*1108 In determining the taxable income of the petitioner and its subsidiary companies for 1928, intercompany transactions may not be disregarded for the purpose of reallocating a consolidated net loss for 1926 and making such net loss available for deduction by the several affiliated companies in 1928.
*361 This proceeding is for the redetermination of a deficiency of $75,753.25 for the calendar year 1928. The petitioner alleges that in determining such deficiency the respondent failed to allow a deduction of the net losses sustained by the petitioner and its subsidiary companies in 1926.
FINDINGS OF FACT.
The petitioner is a Pennsylvania corporation, with its principal office at Ardmore, Pennsylvania. It is engaged in the manufacture and sale of automobile trucks and parts. At all times material in this proceeding the petitioner was the owner of all of the outstanding capital stock of four subsidiary companies, all of which were engaged in the sale and servicing of the automobile*1109 trucks manufactured by the petitioner and the resale or other disposition of automobile trucks taken in trade. The subsidiary companies were as follows:
(a) The Autocar Sales & Service Co., a corporation of the State of New Jersey, having its principal office at Ardmore, Pennsylvania, hereinafter referred to as New Jersey.
(b) The Autocar Sales & Service Co. of Missouri, a corporation of the State of Missouri, having its principal office at St. Louis, hereinafter referred to as Missouri.
(c) Autocar Sales & Service Co. of California, a corporation of the State of California, having its principal office at Los Angeles, hereinafter referred to as California.
(d) Autocar Sales & Service Co. of Texas, a corporation of the State of Texas, having its principal office at Dallas, hereinafter referred to as Texas.
The capitalization of these companies in issued and outstanding capital stock was as follows:
| New Jersey | $3,000 |
| Missouri | 2,000 |
| California | 10,000 |
| Texas | 10,000 |
*362 The petitioner and the four above named subsidiaries were affiliated within the meaning of the Revenue Acts of 1926 and 1928 and they elected to file, and did file, consolidated*1110 income tax returns for the calendar years 1926, 1927, and 1928. The net income and losses of the several companies as reported in the consolidated returns, and the amounts of such income and losses as redetermined and reallocated to the several companies by the respondent, are as follows:
| 1926. | ||
| Net income and | Net income and losses | |
| Losses reported | redetermined and | |
| in returns | reallocated by respondent | |
| Petitioner, income | $602,940.92 | ------------------------- |
| New Jersey, loss | (1,016,739.38) | [574,122.41) |
| Missouri, loss | (157,402.69) | (88,880.61) |
| California, loss | (205,110.66) | (115,819.87) |
| Texas, loss | (5,768.23) | (3,257.15) |
| ------------------------------------------- | ||
| Total | (782,080.04) | (782,080.04) |
| 1927. | ||
| Petitioner, income | $679,235.70 | $43,039.66 |
| New Jersey, loss | (555,810.31) | ------------------------- |
| Missouri, loss | (58,158.63) | ------------------------- |
| California, income | 4,763.90 | 301.86 |
| Texas, loss | (26,689.14) | ------------------------- |
| ------------------------------------------- | ||
| Total | 43,341.52 | 43,341.52 |
| 1928. | ||
| Petitioner, income | $877,431.34 | $631,277.08 |
| New Jersey, loss | (205,146.96) | ------------------------- |
| Missouri, loss | (37,341.15) | ------------------------- |
| California, income | 42,045.89 | 30,196.26 |
| Texas, loss | (17,015.78) | ------------------------- |
| ------------------------------------------- | ||
| Total | 659,973.34 | 661,473.34 |
*1111 The above stated amounts of net income and net losses reported in the consolidated returns are those shown in the petitioner's and its affiliates' books after adjustment for certain unallowable ceductions not material herein. The amounts of such net income and net losses for 1927 and 1928 as reported in the consolidated returns for those years and as redetermined by the respondent have been computed without deduction for any net loss for the calendar year 1926.
