*3118 1. Claim for deductions for losses, in addition to the amounts allowed by the respondent, denied where books of account were kept on cash basis.
2. Income taxes imposed by and paid to the Government of Great Britain and Irelandheld not deductible under the Revenue Act of 1918.
3. Interest on foreign government bonds owned by petitioner, a foreign corporation, is not income from sources within the United States. Standard Marine Insurance Co., Ltd.,4 B.T.A. 853">4 B.T.A. 853.
*1057 The respondent determined deficiencies in income and profits taxes for 1918 in the amount of $129,430.51, an overassessment for 1919 of $305.18, and a deficiency in income tax for 1920 of $109,842.86.
The errors alleged are: (1) The refusal of the respondent to allow deductions for losses sustained, accrued and/or incurred during 1918, 1919, and 1920 arising out of liability and workmen's compensation insurance contracts. (2) The refusal of the respondent to allow as deductions for*3119 the years 1918, 1919, and 1920 taxes imposed by and paid to the Government of Great Britain and Ireland on income derived from sources within the United States. (3) The inclusion in income by the respondent of interest received on the bonds of various foreign governments. (4) The failure of the respondent to correctly compute profits tax under section 328 of the Revenue Act of 1918. This last issue relates only to the year 1918 and upon motion of petitioner the trial of it has been postponed pending decision of the other questions.
*1058 FINDINGS OF FACT.
Petitioner is a British corporation with its head office in London, England, but with a principal office for its operations in the United States located in New York City. It is and was during the taxable years regularly licensed and admitted to the United States for the transaction of miscellaneous casualty insurance lines, including liability and workmen's compensation insurance. In January, 1918, a branch, known as the Pacific Coast Branch, was established in San Francisco, Calif., and operated throughout the remainder of the taxable years here involved. The petitioner is represented in the United States by a*3120 manager and attorney in fact who has full power to sign any and all documents in connection with its financial affairs in this country.
Liability insurance is based on the law of negligence and in a broad sense embraces all kinds of public liability insurance. Workmen's compensation insurance is a form of liability insurance under which the insurer contracts to indemnify the insured for a percentage of the wages of injured employees.
Under the laws of the State of New York in force during the taxable years, casualty insurance companies were required to maintain reserves for outstanding losses in amounts based on a percentage of the earned premiums. The maintenance of this reserve, commonly known as a minimum legal reserve, was compulsory without regard to the amount of losses, and the superintendent of insurance was empowered to require an increase in the reserves if in his opinion the minimum legal reserves were inadequate. During the taxable years petitioner reported reserves for unpaid liability and workmen's compensation losses computed in accordance with the statutory formula. It carried no voluntary additional reserves on these classes of insurance and the superintendent*3121 of insurance did not require any addition to the amounts reported. The reserves reported were as follows:
| Net additions | |||
| Date | Reserves | Amount | Year |
| Dec. 31, 1917 | $2,482,885.46 | ||
| Dec. 31, 1918 | 4,549,920.02 | $2,067,034.56 | 1918 |
| Dec. 31, 1919 | 6,556,807.96 | 2,006,887.94 | 1919 |
| Dec. 31, 1920 | 7,170,973.64 | 614,165.68 | 1920 |
These net additions to the reserves have been allowed by the respondent as deductions from gross income for the respective years.
In the taxable years petitioner actually paid out for losses sustained the following amounts:
| Year | Liability insurance | Workmen's compensation insurance | Total |
| 1918 | $1,360,395 | $2,496,230 | $3,856,625 |
| 1919 | 1,340,227 | 2,641,002 | 3,981,229 |
| 1920 | 1,509,569 | 3,450,513 | 4,960,082 |
*1059 These amounts have been allowed by the respondent as deductions from gross income for the respective years.
