*1154 A solvent purchaser had taken manufacturing equipment and finished products into its accounts at the full price which it agreed to pay for these items. It gave notes in partial payment for these purchases. A number of years later some of the notes were canceled by the seller on account of defects in the manufacturing equipment and finished products furnished to the purchaser. ,Held, the face amount of the notes canceled should be taken into income in the year of the adjustment.
*1394 The Commissioner determined deficiencies as follows:
| Fiscal years ended June 30 - | |||
| Petitioner | Docket No. | 1927 | 1928 |
| B. F. Avery & Sons, Inc | 45636 | $10,233.02 | $23,820.39 |
| B. F. Avery & Sons Plow Company | 45638 | 9,161.57 |
The cases were consolidated. They involve but one issue, Did the Commissioner err in including in income of B. F. Avery & Sons, Inc., for 1927, $300,000 representing notes of the petitioner canceled in that year by the holder as an adjustment for defective goods sold the petitioner?
FINDINGS OF FACT.
*1155 B. F. Avery & Sons, Inc., was incorporated in 1877, under the laws of Kentucky, since which time it has been engaged in the business of manufacturing and selling farm implements, cultivating machinery, and later, under circumstances more fully set forth herein, the Champion line of harvesting machinery. It owned all but qualifying shares of the B. F. Avery & Sons Plow Company, a Kentucky corporation, organized in 1909, engaged in the business of manufacturing plows and other farm implements. Both corporations had their principal places of business in Louisville, Kentucky, and filed consolidated returns for the fiscal years ended June 30 in 1927 and 1928 there.
In order to become a "complete line house," B. F. Avery & Sons, Inc., after a satisfactory investigation, entered into a contract on December 27, 1918, with the International Harvester Company for the purchase from the latter of its old and established line of harvesting machinery known under the name of "Champion." The seller was obliged to dispose of this line of machinery in order to comply with a decision of the Supreme Court of the United States.
Under this contract the petitioner acquired the trade name, good will, *1156 nonexclusive patent shop rights and development outlay for a consideration of $1, certain tools, dies, patterns, templates, and machinery for manufacturing the line for a consideration of $75,000; and certain other selected equipment for the same purpose for a consideration of $10,308. The contract also provided that all salable harvesting machines on hand on January 1, 1919, together with certain repair parts then on hand, should be purchased at fixed prices by the petitioner, and the International Harvester Company should manufacture at its plant at Springfield, Ohio, such machines as the petitioner would order for several seasons until it could build an *1395 addition to its plant at Louisville and install the manufacturing machinery purchased. The contract also contained many other provisions relating to transfer of the domestic and foreign business involved.
The International Harvester Company manufactured machines and parts for the petitioner until the fall of 1920, when additions were completed at Louisville at a cost of over $250,000 and the manufacturing machinery was installed therein.
Soon after the petitioner began selling the Champion machines complaints*1157 began to come in from retailers and users that the machines would not function properly. The petitioner also discovered defects while assembling and testing the machines in its plant. The trouble was finally traced to excessively worn patterns, dies and manufacturing machinery acquired from the International Harvester Company, which caused the working parts to vary in size and shape from the precision necessary to form a satisfactory finished machine. As a result of this condition, the petitioner was put to excessive expense in manufacturing, selling, and servicing the Champion line. Each service trip cost the petitioner from $15 to $25. Extra men had to be employed in the pattern shop to try to correct the patterns. Worn equipment had to be replaced. Gradually the faults were eliminated but in 1923, they were still prominent and as late as 1927 were still apparent. In the meantime sales and collections were adversely affected. The International Harvester Company was informed of the trouble and sent out employees to help service machines.
In January, 1927, the petitioner demanded that the International Harvester Company make some adjustment on account of the defective equipment*1158 transferred. After a conference an agreement was reached and embodied in a letter written by the International Harvester Company to the petitioner on January 12, 1927, as follows:
This is to confirm the understanding reached at our conference in Chicago on January 6 and 7. The subject of our discussion was the unsatisfactory condition of the equipment (jigs, dies, tools, patterns, etc.), transferred to you for the manufacture of the Champion line of harvesting machines sold by us to you in 1918 under order of Court.
This resulted in making it necessary for you to make substantial expenditures in replacing and repairing the equipment so that you have invested a considerably larger sum than you originally anticipated, in fully equipping your Company to manufacture the line.
While both parties recognized when the contract was made that the equipment to be transferred to you was not new, it was believed by both parties that it would prove adequate and satisfactory for the manufacture of the Champion line at your Louisville plant. As you know we manufactured your requirements for some little time before you took over the line at Louisville, with the equipment that was turned*1159 over to you. The officers of this Company *1396 had no idea that this mutual belief that the equipment would prove adequate, was ill founded, though we now recognize that your experience proved that the equipment was not in condition both parties believed it to be at the time of the transfer.
Because of the foregoing facts and bearing in mind that one of the purposes of the Court requiring the sale of the Champion line was to place the purchaser in possession of adequate equipment for its manufacture, we agreed with you at our conference on January 7, that an adjustment should be made with you on account of the facts above stated.
