1945 U.S. Tax Ct. LEXIS 69">*69 Decision will be entered under Rule 50.
1. Inventories -- Opening After Discontinuance of Consolidated Returns. -- A proper downward adjustment of the opening inventory on the first separate return after a period for which consolidated returns were filed, under the circumstances of this case, is the equivalent of the amount of intercompany profit represented in that inventory which has escaped tax up to the date of the opening inventory in question.
2. Deductions -- Ordinary and Necessary Expenses -- Donations by a Corporation. -- Donations by a corporation to local charities, held to have been ordinary and necessary expenses.
5 T.C. 851">*852 The Commissioner determined deficiencies in income tax of the petitioner as follows:
| Docket No. | Year | Amount |
| 2027 | 1934 | $ 336,522.85 |
| 2028 | 1935 | 276,650.28 |
| 2094 | 1937 | 154,005.88 |
| 2094 | 1938 | 141,088.40 |
The principal issue for decision is the correct amount of the petitioner's opening inventory for 1934. The determination of this value is required in order to establish the petitioner's profits in 1934 on accrual sales and profits realized in 1934, 1935, 1937, and 1938 on installment sales which were made in 1934. The deductibility of small donations to local charitable organizations in cities where petitioner carried on business is also in dispute. The parties are in agreement that they can make certain proper adjustments in their computations under Rule 50.
FINDINGS OF FACT.
The petitioner is a corporation. It filed its separate corporate income tax returns for the calendar years 1934, 1935, 1937, and 1938 with the collector of internal revenue for the fifth district 1945 U.S. Tax Ct. LEXIS 69">*71 of New Jersey. It used an accrual method of accounting and reporting.
The Singer Manufacturing Co. (hereinafter called Manufacturing) has always owned all of the stock of the petitioner. The principal business of the petitioner at all times has been the world-wide sale of sewing machines manufactured by Manufacturing. Manufacturing, the petitioner, and other affiliated companies joined in filing consolidated returns for the years 1918 through 1933.
The petitioner, in its accounts and in all returns, used inventories taken upon the basis of cost or market, whichever was lower. Its opening inventory for 1918 was $ 12,138,304. The cost of goods sold by the petitioner used in computing its income reported on the consolidated return for 1918 was determined by adding the cost of 5 T.C. 851">*853 goods purchased during the year to the opening inventory of $ 12,138,304 and subtracting the closing inventory.
The items in the 1918 opening inventory, which had been bought from Manufacturing, had been sold to the petitioner by Manufacturing prior to 1918 at a profit of $ 6,106,560.24. A similar intercompany profit in the 1918 closing inventory of the petitioner amounted to $ 8,245,474.67. The 1945 U.S. Tax Ct. LEXIS 69">*72 excess of the amount of intercompany profit in the closing inventory over the amount in the opening inventory of the petitioner was subtracted on the consolidated return for 1918 from the total net income of the affiliated companies in determining consolidated taxable net income for 1918. This same system was used on all of the consolidated returns filed by the group except that the excess was added as consolidated income if the amount of intercompany profit in the opening inventory for a year was larger than the amount in the closing inventory of the petitioner for that year. The total subtractions exceeded the total additions on the consolidated returns for the years 1918 through 1933 by $ 2,325,015.68.
The closing inventory of the petitioner used in the consolidated return for 1933 was $ 18,422,333.66. The intercompany profit represented in that amount was $ 8,431,575.92. The amount of intercompany profit of Manufacturing in the above closing inventory for 1933, which had escaped taxation under the system used by the petitioner and its affiliates, was $ 2,325,015.68.
The petitioner on its separate return for 1934 used as its opening inventory $ 9,990,757.74, representing cost1945 U.S. Tax Ct. LEXIS 69">*73 to Manufacturing ($ 18,422,333.66, 1933 closing, less $ 8,431,575.92, intercompany profit therein). It did this under protest in the belief that it was required to do so under the regulations then in effect. The Commissioner made no change in this item in determining the deficiencies.
The correct amount of the petitioner's opening inventory for 1934 is $ 16,097,317.98.
The petitioner made 18 donations during 1934 to local charities in 13 cities in the United States and Canada in which it had agencies. These donations ranged from $ 25 to $ 250, and amounted in all to $ 1,400. Each was made upon the recommendation of a local agent for the purpose of maintaining or developing the business of the petitioner in that locality. All but a few were made to community chests or funds, and the others consisted of one to the local Red Cross and three to religious charities. Similar donations, amounting to $ 975, were made during 1935. All of these expenditures were proximately related to and were ordinary and necessary expenses of the business of the petitioner.
The Commissioner disallowed the deductions claimed for payments made "to various charitable corporations and community chests."
1945 U.S. Tax Ct. LEXIS 69">*74 5 T.C. 851">*854 OPINION.
The petitioner, with its parent and other affiliates, had been filing consolidated returns for many years. The law was changed in 1934 and those companies no longer had the privilege of joining in a consolidated return. The petitioner has changed over to a separate return for 1934 and the question is, What is a proper amount for its opening inventory for that year? Save for some special problem inherent in the process of changing over, the petitioner would concededly be entitled to use cost to it or market value, whichever is lower.
The Commissioner contends that the actual amount of inventory taken at cost or market, whichever is lower, must be adjusted to the much lower one of cost to Manufacturing in order to eliminate the intercompany profit to Manufacturing in the larger amount. He does not and can not support this contention by an argument that it is necessary in order to prevent the intercompany profit, thus eliminated from inventory, from escaping tax. The amount which he would eliminate from the opening inventory is not the amount of the profit of Manufacturing which has escaped tax under the method heretofore used by these companies with the approval1945 U.S. Tax Ct. LEXIS 69">*75 of the Commissioner. It is $ 6,106,560.24 greater than the profit which has escaped tax.
