*49 Decision will be entered under Rule 50.
1. Petitioner and its 250 or more subsidiaries elected under section 730 of the Internal Revenue Code to file a consolidated excess profits tax return for the calendar year 1940. Most of the subsidiaries were small loan companies, which kept books and reported income on the basis of cash receipts and disbursements. Two of the subsidiaries were insurance companies, which kept books and reported income on the accrual basis prescribed by section 204 of the Internal Revenue Code. During the base period years, as well as the taxable year, the insurance subsidiaries, in consideration of flat premiums, insured the loan subsidiaries against loss of principal on all loans made by the latter. In each year of the base period, as well as in the taxable year, because of the different accounting systems of the subsidiaries, the aggregate deductions of the loan subsidiaries for premium expense differed from the aggregate gross earned premium income of the insurance subsidiaries. In the taxable year 1940 the Commissioner equalized the premium deductions of the loan companies with the premium income of the insurance companies to determine the consolidated*50 excess profits net income, which adjustment the petitioner did not question. Held, the Commissioner also properly equalized the premium deductions with premium income in the base period years, thereby eliminating the effect of intercompany credit insurance transactions upon consolidated net income for the base period.
2. In 1940 recoveries in the amount of $ 130,785.90 were made on claims paid out by the insurance subsidiaries to the loan subsidiaries prior to 1940 on account of loans which became worthless. Deductions with reference to such claims paid on account of the worthless debts had been allowed to the insurance subsidiaries in years prior to 1940 as part of their losses paid or incurred. The recoveries in 1940 were first made by the loan subsidiaries, through collection of the loans which had earlier become worthless, and were then turned over to the insurance subsidiaries to make the latter whole. Held, that the amount of $ 130,785.90 constitutes income attributable to the recovery of bad debts with reference to which deductions had been allowed in years prior to 1940 and is therefore excludible from consolidated excess profits net income for 1940 under section*51 711(a) (1)(E) of the Internal Revenue Code.
*1020 This proceeding involves an excess profits tax deficiency in the amount of $ 88,288.30 for the calendar year 1940. Petitioner and its wholly owned subsidiaries filed a consolidated excess profits tax return for that year, pursuant to section 730 of the Internal Revenue Code. Two issues are presented for our decision. The first relates to the correct amount of consolidated excess profits credit computed under the income method. In this connection the parties differ over the proper treatment of credit insurance premiums paid by the small loan subsidiaries in the affiliated group of corporations to the insurance subsidiaries, and they disagree as to what adjustments are required, *52 for purposes of the consolidated return, by reason of the fact that the loan companies regularly took deductions for the premiums on the cash basis in the year paid, whereas the insurance companies took the premiums into their income in the year earned, according to the accounting method prescribed in section 204 of the code. The second issue is whether petitioner and its subsidiaries in 1940 had income in the amount of $ 130,785.90 attributable to the recovery of bad debts with reference to which deductions were allowed in prior years, which should be excluded from consolidated excess profits net income under the provisions of section 711(a)(1)(E) of the code. A third issue, concerning the propriety of including in consolidated base period income the incomes of three companies acquired by petitioner in 1940, has been conceded by the respondent; and effect will be given to the concession in a recomputation under Rule 50.
Most of the facts have been stipulated. In addition certain documentary evidence has been submitted.
*1021 FINDINGS OF FACT.
Petitioner Beneficial Industrial Loan Corporation is a Delaware corporation. It is a holding company, owning either directly or indirectly*53 all the stock of numerous subsidiaries, with whom it filed a consolidated excess profits tax return for 1940 with the collector for the district of Delaware.
Petitioner, together with its subsidiaries (some 256 in number in the taxable year), is, and since prior to 1935 has been, one of the largest organizations in the United States engaged in the small loan business. Some of the subsidiaries perform functional services within the organization, e. g., management and technical services. Two of the functional subsidiaries during the years from 1935 to 1940 were insurance companies, "The Guaranty and Indemnity Insurance Company," a Maryland corporation, and "Guaranty and Indemnity Insurance Company," a Delaware corporation. But the great majority of the subsidiaries were engaged directly in the conduct of the small loan business throughout the United States. The insurance subsidiaries indemnified the various loan subsidiaries, under a standard contract and in consideration of a flat premium, against nonpayment of the principal amounts due from borrowers.
