*4168 1. INVESTED CAPITAL. - On December 31, 1916, petitioner charged off of its capital account the amount of $411,775.68, representing the cost of chemical plants and equipment constructed and installed during the years 1915 and 1916 and thereafter, early in 1918, restored the same amount to its capital account. Held, that the petitioner properly restored the full amount of said capital account but that following such restoration for the purposes of ascertaining invested capital for 1918 adjustments must be made for additions and subtractions made during the year 1917 and surplus must be adjusted by setting aside an addition to depreciation reserve of such an amount as will be found by applying depreciation rates allowed by the Commissioner for the year 1918 to these assets for the years 1916 and 1917.
2. Petitioner regularly declared yearly dividends at a rate which absorbed the entire year's profits and credited them to the stockholders' personal accounts. The stockholders withdrew amounts to meet their personal expenses, without regard to stock ownership and petitioner paid interest on the monthly credit balances. In 1918, petitioner issued stock and charged it against*4169 these personal accounts. Held, the credit balances to the extent that they represented earnings of the corporation constituted a distribution of profits and not surplus or undivided profits within the meaning of section 326 of the Revenue Act of 1918.
3. AFFILIATION. - Petitioner controlled the business of the Ault & Wiborg London Co. and owned or controlled 52 per cent of that company's outstanding capital stock; the other 48 per cent of that company's stock was owned by residents of England. Held, that petitioner and the Ault & Wiborg London Co. were not affiliated during 1918.
4. SPECIAL ASSESSMENT. - Petitioner failed to show that there existed during 1918 and abnormal condition affecting the capital or income of the corporation which worked an exceptional hardship. Held, that under the circumstances petitioner is not entitled to special assessment.
*184 This proceeding is for a redetermination of a deficiency in income and profits taxes in the amount of $206,640.18 for the calendar year 1918, as asserted by the Commissioner.
*4170 For the calendar year 1918 the petitioner and its subsidiary companies, namely, Buffalo Branch - the Ault & Wiborg Co., the Ault & Wiborg Co., of New York, and the Ault & Wiborg London Co., made a consolidated income and profits-tax return. The Commissioner in making his final determination of tax liability, eliminated the Ault & Wiborg London Co. from the consolidated return.
The petitioner alleges that the Commissioner erred as follows:
(1) That he refused to restore to invested capital the entire amount expended in construction and development of dye and chemical plants, erroneously charged off as of December 31, 1916;
(2) That he refused to hold that the petitioner and the Ault & Wiborg London Co. were affiliated during 1918, and eliminated the latter company's assets from the invested capital of the affiliated group;
(3) That he refused to permit the petitioner to include in its invested capital amounts representing dividends credited to the personal accounts of stockholders, but retained by petitioner for use in its business; and
(4) That, if the undrawn dividends should not be included in invested capital, the Commissioner should give petitioner relief under sections*4171 327 and 328 of the Revenue Act of 1918.
At the hearing on this proceeding the petition was amended to include the fourth allegation of error and also the petitioner abandoned two allegations of error pertaining to the inclusion of intangibles in invested capital, which allegations have not been set forth above.
FINDINGS OF FACT.
The Ault & Wiborg Co. is an Ohio corporation with its principal place of business at Cincinnati and is engaged in the business of manufacturing printing inks and allied products. Originally the business was conducted as a partnership by L. A. Ault and F. B. Wiborg and in 1891 the petitioner corporation was organized.
