*34 Decision will be entered under Rule 155.
Prior to Dec. 7, 1941, petitioner conducted a business in China of importing, exporting, and contracting for the manufacture of linens and other goods. He sustained a war loss of assets of this business, consisting largely of inventory. In 1966, he recovered an amount with respect to the lost inventory and realized a gain under sec. 1333(3), I.R.C. 1954. A replacement fund was established under sec. 1033(a)(2) and, within the required time, petitioner used the fund to establish a manufacturing business dealing with the same sort of goods as before. The assets of the new business included a complete manufacturing plant as well as inventory. Held, on the facts of this case, the proceeds of the involuntary conversion of inventory were reinvested in property similar or related in service or use only to the extent they were reinvested in inventory.
*264 Respondent determined a deficiency of $ 33,406.45 in petitioner's 1966 Federal income tax. Petitioner has conceded some of the issues raised in the notice of deficiency, *36 leaving for our decision the question whether his taxable income included $ 83,456 recovered during the taxable year with respect to a war loss.
FINDINGS OF FACT
Virtually all of the material facts have been stipulated and are found accordingly.
Petitioner's address at the time the petition was filed herein was in care of Charles Hecht & Co., 595 Madison Avenue, New York, N.Y. 1 His 1966 calendar year income tax return was filed with the District Director of Internal Revenue, Manhattan, N.Y.
From sometime in 1938 until December 7, 1941, when hostilities commenced between the United States and Japan, petitioner operated a sole proprietorship engaged in the general import and export business in China. His head office was at 98 Kialat Road, Swatow, China, which city was the center of the drawnwork business in China. Petitioner had an office and warehouse located at *37 150 Kialat Road, Swatow, China, and two branches -- one in Shanghai, China, and the other in Hong Kong, China.
The business was conducted along traditional lines. Raw materials known in the trade as "piece goods," mostly Irish linens, were purchased in Belfast and other foreign markets and were shipped to China for manufacturing and processing. Some materials were purchased in the United States; others, principally silks, in China and Japan.
The processing and manufacture of the piece goods were preceded by the selection of the designs and colors by the petitioner or by the customers; the designs and colors were subject to frequent change as dictated by changing fashions and by competition. The designs were created by or under the *265 direction of petitioner, at considerable cost, in some cases, and sent by him to his Swatow offices. By far the larger part of the business was the linen drawnwork business, such as handkerchiefs and tableware.
The piece goods, together with the designs, thread, yarn for embroidery, etc., were placed in the hands of Chinese "contractors" in the Swatow area who did the "manufacturing." The procedure was generally as follows:
(a) The designs were*38 made and selected.
(b) The materials were measured on a frame and a thread was drawn to mark each dozen. Then more threads were drawn to square and mark each piece of handkerchief 2 before cutting.
(c) After the handkerchiefs were cut, each one was stamped with a design and style number.
(d) After bargaining, the Chinese contractor or contractors who had submitted the lowest bid was given the contract to do the work. He then proceeded to his village with the cargo; he distributed as many dozens as his village workers could handle, and subcontracted the balance to others.
The petitioner's head office at 98 Kialat Road, Swatow, China, performed the following services: (a) Receiving and storing all piece goods, yarn for embroidery, etc., (b) supervising designs, (c) marking and preparing all materials for processing, (d) distributing and receiving work in process, (e) laundering, finishing, and shipping, (f) local buying, and*39 (g) bookkeeping and general office work.
The petitioner's office at 150 Kialat Road performed the following services: (a) tailoring and finishing all wearing apparel, (b) receiving and storing piece goods, mostly silks, and (c) packing and preparing goods for shipment.
Petitioner's Shanghai office attended to: (a) purchasing Chinese-made silk piece goods, yarn, etc., for embroidery and sewing, (b) purchasing merchandise available in the Shanghai market for export, and (c) transshipment of cargo from Swatow to foreign ports, and from foreign ports to Swatow -- "in transit" cargo.
Petitioner's Hong Kong office attended to the "in transit" cargo which went through Hong Kong.
*266 On or about December 7, 1941, petitioner's business was confiscated by the Japanese, and he sustained a war loss under section 127, I.R.C. 1939. Petitioner's net investment in the business as of the date of the seizure consisted of:
| Assets: | ||
| Accounts receivable | $ 100,553 | |
| Ascertainable inventories, at cost | 342,543 | |
| Real estate, furniture, fixtures, | ||
| and machinery | 3,130 | |
| Miscellaneous other assets | 303 | |
| Total assets | 446,529 | |
| Liabilities: | ||
| Accounts payable | $ 105,207 | |
| Bank loans | 86,351 | |
| Total liabilities | 191,558 | |
| Net business investment | 254,971 |
*40 He deducted $ 254,971 as a war loss on his income tax return for the fiscal year ended July 31, 1942.