While you had no itemized account of your expenditures in connection with this matter, - the repairing and replacing of equipment taken over from us - it was agreed between us that the sum of $250,000 would cover them and any losses occasioned thereby, and that we would credit that amount on the principal of your Company's notes, now held by us on account of Champion harvesting machines manufactured and sold to you, etc.
I am therefore enclosing twenty (20) of your notes for $12,500 each, all dated December 15, 1923, payable to the International*1160 Harvester Company and maturing on the following dates:
| April | 15, 1927 |
| May | 15, 1927 |
| July | 15, 1927 |
| August | 15, 1927 |
| September | 15, 1927 |
| October | 15, 1927 |
| November | 15, 1927 |
| December | 15, 1927 |
| January | 15, 1928 |
| February | 15, 1928 |
| August | 15, 1928 |
| September | 15, 1928 |
| October | 15, 1928 |
| November | 15, 1928 |
| May | 15, 1929 |
| June | 15, 1929 |
| July | 15, 1929 |
| August | 15, 1929 |
| September | 15, 1929 |
| October | 15, 1929 |
We have marked all of these notes as cancelled. This leaves $137,500 still due, as follows:
| June | 15, 1927 | $12,500. |
| March | 15, 1928 | 12,500. |
| April | 15, 1928 | 12,500. |
| May | 15, 1928 | 12,500. |
| June | 15, 1928 | 12,500. |
| July | 15, 1928 | 12,500. |
| Dec. | 15, 1928 | 12,500. |
| Jan. | 15, 1929 | $12,500. |
| Feb. | 15, 1929 | 12,500. |
| March | 15, 1929 | 12,500. |
| April | 15, 1929 | 12,500. |
| $137,500. |
Will you kindly acknowledge the receipt of the enclosures and confirm my understanding of this matter.
Later, the petitioner demanded a further adjustment on account of defective binders furnished by the International Harvester Company and for other reasons. As a result, the International Harvester Company, on June 17, 1927, acknowledged receipt*1161 of $62,500 in discharge of the remaining notes amounting to $112,500 and terminating the transaction relating to the sale of the Champion line.
The petitioner opened an account on its books in which it recorded its various transactions with the International Harvester Company under the contract of December 27, 1918. This account was debited with the amount ($86,308) paid for the machines, patterns, etc., and credited with a like amount representing these assets. It was also *1397 credited from time to time with Champion goods received from the International Harvester Company and debited with various amounts of cash paid to the International Harvester Company and other items. The total amount of Champion goods received up to February 23, 1927, when the account was balanced, was $3,585,744.85. Most of these goods were received prior to April, 1921. On December 15, 1923, the account was debited with $875,000, described as "Bills Payable." This represented a series of notes, all dated December 15, 1923, payable to the International Harvester Company at the rate of $12,500 on the fifteenth of each month, beginning January 15, 1924, without interest until December 15, 1925, provided*1162 they were paid promptly upon maturity. Notes maturing after January 15, 1926, bore interest at 5 per cent from that date. All notes carried interest at 7 per cent after maturity. Of these notes $300,000 was canceled in 1927 in the adjustments described above.
The petitioners reported a net loss on their consolidated return for 1927 and carried it over to reduce income for 1928. The Commissioner made certain adjustments which are not now in dispute. He held that the cancellation of the notes represented income to the petitioner in the amount of $300,000. This adjustment wiped out the loss for 1927.
The patterns, dies, manufacturing machinery and other equipment purchased from the International Harvester Company in 1918 were entered on the petitioner's books at $86,205.48, representing cost in Louisville. In its returns for the years 1919 to 1926, inclusive, it deducted depreciation on this cost of these assets at the rate of 5 per cent annually, or 40 per cent. On its return for 1927 it claimed a loss on these assets of $86,205.48. The Commissioner allowed only 60 per cent, the unexhausted cost, as a loss.
On its various returns the petitioner deducted the amount expended*1163 during the year for labor and expense of servicing machines, materials and labor used in correcting defects, and sales expenses. The following table shows its income or loss for these years before deducting taxes and reserves:
| Year | Profit | Loss |
| 1918 | $1,050,284 | |
| 1919 | 1,087,000 | |
| 1920 | 1,662,687 | |
| 1921 | $1,154,817 | |
| 1922 | 850,929 | |
| 1923 | $213,324 | |
| 1924 | 351,168 | |
| 1925 | 229,906 | |
| 1926 | 397,081 |
OPINION.
MURDOCK: The petitioner argues, and we agree, that the adjust ment on the notes was not made in settlement of damages for breach contract. Thus, , does not apply. Neither was it a gift. Cf. . Counsel for the petitioner has ably and forcefully set forth the arguments and authorities in support of the petitioner's contentions. Yet, no case is cited which is directly in point. Many cases are cited where cancellation of debts was held not to result in income to the debtor. But it is a significant fact that in each the debtor was insolvent. *1164 The petitioner was solvent. Cf. . Furthermore, we can not say, as was said in , that the result of the entire transaction was a loss. If it appeared that the $300,000 was compensation for loss, then of course the petitioner would not be entitled to the deduction of $51,723.29 which the Commissioner has allowed for 1927 on account of loss on machinery and equipment purchased from the International Harvester Company. A loss may be deducted only where not compensated for by insurance or otherwise. Under that view of the case the petitioner would have been compensated for the loss and not entitled to the deduction.
