Opinion
Docket No. 12544.
1948-06-23
CALIFORNIA VEGETABLE CONCENTRATES, INC., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
A. Calder Mackay, Esq., Arthur McGregor, Esq., and Charles J. Higson, Esq., for the petitioner. R. E. Maiden, Esq., for the respondent.
1. Held, on the facts, that amounts of deductions for compensation paid officers pursuant to contingent contract entered into in prior years were reasonable compensation for personal services actually rendered, and were properly deducted under section 23 (a) (1) (A) of the Internal Revenue Code.
2. The petitioner filed with its return a claim for relief under section 722 and under section 710 (a) (5) reduced the amount payable by 33 per cent of the amount of the claim. Held, that the deficiency herein does not include as tax imposed the 33 per cent of the claim under section 722.
3. Credit for debt retirement under section 783 denied for lack of proof.
4. Post-war refund credit under section 780, held, not credit against tax for the taxable years and outside the jurisdiction of this Court in determining deficiencies. A. Calder Mackay, Esq., Arthur McGregor, Esq., and Charles J. Higson, Esq., for the petitioner. R. E. Maiden, Esq., for the respondent.
This proceeding involves deficiencies of $6,153.84 and $846.26 in declared value excess profits tax and of $76,031.67 and $44,779.20 in excess profits tax for the calendar years 1942 and 1943, respectively. The issues are whether the respondent erred in disallowing as deductions certain amounts each year as excessive compensation paid to two of petitioner's officers; whether the deferment of excess profits tax provided for in section 710 (a) (5) of the Internal Revenue Code should be reflected in the deficiencies; and whether petitioner is entitled to a credit under sections 780 and 781 for post-war refunds. The stipulations of fact filed by the parties are incorporated herein by reference as part of our findings of fact.
FINDINGS OF FACT.
The petitioner, a Nevada corporation, organized in June 1929 and having its principal place of business in Huntington Park, California, filed its income, declared value excess profits, and excess profits tax returns with the collector for the sixth district of California. It kept its books and filed its returns on the accrual basis.
In 1927 L. P. Sims purchased for $7,500 a business having machinery adaptable for dehydrating vegetables, and then organized the California Vegetable Products Co., a corporation, to produce onion and garlic powder. W. Stoepel and J. B. Pardieck (hereinafter sometimes referred to as Pardieck) were associated with him in the corporation, the latter as general manager. The corporation was the first producer of high quality onion and garlic powder in the United States. Sims sold his interest in the corporation in 1929 for $76,000 and a short time thereafter organized petitioner, to manufacture and sell vegetable powders other than onion and garlic. Pardieck remained with the California Vegetable Products Co. as vice president in charge of all products, procurement, plant design, and other work. The stock of petitioner consisted of nonvoting 7 per cent cumulative preferred, par value $100 a share, and common stock of no par value. Sims and his associates in the venture, including Pardieck, purchased shares of the preferred stock from petitioner for $50 a share and received shares of common stock without cost, Sims and Stoepel purchasing and receiving the same number of shares of each class of stock. The stock of petitioner outstanding in 1936, 1937 to 1942, inclusive, and 1943, was held as follows:
+-----------------------------------------------------------------------+ ¦Common shares ¦ ¦ ¦Preferred shares¦ ¦ ¦ ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦ ¦1936 ¦1937-1942¦1943 ¦1936 ¦1937-1942¦1943 ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦J.B. Pardieck ¦2,292¦2,292 ¦4,676 ¦62.5 ¦57.5 ¦57.5 ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦J.W. Wigelsworth¦1,834¦1,834 ¦1,559 ¦50.0 ¦50.0 ¦50.0 ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦A.E. Wigelsworth¦1,834¦1,834 ¦1,559 ¦50.0 ¦50.0 ¦50.0 ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦A.L. Webb ¦459 ¦459 ¦390 ¦12.5 ¦12.5 ¦12.5 ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦W. Stoepel ¦5,500¦5,500 ¦4,675 ¦162.5¦162.5 ¦162.5¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦L.P. Sims ¦5,600¦6,364 ¦5,424 ¦162.5¦162.5 ¦162.5¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦W. Stallsmith ¦1,717¦1,717 ¦1,717 ¦0 ¦0 ¦0 ¦ +----------------+-----+---------+----------------+-----+---------+-----¦ ¦A.E. Pardieck ¦0 ¦0 ¦0 ¦0 ¦5.0 ¦5.0 ¦ +-----------------------------------------------------------------------+
In 1936 Sims and Pardieck held 29.11 and 11.92 per cent, respectively, of petitioner's common stock outstanding. During the years 1937 to 1942, inclusive, their holdings were 31.82 per cent and 11.46 per cent, respectively. In 1943 the amount of such stock held by Sims was 27.12 per cent and by Pardieck, 23.38 per cent. L. P. Sims and J. B. Pardieck are not related to each other or to the other stockholders, except that A. E. Pardieck is the father of J. B. Pardieck. Christian H. Hartke was one of petitioner's original stockholders and was its attorney.
Until 1937 most of the petitioner's business consisted of the preparation of vegetable powders for sale for therapeutic purposes under thirteen formulae developed by Sims. In 1936 Sims started to conduct experiments on the dehydration of vegetables for sale in bulk in powdered and flake form. In June 1937 J. B. Pardieck was employed by petitioner to take charge of procurement and production. The experimental work resulted in the production of dehydrated flakes or powders from parsley, celery, tomatoes, and other vegetables. One of the bulk products consisted of various vegetables flakes to make soup, which was known as soup mix. The soup mix was originally sold to noodle manufacturers and comprised about 60 per cent of petitioner's bulk sales in 1943. Other products developed included a pumpkin concentrate, beet powder, dehydrated horse-radish, and dehydrated parsley leaves.
Only one other company produces dehydrated vegetables for therapeutic use, and no other company manufactures the variety of vegetable flakes produced by petitioner. Petitioner is the only dehydrating company successfully producing red tomato flakes. During the last war the number of concerns in the dehydrating vegetable industry increased from about eleven to one hundred and ninety. Since then the number has decreased to about seven.
In connection with his research work, Sims successfully conducted experiments over a period of three years to increase the mineral content of vegetables, primarily in calcium, phosphorus, and iron. The methods employed enabled him to increase the iron content of spinach, parsley, and one or two other vegetables from 40 to 50 per cent.
Sims was in charge of sales of and made sales for petitioner, and he introduced the soup mix to noodle manufacturers. Most of petitioner's sales were made east of the Mississippi River. The nature of the products produced by petitioner required Sims to explain the use thereof and methods of manufacture to prospective customers in order to make the first sale. Adjustments of the formula were necessary at times to meet the requirements of customers. Ordinary salesmen do not possess the technical knowledge required to sell petitioner's products and for that reason petitioner never employed salesmen or brokers to market its product. None of the petitioner's products was sold in a retail package under its name. Sims made one or two trips east a year, each one lasting two or three weeks, to call upon various food-processing companies in the market for its products. Sales of large volume, constituting from 40 to 50 per cent of total sales, were made by personal contact with buyers, and other sales were made by mail. The soup mix was sold in 1938 to seventy-two companies engaged in selling dry soup and noodles. In 1939 petitioner had about three hundred customers for all of its products. In 1940 some large food processors began to use the product. In 1942 one of petitioner's customers began a national distribution of dry vegetable noodle soup and placed an average of six packages in every grocery store in the United States. The usual commission charge for the sale of fresh vegetables as they come from the farm is 15 per cent of the selling price. Some of petitioner's customers purchased large quantities and, after they were established as purchasers for a specified product, sales to them were a routine matter.
Petitioner's products went largely to the civilian trade in the United States, and petitioner's main customers did not, in general, sell its products to the armed forces. The customers, however, had an increased demand for their products, and increased orders, by reason of the war, and had large contracts with the Government.
The dehydration of vegetables is accomplished by first slicing the material and then subjecting it to heat, humidity, and air in certain amounts. Improper use of the method will destroy natural color and flavor of the product.
Pardieck entered the dehydration industry in 1920 as a laborer for a company engaged in producing dried fruits, and in 1926 he was appointed general manager of its plant. He took night school courses to acquire knowledge of food technology and chemistry and otherwise did everything he could to acquire an education for the dehydrated vegetable industry.
In 1931 Pardieck became an employee of a corporation which was conducting a business in Texas for the dehydration of onions and garlic grown in that state. He had charge of procurement, plant design, and general manufacture for the corporation. The venture was not a success on account of inability to grow the right kind of onions in Texas, and the corporation was dissolved. The former stockholders of the corporation, including Pardieck, then formed a partnership and engaged in the same business in California. Pardieck continued with the partnership until June 1937, when he sold his interest and became an employee of petitioner.
Pardieck's duties with petitioner in 1937 were the procurement of fresh vegetables and redesigning the plant to produce vegetable flakes. The work included the creation of a machine to slice tomatoes without bruising them and otherwise to retain natural color during dehydration. No other food manufacturer has a similar machine. The use of the machine enabled petitioner to produce dehydrated tomato flakes of a natural color.
Pardieck continued to have charge of procurement of vegetables. Most of such material was obtained by contacting a few growers in advance and entering into contracts for petitioner's requirements for delivery when desired. About 85 per cent of petitioner's requirements for vegetables was purchased in that manner. Contracts for such raw material were generally negotiated during the course of a few days. Pardieck checked the development of crops during the growing season at least once a month to ascertain the probable yield. Other requirements of petitioner for vegetables were purchased in the open market. In each taxable year petitioner used over fourteen thousand tons of fresh vegetables. The custom among food processors is to pay brokers a fee of one dollar a ton for buying ordinary vegetables for them and in some instances up to five dollars a ton for specified fruits or vegetables. Government subsidies and the removal of Japanese from California increased during the last war the difficulties involved in the purchase of fresh vegetables for dehydration.
The average loss of weight of vegetables in dehydrated processes is about 93 per cent. Savings in shrinkage result in lower production costs and higher profits. The development by Pardieck, with the help of seed companies and others, of tomatoes having a higher solid content than those used for canning purposes resulted in a saving of about fourteen cents a pound in producing the finished product.
Pardieck was also in charge of and was responsible for production. In 1941 petitioner had about one hundred and eighty employees working in three plants. Petitioner had a scientifically trained man in charge of actual dehydration operations and another man, trained by petitioner to be an expert, in charge of the ‘finished‘ department. In 1943 employees engaged in preparing fresh vegetables for dehydration worked two eight-hour shifts and the dehydrating equipment was operated during an additional eight-hour shift. During the period from 1937 to 1943, Pardieck worked six days a week and frequently on Sundays, and he did not take a vacation. He has been recognized as an authority on the technicalities of dehydration of vegetables.
The sales and net profit (per tax return) of petitioner for the years 1935 to 1943, inclusive, were as follows:
+--------------------------------------+ ¦ ¦ ¦ ¦Net profit¦ +----+-----------+----------+----------¦ ¦ ¦Therapeutic¦Bulk ¦(per tax ¦ +----+-----------+----------+----------¦ ¦Year¦products ¦products ¦return) ¦ +----+-----------+----------+----------¦ ¦1935¦$85,260.29 ¦ ¦$20,943.01¦ +----+-----------+----------+----------¦ ¦1936¦110,469.54 ¦ ¦19,522.51 ¦ +----+-----------+----------+----------¦ ¦1937¦125,499.55 ¦$9,394.92 ¦19,683.73 ¦ +----+-----------+----------+----------¦ ¦1938¦110,691.10 ¦17,164.26 ¦13,873.43 ¦ +----+-----------+----------+----------¦ ¦1939¦132,666.36 ¦74,047.51 ¦23,695.36 ¦ +----+-----------+----------+----------¦ ¦1940¦128,187.77 ¦205,230.59¦29,068.90 ¦ +----+-----------+----------+----------¦ ¦1941¦121,219.11 ¦402,463.87¦53,418.05 ¦ +----+-----------+----------+----------¦ ¦1942¦141,394.67 ¦743,763.83¦115,198.10¦ +----+-----------+----------+----------¦ ¦1943¦183,812.20 ¦768,946.85¦78,282.98 ¦ +--------------------------------------+
Petitioner's sales in 1942 and 1943 included a total of about $50,000 made in those years to the United States Army. Its earned surplus increased from $21,000 in 1935 to $201,000 in 1943. Its paid-in capital in and after 1937 was $34,000. It paid dividends of $4,989.40 on preferred stock in 1935, $21,000 in 1936, and $3,500 each year thereafter. The dividends paid on common stock were $15,196.44 in 1937, $1,400 in 1941 and 1942, and $6,300 in 1943. The increase in sales after 1941 was primarily due to natural development of the use of vegetable flakes with other preparations for soup.
Sims was president of petitioner until succeeded by Pardieck on January 1, 1944, and Warren Stoepel was secretary and treasurer. Pardieck had been vice president since 1938. At a meeting of the directors of petitioner on February 4, 1936, Sims expressed the opinion that his salary for 1936 should be $8,000 and 25 per cent of the net profits; for 1937, $9,000 and 30 per cent of the net profits; and for 1938, $10,000 and 35 per cent of the net profits, the net profits in each year to be above the preferred stock dividend requirements. The directors authorized payment of the salaries so requested by Sims.
At a meeting held on February 8, 1938, Sims informed the other directors that his salary arrangement with petitioner terminated at the close of 1938, and advised them that it was satisfactory to him. The directors thereupon adopted a resolution continuing the arrangement ‘until changed at the request of Mr. Sims or by action of this Board.‘
In August 1940 the salary of Pardieck for the last six months of 1940 was fixed at $650 a month, plus a bonus of 10 per cent of net profits after payment of preferred dividends and the compensation to Sims, and for the next four years it was the same basic salary, plus a bonus of 15, 20, 25, and 30 per cent, respectively, of net profits, computed as in 1940.
On November 13, 1940, the directors authorized an additional bonus of $5,000 to Sims, Pardieck, and Stoepel. On April 28, 1941, the directors authorized payment of an additional bonus of $5,000 to Sims and $3,900 each to Pardieck and Stoepel.
At the time of adoption of the resolutions, supra, the directors of petitioner were Sims, Hartke, and Stoepel. Pardieck was elected a director in February 1943. Hartke and Stoepel, as directors, accepted the judgment of Sims with respect to activities of petitioner, except on administrative matters. It was customary for all stockholders to be present at their meetings. Sims and Pardieck never held proxies for other stockholders at such meetings in 1936, 1938, 1941, 1942, and 1943, except that Pardieck might have held proxies to vote his father's stock.
The salary of Sims in 1930, 1931, and 1932 was $3,000; 1933, $3,341.59; 1934, $4,999.92; and 1935, $7,500. The compensation paid or accrued to Sims and Pardieck for the years 1936 to 1943, inclusive, in accordance with the resolutions, supra, was as follows:
+----------------------------------------------------+ ¦ ¦Sims ¦Pardieck ¦ ¦Sims ¦Pardieck ¦ +----+----------+---------+----+----------+----------¦ ¦1936¦$14,910.07¦ ¦1940¦$41,194.36¦$16,064.67¦ +----+----------+---------+----+----------+----------¦ ¦1937¦16,885.17 ¦ ¦1941¦54,160.58 ¦22,609.07 ¦ +----+----------+---------+----+----------+----------¦ ¦1938¦16,485.41 ¦$3,950.00¦1942¦98,191.03 ¦42,599.52 ¦ +----+----------+---------+----+----------+----------¦ ¦1939¦22,521.37 ¦6,025.00 ¦1943¦70,787.05 ¦37,601.13 ¦ +----------------------------------------------------+
The salary paid to Stoepel in each of the years 1935, 1936, 1937, and 1938 was $6,000; 1939, $7,000; 1940, $11,000, and in each of the next three years, $9,000.
Of the compensation paid to Sims and Pardieck for the year 1942, $34,184.46 of the salary of Sims and $12,697.08 of Pardieck's salary were paid by notes dated December 31, 1942, which were paid by petitioner in cash on January 28, 1943. Of the compensation paid to them for the year 1943, $14,990.92 of the compensation of Sims and $6,960.07 of the compensation of Pardieck were paid by notes dated December 31, 1943, which were paid by petitioner in cash on March 14, 1944. The remainder of the compensation each year was paid in cash during the respective taxable years, except that $8,122.71 of Pardieck's compensation for 1943 was not so paid until January 3, 1944.
Sims devoted all of his time to the affairs of petitioner and took only one vacation, lasting three weeks or a month, between 1929 and 1943. He suffered a slight stroke in February 1943, and was absent from work for about five weeks. Thereafter in 1943, Sims spent less time each day at petitioner's office, and he did not make any trips to the eastern part of the United States. The burden of carrying out his duties increased during the year, on account of which Sims decided that he should resign from his position. Accordingly, he resigned from the office of president the latter part of 1943, effective January 1, 1944, and insisted that Pardieck be elected president. Thereafter Sims was elected chairman of the board of directors, and during 1944 received a salary of $7,200. Neither petitioner nor anybody connected with it requested Sims to make such change in his salary. Pardieck, as president of petitioner, took over most of the duties of Sims and has continued to perform them. In 1944 petitioner employed a sales manager.
In his determination of the deficiencies, the respondent allowed as deductions for compensation to Sims and Pardieck amounts equal to the total salary and bonus petitioner paid to each of the officers in 1941, and disallowed the remainder as excessive and unreasonable.
The amounts paid and accrued by petitioner in 1942 and 1943 as compensation for Sims and Pardieck constitute reasonable compensation for personal services actually rendered.
The excess profits tax returns filed by the petitioner for 1942 and 1943 reported adjusted excess profits net income of $82,582.64 and $50,865.60, respectively, and normal tax net income (computed without regard to the credit provided by section 26 (e)) of $115,198.10 and $78,282.98, respectively, thus showing, as to each year, petitioner's excess profits net income was in excess of 50 per cent of its normal tax net income. The petitioner showed on line 17 of the returns, as deferred by reason of the application of section 710 (a) (5), the amount of $12,029.87 for 1942 and $7,231.81 for 1943. The returns for 1942 claimed a credit of $6,229.45 allowable under sections 780 and 781 and a like amount for debt retirement allowable under section 783, the amount in each case being 10 per cent of the balance of excess profits tax in the amount of $62,294.51. Like credits were claimed for 1943 in the amount of $3,854.72.
The petitioner filed claims with the respondent for relief under section 722 of the Internal Revenue Code. No final action has been taken by the respondent on the claims.
In his determination of the deficiencies the respondent did not allow a reduction of excess profits tax under section 710 (a) (5) or a credit under sections 780 and 781, or section 783.
OPINION.
DISNEY, Judge:
The disagreement of the parties on the salary question is whether the amounts paid to Sims and Pardieck constitute reasonable compensation for services actually rendered within the meaning of the applicable statute, section 23 (a) (1) (A) of the code. The issue is essentially a question of fact, controlled by the peculiar circumstances of record. No controversy is joined as to payment, or time of payment.
Each of the salaries in question consisted of a basic amount annually, $10,000 in the case of Sims and $7,800 in the case of Pardieck, plus a portion of the net profits, 35 per cent for Sims, and 25 per cent in 1942 and 30 per cent in 1943 for Pardieck. The contingent compensation in each instance was payable after setting aside an amount for dividends on preferred stock, and such compensation of Sims was deductible before computing like salary of Pardieck.
The Treasury regulations approve broadly the method employed by petitioner to fix the amount of the compensation in question. Section 19.23 (a)-6 (2) and (3) of Regulations 103 and 111, provides, as follows:
(2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.
(3) In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is in general just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.
The salary of Sims, based in part upon profits, was fixed by the board of directors of petitioner in 1936 for a period of three years and in 1938 was continued for subsequent years until changed by proper action. In 1938, when the percentage of profits to be used in computing contingent compensation reached the maximum of 35 per cent, the figure applicable to all subsequent years, the salary of Sims was $16,485.41, or about $38,000 less than the amount respondent determined to be reasonable for each of the taxable years. The total salary of Sims in 1939 was about $22,500 and in 1940, $41,000. The salary of Pardieck, based in part upon profits, was not fixed until 1940, and it, as in the case of Sims, increased or decreased thereafter according to net profits. The arrangements disclose a fixed policy of petitioner to pay its key officers compensation based in part upon net profits. It has been held that such a policy ‘is based primarily upon sound business principles.‘ Gray & Co. v. United States, 35 Fed.(2d) 968. In Austin v. United States, 28 Fed.(2d) 677, the court said that ‘The reasonableness of the contract is to be viewed in the light of the circumstances that existed when it was made,‘ and ‘It is immaterial that in the actual working out of the contract contingent compensation may prove to be greater than the amount which ordinarily would be paid.‘
None of the salaries has any relation to stockholdings and neither officer at any time held a controlling interest in petitioner. It was not until 1943 that their combined stockholdings constituted a majority. Stoepel held about 28 per cent of petitioner's stock when the salaries were fixed by him and other directors, and never received a salary based upon earnings. The earned surplus of petitioner increased about $185,000 from 1936 to the close of 1943, after payment of all dividends on preferred stock and small dividends, total about $24,000, on common stock.
The facts clearly show that the success of petitioner was due primarily to the efforts of Sims, with the assistance rendered by Pardieck, in procuring desirable fresh vegetables, designing machinery, and operating the plant. Their joint efforts resulted in the creation of products which were acceptable to large processors of food at prices highly profitable to it. No other manufacturer was able to produce dehydrated tomato flakes containing the natural red color, and to that extent petitioner, on account of the ability of Sims and Pardieck, had a monopoly in the industry. The large profits in the taxable years were made possible to a large extent by the effort expended by Sims and Pardieck in prior and less profitable years.
Considering all of the facts of record, we conclude and hold that the salaries in question were reasonable, and they are deductible as compensation paid for personal services actually rendered.
Section 710(a)(5) of the code provides that, under circumstances as to the applicability of which the parties are not in disagreement here, ‘the amount of tax payable at the time prescribed for payment may be reduced by an amount equal to 33 per cent of the amount of the reduction in the tax so claimed. * * * ‘ Petitioner elected to accept the benefits of the provision and, following Form 1121 prescribed by the Treasury Department, each taxable year reduced the amount of excess profits tax shown in its returns by 33 per cent of the amount of its claims for relief under section 722. The respondent recognized the action by assessing only the tax liability so reduced by petitioner, as tax due, adjusted in 1942 for mathematical errors. The deficiencies determined by the respondent, however, do not reflect the reduction in ‘Tax payable at the time prescribed for payment,‘ that is, they defer no part of the adjusted excess profits tax liability.
The position of petitioner is, in substance, that there should be no assessment of the amount of the reduction shown on its return until the Commissioner passes upon its claim for benefits under section 722. Respondent's position in that regard is that such deferment is precluded by the provisions of section 271(a), defining ‘deficiency,‘ and the concluding sentence of section 710(a)(5) (immediately following the portion quoted above) which reads as follows: ‘ * * * For the purposes of section 271, if the tax payable is the tax so reduced, the tax so reduced shall be considered the amount shown on the return.‘ He says that, since he has issued a deficiency in this matter, section 272(f) bars him from thereafter issuing another to cover the 33 per cent, if it is not included in the present deficiency, so that it is essential to the protection of the Government revenue that he include the deferred amounts in the deficiencies here involved. He adds that, in the matter of the collection of any deficiency found by this Court herein, it must be presumed that respondent will make the collection in accordance with petitioner's rights under the law, and that the petitioner's claim of deferment is prematurely made and improperly imposed upon this Court.
Section 271 defines the meaning of the term deficiency as used in chapter 1 of the code. It is made applicable to excess profits taxes provided for in subchapter E of chapter 2 of the code by section 729 (a), which reads as follows:
All provisions of law (including penalties) applicable in respect of the taxes imposed by Chapter 1, shall, insofar as not inconsistent with this subchapter, be applicable in respect of the tax imposed by this subchapter.
This provision requires that section 271 be read in connection with any inconsistent provisions of subchapter E of chapter 2.
Section 272 (b) provides that the Commissioner shall assess the entire amount determined as a deficiency by this Court, and that the same shall be paid upon notice and demand from the collector. It is obvious, therefore, that if this Court approves the respondent's view and does not exclude the 33 per cent of the amount claimed under section 722 from the deficiency here being redetermined, the Commissioner may assess it and is, therefore, able to demand payment— and the taxpayer will have secured only temporarily the immunity from assessment, that is, deferment of the 33 per cent granted in section 710 (a) (5). It is our duty to determine the proper amount of deficiency, and therefore to decide whether the 33 per cent forms a part thereof.
Section 710 (a) (5), it seems to us, clearly provides deferment until the completion of the determination of the claim under section 722, for the deferment is provided only under certain circumstances for one who files a claim under section 722, and it seems apparent that the object in view was to recognize that such a taxpayer filing a claim for relief under section 722, where its adjusted excess profits net income was more than 50 per cent of its normal tax net income, should be considered sufficiently likely to prevail at least to some extent on its claim that it would be only fair to let such a taxpayer retain 33 per cent of the amount of such claim until final adjustment thereof. To permit the deferment only until the Commissioner can issue a deficiency notice (prior to section 722 procedure) and collect thereon is not in line with the obvious intent of the statute.
The respondent, however, taking the definition of deficiency under section 271 as (so far as here of interest) ‘the amount by which the tax imposed * * * exceeds the amount shown as the tax by the taxpayer upon his return‘ (quoting section 271 (a) as in the law applicable in 1942; and the effect of section 271 (a) as applicable in 1943 is the same though not in text), apparently feels that, since the latter part of section 710 (a) (5) provides that for the purposes of section 271 the tax payable as reduced shall be considered the amount shown on the return, therefore, unless he includes the 33 per cent in the present deficiency, he will eventually fail to collect that portion of ‘the tax imposed‘ represented by the 33 per cent of the amount of the section 722 claim because section 272 (f) forbids him to issue a second notice of deficiency. This is the crux of our problem. In our opinion, the respondent's fear is not well founded; for we do not think that the 33 per cent is a part of ‘the tax imposed‘ within the language of section 271 defining deficiency, but that the 33 per cent is not ‘imposed,‘ if ever, until the determination, in the section 722 procedure, that there is liability therefor. Obviously, if the 33 per cent is not included in the tax imposed for purposes of the first deficiency, here being redetermined, it therefore does not enter into the amounts involved in section 271 and making up the deficiency, and to that extent the Commissioner is not precluded later from issuing a deficiency. It is true that section 272 (f) provides that with certain exceptions not here pertinent a second notice of deficiency may not be mailed in respect of the same taxable year, but under section 729 (a) we must read section 272 (f), as well as section 271, as modified by the excess profits tax law, including 710 (a) (5); and, since in our view that section delays the imposition of the excess profits tax to the extent of the 33 per cent until the determination under section 722, the object of section 710 (a) (5) and consistency between the provisions of chapter 1 and subchapter E of the excess profits tax law is properly and fairly accomplished by the view here taken, without prejudice to the respondent's right eventually to collect the 33 per cent if it is then determined to be payable by the taxpayer. Moreover, section 732 (a) provides in express language that if a claim under section 722 is disallowed, in whole or in part, the Commissioner's notice of disallowance ‘shall be deemed to be a notice of deficiency for all purposes relating to the assessment and collection of taxes or the refund or credit of overpayments,‘ if a petition is filed with this Court. Though textually the provision applies only if a petition is filed with this Court, we construe this to mean that this Court, when the matter comes before it, shall consider the notice of disallowance under section 722 as a notice of deficiency, but that this does not mean that, if an appeal is not taken to this Court, the disallowance may not be a determination of deficiency as between the Commissioner and the taxpayer. It is clearly a determination of the amount of tax liability of the taxpayer, for it either allows, or, in whole or in part, disallows the relief asked for under section 722, and, so far as the deferred 33 per cent is concerned, determines that there is, or is not, tax liability therefor. In our view, such is the first determination of the taxpayer's liability for the 33 per cent and is not precluded by the provision of section 272 (f), in chapter 1. To hold otherwise would be contrary to the expressed intent of Congress as shown by the report of the Committee on Finance with respect to section 710 (a) (5), reading, in part, as follows:
* * * Thus, at the time required for payment, an eligible taxpayer need pay only 67 per cent of that portion of the tax from which it claims relief. Any reduction in tax determined under section 722 in excess of the amount deferred by the taxpayer will have the effect of producing an overpayment of tax. Any determination of tax greater than the total amount paid will produce a deficiency.
Senate Report No. 1631, p. 205. The language of the report of the Committee on Ways and Means is the same. C.B. 1942-2, p. 481.
Moreover, the above conclusion that the tax imposed (and therefore the deficiency) does not include the 33 per cent reduction is recognized in the Treasury regulations.
Section 35.780-1 of Regulations 112, relating to post-war refunds of excess profits tax, provides, in part:
* * * Pending the final determination of the tax pursuant to section 722, the tax imposed shall, for such purpose, be tentatively considered as an amount determined without regard to the determination under section 722, minus the amount, if any, by which the tax payable at the time prescribed for payment is reduced under section 710 (a) (5) (relating to deferment of payment of tax in case of claim under section 722). * * *
That, on the question of whether section 272 (f) precludes a second notice of deficiency, the excess profits tax law modifies that section, is clearly recognized in Uni-Term Stevedoring Co., 3 T.C. 917, wherein, to the suggestion that ‘section 272 (f) prohibits the determination of an additional deficiency where a petition based upon an existing notice has been filed with this Court,‘ we said:
The flaw in this reasoning is that the provisions of the income tax law, including sections 322 and 272, are made applicable to the excess profits tax only to the extent that they are not inconsistent with the provisions of the excess profits tax subchapter. * * *
To the same effect was Pohatcong Hosiery Mills, 162 Fed.(2d) 146.
The language of section 292 (b) provides in substance that interest shall not be charged under certain circumstances on deficiencies arising from section 722 procedure. But, parenthetically, it specially excludes ‘any portion of a deficiency in excess profits taxes constituting a deficiency by reason of deferment of tax under section 710 (a) (5), and excluding, in case the taxpayer has availed itself of the benefits of section 710 (a) (5), such portion of a deficiency under Chapter 1 as may be determined * * * to exceed any refund or credit of excess profits tax arising from the operation of section 722.‘ This language demonstrates completely that the deferment of tax under section 710 (a) (5) may result in a deficiency.
The excess profits tax return, Form 1121, prescribed by the Treasury Department, provides in line 17 for the reduction of the tax by the amount of deferment provided by section 710 (a) (5). It also provides computation of the debt retirement credit and the post-war refund on the basis of such reduced amount.
Section 722 (d) provides, in connection with relief under section 722, that the taxpayer shall compute its tax, file its return, and pay the tax shown thereon without application of section 722, ‘except as provided in section 710 (a) (5).‘ From all of the above, we conclude that Congress did not intend that the taxpayer should be liable for the 33 per cent until completion of section 722 procedure and as a part of the deficiency, if any, then determined.
We conclude and hold that the Commissioner erred in including in each deficiency the amount of the reduction provided under section 710 (a) (5).
House Joint Resolution 385, recently enacted, amends section 710 (a) (5) of the Internal Revenue Code, retroactively, so as to apply to the taxable years here involved. It provides in substance that notwithstanding any other provision of law, to the extent that any amount of tax remaining unpaid pursuant to section 710 (a) (5) is in excess of the reduction in tax finally determined under section 722, the excess may be assessed within one year from such final determination. In the light of such enactment, the respondent's fear, above referred to, that it was necessary for the protection of the public revenue to include the 33 per cent in the deficiency determined, is not well based. The resolution reads as follows:‘SEC. 3. EXTENSION OF TIME FOR ASSESSMENT OF DEFERRED EXCESS-PROFITS TAX.‘(a) Section 710 (a) (5) of the Internal Revenue Code is hereby amended by adding at the end thereof the following:'Notwithstanding any other provision of law or rule of law, to the extent that any amount of tax remaining unpaid pursuant to this paragraph is in excess of the reduction in tax finally determined under section 722, such excess may be assessed at any time before the expiration of one year after such final determination.'‘(b) The amendment made by this section shall be effective as if made by section 222 (b) of the Revenue Act of 1942.‘
The assessments made by the respondent on the basis of petitioner's returns take into account, as credits, amounts for post-war refunds of excess profits taxes and credit for debt retirements provided for in sections 780, 781, and 783 of the code. The assessments so made were deducted by the respondent in computing the deficiencies, resulting, petitioner argues, in no credit for the amounts taken in the returns, or for the additional tax imposed by the proposed deficiencies.
The respondent, on brief, admits that the deficiencies were determined without regard to post-war refund credits and asserts that the taxes have not been paid and that petitioner will receive in due course any credits to which it is entitled.
With respect, first, to the credit for debt retirement, section 783 provides for a credit against excess profits tax of an amount equal to 40 per cent of the amounts paid during the year in repayment of principal of indebtedness, with a limitation not necessary of consideration here. The proof before us contains no evidence of the debt retirement necessary, or the amount thereof. The petition does not allege error in disallowance of credit for debt retirement. No findings of fact as to debt retirement were requested. No error by the Commissioner is shown in this respect.
Next, as to post-war credits: The credit for post-war refund of excess profits tax provided by section 780
is not a credit against tax imposed, so as to reduce tax liability. It is a credit to the account of a taxpayer for which bonds or cash may be issued, depending upon when the tax is paid. Sec. 780 and 781. The amounts thereof, if any are allowable, form no part of the computation of a deficiency. It is clear that the credits to which a taxpayer may be entitled are matters outside the jurisdiction of this Court. Moreover, a credit for a post-war refund must be reduced by the amount of credit allowed for debt retirement. Sec. 783 (c).
SEC. 780. POST-WAR REFUND OF EXCESS PROFITS TAX.(a) IN GENERAL.— The Secretary of the Treasury is authorized and directed to establish a credit to the account of each taxpayer subject to the tax imposed under this subchapter, for each taxable year ending after December 31, 1941 (except in the case of a taxable year beginning in 1941 and ending before July 1, 1942), and not beginning after December 31, 1943, of an amount equal to 10 per centum of the tax imposed under this subchapter for each such taxable year. * * *(b) APPLICATION OF CREDIT TO PURCHASE OF BONDS.— Within three months after the payment of the amount of the excess profits tax shown on the return for a taxable year to which subsection (a) applies (or, if such taxable year begins or ends in 1942, within one year after payment of the excess profits tax shown on the return for such year), if the payment is made before July 1, 1945, there shall be issued to and in the name of the taxpayer bonds of the United States in an aggregate amount equal to 10 per centum of the tax paid in respect of which a credit is provided under subsection (a), and the credit established under subsection (a) for such taxable year is hereby made available for the purchase of such bonds.
There being, as above seen, no proof here of the amount of debt retirement to which petitioner might be entitled, if we had jurisdiction of the matter we would not, without the essential facts as to the amount of debt retirement, be in a position to allow any amount as a post-war refund credit.
SEC. 783. CREDIT FOR DEBT RETIREMENT.(c) REDUCTION OF CREDIT AND OF BONDS OUTSTANDING UNDER SECTION 780.— If a credit is allowed for debt repayment in a taxable year pursuant to this section, the amount of such credit or refund shall be deducted from the credit under section 780 (a) and the amount of bonds issued under section 780 shall, to the extent necessary, be correspondingly adjusted.
Reviewed by the Court.
Decision will be entered under Rule 50.