash on or before the expiration of 10 years from the date of the contract, and in the interim was to pay dividends of 6 per cent and 4 per cent, respectively, on the preferred and common stock.
    For some reason not entirely clear from the record, Burke rejected the final offer of Westinghouse, which was as stated, above, and refused to carry on negotiations any further.
    At the time of the negotiations above referred to, the tangible assets of the petitioner were approximately of the value of $433,937.28, comprising the original assets acquired from the New Jersey and Keystone companies of a value of $169,856.53, cash paid in for preferred stock in the amount of $250,000, and earnings of approximately $14,080.75.

      The petitioner’s net earnings, before any deduction for exhaustion of patents, and tangible assets for each year from the date of organization to and including the year 1920, were as follows:

    The Commissioner held that the good will acquired from the New Jersey and Keystone companies had an aggregate cash value at the date of acquisition of $332,322, and that the patents and patent applications acquired from the same companies had an aggregate cash value at the date of acquisition of $80,654.26. In the computation of petitioner’s invested capital for the taxable year under consideration, the Commissioner included good will, acquired at organization, in the amount of $249,600, said amount being the 20 per cent limitation applicable to intangibles under the provisions of section 207 (b) of the Revenue Act of 1917, and patents and patent applications, acquired at organization, at a value of $80,654.26.
    The petitioner contends that the aggregate actual cash value of the good will, patents, and patent applications, acquired from the New Jersey and Keystone companies, was $480,143.47 at the date of acquisition, of which amount not more than 10 per cent represented the value of the good will. The petitioner further contends that, since the actual cash value, at the date of acquisition, of the good will thus acquired is less than the 20 per cent limitation imposed by section 207 (b) of the Revenue Act of 1917, it is entitled to include the good will, patents, and patent applications acquired from the New Jersey and Keystone companies in the invested capital of the taxable year at an aggregate value of $480,143.47 in lieu of the total value of $330,254.26 which the Commissioner allowed for invested capital purposes.
    The aggregate cash value, at the date of acquisition, of the good will, patents, and patent applications acquired from the New Jersey and Keystone companies was $412,976.26, of which amount $41,297.63 represents the value of the good will and $371,678.63 represents the value of the patents and patent applications.
    On March 1, 1913, the petitioner was the owner of patent No. 1,053,940, issued February 18, 1913, and which had on March 1, 1913, a remaining life of 16-96/100 years. It was also the owner of 17 other patents, bearing numbers and dates of issue, and having a remaining life, as set forth below:

    The nine patents issued subsequent to March 1, 1918, under applications pending on that date, are as follows:

    The one patent applied for and issued subsequent to March 1, 1913, is the Cuban patent No. 2725, issued April 19, 1917.
    During the period from 1906 to April 30, 1913, the petitioner employed in its manufacturing business average tangible assets and produced earnings as follows:

      During the years 1914 to 1921, inclusive, it employed in its business average tangible assets and produced earnings as follows:

    In the computation of its net income in the original return which it filed for the fiscal year under consideration, petitioner did not claim a deduction for exhaustion of patents. Subsequently, it filed an amended return for that year in which it claimed such a deduction in the amount of $76,770.91, based upon a March 1, 1913, value for its patents of $1,172,495.92. The Commissioner refused to allow the deduction claimed in the amended return on the ground that the petitioner, in failing to claim a deduction for exhaustion of patents in its original return, exercised an option not to claim such a deduction, which was thereafter binding upon it with respect to this particular year.
    The Commissioner has reduced the petitioner’s invested capital for the year under consideration by the amount of $1,435.57, representing the income tax for the preceding taxable year, prorated from the date such tax became due and payable.
    Prior'to 1912 the petitioner had been furnishing motors for electric vacuum cleaners to the Duntley Manufacturing Co., a corporation domiciled in Chicago. By 1912 conditions had developed with respect to the financial resources of the Duntley Manufacturing Co. which made it extremely doubtful whether that company could continue to operate and liquidate its indebtedness to the petitioner. For the purpose of alleviating this situation and working out a plan to save the Duntley Manufacturing Co. from the necessity of passing through a receivership, James Burke, president of the petitioner, and Van Cleave, one of petitioner’s directors, undertook a thorough study of the situation, and finally offered a plan which provided for the organization of a new manufacturing company, known as the Duntley Products Co., leaving the Duntley Manufacturing Co. to continue as a selling company only. Burke and Van Cleave contracted to furnish to the Duntley Manufacturing Co. such funds as were necessary to correct its financial difficulties, that company in turn to assign to Burke and Yan Cleave its right under a license agreement to manulacture electric vacuum cleaners, under the so-called Kinney patent which gave to its owners a virtual monopoly in the manufacture of vacuum cleaners. The whole plan was adopted precisely as outlined.
    Upon organization of the Duntley Products Co., Burke and Yan Cleave assigned to it their contract with the Duntley Manufacturing Co., receiving in exchange therefor the entire authorized common capital stock of a par value of $50,000. The entire authorized preferred stock of $25,000 par value was sold for cash. The preferred stock certificates contained a provision for their redemption on the basis of $105 per share.
    During the period from organization to the time of the sale of its capital stock to the petitioner the average earnings of the Dunt-ley Products Co. were approximately $5,400 per year, an amount equivalent to a return of approximately 7.2 per cent on its entire outstanding capital stock.
    In 1916 the entire capital stock, common and preferred, of the Duntley Products Co. was sold to the petitioner for a price of $26,250 cash, which was equivalent to the redemption price of the preferred stock. At the time of the sale Burke and Van Cleave, both of whom are large stockholders of the petitioner, owned all of the common stock of the Duntley Products Co.
    The Duntley Products Co. operated until some time in the year 1919. However, during the period subsequent to the stock transaction in 1916, its business was seriously hampered and restricted by governmental regulations incidental to the World War, the business having been classified as a non-essential. Such vacuum cleaners as were sold during the period of the war were assembled almost entirely from parts manufactured prior to the war. Because of these regulatory restrictions the business was unable to progress in a normal manner during the period of the war, and the year 1919 found the business in much the same situation as existed late in 1916; and early in 1917.
    Notwithstanding the difficulties under which it had been laboring and its retarded progress because of governmental regulations, the business and assets of the Duntley Products Co. were sold in 1919* at a price of approximately $66,250, which was sufficient to liquidate its preferred stock at $105 per share, and left approximately $40,000' wherewith to liquidate its common stock of a par value of $50,000.
    The petitioner appraised the capital stock of the Duntley Products Co. which it had acquired for $26 250 cash at a value of $70,-603.45, and in its computation of invested capital in the return for the year under consideration included therein a paid-in surplus equal to the excess of the appraised value over and above the cost of the stock, to wit, $44,353.45. The paid-in surplus claimed was disallowed by the Commissioner.
    The Commissioner has held that the petitioner and the Duntley Products Co. were affiliated during the taxable year 1917 and has computed the excess-profits tax upon the basis of such a consolidation.
   OPINION.

Tkussell:

1 and 2. The first issue presented by this appeal involves a determination of the actual cash value, at the date of acquisition, of the patents, patent applications, and good will, acquired from the Burke Electric Co. (New Jersey) and the Keystone Electric Co., and the extent to which such assets may be included in the invested capital for the taxable year under consideration.

The Commissioner has fixed the value of the combined good will of the two predecessor companies at $332,322, and has included the same in the invested capital to the extent of $249,600, the latter amount being the 20 per cent limitation applicable to intangibles imposed by section 207(b) of the Eevenue Act of 1917. The Commissioner also has fixed the value of the combined patents and patent applications acquired from the same companies at $80,654.26, and has included the full amount thereof in invested capital. Thus the full amount which the Commissioner has included in invested capital on account of the intangible properties acquired from the predecessor companies is $330,254.26. For these properties the petitioner had issued capital stock in the sum of $830,143.47.

On the other hand, the petitioner contends that the actual cash value of these properties was $480,143.47, and that not more than 10 per cent of this value was attributable to the good will of the predecessor companies. So, if the petitioner’s contentions in this respect are sustained, the result ivill be an increase in invested capital, over that allowed by the Commissioner, of $149,889.21.

The value of $480,143.47 for the intangible properties acquired from its predecessors, for which the petitioner is contending, is predicated upon a total value of $900,000 for the capital stock which is issued for all the assets of its predecessors, and this capital stock value is in turn predicated upon the compromise offer of George Westinghouse for the purchase of petitioner’s entire outstanding capital stock during his unsuccessful negotiations with James Burke in November, 1906, approximately six months after the petitioner was organized. Counsel for both parties entered into a stipulation that the combined value of the net tangible assets acquired from the two predecessor companies is $169,856.53. By adding to this amount the proceeds of $250,000 realized from the sale of preferred stock and deducting the result of $419,856.58 from Westinghouse’s offer of $900,000, the petitioner arrives at a value of $480,143.47 for the capital stock issued for the intangible properties. Hence, so far as the combined value of the intangible properties is concerned, there is a difference of but $67,167.21 between the petitioner and the Commissioner.

