Appeal from the District Court of the United States for the Eastern District of Pennsylvania; J. Cullen Ganey, Judge.
Before BIGGS, JONES, and GOODRICH, Circuit Judges.
This is an appeal by the plaintiff taxpayer from a judgment in favor of the defendant entered by the court below in a suit to recover a portion of the income taxes which the plaintiff was required to pay for its fiscal year ending March 31, 1938. The Commissioner of Internal Revenue having determined a deficiency in tax for the year in question, the taxpayer submitted to an immediate assessment thereof, paid the additional taxes under protest and instituted the suit here involved after the Commissioner had rejected its claim for refund. The case was tried to the court below without a jury. From the findings made by the trial court we derive the following material facts.
The plaintiff, Keasbey & Mattison Company (a Pennsylvania corporation), is engaged in the business of manufacturing and selling asbestos products, some of which are used in the improvement and repair of houses. It sells such products to dealers and distributors, who sell to retailers or applicators, who in turn sell to home owners and perform the service of installing the products which they sell.
For a period prior to the taxable year here involved, the cost of purchases of such materials by home owners was financed through the FHA, which guaranteed to the applicators the notes given in payment by the home owners. This method of financing purchases served to increase greatly the market for the plaintiff's products. Upon the termination of FHA financing in the latter part of 1936, the plaintiff, in order to maintain the widespread market for its products which had thus been built up, entered into a contract on January 26, 1937, with the Bancredit Corporation (hereinafter referred to as the Finance Company).
Under the contract between the plaintiff and the Finance Company, the latter agreed to discount, for applicators, notes of home owning purchasers of the plaintiff's products, for which service the Finance Company was to make a charge of seven per cent of the amount of the notes so discounted. Payment of the notes by the makers was to be arranged on an installment basis. Five of the seven per cent charge made by the Finance Company was to go to the Finance Company as compensation for its financing services, and the balance (two per cent) was to be placed in a reserve fund by the Finance Company to liquidate possible losses from uncollectible notes. The contract authorized the Finance Company to charge against the reserve fund any discounted notes of home owners delinquent for sixty days or more. It further provided that whenever the total reserve fund should exceed ten per cent of the unpaid balance of the outstanding discounted notes such excess should be paid to the plaintiff at its option on January 3rd of each year of the life of the contract and that, upon termination of the agreement and when all installment notes discounted thereunder had been liquidated in full and all sums due the Finance Company had been paid, any balance remaining in the reserve fund was to be paid to the plaintiff. The contract also contained an express assumption of liability on the part of the plaintiff to the Finance Company for unpaid notes, in addition to the protection afforded by the reserve fund, up to ten per cent of the aggregate amount of notes discounted by the Finance Company under the agreement.*fn1
At no time during the taxable year did the amount in the reserve fund exceed ten per cent of the unpaid notes discounted by the Finance Company under the agreement. Nor was any part of the reserve fund either paid or payable to the plaintiff during the taxable year. On the other hand, the aggregate amount of delinquent notes was always less than the amount of the reserve fund during the taxable year so that nothing was paid, nor did anything become payable, by the plaintiff to the Finance Company during the taxable year on account of the plaintiff's assumption of additional liability for delinquent or unpaid notes.
The plaintiff, which kept its books on the accrual basis, did not show as an asset, and therefore did not reflect in its income, any part of the reserve for bad debts set up on the books of the Finance Company under the contract.Neither did the plaintiff include among its liabilities its possible liability to the Finance Company for delinquent or unpaid notes in excess of the reserve fund up to ten per cent of the aggregate amount of the notes discounted by the Finance Company.
The Commissioner held that the reserve fund for delinquent notes shown by the books of the Finance Company ($25,812.56 after a charge thereto of $3,980.23 for currently unpaid notes) was an asset of the plaintiff accruable for the taxable year in question and should have been so accounted for but that the plaintiff's additional liability on account of the notes discounted by the Finance Company during the taxable year (viz., ten per cent of $503,592.21, less the reserve fund) was contingent and therefore not accruable. Accordingly, the Commissioner recast the plaintiff's balance sheet for the taxable year and thereupon determined the deficiency which led to the assessment and tax payment giving rise to the suit involved on this appeal. The court below upheld the Commissioner's determination and entered the judgment for the defendant.
Thus, the court below approved and followed the Commissioner's rulings, viz., (1) that the reserve fund on the books of the Finance Company was an accruable asset of the plaintiff for the taxable year and should have been so reflected in its return of income and (2) that no liability rested upon the plaintiff on account of delinquent or unpaid notes, over and above the reserve fund, which was accruable for the taxable year. The question presented by the appeal is whether the action so taken by the court below constituted error.
While approved standard methods of accounting are ordinarily regarded as clearly reflecting a taxpayer's income (Art. 41-2 of Treasury Regulations 101 promulgated under the Revenue Act of 1938), and although the plaintiff's system of accounting (accrual) is an approved method, we think that the court below was correct in saying that it was within the Commissioner's discretionary power under Sec. 41 of the applicable Revenue Act*fn2 to revise and restate the taxpayer's accounts in order clearly to reflect its income. See Brown v. Helvering, 291 U.S. 193, 203, 54 S. Ct. 356, 78 L. Ed. 725. But the question here is not as to the Commissioner's power in such regard but whether, in the exercise of his conceded power, he included as an accruable asset of the plaintiff for the year in question an item which, as a matter of law, did not so qualify. We think that such was the effect of the Commissioner's action in respect of the reserve fund and that, consequently, the court below erred in including in the plaintiff's balance sheet for the year in question, as an accruable asset, the reserve fund shown on the books of the Finance Company.
In our opinion the instant case is indistinguishable from the case of Beaudry v. Commissioner, 43 B.T.A. 1209, where the Board of Tax Appeals in a memorandum opinion held that, where the amount of the reserve on the books of the finance company included no excess which might become due the taxpayer, his income should not be increased by the amount of the reserve fund. Here, likewise, it is not because of any excess in the reserve, either supposed or estimated, that the Commissioner augmented the taxpayer's income. The reserve was always less than the maximum prescribed. Plainly, therefore, there was no reserve excess payable to the taxpayer. In the Beaudry case, an automobile dealer assigned to a finance company notes given him by his customers. Out of the gross financing charges made by the finance company on each note transaction a portion was credited on the books to an account called "dealer's reserve" to take care of any losses that might result to the finance company from notes so purchased by it. The dealer, who kept his books on an accrual basis, did not reflect on his balance sheet any part of the reserve as an asset. The marked similarity between the Beaudry case and the instant case renders the ruling in the former equally applicable here if the decision of the Board of Tax Appeals in the Beaudry case was correct.
The court below sought to distinguish the instant case from the Beaudry case on the ground that here the ultimate balance of the reserve fund, after payment of all notes discounted under the agreement and payment of all charges due the Finance Company, is to be paid to the plaintiff. But it does not appear from the Board's memorandum opinion that that was not also the situation in the Beaudry case. Indeed, it would seem that one of the purposes of making a reserve of the moneys so retained by the finance company in the Beaudry case was to segregate the residue of the reserve, after the payment of all delinquent notes and the charges due the finance company, for payment to the taxpayer. That such was the intent of the arrangement is further impliedly confirmed by the fact appearing in the Board's opinion that the excess in the reserve at any time over the maximum prescribed amount was payable to the dealer forthwith. But even if the distinction were present in fact, it would not be material to the principle pertinent. Whether any ...