In the consolidated return filed by the petitioner and its affiliated companies for 1928 the consolidated net loss for 1926, in the amount of $782,080.04, in excess of the consolidated net income for 1927, in the amount of $43,341.52, was applied against the total net income for the taxable year reported in the amount of $659,973.34. The consolidated return showed no net income for the affiliated group and no tax was paid on the basis of that return. Upon his audit of the return the respondent disallowed the deduction of the excess of the *363 1926 consolidated net loss over the 1927 consolidated net income and determined a deficiency against the petitioner for the year 1928 in the amount of $75,753.25.
During*1112 each of the years 1926, 1927, and 1928 the petitioner manufactured and sold automobile trucks and parts to its subsidiary companies as follows:
| Billing price | |||
| Sales to - | 1926 | 1927 | 1928 |
| New Jersey | $7,529,920.24 | $6,218,939.27 | $6,446,551.85 |
| Missouri | 170,360,58 | 157,846.01 | 116,642.36 |
| California | 517,059.55 | 515,665.92 | 563,040.28 |
| Texas | 160,510.90 | 92,202.76 | 103,522.56 |
| --------------------------------------------- | |||
| Total | 8,377,851.27 | 6,984,653.96 | 7,229,757.05 |
Such sales were charged to the subsidiaries on the petitioner's books in the amounts shown and were included in such amounts in computing the gross income of the petitioner on the consolidated returns for those years. On the books of each subsidiary the amounts were charged to purchases and have been included in cost of goods sold to the extent that sales thereof were made by the subsidiaries during the taxable years. The cost of goods sold including such purchases has been deducted in determining the gross profit of the subsidiaries as reported on the returns for the taxable years.
The costs of the sales made by the petitioner to its subsidiaries in the years 1926, 1927, *1113 and 1928, in the amounts above shown, were as follows:
| 1926. | |||
| Commercial, | |||
| Material and | Factory | administrative, | |
| labor costs | overhead | and sales costs | |
| New Jersey | $4,460,188.35 | $1,402,917.29 | $1,249,014.24 |
| Missouri | 106,358.28 | 31,320.69 | 28,258.77 |
| California | 282,298.12 | 94,198.24 | 85,766.50 |
| Texas | 95,064.31 | 30,963.87 | 26,634.30 |
| --------------------------------------------------- | |||
| Total | 4,943,909.06 | 1,559,400.09 | 1,389,663.81 |
| 1927. | |||
| New Jersey | $3,555,253.71 | $1,079,507.04 | $1,012,013.84 |
| Missouri | 88,037.58 | 29,199.68 | 25,666.18 |
| California | 283,856.89 | 92,507.60 | 83,966.72 |
| Texas | 51,895.39 | 16,361.89 | 14,981.62 |
| --------------------------------------------------- | |||
| Total | 3,979,043.57 | 1,217,576.21 | 1,136,628.36 |
| 1928. | |||
| New Jersey | $3,822,488.48 | $1,050,533.24 | $853,196.31 |
| Missouri | 67,172.31 | 20,164.80 | 15,498.02 |
| California | 322,174.54 | 91,832.90 | 74,471.02 |
| Texas | 62,779.07 | 18,118.72 | 13,686.57 |
| --------------------------------------------------- | |||
| Total | 4,274,614.40 | 1,180,649.66 | 956,851.92 |
*364 These costs were taken as deductions of the petitioner in determining its net income as shown on*1114 the returns for such years. The material and labor costs are those shown on the petitioner's books for direct labor and material applied to the manufacture of the trucks and parts represented by the sales made to the respective companies. The factory overhead costs were allocated to such sales on the basis of labor costs, which is the method generally accepted in the automotive industry, when, as is the case with the petitioner, the rates paid for labor are fairly uniform and there is only one class of product. The commercial, administrative, and sales costs were allocated on the basis of the sales made to the respective companies as compared to the total sales as shown by the petitioner's books.
