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CELLULOID COMPANY, PETITIONER,
v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Celluloid Co. v. CommissionerDocket Nos. 8543, 19459.United States Board of Tax Appeals 9 B.T.A. 989; 1927 BTA LEXIS 2474;December 29, 1927, Promulgated *2474 1. The claim of petitioner for the deduction of a loss for obsolescence of machinery, equipment and a portion of a building, in 1919, is not sustained. Amount of loss sustained in the year 1920 as a result of the discarding of certain machinery and equipment determined.
2. Where an inventory was originally taken at cost or market, whichever was lower,
held that upon the discovery early in the succeeding year that it contained on the inventory date a large quantity of defective material it may be corrected to accord with the actual facts.3. Where an accounts receivable account reflects the selling price of goods containing latent defects,
held that it may not be reduced in the year in which the goods were sold by an amount representing the original selling price of such of the defective goods as were returned in the succeeding year, even though such amount could have been very closely approximated in the year of sale.R. Kemp Slaughter, Esq., andH. C. Bickford, Esq., for the petitioner.M. N. Fisher, Esq., for the respondent.SMITH*990 This proceeding is for the redetermination of income taxes for the calendar years*2475 1918, 1919, and 1920. The petitioner filed two appeals, one covering the years 1918 and 1919 and the other covering the year 1920. On motion made and granted the two appeals were consolidated for trial and decision. The Commissioner asserts that for 1918 there was an overassessment of $1,023.58; that for 1919 there is a deficiency of $65,749.54; and that for 1920 there is a deficiency of $23,512.41. The petitioner alleges that the Commissioner erred in that he failed (1) to allow as a deduction from gross income for each of the years 1919 and 1920 an amount sufficient to cover losses due to obsolescence and loss of useful value of structure and machinery; (2) to adjust the value of the closing inventory for the year 1920 on account of defective goods contained therein; and (3) to adjust the accounts receivable account as at December 31, 1920, on account of billings to customers contained therein covering defective goods which were returned after the close of the taxable year.
FINDINGS OF FACT.
Petitioner is a New Jersey corporation with its principal office in New York City. Its manufacturing plant, covering about 28 acres of land, is located in Newark, N.J., where it manufactures*2476 celluloid in the form of rods, sheets, and tubes, finished articles manufactured therefrom, and the base for photographic film. The enterprise is divided into departments, among which are the Roll Celluloid Department, Converting Department, Acid Department, and Specialty Department.
The date of acquisition, cost, percentage of depreciation reserve from date of the erection to January 1, 1919, amount of depreciation from date of acquisition to January 1, 1919, and net book value on January 1, 1919, of a portion of a building and certain machinery which were abandoned by petitioner are shown in what is hereinafter referred to as Table No. 1, as follows:
*2477 *2478TABLE No. 1. - Building No. 42 ROLL CELLULOID DEPARTMENT Description Date of acquisition STRUCTURE 1. 1 brick and concrete building 25 feet wide, 75 feet long, 3 stories high. Interior construction, cellular type of concrete and tile partitions arranged to allow a separate room on each floor for each wheel and auxiliary equip- ment. NOTE. - This structure constituted a portion of the new addition to film building No. 42 and erected in the year 1909. The entire building, addition and alterations to the old building of which it became a part, cost $37,893.22 Deduct alterations and changes to old building included in above total cost 1,775.66 Net cost 36,117.56 Deduct portion of addition continued in use and not affected on account of building become obsolete, nine- sixteenths cost 20,316.13 15,801.43 Balance, cost of obsolete portion. Dec. 20, 1909 MACHINERY 2. 3 film wheels, cast iron, 14 feet diameter, 26-inch face, polished and nickel plated with dryers, drives and auxiliary equipment (wheels Nos. 9, 10, 11). Dec. 16, 1909 3. 1 film wheel (wheel No. 12) Mar. 16, 1910 2a. 1 film wheel, cast iron, 14 feet diameter, 26-inch face, with drives and auxiliary equipment (without dryers wheel No. 8): Cost complete $3,933.85 Less dryer 1,345.28 Dec. 16, 1909 4. 5 wheel foundations, concrete, (wheels Nos. 8, 9, 10, 11, 12). Dec. 20, 1909 5. 1 Landis grinder, 24-inch stroke, arranged special for grinding face of film wheels. Dec. 16, 1909 6. 1 portable plating tank for 20 inch wheels. Dec. 16, 1909 7. 2 1,000-pound hand-power hoists Dec. 16,1909 8. 