*88 Decision will be entered for petitioner that there are no deficiencies.
Petitioner, a domestic corporation, is a wholly owned subsidiary of a Canadian corporation. The parent company owns and operates a radio station in Canada. Petitioner's business is to sell radio time over the parent company's station for its own account. During the taxable years 1938 and 1939 the parent company, under an arrangment with petitioner by which it was to be reimbursed for a part of its costs of operation, allocated a portion of its broadcasting costs of operating its radio station to petitioner. The respondent accepted this allocation in principle but, acting under section 45 of the Revenue Act of 1938 and the same section of the Internal Revenue Code, excluded from the total cost of operations certain amounts paid by the parent company to a third corporation "for sustaining programs and other broadcasting services." Held, that in so doing the respondent erred. The accounting records of the parent corporation and petitioner, except as to certain minor items which are not in dispute, correctly reflected the net income from the property and business of each of the corporations and were not*89 devised for the purpose of reducing or avoiding taxes by shifting or distorting income or deductions of either corporation from one to the other.
*523 This proceeding involves the determination by the respondent against petitioner of a deficiency in income tax for the calendar year 1938 of $ 570.80 and of deficiencies in income and declared value excess profits taxes for the calendar year 1939 in the amounts of $ 3,093.53 and $ 2,150.78, respectively. To this determination petitioner assigns errors as follows:
(a) The respondent erred in determining that the method used in apportioning broadcasting costs between Essex Broadcasters, Incorporated, and Western Ontario Broadcasting Company, Ltd., a Canadian corporation, of which petitioner is a wholly owned domestic subsidiary, does not clearly reflect petitioner's income for Federal Income Tax and Excess Profits Tax purposes.
(b) The respondent erred in determining that the amounts of $ 55,063.26 and $ 50,426.36 for the years 1938 and 1939 respectively paid to the Mutual Broadcasting Company by the Western Ontario Broadcasting*90 Company, Ltd., should be deducted before making the apportionment of broadcasting costs and before determining the proportionate amount of such costs which should be charged to petitioner.
Not all of the adjustments made by the respondent in determining the above mentioned deficiencies are contested, as will appear from our findings of fact.
*524 FINDINGS OF FACT.
Petitioner is a corporation duly organized and existing under and pursuant to the laws of the State of Michigan, with its principal office at Detroit. It filed its corporation income and excess profits tax returns for the calendar years 1938 and 1939 with the collector for the district of Michigan. It is a wholly owned subsidiary of Western Ontario Broadcasting Co., Ltd., sometimes hereinafter referred to as the parent company.
The parent company is incorporated under the laws of the Dominion of Canada and owns and operates the radio broadcasting station CKLW, with transmitter located at Windsor, Ontario. The parent company also maintains its own separate organization, including administrative and selling staff, and bears its own general and administrative overhead expense. Petitioner is maintained entirely for *91 the purpose of selling radio station time to local advertisers in Detroit and vicinity, collecting its own accounts, and having general management of the business thus secured, and bears its own general and administrative overhead expense.
The parent company provides the broadcasting facilities both for its own sales and for those of petitioner, and it is by reason of such facilities that petitioner is enabled to sell station time to local accounts in Detroit and vicinity.
The charges not borne directly by the respective companies are the broadcasting costs which consist of salaries of announcers, engineers direct operating costs of the station, program talent, newscast services, depreciation of broadcasting equipment, and other items as set out in the schedules attached to the tax returns filed for the years 1938 and 1939.
Broadcasting costs, whether incurred in Canada or the United States, are borne by the parent company and apportioned between the petitioner and the parent company in proportion to their respective sales volume.
