Rockwell Int'l Corp. v. Comm'r of Internal Revenue, Docket No. 3121-77.

• Decision Date: 13 October 1981
• Docket Number: Docket No. 3121-77.
• Parties: ROCKWELL INTERNATIONAL CORPORATION, PETITIONER v. COMMISSIONER of INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

77 T.C. 780

ROCKWELL INTERNATIONAL CORPORATION, PETITIONER
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT

Docket No. 3121-77.

United States Tax Court

Filed October 13, 1981.

In 1966, petitioner's predecessor in interest entered into a fixed-price incentive-type subcontract (P.O. 181) with General Dynamics Corp., which had contracted with the U.S. Air Force to oversee the development of the F-111 aircraft. P.O. 181 required petitioner to develop and manufacture components for the avionics systems of these aircraft. Under the contract, petitioner was to receive progress payments equal to a certain percentage of its incurred costs. The contract also provided that title to all materials acquired or manufactured under the contract was at all times vested in the Government. Prior to final delivery of the contract end items, however, petitioner bore the risk of loss with respect to such property.

In reporting the income from P.O. 181, petitioner used an accrual method based on deliveries, the same method it employed for its other fixed-price contracts. Under this method, if an overall profit was projected on the contract, petitioner would report a pro rata portion of the profit based on the ratio of the cost of units delivered during the year to the total estimated costs at completion of the contract. On the other hand, if a loss was projected, petitioner would take the entire amount of the loss into income by means of a lower of cost or market (LCM) adjustment to its contract ending inventory. Petitioner and its predecessors had elected to value their inventories under the LCM method since 1930.

Early in November 1969, petitioner determined that the most probable financial outcome on P.O. 181 was a $16,250,000 loss. This projection was based on petitioner's best estimate of the remaining costs to completion and the gross contract revenue to be received, and reflected the reaching of an agreement with General Dynamics and the Air Force approximately 1 month after yearend on a ceiling price for a portion of the contract which was $16,250,000 less than the price which petitioner had anticipated. Petitioner took this projected loss into income for the taxable year ended Sept. 30, 1969, by writing down the value of its contract ending inventory. It also recognized the loss in that year for financial reporting purposes in accordance with generally accepted accounting principles. Although the loss claimed was an estimated loss on the overall contract, the contract was only about half completed as of yearend. Petitioner completed its work on P.O. 181 in 1976, and the net loss ultimately realized was approximately $9,830,000 rather than the predicted loss of $16,250,000.

Held: Even assuming the title provision of P.O. 181 did not bar petitioner from using an inventory method of accounting with respect to costs incurred under P.O. 181, the writedown nevertheless failed to meet the requirements of either sec. 1.471-2(c) or 1.471-4, Income Tax Regs., which specify the circumstances under which inventories may be valued at less than actual cost, because there was insufficient objective evidence to establish the value of such inventory as of Sept. 30, 1969. Hence, respondent's determination that the writedown did not clearly reflect petitioner's income, as required by secs. 471 and 446(b), I.R.C. 1954, was not plainly arbitrary. Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979), followed. Space Controls, Inc. v. Commissioner, 322 F.2d 144 (5th Cir. 1963), revg. a Memorandum Opinion of this Court, and E. W. Bliss Co. v. United States, 224 F. Supp. 374 (N.D. Ohio 1963), affd. 351 F.2d 449 (6th Cir. 1965), distinguished.

Held, further: Assuming petitioner was not entitled to use an inventory method of accounting with respect to P.O. 181, the deduction of the estimated loss on the contract did not clearly reflect petitioner's income under sec. 446(b) because the loss was unrealized and the estimates upon which it was based were too uncertain to permit current recognition. Respondent was not required, as a precondition to the exercise of his discretionary authority under sec. 446(b), to advise petitioner of an acceptable method of accounting for the estimated contract loss in subsequent taxable years.

[77 T.C. 781]

Richard A. Mullens and Robert E. Liles II, for the petitioner.

Russell F. Kurdys, for the respondent.

DAWSON , Judge:

Respondent determined a deficiency in petitioner's Federal income tax for the taxable year ended September 30, 1969, in the amount of $8,580,000. The basic question presented for decision is whether petitioner's predecessor in interest, North American Rockwell Corp., improperly claimed a lower of cost or market inventory writedown during the year in issue in the amount of $16,250,000 with respect to

[77 T.C. 782]

costs accumulated under a partially completed defense subcontract.¹

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation and the attached exhibits are incorporated herein by reference.