The subsidiary companies have always been operated as factory branches, as such organizations are commonly known to the automotive trade. Each of the subsidiary companies had sales branches and subbranches located in large centers, through which its operations were carried out. During 1926, 1927, and 1928, there were about 50 such branch locations. Each branch territory had a manager to whom all branch employees were responsible and who, in turn, was responsible directly to the officers*1115 of the petitioner. The petitioner directly controlled the policies of the branches in all matters. The accounts of the subsidiaries were set up by the petitioner and were at all times under control of its officers. The petitioner and the subsidiary companies had the same officers and corporate personnel.
The subsidiary companies purchased all of the products sold to the public, such as automobile trucks and parts, from the petitioner. The sales are made by the petitioner to the subsidiary companies as follows: An order for a truck is forwarded by the branch to the petitioner at its office at Ardmore, and the truck is prepared by the petitioner according to specifications and shipped to the branch, which delivers it to the customer. Trucks are delivered to the branches before a sale is made to a customer only in a few instances where they are to be used for demonstration or exhibit purposes. When the trucks or materials are shipped to the branches a charge is made in the accounts of the subsidiary company in which the branch is located. The charge is taken up in the accounts of the branch and the liability account of the petitioner is credited with the amount. Cost of sales*1116 is charged and a credit is made of the actual sale price to the branch. As payments are received by the branch from the customer the notes representing the deferred payment sales, if notes are taken, are immediately forwarded to the petitioner and entered as assets and credited to the accounts receivable of the subsidiary companies. The cash received by the *365 branch from the customer is deposited in the local bank account and as balances are accumulated they are transferred to the petitioner in units of about $1,000. The expenses of the branches for pay rolls and supplies needed for operation are paid from the account in the local bank.
From time to time the subsidiary companies issue notes payable which are turned over to the petitioner and credited to the accounts receivable from the subsidiary companies. The total of such accounts receivable was $11,468,331.07 as of December 31, 1926, $11,999,951.79 as of December 31, 1927, and $11,922,539.38 as of December 31, 1928.
The accounts of the subsidiary companies show the following net deficits for the years involved:
| 1926 | 1927 | 1928 | |
| New Jersey | $6,127,462.85 | $6,684,417.06 | $6,890,649.52 |
| Missouri | 603,688.25 | 661,994.27 | 699,815.42 |
| California | 664,092.89 | 659,554.99 | 617,704.10 |
| Texas | 148,079.16 | 174,868.30 | 191,934.08 |
| ----------------------------------------------- | |||
| Total | 7,543.323.15 | 8,180,834.62 | 8,400,103.12 |
*1117 The above amounts represent the accumulated losses in the operation of the branches or the excess of their liabilities over their assets at the close of each year.
In billing trucks and parts to the subsidiary companies the prices were fixed by the petitioner at an arbitrary figure which represented neither the market price nor the cost of the article and had no relation to the price at which the article was to be sold to the public. It was a list price less a discount and served merely as a basis on which the branch might make a price to the customer. The price was uniform to all branches. The prices at which the trucks and parts were sold to the public were fixed by the petitioner. In the case of trucks each sale was a matter of bargaining between the branch and the customer, but the sale price had to be finally approved by the petitioner. The petitioner felt that the higher the sale price to the subsidiaries the better the deals the sales organizations would make with the customers.
Over 95 percent of the petitioner's entire output is sold through its various branches. The small amount of trucks and parts sold to dealers or those other than the branch organizations*1118 are sold at the same price as to the various branches.
In 1919 the petitioner found it necessary to pass a resolution guaranteeing any and all obligations and accounts of the subsidiary companies in order that they might be given the necessary financial rating to conduct their business operations. This guarantee of all of the accounts of the subsidiary companies by the petitioner was in effect during the years 1926, 1927, and 1928.
*366 There were no contracts between the petitioner and the subsidiary companies and there were no intercompany transactions other than those described above.
