*130 Decision will be entered under Rule 50.
Petitioner, a manufacturer of silk cloth, in 1939 had a large inventory of raw silk on hand. It was meeting with increasing sales resistance to its product because of competition with synthetic fabrics. For the purpose of protecting a part of its inventory against unfavorable market fluctuations and at the insistence of its financier, petitioner sold silk futures on the Commodity Exchange covering approximately one-third of its holdings. After the outbreak of war in Europe in September 1939, raw silk prices rose tremendously and petitioner was forced to close out its futures contracts, in the main by offsetting purchases on the exchange and in part by deliveries of actuals from its inventory. Petitioner sustained a loss on these transactions. Held, the transactions in futures on the exchange were hedges entered into for the purpose of protection against a business risk rather than for speculation, and the resulting loss is deductible in full.
*174 In this case the respondent determined deficiencies in income, declared value excess profits, and excess profits taxes for the calendar year 1941 in the respective amounts of $ 14,642.13, $ 3,557.40, and $ 43,366.94. The deficiencies result principally from respondent's disallowance of most of a net operating loss carry-over from 1939 claimed by the petitioner. The question for decision is whether certain futures transactions in silk entered into by petitioner on the Commodity Exchange in 1939 were hedges or only speculation.
*175 FINDINGS OF FACT.
Petitioner is a Pennsylvania corporation, with its principal office in Easton, Pennsylvania. It was organized on September 3, 1930, and commenced operations in that year. The returns for the period here involved were filed with the collector of internal revenue for the twelfth district of Pennsylvania*132 at Scranton.
Petitioner manufactures silk cloth from raw silk. At the end of 1930 petitioner was in a strained financial condition, and at that time Stern & Stern Textile Importers, Inc., (hereinafter called Stern) became the exclusive sales and purchasing agents, as well as factors and bankers, for petitioner. Thereafter Stern advanced sums of money to supply petitioner's inventory needs. Stern operates its finances conservatively and does not engage in or approve of speculation in commodities.
From 1931 through 1939 petitioner never had any substantial sums of money in its own bank account. Its assets in 1939 consisted principally of plants and equipment, accounts receivable, and large inventories.
In the beginning of 1939 petitioner had an inventory of 2,401 bales of silk (130 to 136 pounds per bale), at an average cost of $ 1.644 per pound. The inventory was large in proportion to petitioner's forward sales of finished goods. Prices of raw silk were rising at that time. Ordinarily raw silk prices declined at the end of the spring season, when a new crop became available from Japan. Developments in synthetic fabrics and artificial yarns, such as rayon and celanese, gave*133 rise to considerable competition with silk fabrics, and in 1939 petitioner was meeting with increasing sales resistance to its finished product.
Based on the usual occurrence in its own past experience, on the views of silk experts and trade publications, and on the competition with synthetics which was holding down the price of finished silk cloth, petitioner believed that the price of raw silk would decline at the end of the spring season. A sharp decline would result in substantial loss in its inventory value. Stern was of the same opinion and thought that the financial risk involved was too great.
Some consideration was given to disposing of the inventory and closing the plant. Both petitioner and Stern concluded, however, that, despite a likely operating loss from continued manufacturing operations, a greater loss would have been entailed through a shutdown of the plant, because of fixed charges, such as overhead, insurance, taxes, and the like, and the costs of reopening. In order to continue manufacturing, it would be necessary for petitioner to purchase additional raw silk of different grades from time to time. But Stern was unwilling to make further advances for the *134 purchase of additional *176 spot goods during the year unless some protection could be obtained against the risk of market fluctuations.
Reputable and experienced silk experts were consulted by petitioner and Stern with respect to how petitioner might continue manufacturing and eliminate a part of its risk. The experts advised hedging operations by sales of futures on the exchange. At the insistence of Stern that the market risk be lightened to the extent of about one-third of petitioner's holdings, petitioner sold a total of 780 bales of raw silk futures on the Commodity Exchange, Inc., in New York City, in the period from March to July 1939. The following table shows the sales of futures by month, the price at which sold, and the purchases of actuals during the same period.
| Spot goods | |||
| Month | Futures | Price per | bought -- |
| sold -- bales | pound | bales | |
| March | 200 | $ 1.921 | 65 |
| April | 300 | 1.938 | 5 |
| May | 180 | 2.145 | None |
| June | 80 | 2.174 | 90 |
| July | 20 | 2.295 | 225 |
Delivery dates on the futures sold were 70 bales in August, 220 in September, 320 in October, 150 in November, and 20 in February of the following year (1940). Throughout the year petitioner had on hand*135 more than enough raw silk to cover all its futures commitments on the exchange.