In its tax return for the year 1938 petitioner reported a net loss of $ 18,131.57. In arriving at this net loss, in addition to other items of income and*92 other items of deductions not involved herein, petitioner, under item No. 5 of page 1 of its return, deducted from its gross receipts "cost of operations (from Schedule B-2) $ 114,307.64." Schedule B-2 attached to the return was an itemized list of the "Broadcasting Account" of the parent company for the calendar year 1938 showing a total cost of operations, sometimes referred to herein as "Broadcasting costs," of $ 175,688.36 which was apportioned to the parent company and petitioner on the basis of the net sales made by each company. Schedule B-2 showed net sales made by petitioner of $ 174,120.27 and net sales made by the parent company of $ 93,498.80, or *525 a combined net sales of $ 267,619.07. Upon this basis there was allocated to petitioner 174,120.27/267,619.07 of the total cost of operations of $ 175,688.36, or the above mentioned amount of $ 114,307.64. The items making up the total cost of operations (or broadcasting costs) may be summarized as follows:
| Mutual broadcasting costs | $ 55,063.26 |
| Depreciation | 18,454.68 |
| Amortization of broadcasting rights | 3,200.00 |
| All other costs (separate items need not be stated here) | 98,970.42 |
| Total cost of operations | 175,688.36 |
*93 The respondent excluded from the above mentioned total cost of operations all of the Mutual broadcasting costs of $ 55,063.26, $ 5,799.66 of the depreciation, and all of the amortization of broadcasting rights of $ 3,200, thus reducing the total cost of operations down to an amount of $ 111,625.44. He also reduced the net sales of the parent company from $ 93,498.80 to $ 38,435.54 by the amount of the Mutual broadcasting costs of $ 55,063.26. This also had the effect of reducing the combined net sales from $ 267,619.07 to $ 212,555.81. The respondent then apportioned the revised total cost of operations of $ 111,625.44 to the parent company and petitioner upon the basis of the revised net sales made by the parent company and the net sales of $ 174,120.27 made by petitioner, thereby allocating to petitioner 174,120.27/212,555.81 of $ 111,625.44, or $ 91,440.70, which he allowed as a deduction under item No. 5, supra, instead of the amount of $ 114,307.64 deducted on the return.
In a statement attached to the deficiency notice the respondent adjusted the net loss of $ 18,131.57 reported by petitioner as follows:
| Net income as disclosed by return (loss) | ($ 18,131.57) |
| Unallowable Deductions and Additional Income: | |
| (a) Broadcasting costs | 22,866.94 |
| Total | $ 4,735.37 |
| Nontaxable Income and Additional Deductions: | |
| (b) Capital stock tax | 169.00 |
| Net income as adjusted | $ 4,566.37 |
*94 Explanation of Adjustments
(a) It has been determined that the method used in apportioning broadcasting costs between your company and the Western Ontario Broadcasting Company, Ltd., a Canadian corporation of which you are a wholly owned domestic subsidiary, does not clearly reflect your income for Federal income tax and excess-profits tax purposes.
It is held that in determining the proportionate amount of the cost of operating radio station CKLW which should be charged you for broadcasting time, the amounts paid the Mutual Broadcasting Company by the Western Ontario*526 Broadcasting Company, Ltd., of $ 55,063.26 and $ 50,426.36 in 1938 and 1939, respectively, should be deducted before making the apportionment.
The adjustment is summarized as follows:
| Broadcasting costs deducted | $ 114,307.64 |
| Amount as corrected | 91,440.70 |
| Unallowable deduction | $ 22,866.94 |
See sections 41 and 45, Revenue Act of 1938, and Article 45-1 of income tax Regulations 101.
The foregoing reflects also the elimination of excessive depreciation applicable to assets of the parent company in amount of $ 5,799.66, as set forth in detail in the attached Exhibit A, and its charge of $ 3,200.00 for*95 amortization of broadcasting rights.