Counsel for both parties entered into a stipulation that the combined value of the intangible properties acquired from the two predecessor companies, at the date of acquisition, was at least $412,976.26; and when we consider the financial history of these two companies, as well as that of the petitioner subsequent to organization, we feel that this amount represents the maximum value of the intangibles at the date of acquisition. The difference between this value for the intangibles and that predicated upon the offer of Westinghouse, we feel, may fairly be attributed to development subsequent to the acquisition of these properties. It was then, for the first time, that their earning power was demonstrated. Prior to that time there had been no such demonstration. The operations of the Keystone Company had proved a failure, while the New Jersey' Company had not as yet undertaken to venture into the field of commerce and trade. The earnings of the petitioner for the first year after organization were in excess of $30,000, a nominal return on its outstanding capital stock, it is true, but a vast improvement over the results obtained by its two predecessors.

Having reached a combined value of $412,976.26 for the patents, patent applications and good will acquired from the two predecessors, the next problem confronting us is the segregation of such value between good will and patents. Such a segregation is necessary under section 207 of the Revenue Act of 1917, since the good will value is subject to the 20 per cent limitation imposed by the proviso to subdivision (a) of that section and patents are not. O'f the total combined value the Commissioner assigns $332,322 to good will and $80,654.26 to the patents and patent applications. A consideration of all the facts outlined in our findings of fact which have a bearing upon the intangible values, and the facts which we have commented upon in the preceding paragraph, convinces us that the reverse of the Commissioner’s assignment of values would more accurately reflect the real situation. Out of a combined value of $412,976.26, the assignment of a value of $332,322 to good will is not justified by the facts in this case. Indeed, when we consider the fact that the operations of the Keystone Company resulted in such a total failure that the petitioner contemplated the abandonment of most of its line of products and undertook to rid itself entirely of the name of, and of any other resemblance to, the Keystone Company, and that the New Jersey Company had not at the time established a market for its products, the utter fallacy of the Commissioner’s segregation of intangible values is readily apparent.

James Burke, president of the petitioner, expressed an opinion on the witness stand that the value of the good will acquired from the two predecessor companies did not exceed 10 per cent of the total value of the intangibles. On the facts developed in this case, we are convinced that such was the situation, and we subscribe to that opinion as fully confirmed by the evidence.

In view of the foregoing, we conclude that a fair segregation of the total value of $412,976.26 for the assets hereinbefore mentioned results from the assignment of a value of $371,678.63 to the patents and patent applications and of $41,297.63 to the good will, and that the values so assigned represent the actual cash values of the respective properties at the date of their acquisition.

3. The third issue raised by the pleadings in this appeal relates to a question of the fair market value, at the date of acquisition, of the entire outstanding capital stock of the Duntley Products Co. acquired by this petitioner for cash and by gift from its stockholders, and the extent to which such value may be included in invested capital.

It is apparent to us from the facts in this case that the capital stock of the Duntley Products Co. had a value at the date acquired by this petitioner in excess of the amount paid therefor and that such value was $66,250, or $40,000 in excess of the consideration paid by the petitioner. It appears, however, that upon this petitioner’s acquiring the stock of the Duntley Products Co. that company became affiliated with the petitioner and so continued until the year 1919; that the Commissioner has allowed the petitioner and the Duntley Products Co. to make a consolidated return for the year here in question, and, therefore, for invested capital purposes, it matters not at what figure the Duntley Products Co.’s stock is carried on the books of the petitioner, and any change in the book value of such stock can have no effect upon the invested capital of the consolidated group for the year in question.

4. The elimination of $1,435.57, on account of income taxes paid for the period ending April 30, 1916, from invested capital for the fiscal year ended April 30, 1917, appears to have been made by the Commissioner in accordance with the regulations of the Treasury Department, and in view of section 1207 of the Bevenue Act of 1926 and our decision in the Appeal of Russel Wheel & Foundry Co., 3 B. T. A. 1168, the Commissioner’s action can not now be modified.

5. On March 1, 1913, this petitioner was the owner of eighteen patents relating to machinery and devices connected with the use of electricity as motive power. It also owned at the same time nine specific inventions of other like machines and devices which were on that date protected by applications for patent, upon which applications patents were thereafter issued. It is the contention of the petitioner that all of these patents and inventions had on March 1, 1913, a capital value subject to the allowance of a deduction for exhaustion in accordance with the provisions of the several revenue acts.