Prior to the World War, petitioner purchased from Germany certain anilines, intermediates, and chemicals necessary in its business. When their source of supply was cut off petitioner endeavored to manufacture said products, and in 1915 commenced the construction of the necessary plants. Most of the plants were constructed *185 and equipped during 1916 at Norwood and St. Bernard, near Cincinnati. At the close of the calendar year 1916, petitioner's books contained an account, designated "development expense," representing*4172 the amount expended for the plant and equipment as aforesaid in a total sum of $411,775.68. Due to the fact that such dyes and chemicals had not been manufactured in this country; that there were no experts in that line to be employed; that the success of the whole venture was problematical, and due to the conservative business policies of petitioner as dictated by its president, L. A. Ault, the entire "development expense" accounts were charged to profit and loss as of December 31, 1916. No deduction was taken nor claimed in petitioner's 1916 return on account of said charge-off. Subsequently, on March 27, 1918, the entire account of $411,775.68 was restored to invested capital by journal entries as of January 1, 1917. The Commissioner in his examination of petitioner's 1916 return, and after an investigation of pertitioner's plant, restored to invested capital, as of January 1, 1918, $314,278.51 of the development account for which amount petitioner was able to produce invoices and refused to restore the balance, namely, $97,497.17 the amount for which petitioner could not produce invoices, but the said restoration was made without any reduction on account of depreciation. Petitioner*4173 now claims that the entire $97,497.17 should also be restored to invested capital for the year 1918. Petitioner kept its plant and equipment in constant repair and charged such repairs of whatever nature, to expense so as not to inflate its invested capital. Petitioner's plant and equipment depreciated, but the evidence does not show as to what extent, from the time it was acquired until January 1, 1918, during which time it was in operation.
The Ault & Wiborg London Co. was incorporated under the laws of the State of Ohio in 1908; its principal office is in Cincinnati, but its place of business is in London, England, where it markets the products of petitioner. The said corporation issued common stock in the amount of $50,000, represented by 500 shares of a par value of $100 each. All the shares were similar and had voting privileges. The officers and directors of the petitioner and of the London Company during 1918 were as follows:
| Officers | |
| Ault & Wiborg Co. | Ault & Wiborg London Co. |
| L. A. Ault, president and treasurer. | L. A. Ault, president. |
| Robert Hochstetter (Hilton), | Bertrand Russell, vice president. |
| vice president. | |
| L. B. Ault, secretary and | H. A. Drummond, general manager. |
| assistant treasurer. | |
| J. B. Hawley, assistant secretary and | L. B. Ault, secretary and treasurer. |
| sales manager. | |
| Directors | |
| L. A. Ault. | L. A. Ault. |
| L. B. Ault. | L. B. Ault. |
| F. B. Wiborg. | F. B. Wiborg. |
| Robert Hochstetter (Hilton). | Bertrand Russell. |
| J. B. Hawley. | H. A. Drummond. |
As of January 1, 1918, and December 31, 1918, the stock of the petitioner and of the Loncon Company was held as follows:
| Stockholders as of Jan. 1, 1918 | Ault & Wiborg Co., Cincinnati | Ault & Wiborg London Co. |
| Shares | Shares | |
| L. A. Ault | 3,135 | 128 |
| Ida M. Ault | 5,000 | 0 |
| L. B. Ault | 3,000 | 1 |
| F. B. Wiborg | 3,565 | 129 |
| Sara S. Wiborg | 2,000 | 0 |
| Mary H. Wiborg | 2,000 | 0 |
| Olga Wiborg | 2,000 | 0 |
| Robert Hochstetter (Hilton) | 500 | 2 |
| W. H. Armstrong | 200 | 0 |
| H. B. Hawley | 200 | 0 |
| J. B. Hawley | 200 | 0 |
| E. Lyon | 200 | 0 |
| Bertrand Russell | 0 | 239 |
| H. Drummond | 0 | 1 |
| Total | 22,000 | 500 |
| Stockholders as of Jan. 1, 1919 | Ault & Wiborg Co., Cincinnati | Ault & Wiborg London Co. |
| Shares | Shares | |
| L. A. Ault | 6,515 | 128 |
| Ida M. Ault | 5,000 | 0 |
| Estate of L. B. Ault | 3,000 | 0 |
| L. A. Ault, Trustee for - | ||
| Hildegard V. S. Ault | 667 | 0 |
| Olga Marie Ault | 667 | 0 |
| Lee A. Ault, jr | 666 | 0 |
| F. B. Wiborg | 5,185 | 129 |
| Mary Hoyt Wiborg | 3,000 | 0 |
| Sara Wiborg Murphy | 3,000 | 0 |
| Olga Wiborg Fish | 3,000 | 0 |
| J. B. Hawley | 450 | 1 |
| D. M. Hilton | 600 | 0 |
| Robert Hochstetter (Hilton) | 250 | 2 |
| Bertrand Russell | 0 | 239 |
| H. A. Drummond | 0 | 1 |
| Total | 32,000 | 500 |
*4175 When this company was organized its entire capital stock was issued to L. A. Ault and F. B. Wiborg. Later, Charles H. Ault became the owner of 240 shares of its stock and in 1912 Bertrand Russell purchased from Charles H. Ault 240 shares of the stock of the London Company, and until he went into the active service of the English army in 1914, he was the manager of that company. Russell sold one share of his stock in said company to his brother-in-law, H. A. Drummond, who represented Russell during his absence.