(b) * * *
In its tax return for the year 1939 petitioner reported a net income of $ 37,304.42. In arriving at this net income, in addition to other items of income and other items of deductions not involved herein, petitioner, under item No. 5 of page 1 of its return, deducted from its gross receipts "cost of operations (from Schedule D) $ 116,488.39." Schedule D attached to the return was an itemized list of the "Broadcasting Account" of the parent company for the calendar year 1939 showing a total cost of operations or broadcasting costs of $ 170,364.21, which was apportioned to the parent company and petitioner on the basis of the net sales made by each company. Schedule D showed net sales made by petitioner of $ 218,606.68 and net sales made by the parent company of $ 101,105.49, or a combined net sales of $ 319,712.17. Upon this basis there was allocated to petitioner 218,606.68/319,712.17 of the total cost of operations of $ 170,364.21, or the above mentioned amount of $ 116,488.39. The items making up the total cost of operations or broadcasting costs were the same kind of items as those for the year 1938 and are summarized as follows: *96
| Mutual broadcasting costs | $ 50,426.36 |
| Depreciation | 5,807.72 |
| Amortization of broadcasting rights | 3,200.00 |
| All other costs (similar to those of 1938) | 110,930.13 |
| Total cost of operations | 170,364.21 |
The respondent excluded from the above mentioned cost of operations all of the Mutual broadcasting costs of $ 50,426.36 and all of the amortization of broadcasting rights of $ 3,200, and added to the cost of operations an additional allowance for depreciation of $ 4,286.65, thus reducing the net total cost of operations to an amount of $ 121,024.50. He also reduced the net sales of the parent company from $ 101,105.49 to $ 50,679.13 by the amount of the Mutual broadcasting costs of $ 50,426.36. This also had the effect of reducing the combined net sales from $ 319,712.17 to $ 269,285.81. The respondent then allocated *527 to petitioner 218,606.68/269,285.81 of $ 121,024.50, or $ 98,247.90, which he allowed as a deduction under item No. 5, supra, instead of the amount of $ 116,488.39 deducted on the return.
In a statement attached to the deficiency notice the respondent adjusted the net income of $ 37,304.42 reported by petitioner as follows:
| Net income as disclosed by return | $ 37,304.42 | |
| Unallowable Deductions and Additional Income: | ||
| (a) Broadcasting costs | 18,240.49 | |
| Total | 55,544.91 | |
| Nontaxable Income and Additional Deductions: | ||
| (b) Capital-stock tax | 631.00 | |
| Net income as adjusted | 54,913.91 |
| Explanation of Ajustments | ||
| (a) Excessive apportionment of broadcasting costs is disallowed as follows: | ||
| Amount deducted | $ 116,488.39 | |
| Amount as corrected | 98,247.90 | |
| Unallowable deduction | 18,240.49 |
See item (a) for the year 1938.
The foregoing reflects also the allowance of additional depreciation in amount of $ 4,286.65 applicable to assets of the parent company, and elimination of its charge of $ 3,200.00 for amortization of broadcasting rights. Details of depreciation are shown in Exhibit A attached.
See sections 41 and 45 of the Internal Revenue Code.
(b) * * *
The parent company has a contract with Mutual Broadcasting System Inc. which provides that Mutual has the right to sell station time over CKLW to its advertisers, and Mutual makes payment to the parent company for the station time so sold. Mutual Broadcasting System Inc. agrees to provide the parent company with sustaining programs and to pay certain line charges and to furnish other services more particularly set out in the contract. For these services the parent company makes payment to Mutual Broadcasting System Inc. of certain sums as provided in the contract. The proportion of these latter payments*98 which have been charged to petitioner are the items which have been disallowed by the respondent. If the parent company did not have this contract with Mutual it would be obliged to engage singers, musicians, and other talent and to pay out substantial sums therefor, and it could not provide sustaining programs of the quality and character which it receives from Mutual for the amount of money which it pays therefor.
