*212 Decision will be entered for the respondent.
Deduction for partially worthless debts disallowed for failure to charge off specific debts.
*133 The respondent has determined a deficiency of $ 1,725 in the petitioner's income tax for the calendar year 1946. The deficiency resulted *134 from the disallowance of a deduction in the amount of $ 7,500 for partially worthless debts.
All stipulated facts are found as stipulated.
FINDINGS OF FACT.
The petitioner is a Delaware corporation organized in 1920. Its principal address is in Dayton, Ohio. The petitioner at all times computed and reported its income on the accrual basis and by the calendar year.
Under a contract dated February 16, 1922, the petitioner purchased for $ 1,250,000 the entire capital stock of a company known as Cooper Medicine Company (hereinafter referred to as Cooper Company) which, in turn, owned the entire capital stock (except for qualifying shares) of two subsidiary corporations known as Tanlac Company Limited, and The Tanlac Company, Inc. (referred to herein as Tanlac Limited*213 and Tanlac, Inc., respectively). On December 16, 1922, final payment on the purchase price was made and the petitioner acquired the capital stock and control of the Cooper Company. On that date, the petitioner liquidated the Cooper Company and became the owner of Tanlac Limited and Tanlac, Inc., which it operated as it subsidiary corporations.
Subsequent to the time of its acquisition of Tanlac Limited and Tanlac, Inc., the petitioner carried the capital stock of Tanlac Limited as assets in the amount of $ 63,529.71 and the capital stock of Tanlac, Inc., as assets in the amount of $ 5,000. On November 21, 1939, the petitioner created an account labeled "Reserve for Stock Affiliated Co.'s" in the amount of $ 68,529.71.
At the time the Cooper Company was acquired by the petitioner, its assets totaled $ 689,697.74, of which $ 224,701.53 consisted of current assets. Its liabilities totaled $ 46,748.07 and its net profits for the years 1920 to 1922 were $ 452,107.03, $ 256,457.98, and $ 557,734.98, respectively. In 1922, Tanlac Limited earned a net profit of $ 15,049.47 and had a net worth of approximately $ 77,000. In the same year, Tanlac, Inc., earned a net profit of $ 17,298.95*214 and had a net worth of approximately $ 20,000.
The petitioner and both its subsidiaries are engaged in the sale of proprietary medicines which are manufactured by Tanlac, Inc. Prior to 1938, the petitioner and Tanlac Limited were also engaged in the manufacture of medicines.
Prior to its acquisition of the Cooper Company, the petitioner had dealt on open account with the Cooper Company and its subsidiaries. When the petitioner became the owner of the Cooper Company and its subsidiaries, it was indebted to those three companies for merchandise which it had purchased but had not paid for. On December 31, *135 1922, the petitioner owed $ 9,797.85 to Tanlac Limited and $ 17,649.40 to Tanlac, Inc. The outstanding balances were carried on the petitioner's books as "accounts payable" and on January 31, 1923, they were designated as "Inter-Company -- Tanlac Company Limited" and "Inter-Company -- The Tanlac Company, Inc." accounts on the petitioner's books as well as on the books of the two subsidiary corporations. From that date until the present, such advances, the additions thereto, and repayments thereof have at all times been carried on the books of account of the petitioner*215 and the two subsidiaries under the same designations.
Beginning January 1, 1923, various amounts were advanced to the two subsidiaries. These advances exceeded the outstanding balances of December 31, 1922, so that by the close of 1926 both balances were in favor of the petitioner.
The amounts so advanced by the petitioner on open account to the subsidiaries from January 1, 1923, through December 31, 1946, were comprised, inter alia, of cash, merchandise, direct payments of the subsidiaries' obligations to third parties, and a proportionate share of overhead charges incurred by the petitioner on behalf of the subsidiaries such as taxes, sales expense, and salaries.
From January 1, 1923, through December 31, 1946, the subsidiaries made payments to or for the benefit of the petitioner. These payments consisted mainly of cash, but some amounts were represented by merchandise or the payment of the obligations incurred by the petitioner with third parties. The amounts attributable to each of the above classifications varied for each year.
The sum due the petitioner from Tanlac Limited was $ 34,580.95 on December 31, 1931. From that date to the end of 1946, the total advances from*216 the petitioner to Tanlac Limited were less than the total repayments and on December 31, 1946, the sum due the petitioner was $ 21,919.44.
The sum due to the petitioner from Tanlac, Inc., was $ 198,779.45 on December 31, 1926. From that date to the end of 1946, the total advances from the petitioner to Tanlac, Inc., were less than the total repayments, and on December 31, 1946, the sum due petitioner was $ 191,274.11.
At no time has the petitioner or its subsidiaries treated the intercompany advances as an investment in capital stock on their books. The inter-company advances by the petitioner were not capital investments but were, instead, bona fide debts arising in the regular course of business.
