Opinion
Docket No. 5364.
1946-12-12
THE HOMER LAUGHLIN CHINA COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
M. L. Aaron (an officer), for the petitioner. Jacquin Bierman, Esq., for the respondent.
In the petitioner's claim for relief under section 722, Internal Revenue Code, the constructive average base period net income was computed by the use of the formula or rule set forth in section 713(f). Held, that the petitioner failed to establish that the tax computed without benefit of section 722 resulted in an excessive and discriminatory tax, or to establish what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income, and claim for refund was properly denied. M. L. Aaron (an officer), for the petitioner. Jacquin Bierman, Esq., for the respondent.
This proceeding arises from the Commissioner's rejection of the petitioner's application for excess profits tax relief under section 722, Internal Revenue Code. The Commissioner sent petitioner a deficiency notice asserting deficiencies in income tax for 1940 and excess profits tax for 1941 in the respective amounts of $12,815.56 and $67,246.77. The deficiency notice states that petitioner's application for excess profits tax relief under section 722 for 1941 in the amount of $65,031.12 has been disallowed.
Petitioner's claim for relief under section 722 is based solely upon the ground that alleged excessive depreciation deductions were taken in its income tax returns for the base period years 1936 to 1939, inclusive. The question has been submitted to us on a written stipulation of facts, which we adopt and incorporate herein by reference. The following findings contain all of the stipulated facts substantially as set forth in the stipulation, together with such additional material facts as are shown by the exhibits.
FINDINGS OF FACT.
Petitioner is a Delaware corporation, organized in the year 1927, having its principal office and place of business at Newell, West Virginia. It field its income tax returns for the years 1937, 1938, 1939, 1940, and 1941 and its excess profits tax returns for the years 1940 and 1941 with the collector of internal revenue for the district of West Virginia, at Parkersburg.
From its organization in 1927 to December 1, 1936, the petitioner acted as a holding corporation only.
On December 1, 1936, the petitioner succeeded through the liquidation of its wholly owned subsidiary, the Homer Laughlin China Co. (West Virginia), to the business of that corporation, and has at all times since that date engaged in the manufacture of earthenware.
On December 18, 1936, petitioner succeeded through the liquidation of another wholly owned subsidiary, the North American Manufacturing Co. (West Virginia), to the business of that corporation.
Petitioner and its subsidiaries, the Homer Laughlin China Co. (West Virginia) and the North American Manufacturing Co. (West Virginia), filed separate income tax returns for the year 1936 with the collector of internal revenue for the district of West Virginia, at Parkersburg.
In its excess profits tax returns for 1940 and 1941 petitioner elected not to compute average base period net income under section 742 of the Internal Revenue Code.
The adjustments made by the Commissioner in the case of petitioner's wholly owned subsidiary, the Homer Laughlin China Co. (West Virginia), which decreased its depreciation by $916.67 and increased its capital gain by $220.28 for the taxable year 1936, have been accepted both by the subsidiary and by the petitioner.
Depreciation claimed by the petitioner on its properties for the years 1936 to 1939, inclusive, and approved by the Commissioner, was as follows:
+-------------------------------+ ¦1936, December only ¦$16,442.05¦ +--------------------+----------¦ ¦1937, entire year ¦205,324.70¦ +--------------------+----------¦ ¦1938, entire year ¦189,532.89¦ +--------------------+----------¦ ¦1939, entire year ¦184,226.12¦ +-------------------------------+
Depreciation claimed by the petitioner for 1940 and 1941, calculated at the rates and upon the basis approved by the Commissioner for the prior years 1936-1939, depreciation allowed by the Commissioner, and the difference between depreciation claimed and allowed were as follows:
+----------------------------------------------------------+ ¦ ¦ ¦Depreciation ¦ ¦ +-------+-----------------------+-------------+------------¦ ¦Year ¦Depreciation claimed ¦allowed ¦Difference ¦ +-------+-----------------------+-------------+------------¦ ¦1940 ¦(corrected) $184,745.92¦$133,934.62 ¦$50,811.30 ¦ +-------+-----------------------+-------------+------------¦ ¦1941 ¦183,545.66 ¦132,349.08 ¦51,196.58 ¦ +-------+-----------------------+-------------+------------¦ ¦Average¦184,145.79 ¦1 133,141.85¦2 51,003.94¦ +----------------------------------------------------------+
The properties of the petitioner were subject to normal physical depreciation in each of the years of the base period 1936-1939 and in each of the taxable years 1940 and 1941. Neither the petitioner nor the Commissioner claims that abnormal usage of the properties occurred in any of the base period years or in 1940 or 1941.
