*3512 1. That portion of petitioner's inventory of raw materials on hand at December 31, 1918, required to fill firm sales contracts for finished goods on that date must be priced at cost in determining net income for that period.
2. Petitioner is entitled to have its taxes computed under the provisions of sections 210 and 328 of the Revenue Acts of 1917 and 1918, respectively.
*578 This is a proceeding for the redetermination of deficiencies in income and profits taxes of $13,189.29 and $423,083.78 for the taxable years 1917 and 1918, respectively.
The errors alleged to have been committed by the respondent are:
1. That he reduced invested capital for the years 1917 and 1918 on account of income and profits taxes for the years immediately preceding;
2. His failure to allow as a deduction in the year 1918 an inventory adjustment of $406,838.32 on the ground that the inventory was held by the petitioner for delivery under firm sale contracts; and
3. His failure to grant the petitioner relief for the year 1917 under the provisions of section*3513 210 of the Revenue Act of 1917 and for 1918 *579 under the provisions of sections 327 and 328 of the Revenue Act of 1918.
FINDINGS OF FACT.
The petitioner is a corporation organized and incorporated under the laws of the State of New Jersey in 1908 to engage in the manufacture of chemicals.
Upon incorporation the petitioner acquired the assets of three other chemical manufacturers, consisting of tangible and intangible property, in consideration of the entire issue of its capital stock of $4,000,000. No recent appraisals had been made of all those assets. The company's officers, in recording the values in the books of account, arbitrarily allocated $1,450,000 to the tangible assets and $2,550,000 to the intangible assets. The intangible assets consisted of brands, patents, good will, and processes of manufacture. While the processes of manufacture are not of a secret nature, continuous improvements, which are carefully guarded, have been made therein from time to time by chemists.
The three companies comprising the original consolidation were the Henry Bauer Chemical Manufacturing Co., which had been in existence since 1847 and had enjoyed a rather large business, *3514 the Mutual Chemical Co., which had been in business since about 1895, and the American Chrome Co., which had been in business since about 1898. The records of some of these companies have been lost or destroyed.
At the time of the reorganization in 1908 petitioner acquired a mixed aggregate of tangible and intangible assets the respective values of which can not be determined.
The value of good will of the petitioner has been augmented in a measure by the manner in which its customers have been treated and the quality of chemicals produced and sold. Petitioner has always made deliveries contracted for even when the market has adversely affected it and when the customer is adversely affected by changes in market prices it has modified its contract prices accordingly. During the World War the price of bichromates was as high as 65 and 70 cents on bichromate of soda. The petitioner had sales contracts at that time at 7 1/s cents, and, notwithstanding this great disparity in price, deliveries were made according to contract.
The respondent's final determination resulted in the following:
| 1917 | 1918 | |
| Net income | $5,605,842.77 | $2,857,263.62 |
| Statutory invested capital | 3,449,971.43 | 4,966,031.79 |
| Profits taxes | 2,948,909.10 | 1,788,001.18 |
| Ratio of profits tax to net income | 52% | 62% |
| Ratio of net income to invested capital | 162% | 57% |
| Value of good will (per books) | $1,995,664.50 | $1,995,664.50 |
| Good will included in above invested capital by | ||
| respondent | 666,840.00 | 833,550.00 |
| Part of good will excluded | 1,328,824.50 | 1,162,114.50 |
*3515 *580 Petitioner's competitors are the Natural Products Refining Co. and the Martin Dennis Co.
The petitioner purchases chrome ore and manufactures therefrom bichromate of soda and bichromate of potash and sells the finished products to its customers under contracts and on spot sales. Contracts are first arranged between the petitioner and its customers and then the chemicals are manufactured to fill them. Although these chemicals were sold under contracts arranged prior to manufacture thereof, there was no attempt made to allocate the chrome ore to particular contracts nor were the chemicals, as finally produced therefrom, allocated to any particular sales contracts. In fact it was not necessary for the petitioner to allocate any of its raw materials for completion of finished products under any particular sales contract, because the products are standard and the business is a continuous process in which the ore is worked through to the finished product and then packed in casks for shipment.
