Decision will be entered under Rule 50.
1. Held, petitioner is not entitled to a deduction of $ 750,000 in 1952 for purposes of creating a reserve account in anticipation of a refund it may have to make under a Government contract since the liability is (1) contingent and not accruable, and (2) subject to a statutory scheme of mitigation under section 3806, I.R.C. 1939.
2. Held, further, section 3806 is applicable and provides for the computation of a tax credit to which petitioner is entitled, which credit is treated as an "overpayment" for the year in issue and should be so treated here in a computation under Rule 50.
3. Held, further, the Tax Court has authority to determine an allocation between 1951 and 1952 of "excessive profits" refunded in 1954 since a proper allocation is necessary in order to determine the appropriate tax credit overpayment applicable to the year in issue.
4. Held, further, petitioner is not entitled to reduce its net income for 1952 by $ 103,524.71 which it alleges was expended in 1951 and should have been capitalized in that year as deferred expense and deducted in 1952.
*504 Respondent determined a deficiency in income tax of petitioner for the year 1952, the only year before us, of $ 237,269.31. Respondent also determined overassessments for 1951 of $ 9,341.71 and for 1953 of $ 35,075.98. By an amendment to answer respondent asks for an increased deficiency of $ 370,327.62. The reasons stated by respondent as the basis for the above-stated amount of increased deficiency are alleged in his amendment to answer as follows:
(a) That in computing the deficiency for 1952 respondent reduced income by $ 397,122.68 as set forth on page 4 of the statement attached to the statutory notice, by allowing adjustment "(K) Renegotiation Adjustment" in such amount.
(b) That in allowing such a reduction of income for the purpose of computing the statutory deficiency in income tax for 1952, respondent purported to act under Section 3806 of the Internal Revenue Code of 1939. Neither Section 3806 nor any other section of the Internal Revenue Code of 1939 or 1954 authorized such a reduction in income in computing the statutory deficiency.
Petitioner, by appropriate assignments of error, contested all of the deficiency for 1952 and the *163 increased deficiency claimed by respondent and by an amendment to petition made the following additional assignments of error:
(b) In determining the net income for the year ended December 31, 1952, the respondent erroneously disallowed a deduction of $ 750,000, taken on the return as a "Provision for Recapture of Excess Profits on Government Contracts".
(c) In determining the net income for the year ended December 31, 1952, the respondent erroneously failed to reduce the reported net income by $ 103,524.71, representing amounts expended in 1951 for research and experimental expenses incurred in the development of wire dispenser packages, which should have been capitalized in 1951 as deferred expenses and deducted in 1952.
Certain adjustments in the deficiency notice were not contested.
The following questions are presented by the pleadings for our decision:
(1) Whether or not petitioner erroneously claimed a deduction in 1952 in the amount of $ 750,000 as a "Provision for Recapture of Excess Profits on Government Contracts."
*505 (2) Whether or not the amounts of $ 475,612.17 refunded by petitioner in 1954 and $ 312,773.85 in 1955, pursuant to a price renegotiation of Government contracts, *164 entitle petitioner to a tax credit under the provisions of section 3806 of the 1939 Code or whether said amounts constitute deductions from gross income in the year or years they were originally accrued.
(3) If section 3806 is applicable, whether or not the Tax Court should determine a proper allocation between the years 1951 and 1952 of the amounts refunded by petitioner in 1954 for the purpose of determining the tax credit applicable to the year in issue, and, if so, what allocation should be made.
(4) Whether or not petitioner incurred expenditures of $ 103,524.71 in 1951 for research, experiments, and development costs of wire dispenser packages, all of which packages were shipped to the Signal Corps Procurement Agency during the year 1952, and whether these expenditures should have been capitalized by petitioner in 1951 as deferred expenses and deducted in 1952.
FINDINGS OF FACT
Many of the facts have been stipulated by the parties and the stipulation of facts, together with exhibits attached thereto, is incorporated herein by this reference. There was also oral testimony by several witnesses at the hearing.
Petitioner, the Overlakes Corporation, sometimes hereinafter called Overlakes, *165 is a corporation organized under the laws of Delaware. Its principal place of business is New York City. Its returns for the calendar years 1951, 1952, and 1953 were filed with the district director for the Lower Manhattan district. Petitioner's returns were prepared and its books of account were kept on the calendar year and on the accrual method of accounting.
Contract No. 8375On January 17, 1951, petitioner and the Signal Corps Procurement Agency, sometimes hereinafter called the contracting agency, entered into a contract, hereinafter called contract No. 8375. The formal contract was executed on or about March 16, 1951. Nine modifications were made in the contract. Contract No. 8375 was entered into under the provisions of section 2(c)(1) of the Armed Services Procurement Act of 1947 (Pub. L. 413, 80th Cong.) and Presidential Proclamation 2914 and contained the following provisions:
Form IV -- Price Revision Article (JFR 4-307.4)
(a) Because of the experimental and developmental nature of the work called for by this contract and the great uncertainty as to the cost of performance hereunder, the parties agree that the contract price fixed herein may be increased or decreased *166 in accordance with the provision of this Article.
*506 (b) Within 90 days after the completion or termination of this contract, the contractor will file with the Contracting Officer a statement showing, in such form and detail as the Contracting Officer may prescribe, the contractor's cost of producing the supplies or furnishing the services called for hereunder, together with such other information as may be pertinent in the negotiations for a revised price pursuant to this Article. Such statement of cost shall fairly reflect the normal operation of the contractor's cost system. The Contracting Officer shall have the right at all reasonable times to make or cause to be made such examinations and audits of the contractor's books, records and accounts as he may request.
(c) Upon the filing of the statement and other pertinent information required by paragraph (b) of this Article, the contractor and the Contracting Officer will promptly negotiate in good faith to agree upon a reasonable revised price for the entire contract which, upon the basis of such statement and other pertinent information, will constitute fair and just compensation to the contractor for the performance of this contract. *167 In determining the extent of any estimated allowance for profit to be taken into account in fixing such revised price, consideration will be given to the extent to which the contractor has performed the contract with efficiency, economy and ingenuity. In no event shall the revised price exceed the sum of $ 5,266,792.90. The revised price shall be evidenced by a supplemental agreement to this contract.