The petitioner and its affiliated companies kept their books and made their returns on the accrual basis and for a calendar year.
The adjustments made on the petitioner's books for the several years for consolidated statement purposes to eliminate factory profits shown in the closing inventories of the subsidiary companies are as follows:
| 1926 | 1927 | 1928 | |
| New Jersey | $91,374.77 | ($90,489.06) | $19,979.42 |
| Missouri | 7,047.26 | (2,325.13) | 1,791.78 |
| California | 17,707.67 | (17,986.62) | 17,878.39 |
| Texas | (1,688.86) | (9,773.53) | 5,256.20 |
These adjustments are*1119 reflected in the income of the petitioner as shown in the consolidated returns filed.
OPINION.
SMITH: The petitioner contends that the income and losses of the members of the affiliated group should be redetermined for the years 1926, 1927, and 1928, and that the net losses as redetermined should be carried forward and allowed as deductions in 1928 in accordance with the provisions of section 117 of the Revenue Act of 1928. It contends that the net income of the several affiliated companies as shown in the deficiency notice is not the correct taxable income of such companies, since it includes the gains from intercompany transactions, viz., the sale of trucks and parts by the petitioner to the subsidiary companies; that the amounts at which such sales were made and entered in the accounts of the several companies were not true sale prices and did not reflect the true income or losses of the several companies; and that such transactions should be eliminated in computing the income and losses of the several companies and of the consolidated group for each of the years 1926, 1927, and 1928.
Except for the net loss provision of the statute, the allocation among the several companies*1120 of the income or losses of the affiliated group would not affect the consolidated income or loss or the tax liability of the consolidated group, because the increase in the income of one company would be offset by an increase in the loss of another. Since, however, the net losses of the several companies can be availed of as a deduction in subsequent years only by the separate companies sustaining such prior net losses. Woolford Realty Co. v. Rose,286 U.S. 319">286 U.S. 319, it becomes necessary to determine the correct income or loss of each company for 1926 and 1927 in order to ascertain *367 the correct separate incomes and losses and the correct consolidated net income or loss for the year 1928.
According to the books kept by the petitioner and its subsidiary companies and the income tax returns filed by them, the petitioner had a large income in each of the years 1926, 1927, and 1928, while three of the subsidiaries had large losses in each of the years and one of them had a loss in 1926 and a small income in 1927 and 1928. The respondent has determined the same amount of consolidated income or loss as that reported in the returns for the years 1926 and 1927, *1121 but has made a reallocation of the separate income and losses for the several companies for each of the years 1926, 1927, and 1928, as shown above. In his deficiency notice the respondent states that such reallocation was made in accordance with General Counsel Memoranda Nos. 8132 and 8618, by eliminating from the income and deductions of each company only the unrealized intercompany profits and losses. The respondent stated in his deficiency notice that the petitioner's contention for the elimination of all intercompany transactions was denied. The petitioner contends in this proceeding that all intercompany transactions, consisting, in so far as here material, of only the sales of trucks and parts by the petitioner to the subsidiary companies, should be eliminated, with the result that the petitioner would show no net income or loss for any of the years 1926, 1927, and 1928, and the consolidated net losses or incomes would all be allocated to the subsidiary companies. If this were done, all or a large part of the consolidated net loss for 1926 might be carried forward and deducted in computing the net incomes of the subsidiary companies and the consolidated income for 1928.
