*2905 1. A company owned a one-half interest in fee of an iron mine which was operated by another company under an operating agreement. The fee owner included in its account of income only money actually received from the operating company. The operating company kept complete records of the operations of the mine on the accrual basis. Held, that the fee owner was engaged in the operation of an iron mine and its income would not be properly reflected by its own book alone and should also be based upon the books and records kept by the operating company on the accrual basis.
2. Invested capital for 1917 can not be computed under section 207(a)(2) of the Revenue Act of 1917 in the absence of proof of the value of assets for which stock was specifically issued.
*830 In this proceeding the petitioner seeks a redetermination of the income and profits taxes for the calendar years 1917, 1918, and 1919, for which the Commissioner has determined deficiencies of $27,721.65, $24,274.35, and $8,422.41, respectively. The petitioner*2906 alleges error on the part of the Commissioner (1) in failing to recognize the petitioner as a joint operator of an iron mine under the terms of a certain contract dated January 2, 1913, and in consequence in failing to compute income based upon the books of account containing the records of mine operation, and instead thereof, in holding that the petitioner's income should be computed on the basis of cash receipts and disbursements instead of on the accrual basis; (2) in failing to recognize the element of constructive receipts under clause 11 of the above mentioned contract; (3) in erroneously computing the invested capital for the year 1917 by failing to find that the January 1, 1914, value was in excess of the par value of the stock specifically issued for the assets, and for all years in failing to take into consideration accrued income and inventories.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the State of Minnesota, with its principal place of business in Duluth, Minn.
In 1897 the petitioner purchased a one-half fee interest in an iron ore mine known as the Norman Mine in consideration for the issuance of $300,000 par value of its*2907 capital stock plus $35,000 in cash or its *831 equivalent. Prior to January 2, 1913, the Norman Mine was leased to an operator on a royalty basis. On January 2, 1913, the petitioner, together with the owners of the remaining fractional fee interests, entered into a joint operating agreement with the Oliver Iron Mining Co. which provided in part as follows:
The parties of the first part were the Leon Iron Company, the Higgins Company, Gilbert Investment Company, corporations, and Clara A. H. Smith and Frank Sullivan Smith, her husband, and the party of the second part was the Oliver Iron Mining Company.
WHEREAS, a large amount of merchantable iron ore remains in said land and all of the parties hereto have fully informed themselves of the present condition of said mine and the probable cost of mining the said ore therefrom, and it is the mutual desire of the parties hereto to enter into this agreement for the mining and marketing of said ore for the joint account of the first and second parties, the profits and losses to be divided upon the basis of seventy-five per cent (75%) to the first parties and twenty-five per cent (25%) to the second party as hereinafter provided:
*2908 NOW THEREFORE, in consideration of one dollar and other things of value paid the first parties by the second party, the receipt whereof is hereby acknowledged, and in consideration of the mutual covenants and promises of the parties as herein set out, it is agreed as follows:
FIRST: That the second party shall, beginning on the 2nd day of January, A.D. 1913, commence the operation of said mine and mine and market the merchantable iron ore therefrom and continue such operation as herein provided for until said merchantable ore in said mine is exhausted and until this agreement is terminated as provided for herein. It is agreed that the second party shall have the direct supervision of the mining operations; shall take out the merchantable ore and shall ship the same and said ore may be purchased by the second party or sold by the second party to any person, firm or corporation that it shall see fit, provided no commission for the sale of ore shall be allowed, and the market price of ore at the "Lower Lake Ports" as fixed in the market from year to year for the ensuing shipping season shall control the price of all ore for such season to be mined and taken out under this contract*2909 as herein specified. The second party shall employ all labor, purchase all machinery, make all repairs and expend all moneys of every nature and description provided for herein, for the purpose of mining and shipping said ore, and shall charge such expenditures to joint account.