No agreement existed between Russell or Drummond and any of the petitioner's stockholders as to the control or ownership of the stock of the London Company. Russell had complete ownership of his stock and retained possession thereof. Neither Russell nor Drummond attended any stockholders' meetings, which were held annually in Ohio, and the stock was vote by proxy by L. A. Ault. Each year Ault would write to Russell and Drummond, send forms and ask them to execute the proxies if they were not going to be present at the stockholders' meeting. However, there existed no agreement *187 requiring the execution of such proxies. The policies of the London Company were*4176 formed and controlled by L. A. Ault and F. B. Wiborg. The petitioner sold its products, both raw and finished, to the London Company at a small margin above cost and also furnished the London Company, without cost, formulae to be used in production of finished goods. The petitioner did not make loans to the London Company, but did carry its open account in large amounts during 1918 for products sold to it.
During the years that the business was conducted as a partnership the annual profits were ascertained and credited proportionately to the personal accounts of the two partners Ault and Wiborg who drew on their respective accounts for their personal needs and left the balance for the use of the business. Interest was paid on those balances to equalize the situation if one partner left a larger balance than the other. After the business was incorporated that same practice was continued by declaring dividends at a rate which would absorb the profits which were credited to the personal accounts of the stockholders. From January, 1906, to January, 1918, corporate resolutions were passed annually declaring dividends of from 15 per cent to 35 per cent to be credited to the stockholders' *4177 accounts and payable at the convenience of the corporation and also providing for payment of interest at the rate of 6 per cent on all dividends until paid. Ault and Wiborg also made a practice of depositing with petitioner and having credited to their personal accounts, monies received from sources other than petitioner. No restriction was ever placed upon the time nor amounts of withdrawals, except that the full credit balances could not have been withdrawn at any one time, for the money was used in the business. Withdrawals were not made pro rata according to stock ownership and were made against the stockholders' credit balances, which included dividends, other sums deposited and credited and interest credits without any specific application to any particular credit. Interest was credited at the rate of one-half of 1 per cent on monthly balances. The stockholders' personal accounts, totaling $1,632,167.47 on January 1, 1918, constituted, and were so considered by the stockholders, an indebtedness of the petitioner corporation to its stockholders, and there existed no agreement whereby corporate stock was to be issued for such credit balances prior to the time stock was actually*4178 issued therefor in 1918. On April 4, 1918, a meeting of the directors of the petitioner was held, at which time there was adopted a resoluting authorizing, among other matters not material to this proceeding, the issuance of and delivery to -
(1) L. A. Ault and L. B. Ault interim certificate for 3,000 shares of the preferred stock of this company fully paid and non-assessable upon the cancellation *188 by said L. A. Ault and L. B. Ault of $300,000 of indebtedness due them from this company;
(2) L. A. Ault and I. M. Ault interim certificates for 5,380 shares of the common capital stock of this company fully paid and non-assessable upon the cancellation by them of $538,000 of indebtedness of this company to them;
(3) Frank B. Wiborg, Sarah W. Murphy, Harry Hoyt Wiborg, and Olga W. Fish interim certificates for 4,620 shares of the common capital stock of this company fully paid and non-assessable upon the cancellation by said Frank B. Wiborg, Sarah W. Murphy, Harry Hoyt Wiborg and Olga W. Fish of $462,000 of indebtedness due them from this company.