*1122 The petitioner argues that the intercompany transactions should be eliminated for the reason, among others, that the subsidiary companies are merely sales agencies of the petitioner and that the intercompany transactions were not conducted at arm's length so as to reflect true profits and losses to any of the companies. This is substantially the contention that was made by the taxpayer in Post & Sheldon Corporation,28 B.T.A. 26">28 B.T.A. 26. We there held, in accordance with the taxpayer's contention, that in computing consolidated net income for 1928 of affiliated corporations having prior net losses, intercompany transactions which in any way affect the total net income or the separate net income or apportioned tax of any member must be eliminated. That case, however, was reversed by the Circuit Court of Appeals for the Second Circuit in Helvering v. Post & Sheldon Corporation, 71 Fed.(2d) 930. The court there held that article 734 of Regulations 74, which provides that the consolidated taxable income of affiliates shall be their combined income, *368 subject to the elimination of intercompany transactions, "must be read in subjection to the limitations*1123 already imposed upon the 'carry-over' sections; and that the position of the Treasury is a corollary of the decision in Woolford Realty Co. v. Rose, supra, (286 U.S. 319">286 U.S. 319)."
The instant case is not distinguishable in principle from the Post & Sheldon case and in the circumstances we feel constrained to follow the court in its reversal of our former position. The petitioner's contention that the intercompany transactions for all of the years involved should be eliminated in computing the taxable income of the affiliated group for 1928 is not sustained.
The petitioner contends, in the alternative, that the income of the several affiliated companies should be redetermined in accordance with the provisions of section 45 of the Revenue Act of 1928. This section reads as follows:
SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.
In any case of two or more 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*1124 such 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 trades or businesses.
We think that this contention must likewise be denied. Even if this provision of the statute were construed as intending to apply to a situation such as the one under consideration, the evidence of record does not offer any basis for a reallocation of the income or deductions of the several companies. It seems to us that it would be entirely unreasonable and arbitrary to allocate all of the income and losses to the subsidiary companies, as the petitioner would have us do. No facts are given us from which we can determine that the income or losses of the several affiliated companies were other than those shown in their books and reported in their income tax returns. It appears that the respondent has computed the tax liability of the several companies and of the consolidated group in accordance with those figures, with, in some instances, a reallocation of the income and losses among the several companies. The evidence before us does not show that the respondent's*1125 reallocation of income and losses or his determination of the petitioner's tax liability for the year 1928 was in error. See Broadway Strand Theatre Co.,12 B.T.A. 1052">12 B.T.A. 1052; Western Hide & Fur Co.,26 B.T.A. 354">26 B.T.A. 354; Flambeau Public Service Co.,27 B.T.A. 299">27 B.T.A. 299; and Drawoh, Inc.,28 B.T.A. 666">28 B.T.A. 666.
Reviewed by the Board.
Judgment will be entered for the respondent.
*369 MATTHEWS, dissenting: I think this is clearly a case where section 45 of the Revenue Act of 1928 and section 240(f) of the Revenue Act of 1926 should be applied. The real profit to the business in this case is the difference between the cost of manufacture plus the cost of selling and the selling price. The subsidiaries were wholly owned by petitioner and had a nominal capitalization. They were used by petitioner as sales and service branches. The accounts of the subsidiaries were guaranteed by petitioner and at the end of the years 1926, 1927, and 1928 the accounts receivable of the subsidiaries due the parent corporation were considerably over $11,000,000. The purpose of the list price at which trucks were charged to*1126 the subsidiaries was to obscure the cost of manufacture from the sales department, and to form the basis on which such department might figure a price to the customer. But the price to the customer had to be finally approved by the petitioner.
There were no real sales between the parent corporation and its subsidiaries. The real sales were to the customers. Petitioner did not expect, and subsidiaries could not have paid the parent, any more than was charged the customer. The difference between the cost of manufacture and operation of the subsidiaries and the selling price represents the profit or loss of the whole enterprise. And as the receipts of the branches, over expenditures for pay roll and supplies needed for operation, are transferred to petitioner in units of $1,000, as balances are accumulated, whatever profit there is in the sales of the trucks to customers, is in fact received by petitioner. For these reasons I think the income for 1926 and 1927 should be determined after consolidation of accounts, and for 1928 in accordance with section 45. Cf. *1127 Roessler & Hasslacher Chemical Co.,25 B.T.A. 915">25 B.T.A. 915.
GOODRICH and LEECH agree with this dissent.