SECOND: In arriving at the cost of mining for the purpose of settlement hereunder, the items of expense that shall be allowed shall be all those expenses incurred under the headings of the second party's mining cost sheet (included in which costs are proration of district laboratory costs and proration of district office expense), a copy of which is hereto annexed marked Exhibit "A" and expressly made a part hereof, with the following exception: no depreciation of equipment shall be allowed the second party, nor interest upon the value of such equipment or upon any of the improvements of the second party at said mine or hereafter purchased or made, pursuant to the terms of this contract, neither shall any allowance be made the second party on account of development work of said mine made by it up to date; and the second party shall allow the use, free of charge, of the shaft located on the adjoining property*2910 known as the Ohio Mine, for the mining of the ore on the land covered by this contract. It is further agreed, however, that all purchases for repairs of said equipment or supplying or replacing worn out, damaged or destroyed machinery and other *832 property for the use of said mining carried on under this contract, shall be considered as a part of the mining costs herein.
THIRD: Except as hereinafter specifically provided, no allowance shall be made to the second party on account of moneys or damages paid out for personal or other injuries suffered by employees or others at said mine during the life of this contract, but an allowance of four per cent on the pay-roll shall be allowed the second party to cover such expenses, and in consideration of such allowance the second party agrees to pay all claims for damages of every nature and description sustained by employees or others in the mining operations and the carrying on of the work under this contract. The method of litigating all claims for injuries and paying damages on account of the same, whether to persons or property, is to be carried on by the second party in the same way that it carries on business of like nature, *2911 concerning its other mining operations on the Missabe Range, and except as hereinafter specifically provided, no allowance shall be made to the second party on account of the following named costs or over-head charges, to-wit:
a. General District Superintendence;
b. Insurance on buildings of the second party at said mine;
c. Bookkeeping in General Offices;
d. Services as required of District Master Mechanic;
e. Services of District Boss Carpenter;
f. Services of General Mechanic and Mining Engineers;
g. Services of Claim Agents, Claim Departments and Attorneys in investigating, litigating and setting claims against the Company on account of mining operations carried on hereunder;
h. Services in shipping, selling and marketing of ores gotten out pursuant to the terms of this contract; But the second party hereby agrees to furnish all such services enumerated in items designated a to h inclusive hereinabove, as may be required in the carrying out of this contract, and shall receive as full compensation therefor the sum of four cents per ton on each ton of merchantable iron ore mined from said mine pursuant to the terms of this agreement, and such sum of four cents*2912 per ton shall be accepted by the second party in full satisfaction of all claims for such services and services of every nature and description not herein specifically set out or covered by said Exhibit "A"; and the said four cents per ton shall be charged to joint account.
FOURTH: It is further understood and agreed that the second party shall furnish all fuel and explosives for the carrying on of the mining operations hereunder, and the prices for such fuel and explosives shall not exceed the fair market price that mining operators on the Missabe Range pay for like materials, and the exact price of such fuel and explosives consumed, if a price is allowed less than said market price, shall be agreed upon and settled by Mr. Joseph Sellwood and Mr. William J. Olcott.
FIFTH: It is further agreed that the second party shall be allowed as a part of the costs hereunder the actual charges for freight, both lake and rail, for transporting said ore from the mine to the Lower Lake Ports, including all dockage, storage and unloading charges, provided the same is sold at such Lower Lake Ports; it being the intention hereof that the actual charges for freight and transportation paid by the*2913 second party for handling the ore from the mine to the place where said ore is sold shall be allowed said second party as a part of the expense hereunder and deducted from the sale price of said ore as herein specified. The second party shall be allowed in addition to the transportation charges herein specifically provided for, one mill per ton on all merchantable iron ore transported on the Great Lakes, as marine insurance on account of lake transportation, and the second party hereby *833 agrees to insure all ore at its full insurable value, shipped by vessel in consideration of being allowed said one mill per ton as aforesaid.