The petitioner purchased its chrome ore sufficiently in advance so that it customarily had on hand about one year's supply. As the ore was received in ships it was dumped in*3516 the petitioner's yards in piles, from where it was removed as needed for the manufacture of chemicals. Since the shipment arriving last was usually dumped on the top of the piles the last shipment was frequently placed in process of manufacture first.
The sales contracts of 1918 were not carried out according to their original terms in that the petitioner granted reductions of about 7 cents a pound in the sales prices due to a decline in the market price of the finished product and a desire to maintain the good will of its customers and to protect them against these declines. The respondent found that the petitioner had about fourteen million pounds of finished product under contract on December 31, 1918.
The inventory as of December 31, 1918, of raw materials, goods in process, finished goods, and supplies, on the basis of cost, as computed by the petitioner and respondent was $1,593,771.92 and $1,612,191.91, respectively. These figures were determined as follows:
| Inventory of - | By petitioner | By respondent |
| Chrome ore: | ||
| In United States yards | $654,776.54 | $673,196.53 |
| Elsewhere | 274,546.04 | 274,756.04 |
| Total | 929,532.58 | 947,952.57 |
| Goods in process | 207,889.79 | 207,889.79 |
| Finished goods on hand | 228,857.91 | 228,857.91 |
| Supplies | 227,491.64 | 227,491.64 |
| Total | 1,593,771.92 | 1,612,191.91 |
*3517 *581 The petitioner adjusted the inventory hereinabove, valued on the basis of cost, to cost or market whichever was lower, arriving at the following figures after said adjustments:
| Inventory of: | |
| Chrome ore - | By petitioner |
| In United States yards | $252,713.76 |
| Elsewhere | 130,723.12 |
| Total | 383,436.88 |
| Goods in process | 154,171.24 |
| Finished goods on hand | 177,756.32 |
| Supplies | 227,491.64 |
| Total | 942,856.08 |
Said inventory, showing a reduction in valuation of $650,915.84 was used by the petitioner in its return for 1918 as the closing inventory. That reduction was allocated to the various articles as follows:
| Chrome, ore: | |
| In United States yards | $402,062.78 |
| Elsewhere | 114,032.92 |
| Total | 546,095.70 |
| Goods in process | 53,718.55 |
| Finished goods on hand | 51,101.59 |
| Supplies | None |
| Total | 650,915.84 |
The respondent allowed $244,077.52 of the reduction of $650,915.84 claimed by the petitioner, allocated to the components of the inventory as follows:
| Chrome ore: | |
| In United States yards | $118,464.59 |
| Elsewhere | 125,612.93 |
| Total | 244,077.52 |
| Goods in process | None. |
| Finished goods on hand | None. |
| Supplies | None. |
| Total | 244,077.52 |
*3518 The respondent increased the closing inventory by $406,838.32, the difference between $650,915.84 and $244,077.52, allocated to the various ous articles as follows:
| Amount disallowed by respondent. | |
| Inventory of: | |
| Chrome ore - | |
| In United States yards | $302,018.18 |
| Elsewhere | None. |
| Total | 302,018.18 |
| Goods in process | 53,718.55 |
| Finished goods on hand | 51,101.59 |
| Supplies | None. |
| Total | 406,838.32 |
*582 The respondent arrived at this increase as follows: He held that 71.82653 per cent of the chrome ore inventory in the United States was required for the manufacture of goods under firm sales contracts; consequently the petitioner, in valuing this part of the inventory, was limited to the basis of cost. To place this part of the inventory on the cost basis respondent added to the market value of chrome ore in the United States the sum of $302,018.18, which is 71.82653 per cent of the difference between his total cost of $673,196.53 of chrome ore in the United States, and the market value of $252,713.76 of that same ore. The balance of the increase results from the respondent placing that part of the inventory of goods in process and finished goods on a*3519 cost basis instead of market, thereby adding $53,718.55 and $51,101.59, respectively. The petitioner does not now contest the correctness of the respondent's action in regard to that part of the inventory relating to goods in process and finished goods on hand, thus leaving in dispute only the increase of $302,018.18.
The market value of chrome ore on December 31, 1918, was lower than cost.
The respondent denied the petitioner's application for apecial assessment.
OPINION.
MORRIS: The petitioner's counsel has conceded the correctness of the respondent's action in reducing invested capital for the years 1917 and 1918 by an amount of income and profits taxes for prior years. Therefore, we shall address ourselves to the second and third allegations of error set forth herein.