(d) If within 90 days after the completion or termination of this contract, the parties shall fail to agree upon a revised price in accordance with the provisions of this Article, the failure to agree shall be deemed to be a disagreement as to a question of fact which shall be disposed of in accordance with Provision 12 (Disputes).
(e) In the event of a price increase the Government will pay or credit to the contractor the amount by which the revised price shall exceed the contract price aforesaid. In the event of a decrease in price the contractor will repay or credit the amount of such decrease to the Government in such manner as the Contracting Officer may direct.
(f) For any of the purposes of the Additional Provision, Termination for Convenience of the Government (CP DIR 41-FY 1950) *168 of this contract (including without limitation, computation of "the total contract price" and "the contract price of work not terminated") the contract price shall be the revised contract price agreed upon under paragraph (c) of this Article or determined under paragraph (d) of this Article, as the case may be.
In modification No. 8 approved in 1954 the parties agreed to a final price for the entire contract in the amount of $ 4,548,986.64. The modification states in part as follows:
Whereas, the Government and the Contractor have entered into Contract No. [8375] * * * under date of 16 March 1951, hereinafter referred to as "the Contract"; and
Whereas, it has been determined to be in the best interest of the Government to modify the contract in accordance with the terms of this Supplemental Agreement; and
Whereas, the said contract contained Contract Provisions 8(i) Price Revision Article Form IV (JFR-4-307.4) pursuant to which the contract price may be increased or decreased under the terms specified in the Article; and
Whereas, the contractor delivered under the terms of said contract a total of 58,719.9196 miles of Wire WB-1/TT which includes 29,706.1322 miles and 999.5881 miles on *169 Government-Furnished Reels DR-4-Item 1A; 5,820 miles and 6,127.1672 miles on Government-Furnished Spools DR-8-A -- Item 1B; 16,067.0321 *507 miles in Dispenser MX-306 A/G -- Item 1C; Wire WD-1/TT delivered under the Variation in Quantities clause, Provision 5; and
Whereas, the parties hereto, after due negotiation and study of cost and profit factors, have agreed that the total redetermined contract price of $ 4,548,986.64 represents the fair and reasonable value of all material delivered under the said contract;
Now, Therefore, the parties hereto do mutually agree as follows:
Article I: The gross quantity of Government-Furnished reels used during the performance of this contract is set forth below:
| Description | Gross quantity |
| Reels, DR-4 | 22,153 each |
| Spools, DR-8-A | 46,473 each |
Article II: The redetermined total contract consideration herein is hereby fixed at the sum of $ 4,548,986.64 for all material delivered under the terms of said contract.
Article III: As a result of the change set forth above, the total consideration of the contract is hereby decreased by $ 315,633.36 from $ 4,864,620.00 to $ 4,548,986.64.
The amount of the decrease, $ 315,633.36, will be deducted from the charges previously *170 charged against the following Allotment(s)
* * * *
Petitioner received, for deliveries of wire under contract No. 8375, a total consideration of $ 5,024,598.82 based on the estimated or target price and accrued such income commencing in June 1951 and ending August 1952, as follows:
| 1951 | ||
| Amount billed and | ||
| amount accrued | ||
| Item | Miles shipped | as Income |
| 1A (reels furnished by contractor) | 999.5881 | $ 81,936.24 |
| 1A (reels furnished by Government) | 22,222.7963 | 1,754,934.22 |
| 1B (regular spools) | 3,325.0341 | 279,635.37 |
| 26,547.4185 | 2,116,505.83 | |
| 1952 | ||
| 1A (reels furnished by Government) | 7,483.3359 | 590,959.04 |
| 1B (1/4 mile spools) | 5,820.0000 | 488,589.00 |
| 1B (regular spools) | 2,802.1331 | 235,659.39 |
| 1C (dispensers) | 16,067.0321 | 1,592,885.56 |
| 32,172.5011 | 2,908,092.99 | |
| Totals under Contract No. 8375 | 58,719.9196 | 5,024,598.82 |
Pursuant to the terms of the contract, after the contract was completed petitioner submitted its statement of costs to the contracting agency. An audit by the Army audit agency was made. Thereafter a review of costs incurred in connection with the performance under the contract was made by the economics branch of the contracting agency. Such economics branch prepared a memorandum reflecting *508 such review captioned: "Subject: Lowell *171 Insulated Wire Division of The Overlakes Corporation Order No. 8375 * * * Price Redetermination WD-1/TT Wire" dated August 21, 1953, which provides in part as follows:
3. Price Redeterminationa. Contractor submitted cost and profit data for the performance of the contract in the total amount of $ 5,024,597.31. Administration of the contract Price Redetermination Article, Form IV results in the following:
| AAA Rpt. dd 3-26-53 NYRO | ||||
| 6-1007 | ||||
| Contractor's | Proposed | |||
| cost | Costs | Costs | redetermined | |
| submission | accepted | questioned | price | |
| Material | $ 3,527,876.84 | $ 3,114,925.94 | $ 412,950.90 | $ 3,508,181.84 |
| Direct labor | 260,257.79 | 161,058.58 | 99,199.21 | 214,052.81 |
| Overhead (burden) | 491,277.30 | 274,185.26 | 217,092.04 | 355,341.17 |
| Total | ||||
| manufacturing | ||||
| cost | 4,279,411.93 | 3,550,169.78 | 729,242.15 | 4,077,575.82 |
| G&A expense | 110,861.50 | 66,386.94 | 44,474.56 | 99,257.78 |
| Total cost | 4,390,273.43 | 3,616,556.72 | 773,716.71 | 4,176,833.60 |
| Profit | 634,323.88 | 372,153.04 | ||
| Proposed price | 5,024,597.31 | 4,548,986.64 | ||
| Terms: Net |
| Recapitulation of redetermined price | ||||
| Quantity in | ||||
| Item | Description | miles | Unit price | Total |
| 1A | WD-1/TT on DR-4 reels | 30,705.7203 | $ 71.5428 | $ 2,196,773.31 |
| 1B | WD-1/TT on DR-8A spools | 11,947.1672 | 75.1314 | 897,607.44 |
| 1C | WD-1/TT on MX-306 A/G dispensers | 16,067.0321 | 90.5336 | 1,454,605.89 |
| Total redetermined price | 58,719.9196 | 4,548,986.64 | ||
| Terms: Net |
*172 b. Summary of Redetermined Price
| Total cost recommended for acceptance per Army Audit Agency's | |
| Report (NYRO 6-1007(2)) dated 26 March 1953 | $ 3,616,556.72 |
| Partial allowance of cost question deemed acceptable and | |
| applicable for redetermination purposes: | |
| (1) Material | 393,255.90 |
| (2) Direct labor | 52,994.23 |
| (3) Manufacturing overhead | 81,155.91 |
| (4) General and administrative expense | 32,870.84 |
| Redetermined contract costs | 4,176,833.60 |
| (5) Profit | 372,153.04 |
| Redetermined contract price | 4,548,986.64 |
c. Allowance of Costs Questioned
(1) Direct Material:
Army Audit Agency's Auditors used the period 1 January 1952 to 31 August 1952 for the purposes of determining unit cost. Contractor's statement of costs reflected the unit costs on the basis of the total costs of wire production incurred, as divided by the total miles shipped, during the period 1 June 1951 to 31 August 1952. Said period being identical with production period under subject contract. Costs recommended by SCSA are predicated on costs of period 1 June 1951 to 31 August 1952, taking into consideration opening and closing inventories.