SIXTH: It is further agreed that the amount of ore to be taken from said mine in any one year during the life of this contract shall be fixed by the first parties, the tonnage and grades to be designated in writing, such writing to be signed by two persons authorized and designated in writing by the first parties to act for such first parties in said capacity. * * *
EIGHTH: The second party agrees to advance all moneys necessary to carry on the mining and transportation operations provided for by this contract and shall be allowed as interest*2914 on all moneys so advanced the sum of five per cent per annum during the time that the moneys so advanced are in actual use hereunder; provided all moneys when in the hands of the second party from the sale of ore and not disbursed as herein provided for, shall be deducted from the amount of money advanced by second party for the carrying on of the operations under this contract, in-so-far as the computation of interest on advancements is concerned.
NINTH: The second party, during the life of this contract, shall pay all taxes and assessments, general or special, of every nature or description that shall be levied or assessed against the property used in operating said mine and said ore and said land hereinabove described; the amount of such taxes and assessments shall be charged to joint account, except the taxes on the land and the mine hereinabove described for the year 1912 and which must be paid prior to the 1st day of June, 1913, to avoid a penalty, shall be paid by the second party, for which no reimbursement shall be made.
TENTH: The second party shall explore said land at such times and in such manner as the first parties acting jointly shall direct through their respective*2915 agents appointed as hereinbefore provided for, and the expense of such exploration shall be paid for as an expense of mining operation and shall be charged to joint account as other costs of mining, before a division of the profits is made, as herein specified.
ELEVENTH: The second party agrees to mine, ship, take or sell said ore each year during the life of this contract as hereinabove provided for, and out of the proceeds received for the ore so disposed of, it shall first deduct all of the moneys advanced by or due it, pursuant to the terms of this agreement, including the expenses and costs of mining and transportation as specified above, and the balance of the said proceeds, if any, shall be divided as follows: the second party shall retain twenty-five per cent (25%) thereof, and shall pay to the first parties according to their pro rata ownerships in the fee of said land as hereinafter specified, the balance thereof, to-wit: seventy-five per cent (75%) of such proceeds. The second party shall pay the first parties said seventy-five per cent (75%) of said proceeds every three months during the life of this contract, commencing the 1st day of April, A.D. 1913. * * *
The*2916 first parties expressly reserve unto themselves, (and the second party agrees) that the first parties or any of them shall have the right in person or by their agents or servants, to enter into or upon the above described premises and any part or parts thereof at any time or times to inspect and survey the same. The second party shall have no right to assign or sublet this contract or any part thereof without the written consent of all the first parties, their successors, executors, administrators, heirs or assigns, as the case may be, indorsed upon the back of this contract and signed, and any voluntary or involuntary assignment of this contract by the second party without such consent shall, at the option of the first parties exercised in writing, terminate this contract.
*834 When the merchantable ore is all taken from said mine, pursuant to the terms of this contract, the second party shall have the right to remove therefrom all of the property used by it in connection with its mining operations, and when all the moneys received from the sale of said ore are disbursed and all accounts adjusted according to the terms of this contract, the same shall be terminated. Complete*2917 and accurate monthly statements in the form of Exhibit "A" shall be furnished each of the first parties by the second party during the life of this contract, of all expenses incurred and moneys paid out of every nature and description during the preceding month. Such statement shall also include all other items herein provided for and shall include the quantity of ore mined, shipped or stockpiled.
TWELFTH: It is the express intention hereof that the mining operations hereunder shall during the existence of this contract be conducted on such a scale at least as shall be sufficient to warrant the second party in maintaining upon said mine and in connection therewith a mining organization adequate to carry on the business of mining continuously at said property, and that when it is no longer profitable to maintain such organization and merchantable ore cannot longer be mined from said property at a profit by such continuous working, said mine shall be deemed to be exhausted; and in case of any dispute as to whether said mine is exhausted said question shall be submitted to arbitration and be finally determined in the same manner as provided in subdivision Seventh hereof.
It is*2918 further agreed and understood between the parties hereto that if said mining enterprise in any calender year results in a loss, as shown by said joint account, said loss shall be adjusted at the end of such year or as soon thereafter as conveniently may be, and the first parties shall pay three-fourths, and the second party one-fourth, of such loss.