During all the years material here the loan subsidiaries kept their books and reported their income on the basis of cash receipts*54 and disbursements (with a few minor exceptions of no importance here). Petitioner and the management subsidiaries kept their books and reported income on an accrual basis. The insurance subsidiaries kept accounting records and reported income on the basis prescribed by section 204 of the code, which is the accrual method.
Petitioner and its subsidiaries filed separate income tax returns for 1940, as well as for the base period years. In the consolidated excess profits tax return for 1940 petitioner, in computing the consolidated excess profits credit based on income, used the normal tax net incomes reflected in the separate income tax returns of the various subsidiaries for the base period years 1936 to 1939, inclusive, with certain adjustments not material here.
Inasmuch as the income tax returns of the loan subsidiaries for the base period years were prepared on the basis of cash receipts and disbursements, while those of the insurance subsidiaries were prepared on the basis prescribed in section 204 of the code and prior revenue acts, the aggregate gross premium income reported by the insurance subsidiaries differed from the aggregate deductions claimed by and *1022 allowed*55 to the loan subsidiaries for premium expense in the following respects:
| Premiums | Deduction for | ||
| reported as | premiums paid | ||
| Year | income by | as claimed by | Difference |
| insurance | other | ||
| subsidiaries | subsidiaries | ||
| 1936 | $ 2,066,017.08 | $ 1,706,012.84 | $ 360,004.24 |
| 1937 | 1,583,361.77 | 1,600,206.33 | (16,844.56) |
| 1938 | 2,021,155.15 | 2,315,929.32 | (294,774.17) |
| 1939 | 2,334,200.03 | 2,074,114.30 | 260,085.73 |
| Total | 8,004,734.03 | 7,696,262.79 | 308,471.24 |
At the beginning of 1936 the insurance subsidiaries had unearned premiums in the amount of $ 1,163,521.04 applicable to risks extending beyond January 1, 1936, which had been paid by the loan subsidiaries and allowed as a deduction in the determination of their net income prior to December 31, 1935. At the end of 1939 the insurance subsidiaries had unearned premiums in the amount of $ 855,049.80 applicable to risks extending beyond December 31, 1939, which had been paid by the loan subsidiaries and allowed as a deduction in the determination of their net income prior to December 31, 1939.
Upon examination of the consolidated excess profits tax return for 1940, respondent, in computing the consolidated excess profits*56 credit, increased or decreased the aggregate deductions for premiums paid by the loan subsidiaries (or, conversely, the gross income reported by the insurance subsidiaries) for each of the years in the base period by the amounts of the differences shown in the third column of the above table. That is to say, he decreased the consolidated income for 1936 and 1939 by the amounts of $ 360,004.24 and $ 260,085.73, respectively, and increased the consolidated income for 1937 and 1938 by the amounts of $ 16,844.56 and $ 294,774.17, respectively -- a net reduction of $ 308,471.24 in the aggregate profit shown on the separate income tax returns of the various subsidiaries for the base period years. Thus, the premium expense deductions of the loan subsidiaries and the premium income of the insurance subsidiaries for those years were equalized.
The standard indemnity contract under which the insurance subsidiaries wrote credit insurance for the loan subsidiaries during the years 1936 to 1940, inclusive, as well as in years prior thereto, contained, inter alia, the following clause:
17. If the Assured shall collect any loan theretofore claimed against and settled by the Company, or any*57 part of the principal thereof, such collection, less the court costs and attorneys' fees, if any, incurred in making such collection, shall inure to the benefit of the Company and be promptly paid to it.
All subsequent collection activities on loans for which claims had been paid by the insurance subsidiaries pursuant to the contract were *1023 conducted by the loan subsidiaries. Recoveries were credited to the insurance subsidiaries until they were made whole, and any excess became the property of the loan subsidiaries.