*509 A breakdown of the individual material costs reinstated as elements of acceptable costs is summarized below and pertinent *173 comments in connection therewith are set forth in the ensuing subparagraphs.
| Item 1A | Item 1B | Item 1C | Total | |
| Common materials | $ 193,077.57 | $ 75,123.79 | $ 101,029.50 | $ 369,230.86 |
| Packing costs | 21,529.82 | 21,529.82 | ||
| Dispenser costs | 2,495.22 | 2,495.22 | ||
| Total | 193,077.57 | 75,123.79 | 125,054.54 | 393,255.90 |
(a) Common Material
Costs for common materials were premised on the total cost of materials, common to Government wire, sold during the period from 1 June 1951 to 31 August 1952 divided by the total shipments of wire to the Government during the period. The total cost of common materials sold was determined by adding the purchases for the period to the difference of the 31 May 1951 and the 31 August 1952 physical inventory values. The AAA Auditor used the period 1 January 1952 to 31 August 1952 for purposes of determining unit costs. For said period the AAA Auditor determined that the cost of the common material for a mile of wire shipped amounted to $ 50.1779. For the period 1 June 1951 to 31 August 1952, a redetermined common material cost per mile of $ 56.4659 was calculated by SCSA. Upon review by Contracting Officer's Representative (L. Drake) redetermined cost of common materials of $ 56.4659 per mile was *174 deemed reasonable and acceptable.
(b) Packing Costs
Packing cost peculiar to Item No. 1C was for export packing. This item was export packed six to a box at a contracted cost of $ 1.34 per mile by the Export Crate & Process Company, Boston, Massachusetts. Invoices cover said costs were examined and deemed allocable and acceptable and were concurred in by Contracting Officer's Representative.
(c) Dispenser Costs
AAA Auditor determined dispenser costs to be $ 8.1484 per mile for Item No. 1C. As a result of review and analysis of said costs, a redetermined cost of $ 8.3037 was calculated and deemed acceptable.
(2) Direct Labor
Army Audit Agency Auditor used the period 1 January 1952 to 31 August 1952 for the purpose of determining unit labor cost. AAA period utilized by Signal Corps in calculation of subject redetermination was 1 June 1951 to 31 August 1952 as said period is identical with production period under subject contract. Period used by AAA was not deemed representative of the period of production as it did not reflect production problems encountered in the initial stages of producing wire on dispensers that took place prior to 1 January 1952.
(a) Common Labor
AAA Auditor determined *175 a rate of $ 2.4926 per mile for common labor, utilizing the period 1 January 1952 to 31 August 1952. Utilizing the period from 1 June 1951 to 31 August 1952, a redetermined rate of $ 2.8792 was calculated by SCSA. Upon review by Contracting Officer's Representative redetermined cost of common labor of $ 2.8792 per mile was deemed reasonable and acceptable.
*510 (b) Packing and Taping Labor Costs
Contractor's submission of $ 3.78 per mile for additional labor costs necessary to complete dispensers, Item No. 1C, was based on estimated hours and rates. AAA Auditor computed cost of $ .9145 per mile. Upon review and analysis Contracting Officer's Representative and Engineer (L. Drake) determined cost of $ 2.80 per mile as reasonable and acceptable. In this instance it should be noted that cost of packing and taping labor was part of total acceptable labor pool, the balance of pool was deemed common labor for Government wire and was distributed on basis of miles shipped during life of subject contract.
(3) Manufacturing Overhead
AAA Auditors computed and applied a manufacturing overhead recovery rate of 170.24% for the period 1 January 1952 to 31 August 1952. Upon review and analysis, a composite *176 rate of 166.01% was calculated and deemed acceptable by this office. The reduced rate of 166.01% covers the period of production under subject contract, 1 June 1951 to 31 August 1952.
(4) General and Administrative Expense
AAA Auditors computed and applied a rate of 1.87% to Total Manufacturing Costs for the period 1 January 1952 to 31 August 1952. Upon review and analysis a composite rate of 2.43% was computed for the period 1 June 1951 to 31 August 1952. The increase resulted from the reinstating applicable selling expenses, legal and audit fees and the reclassification of scrap sales to direct materials.
The selling expenses reinstated to expense pool cover partial salaries of Vice-President and Sales Manager and the costs incidental to their functions in the organization. The costs reinstated do not include any branch office expenses or commissions. The function performed by the Vice-President and Sales Manager include Government as well as commercial business.
The legal and auditing fees accrued and reinstated to the pool represent audit fees to adjust expense to conform to period under review.