There was maintained in petitioner's organization a department known as the claim department, and another designated as the statistical department. When an accident or injury covered by a policy written by petitioner was reported to it an investigation was instituted and an amount*3122 representing petitioner's probable liability under the policy was entered by the claim department in a folder or jacket prepared for that particular case. In determining the amounts so entered the claim department made use of mortality, remarriage, and other actuarial tables. In the case of workmen's compensation insurance the amounts to be paid an injured person are regulated by State statutes and are based on a percentage of the wages of the injured party. Reports covering these cases are filed with the industrial or compensation commissions of the various States. The amounts entered in the folders or jackets are transcribed on claims cards and then transferred to machine cards which are punched in such manner that by passing them through a second machine the amounts and other data are automatically summarized for the use of the statistical department. The estimates so set up were constantly revised as reports were received on individual cases. This procedure was followed in both the main office in New York and the Pacific Coast Branch. The totals of the estimates made at the Pacific Coast Branch for the years 1918 and 1919 were entered on a typewritten sheet headed "Pacific*3123 Coast Branch Revenue Account." This sheet was forwarded to the New York office.
Petitioner's experience based on actual payments subsequently made shows that the estimated amounts for alleged losses sustained, but unpaid, were within 1 7/40 per cent of being accurate.
As of December 31, 1917, and the close of each of the taxable years petitioner set up on summary sheets amounts claimed as sustained, but unpaid, losses. These amounts, including similar summaries for the Pacific Coast Branch, and the increase for each of the taxable years are as follows:
| Date | Liability claims | Compensation claims | Total | Increase |
| Dec. 31, 1917 | $1,263,352 | $1,932,091 | $3,195,443 | |
| Dec. 31, 1918 | 1,410,175 | 2,696,145 | 4,106,320 | $910,877 |
| Dec. 31, 1919 | 1,485,132 | 3,431,397 | 4,916,529 | 810,209 |
| Dec. 31, 1920 | 1,442,559 | 3,519,943 | 4,962,502 | 45,973 |
*1060 These estimates were not entered on petitioner's books as liabilities. The estimates were, however, considered necessary to determine the financial condition of the company and to fix premium rates.
The method most generally used by casualty insurance companies to determine the amount of their losses in any*3124 year is to deduct the accrued, but unpaid, losses as of the beginning of the year from the similar accruals at the end of the year and add to the resulting figure the losses paid within the year. This method applied to the figures claimed by petitioner to represent its accruals for sustained, but unpaid, losses, and using the amounts actually paid for losses, gives the following result:
| 1918 | 1919 | 1920 | |
| End of year | $4,106,320 | $4,916,529 | $4,962,502 |
| First of year | 3,195,443 | 4,106,320 | 4,916,529 |
| Difference | 910,877 | 810,209 | 45,973 |
| Paid | 3,856,625 | 3,981,229 | 4,960,082 |
| Total claimed loss | 4,767,502 | 4,791,438 | 5,006,055 |
Petitioner paid income taxes to the Government of Great Britain and Ireland, on the basis of profits from all sources, as follows:
| Amount | Paid | For year ended | Entered as liability |
| $527,201.46 | 1919 | Apr. 5, 1918 | 1918 |
| 493,320.13 | 1920 | Apr. 5, 1919 | 1919 |
| 550,642.45 | 1921 | Apr. 5, 1920 | 1920 |
The taxes for each year were computed on the basis of the average annual net profits for the three preceding years. Petitioner's average annual net profits from all sources and the portion thereof derived from its United*3125 States Branch were as follows:
| Years | (a) All sources | (b) United States Branch | Percentage (b) of (a) |
| 1915, 1916, 1917 | Pound 373,618 | Pound 114,747.17.1 | 30.7 |
| 1916, 1917, 1918 | 447,819 | 174,772.13.7 | 39.03 |
| 1917, 1918, 1919 | 469,178 | 208,085.10.11 | 44.3 |
Petitioner's gross income for each year from all sources and the portion thereof derived from its United States Branch were as follows:
| Year | (a) All sources | (b) United States Branch | Percentage (b) of (a) |
| 1918 | $25,693,061.05 | $15,913,955.23 | 61.9 |
| 1919 | 29,661,091.97 | 17,419,379.78 | 58.7 |
| 1920 | 36,425,460.85 | 20,508,777.54 | 56.3 |
*1061 The portion of British income taxes for each year allocable to gross income from the United States branch on the basis of the percentage of such income to income from all sources is as follows:
| 1918 | $326,337.70 ($527,201.46X61.9 per cent) |
| 1919 | 289,578.91 ( 493,320.13X58.7 per cent) |
| 1920 | 310,011.70 ( 550,642.45X56.3 per cent) |
Total net premiums and the portion thereof from the United States Branch were as follows:
| Year | (a) Total net premiums | (b) United States Branch | Percentage (b) of (a) |
| 1918 | Pound 3,769,260.13.9 | Pound 2,288,446.15.8 | 60.71 |
| 1919 | 4,333,288.14.10 | 2,464,466.17.2 | 56.94 |
| 1920 | 5,495,007 | 3,062,095 | 55.72 |
*3126 During the taxable years the petitioner owned certain bonds of foreign governments, to wit, bonds of the British Government, known as the United Kingdom of Great Britain and Ireland, 10-year convertible 5 1/2 per cent bonds due in 1922, and certain bonds constituting a joint obligation of the Governments of Great Britain and Ireland and of the French Republic, known as Anglo-French 5-year External Loan bonds, due in 1920. Interest on these bonds was paid to petitioner by the obligors when it was due during the taxable years in amounts as follows:
| 1918 | $15,470.83 |
| 1919 | 19,391.67 |
| 1920 | 15,134.77 |
Respondent included these amounts in petitioner's gross and taxable net income for the several years as income from sources within the United States.