1 500-pound bridge crane Dec. 16, 1909 9. 1 exhaust system (42-A-36) Dec. 31, 1918 10. 1 double-pipe water cooler (42-D-3). Mar. 25, 1915 11. 1 complete air washing apparatus (for old 10-foot wheels Nos. 1 to 5, and 14-foot wheels Nos. 7 to 12, inclusive). Dec. 16, 1909 12. 1 refrigerating apparatus and connections. Dec. 11, 1909 13. 1 film wheel, cast iron, 15 feet diameter, 49-inch face, polished and nickel plated (old No. 6). Dec. 29, 1910 CONVERTING DEPARTMENT MACHINERY 14. 14 Burroughs absorbing presses hydraulic, upright style, 26 by 38 inches, 14-inch ram, 14-inch stroke: 11 at $790 $8,690.00 3 2,288.65 1909 15. 1 cracker mill, 20 by 55 inches, power driven, iron frame, 4-inch cracker roll 1909 16. Pad dryer: 2 60-inch fans and installation $116.37 116.36 2 steel pad dryers, 115 sections, pockets, frame 2,875.00 And tracks 2,875.00 Racks and trays 45.00 Piping 2,057.17 Power wiring 40.49 Foundations 335.01 Shafting 87.50 1909 ACID DEPARTMENT MACHINERY 17. 1 Downingtown beating engine (220-A-1) Dec. 8, 1915 18. 1 Miller duplex beating engine and installing 2 beaters Aug. 3, 1920 19. Carrier air washer system: 1 80-inch steel plate fan, belt drive, 3 by 3 feet outlet, heating coil, in 5 feet 4 inches by 5 feet 4 inches by 5 feet 4 inches galvanized housing $339.00 With ducts and connections 151.00 60.37 4 consecutive entries 695.00 July 31, 1918 SPECIALTY DEPARTMENT MACHINERY 20. 6 Burroughs semiautomatic hydraulic presses, 8-inch, operating at 2,800 pounds pressure Apr. 19, 1917 *992 The manufacture of photographic film base or support is carried on in the Roll Celluloid Department, and in the manufacture thereof nitrate of cellulose is dissolved to form a mass which, after filtration and other treatment to get it into proper condition, has the color and consistency of stiff honey. The mass is then allowed to fall into a *993 trough-shaped hopper mounted at the top of a large wheel which revolves at a slow speed. After the wheel has made one revolution, the partly dried material is stripped off, allowed to dry, and then spooled up.
Each of these wheels extends through three stories of the building in which they are located, weighs approximately 13 tons, and is finished in place by expensive plating apparatus. The surfaces of the wheels are copper plated, then nickel plated, and then brought to a mirror-like finish. Their accuracy must be within 2/000 of an inch.
In Building No. 42, Roll Celluloid Department, there were five film wheels 14 feet in diameter with a 26-inch face, which were installed in the year 1909 and one "Jumbo wheel" 15 feet in diameter with a 49-inch face which was installed in the year 1910*2479 in order to increase the capacity of the plant and at the same time to reduce the cost as well as to improve the process of manufacturing film. (Items 2, 3, and 2a and item 13, Table No. 1.) As a further step forward, five more wheels of a later design and 16 feet in diameter were installed in 1911, and five additional 16-foot wheels with improvements in the design of the wheel structure were installed in 1914.
On October 15, 1919, the manager of the Roll Celluloid Department made a report to the president of the company in which he recommended the installation of five additional 16-foot wheels, and the subsequent removal of the 14-foot wheels and the utilization of the space occupied by the 14-foot wheels together with the locker room and the refrigerating room for the installation of more 16-foot wheels. This report contemplated a total project of 26 wheels, which was within the physical capacity of the area covered by the building. Plans were begun at or prior to the time of the report for the carrying out of the recommendations embodied therein, and on December 2, 1919, the president of the corporation authorized the installation of the five 16-foot wheels. This authorization*2480 also stated that the company did not contemplate any further increases of plant for the production of roll celluloid on the premises then occupied by the Roll Celluloid Department and directed that the plans for the manufacture of roll celluloid would be developed accordingly. Only that portion of the recommendation of October 15, 1919, providing for the installation of five 16-foot wheels was carried out.
After the installation in 1911 of the five original 16-foot wheels the five 14-foot wheels installed in 1909 were held in reserve and were used only spasmodically in the peak of business, up until February, 1920, when structural changes completely threw the 14-foot wheels out of service. They could not be used after that time. Wheels Nos. 9, 10, and 12 produced film in the week ended February 8, 1920, *994 and shortly after that date the floor of that portion of the structure in which they were housed was raised and the complementary spooling apparatus was removed.