The second allegation of error alleged to have been committed is the failure of the respondent to allow as a deduction, in the computation of net income for the year 1918, an inventory adjustment of $406,838.32. At the hearing of this proceeding the petitioner conceded the correctness of the respondent's adjustment with respect to goods in process amounting to $53,718.55 and finished goods on hand*3520 amounting to $51,101.59. The amount of the inventory adjustment here in dispute is, therefore, $302,018.18 instead of $406,838.32, as pleaded.
Section 203 of the Revenue Act of 1918 provides:
That whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.
Pursuant to the authority vested in the respondent by section 203, supra, Regulations 45 was promulgated. Article 1584 thereof, as amended by T.D. 3296, provides in part as follows:
*583 Under ordinary circumstances, and for normal goods in an inventory, "market" means the current bid price prevailing at the date of the inventory for the particular merchandise in the volume in which usually purchased by the taxpayer, and is applicable in the cases (a ) of goods purchased and on hand, and (b ) of basic elements of cost (materials, labor and burden) in*3521 goods in process of manufacture and in finished goods on hand: exclusive, however, of goods on hand or in process of manufacture for delivery upon firm sales contracts (i.e., those not legally subject to cancellation by either party) at fixed prices entered into before the date of the inventory, which goods must be inventoried at cost. * * *
The question presented reduces itself to whether the foregoing article of the regulations is applicable to raw materials on hand when, as in the instant case, the petitioner has contracted for future delivery of finished products, but neither the raw materials nor finished products have been allocated or apportioned to any particular contracts.
The petitioner's counsel contends that as matter of law the term "goods on had" as used in the regulations does not include raw materials and he cites as authority for his contention Cumpston v. Haigh, 2 Bing N.C. 449. In our opinion that case is wholly inapplicable to the peculiar facts and circumstances which must be considered in determining the amount of income subject to taxation under the revenue acts. Indeed it is conceivable that the term" goods on hand" may mean any class*3522 of goods entering to and becoming a part of an inventory which is used for the purpose of determining profits for a given taxable period. The petitioner's counsel contends further that as a matter of fact the raw materials in question were not held "for delivery upon firm sales contracts" for the reason that the term "for delivery" necessarily implies an allocation of the goods to such contracts, and, furthermore, article 1584, supra, does not require any goods to be held at cost in the inventory unless those goods have been sold under a "sales contract." He argues that the sales contracts here under consideration called for finished products only, and that since no raw materials were sold by it, either by contract or otherwise, there is no reason why those raw materials should not be reduced to cost or market, whichever is lower.
Section 203 of the Revenue Act of 1918 gives the Commissioner
Section 203 of the Revenue Act of 1918 gives the Commissioner authority to prescribe the basis upon which inventories must be taken, when in his opinion their use is necessary in order clearly to determine the income of the taxpayer. The purpose of the regulations promulgated under*3523 that section of the Act of allowing taxpayers to compute inventories on the basis of cost or market, whichever is lower, as distinguished from the cost basis, is to allow an accounting for any reduction in the value of the inventory which has in fact taken place during a taxable year, thereby more clearly *584 reflecting income. Where the inventories on hand, whether in the form of raw materials, goods in process, or finished goods, are required to fulfill legally enforcible contracts, it is obvious that the taxpayer is protected against any reduction in value occasioned by declining market prices; and to allow a taxpayer, where he is protected by sales contracts at a price in excess of cost or market, to inventory those items at market, would distort his income in that he would show a loss in one year when in fact none was sustained and a greater gain than the true gain in the following year when the sales were executed. The mere fact that the petitioner voluntarily reduced the sales price under contracts held by it in 1918 does not render those contracts any the less firm sales contracts should it choose to enforce the obligations created thereby.
