The opinion of the court was delivered by: GANEY
This case involves two actions brought to recover $ 71,548.77 plus interest alleged to have been erroneously paid by the taxpayer as income taxes for the years 1942, 1943 and 1944. For the three taxable years involved the issue in both actions is the same. Stated broadly the question posed is whether the taxpayer, an insurance company taxable under section 204 of the Internal Revenue Code, 26 U.S.C.A. § 204, could have included in its allowable deductions for income tax purposes the increase over the previous year in its reserve for losses recoverable on reinsurance placed by it with non-admitted companies. The taxpayer claims that it may have done so.
From a revised stipulation of facts entered into between the parties, the exhibits presented to it, and the taxpayer's income tax returns, the court makes the following special
1. The taxpayer, a company organized and subject to the laws of Pennsylvania is engaged in the business of writing fire and allied lines of insurance on the stock plan throughout the forty-eight states and various territories of the United States. Its principal office and place of business is in Philadelphia, Pa.
2. In the years 1941 through 1944 it reinsured a portion of its insurance risks with admitted and non-admitted companies.
The reinsurance placed with the latter companies was excess coverage on marine risks, principally cargo coverage for particular voyages. All except a very small portion of this reinsurance was placed with London underwriters o?r London underwriters' agents. The amount of paid and unpaid losses, the liability for which had been reinsured by the taxpayer with non-admitted companies for those years, and for which it had claims against them in an equal amount, was as follows: 1941, $ 72,916.60; 1942, $ 134,365.48; 1943, $ 244,661.81; and 1944, $ 294,189.09.
3. Pennsylvania has been requiring companies, such as the taxpayer in the instant case, authorized to do business in the State, with the exception of reinsurance placed with admitted companies, to maintain at least two reserve funds. The first must be equal to a certain pro rata percentage of the unearned premiums for all risks undertaken by the companies; the second must be equal to the unpaid losses, for which they are primarily liable, claimed to have been sustained by the insured. The purpose of the latter reserve is to cover contingent liabilities for losses; that is, the possible default of the non-admitted companies on their obligations to the local company concerning the reinsurance ceded to them. Thus Pennsylvania is one of those states which maintains the fiction that, as far as reserve funds are concerned, insurance retained and reinsurance ceded to non-admitted companies are the same.
5. In making its annual statement to the Insurance Department of Pennsylvania and other states for the years 1941 through 1944, the taxpayer allegedly followed the annual statement blank approved by the National Convention of Insurance Commissioners. This thirty-one page model blank, known as the Convention Form, is a uniform classification of accounts peculiar to insurance companies subject to Sec. 204 of the Internal Revenue Code. It also contains two recapitulation charts, three exhibits, and a number of general interrogatories and schedules requesting information concerning the company's assets and business transactions. Pages 2 and 3 of the Convention Form reflect all cash receipts and disbursements during the year of the report and represents the cash part of the accounting system. Pages 4 and 5 represent the balance sheet and show the accrual of all items at the year's end. The Underwriting Exhibit on page 10, and the Miscellaneous Exhibit on page 11 are in effect a reflection or summary of both the prior cash and accrual items.
(a) Under the heading of 'Income' on page 2 of each of the four annual statements, the amount of the premiums written in policies by the taxpayer during the year was reduced by the sum of premiums paid for reinsurance both for admitted and non-admitted companies. The several columns of item 17 respectively reflected the totals of those two amounts and also the net amount of premiums retained by the taxpayer. Item 18 showed the gross amount of deposit premiums written on perpetual risks.
(b) On page 3, under the heading 'Disbursements', gross losses paid were reduced by amounts recovered on salvage and reinsurance from both admitted and non-admitted companies. The several columns of item 14 respectively reflected the totals of those two amounts and also the net losses paid after such deduction. The amount of deposit premiums returned on perpetual risks was shown as item 31 of the same page.
(c) At item 12 and 'item 12A' on page 4, on which Ledger Assets were set forth, the amount of reinsurance recoverable from both admitted and non-admitted companies on paid losses was shown. 'Item 12A' was an added item; that is, one that was printed in by the taxpayer to show a breakdown of the above amount between non-marine and marine risks.
(d) On page 5, under the heading 'Liabilities', gross unpaid losses incurred were reduced by amounts recoverable on reinsurance from both admitted and non-admitted companies. The several columns of item 15 respectively reflected the totals of those two amounts and also the net unpaid losses after such deduction. Also listed at item 18 was the total gross premiums, less reinsurance received and recoverable from both admitted and non-admitted companies upon all unexpired risks; and, at item 19, amounts reclaimable by the insured on perpetual fire insurance policies. Although there was no such item, the taxpayer caused to be printed on this page 'item 32B' in order to show the following sums recoverable from non-admitted companies: (a) the amount (of its reserve) for reinsurance on paid losses, and (b) the amount (of its reserve) for reinsurance on unpaid losses. The effect of showing the latter sum was to add back that figure after it had been previously deducted at item 14. The obvious purpose of the entire 'Item' was to increase the total amount of liabilities by the amount shown. Item 33 reflected the total of items 1 to 'item 32B' inclusive on that page.
(e) On page 10, under the heading 'Underwriting Exhibit', the total amount of both the premiums earned and the losses incurred during the year were computed. These computations took into account the items set forth in paragraphs 3 (a, b, c and d) above. In arriving at the amount of premiums earned during the year, shown as item 5, the taxpayer treated reinsurance with admitted and non-admitted companies alike, and reached the same figure which would be obtained if it followed the computation set forth in Sec. 204(b)(5) of the Code. Item 14 reflected the total losses incurred during the year. This sum did not include any portion of the amounts appearing at 'item 32B' on page 5 of the annual statement, and it equaled the amount which would be obtained if the computation directed by Sec. 204(b)(6) of the Code were followed.
(f) On page 11, under the heading 'Miscellaneous Exhibit', the taxpayer caused to be printed 'item 70B' so that the increase over the previous year in the amount of reinsurance on paid and unpaid losses recoverable from non-admitted companies could be shown. The effect of this item was to increase the loss in surplus by that amount. For the three taxable years involved the following amounts were reflected after that 'item': 1942, $ ...