On November 21, 1939, when the balance in the petitioner's intercompany advance accounts was $ 216,298.65, petitioner created a reserve account entitled "Reserve for Inter-Company Advances" and *136 credited to it $ 202,017.37. A corresponding sum was debited to its surplus account.
The book value of the assets of the two subsidiaries that remained after deducting all liabilities except debts due to the petitioner were as follows:
| Tanlac | ||
| Year | Tanlac, Inc. | |
| Limited | ||
| 1938 | $ 39,442.91 | $ 10,278.67 |
| 1939 | 34,388.03 | 10,762.89 |
| 1940 | 34,776.23 | 10,838.66 |
| 1941 | 32,956.18 | 10,833.73 |
| 1942 | 33,174.29 | 10,965.90 |
| 1943 | 33,601.00 | 1,600.43 |
| 1944 | 32,943.47 | 1,634.29 |
| 1945 | 32,586.29 | 1,593.14 |
| 1946 | 32,341.86 | 1,899.33 |
*217 The net assets of Tanlac Limited, as shown on its balance sheets, included an account entitled "Good Will, etc." which was carried at a book value of $ 30,062.50 during 1945 and 1946 and for many years prior thereto. Tanlac Limited and Tanlac, Inc., both operated at a net loss during each of the years 1943 through 1947.
At a meeting of petitioner's board of directors held on December 27, 1946, petitioner's president reported that the total indebtedness due from its two subsidiaries was $ 11,034.18 in excess of the reserve established on the petitioner's books for such indebtedness, and that the total assets of the two subsidiaries, with the exception of good will, trademarks, etc., amounted only to $ 3,523.76. He further reported that the good will and trademarks were of no value and recommended that the total indebtedness due from the two subsidiaries be charged off as partially worthless to the extent of $ 7,500.
The petitioner's board of directors thereupon voted in favor of the charge-off and ordered that the "sum of $ 7,500 be charged against the surplus account." The board of directors did not indicate to what account the corresponding sum of $ 7,500 should be credited.
On*218 December 31, 1946, the petitioner charged this $ 7,500 sum to its surplus account and increased by a corresponding credit of $ 7,500 the reserve account entitled "Reserve for Inter-Company Advances." The petitioner did not reduce the two accounts receivable entitled "Inter-Company -- Tanlac Company Limited" and "Inter-Company -- The Tanlac Company, Inc." which recorded the indebtedness due from each subsidiary. No entry was made in these accounts, nor was the worthlessness in the amount of $ 7,500 apportioned in any manner to the respective indebtedness of the subsidiaries.
The debit balances in the two accounts receivable entitled "Inter-Company -- Tanlac Company Limited" and "Inter-Company -- The Tanlac Company, Inc." at the end of the years 1945, 1946, and 1947 were as follows: *137
| 12/31/45 | 12/31/46 | 12/31/47 | |
| Inter-Company -- Tanlac Company Limited | $ 21,619.44 | $ 21,919.44 | $ 22,219.44 |
| Inter-Company -- The Tanlac Company, Inc | 190,912.11 | 191,274.11 | 191,584.11 |
A consolidated return was filed by the petitioner and Tanlac, Inc., for the calendar year 1943 and the petitioner used the net loss of that subsidiary in the amount of $ 3,934.47 to offset its income. *219 This was the only consolidated return filed by the petitioner.
The petitioner claimed a deduction of $ 7,500 in its 1946 Federal income tax return for a partially worthless bad debt. Neither this sum nor any other portion of the inter-company advances was charged off or claimed or allowed as a bad debt deduction for any prior taxable year.
The petitioner did not employ the reserve method for deduction of bad debts but instead employed the specific or direct charge-off method.
Neither of the inter-company accounts was completely worthless at the beginning of the year 1946 and neither was completely worthless at the end of that year.
During the taxable year 1946 the petitioner did not charge off as partially worthless $ 7,500 of the total indebtedness due from its two subsidiaries, or apportion any part of that sum to the specific debts owing from the two subsidiaries for which it sought a partially worthless debt deduction.
OPINION.
The sole question before us is whether the Commissioner abused his discretion in disallowing a partially worthless debt deduction in the amount of $ 7,500 claimed by the petitioner for the taxable year 1946. Section 23 (k) (1), Internal Revenue Code. *220
Section 23 (k) (1), the statutory provision relied on by the petitioner, allows deductions for worthless debts and, in addition, permits deductions for partially worthless debts in language worded as follows: "* * * and when satisfied that a debt is recoverable only in part, the Commissioner may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction."
The Commissioner's disallowance was based in part on his conclution, controverted by the petitioner, that the sum sought as a partially worthless debt deduction was not "charged off" as required by section 23 (k) (1) and was not apportioned to specific debts as required by his Regulations 111, section 29.23 (k)-1. The Commissioner, in effect, concedes that the debtor-creditor relationship was bona fide and that the debts were worthless to the extent of at least $ 7,500.