In 1945, petitioner recovered a portion of the seized assets, consisting of merchandise valued at $ 81,388 which had cost $ 71,981. He also obtained cancellation of bank loans of $ 41,825, resulting in a total recovery of $ 123,213. He elected, pursuant to subparagraphs (3) and (5) of section 127(c), I.R.C. 1939, to report his war loss recovery by reducing the war loss deduction to $ 131,758. The amount of the net war loss was subsequently fixed at $ 94,000 by agreement between petitioner and respondent's agents.
On July 2, 1964, pursuant to the War Claims Act of 1948, 50 U.S.C. app. sec. 2001 et seq. (1970), petitioner claimed that he sustained losses as follows:
(a) Swatow losses. -- On December 8, 1941, the properties of the petitioner in Swatow, China, were taken over by the Japanese military forces. From time to time thereafter during the period of the war, the petitioner's large inventory was taken by the Japanese military authorities. Also confiscated were the contents of a five-room apartment located at 98 Kialat Road which was*41 the personal residence of petitioner.
(b) Shanghai losses. -- The losses in Shanghai consisted of an inventory of merchandise in stocks; 22 cases of drawnwork and embroidered articles which had been received at the Shanghai office a few days prior to Pearl Harbor day and which were *267 awaiting transshipment to the United States; and some Chinese antiques which were the personal possessions of the petitioner.
(c) Hong Kong losses. -- The losses in Hong Kong consisted of merchandise in transit stored in Holts Wharf and in the godown of the Hong Kong and Kowloon Wharf and Godown Co., Ltd., and some of petitioner's personal effects which were in the custody of petitioner's Hong Kong manager.
(d) Ship cargo losses. -- In November of 1941, petitioner shipped 35 cases of linen goods from his Swatow offices to his Shanghai offices for transshipment to the United States. This cargo was loaded in Shanghai on the S.S. Bernadin de St. Pierre for transshipment via Manila to the United States and a bill of lading was issued therefor to petitioner. This cargo never reached its destination in the United States.
On June 1, 1966, the Foreign Claims Settlement Commission found*42 that petitioner sustained war losses and awarded him $ 331,912.37 with respect to lost business property (consisting entirely of inventory items) and $ 22,090 with respect to his personal property. Petitioner determined that $ 83,456 of this amount should be treated as gain from an involuntary conversion of property by virtue of section 1333(3)3*43 and reported it accordingly on his 1966 return. Since the involuntary conversion involved herein occurred prior to January 1, 1951, he applied for and received the consent of the Internal Revenue Service to establish a fund to replace his business which was destroyed *268 during the war. 4 Including extensions of time, petitioner was allowed until July 1, 1969, to expend the fund in reestablishing his business.
On January 9, 1969, petitioner registered the Frederick Trading Co. in Hong Kong as a sole proprietorship engaged in general import-export and manufacturing. Petitioner had invested HK$ 728,087.74 in that business by April 30, 1969. The company's balance sheet as of that date showed the following assets at cost: 5
| HK $ | US $ | |
| Current assets other than | ||
| inventory | $ 136,848.01 | $ 22,511.50 |
| Inventory | 90,816.59 | 14,939.33 |
| Land and building (before | ||
| depreciation) | 356,100.00 | 58,578.45 |
| Plant and machinery (before | ||
| depreciation) | 68,633.00 | 11,290.13 |
| Furniture and fixtures (before | ||
| depreciation) | 35,574.90 | 5,852.07 |
| 687,972.50 | 113,171.48 |
Schedule C of petitioner's 1969 return shows that Frederick Trading Co. had no opening inventory.
At least until June 30, 1969, the business*44 of Frederick Trading Co. was conducted as follows: Cotton, silk, yarn, and synthetic fabrics were purchased in Hong Kong or were imported. The materials in some cases were knotted and in all cases were cut and sewn in the company's Hong Kong factory. Finished goods were sold and delivered to retail outlets, primarily in the United States.
Schedule C of petitioner's 1968 return shows that, during that year, he operated a sole proprietorship in Hong Kong under the designation Fortuna & Co., whose principal activity was manufacturing knitwear.