For the purpose of considering this matter, it appears that the petitioner’s patents may be taken as falling into two groups, and that in the first group there should be included seventeen of the patents, the individual character of which is not here important, and in the second group the one patent, No. 1,053,940, covering a device known as the “ Universal Motor.” This last patent was issued on February 18, 1913, and therefore on March 1, 1913, was only 11 days old. The group of seventeen patents had on March 1, 1913, an average remaining life of 12 years, 2 months, and 25 days. These patents, together with the nine inventions still pending under applications for patents, had been the basis of the petitioner’s business from the time of its organization in 1906. The petitioner’s manufacturing business during those j^ears had been devoted exclusively to the manufacture of machines and devices covered by these patents and inventions, and whatever income and profits the petitioner’s business had produced was in a large measure the product of the exploitation of these patents and inventions.

In view of the history of these patents and inventions, the earnings and profits produced by their use in business, and in the light of subsequent profits from 1914 to 1921, inclusive, we are of the opinion that the above-mentioned group of seventeen patents, together with the nine inventions covered by applications for. patents, had on March 1, 1913, a capital value of $220,000.

The one patent covering the device known as the “ Universal Motor ” is, we believe, of such a character as to require specific consideration. The testimony of the inventor and other patent experts convinces us that this device is so thoroughly basic in character as to be almost revolutionary in the business of producing electric motors, and that it therefore has a value all its own. On March 1, 1913, the invention was complete, the patent had been issued, and the petitioner was ready to apply it to its manufacturing business. Its true capital value was then a fact, although men might differ as to the amount of that value. The testimony of the inventor shows that he then believed this patent had a value of more than $600,000, while other witnesses thoroughly familiar not only with this patent but with others testified that in their opinion this patent had a value of more than $1,000,000. The record of this appeal shows the history of this patent from the date of issue to April 30, 1921. This petitioner began at once to produce electric motors covered by this patent and at the same time many of its competitors immediately began to produce similar articles; this action produced a period of litigation involving the validity of the patents and such litigation continued over the first three years of the life of the patent. When the suits growing out of the infringement of this patent had 'finally been determined in favor of this petitioner, it first entered upon the successful exploitation of this patent, and the results obtained during the years 1917 to 1921, inclusive, have been placed in the record as evidence in support of the values which the inventor and his associates placed upon the patent at the time it was first issued. We have examined this evidence and, in view of all the facts, we have arrived at the conclusion that on March 1, 1913, this patent, No. 1,053,940, had a capital value of $440,000.

6. Following the rule laid down in the Appeal of Union Metal Mfg. Go., 1 B. T. A. 395, the petitioner may now properly claim a deduction from gross income on account of the cost of the capital value of patents although not claimed in its original return.

Order of redetermination in accordance with the foregoing findings of fact and opinion will be entered on 15 days' notice, pursuant to Rule 50.

TRammell dissents.


author: Sternhagbn:

text:
    Appeal of 719 Fifth Avenue Co.
    Docket No. 6031.
    Decided November 20, 1926.
    The opinions of witnesses as to the value of a leasehold on March 1, 1913, considered and held to be not sufficiently well founded to prove value.

      Frank S. Bright, Esq., and Walter J. Rosston, Esq., for the petitioner.