The revenue of the petitioner is derived by the sale to advertisers of station time for the purpose of broadcasting music, news, and entertainment sponsored by such advertisers. The petitioner derives revenue *528 from advertisers only during a limited number of hours each day. Such programs are known as commercial programs. It is essential in the broadcasting business that the station broadcast continuously in order to build up and retain its listener audience. During the hours that are not sold as commercial programs the station CKLW must provide programs from which no revenue is derived. Such programs are known as sustaining programs. The item of broadcasting costs of Mutual which has been disallowed by the respondent is the proportion of the actual cost*99 incurred and paid to Mutual for sustaining programs and other broadcasting services.
The accounting records of the parent company and petitioner have been set up in accordance with the practice as set out above and petitioner has made returns to the United States Federal tax authorities in accordance therewith.
The parent company has made returns to the Dominion of Canada income tax authorities also based upon its book records in accordance with the accounting practice above set out.
By this arrangement of proportioning broadcasting costs no profit is added by the parent company for its services on the portion of the broadcasting costs ultimately borne by petitioner.
The accounting records of the parent company and petitioner correctly reflected the net income from the property and business of each of the corporations and were not devised for the purpose of reducing or avoiding taxes by shifting or distorting income or deductions of either corporation from one to the other.
OPINION.
The question involved in this proceeding is to what extent, if any, the respondent, acting under section 45 of the Revenue Act of 1938 and the Internal Revenue Code, erred in refusing to allow to petitioner*100 as a deduction from gross income a part of certain broadcasting costs incurred by petitioner's sole stockholder, a Canadian corporation, for the calendar years 1938 and 1939 in the amounts of $ 55,063.26 and $ 50,426.36, respectively. Section 45 of the Revenue Act of 1938 (applicable to the year 1938) is the same as section 45 of the Internal Revenue Code (applicable to the year 1939) and is set forth in the margin. 1
*101 The parent company owns and operates a radio station in Canada known as station CKLW. Petitioner's sole business is to sell radio *529 time over station CKLW to advertisers in Detroit and vicinity for its own account and collect for such services. Petitioner's income depends to a large extent on the popularity of station CKLW with the listening public. The popularity of the station depends on the kind of programs that are broadcast. The parent company in order to operate station CKLW and make it an effective and popular station incurred during 1938 and 1939 certain broadcasting costs of $ 175,688.36 and $ 170,364.21, respectively. These costs were shared by petitioner and its parent corporation in proportion to the volume of sales by each corporation. Included in these broadcasting costs, the totals of which are given above, were the amounts of $ 55,063.26 and $ 50,426.36 paid by the parent company to Mutual Broadcasting System, Inc. during the years 1938 and 1939, respectively, "for sustaining programs and other broadcasting services." The respondent determined that the business relationship between the parent company and petitioner was such that the greater part of the*102 broadcasting costs incurred by the parent company should be distributed, apportioned, or allocated between the parent company and petitioner under section 45, supra. He determined, however, that the above amounts of $ 55,063.26 and $ 50,426.36, here in controversy should first be excluded from the total broadcasting costs of $ 175,688.36 and $ 170,364.21, respectively, before making the apportionment. As set out in detail in our findings, the respondent also made similar adjustments relative to depreciation and amortization of broadcasting rights which the parent company had included in its broadcasting costs, but these adjustments are not in controversy. The respondent in his determination also changed the apportionment fraction by deducting the above amounts of $ 55,063.26 and $ 50,426.36 from the net sales of the parent company for the years 1938 and 1939, respectively. The explanation given by the respondent in his deficiency notice for all of these adjustments is that:
It has been determined that the method used in apportioning broadcasting costs between * * * [petitioner and the parent company] does not clearly reflect your income for Federal income tax and excess-profits*103 tax purposes.
* * * *
See sections 41 and 45, Revenue Act of 1938, and Article 45-1 of income tax Regulations 101.
The parts of article 45-1 of Regulations 101 pertinent to this proceeding are printed in the margin. 2 Where the Commissioner has acted under section 45 in making his determination, the taxpayer has *530 the burden of showing that such determination was purely arbitrary and not made under any of the situations prescribed by the statute as a proper foundation for allocation of the expenses in question. Glenmore Distilleries Co., 47 B. T. A. 213, and cases there cited. We think the petitioner has met its burden of proof in the instant case.