Petitioner's purpose in making the futures sales was to "freeze" the value of an equivalent portion of its silk holdings and eliminate the risk of market fluctuations with respect thereto. It intended to close out the futures sales contracts by counter-contracts, as a corresponding portion of its "frozen" inventory was disposed of in the course of its business.
Petitioner's sales of futures on the exchange were on what was known as a "Number 1 Contract." That was the first type of contract originated by the exchange when it began operating in 1933. Under the provisions of that contract, certain grades of silk were permitted to be tendered as delivery, and other grades were not good tender. After some agitation by importers of Italian and Chinese silks, which were not good tender on the Number 1 Contract, the exchange, in March 1939, adopted what was known as a "Number 2 Contract," under which silks of those types could be tendered. Very little trading, however, was done on the Number 2 Contract on the exchange, and that type of contract was abandoned in August 1940. Practically all hedging transactions*136 by silk merchants and manufacturers were carried out on the exchange on the Number 1 Contract.
In its operations in 1939 petitioner used both 13/15 denier and 20/22 denier raw silk, the difference between the two being in the thread *177 size. On the Commodity Exchange, futures sales contracts are closed out most frequently by offsetting purchase contracts. If necessary, however, a seller may make good any commitment on the exchange by actual delivery. The custom in the silk trade permits the exchange of any grade of 13/15 denier raw silk for any grade of 20/22 denier, or vice versa, with minor price adjustments for differentials in the grades.
Selling futures on the exchange was the only practical means available to petitioner to lessen its inventory risk and to protect itself from fluctuations on the market.
Instead of the price of the raw silk declining at the end of the spring season, as petitioner had anticipated, it continued to rise. Japan was secretly pushing up the price of raw silk to obtain more American dollars in her preparation for war. In July 1939 petitioner closed out short sales for 20 bales by offsetting purchase contracts at $ 2.555 per pound, and in *137 August it similarly closed out futures for 50 bales at $ 2.651 a pound. At the beginning of September, war broke out in Europe and raw silk prices here rose tremendously. Petitioner was forced to close out the remainder of its futures sales contracts. In the condition of the market, it was able to obtain counter-contracts for only 510 bales, and that at a price of $ 3.027 per pound. It had to cover the remaining 200 bales of futures sales by actual deliveries from its inventories.
Petitioner sustained a loss of $ 101,344.97 on its futures transactions in 1939. By the close of 1939 petitioner's inventory had been reduced to 1,977 bales.
Prior to 1939 petitioner had not used the facilities of the Commodity Exchange, because it had never before been in the peculiar position in which it found itself in March 1939. After September 1939 futures transactions in silk on the exchange ceased for all practical purposes, in view of the outbreak of war. Since that time, petitioner has had no futures transactions on the exchange. In July 1941 silk was frozen by the United States Government, and only then did the broad silk cloth market improve. From that time up to the time of the hearing*138 in the present case there were no trading operations in silk on the exchange because of governmental control of the commodity.
Petitioner's futures transactions on the Commodity Exchange were for the purpose of business risk protection and to avoid the hazards of fluctuations in market prices. They were directly related to petitioner's dealings in actual raw silk and its silk inventories. They constituted hedging transactions rather than speculation.
OPINION.
Although the tax year involved is 1941, the facts giving rise to the deficiencies occurred in 1939, and the issue *178 concerns the amount of petitioner's net operating loss in 1939, for purposes of carry-over to the tax year. The parties have stipulated that, if respondent correctly determined that petitioner's loss on the futures transactions in 1939 was a capital loss, subject to the $ 2,000 limitation of section 117(d) of the Internal Revenue Code, the deficiencies determined are proper, but that if, as petitioner contends, those transactions were hedges, the loss of $ 101,344.97 is allowable in full. This agreement is in accord with the principles of such decisions as Ben Grote, 41 B. T. A. 247;*139 Kenneth S. Battelle, 47 B. T. A. 117; Estate of Dorothy Makransky, 5 T. C. 397; affd. (C. C. A., 3d Cir.), 154 Fed. (2d) 59; and Commissioner v. Farmers & Ginners Cotton Oil Co., 120 Fed. (2d) 772.