The respondent determined petitioner's net income in the following amounts:
| 1918 | $1,041,956.99 |
| 1919 | 734,966.22 |
| 1920 | 1,868,103.41 |
For the year 1918 respondent computed petitioner's profits tax under section 328 of the Revenue Act of 1918.
OPINION.
ARUNDELL: The respondent has determined deficiencies for the years 1918 and 1920 and on overassessment for the year 1919. Inasmuch as the petitioner*3127 contends that it had a net loss for both 1918 and 1919 which would result in the alleged 1919 net loss being applied against 1920 income, we have jurisdiction to examine the facts with respect to the year 1919 in so far as they may affect taxes for *1062 1918 and 1920. Section 274(g) of the Revenue Act of 1926. The losses paid by petitioner in the several years involved and the additions required by law to be made to reserve funds have been allowed by the respondent as deductions and are not in controversy here.
The claim of petitioner is that it is entitled to deductions of additional amounts which were estimated by its claim department upon claims received as representing petitioner's probable liability on policies it had written. It is the contention of petitioner that these amounts are allowable under section 234(a)(10) of the Revenue Act of 1918, which allows as deductions "the sums other than dividends paid within the taxable year on policy and annuity contracts." The amounts claimed as deductions were not actually paid within the taxable years, but petitioner says that its method of setting up the amounts brings it within section 200, which provides that for the*3128 purposes of deductions and credits the term "paid" means "paid or accrued" or "paid or incurred."
If petitioner is entitled to deduct by way of an accrual the items sought to be deducted, it is clear that it must establish that its books were kept on a basis other than that of cash receipts and disbursements. It is well to have before us in reaching a conclusion on this point the testimony of petitioner's comptroller, which, in so far as it is material, reads as follows:
Direct Examination:
Q. During the years 1918, 1919, and 1920, do you know whether the books of the petitioner and its records were kept on an accrual basis?
* * *
A. The books of the petitioner and its records were kept on an accrual basis. Cross Examination:
Q. But you made no entry on your books of account with respect to these reserves.
A. No entry on the books of account was made as to the reserves. The books of account show cash income and cash disbursements.
Q. Now, you have just made a statment in reply to a question that the books of account were kept on an accrual basis, have you not?
A. I did not. I said that the records were kept on an accrual basis. I did not say the books*3129 of account.
Q. Well, how were the books of account kept?A. The books of account reflect the cash income and cash disbursements.
Q. Then, they were kept on a cash basis?A. Yes. Now, you are talking about reserves still, aren't you?
Q. I am talking about the books of account. A. All right.* * *
By the Member:
Q. Are any items accrued on your books other than these claims that are here?
A. No; no reserves for items are accrued on our books of account; that is, I mean on our general ledger. Of course, when I say "accrued" I mean subjects of reserves and liabilities.
*1063 Q. Well, are your books, other than in connection with this reserve, kept on the cash basis?