A charge-off by the taxpayer is no longer required for the deduction of worthless debts, but in the case of a partially worthless debt the *138 deduction is permitted only to the extent that the taxpayer executes a proper charge-off. The charge-off prerequisite to deductions for partially worthless debts was *221 inadvertently eliminated by the Revenue Act of 1942 but was quickly reinstated by the Revenue Act of 1943 and made retroactive to taxable years beginning after December 31, 1938. Senate Finance Committee Rept. No. 627, 78th Cong., 1st Sess., pp. 20, 43; H. Rept. No. 1079, 78th Cong., 2d Sess., pp. 41-42. Under this provision, the allowance of deductions for partially worthless debts is "committed to the discretion of the Commissioner and his judgment is controlling unless it is plainly arbitrary or unreasonable." Wilson Bros. & Co. v. Commissioner, 124 F.2d 606">124 F. 2d 606, 609; Stranahan v. Commissioner, 42 F. 2d 729, certiorari denied 283 U.S. 822">283 U.S. 822.
The deduction claimed by the petitioner was for debts of its two wholly-owned subsidiaries. The indebtedness of each was recorded in separate accounts receivable on the petitioner's books of account.
On December 27, 1946, the petitioner's board of directors voted to charge off $ 7,500 of the total indebtedness due from the two subsidiaries and directed that the petitioner's surplus account be reduced by that amount. The board of directors did not *222 indicate in what account the corresponding credit should be entered; it did not refer to the two accounts receivable or the specific debts or in any way indicate how the $ 7,500 sum was to be apportioned to the two specific debts.
In fact, no entry was made in these two accounts receivable. The surplus account was reduced as directed and the only other change in the petitioner's books of account was an increase in a reserve account, similar to a reserve for bad debts account, although the petitioner did not employ the reserve method for deducting worthless debts. There was no reduction of the assets on the petitioner's books of account and no evidence of the extent to which the $ 7,500 sum applied to one or the other of the two specific debts.
Certainly this procedure did not comply with the statutory requirement that there be charge-offs, or the Commissioner's regulations which provide that "Partial deductions will be allowed with respect to specific debts only," Regulations 111, section 29.23 (k)-1, and we therefore cannot conclude that the respondent abused his discretion in disallowing the deduction.
The requirement that a taxpayer seeking a deduction for partially worthless *223 debts must charge off specific debts is a reasonable one based on realistic necessities and is not a mere technicality. The Congress in re-enacting the partially worthless debt provision as presently worded has indicated its insistence that the charge-off be the criterion that determines the year in which the deduction for partially worthless debts is to be allowed. Furthermore, as illustrated by the facts of the instant case, unless there is a charge-off of specific debts the extent to which the petitioner will realize income if perchance the *139 indebtedness of one of the subsidiaries is later recovered in full will be difficult, if not impossible, to ascertain. A similar problem as to the determination of basis may arise if the petitioner sells one of these open accounts.
The conclusion we have reached here is supported also by two of our most recent decisions relating to the prerequisites to the partially worthless debt deduction. Capital National Bank of Sacramento, 16 T.C. 1202">16 T. C. 1202. Commercial Bank of Dawson, 46 B. T. A. 526. In the latter case, in disallowing a partially worthless debt deduction, where a similar*224 procedure of merely increasing a reserve account was resorted to by a taxpayer who had regularly employed the specific charge-off method for deducting worthless debts, we stated:
* * * [this procedure] did not "effectually eliminate the amount of the bad debt from the book assets of the taxpayer." * * * there is no authorization for a taxpayer to use at the same time a charge-off and a reserve method for the deduction of bad debts. * * * A taxpayer on the charge-off system can only comply with the statute by specific charge-off; and a reserve can not exist in such a system as an over-all general treatment disregarding specific items, even if properly created in the first instance. * * * It follows that petitioner did not charge off these items, as it was required to do, and the deduction must be disallowed.
Malden Trust Co. v. Commissioner, 110 F. 2d 751, decided by the Court of Appeals for the First Circuit, was a case where the sufficiency of the charge-off of a debt ascertained to be worthless was before the court. In affirming our decision, the court said:
We agree with the Board that the taxpayer must eliminate the debt as an asset on its*225 books in order to comply with the statutory requirements of charge-off.
The decision we reach here will not necessarily be of ultimate disadvantage to the petitioner. The benefit of the deduction as either a partially or completely worthless debt may still be available to it in later years. Moock Electric Supply Co., 41 B. T. A. 1209; E. Richard Meinig Co., 9 T.C. 976">9 T. C. 976; see Commercial Bank of Dawson, supra.
Decision will be entered for the respondent.