The income tax returns of the insurance subsidiaries for the base period years 1936 to 1939, inclusive, claimed deductions aggregating $ 5,446,589.64 variously labeled "losses incurred," "losses paid," or "losses paid or approved for payment." In the same returns income aggregating $ 313,260.68 was reported under the denominations "recoveries from claims paid," "recovery of claims paid," and "recovery from claims." For the year 1940 the income tax return of Guaranty & Indemnity Insurance Co. (Delaware) reported losses incurred in the amount of $ 13,557.45 and recoveries from claims paid in the amount of $ 3,627.55. For that year the return of the Guaranty & *58 Indemnity Insurance Co. (Maryland) took deductions for losses approved for payment in the amount of $ 1,122,641.24 and reported income of $ 155,657.67 as "bad debts recovered."
The insurance subsidiaries are required by the laws of the respective states of incorporation to file annual statements with the state insurance commissions in the form approved by the National Convention of Insurance Commissioners. In the annual statement of the Maryland insurance subsidiary for 1940 the recoveries of $ 155,657.67 were shown under the heading of "Disbursements" and as "Gross Salvage" from loan insurance and were deducted from the "gross amount paid for losses" in the amount of $ 1,077,521.32 to arrive at the amount of $ 921,863.65 shown under the heading of "Losses Paid." The latter amount was carried forward to the underwriting exhibit of the annual statement and there used in computing the "losses incurred during the year," $ 966,983.57, in accordance with the formula prescribed in section 204 (b) (6) of the Internal Revenue Code. This amount of $ 966,983.57, representing the "losses incurred during the year," plus the amount of $ 155,657.67, representing "gross salvage" from loan insurance, *59 equals the amount of $ 1,122,641.24 which was deducted in the 1940 income tax return as "losses approved for payment."
The corresponding items were treated in the same manner in the annual statement of the Delaware insurance subsidiary for 1940 filed with the insurance commissioner of Delaware.
Of the total recoveries of the two insurance subsidiaries in 1940, the amount of $ 130,785.90 is applicable to losses of years prior to 1940. Petitioner contends that that amount is to be excluded from excess profits net income for 1940 under the provisions of section 711 (a) (1) (E) of the code.
*1024 OPINION.
Petitioner and its 250 odd subsidiaries availed themselves of the privilege conferred by section 730 (a) of the code to file a consolidated excess profits tax return for the calendar year 1940. In so doing they were required by statute to consent to all of the regulations promulgated by respondent under section 730 (b) and in effect on the last day prescribed by law for filing the return.
One of the regulations adopted by the respondent pursuant to section 730 (b) of the code is section 33.44 (b) of Regulations 110, which reads as follows:
Sec. 33.44. Methods of Accounting.
*60 * * * *
(b) Combination of methods.
For the purpose of determining consolidated excess profits net income, if the members of an affiliated group have established different methods of accounting. each member may retain such method with the consent of the Commissioner, provided that the consolidated excess profits net income is clearly reflected, and, provided further that intercompany transactions affecting consolidated excess profits net income, between members of the group shall be eliminated and adjustments on account of such transactions shall be made with reference to a uniform method of accounting, to be selected by the members of the group with the consent of the Commissioner. [Italics supplied.]
For the taxable year 1940 the earned premium income of the insurance subsidiaries computed on the accrual method prescribed by section 204 of the code amounted to $ 2,112,009.55, while at the same time the deductions for premium expense taken by the loan subsidiaries on the cash basis amounted to $ 2,125,954.26. Because of the different accounting systems of the loan and insurance subsidiaries, these intercompany credit insurance transactions had the effect of reducing consolidated*61 net income by the excess of the premium deductions over the premium income, or $ 13,944.71. Acting pursuant to the above quoted regulation, the respondent made adjustments reducing the premium deductions to $ 2,112,009.55 and restoring the excess of $ 13,944.71 to consolidated excess profits net income. In this manner the premium deductions were equalized with the premium expense, the consolidated excess profits net income was "clearly reflected," and the "intercompany transactions affecting consolidated excess profits net income" were eliminated. Petitioner makes no complaint as to these adjustments.
With respect to the base period years, the adjustments made by respondent were of exactly the same nature as those he made in the taxable year. In other words, he increased the consolidated income for the years 1937 and 1938 by the amount of the excess of premium deductions over premium income, and reduced the consolidated income for the years 1936 and 1939 by the amount of the excess of premium *1025 income over premium deductions -- a net reduction in the aggregate of $ 308,471.24. Thus, premium deductions were equalized with premium income throughout the base period years, *62 and the intercompany transactions affecting consolidated excess profits net income in the base period years were thereby eliminated.