OPINION
Section 1333(3) provides that any amount which it requires to be treated as gain from an involuntary conversion "shall be recognized or not recognized as provided in section 1033." Under the latter section, where a taxpayer realizes a gain on the *269 involuntary conversion of property used in his own trade or business, it is clear that the reinvestment must be made in substantially similar business property. Ellis D. Wheeler, 58 T.C. 459">58 T.C. 459, 463 (1972). Stated differently, the statute requires a "reasonably similar continuation of the petitioner's prior commitment of capital and not a departure from *45 it." Harvey J. Johnson, 43 T.C. 736">43 T.C. 736, 741 (1965). While it is not necessary to acquire property which duplicates exactly that which was converted ( Loco Realty Co. v. Commissioner, 306 F.2d 207 (8th Cir. 1962), revg. 35 T.C. 1059">35 T.C. 1059 (1961)), the fortuitous circumstance of involuntary conversion does not permit a taxpayer to change the character of his investment without tax consequences (see Liant Record, Inc. v. Commissioner, 303 F. 2d 326 (2d Cir. 1962), revg. 36 T.C. 224">36 T.C. 224 (1961)).6
*46 The main point of contention between the parties is whether the conversion proceeds were reinvested in property "similar or related in service or use" to the converted property, a condition precedent to nonrecognition under section 1033(a)(2). Both parties agree that the appropriate test is one of "functional use." Petitioner argues that this test is satisfied without reference to the nature of particular assets, if the general character of the new business is substantially the same as that of the old. Respondent asks us to apply the test to the particular assets and to rule that because the 1966 award was received entirely with respect to merchandise, only that portion of the gain which was reinvested in inventory items is entitled to nonrecognition.
Where a taxpayer suffers a loss of business assets and uses the replacement property to continue or reenter the same business, opinion is divided as to whether different classes of assets must be considered separately or together for the application of section 1033. Compare The International Boiler Works Co., 3 B.T.A. 283 (1926), Rev. Rul. 70-465, 2 C.B. 162">1970-2 C.B. 162, and Rev. Rul. 70-501, 2 C.B. 163">1970-2 C.B. 163,*47 with O. N. Bymaster, 20 T.C. 649">20 T.C. 649 (1953), Massillon-Cleveland-Akron Sign Co., 15 T.C. 79 (1950), and Rev. Rul. 73-225, 1 C.B. 32">1973-1 C.B. 32. Petitioner and respondent seek to utilize the authorities in this area to support their positions herein. We think they are both in error. Neither an *270 aggregate nor an atomistic approach is adequate to determine in every case whether converted property has been replaced with other property which is similar or related in service or use. Section 1033 provides a means by which a taxpayer whose enjoyment of his property is interrupted without his consent may arrange to have that interruption ignored for tax purposes, by returning as closely as possible to his original position. Cf. Gaynor News Co., 22 T.C. 1172 (1954). Granted that it is a relief provision entitled to liberal and realistic construction, still the taxpayer may claim its protection only if he does not "materially alter his type of business." S. E. Ponticos, Inc., 40 T.C. 60">40 T.C. 60, 64 (1963), revd. 338 F. 2d 477 (6th Cir. 1964).*48 7 Thus, for example, as in Massillon-Cleveland-Akron Sign Co., supra, some rearrangement of his investment among depreciable real and personal property may be tolerated where the overall effect is to reproduce the converted facility as closely as changed conditions permit. See also Rev. Rul. 73-225, supra.
But, there are limits to the extent of the change which can be countenanced and we think petitioner has exceeded those limits. His old business consisted primarily of the acquisition of raw materials, design, and marketing of finished products. Over 99 percent of his investment was in inventory and accounts receivable. The business which he established in 1969, by contrast, included an entire manufacturing plant. Well over half of his investment went into fixed assets such as real and depreciable personal property. *49 This disproportionate shift from current to fixed assets reflects a fundamental change in the nature of the business itself. The acquisition of a manufacturing operation cannot be equated with the reestablishment of petitioner's former enterprise; a substantial change from inventory to depreciable assets, such as is the case herein, cannot be regarded as satisfying the "similar or related in service or use" requirement of section 1033. Cf. United Development Co. v. United States, 212 F. Supp. 664">212 F. Supp. 664 (E.D. Mo. 1962), where the benefits of section 1033 were held unavailable to a taxpayer who used the proceeds of condemnation of cemetery lots to construct an administration building to house the offices from which the cemetery was operated.
*271 Our view that, in a situation such as the one before us, section 1033 requires a reasonable degree of continuity in the nature of the assets as well as in the general character of the business is confirmed by the legislative history of section 1033. Thus, when the involuntary conversion provision was first enacted as section 217 of the Revenue Act of 1921, the floor manager in the House spoke in terms of a *50 situation where the taxpayer "immediately proceeds to invest the moneys received in other similar property." (Emphasis added.) See 61 Cong. Rec. 5201 (1921). And when the provision was amended in 1951 (by which time it had become section 112(f) of the Internal Revenue Code of 1939), the then chairman of the House Ways and Means Committee observed on the House floor (see 97 Cong. Rec. 10348 (1951)):
Although proposals were received for broadening still further the relief granted by the bill, it was the unanimous decision of the Committee on Ways and Means that the relief should be granted within the basic framework of existing law requiring that the replacement property be similar or related in service or use to the property converted. To permit the taxpayer to defer gain while changing the nature of his investment would be a serious departure from the policy of existing law which the Committee on Ways and Means believes should not be allowed. [Emphasis added.]