The said resolution also authorized the issuance and delivery of permanent certificates for such stock as soon as they were*4179 ready for delivery. The issuance of the stock as provided for by the above resolution absorbed practically all of the credits appearing in favor of stockholders on their personal accounts and the word "indebtedness" as used in the above resolution meant the credit balances of the personal accounts. The Commissioner refused to allow petitioner to include the undrawn dividends in invested capital from January 1, 1918, up to the time stock was issued for such undrawn dividends credited to the personal accounts of the stockholders. The additional stock issued in 1918 has been included in petitioner's invested capital for 1918 from the date of its issuance.
The amount of $249,000 has been allowed as the value of intangibles at the date of incorporation for purposes of petitioner's invested capital. During the period from 1891 to the close of the year 1918 petitioner employed chemists on a salary basis for research work. Petitioner maintained in its plant, laboratories for the use of its chemists, who devoted their time to experimental work, and petitioner has charged the cost of materials, salaries, etc., to expense and no part has been capitalized. The petitioner had developed*4180 a number of secret processes and formulae which have not been patented for fear the processes would be disclosed. The petitioner developed a process for the manufacture of mimeograph ink, which was patented about 1900 and was renewed prior to the expiration of the patent, which produced a profit of over $1,000,000 over the course of about 27 years. For the year under review, after eliminating the London Company, the Commissioner found that the average consolidated invested capital was $5,829,025.81; that the net income was $1,196,110.68; that the excess and war-profits tax was $420,558.53, and that the total of income and profits taxes was $501,701.96. The balance sheet attached to the consolidated return showed that on December 31, 1918, the parent company had bills payable representing borrowed capital in the amount of $2,050,000. The question of special assessment has not been considered by the Commissioner and has been raised by amendment to the petition at the trial of this action.
*189 OPINION.
TRUSSELL: The record of this action establishes the fact that during a period beginning in the year 1915 and ending December 31, 1916, the Ault & Wiborg Co. of Cincinnati*4181 constructed new factory buildings and installed therein equipment and machinery at a cost 3f $411,775,68 and that on December 31, 1916, this amount was charged off to profit and loss but that neither this amount, nor any part of it, was taken as a deduction from gross income. Subsequently, in the early part of the year 1918, this same figure of $411,775.68 was restored to the capital account of the company. We are of the opinion that the restoration to capital account of the full amount of $411775.68 was properly and lawfully made. However, having made such restoration, it follows as a matter of course that in ascertaining invested capital for the year 1918 account must be taken of capital additions and subtractions to and from this capital account and the company's surplus must be adjusted by setting aside an addition to depreciation reserve computed upon this capital asset during the two years of 1916 and 1917 and for the purpose of this action the rates of depreciation allowed by the Commissioner upon this asset or its component parts, as the case may be, should be applied in ascertaining the amount to be added to the reserve for the years 1916 and 1917.
The second issue presented*4182 with respect to whether or not petitioner was during 1918 affiliated with the Ault & Wiborg London Co., is governed by section 240 of the Revenue Act of 1918, the pertinent portion of which reads as follows:
SEC. 240. (b) For the purpose of this section two or more domestic corporations shall be deemed to be affiliated (1) if one corporation owns directly or controls through closely affiliated interests or by a nominee or nominees substantially all the stock of the other or others, or (2) if substantially all the stock of two or more corporations is owned or controlled by the same interests.