It is obvious, therefore, that the Commissioner has been consistent in his treatment as between adjustments made to the consolidated income of the taxable year before us and adjustments made to the consolidated income of the base period years. The first issue raised by petitioner, however, challenges the correctness of the Commissioner's adjustments made to the consolidated base period income.
Petitioner's first contention on this issue is that the item of $ 1,163,521.04 credit insurance premiums paid by and allowed as deductions to the loan subsidiaries before January 1, 1936, is not an "intercompany transaction occurring during the base period" and hence is not subject to adjustment. This argument is premised on the mere fact that the premiums had been paid and deducted by the loan subsidiaries in 1935. Respondent answers that the act of making payment does not close the transaction, for the risk continues to be borne by the insurance subsidiaries which remain liable under their contracts during the succeeding years in the base period, and that *63 accordingly these were "intercompany transactions occurring during the base period." Be that as it may, we think the petitioner's argument is of no particular moment and ignores the important factor, namely, the effect on consolidated excess profits net income in the base period. There is no doubt that the transactions whereby the insurance subsidiaries agreed for a cash consideration to indemnify the affiliated loan subsidiaries against loss of principal were intercompany transactions; there is likewise no doubt that such transactions, because of the combination of accounting systems employed by the affiliated corporations, affected the consolidated net income in the base period years. That is the factor which necessitates adjustment.
Petitioner next contends that the adjustments made by respondent to base period income had the effect of permitting a double deduction of the item of $ 1,163,521.04, first in 1935, and again in the base period years -- which is said to violate section 33.44 (c) of Regulations 110, quoted in the margin. 1*65 This argument, we think, is equally without merit. Subsection (c) of section 33.44 makes no mention of intercompany transactions. It is concerned*64 only, as its heading states, with *1026 an instance in which a corporation which formerly reported its income on a different basis is required to report its income on an accrual method, and it provides for the proper treatment of items of income as well as deductions in making the change. It is an amplification of the general provisions contained in subsection (a) 2 to the effect that one member of the group will not be permitted to report income and deductions on the cash basis while another member reports the same items on an accrual basis. The provisions of subsection (a), however, are expressly made subject to the exceptions in subsection (b) relating to retention of a combination of accounting methods.
In arguing that the adjustments of the respondent have the effect of permitting a double deduction in violation of section 33.44 (c), petitioner proceeds upon the theory that all the loan subsidiaries were required to change to an accrual method of accounting. We do not understand that to be the case. It is true that *66 in the prefatory portion of the deficiency notice there appears a statement to the effect that the income of the loan companies in base period years was computed on the accrual method to conform to the basis of computing the income of the other subsidiaries for those years. However, it appears that the real import of the statement was that adjustments had been made on account of the credit insurance premium transactions. The parties have stipulated that, for the purpose of computing the consolidated excess profits credit on the 1940 return, the petitioner used the normal tax net income reflected in the separate income tax returns of the various subsidiaries for the base period years 1936 to 1939. They have also stipulated that the loan subsidiaries' returns for those years were on a cash basis. A comparison of petitioner's computations of base period income in the consolidated return for 1940 with the respondent's computations of base period income in the deficiency notice reveals that the same figures were used for the normal tax net incomes of the various subsidiaries in the computations of both parties.
It is apparent, therefore, that respondent did not recompute the income*67 of the various subsidiaries for base period years on an accrual method. This the parties have recognized by stipulating that the adjustments made by the Commissioner to equalize premium deductions with premium income for base period years "have the effect of reducing the aggregate profit shown on the separate income tax returns of the *1027 various subsidiaries for the years 1936 to 1939, inclusive, by the amount of $ 308,471.24." (Italics supplied.)
Thus, instead of the respondent's requiring a change of the loan subsidiaries' accounting method under section 33.44 (a) and (c) of Regulations 110, it appears that actually this is a case where respondent allowed the various subsidiaries to retain their combination of accounting systems under section 33.44 (b), with appropriate adjustments to eliminate the effect of intercompany transactions upon consolidated net income. That petitioner was not unaware of this fact further appears from the statement in its reply brief that "Both the petitioner-taxpayer and the respondent-Commissioner have agreed that each company retain its method of accounting with the one exception in the case of the loan subsidiaries; i. e., in the manner*68 of reporting credit insurance premiums on a cash basis while the credit insurance subsidiary reports such credit insurance premiums on a Section 204 basis."