We think the petitioner is right in contending that its futures transactions were hedges, and we have so found. The essence of hedging, as pointed out in the Farmers & Ginners case, supra, is the maintenance of an even or balanced market position. It is a form of price insurance -- often the only kind available for the purpose of avoiding the risk of changes in the market price of a commodity. The reason the transactions involved in that case were held not to be hedges was that the taxpayer's raw materials had been purchased, processed, sold, and delivered to its customers at a loss before the futures transactions were even entered into and the futures were in a different commodity. At no point of time was there any concurrence of the risk on the actuals with that on the futures. The risk on the actuals was over, that transaction had been completed and*140 closed, and consequently there was no risk to hedge against when the futures were bought.
Hedging transactions in commodities may take several different forms, depending upon the particular circumstances in which the hedger finds himself and the type of risk he seeks to avoid. For example, if a manufacturer or processor of raw materials is short on inventory and makes sales of his finished product for forward delivery, the appropriate hedging transaction in that instance would be the purchase of raw material futures at or about the time he makes the sale. See G. C. M. 17,322, XV-2, C. B. 151, 152. It serves to fix the cost of raw materials in the finished product and to assure him a certain margin of profit, regardless of market fluctuations. The futures purchase offsets his forward sales commitments. Such would have been the transactions involved in the Makransky case, supra, but for the fact that the taxpayer there had not made any forward commitments for sales of its manufactured product. There was no fixed risk for its purchase of raw material futures to offset, and it was accordingly held that the futures were not balancing transactions and did not qualify as hedges.
*141 On the other hand, if a manufacturer wishes to hedge against either the purchase of spot goods or actuals already on hand in inventory, the *179 appropriate transaction would be, not the purchase, but the sale of futures. That is what the instant petitioner did. The sale of futures against inventory or against actuals purchased and added to inventory serves to freeze or fix the value of the raw materials of the manufacturer. Thus, loss of inventory value is offset by gain on the futures sales, and conversely loss on the futures sales is offset by rise in inventory value, which will be realized upon the sale of the manufactured product.
Petitioner makes no contention that it sought to hedge its entire market risk 100 per cent. And, we do not understand that in order to constitute a true hedge it was necessary for petitioner to cover its entire inventory and offset every purchase of actuals with a corresponding futures contract. Actuals already on hand or purchased and added to inventory may be hedged entirely or in part; and if only in part, the protection against market fluctuations is obtained pro tanto. Under the rules of the Commodity Exchange relating to margin *142 requirements, one definition of a hedging transaction, which covers the instant case, is as follows:
A sale of any commodity for future delivery on Commodity Exchange, Inc., to the extent that such sale is offset in approximate quantity by the ownership or purchase of the same cash commodity or related commodity. [Italics supplied.]
Though petitioner purchased only 385 bales of spot goods during the same period it sold the 780 bales of futures, it at all times "owned" and had on hand in inventory more than enough actuals to cover all its futures commitments on the exchange. That it is not necessary that the futures transactions be entered into simultaneously with the attaching of the risk sought to be protected against, and in exactly equivalent quantities, is recognized in G. C. M. 17,322, supra, which states: "Futures contracts representing true hedges against price fluctuations in spot goods are not speculative transactions though not concurrent with spot transactions." See also Kenneth S. Battelle, supra. It is enough that the offsetting transaction be made while the risk is extant.
Here the petitioner had a definite*143 existing risk when it sold the futures. A sharp decline in the market price of raw materials could have produced a disastrous loss in inventory value unless offset by hedges. Petitioner's factor, Stern, was unwilling to finance the purchase of such additional spot goods as might be needed for continued manufacturing operations unless the risk could be lightened. Stern insisted that with the purchase of additional spot goods petitioner sell futures to the extent of about one-third of its holdings in order to obtain, to that extent, protection from the hazards of market fluctuations. It was contemplated that the futures contracts would be closed out by offsetting purchase contracts, as a corresponding portion of *180 the "frozen" inventory was disposed of in the ordinary course of business. But, with the outbreak of war in September, the market went wild and petitioner was forced to close out all its futures sales as best it could. It had difficulty in obtaining offsetting purchase contracts and had to cover in part by actual delivery from its inventories.
Unlike the Makransky and the Farmers & Ginners cases, supra, petitioner's risk on its actuals was open while*144 its futures transactions were open. Thus, its dealings in futures were offsetting or balancing transactions, and they were clearly entered into for the purpose of business risk protection rather than speculation. We hold that they were hedges, and that the loss incurred therein is deductible in full.
Decision will be entered under Rule 50.