      M. N. Fisher, Esq., for the Commissioner.
    Deficiencies of $3,830.25 for 1920, and $10,837.24 for 1921, income and profits taxes, arising from disallowance by the Commissioner of a deduction of exhaustion of a leasehold, and of part of a deduction of exhaustion of a building erected on leased land.
    FINDINGS OF FACT.
    The petitioner is a New York corporation organized in 1911.
    On April 4, 1911, it entered into a lease agreement with Wood-bury G. Langdon, whereby it became the lessee of the property located at 719 Fifth Avenue, New York City. It agreed to erect on the land a twelve-story apartment and hotel building of such construction that it might be converted into an office building. The building was erected in accordance with the agreement at a cost of approximately $438,921.19, and was carried on petitioner’s books of account at that figure. The building was completed in the latter part of 1912 and was opened in November or December of that year.
    The building when completed had a 52 foot frontage on Fifth Avenue and a depth of 110 feet. There were three stores on the ground floor and 120 rooms above the first floor. These rooms were arranged in suites of two rooms and bath. The probable useful economic life of the building was 33½ years.
    The original term of the lease was 21 years from July 1, 1911. with options to renew for two additional terms of 21 years each, set out in detail below. The rent agreed upon was $45,000 a year from July 1,1912, to July 1,1921, and $50,000 a year for the balance of the original term. In addition, the petitioner agreed to pay all taxes, duties, assessments, water rates and payments of all kinds which might be imposed on the property. These amounted on or about March 1, 1913, to approximately $18,000 or $19,000 a year. The annual rent reserved for the first and second renewals of the lease, in the absence of agreement between the parties, was to be the equivalent of 4½ per cent of value of the land at the beginning of the term, as determined in an impartial appraisal in a manner set forth in the lease. In no event, however, was it to be less than the rent reserved for the last preceding term.
    The provisions of the lease, with regard to the options for renewal, are as follows:
    AND it is mutually covenanted and agreed by and between tbe parties to these presents that if the said tenant, its successors or assigns, shall within the times above provided have erected and built, or caused to be erected and built, upon the premises hereby demised such building as is above described * * * so that such building well and satisfactorily * * * finished shall be standing on the said premises at the end and expiration of the said term and if the tenant, its successors or assigns, shall, during the whole of said term, well and faithfully keep all and every of the covenants and agreements herein contained on its part and behalf, then the landlord, his heirs or assigns shall and will, at the expiration of the term hereby demised, grant and execute unto the- tenant, its successors or assigns, at its expense a new lease for the further term of twenty-one years, to commence from the expiration of the term hereby demised, at and for such annual rent, payable monthly in advance, as shall be ascertained as hereinafter mentioned, but not to be less than the yearly' rental by these presents reserved. Such second lease to contain like covenants, provisions, conditions and agreements as are herein contained, except the covenant for the erection of any building on the said premises, and excepting this covenant for renewal, in lieu whereof such second lease shall contain a covenant on the part of the landlord that in case the tenant shall during the whole of such second term well and faithfully keep all and every covenant, condition, provision and agreement in such second lease contained on its part and behalf, and that if the tenant, its successors or assigns, shall maintain such a building as is above described and in case of damage or destruction of the same by fire or other casualty shall rebuild and restore the same, so that such building well and satisfactorily repaired or rebuilt shall be standing on said premises at the expiration of said term contained in said second lease, then the landlord shall and will either pay to the tenant, its successors or assigns, the just and full value at that time of the building constructed in the manner hereinabove mentioned, which may be standing on said demised premises at the expiration of said second term, such value to be ascertained in the manner hereinafter provided, or shall and will at the end and expiration of the term contained in said second lease grant and execute unto the tenant, at its expense, a new lease for the further term of twenty-one years to commence from the expiration of the term granted by said second lease and for such annual rent payable monthly in advance as shall be ascertained as hereinafter mentioned, but not to be less than the yearly rent by said second lease reserved. Such third lease to contain like covenants, conditions, provisions and agreements as are in said second lease contained, except the foregoing covenant for renewal, in lieu whereof such third lease shall contain a covenant on the part of the tenant, its successors or assigns, that upon the termination of said third term, or upon any earlier termination of the term thereby granted, all buildings and improvements on said demised premises shall become the absolute property of the landlord.
    AND it is further mutually covenanted and agreed by and between the parties thereto that at the expiration of the term of the first renewal hereof, if the same shall be given as herein provided, the landlord, his heirs, or assigns, shall have the full liberty and choice either to grant at the expense of the tenant a renewal of the lease then to be terminated for the further term of twenty-one years thence ensuing at a yearly rental, payable monthly in advance, to be ascertained in the manner hereinafter mentioned, but not to be less than the yearly rent reserved for and during the term then about to expire, or, on giving sixty days notice of his election to purchase said building, to pay unto the tenant, its successors, or assigns, the value of any building which shall have been so erected and built on said lots, constructed in the manner hereinabove provided, which may be then standing thereon, which value shall be ascertained as hereinafter stated.
    AND it is expressly agreed that the landlord, his heirs or assigns shall be under no obligation hereunder to pay to the tenant, its successors or assigns, any sum for the building to be erected on said demised premises except as above specifically provided and that in ease, by reason of default on the part of the tenant, its successors or assigns, in the performance of any of the covenants or conditions contained in this lease or in any renewal thereof, such lease shall be terminated, then and from thenceforth, such buildings as shall then be standing upon the demised premises, shall become the absolute property of the landlord, his heirs or assigns.
   OPINION.

Sternhagbn:

In attempting to prove that on March 1, 1918, it owned a leasehold which had a net value of $300,000 over and above its obligations, the petitioner has offered the opinions of three witnesses. These opinions, considered in the light of the experience and reasoning upon which they are founded, may not safely be relied upon as establishing the price which a willing purchaser able to buy would pay for the leasehold in addition to the cost of the building and the current obligations fixed by the lease. Two of the witnesses had little or no qualifications to give weight to their opinions. The opinion of one was expressed in response to a hypothetical question which was not in accordance with the facts. It assumed that the building had been constructed and fully occupied for a year, whereas it was actually completed less than three months and there is no evidence whatever that it was occupied at all. Many of the facts were entirely omitted from the hypothesis. The other, who was the petitioner’s president, supported his valuation by general statements in reference to the history and experience of hotel buildings in the neighborhood, leaving it entirely uncertain how much of such experience was known on March 1, 1913. It was clear that some of the circumstances which he considered had occurred between March 1, 1913, and the time of hearing. The third witness arrived at a valuation by an empirical process. He took an assumed cost of the building at 60 cents per cubic foot, to which he added assumed annual costs such as taxes (assumed to remain constant) and maintenance and the fixed rental stated in the lease. These he compared with an assumed future income from the building based upon continued occupancy and rentals from the stores and 90 per cent occupancy at assumed rentals from the hotel apartments. The net income thus arrived at was reduced to a present value as of the beginning of the period. His assumptions, however, are not sufficiently established to warrant their acceptance. The record shows that a small apartment hotel in this vicinity was practically a new venture in 1913, the success of which was so doubtful that the lessor prescribed that the building to be erected should be readily convertible into an office building. Hotels in this vicinity were not an assured success and several of them were abandoned and the buildings either torn down or reconstructed for other purposes.

The testimony of the witnesses as to the uncertainties of the future is difficult to reconcile with their testimony as to the reliability of mathematical prognostications made as of March 1, 1913. For the purpose of proving that the building and the leasehold should be depreciated upon the basis of a short life, the testimony of the witnesses is to the effect that the uncertainties of the future require the o per cent depreciation rate claimed. The same witnesses, however, expressed with assurance their opinion that on March 1, 1913, they would have been reasonably certain that conditions of the then future would have been so reliable as to justify an appraisal of the leasehold with no discount factor except the 10 per cent vacancy of the hotel space. This is not consistent and does not justify the finding of fact of value sought by the petitioner. Furthermore, it precludes a finding of any value. Since it is entirely a constructive value and the method of its construction fails, there is nothing left upon which the Board can find value in any other amount. It is therefore held that the petitioner has proven no value on March 1, 1913, of the leasehold and is entitled to no deduction for its exhaustion during the years in question.

It is sufficiently clear from the evidence that on March 1, 1913, and ever since, rapid changes were and have been taking place in the vicinity of the property in question. The question then is whether in 1920 and 1921 the building which had cost $438,921.19 in 1912 could reasonably be expected to represent capital value to this taxpayer beyond the expiration of the initial term of the lease in 1931. IVe are of opinion that 3 per cent is a reasonable allowance to take care of the preservation of the petitioner’s capital investment unimpaired. In other words, giving consideration to the conditions of the neighborhood and the probabilities of the future as indicated by the facts of the past, we are of opinion that the allowance for exhaustion, wear and tear and obsolescence may reasonably be based upon a probable life of 33½ years from the date of construction of the building.

It can not be said that merely because the lessee has reserved the legal right to quit the premises at the end of 21 years this fact measures the reasonable allowance for exhaustion of the building. The word “reasonable ” in the statute implies an appraisal of the probabilities. An examination of the lease in its entirety indicates that the parties contemplated that the lessee would continue to occupy the premises and that provision should be made for an alteration from time to time of the rental. Since some estimate must be made, we are of opinion that it is more probable that the lessee will continue to occupy the building than that it will abandon the entire project at the end of the initial term under the conditions prescribed in the lease. That it can not be said as a matter of law that the mere term of the lease establishes the meas'ure of the exhaustion allowance, could be illustrated by assuming a lease of an initial term of three years with a renewal for a much longer period. Such a lease would clearly not justify the lessee in writing off the building in the first three years.

It thus becomes necessary in the light of the evidence to determine only what is a reasonable allowance for exhaustion, wear and tear and obsolescence of the building itself, and as to this it is our judgment that this deduction should be based upon an assumed life of 33½ years, th'us giving a 3 per cent annual deduction.

The deficiency should be redetermined by excluding any deduction for the exhaustion of the leasehold and by including a deduction for the exhaustion and obsolescence of the building measured by 3 per cent on its cost to the petitioner.

Judgment will 5e entered in accordance with the foregoing opinion on 15 days’ notice, under Bule 50.


author: Smith:

text:
    Appeal of F. C. Henderson Co. and National Talking Machine Sales Corporation.
    Docket No. 5272.
    Decided November 20, 1926.
    Book inventory at the close of the year was properly reduced to accord with the physical inventory. Where the book inventory reflects an increase in value offset by a “ reserve for appreciation,” the action of the Commissioner in adding the amount of the reserve for appreciation to the net income returned by the petitioner is, in the absence of evidence showing material facts, approved.

      Da/vid Greer, Esq., for the petitioners.