The second party shall not be liable for damages or failure to perform this contract when and in-so-far as it may be prevented from so doing by riots, strikes or unavoidable accidents at the mine or on railroads, docks or vessels or by act of God or of the public enemy.
THIRTEENTH: In consideration hereof the second party hereby surrenders the mining lease hereinbefore described, and the first parties hereby accept said surrender and acknowledge that all other agreements between the parties with reference to said premises, or in connection therewith, are hereby terminated, and in consideration hereof and for other good and valuable considerations, hereby acknowledge the settlement and adjustment of all claims and demands of every nature whatsoever and hereby expressly relieve and discharge the second party from all obligations or*2919 liabilities heretofore existing or which may ever exist on account of said mining lease or its mining operations thereunder and hereby accept said property and authorize the second party to enter into the possession of the same under this contract as an entirely new transaction.
FOURTEENTH: The first parties, and each of them, by their deputed agent or agents in writing shall have the right, from time to time, to inspect and verify and take copies of all books of account, documents and papers, including blue prints, surveys, exploration reports, analysis reports and all other records relating to said Norman Mine and used or employed by the second party in conducting said mining enterprise and carrying out and performing this contract.
Pursuant to this agreement the Oliver Iron Mining Co. operated the property and kept books of account of the operations of the mine. These books were kept on the accrual basis, and there was represented therein inventories of iron ore. The Oliver Iron Mining Co. made *835 distributions of profits as provided for in the agreement, but retained possession for the benefit of the mine at the end of each year a certain portion of the profits*2920 previously earned from the operation to provide working capital for future operations, so that the actual cash distribution to the fee-owning parties did not represent in any year the profits from the operation of the mine as determined in the books of account kept by the Oliver Iron Mining Co.
The petitioner was engaged in no business during the years involved other than its participation and operation of the Norman Mine, and the records maintained by it consisted of monthly, quarterly, and annual statements furnished by the Oliver Iron Mining Co. in accordance with the agreement, giving records of operating details, ore production, ore sales, accounts receivable, inventories of ore and supplies. Other records consisted of a check book, a journal with no entries after December 31, 1912, and a ledger, the entries in which were made direct from one account to another without passing through any books of original entry. On the check stubs were entered all the amounts received and amounts disbursed by the petitioner during the years 1917, 1918, and 1919. The receipts are indicated as follows:
| Feb. 2, 1917 (Norman mine) | $81,220.62 |
| April 23, 1917 (Norman mine) | 100,796.25 |
| July 30, 1917 (Norman mine) | 18,414.80 |
| Nov. 23, 1917 | 375.00 |
| 200,806.67 | |
| May 6, 1918 | 202.20 |
| May 23, 1918 | 256.66 |
| June 24, 1918 | 15,060.42 |
| Dec. 19, 1918 | 256.10 |
| 15,775.38 | |
| Jan. 18, 1919 | 256.66 |
| Jan. 23, 1919 (Norman mine) | 125,056.12 |
| Feb. 5, 1919 (Norman mine) | 9,392.65 |
| Mar. 9, 1919 | 29.00 |
| Apr. 26, 1919 (Norman mine) | 27,562.65 |
| June 14, 1919 | 14,947.23 |
| July 28, 1919 (Norman mine) | 3,216.16 |
| Aug. 13, 1919 | 232.31 |
| Oct. 2, 1919 (Norman mine) | 39,042.42 |
| 219,735.18 |
*2921 The cash received by the taxpayer from the Oliver Company as shown by the check stubs and the income received from the Oliver Company, as determined by the Commissioner in the deficiency letter from which this appeal was taken, are as follows:
| Cash received from Oliver Co. as per check stubs | Income received from Oliver Co. as per deficiency letter | Difference | |
| 1917 | $200,431.67 | $217,484.11 | $17,052.44 |
| 1918 | None. | 98,530.66 | 98,530.66 |
| 1919 | 204,269.98 | 88,686.88 | |
| 404,701.65 | 404,701.65 |
*836 The item of $17,052.44 indicated in the last tabulation above represents the amount of a check mailed by the Oliver Company and received by the taxpayer in 1917, which check was returned to the Oliver Company by the taxpayer. The item of $98,530.66 appearing in the last tabulation above represents four checks mailed by the Oliver Company to the taxpayer and received by it during 1918, which checks were returned uncashed. The item of $125,056.12, appearing on the back of the check stub dated January 23, 1919, includes the items of $17,052.44 and $98,530.66, and interest thereon.