So, section 33.44 (c) has no application to the instant issue, and thus falls the basis for petitioner's argument in that connection. But a further difficulty with petitioner's position lies in the fact that, even if a change in accounting had been required so as to make section 33.44 (c) applicable, the same type of adjustment for which petitioner contends in respect of the first base period year, that is, reducing the loan subsidiaries' premium deductions (with corresponding increase in consolidated base period income) by the amount of deductions taken in 1935, would also have to be made in respect of the first excess profits tax taxable year, with the result that consolidated excess profits net income for 1940 would be greater than that determined by respondent, and it appears to us that the net effect would be disadvantageous to petitioner. Petitioner, however, has not suggested that such an adjustment should be made in consolidated income for 1940, and it has thus been inconsistent in the application of the method for which*69 it contends.
Since, in the case of the excess profits credit computed under the income method, the average earnings or income of the base period years 1936 to 1939, inclusive, afford the measure for determining how much of the earnings or income an excess profits tax taxable year constitutes "excess" profits, consistency requires that the same type of adjustment made to consolidated net income for the excess profits tax taxable year also be made to the base period years, if the latter are to be a proper standard of comparison. Section 33.44 (b), which the respondent applied in adjusting the consolidated net income for 1940, is equally applicable with respect to corresponding adjustments required for base period years. Respondent has been consistent throughout in his treatment and has made the same type of adjustments to the base period income that he made to the income for 1940.
*1028 On the first issue we conclude that the respondent's adjustments were proper.
The second issue is whether recoveries in the net amount of $ 130,785.90 on claims paid by the insurance subsidiaries prior to 1940 constitute "income attributable to the recovery of a bad debt" which, under section *70 711 (a) (1) (E) of the code, is to be excluded from excess profits net income for the taxable year 1940 "if a deduction with reference to such debt was allowable from gross income for any taxable year beginning prior to January 1, 1940."
Petitioner argues that the aggregate net income of the affiliated group for the four base period years was depressed by "bad debts" amounting to $ 5,422,131.04 (obviously referring to the aggregate deductions claimed in those years by the insurance subsidiaries for "losses paid" or "losses incurred"), and that there was income attributable to recoveries in 1940 of such "bad debts" in the amount of $ 130,785.90. It also argues that the purpose of Congress in enacting the consolidated returns statute was to get a complete report on a "unitary business unit"; and that when the affiliated group of corporations is considered as a unit engaged in the small loan business, it is "preposterous" to say that the business unit had no bad debt.
Respondent's position is substantially the following: The recoveries of losses paid by the insurance subsidiaries constitute "salvage," within the meaning of section 204 (b) (6) of the code, which serves to reduce the*71 amount of "losses incurred" during the taxable year. They are not recoveries of "bad debts." Section 33.31 (a) (12) of Regulations 110 provides that "the consolidated excess profits net income shall be the consolidated normal-tax net income increased or decreased, as the case may be, by the consolidated section 711 (a) adjustment"; and section 33.31 (a) (13) defines the consolidated section 711 (a) adjustment as "the net amount of the aggregate adjustments provided by section 711 (a) (1) * * * computed and determined in the case of each affiliated corporation * * * in the same manner and subject to the same conditions as if a separate return were filed * * *." Then, he continues, the loan subsidiaries have no bad debt deductions because they are indemnified by the insurance subsidiaries; and when the insurance subsidiaries pay claims under their indemnity contracts, they obtain deductions, not for "bad debts," but for "losses incurred" as defined in section 204 (b) (6) of the code. Therefore, he argues that neither the loan subsidiaries nor the insurance subsidiaries would have deductions for bad debts in separate returns; that consequently neither would make recoveries of bad debts; *72 and that the regulations prevent a different treatment in filing the consolidated return.