Corporate and Business Background

Rockwell International Corp. (Rockwell) is a corporation organized and existing under the laws of the State of Delaware. Its principal office is located in Pittsburgh, Pa.

On September 22, 1967, Rockwell-Standard Corp., a Delaware corporation, merged into North American Aviation, Inc. (North American), a Delaware corporation and a predecessor in interest to Rockwell, and on that same date the latter corporation changed its name to North American Rockwell Corp. (also, for purposes of clarity, referred to as Rockwell). On February 16, 1973, Rockwell Manufacturing Co., a Pennsylvania corporation, merged into North American Rockwell Corp., and the latter corporation changed its name to Rockwell International Corp. During the fiscal year ended September 30, 1969, Rockwell and its consolidated subsidiaries were engaged in the manufacture of military and civilian aircraft, spacecraft, rocket engines, military and civilian electronics components and equipment, automotive and truck components, commercial printing presses, power boats, and textile machinery. Rockwell and its consolidated subsidiaries still engage in the majority of these lines of business.

Rockwell timely filed its Federal corporate income tax return for its fiscal year ended September 30, 1969, with the District Director of Internal Revenue, Los Angeles, Calif., under the name North American Rockwell Corp. and Domestic Subsidiary Cos.

Purchase Order No. 181

The subcontract relevant to the issue in this case covered the research, development, and production of military electronics

[77 T.C. 783]

components and equipment for the F-111 aircraft. The subcontract was designated “Purchase Order No. 181” (P.O. 181) and was executed on June 27, 1966, by North American, as subcontractor, and by General Dynamics Corp. (General Dynamics), the prime contractor, with the U.S. Air Force responsible for the development and manufacture of the F-111 aircraft. North American assigned responsibility for P.O. 181 to its Autonetics Division (Autonetics). The specific subject matter of P.O. 181 was specialized attack radars, navigation devices, cockpit instrument panels, and computers, referred to as “avionics.” These components and equipment were named the “Mark II” and “Mark II-B” avionics systems, and are collectively referred to herein as “Mark II.”

There were 16 major end items (i.e., finished products) to be manufactured under P.O. 181:

+-------------------------------------+
                ¦FB—111A (Strategic bomber) ¦
                +-------------------------------------¦
                ¦1. Inertial navigational system (INS)¦
                +-------------------------------------¦
                ¦2. General purpose computer (GPC) ¦
                +-------------------------------------¦
                ¦3. Electronic equipment rack (RK) ¦
                +-------------------------------------¦
                ¦4. Converter(CV) ¦
                +-------------------------------------¦
                ¦5. Central control unit (CCU) ¦
                +-------------------------------------¦
                ¦6. Numeric display unit (NDU) ¦
                +-------------------------------------+
                

F—111D (Tactical fighter-bomber)
                7. Stores management set (SMS)
                8. Attack radar set (ARS)
                9. Integrated display set (IDS)
                10. Radar (RAD)
                11. Electronic equipment rack (RK)
                12. Panels (various)
                13. General purpose computer (GPC)
                14. Inertial navigational system (INS)
                15. Doppler radar (DR)
                16. Horizontal situation display (HSD)
                

P.O. 181 was a fixed-price incentive-type contract. Such contracts generally specify a target cost, target price, and ceiling price, and also provide for cost or performance incentives in the form of upward or downward adjustments to the target profit (i.e., target price less target cost) based on a sharing ratio. The incentive clause of P.O. 181 operated in the following manner. In the event Rockwell's actual cost equaled target cost, it would be entitled to receive the target price (i.e.,

[77 T.C. 784]

cost plus target profit). If actual cost turned out to be less than target cost, Rockwell would receive an amount equal to the target price reduced by 80 percent of the cost underrun. On the other hand, if actual cost exceeded target cost, the price would be determined by adding actual cost plus target profit less 20 percent of the cost overrun. Under no circumstances, however, would Rockwell be entitled to receive more than the contract ceiling price.²

The price incentive provision of P.O. 181 contemplated only a single target cost, target price, and ceiling price. As additional tasks were added to the basic contract (i.e., extra work outside the scope of the performance originally contracted for), these three amounts were increased to take into account the newly negotiated figures pertaining to the additional tasks. Thus, in the event Rockwell was able to complete a particular task at, or below, target, the unused ceiling price negotiated for that task would be available to offset cost overruns on some other part of the contract.

Under paragraph 18 of the schedule to P.O. 181 (relating to prices to...