The men who owned or controlled substantially all of petitioner's stock owned or controlled 260 shares of the London Company's stock and directed and operated the business of the London Company, which was established for the purpose of marketing in England the petitioner's products. The facts establish that petitioner or its stockholders controlled the London Company's business as effectively as they controlled the business at Cincinnati. Bertrand Russell purchased 240 shares of the London Company's stock without any restrictions as to his ownership thereof, as to how he should vote it or*4183 dispose of it. When so desired he sold one share to H. A. Drummond, who looked after Russell's interests while he was in active army service.
It seems apparent from this record that the Ault & Wiborg London Co. was nothing more than a selling agency of the Ault & Wiborg *190 Co. of Cincinnati, and that its business was conducted simply as a unit of the Cincinnati Company's business. It appears, however, that in 1912 the ownership of 240 of the 500 shares of the London Company passed into the hands of a British subject who continued to own the same until 1920, when this stock was again reacquired by the Cincinnati interests. In the cases of ; ; and , the Board has held that owing to the substantial minority interest affiliation could not be allowed. The rule laid down in these and other cases may be followed in the instant case.
The third issue presented relates to the Commissioner's refusal to include in petitioner's invested capital as of January 1, 1918, the balance of undrawn dividends credited to*4184 the stockholders' personal accounts. During its corporate existence up to and including the year 1918, the petitioner kept no regular surplus and undivided profits accounts. Each year dividends were declared at a rate which absorbed the year's profits and such dividends were credited to the stockholders' personal accounts. The personal accounts were controlled by the respective stockholders, who deposited therein sums of money received from sources outside the corporation and who made such withdrawals from time to time as were needed for personal expenses, such withdrawals being made without any relation to stock ownership. Petitioner paid interest at the rate of 6 per cent per annum on the monthly balances of the said personal accounts. Over the course of a number of years, the credits to these personal accounts amounted to a very large sum which was invested in petitioner's business. However, petitioner was practically a close corporation and the stockholders willingly used a good portion of the profits in expanding the business. The stockholders considered petitioner indebted to them in the amounts of their respective balances and the petitioner considered itself so indebted*4185 as evidence by the resolution of April 4, 1918, for the issuance of stock upon the cancellation of petitioner's indebtedness to the stockholders. The president of petitioner corporation testified that the word "indebtedness" used in said resolution, meant the credit balances in the stockholders' personal accounts. In view of all the facts and the continuous practice of the several stockholders, the credit balances in the personal accounts must be taken to represent corporate earnings distributed and not surplus or undivided profits within the meaning of section 326 of the Revenue Act of 1918. See .
The last issue presented is with respect to petitioner's claim for special assessment under the relief provisions of sections 327 and 328 of the Revenue Act of 1918. Petitioner has shown that it has *191 developed secret processes and formulae, but it has not shown to what extent they produced petitioner's income except in one instance where a certain patent has produced over $10,000,000 profits in about 27 years. We have not been shown the relation of the profits from that patent to the year 1918. The credit balances of*4186 the personal accounts constituted borrowed capital for only about three months of the year 1918, and then the stock issued therefor was included in invested capital for 1918. L. A. Ault testified, "My recollection is that we owed borrowed money at something over two million dollars," as of January 1, 1918.
An examination of the figures of invested capital, net income, and tax liability, discloses that on the basis of the Commissioner's adjustment the consolidated net income was only a trifle more than 20 per cent of the invested capital; that the excess and war-profits taxes were approximately 35 per cent of the net income; and that the total liability for income and profits taxes was approximately 42 per cent of the adjusted net income. From a consideration of all the facts in the record we are of the opinion that these facts do not disclose any such abnormality of capital, net income, and tax liability as to bring the petitioner and its admitted subsidiaries within the provisions of section 327 of the Revenue Act of 1918.
The deficiency should be computed in accord with the foregoing findings of fact and opinion.
Judgment will be entered on 15 days' notice, pursuant*4187 to Rule 50.