The disallowance of depreciation by the Commissioner for the years 1940 and 1941 was based on a revised estimate of the remaining useful life of various assets (buildings and kilns) of the petitioner from December 31, 1939. The method of disallowance was to spread the unrecovered cost over the newly determined remaining useful life and to limit current depreciation to an amount so ascertained.
Depreciation on buildings installed prior to December 31, 1937, at petitioner's plant #4 was claimed by petitioner for 1936 and 1937 on a life limit of 7 years from December 31, 1931. Depreciation on the same account for 1938 and 1939 was claimed on a life limit of 5 years from December 31, 1937, with 3 per cent straight line depreciation on 1938 and subsequent additions. The life limit of these buildings as redetermined by the Commissioner for 1940 and 1941 is 7 years from December 31, 1939, with 3 per cent straight line depreciation on 1938 and subsequent additions.
Depreciation on buildings installed from 1915 to 1939, inclusive, at petitioner's plant #5 was calculated for 1936 to 1939, inclusive, at 3 per cent straight line. The life limit of these buildings as redetermined by the Commissioner for 1940 and 1941 is 12 years from December 31, 1939.
Depreciation on kilns at petitioner's plant #4 for 1936 to 1939, inclusive, was calculated at 7 1/2 per cent straight line. The line limit of these kilns as redetermined by the Commissioner for 1940 and 1941 is a 25-year life from installation.
The petitioner accepts as correct for the purpose of income tax calculation the adjustment in depreciation made by the Commissioner for 1940 and 1941.
Net sales of the petitioner in each of the base period years, as disclosed by its income tax returns, were as follows:
+--------------------------------+ ¦1936, December only¦$445,159.01 ¦ +-------------------+------------¦ ¦1937, entire year ¦5,135,405.14¦ +-------------------+------------¦ ¦1938, entire year ¦5,762,106.98¦ +-------------------+------------¦ ¦1939, entire year ¦5,866,300.83¦ +--------------------------------+
The December 1936 net sales of $445,159.01 were for the period following petitioner's absorption of its two subsidiary companies. The net sales of the petitioner and its subsidiaries for the entire year 1936 amounted to $5,034,140.47.
On May 10, 1943, petitioner filed with the Commissioner its application for relief under section 722 of the Internal Revenue Code from the excess profits tax which would result for 1941 from the disallowance of depreciation for that year and from the reduction in carryover of unused excess profits credit from the disallowance of depreciation for the year 1940. It was stated in the claim in material part, in answer to questions and otherwise, as follows:
+-----------------------------------------------------------------------------+ ¦ ¦Year¦Amount ¦ +----------------------------------------------------------+----+-------------¦ ¦4. Excess profits net income or deficit in excess profits ¦1936¦$32,006.90 ¦ +----------------------------------------------------------+----+-------------¦ ¦net income for each taxable year in the base period, ¦1937¦264,223.06 ¦ +----------------------------------------------------------+----+-------------¦ ¦computed without regard to section 722. ¦1938¦409,623.77 ¦ +----------------------------------------------------------+----+-------------¦ ¦ ¦1939¦336,483.59 ¦ +----------------------------------------------------------+----+-------------¦ ¦Total ¦ ¦$1,042,337.32¦ +----------------------------------------------------------+----+-------------¦ ¦5. Average base period net income determined without ¦ ¦409,623.77 ¦ ¦regard to section 722 ¦ ¦ ¦ +----------------------------------------------------------+----+-------------¦ ¦(a) Is the benefit of section 713 (e) (1) (relating to ¦ ¦ ¦ ¦exclusion of deficit or to increase in lowest year in base¦ ¦ ¦ ¦period) claimed? No. ¦ ¦ ¦ +----------------------------------------------------------+----+-------------¦ ¦(b) Is the benefit of section 713 (f) (relating to ¦ ¦ ¦ ¦increased earnings in last half of base period) claimed? ¦ ¦ ¦ ¦Yes. ¦ ¦ ¦ +----------------------------------------------------------+----+-------------¦ ¦(c) If answer to (a) or (b) is “yes,” furnish computation.¦ ¦ ¦ +----------------------------------------------------------+----+-------------¦ ¦Year 1938 used. ¦ ¦ ¦ +----------------------------------------------------------+----+-------------¦ ¦6. Amount of constructive average base period net income ¦ ¦ ¦ ¦claimed for use in computing excess profits tax for ¦ ¦$466,466.78 ¦ ¦taxable year. (Furnish particulars supporting amount ¦ ¦ ¦ ¦claimed and details involved in computation) ¦ ¦ ¦ +----------------------------------------------------------+----+-------------¦ ¦7. Has Supplement A been availed of in determining average¦ ¦ ¦ ¦base period net income? No. ¦ ¦ ¦ +-----------------------------------------------------------------------------+
The use of the excess profits credit based upon income would result in an excessive and discriminatory tax, because of the drastic alteration in depreciation schedules proposed in the Revenue Agent's report for 1940 and 1941. The Agent has proposed to reduce depreciation for 1940 from $185,975.05 to $133,934.62 and for 1941 from $183,545.66 to $132,349.08— an average reduction of $51,618.51. Such radical alteration of depreciation destroys all basis of comparison between base period and current years. With current income rated up by the sharp curtailment of depreciation and with base period allowed to remain as it was, average base period net income becomes an inadequate standard of normal earnings. Section 722(b)(5).
Two substitute calculations are appended hereto:
(1) Based on the application of uniform depreciation to base period and current years.
(2) Based on the addition to average base period net income per return of the average differential applied by the Revenue Agent in reduction of depreciation allowances for 1940 and 1941.
The basis for these calculations is more fully stated in a protest of even date filed with the Internal Revenue Agent in Charge, Huntington, West Virginia.
Respectfully submitted,
THE HOMER LAUGHLIN CHINA COMPANY (Signed) M. L. Aaron M. L. AARON
EXHIBIT A— CALCULATION OF CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME BASED ON THE APPLICATION OF UNIFORM DEPRECIATION TO BASE PERIOD AND CURRENT YEARS.
+-----------------------------------------------+ ¦ ¦Depreciation ¦Depreciation¦Additional¦ +----+------------------+------------+----------¦ ¦ ¦claimed or allowed¦corrected ¦income ¦ +----+------------------+------------+----------¦ ¦1936¦$16,442.05 ¦$10,662.83 ¦$5,779.22 ¦ +----+------------------+------------+----------¦ ¦1937¦205,324.70 ¦129,244.59 ¦76,080.11 ¦ +----+------------------+------------+----------¦ ¦1938¦189,532.89 ¦132,689.88 ¦56,843.01 ¦ +----+------------------+------------+----------¦ ¦1939¦184,226.12 ¦135,911.21 ¦48,314.91 ¦ +----+------------------+------------+----------¦ ¦1940¦185,975.05 ¦146,567.87 ¦39,407.18 ¦ +----+------------------+------------+----------¦ ¦1941¦183,545.66 ¦145,368.82 ¦38,176.84 ¦ +-----------------------------------------------+
Excess Additional Corrected profits net excess income per income profits net return income 1936 $32,006.90 $5,779.22 $37,786.12 1937 264,223.06 76,080.11 340,303.17 1938 409,623.77 56,843.01 466,466.78 1939 336,483.59 48,314.91 384,798.50 Aggregate $1,229,354.57 Average 307,338.64 Constructive average base period net income-growth formula Year 1938 used 466,466.78
EXHIBIT B— CALCULATION OF CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME BASED ON THE ADDITION TO AVERAGE BASE PERIOD NET INCOME PER RETURN OF THE AVERAGE DIFFERENTIAL APPLIED BY THE REVENUE AGENT IN REDUCTION OF DEPRECIATION ALLOWANCES FOR 1940 AND 1941.
+----------------------------------------------------------------------+ ¦Average base period net income per return (year 1938 used)¦$409,623.77¦ +----------------------------------------------------------+-----------¦ ¦Add average reduction in current depreciation allowances ¦51,618.51 ¦ +----------------------------------------------------------+-----------¦ ¦Constructive average base period net income ¦$461,242.28¦ +----------------------------------------------------------------------+
The Commissioner in the deficiency notice allowed the petitioner a 95 per cent excess profits tax credit of $389,142.58— which is 95 per cent of $409,623.77, average base period net income computed by applying section 713(f) to actual income as reported in the base period.
OPINION.
DISNEY, Judge:
Is the petitioner, in the light of the facts above found, entitled to relief under section 722(a), (b)(5) of the Internal Revenue Code,
as contended? Briefly stated, the petitioner's position is that the reductions in depreciation deductions in the years 1940 and 1941 by the Commissioner, because of use of a revised rate, show that excessive depreciation had been claimed, and allowed, for the base period years 1936 to 1939; that such excessive depreciation depressed earnings below a normal standard and was thus a ‘factor affecting the taxpayer's business * * * resulting in an inadequate standard of normal earnings,‘ within the language of section 722(b)(5); and that ‘a fair and just amount representing normal earnings to be used as a constructive average base period net income‘ is to be determined by using the figures for the base period years which it computes by increasing the income of such years (by deceasing depreciation deductions in accordance with its theory of applying the same rates used by the Commissioner in 1940-1941) and on such figures making a computation under section 713(f), the ‘growth formula,‘ as shown in the application for section 722 relief, shown above in our findings of fact. However, since that method produces $466,466.78, a result slightly greater than merely adding to the growth formula computation (under the original income figures for 1936-1939, inclusive) the $51,003.94, the average decrease of depreciation under the Commissioner's rates in 1940-1941, the petitioner is willing to limit its result to $460,627.71 (the $51,003.94 plus $409,623.77, the result of growth formula computation on the original actual income figures for 1936-1939) instead of $466,466.78.
SEC. 722. GENERAL RELIEF— CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.(a) GENERAL RULE.— In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, except that, in the cases described in the last sentence of section 722(b)(4) and in section 722(c), regard shall be had to be change in the character of the business under section 722(b)(4) or the nature of the taxpayer and the character of its business under section 722(c) to the extent necessary to establish the normal earnings to be used as the constructive average base period net income.(b) TAXPAYERS USING AVERAGE EARNINGS METHOD.— The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because—(5) of any other factor affecting the taxpayer's business which may reasonably be considered as resulting in an inadequate standard of normal earnings during the base period and the application of this section to the taxpayer would not be inconsistent with the principles underlying the provisions of this subsection, and with the conditions and limitations enumerated therein.
The $466,466.78 is the figure used in the petitioner's application for relief. The figure used on brief is $464,475.92 due apparently to a correction. The figure $51,003.94 is corrected on brief from $51,618.51 used in the application, as appears above in the findings of fact.
The petitioner has the right, under section 722(b)(5), to show that its average base period net income is an inadequate standard of normal earnings because of some ‘factor affecting the taxpayer's business which may reasonably be considered as resulting in an inadequate standard of normal earnings during the base period,‘ provided the application of section 722 is consistent with the principles, conditions, and limitations of section 722(b). If an inadequate standard for the base period is so proved, thereupon the excess profits tax (computed without benefit of section 722) shall be considered excessive and discriminatory. Having so demonstrated, the petitioner may then secure the benefits of section 722(a) by further establishing a constructive average base period net income, consisting of ‘a fair and just amount representing normal earnings.‘ East Texas Motor Freight Lines, 7 T.C. 579.
The question therefore arises here as to whether computation under section 713(f) may be utilized to raise the figures for base period net income so as to demonstrate the ‘inadequate standard of normal earnings‘ required by section 722(b) and to establish constructive average base period net income under section 722(a).
In Stimson Mill Co., 7 T.C. 1065, we had a situation where it was admitted that due to a strike in 1937 the corporate income was affected by ‘events unusual and peculiar in the experience of such taxpayer,‘ within the language of section 722(b)(1); nevertheless, we denied relief to the taxpayer for the reason that, in computing the ‘fair and just amount representing normal earnings to be used as a constructive average base period net income,‘ it did not merely use the actual base period net income, adding thereto the effect of section 713(e), but first raised the income for 1937, under section 722, because of the strike, and then computed under section 713(e) upon the amount so obtained.