The petitioner did not segregate on its books the business of manufacturing, selling and servicing the Champion machines from its other business. Consequently, it must resort to various estimates to show the amount it was required to spend as a result of receiving defective equipment and machines from International Harvester Company. Extra expense in the pattern shop, consisting of labor and material, was estimated to have amounted to*1165 $80,000 or $90,000. A witness estimated that 80 per cent of the machines sold in the Argentine required servicing at $25 each and about 4,000 machines were sold. Another estimate was that the petitioner had lost $323,991 on the sale and servicing of the Champion line. This estimate was arrived at by multiplying the known number of each kind of machine by a cost price and a selling price. The difference, gross profit, was reduced by 25 per cent of sales price, representing administration and selling expense, and by extra servicing, arrived at by multiplying $15 by 80 per cent of the number of machines sold. However, more than one-third of the machines were manufactured by the petitioner. The cost of these was not shown. Instead, their cost was assumed to be the same as those purchased from the International Harvester Company. The evidence does not show that normal selling and administration expenses were 25 per cent of the sales price. Furthermore, the cost of servicing and the number serviced were estimated in an offhand fashion, without reference to any records. Thus, we can have no confidence in the estimate made, and can not find that the petitioner suffered an actual*1166 loss from its *1399 Champion business. The most shown by the record is that profits were less than they would have been had the manufacturing equipment and finished goods obtained from the International Harvester Company been up to expectations.
We are satisfied that the petitioner was put to considerable expense on account of the defects in machines and equipment purchased, and we feel reasonably sure that the additional expense to which it was put exceeded the amount of the canceled notes. It has deducted in past years most, if not all, of these expenditures from income through cost of goods sold, ordinary and necessary expenses and other means. Deductions for depreciation and loss, the latter allowed for the year before us, have permitted the petitioner to offset the entire cost of the manufacturing machinery against income. These deductions were based upon the assumption that the company would actually pay the costs accrued as liabilities.
The cost of this machinery and the cost of goods manufactured for the petitioner by the International Harvester Company, as originally agreed upon, were accrued on the petitioner's books in an open account. *1167 At a time when this account showed a large amount owing from the petitioner to the International Harvester Company, the petitioner gave its notes for the balance due. This transaction had no significance from an income standpoint. Later, some of the notes, having a total face value of $300,000, were canceled by the International Harvester Company. The cancellation took place in the taxable year before us. If all of the petitioner's transactions with the International Harvester Company had taken place in one year, the adjustment necessitated by the note cancellation probably would have been accomplished by eliminating the basis for depreciation and loss on the manufacturing machinery and reducing inventory and cost of goods sold. Cf. . The effect of this would have been to increase net income for that year and perhaps for some later years. The total increase in net income would have amounted to $300,000.
But the various transactions did not take place in one year. Instead, they were spread out over ten years. Income or loss of the first nine years has been computed on an accrual basis on facts known in those years, *1168 as was proper. In the tenth year it was known for the first time that $300,000 theretofore accrued as cost liability and offset against income would not have to be paid. It is not proper or possible to go back over prior years and adjust income in the light of this new development. Cf. ; ; ; . Does the fact that the cancellation occurred in the tenth year after almost all of the cost had been offset against income, and after it was too late to change the tax situation for prior years, deprive the cancellation of incometax significance?
In , the Court said:
Here there was no shrinkage of assets and the taxpayer made a clear gain. As a result of its dealings it made available $137,521.30 assets previously offset by the obligation of bonds now extinct. * * * The defendant in error has realized within the year an accession to income, if we take words*1169 in their plain popular meaning, as they should be taken here.
In the present case there was no shrinkage of assets. The whole transaction was of a business nature, entered into for profit. As a result of its dealings resulting in cancellation, not only was there an improvement in the balace sheet and a bookkeeping profit, but also $300,000 of assets, previously offset by the obligation of the notes now extinct, were made available to the petitioner. Why was this not an accession to imcome in plain popular terms, whether a forgiveness of indebtedness or a revision of the original contract? While in a sense it was a return of expenditures made in purchasing its machinery and producing and selling its merchandise, still these expenditures were made in conducting its business for the purpose of making profits. The use of fixed accounting periods requires that the amount by which expenses, once deducted because paid or accrued, are reduced by later adjustments must be taken into income in the year of the adjustment. Only in this way can the amount of the taxpayer's reported income be made to agree with its actual income. We, therefore, hold that the amount in question was imcome*1170 to the petitioner for the year 1927. Cf. ;; ; affirmed on this point, ; certiorari denied, ; ; affd., ; ; ; (this point not passed on by Circuit Court of Appeals).
Judgment will be entered for the respondent.