      F. 0. Graves, Esq., for the Commissioner.
    This is an appeal from the determination of a deficiency in income and profits taxes for the calendar year 1920 in the amount of $11,-879.17. Only a part of this deficiency is in controversy. The question presented is whether an appreciation in the value of an inventory offset by a “reserve for appreciation” constitutes taxable income of the year 1920.
    FINDINGS OF FACT.
    The F. C. Henderson Co. and the National Talking Machine Sales Corporation were affiliated for the year 1920. These corporations are engaged in the sale of sewing machines, pianos, talking machines, talking machine records and accessories for talking machines. The F. C. Henderson Co. operates thirty odd departments in stores owned and generally operated by others under leasing agreements in different parts of the United States. When merchandise is delivered to these stores, the stores are charged upon the books of the corporation with such merchandise at the selling price. In the case of sewing machines, pianos, and talking machines, an accurate record by number of each article is maintained in the principal office in Boston. In the case of talking machine records such procedure is physically impossible. Each month the person in charge of each department in the several stores located throughout the United States reports to the head office in Boston the merchandise which is on hand in that store. This report is not priced. At the close of the year these inventory sheets are priced and become the closing and opening inventories upon the books of the petitioners. The inventories of sewing machines, pianos, and talking machines are priced at the actual cost as ascertained from the detailed record kept by the F. C. Henderson Co. at its principal office in Boston. Inasmuch as the selling price of records during the year 1920 was as a matter of custom and fact determined by the manufacturers of such records, and inasmuch as records were sold by the manufacturer to the petitioners on the basis of 40 per cent off the advertised retail price, the records were priced for the purpose of the inventory by taking 40 per cent off the advertised retail price. This practice has been consistently followed by the F. C. Henderson Co. and its subsidiary, the National Talking Machine Sales Corporation,.from and including the year 1913 down to the present time.
    During the calendar year 1920 the advertised retail price of certain records was advanced by the manufacturers. The petitioners thereupon set up on their books an account called “ reserve for appreciation,” crediting this account with an amount which would represent the increase in the cost price of such records as they had on hand. A corresponding debit was made to merchandise. Later in the year 1920 certain reductions were made in the price of records which had thus been increased in price and the petitioners reduced their reserve for appreciation correspondingly, an offset credit being made to merchandise. At the close of the year 1920 the amounts standing to the credit of the “ reserve for appreciation ” in the case of the F. C. Henderson Co. was $7,429.73, and in the case of the National Talking Machine Sales Corporation $9,584.38. The net income shown upon the consolidated return filed for the year 1920 was exclusive of these reserves. The Commissioner has increased the net income by the sum of these two reserves or $17,014.11.
    The inventory at December 31, 1920, of both corporations is shown by the petitioners’ books of account to have been $420,004.30, and this is the amount of the inventory used by the petitioners in computing the consolidated net income for the year 1920.
   OPINION.

Smith:

In their petition to this Board, the petitioners allege a number of errors on the part of the Commissioner in computing the deficiency in income tax for the year 1920. Most of these allegations of error were withdrawn at the hearing. The allegations of error not withdrawn are that the Commissioner erred in increasing the inventory at December 31, 1920, by $9,925.60, and also in adding to the net income reserves for appreciation in the value of merchandise in an aggregate amount of $17,014.11.

The Commissioner increased the petitioners’ inventory, at the close of the year 1920, by the amount of $9,925.00, the increase being predicated upon the ground contained in the revenue agent’s report that “it was found that this amount was deducted from cost of records * * * and we have therefore adjusted the inventory to actual cost.” Denial of this ground has been entered by the petitioners and proven by competent witnesses. The evidence is that the perpetual inventory carried on the books proved to be $9,925.60 in excess of the physical inventory, taken at the close of the year and upon the basis usually employed by the petitioners, and that the book inventory was adjusted to conform to the actual physical inventory. Further, it is apparent from the facts in this case that any revision of the petitioners’ inventory upward would not reflect an inventory valued on the basis of cost, which was the purpose of the revenue agent’s adjustment. The evidence shows conclusively that the inventory used by the petitioners in computing the consolidated net income, to wit, $420,004.30, represented the cost of all merchandise other than records, and in the case of the latter, cost plus 60 per cent of the net increase in the retail selling price of records where said retail selling price was advanced by the manufacturers in respect of records on hand. To accomplish the purpose of the revenue agent and restate the inventory at actual cost, a revision downward of the petitioners’ valuation would be necessary. The Commissioner’s action in increasing the petitioners’ inventory at the close of the year 1920 by the amount of $9,925.60, which results in an increase of the same amount in the net income, as reported by the petitioners in the consolidated return, is in error.