Respondent's argument is an extremely technical one, and to sustain it we should have to close our eyes to the practical aspects of the *1029 situation. Furthermore, his position with respect to this issue is somewhat inconsistent with his treatment in connection with the first issue. There he looked upon the affiliated group as a single business unit and determined the true consolidated net income by making adjustments to eliminate intercompany transactions. Here, on the contrary, he seeks to break down the organization into its component parts, segregating the insurance subsidiaries and contending that what are for all practical purposes bad debts, are not "bad debts" after all but technically "losses."
The practical effect of the Commissioner's adjustments on the first issue, equalizing or eliminating the intercompany credit insurance transactions, is as if those transactions had never occurred. In other words, it is all the same as if the loan subsidiaries had not reduced their gross income by taking deductions for insurance premiums but had instead suffered and taken deductions *73 for their own bad debt losses. In this consolidated organization, looked upon as a business unit, the use of intercompany credit insurance at all serves somewhat the same purposes as a bad debt reserve. Petitioner, indeed, has characterized the system as a sort of "glorified bad debt reserve."
The principal occupation of the affiliated group is the making of small loans. The business of the entire organization is concerned primarily with "debts." All other functions are subordinate and ancillary to that business. It can not be gainsaid that during the base period years the loan subsidiaries had loans outstanding or "debts" which became worthless. When some of the loans which had been charged off during the base period were later recovered in the taxable year, it requires no stretch of terminology to say that there arose "income attributable to the recovery of * * * bad [debts]" within the meaning of the statute. Furthermore, the credit insurance dealt in by the insurance subsidiaries is by its very nature "bad debt" insurance. When, therefore, the insurance subsidiaries take deductions for claims paid, they are in reality taking deductions because of or on account of debts which*74 have become worthless. Hence, it likewise requires no stretch of terminology to say that the deductions which the insurance subsidiaries take are deductions which are allowable "with reference to such [debts]" within the meaning of the statute here under consideration.
We think the principles of our decisions in J. F. Johnson Lumber Co., 3 T. C. 1160, and Boyd-Richardson Co., 5 T. C. 695, are pertinent here. Those cases dealt with exclusions under section 711 (a) (1) (E) in the case of taxpayers using the reserve method of treating bad debts. It was there held that the taxpayers were entitled to exclude bad debt recoveries and that, in effect, when they had been allowed deductions in base period years for additions to their reserves, they were allowed *1030 deductions "with reference to bad debts." In the Boyd-Richardson case we said:
The intent of Congress is not ambiguous. It did not want excess profits net income to include recoveries on bad debts, since they had no real relation to the operations of the current year, but represented earnings of a previous year for which there was no excess profits tax.
*75 So here, the recoveries in question had no real relation to the operations of the consolidated group in the current year, but represented earnings of a previous year for which there was no excess profits tax. We think it an altogether immaterial circumstance that the recoveries were made in the first instance by the loan subsidiaries and thereafter turned over to the insurance subsidiaries pursuant to their contractual obligations.
On this issue we conclude that the express language of section 711 (a) (1) (E) is met and that the respondent's regulations do not prevent the relief which petitioner seeks. In the hands of the insurance subsidiaries these recoveries constitute income "attributable to" the recovery of bad debts "with reference to" which deductions had been allowed in the base period, notwithstanding the deductions might technically have been claimed under the designation of "losses incurred." In the recomputation, therefore, the sum of $ 130,785.90 should be excluded from consolidated excess profits net income.
Decision will be entered under Rule 50.
Footnotes
1. (c) Change to Accrual Method.
In the case of a corporation which previously has reported its income * * * in accordance with a method other than the accrual method and is required under this section to report its income for the taxable year under the accrual method, * * * deductions which were properly included in the determination of net income under the method of accounting formerly followed shall not be allowed in the determination of net income for the taxable year of change or any subsequent year.↩
2. (a) In General.
For the purpose of determining consolidated excess profits net income, all members of the affiliated group shall adopt that method of accounting which clearly reflects the consolidated excess profits net income. A method of accounting which does not treat with reasonable consistency all items of gross income and deductions of the various members of the group shall not be regarded as clearly reflecting the consolidated excess profits net income. For example, one member of the group will not be permitted to report items of income or deductions on the cash method of accounting, while another member of the same group reports the same or similar items on the accrual method. The provisions of this paragraph are subject to the exceptions stated in paragraph (b).↩