The petitioner contends, but not obstinately, that no adjustment whatsoever should be made to its actual inventory at cost or market. But it urges with all earnestness that in no event should its cost or market figure be reduced by more than $ 2,325,015.68, the amount of the intercompany profit of Manufacturing which had not been taxed on the consolidated returns at the close of 1933 and which might completely escape taxation if the adjustment is not made.
The $ 6,106,560.24 of intercompany profits of Manufacturing represented in the petitioner's opening inventory for 1918, the first consolidated return year, had been reported previously as income of Manufacturing on its separate returns. All profits on goods thereafter acquired by the petitioner from Manufacturing and sold prior to the close of 1933 were reported and taxed as income on the consolidated returns. A large part of the goods acquired by the petitioner from Manufacturing during the years 1918 through 1933, inclusive, never appeared in any inventory. The adjustments made from year to year represented only a relatively small part1945 U.S. Tax Ct. LEXIS 69">*76 of that part of Manufacturing's profits represented in the petitioner's opening and closing inventories. The method used by the petitioner and its affiliates did not result in the permanent elimination from consolidated income of amounts once treated as intercompany profits, but served rather to reflect those amounts in the year in which they were earned by the group. The adjustments washed out during the consolidated return period, 5 T.C. 851">*855 except for the $ 2,325,015.68 of intercompany profits of Manufacturing which had not yet been reported in 1933 at the end of the consolidated return periods. Even the use of market value in the petitioner's inventories, if there ever was such a use during the consolidated return years, did not prevent the adjustments from canceling one another except for the amount just mentioned.
The shift from consolidated to separate returns should be made so that the revenues will not suffer. However, no greater burden than necessary for this purpose should be imposed upon the petitioner. It is true that any downward adjustment of the cost or market inventory of the petitioner will tax to it a profit which is not its own and which will never be realized1945 U.S. Tax Ct. LEXIS 69">*77 by it. But if it is taxed with a profit of its sole stockholder, Manufacturing, which would otherwise escape taxation due principally to the consolidated return method used from 1918 up to 1934, then the hardship would be really none at all and an adjustment should be made. Commissioner v. Liberty National Co., 58 Fed. (2d) 57, certiorari denied, 287 U.S. 603">287 U.S. 603 (reversing 18 B.T.A. 510">18 B.T.A. 510). The petitioner concedes that the statutes and regulations beginning with the Revenue Act of 1928, applicable to the year 1929 and subsequent years, require an adjustment in the opening inventory for 1934 for any intercompany income subsequent to 1928 which escaped taxation on consolidated returns. But it points out that during that period no intercompany profits escaped taxation. It then argues that those acts and regulations may not be retroactively applied to make an adjustment for any intercompany income which may have escaped taxation prior to 1929. The holding in the last cited case is to the contrary. The court pointed out that the provisions to which the petitioner here refers were only a recognition1945 U.S. Tax Ct. LEXIS 69">*78 and a crystallization of prior existing law.
Congress authorized the Commissioner to promulgate regulations in regard to consolidated returns to cause income to be clearly reflected and to prevent the avoidance of tax. Those filing consolidated returns were deemed to have consented to the regulations in so far as they were not inconsistent with the act. Sec. 141 (a) and (b), Revenue Act of 1932. Those regulations have differentiated somewhat between property generally and that which is inventoried. They provided that the opening inventory for the first separate return after consolidated returns shall be "the proper value of the closing inventory" used in computing consolidated income on the last consolidated return. See Regulations 78, article 39 (b), promulgated pursuant to the Revenue Act of 1932 and Regulations 86, article 113 (a) (11)-1 under the Revenue Act of 1934, applicable here. It has been held that these regulations authorize an adjustment to the opening inventory for the first separate return to prevent the avoidance of tax resulting from any previous 5 T.C. 851">*856 elimination of intercompany profits of the affiliate which brought goods into the group during the consolidated1945 U.S. Tax Ct. LEXIS 69">*79 return period. Bostonian National Shoe Stores, Inc., 39 B. T. A. 444; Tung-Sol Lamp Works, Inc.v.United States, U. S. Dist. Ct., S. Dist. New York, Dec. 7, 1942; Magnolia Petroleum Co.v. Thomas, U. S. Dist. Ct., N. Dist. Texas, Oct. 4, 1944. See also section 113 (a) (11), Revenue Act of 1934, which provides that the basis after affiliation of property acquired during affiliation shall be determined in accordance with the regulations "without regard to intercompany transactions in respect of which gain * * * was not recognized." The implication is clear that no adjustment should be made for intercompany transactions in respect of which gain has been recognized. The unrecognized gain in this case was $ 2,325,015.68 and we have adjusted the petitioner's opening inventory accordingly. The statute and regulations require that and no more. This is now clearly spelled out in later regulations. See Regulations 104, sec. 23.39 (b) (3).
The small amounts of donations for 1934 and 1935 which the petitioner seeks to deduct as ordinary and necessary expenses bear a reasonable relationship to the business of the petitioner and were made with1945 U.S. Tax Ct. LEXIS 69">*80 a reasonable expectation on the part of the executives that they would produce a financial return to the corporation commensurate with their amount. See Regulations 86, art. 23 (o)-2. Our conclusion in respect to these relatively small items is supported by a fair preponderance of the evidence in the light of all the circumstances.
Decision will be entered under Rule 50.