In its original returns for the years 1917, 1918, and 1919, the petitioner*2922 did not report any of the profits from the operations of the Norman Mine as taxable income either on an accrual or on a cash receipts and disbursements basis, on the theory that the amounts realized from operations represented conversion of assets from one form to another without profit.
The value of the petitioner's interest in the Norman Mine at January 1, 1914, was $400,111.
OPINION.
LANSDON: The issues and facts of this proceeding are fully set forth above. A careful study of the operating agreement convinces us that the fee owners of the Norman Mine and the Oliver Mining Co. were engaged in a joint venture. With this conclusion the respondent agrees, since his attorney, in his brief, says that "It is submitted that the taxpayer's attorney clearly designated the nature of the relationship created by the agreement dated January 2, 1913, as a joint venture." It follows, therefore, that the fee owners, including the petitioner, were engaged in the business of mining and selling iron ore, and that the profits therefrom should be accounted for in the respective years in which they were realized.
The Oliver Iron Mining Co. kept its books in the manner provided by the agreement*2923 and at regular intervals submitted copies of its accounts to the petitioner. Such accounts established no basis for ascertaining the income of the Oliver Iron Mining Co., since their sole purpose was to show the net profits flowing from the operation *837 of the mine under the agreement. No allowances were made for the depreciation of assets or for the depletion of the ore reserves. Many of the cash items were artificial, because they were based upon fair market value rather than actual outlay by the Oliver Iron Mining Co. In these conditions we are satisfied that the books so kept represented the accounting of the joint venture in which the petitioner had an interest. Except for a few expense items, the books kept by the petitioner were no more than a record of banking entries and certainly do not constitute a complete record in an accounting sense of the business in which it was engaged, and, therefore, do not reflect its true income for the taxable years here involved.
Section 212(b) of the Revenue Act of 1918, which deals with the bookkeeping methods of taxpayers, provides that, "if the method [of accounting] does not clearly reflect the income, the computation*2924 shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income." In the instant proceeding the petitioner realizes income when ore is sold from the property. Some of the profits were retained in the business to provide capital for future operations. Failure to include the amounts so retained in the computation of the petitioner's tax liability as and when received would permit such income to escape taxation in the year in which it was realized. We are of the opinion, therefore, that the income of the petitioner should be computed on the accrual basis and that the accounts of the Oliver Iron Mining Co. in respect of the Norman Mine in connection with the fragmentary books of the petitioner contain the proper and necessary data for such computation.
Inasmuch as we have held that the income of the petitioner should be based upon accruals, it is unnecessary to determine the question of constructive receipts, since all accrued items would be included in income in the year when such items were accruable.
This decision also necessitates a complete recomputation of invested capital, since the earnings and surplus for each year*2925 would be affected. For the year 1917 the petitioner claims that the January 1, 1914, value of its assets was in excess of the par value of the stock specifically issued therefor. In this connection it is noted that the one-half fee interest in the Norman Mine, acquired by the petitioner, was paid for with $300,000 par value of its capital stock and $35,000 in cash or its equivalent. We are not informed as to the value of the one-half fee interest on the date when acquired by the petitioner, and therefore are unable to find what proportion of such interest was acquired by the payment of stock. It is clear, however, that the issuance of stock did not purchase the entire half interest, and that a certain proportion thereof was paid for with cash. In view of *838 this situation we are unable to hold that the Commissioner erred in determining the invested capital for the year 1917, except to the extent that this decision affects the computation.
Reviewed by the Board.
Judgment will be entered under Rule 50.
MARQUETTE, SMITH, and TRAMMELL dissent.