*104 The amounts in controversy of $ 55,063.26 and $ 50,426.36 which the parent company paid to Mutual Broadcasting System, Inc. "for sustaining programs and other broadcasting services" were in our opinion just as necessary to make station CKLW a popular and effective radio station as any of the other items making up the amounts of $ 111,625.44 and $ 121,024.50 included in the totals of $ 175,688.36 and $ 170,364.21, respectively, of broadcasting costs. It was alleged in the petition and admitted in the amended answer that:
The revenue of the taxpayer corporation is derived by the sale to advertisers of station time for the purpose of broadcasting music, news and entertainment sponsored by such advertisers. The taxpayer corporation derives revenue from advertisers only during a limited number of hours each day. Such programs are known as commercial programs. It is essential in the broadcasting business that the station broadcast continuously in order to build up and retain its listener audience. During the hours that are not sold as commercial programs the taxpayer corporation must provide programs from which no revenue is derived. Such programs are known as sustaining programs. *105 The item of broadcasting costs of Mutual which has been disallowed by the Commissioner is the proportion of the actual cost incurred and paid to Mutual for sustaining programs and other broadcasting services.
We hold that the respondent erred in excluding the amounts of $ 55,063.26 and $ 50,426.36 from the broadcasting costs of $ 175,688.36 and $ 170,364.21, before making the distribution, apportionment, or allocation. We hold further that the respondent also erred in arriving at the apportionment fraction for both years by reducing the net sales of the parent company by the amounts of $ 55,063.26 and $ 50,426.36, respectively. These amounts represented expenses paid by the parent *531 company for which it was reimbursed in part by petitioner and had no effect on the net sales of the parent corporation. Cf. Glenmore Distilleries Co., supra. Any amount apportioned to the petitioner would increase the net profit of the parent company and vice versa, but would not affect its net sales.
The result of our sustaining petitioner in its assignment of error is that there will be no deficiency for either of the taxable years.
There were some other*106 adjustments made by the Commissioner in his determination of the deficiencies which were not contested, but giving effect to these adjustments does not result in any deficiency for either taxable year after giving effect to our sustaining petitioner's assignments of error. Petitioner has not alleged nor proved any overpayment for either taxable year.
Decision will be entered for petitioner that there are no deficiencies.
Footnotes
1. SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income or deductions between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.↩
2. Art. 45-1. Determination of the taxable net income of a controlled taxpayer. -- * * *
* * * *
(b) Scope and purpose. -- The purpose of section 45 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true net income from the property and business of a controlled taxpayer. The interests controlling a group of controlled taxpayers are assumed to have complete power to cause each controlled taxpayer so to conduct its affairs that its transactions and accounting records truly reflect the net income from the property and business of each of the controlled taxpayers. If, however, this has not been done, and the taxable net incomes are thereby understated, the statute contemplates that the Commissioner shall intervene, and, by making such distributions, apportionments, or allocations as he may deem necessary of gross income or deductions, or of any item or element affecting net income, between or among the controlled taxpayers constituting the group, shall determine the true net income of each controlled taxpayer. The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.
* * * *
(c) Application↩. -- Transactions between one controlled taxpayer and another will be subjected to special scrutiny to ascertain whether the common control is being used to reduce, avoid or escape taxes. In determining the true net income of a controlled taxpayer, the Commissioner is not restricted to the case of improper accounting, to the case of a fraudulent, colorable, or sham transaction, or to the case of a device designed to reduce or avoid tax by shifting or distorting income or deductions. The authority to determine true net income extends to any case in which either by inadvertence or design the taxable net income, in whole or in part, of a controlled taxpayer, is other than it would have been had the taxpayer in the conduct of his affairs been an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer.