McKay Mach. Co. v. Comm'r of Internal Revenue
| Citation | 28 T.C. 185 |
| Decision Date | 26 April 1957 |
| Docket Number | Docket No. 55214. |
| Parties | THE McKAY MACHINE COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. |
| Court | United States Tax Court |
OPINION TEXT STARTS HERE
James W. Frey, Esq., and H. H. Hoppe, Esq., for the petitioner.
Robert E. Johnson, Esq., for the respondent.
EXCESS PROFITS TAX CREDIT.— An inventory adjustment at the close of 1949 to reflect a reduction from cost to recoverable value of component parts of a mill produced by the petitioner, which it was unable to deliver because of inability to procure an export license, is not a deduction as contemplated by section 23 of the Internal Revenue Code of 1939 and is therefore not a disallowable abnormal deduction under section 433(b)(9) for the purpose of computing the excess profits tax credit, based on income, for the year 1950.
The respondent determined a deficiency in the petitioner's income tax for the calendar year 1950 in the amount of $8,309.89. The primary issue is whether in computing the petitioner's excess profits credit the petitioner is entitled to increase its base period net income by restoring to income for the year 1949 the amount of an inventory adjustment which the petitioner had taken with respect to certain machinery which the petitioner had produced under contract.
The petitioner is an Ohio corporation with principal office in Youngstown, Ohio. Its Federal income tax return for the year 1950 was filed with the collector of internal revenue for the eighteenth district of Ohio at Cleveland. It employs an accrual method of accounting and operates on a calendar year basis. It is a manufacturer of machinery. During the years 1945 through 1950 all of its manufacturing, with the possible exception of the manufacture of one or two sheet leveler machines, was done under contract with customers.
During the years of World War II petitioner had some contracts for delivery of goods to the Union of Soviet Socialist Republics (U.S.S.R.). Most of these contracts were obtained through the Treasury Department.
During the years 1946 through 1950 the petitioner had no contracts with any purchasing agent of the U.S.S.R. or any of its satellite countries, except one which was executed on October 25, 1946, with V. O. Machinoimport, a purchasing agent of the U.S.S.R., created and existing under the laws of the U.S.S.R. with main office in Moscow and a suboffice in Washington, D.C. Under the contract the petitioner undertook to manufacture, according to the purchaser's specifications, all of the material and equipment for the erection and operation of an atomic hydrogen weld tube mill, to be erected by the purchaser in the U.S.S.R. The total contract price was $600,000, and it was provided that the delivery should be completed not later than November 30, 1947. Such date could be changed only by written consent of the purchaser. The petitioner was to deliver the material and equipment for the mill f.o.b. its plant, packed for export shipment to the U.S.S.R. It was provided that if by reason of a law of the United States or for any other reason beyond the petitioner's control the equipment could not be shipped from the plant, payment was to become due as if the equipment had been shipped.
Pursuant to section 6 of the National Defense Act (Act of July 2, 1940, 54 Stat. 712), governmental regulations were issued requiring the application for a license to export the type of machinery covered by the contract in question. (8 Fed. Reg. 1494; 10 Fed. Reg. 4418-4490.) By October 25, 1946, when the petitioner entered into its contract, this type of machinery had been removed from the restricted commodity list and could have been exported under a general license without the necessity for application. (10 Fed. Reg. 11793.) However, such regulations were amended, effective March 1, 1948 (13 Fed. Reg. 1120), and thereafter an individual license was required for export of machinery of this type.
The mill was not completed and ready for shipment at the time specified and it had not been completed by March 1, 1948 when the Government regulations were promulgated requiring application for an export license. Machinoimport would have accepted the machinery in 1948 and 1949 if the petitioner had been able to export it to Russia. However, without an export license, the railroads would not have accepted the material for shipment to any port.
On February 24, 1948, the petitioner made application for an export license to ship the machinery in question to the U.S.S.R., but such application was denied on August 16, 1948. An appeal was taken by the petitioner on September 7, 1948, but such appeal was verbally denied at sometime in 1949 prior to October, and was formally denied on March 8, 1950. During the year 1949, the petitioner was advised that Machinoimport had closed its offices in this country and had returned to Moscow.
Machinoimport had made an advance payment of $270,234, but thereafter paid nothing further to the petitioner for any of the goods which had been produced under the contract.
Throughout the years 1945 to 1950 the inventory on the petitioner's books was carried at the lower of cost or market value and the tax returns were filed on that basis, but there was generally no occasion for reducing the inventory below cost since practically all of the petitioner's production was done under contract. However, if the costs should exceed the contract price, the inventory would be adjusted downward. The inventory consisted of three classifications, namely, raw materials, labor in process, and manufacturing expense in process. It has been the petitioner's practice to take an actual or physical inventory once each year and to make proper correction by adjusting journal entries to reflect any difference between the inventory shown on the books and the inventory actually on hand at the end of each year. This is necessary because of spoiled materials, material charge-outs, etc. The inventory is adjusted either downward or upward as required and corresponding debits or credits are made to labor, material consumed, and manufacturing expense absorbed. In the event of a downward adjustment of inventory and a debiting of these accounts, the result is an increase in cost of goods sold.
The inventory adjustments made by the petitioner, by way of reduction (and the average of such annual inventory adjustments), for the years 1945 through 1948 were as follows:
+-----------------------------------------------------------+
¦ ¦ ¦
+-------------------------------------------------+---------¦
¦1945 ¦$3,028.94¦
+-------------------------------------------------+---------¦
¦1946 ¦13,524.90¦
+-------------------------------------------------+---------¦
¦1947 ¦4,423.96 ¦
+-------------------------------------------------+---------¦
¦1948 ¦42,251.86¦
+-------------------------------------------------+---------¦
¦Total inventory adjustments for 1945 through 1948¦63,229.66¦
+-------------------------------------------------+---------¦
¦Average of annual inventory adjustments ¦15,807.42¦
+-----------------------------------------------------------+
Prior to the 1949 year-end adjustment the work in process under the Russian contract was carried in the inventory as follows:
+--------------------------------------------+
¦Material ¦$325,081.66¦
+--------------------------------+-----------¦
¦Labor in process ¦54,532.27 ¦
+--------------------------------+-----------¦
¦Manufacturing expense in process¦40,899.24 ¦
+--------------------------------+-----------¦
¦ ¦420,513.17 ¦
+--------------------------------------------+
In view of the fact that no expert license could be procured for shipment of the machinery to Russia and Machinoimport would not accept delivery in this country and pay the remainder of the contract price of this machinery, and because Machinoimport had closed its offices in this country and returned to Moscow, the petitioner concluded that it would not recover the costs it had incurred under the contract. In consequence thereof at December 31, 1949, it made entries in its general journal reducing its inventory by a net figure which reflected, on account of the Russian contract, a reduction of raw material by the amount of $61,649.19, labor in process by the amount of $9,679.76, and manufacturing expense in process by the amount of $7,260.01, a total of $78,589.17. Corresponding changes were made to the profit and loss account. These entries resulted in an increase in the cost of goods sold by that amount and such increase was reflected in its income tax return for 1949.
In arriving at the total 1949 year-end inventory reduction of $78,589.17, the petitioner determined what machinery could be resold and the price which could be obtained therefor. It then determined what machinery could not be sold but would have to be scrapped. it then multiplied the number of tons of scrap steel involved by $30 per ton, which was the market value at that time. The total amount recoverable from these sources was determined to be $61,690. It then added the advance payment of $279,234 to such resale and scrap values and arrived at a figure of $341,924 as the total amount realized and to be realized for the work under the Russian account. It then subtracted that figure from the cost of production under the contract as reflected in the inventory, namely, $420,513.17, which left the amount of $78,589.17 as the amount of the inventory reduction.
In its income tax return for the year 1950, the petitioner, in determining its excess profits credit, used the so-called growth formula provided for in section 435(e) of the Internal Revenue Code...
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