*3524 The petitioner relies on Ewing-Thomas Converting Co.,1 B.T.A. 121">1 B.T.A. 121, to support the proposition that as there had been no allocation of the raw materials to any sales contract such materials may be inventoried at the lower of cost or market. In that case the taxpayer's inventory was taken at cost. The taxpayer sought to value that part of its goods on hand which were required to complete certain firm sales contracts at a price approximating the contract prices, which were lower than either cost or current bid (market) prices at the close of the year, under the provisions of article 1584 of the regulations 45 permitting the taxpayer, who has regularly sold merchandise "at prices lower than the current bid price" to value such merchandise at the lower selling prices. The Board denied the relief sought mainly because of the insufficiency of the evidence, the taxpayer having failed to prove the sale of the merchandise at prices less than "current bid price" or even that the merchandise in question had been definitely allocated to firm sales contracts at prices less than "current bid price." The fact that the merchandise in question had not been allocated to the firm sales*3525 contracts was not determinative of the question there at issue; and our decision was not based on the fact that there had not been such an allocation.
Considering the facts and circumstances of this case in the light of the spirit and intent of the law and the regulations promulgated thereunder, we are of the opinion that the action of the respondent should be approved.
The third allegation of error urged by the petitioner is the failure of the respondent to compute its profits taxes under the provisions of section 210 of the Revenue Act of 1917 and sections 327 and 328 of the Revenue Act of 1918. Section 210, supra, provides:
That if the Secretary of the Treasury is unable in any case satisfactorily to determine the invested capital, the amount of the deduction shall be the sum of (1) an amount equal to the same proportion of the net income of the trade or business received during the taxable year as the proportion which the *585 average deduction (determined in the same manner as provided in section two hundred and three, without including the $3,000 or $6,000 therein referred to) for the same calendar year of representative corporations, partnerships, and individuals, *3526 engaged in a like or similar trade or business, bears to the total net income of the trade or business received by such corporations, partnerships, and individuals, plus (2) in the case of a domestic corporation $3,000, and in the case of a domestic partnership or a citizen or resident of the United States $6,000.
* * *
Section 327 supra, insofar as applicable to the instant case, provides:
That in the following cases the tax shall be determined as provided in section 328:
(a) Where the Commissioner is unable to determine the invested capital as provided in section 326;
(b) In the case of a foreign corporation;
(c) Where a mixed aggregate of tangible property and intangiblep roperty has been paid in for stock or for stock and bonds and the Commissioner is unable satisfactorily to determine the respective values of the several classes of property at the time of payment, or to distinguish the classes of property paid in for stock and for bonds, respectively.
The undisputed testimony shows that the petitioner when organized in 1908 acquired the assets of three other companies consisting of a mixed aggregate of tangible and intangible property for its entire*3527 issue of capital stock of $4,000,000; that the petitioner's officers arbitrarily allocated $1,450,000 to the tangible assets and $2,550,000 to the intangible assets. Therefore, we have only to determine whether the respondent could have satisfactorily determined the respective values of the several classes of property at the time of payment and if we find that he could not, relief under the provisions of section 210 supra, and 328 supra, should be granted. Davis & Andrews co.,2 B.T.A. 328">2 B.T.A. 328. Assuming that the $4,000,000 paid for the assets acquired by the petitioner upon organization represented the correct value of those assets, we are confronted with the further difficulty of establishing the correct values of the two classes of property, viz, tangible and intangible, which were placed upon the books of account at arbitrary figures. This difficulty was recognized in The Viscose Co.,3 B.T.A. 444">3 B.T.A. 444, wherein it was said:
How is it possible for the Commissioner to determine the respective values of the several classes of tangible and intangible property acquired by the taxpayer in exchange for stock? * * * The book value of the tangible property*3528 acquired from the predecessor corporation is the basis or starting point for the Commissioner's computation of invested capital.
The evidence shows that the books and records of some of the corporations entering into the consolidation in 1908 have been lost or destroyed. It is, therefore, impossible to gain from those records knowledge of the financial history and success of those corporations *586 for the purpose of aiding in the determination of the value of the intangible assets and also for the purpose of learning the values at which the tangible assets were recorded prior to acquisition by the petitioner.
We are satisfied that the respective values of the tangible and intangible assets taken over by the petitioner at the time of the reorganization can not be determined.
We are, therefore, of the opinion that the petitioner is entitled to have its taxes computed under the provisions of section 210 of the Revenue Act of 1917 and section 328 of the Revenue Act of 1918.
Reviewed by the Board.
Recomputation of the deficiency should be made under Rule 62(c).
GREEN, dissenting: I am unable to concur in that portion of the prevailing opinion*3529 that approves the Commissioner's action as to inventories.
TRUSSELL agrees with the dissent.