(5) Profit
On the basis of the Contracting Officer's Representative's Statement (L. *177 Drake), the contractor's performance was satisfactory, and that the agreed upon profit is fair and reasonable, and also on the basis of a review conducted by this office the agreed upon profit allowed, the same dollar amount per unit, as set forth at time of negotiating basic contract, is deemed acceptable. The redetermined profit allowed in the amount of $ 372,153.04 is equivalent to 8.91% of total cost.
4. Comments on Redetermined PriceEach element of cost and profit was discussed with and concurred in by the contractor and Contracting Officer's Representative (L. Drake). Contractor agreed to proposed redetermined price and will confirm same by letter and the refund due will be made upon receipt of modification to subject contract.
Army Audit Agency, in letter date 26 June 1953 to Contracting Officer, subject: "Price Redetermination Audit, Lowell Insulated Wire Company" stated that the production problems referred to by the contractor were productions during 1951 "would be those of a normal and ordinary nature, rather than unusual *511 as inferred by the contractor, in light of the contractor's prior and continuous wire production since 1950." In this instance, it should be noted that *178 subject contract is the first contract received by Lowell Insulated Wire for the production of wire in dispensers. During the year 1951, wire was produced in dispensers but as cost for the period was based on wire shipped, and no shipments having been made, no recognition to the preproduction and initial production of wire in dispensers was reflected in the Army Audit Agency figures.
Army Audit Agency, in report on audit of total and unit costs incurred under contract No. DA-36-039-SC-11875, NYRO 6-1007(2) dated 26 March 1953, on pages 5 and 6, states that the erratic costs for June 1951 could not be accounted for by the contractor, and in view of this contractor used the fiscal year-end inventory as of December 31st in the calculation of acceptable costs. Contractor contends that the inventory taken during the life of contracts are for internal control only and do not reflect short lengths that may be on hand. The only time an actual inventory including short lengths is taken to be used for cost calculations is at the beginning and end of specific contracts. Therefore, the inventory taken on 31 May 1951 reflected a realistic inventory of the contractor's viewpoint, while the 30 *179 June 1951 inventory did not take into account the short lengths that were on hand.
Army Audit Agency calculated a rate of 91.45 cents per mile for packing and taping labor costs necessary to complete dispensers, and that the contractor concurred with the Army Audit Agency Auditor's basis of computation, but reserved opinion as to the result.
Contractor, in letter dated 6 May 1953 to Contracting Officer, stated "the contractor did not concur with the auditor's basis of computation. Any computation of packing and taping operations would necessarily have to take into consideration dispensers lost in making various tests required, and dispensers lost because of failures during final testing. It would appear that the auditor considered only the labor in the coiling and taping operations, without taking into consideration all the additional labor necessary to production and testing of dispenser packages."
Upon review by SCSA engineer, Mr. L. Drake, it was his opinion that the contractor's contention was well founded, and further substantiated by preparing cost for like operations as submitted by other contractors. The Army Audit Agency auditor reports this export packaging cost on dispensers *180 as nil, in spite of the fact that these items were export packaged by outside contractor, and bills covering same were submitted to SCSA personnel and found to be in order.
It should also be noted that during 1951 subject contractor produced packaged and taped dispensers, which were utilized in testing under the normal testing procedures as required by SCSA. In a production of quantity of from 0 to 180, contractor was required to test 15, and all 15 were to pass the "pay-out" test. In a production of 181 to 800, 25 dispensers were required to be tested and only one (1) failure was allowable.
It was not until 1952 that subject contractor was put on reduced sampling, which necessitated only the testing of one-fifth of the quantities required under normal testing. Thus, in the early stages of the contract where the contractor was under normal testing, Army Audit Agency gave no recognition to said costs.
The Contracting Officer's attention is invited to the following:
a. Authority to Approve Price Redetermination Modification
Memorandum from Chief, Procurement Staff, dated 17 December 1952, subject: "Delegations of Authority to Approve Definitive Contracts, Awards, Letter Contracts, *512 Supplemental *181 Agreements, Modifications and Change Orders," to which is inclosed a "Summary of Delegations of Authority Contained in Memoranda from the Chief Signal Officer Dated 21 November 1952 and 9 October 1952," which in conjunction with Staff Memorandum No. 4, dated 4 January 1953, furnishes a list of approving officials where price redetermination is concerned.
b. Reduction in target price due Government is $ 475,612.18, the difference between the target amount of $ 5,024,598.82, and the determined price of $ 4,548,986.64.
5. Recommendation:
Based on the above, it is the opinion of this office that the redetermined price of subject contract be established in the amount of $ 4,548,986.64.
Modification No. 8 also sets forth the adjusted contract prices as shown above.
Pursuant to such price redetermination petitioner refunded $ 475,612.17 to the contracting agency in the following manner: The contracting agency offset such sum against amounts it owed petitioner for articles manufactured and delivered under other unrelated contracts on the dates and in the amounts set forth below:
| Date | Amount |
| June 11, 1954 | $ 84,177.83 |
| June 24, 1954 | 83,759.64 |
| Aug. 5, 1954 | 83,713.84 |
| Aug. 25, 1954 | 50,153.34 |
| Sept. 11, 1954 | 33,418.46 |
| Oct. 7, 1954 | 46,270.67 |
| Oct. 13, 1954 | 36,821.48 |
| Nov. 6, 1954 | 57,296.91 |
| 475,612.17 |
The *182 difference between the total consideration received by petitioner under contract No. 8375 of $ 5,024,598.82 and the revised contract price of $ 4,548,986.64 is $ 475,612.18 (the difference of 1 cent is unexplained).
Contract No. 2704On or about February 1, 1952, petitioner entered into a second contract with the contracting agency, which contract is referred to as contract No. 2704. This contract was for the same kind of wire as that produced under contract No. 8375. Shipments under contract No. 2704 were begun in June 1952 and were concluded in October 1953. Under contract No. 2704, price redetermination was to be made upon 40-percent completion. However, the price redetermination was not made until completion of the contract in 1953. The final audit report closing the price redetermination took place in 1954.
*513 Pursuant to the price redetermination clause of contract No. 2704, the petitioner and the contracting officer, by modification No. 4 executed in 1955, agreed to a final revision of the contract price per mile, as well as a revised total contract price for the deliveries made in the entire contract period.
Pursuant to such price redetermination, petitioner agreed to and did *183 refund to the contracting agency the amount of $ 312,773.85 with respect to contract No. 2704. Such refund was made in 1955 by the application thereof as an offset against other amounts due to petitioner.
During the year 1952, petitioner shipped 20,288.4089 miles of wire under said contract No. 2704 and billed and accrued as income $ 1,623,287.33 with respect thereto. The redetermined price of said shipments was $ 1,464,521.01. The difference between the aforesaid accrued amount and the redetermined price (namely, $ 158,766.32) represents that portion of the excessive profits refund which was attributable to the year 1952.
During the year 1953, petitioner shipped 26,791.3231 miles of wire under contract No. 2704 and billed and accrued as income thereon $ 2,168,044.72. The redetermined price of said shipments was $ 2,014,037.19. The difference between the aforesaid accrued amount and the redetermined price (namely, $ 154,007.53) represents that portion of the excessive profits refund which was attributable to the year 1953.
In making the refunds of the price reduction in the amounts of $ 475,612.17 in 1954 and $ 312,773.85 in 1955, petitioner was allowed no tax credit as provided *184 in section 3806 of the 1939 Code. Petitioner refunded by way of offset the full amount in both years.
Petitioner used the inventory system of establishing its cost of goods sold for 1952. It added to its inventory at the beginning of 1952 the inventory purchased during the year and subtracted from this total inventory on hand at the end of 1952. In so doing, petitioner established the cost of items removed from inventory and sold in 1952 at $ 4,650,412.68, which amount was deducted in 1952 as the cost of goods sold. Among the items removed from inventory and sold during 1952 were 16,067.0321 miles of WD-1/TT wire with dispensers described by the parties as item 1C. The income from the sale of this type of wire was $ 1,592,885.56 and was included in the gross income reported on petitioner's 1952 return.
OPINION
Petitioner manufactured and sold Signal Corps field wire to a contracting agency of the Federal Government under two contracts, both of which were subject to price redeterminations with the contracting agency. Under the first contract, No. 8375, *514 deliveries were made in 1951 and 1952 and proceeds were accrued in 1951 and 1952 by Overlakes. Deliveries under the second contract, *185 No. 2704, were made in 1952 and 1953 and proceeds were also accrued by Overlakes in those years, the taxpayer being on the accrual system of accounting.
The price of wire under both contracts was later adjusted downward and the adjustments took place in 1954 with respect to contract No. 8375 and in 1955 with respect to contract No. 2704.
Overlakes refunded $ 475,612.17 to the contracting agency in 1954 with respect to income accrued on its books in 1951 and 1952 under contract No. 8375, simply by deducting that amount from amounts due to Overlakes by the same contracting agency on unrelated contracts. In 1955, petitioner made a refund of $ 312,773.85 by the same process which represented amounts accrued by Overlakes in 1952 and 1953 under contract No. 2704.
With respect to Overlakes' tax returns for 1952 and 1953, the petitioner attempted to anticipate the refunds and it set up reserve accounts and claimed deductions. The deduction for each year was called "Provision for Recapture of Excess Profits on Government Contracts." Petitioner deducted $ 750,000 on its Schedule J "Other Deductions" in its 1952 tax return and placed this amount in a reserve account. In 1953 it deducted $ 50,000 *186 in the same manner and placed this amount in the reserve account; we do not have the year 1953 before us. In the notice of deficiency for 1952, which is the only year before us, the respondent disallowed the deduction of $ 750,000 with the following explanation:
(c) It has been determined that the sum of $ 750,000.00 claimed as a deduction on line 30, page 1, of the Federal income tax return filed, and explained in Schedule J attached to the return as a "Provision for Recapture of Excess Profits on Government Contracts," is not allowable under any provision of the Internal Revenue Code of 1939.
Issue 1The first issue before us is whether or not petitioner is entitled to take a deduction of $ 750,000 as a provision for recapture of excess profits on Government contracts.
As a general rule, a liability or an expense is deductible in the taxable year in which all the events have occurred which determine the fact of the liability and the amount of the liability can be determined with reasonable accuracy. 1 Where the liability is contingent and not fixed *515 it cannot be deducted. The parties are not in disagreement with these general statements of law, Brown v. Helvering, 291 U.S. 193 (1934), *187 and United States v. Anderson, 269 U.S. 422">269 U.S. 422 (1926), which cases still represent the present law on this matter 2 as well as that under the 1939 Code, which Code is applicable to this case.
It is petitioner's position, however, that the additions to the reserve of $ 750,000 in 1952 and $ 50,000 in 1953 were within 2 percent of the actual net amount of the renegotiation refunds and that *188 by the end of 1952 it was definitely known that substantial excessive profits had been accrued under the contracts. In other words, petitioner contends that the liability for repayment under the contracts was not contingent in 1952 but had already become a fixed liability in that year. We cannot agree with this conclusion. There was no legally enforceable claim against petitioner for any refund in 1952 or, for that matter, in 1953. The audits necessary for a redetermination of the contract price were not completed until 1954 on contract No. 8375 and 1955 on contract No. 2704. Until there was a final determination by the contracting agency there was no claim against petitioner; the claims were still contingent.
This is not a case where petitioner was making annual additions to a reserve account based on a prior history of past experience with contingencies such as in the case of a bad debt reserve. On the contrary, we have before us a situation where petitioner was attempting to anticipate a price adjustment under a Government contract which was subject to a price redetermination under the Armed Services Procurement Act. That Act, in conjunction with the provisions in the 1939 *189 Code as will be discussed hereinafter, provides for a specific method of relief for handling refunds under Government contracts such as we have here and we do not believe that petitioner is entitled to depart from that scheme and attempt to handle the adjustments by claiming a deduction for a reserve for the recapture of excessive profits on Government contracts.
We hold that petitioner's accrual of a reserve of $ 750,000 in 1952 as a "Provision for Recapture of Excess Profits on Government Contracts" is not sustained.
Issue 2Petitioner contends, in the alternative, in the event that we determine it is not entitled to the deduction described above that section *516 3806 of the 1939 Code 3*190 *191 *192 *193 *194 *195 provides for the reduction of gross income in *517 1952, the year petitioner alleges the "excessive profits" 4 were earned so far as contract No. 8375 is concerned. We cannot agree with this contention since that section provides for a tax credit computation as a measure of relief and not a deduction from gross income.
Section 3806 was added to the 1939 Code in 1942 to effectuate into law the Commissioner's Rev. Rul., I.T. 3577, 2 C.B. 163">1942-2 C.B. 163. Fleet Carrier Corporation, 37 T.C. 527">37 T.C. 527, 535 (1961). The immediate problems which gave rise to the enactment of section 3806 resulted from the Renegotiation Act of 1942, 56 Stat. 245, 50 U.S.C. App. 1191. However, section 3806 is also applicable to renegotiations under the Armed Services Procurement Act of 1947. The technique employed in section 3806 provides for the computation of a tax credit. No deduction is to be made in either the year the amount is actually refunded, section 3806(a)(3), or in the prior taxable year in which the amount was originally included in taxable income, section 3806 (a)(1). The tax credit is determined by computing the tax for the year of accrual with the refunded sales proceeds included in the gross income and computing *196 the tax for such year without such refunded proceeds included in gross income. The difference between the tax as thus computed is the amount of the tax credit to be allowed. The statutory scheme embodied in section 3806 normally makes it unnecessary to open up the prior year since the tax credit is applicable to the contract refund and used as an offset against the contract refund in the year of repayment. In Standard Roofing & Material Co. v.*518 , 199 F. 2d 607 (C.A. 10, 1952), this method was explained at p. 610, as follows:
The renegotiation did not operate to wipe out any taxes or interest due, nor did it alter the total tax liability. Rather, it merely operated to decrease the amount of excessive profits to be repaid the United States by the amount of taxes previously paid.
However, in the instant case the contracting agency did not allow Overlakes the credit to which it was and is entitled. Our Findings of Fact show that fact.
The facts show that Overlakes refunded $ 475,612.17 in 1954 and $ 312,773.85 in 1955, which amounts represent the full amounts of the price adjustments by the contracting officers under both contracts and no offset was calculated under the provisions *197 of section 3806. This tax credit is not lost to petitioner since section 3806 anticipated situations where the tax credit was not allowed or where it was allowed in insufficient amounts. Subsection (c) of section 3806 provides in part as follows:
(c) * * * If the amount allowable as a credit under subsection (b) exceeds the amount allowed under such subsection, the excess shall, for the purposes of the internal revenue laws relating to credit or refund of tax, be treated as an overpayment for the prior taxable year which was made at the time the payment, repayment, or offset was made.
In view of the above, Overlakes is entitled to a tax credit and all of it is to be treated as an overpayment since the "amount allowed" by the contracting agency was zero. Therefore, the correct taxable income of petitioner must be determined and correct tax liability ascertained. When this is known the amount of the allowable tax credit can be computed and the excess of the allowable tax credit over the amount allowed is treated as the overpayment.
We conclude that section 3806, insofar as it is applicable here, relates only to a tax credit and that any overpayments computed thereunder cannot be claimed *198 as a deduction from income. As to this issue, we decide for the respondent.
Issue 3The next question before us concerns the computation of this tax credit. Respondent contends that the computation of the tax credit is not a matter for the Tax Court but that it can be handled administratively. Apparently, it is respondent's position that we have either (1) no authority to determine the principles applicable to the computation of the tax credit, or (2) that this matter can best be handled by administrative settlement.
Our authority, we think, to make the allocation from which the tax credit can be computed is based on the provisions of sections 3806, *519 supra, and 322(d) of the 1939 Code. 5*199 Subsection (c) of section 3806 which we have referred to earlier provides that the amount allowable as a credit shall be treated as "an overpayment for the prior taxable year." The latter subsection is set out in the margin and it appears that the present case comes within those provisions.
In view of the foregoing sections, we find proper jurisdiction to redetermine the overpayment of tax applicable to the year in issue, 1952. It is not our intention, however, to mathematically compute the overpayment which can be handled by a Rule 50 computation.
The computation of an allowable tax credit under the provisions of section 3806 first requires a computation of the petitioner's tax for the prior taxable year without reference to section 3806. Secondly, the tax is recomputed by omitting from gross income for the prior taxable year the amounts which have been determined to be "excessive profits" by the contracting agency. The difference between the two computations of tax is the amount of the tax credit to which petitioner is entitled, Standard Roofing & Material Co. v. United States, supra at 610.
The *200 term "prior taxable year" as it is used in section 3806 is a term of art and has reference to the original year in which "excessive profits" were accrued in income by the contractor. The problem in the instant case results from the fact that contract No. 8375 was a 2-year contract with deliveries made and proceeds accrued in 1951 as well as 1952. In other words, the "prior taxable year" as it is used in section 3806 applies to 1951 as well as 1952 in the instant case.
In view of a concession made by respondent in his brief, there is now no dispute as to the computation of the tax credit under contract No. 2704 so that the only remaining dispute as to the computation of the tax credit concerns contract No. 8375.
With respect to contract No. 8375, it is petitioner's position that it earned no excessive profits under the contract in 1951 so that any allocation of "excessive profits" must be attributed to 1952, the second year of the contract, and none to 1951; in other words, that the entire refund of $ 475.612.17 made on contract No. 8375 should be attributed to 1952. On the other hand, it is respondent's position that the price redetermination made in 1954 by the contracting agency *201 which, for purposes of section 3806 is deemed to be "excessive profits," is allocable to the years in issue in proportion to the amounts originally accrued *520 in income in those years. The problem is illustrated by the following ruling in Rev. Rul. 54-82, 1 C.B. 286">1954-1 C.B. 286:
(B) The prime contractor had a price redetermination made in 1952 and made refund to the Government agency in 1952. Income under the prime contract was accrued in 1951 and 1952. The prime contractor treated such refund, in 1952, as a reduction of sales for such year. No tax credits have been allowed under section 3806 of the Code since the refunds paid were in the amount of the determination.
* * * *
With respect to (B), above, since the repayment of excessive profits was made by the prime contractor to the United States Government, the provisions of section 3806 of the Code are applicable to the prime contractor. In the absence of the application of section 3806(a)(4) of the Code to the case, the excessive profits should be properly allocated between 1951 and 1952 in order to comply with the provisions of section 3806(a)(3) of the Code, which reads:
"(3) Deductions disallowed. -- The amount of payment, repayment, *202 or offset described in paragraph (1) or paragraph (2) shall not constitute a deduction for the year in which paid or incurred."
If the excessive profits have been repaid without the benefit of a tax credit, where such credit is allowable under 3806(b), section 3806(c) of the Code provides in part as follows:
"(c) Credit in Lieu of Other Credit or Refund. -- * * * If the amount allowable as a credit under subsection (b) exceeds the amount allowed under such subsection, the excess shall, for the purposes of the internal revenue laws relating to credit or refund of tax, be treated as an overpayment for the prior taxable year which was made at the time payment, repayment, or offset was made. [Italics supplied.]"
* * * *
In the event that excessive profits have been repaid without benefit of a tax credit, where such credit is allowable under section 3806(b) of the Code, the credit shall be treated as an overpayment of tax for the prior taxable year. Such overpayment is considered as made at the time the payment, repayment, or offset was made, for the purpose of computing interest under section 3771(b) of the Code.
Respondent's position is that what was refunded by Overlakes to the contracting *203 agency was that part of the contract price which was reduced. Respondent's allocation, between 1951 and 1952, proceeds from an inquiry which seeks to determine how much of the contract price received in each year was reduced and returned. Respondent takes the position that the purpose of section 3806 is to provide tax relief equal to the tax savings to petitioner that would have resulted had it known at the time it filed its returns what the final prices would be.
Petitioner takes the view that what is being returned is "excessive profits" and that it had none in 1951. It submitted most of its evidence in an effort to prove that it had "excessive profits" as to contract No. 8375 only in 1952, and not in 1951. The purpose of this contention was to provide a basis to argue that all of the refund under contract No. 8375 should be attributed to 1952. We believe that petitioner's *521 view of "excessive profits" as that term is used in section 3806 is defined too narrowly. As defined in section 3806(a)(1)(B), "excessive profits" includes "any part of the contract price of a contract with the United States" and it is not limited to "profits" alone. We agree with respondent that there was *204 a price revision of the entire contract costs and profits as provided by the Price Revision Article of contract No. 8375 set forth in our Findings of Fact and not merely a revision of profits. We have carefully reviewed that contract and the modifying agreements and have found that there was a sales price revision of costs and profits and not merely a revision of profits alone. "Excessive profits" is broadly defined to include costs and profits.
Of the refund payment of $ 475,612.17 made on contract No. 8375, we find that respondent's allocation between 1951 and 1952 is reasonable and that petitioner has failed to prove that any other allocation is proper. Except for the mathematical discrepancies in the statutory notice conceded by respondent on brief, we find for respondent. There is no controversy as to the allocation of the refund of $ 312,773.85 under contract No. 2704 to the respective years 1952 and 1953.
Issue 4By an amendment to the petition, Overlakes added to paragraph 4 the following:
(c) In determining the net income for the year ended December 31, 1952, the respondent erroneously failed to reduce the reported net income by $ 103,524.71, representing amounts expended *205 in 1951 for research and experimental expenses incurred in the development of wire dispenser packages, which should have been capitalized in 1951 as deferred expenses and deducted in 1952.
And to paragraph 5 the following subparagraphs were added to the petition:
(f) In 1951 the petitioner entered into a contract with the Signal Corps Supply Agency for the manufacture of wire dispenser packages, including insulated wire and container, which were designed to permit the laying of wire from a moving vehicle or airplane.
(g) In 1951 the petitioner expended $ 103,524.71 for materials used in the research and experimentation necessary for the development of the wire dispenser packages.
(h) Because of the difficulty of producing a satisfactory product to meet the requirements of the Signal Corps Supply Agency, no wire dispenser packages were shipped in 1951 and the entire quantity contracted for was produced and shipped in 1952.
(i) The expenses of developing this product which were incurred in 1951 were erroneously deducted by the petitioner in its 1951 income tax return, but should have been capitalized as deferred expenses in that year and deducted in 1952.
Under normal cost accounting procedures *206 the expenses incurred in the production of the 1C wire dispensers would have been deemed incurred and included in cost of goods sold in the year the dispensers were sold and the income therefrom included in income. It is, therefore, *522 to be presumed that petitioner's costs were included in inventory and cost of goods sold was deducted in 1952. Petitioner operated under a supply contract and not a research contract. Petitioner's opening inventory for 1952 represents unexpired costs carried forward from the preceding accounting period to be applied against the sales income of the period to which they are carried, to the extent the articles in the inventory are sold in the second period. A larger opening inventory in 1952 would therefore tend to reduce taxable income; cf. Lela Sullenger, 11 T.C. 1076">11 T.C. 1076 (1948), and C. C. Humphries, 17 B.T.A. 811">17 B.T.A. 811 (1929). If petitioner would increase the cost of goods sold for 1952 by $ 103,524.71, it must show that it has not previously included this sum in the cost of goods sold. This has not been done. The record does not show any costs of item 1C not taken into account in the cost of goods sold deduction taken by petitioner on its 1952 return. *207 Therefore, petitioner's assignment of error as to this item is not sustained.
Decision will be entered under Rule 50.
Footnotes
1. Internal Revenue Code of 1939.
SEC. 43. PERIOD FOR WHICH DEDUCTIONS AND CREDITS TAKEN.
The deductions and credits (other than the corporation dividends paid credit provided in section 27) provided for in this chapter shall be taken for the taxable year in which "paid or accrued" or "paid or incurred," dependent upon the method of accounting upon the basis of which the net income is computed, unless in order to clearly reflect the income the deductions or credits should be taken as of a different period. * * *↩
2. Internal Revenue Code of 1954.
SEC. 461. GENERAL RULE FOR TAXABLE YEAR OF DEDUCTION.
(a) General Rule. -- The amount of any deduction or credit allowed by this subtitle shall be taken for the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.↩
3. SEC. 3806. MITIGATION OF EFFECT OF RENEGOTIATION OF WAR CONTRACTS OR DISALLOWANCE OF REIMBURSEMENT.
(a) Reduction for Prior Taxable Year. --
(1) Excessive profits eliminated for prior taxable year. -- In the case of a contract with the United States or any agency thereof, or any subcontract thereunder, which is made by the taxpayer, if a renegotiation is made in respect of such contract or subcontract and an amount of excessive profits received or accrued under such contract or subcontract for a taxable year (hereinafter referred to as "prior taxable year") is eliminated and, in a taxable year ending after December 31, 1941, the taxpayer is required to pay or repay to the United States or any agency thereof the amount of excessive profits eliminated or the amount of excessive profits eliminated is applied as an offset against other amounts due the taxpayer, the part of the contract or subcontract price which was received or was accrued for the prior taxable year shall be reduced by the amount of excessive profits eliminated. For the purposes of this section --
(A) The term "renegotiation" includes any transaction which is a renegotiation within the meaning of the Federal renegotiation act applicable to such transaction, any modification of one or more contracts with the United States or any agency thereof, and any agreement with the United States or any agency thereof in respect of one or more such contracts or subcontracts thereunder.
(B) The term "excessive profits" includes any amount which constitutes excessive profits within the meaning assigned to such term by the applicable Federal renegotiation act, any part of the contract price of a contract with the United States or any agency thereof, any part of the subcontract price of a subcontract under such a contract, and any profits derived from one or more such contracts or subcontracts.
* * * *
(D) The term "Federal renegotiation act" includes section 403 of the Sixth Supplemental National Defense Appropriation Act (Public 528, 77th Cong., 2d Sess.), as amended or supplemented, the Renegotiation Act of 1948, as amended or supplemented, and the Renegotiation Act of 1951, as amended or supplemented.
* * * *
(3) Deduction disallowed. -- The amount of the payment, repayment, or offset described in paragraph (1) or paragraph (2) shall not constitute a deduction for the year in which paid or incurred.
(4) Exception. -- The foregoing provisions of this subsection shall not apply in respect of any contract if the taxpayer shows to the satisfaction of the Commissioner that a different method of accounting for the amount of the payment, repayment, or disallowance clearly reflects income, and in such case the payment, repayment, or disallowance shall be accounted for with respect to the taxable year provided for under such method, which for the purposes of subsections (b) and (c) shall be considered a prior taxable year.
(b) Credit Against Repayment on Account of Renegotiation or Allowance. --
(1) General rule. -- There shall be credited against the amount of excessive profits eliminated the amount by which the tax for the prior taxable year under Chapter 1, Chapter 2A, Chapter 2B, Chapter 2D, and Chapter 2E, is decreased by reason of the application of paragraph (1) of subsection (a); and there shall be credited against the amount disallowed the amount by which the tax for the prior taxable year under Chapter 1, Chapter 2A, Chapter 2B, Chapter 2D, and Chapter 2E, is decreased by reason of the application of paragraph (2) of subsection (a).
* * * *
(3) Credit for barred year. -- If at the time of the payment, repayment, or offset described in paragraph (1) or paragraph (2) of subsection (a), refund or credit of tax under Chapter 1, Chapter 2A, Chapter 2B, Chapter 2D, or Chapter 2E, for the prior taxable year, is prevented (except for the provisions of section 3801) by any provision of the internal-revenue laws other than section 3761, or by rule of law, the amount by which the tax for such year under such chapters is decreased by the application of paragraph (1) or paragraph (2) of subsection (a) shall be computed under this paragraph. There shall first be ascertained the tax previously determined for the prior taxable year. The amount of the tax previously determined shall be the excess of --
(1) the sum of (A) the amount shown as the tax by the taxpayer upon his return (determined as provided in section 271(b)(1) and (3)), if a return was made by the taxpayer and an amount was shown as the tax by the taxpayer thereon, plus (B) the amounts previously assessed (or collected without assessment) as a deficiency, over --
(2) the amount of rebates, as defined in section 271(b)(2), made.
There shall then be ascertained the decrease in tax previously determined which results solely from the application of paragraph (1) or paragraph (2) of subsection (a) to the prior taxable year. The amount so ascertained, together with any amounts collected as additions to the tax or interest, as a result of paragraph (1) or paragraph (2) of subsection (a) not having been applied to the prior taxable year shall be the amount by which such tax is decreased.
(4) Interest. -- In determining the amount of the credit under this subsection no interest shall be allowed with respect to the amount ascertained under paragraph (1) or paragraph (2); except that if interest is charged by the United States or the agency thereof on account of the disallowance for any period before the date of the payment, repayment, or offset, the credit shall be increased by an amount equal to interest on the amount ascertained under either such paragraph at the same rate and for the period (prior to the date of the payment, repayment, or offset) as interest is so charged.
(c) Credit in Lieu of Other Credit or Refund. -- If a credit is allowed under subsection (b) with respect to a prior taxable year no other credit or refund under the internal revenue laws founded on the application of subsection (a) shall be made on account of the amount allowed with respect to such taxable year. If the amount allowable as a credit under subsection (b) exceeds the amount allowed under such subsection, the excess shall, for the purposes of the internal revenue laws relating to credit or refund of tax, be treated as an overpayment for the prior taxable year which was made at the time the payment, repayment, or offset was made.
4. The term "excessive profits" is a term of art found in section 3806↩ and will be discussed hereinafter.
5. SEC. 322. REFUNDS AND CREDITS.
(d) Overpayment Found by Board. -- If the Board finds that there is no deficiency and further finds that the taxpayer has made an overpayment of tax in respect of the taxable year in respect of which the Commissioner determined the deficiency, or finds that there is a deficiency but that the taxpayer has made an overpayment of tax in respect of such taxable year, the Board shall have jurisdiction to determine the amount of such overpayment, and such amount shall, when the decision of the Board has become final, be credited or refunded to the taxpayer. * * *