Again, when the provision (by this time, sec. 1033 of the Internal Revenue Code of 1954) was amended in 1958, the committee reports referred to the "purchase [of] other property similar in nature to the property*51 converted." (Emphasis added.) See H. Rept. No. 775, 85th Cong., 1st Sess. (1957), 3 C.B. 811">1958-3 C.B. 811, 838; S. Rept. No. 1983, 85th Cong., 2d Sess. (1958), 3 C.B. 922">1958-3 C.B. 922, 992. At that time, Congress also added subsection (g) to section 1033 in order to incorporate the more liberal "like kind" test of section 1031 but, in doing so, carefully limited its liberalization to real estate investments. See S. Rept. No. 1983, supra, 1958-3 C.B. at 994; Conf. Rept. No. 2632, 85th Cong., 2d Sess. (1958), 3 C.B. 1188">1958-3 C.B. 1188, 1219.
Petitioner did not replace an old manufacturing plant with one of modern design; rather, he replaced a business involving subcontracting most of the necessary labor over which he apparently exercised little control with one which has an integrated and mechanized operation of his own. Petitioner asks us to take judicial notice of advancing technology which rendered his former mode of operation impracticable. But, even if we were *272 to accede to his request, it would be of no avail. The test of section 1033 would still not be satisfied, since difficulty*52 of compliance does not make the requirements of the statute inapplicable to petitioner. Fullilove v. United States, 71 F. 2d 852 (5th Cir. 1934); United Development Co. v. United States, supra.
Petitioner argues in the alternative that, in any event, no gain was realized in 1966 because his cost basis in the seized inventory items exceeded the amount of the award which he received. Respondent correctly states that petitioner has stipulated to the cost of the inventory included in his old business and to the recovery of a portion thereof in 1945 and that he may not now argue for a higher cost.
We hold that, except for purchases of inventory, petitioner did not replace his converted property with other property similar or related in use within the meaning of section 1033. Within this holding, however, we are left with one loose end. Respondent concedes that nonrecognition is proper with respect to $ 14,939.33 invested in inventory of Frederick Trading Co. by April 30, 1969. Petitioner is entitled to the same treatment of amounts expended from the replacement fund for the acquisition of inventory from May 1 to June 30, *53 1969, as well as amounts so expended for "similar or related" items in 1968. 8 In this latter connection, it is also possible that the operations of Fortuna Co. in 1968 involved some qualifying reinvestment in inventory. As to these elements, the record is incomplete. 9 We anticipate that the parties will be able to reach agreement under the Rule 155 computation, but, if they do not, we will, in accordance with our undertaking at the trial, reopen the record in order to take further evidence.
Decision will be entered under Rule 155.
Footnotes
1. This is apparently a business address; petitioner's residence is not indicated on the record. At the time of trial, his address was in Reading, Pa.↩
2. Presumably, a similar process was followed with respect to items other than handkerchiefs.↩
3. Unless otherwise indicated, statutory references are to the Internal Revenue Code of 1954, as amended and in effect for the year in issue. Petitioner apparently elected to treat his war loss recovery under sec. 1333, although the record contains no evidence of a formal election. See sec. 1.1335-1, Income Tax Regs.
The $ 83,456 figure results from reducing a net recovery of $ 305,021 by the following:
↩
Losses for which no tax benefit was received: Losses not claimed $ 89,807 War loss claimed $ 254,971 Less 1945 recovery at market value 123,213 131,758 War loss allowed 94,000 37,758 127,565 Loss previously allowed taxable at prior years' rates 94,000 221,565 4. See sec. 1033(a)(2); sec. 1.1033(a)-4, Income Tax Regs.↩
5. Respondent and petitioner apparently agree on an exchange rate of HK$ 1 = US$ .1645↩
6. The two cited cases involved a type of situation not involved in this case; in any event, the basis of the reversals was accepted by this Court in Harvey J. Johnson, 43 T.C. 736">43 T.C. 736, 741 (1965). Since the involuntary conversion occurred prior to Jan. 1, 1951, tracing of the funds is necessary (see sec. 1.1033(a)-3(c), Income Tax Regs.), a requirement not demanded under the current statutory provision (see sec. 1.1033(c)-1, Income Tax Regs.↩).
7. The basis of this reversal was also accepted by this Court in Harvey J. Johnson, supra↩ n. 6.
8. See Paul Haberland, 25 B.T.A. 1370">25 B.T.A. 1370↩ (1932).
9. We do not consider petitioner necessarily bound by the manner of treatment he accorded these elements on his tax returns.↩