A. They are kept on the cash basis.Q. And this particular item is the only item that is on the accrual basis, the estimate of the claims?
A. None of your estimates - anything that is not reduced to a known factor would not be put on your general books. When it comes to taxes, the best you could do would be to estimate your liability for taxes. Such a liability would not go on the books. Do you wish me to explain the purpose of the annual statement?
From this*3130 testimony one thing is clear - that petitioner's books of account, as its witness understood that term, were kept on a cash receipts and disbursements basis. The "records" which, according to the testimony, were kept on an accrual basis, consist of the books of account and the summary of the estimates to cover petitioner's probable liability in cases of reported accidents and injuries. We seriously doubt whether these estimates can be said to be a part of petitioner's accounting records for the purpose of determining income, the evidence being to the effect that the estimates were made and summarized for statistical purposes, for the purpose of determining the financial condition of the company, and to determine premium rates. Neither the estimates on individual cases nor the summaries were ever entered on the ledger or other books of account. It may well be that the scope of petitioner's business required the maintenance of records of the different phases of its business for various purposes, for example, such as making reports to the States in which incorporated and in which it operates, for advertising purposes, for the information of its solicitors; but it does not follow that*3131 all such records are parts of the accounting system maintained for the purpose of determining income.
Even if we were able to find that the estimates of losses as summarized constituted a part of petitioner's accounting system, this would still be short of establishing that the accrual system prevailed and that accruals are necessary in order to reflect income. These items relfect claimed accrued losses in respect of only two lines of insurance written by petitioner. Whether it accrued unpaid losses for other lines, and whether it accrued items of expense and incom is not shown, nor was any attempt made to put in evidence on this point. The only conclusion we can reach from the evidence is that the books of account were kept on a cash receipts and disbursements basis. Having reached the conclusion that we have, it becomes unnecessary to decide whether or not, if other methods of keeping its books of account had been followed, estimates or claimed losses might be deducted. No testimony was offered as to the history of individual claims; whether in fact petitioner conceded its liability in any specific case, and which claims, if any, it in fact was ever required to pay.
*1064 *3132 As to the taxes imposed by and paid to the Government of Great Britain and Ireland, the claim is that a part thereof represented taxes on income from sources within the United States and that such part is an allowable deduction under certain of the provisions of section 234 of the Revenue Act of 1918. These provisions read as follows:
SEC. 234. (a) (3) Taxes paid or accrued within the taxable year imposed * * * (e) in the case of a foreign corporation, by the authority of any foreign country (except income, war-profits and excess-profits taxes, and taxes assessed against local benefits of a kind tending to increase the value of the property assessed), upon the property or business: * * *
SEC. 234. (b) In the case of a foreign corporation the deductions allowed in subdivision (a) * * * shall be allowed only if and to the extent that they are connected with income arising from a source within the United States; * * * (Italics ours.)
It is obvious that the income taxes paid to the Government of Great Britain and Ireland are not deductible under section 234(a)(3); they are expressly excepted from the deductible taxes. Subdivision (b) of section 234 refers to the deductions*3133 allowed in subdivision (a), and as the taxes here involved are not allowed as deductions in subdivision (a), the provisions of subdivision (b) are not applicable. Petitioner argues that the two subdivisions when read together must be construed to provide that foreign income and profits taxes are to be apportioned on the percentage of income derived from sources within the United States to the total income and allowed as a deduction; that otherwise there would be no meaning to subdivision (b) because we can not have a tax "connected with income" which is not an income tax. This is not necessarily so. It seems to us that the corporation excise tax imposed by the Act of 1909 is a good illustration of a tax connected with income but which nevertheless was not an income tax.
That the interest received by petitioner on bonds of foreign governments was improperly included in income is now conceded by the respondent in view of the decisions in , and . These amounts are: $15,470.83 for 1918; $19,391.67 for 1919; and $15,134.77 for 1920. In so far as the deficiencies*3134 result from the inclusion of these amounts in income, they will be revised under Rule 50. In other respects the respondent's determinations for the years 1919 and 1920 are approved and the case in so far as those years are concerned will be closed under the Rule 50 settlement. As to 1918 the case will be retained on the docket for further proceedings under Rule 62.
Judgment will be entered under Rule 50.