The Commissioner increased the consolidated net income, as returned by the petitioners for the year 1920, by the amount of $17,-014.11, being the total of amounts carried on the petitioners’ books in reserves for appreciation and, as shown by the revenue agent’s report, is composed of the following:

Discounts received in 1920 credited to the reserve for appreciation instead of to profit and loss_$4, 904.41
Amounts set up to take care of the increase in market value of Columbia records on hand and corresponding charge made to merchandise_12,109.40
Total_17,014.11

From the evidence of record we must approve the action of the Commissioner in adding to the net income the $4,904.41, above referred to, which represents discounts received in 1920. We see no reason why that amount should not have been credited to profit and loss instead of to the reserve. The action of the Commissioner in making this addition to net income is approved.

During the year 1920 the petitioners carried a considerable stock of talking machine records. The retail selling price of these records was fixed by the manufacturers thereof. The cost of the records to the petitioners was the retail selling price, at the time of acquisition, less a discount of 40 per cent. The actual cost of these records was charged to the merchandise account. From time to time, during the year 1920, the manufacturers made changes in the retail selling price of records contained in the petitioners’ stocks. If the retail selling price was increased, the petitioners adjusted the merchandise account to reflect the new costs of records on hand, in respect of which the advance in selling price was made, by charging to merchandise account and crediting to the reserve for appreciation an amount sufficient to increase the book value of the records to reflect their replacement costs. If the retail selling price was decreased, the merchandise account was credited and the reserve for appreciation charged with an amount sufficient to reduce the book value of the records, in respect of which the decrease in selling price was made, to reflect their replacement costs. In other words, the book value of records on hand was always equivalent to the replacement cost thereof. The result of all the adjustments made during the year was a net increase in book value of records, over actual cost, of $12,109.70, and this is the amount carried in the reserve for appreciation to take care of the write-up in the book value of records. Since purchases were included by the petitioners in the cost of goods sold, for the purpose of computing net income, at the higher book value, instead of being included at actual cost figures, the Commissioner has added to the net income the whole amount in the reserve for appreciation in order to offset the overstatement in the cost of goods sold and its resulting understatement of net income. However, the closing inventory, which the petitioners used in computing the cost of goods sold, included all records on hand at the close of the year, at the retail selling price less 40 per cent, or their then replacement cost.

Obviously, one of three situations existed at the close of the taxable year in question. Either all of the records, in respect of which there had been a change in the selling price during the year and an adjustment made on petitioners’ books of account that they might reflect the replacement cost of these records rather than the actual cost, were on hand and included in the inventory at their replacement cost; or all of them had been sold during the year and none remained on hand at the close of the year; or some of them were sold during the year while others remained on hand to be included in the inventory at their replacement cost. The correctness of the Commissioner’s determination depends upon which of these three situations actually existed. If the first mentioned situation is the correct one, then the Commissioner is entirely in error in increasing the net income by the amount of $12,109.70, representing the reserve for appreciation of merchandise, since any overstatement of the cost of goods sold which might otherwise result from computing such cost on the basis of the replacement cost, rather than actual cost, of purchases, has been entirely offset by the petitioners’ compensating error in taking the inventory into the cost computation at a valuation which is $12,109.70 in excess of actual cost. On the other hand, if the second mentioned situation existed, and none of the records remained on hand at the close of the year, it is clear that the overstatement of the cost of goods sold, occasioned by taking purchases into the cost computation at an amount in excess of cost, could not be compensated for except by increasing the net income by the amount of the reserve for appreciation of merchandise, which is precisely what the Commissioner has done. If only a part of these records were sold during the year and a part remained on hand at the close and were included in the inventory at their replacement cost, then the overstatement in the cost of goods sold has been partially compensated for, that is, to the extent that the inventory value of records on hand at the close of the year exceeds their actual cost; and to make a full compensation for the overstatement the net income must be increased by such an amount as represents the portion of the reserve for appreciation of merchandise attributable to the overstatement on the books of the cost of records sold during the year.

Which of the three possible situations above referred to actually existed at the close of the taxable year in question, we have not been advised. We can only infer, from statements made in the petitioners’ brief which was filed after the hearing, that it is the last mentioned situation with which we are dealing. If that be true, then the Commissioner is justified in restoring to net income only that portion of the reserve for appreciation attributable to the overstatement of the cost of such records as were sold during the year. But our decision must be predicated upon findings of fact which are clearly supported by the evidence, it being obviously without our province to make any assumption or to draw inferences as to what the facts may be. Such being the case, our decision must necessarily be for the Commissioner.

Judgment will ~be entered on 15 days' notice, under Bule 50.