Here, the petitioner contends that, having shown that in the taxable years the respondent calculated depreciation by using a lower rate than had been used in the base period years, it has shown that depreciation deductions were excessive in the base period years and, therefore, that it has established a factor demonstrating that its ‘average base period net income is an inadequate standard of normal earnings.‘
In the Stimson case it was not denied, in fact was agreed, that the proof necessary for section 722 relief up to that point had been produced, that is, that in one year, due to a strike, income would, in a computation under section 722, be raised; yet, relief under section 722 was denied for the reasons to which we have above adverted. There is, therefore, a complete parallel between the stipulated proof in the Stimson case (of a strike adversely affecting petitioner's business) and the alleged, but denied, proof here (of change in depreciation rate in the taxable years, indicating excessive rate in the base period years). Here, just as in the Stimson case, the petitioner goes forward and attempts to establish a constructive average base period net income. It does so in precisely the same way as was done in the Stimson case, except that here section 713(f) is used to raise the base period income average, instead of section 713(e). Here, just as in the Stimson case, after giving effect in the computation of average base period net income to the factor affecting business (admitted by the respondent in the Stimson case, but vigorously denied in this), the petitioner utilizes one of the two formulae of section 713 to raise the amount of the computation, and calls the result constructive average base period net income. Since, as in the Stimson, case and for the reasons set forth therein, such a showing is not sufficient to establish a ‘fair and just amount representing normal earnings to be used as a constructive average base period net income,‘ within the language of section 722(a), the petitioner here also, as in that case, has failed to show a right to further relief than it was originally granted in the deficiency notice. Therein the Commissioner allowed an excess profits credit of 95 per cent of $409,623.77, which is the section 713(f) average base period net income based on the actual and reported income in the base period. Moreover, as was true of the amount of relief allowed in the Stimson case, 4409,623.77, which is the section 713(f) average base period net income based on the actual and reported income in the base period. Moreover, as was true of the amount of relief allowed in the Stimson case, $409,623.77 is more than an average base period net income computed upon the petitioner's theory, but without application of section 713(f); that is, computed upon the figures resulting from raising the net income actually determined by the taxpayer and reported by it, to the extent of the effect of application of petitioner's theory of decreasing depreciation deductions in the base period years, because they were decreased in the taxable years. Such changed and increased figures on petitioner's theory are as follows:
+-------------------+ ¦1936 ¦$37,786.12 ¦ +-------+-----------¦ ¦1937 ¦340,303.17 ¦ +-------+-----------¦ ¦1938 ¦466,466.78 ¦ +-------+-----------¦ ¦1939 ¦384,798.50 ¦ +-------+-----------¦ ¦Average¦307,338.64 ¦ +-------------------+
The average, $307,338.64, is the average base period net income, on petitioner's theory, up to the point of applying section 713(f). Therefore, we see, since this figure is less than $409,623.77, that, just as in the Stimson case, the petitioner has shown no right to relief under section 722, because without the further assistance of section 713(f) to raise the ‘actual‘ base period average, such average is less than already allowed by the Commissioner, who has allowed, as he must, the benefit of section 713(f) to be added to the original income figures. Even if we assume then, without deciding, that petitioner has proven a right to use in the base period the depreciation rate used by the Commissioner in the taxable period, it has shown no right to relief; for it is apparent that a showing that average base period net income is an ‘inadequate standard of normal earnings,‘ resulting in excessive discriminatory tax, is not made by the alleged ‘factor affecting the taxpayer's business,‘ introduced by the petitioner, when, without adding the effect of section 713(f) the result is less relief than already allowed. Such a factor is not one ‘reasonably to be considered as resulting in an inadequate standard of normal earnings during the base period,‘ within the words of section 722(b)(5). It is apparent also, for the reasons set forth in the Stimson case, that such use of section 713(f) sets up no ‘fair and just amount representing normal earnings,‘ which is, under section 722(a), to be used as a constructive average base period net income, but sets up only a statutory computation. It is immaterial that the petitioner does reduce, by a small amount, the full effect of applying section 713(f) to its increased base period average, for as above seen, the petitioner is not entitled to use that section at all upon figures already increased upon its theory, and without such use the relief already afforded, in the deficiency notice and after applying section 713(f) to the actual income, is far greater, for 95 per cent credit is based upon $409,623.77, while petitioner's theory, without the assistance of section 713(f), produces only $307,338.64. We hold, therefore, that the petitioner has not shown itself entitled to relief under section 722.
This conclusion renders it unnecessary to consider the respondent's contentions that petitioner's relief should be based upon section 734, that in relying upon the change in depreciation rates in the taxable years the petitioner, contrary to the provisions of section 722(a), was relying upon an event or condition after December 31, 1939, and that the fact that depreciation rates were lowered in the taxable years is no proof that they were improper, either in those years or in the base period years.
Reviewed by the Special Division.
Decision will be entered that the petitioner is not entitled to relief under section 722, and that there is a deficiency in the amount determined by the Commissioner.