During the period of construction and installation of the five new wheels, which began early in 1920 and which continued for about 13 months, the five 14-foot wheels installed in 1909 were not available*2481 for emergency work, the floor level having been moved up 36 inches and the applicances for spooling film having been thrown out. Wheels 8, 9, 10, 11 and 12 (items 2, 3, and 2a, Table No. 1) were still standing on their original bearings, but they had been stripped of their driving equipment. The Jumbo wheel (item 13, Table No. 1) was last used in the fall of 1920. It was abandoned at that time for the manufacture of film and was scrapped in the spring of 1921.
Because of the question of fire hazard it was the practice of petitioner to install these film wheels in separate wells, divided originally by fire walls and fire doors, so that for all practical purposes each wheel was enclosed in its own building. There was a common roof and common outside walls, but all separated by partitions, and in the earlier designs, wooden floors. Subsequently the wheels were housed in a fire-proof building, using concrete floors on which to place the dryer over the wheel proper, the wheels themselves being installed through three levels of slat flooring. The lower portion of the wheels was in the basement, the pedestal and bearings on an intermediate floor, the hopper on the third floor, and*2482 the drier on a separate floor.
Originally the finished product was removed from the wheels through the fire wall into the main central bay of the building, where it was spooled up, but with the installation of the Jumbo wheel the operation of spooling up the film was carried on in the room containing the wheel so that the man who turned the hopper also attended to the spooling of the film. This arrangement was also employed with respect to the operation of the 16-foot wheels. With respect to the operation of the 14-foot wheels the finished product was spooled up in the central bay of Building No. 42 so that when structural changes were made in that building all of the spooling appliances had to be torn out and transferred to the rooms containing the wheels and the wheels became useless for the manufacture of film.
The building known as Building No. 42 formed the original structure of the Roll Celluloid Department. Originally it consisted of two bays, one of the cellular type containing six cells housing film wheels. The other bay was used for taking care of the solvents in the preparation of the honey-like syrup known as "dope" and for the spooling and packing of the film. *2483 The 14-foot wheels installed in 1909 were placed in a similar group of cells on the south side of the middle bay. These cells were of the same general type of structure *995 as the cells housing the original wheels, except that they were fire proof, the floors being constructed of concrete instead of wood. In 1911 Building No. 42 was extended west to an adjoining street so that thereafter the structure ran from street to street and provided space for 10 machines, a group of five cells on each of the upper bays and the central bay, as before, but the floor level of the central portion was at a different level, a difference of 36 inches. At that time five wheels were installed on the southern side, and in 1914 five wheels were installed on the north side. The original wheels that were on the north face of the older portion were left there, but the doors were closed. They were left because it was cheaper and easier to leave them there than to take them out. At that time the petitioner was using the 14-foot wheels installed in 1909 and the five wheels installed in 1911.
The manager of the roll celluloid department recommended to the president of the company on October 15, 1919, that*2484 the five 14-foot wheels be torn out and that the space occupied by them be used for five new 16-foot wheels. This recommendation was not adopted. The 14-foot wheels were not torn out. They were allowed to remain in the portion of the building built to house them. This represented seven-sixteenths of the total building. No use has been made of the portion of the building in question since 1920. The five 14-foot wheels (items 2, 3, and 2a, Table 1) had no value whatsoever from the date their use was discontinued in 1920. The same is true of the Jumbo wheel (item 13, Table 1), the use of which was also discontinued in 1920.
Five wheel foundations, one Landis grinder, one portable plating tank, two hand-power hoists, one double-pipe water cooler, one complete air-washing apparatus and one refrigerating apparatus (items 4, 5, 6, 7, 8, 9, 10, 11 and 12, Table 1) are units pertaining to the wheels and structure, the use of which was discontinued in 1920. They were discarded in 1920 at the same time that the wheels were discarded and they had only a scrap value at that date.
Due to a change in the process of manufacturing celluloid, 14 Burroughs Hydraulic Absorbing Presses, one*2485 cracker mill and one pad drier (items 14, 15 and 16, Table 1) were also discarded in 1920. They were dismantled and placed in the cellar. They were junked - not even sold for scrap, and had no value at the time they were discarded.
The use of the Downingtown beating engine, the Miller duplex beating engine, and the Carrier air-washer system items 17, 18 and 19, Table 1) was discontinued in 1920. The Downingtown beating engine was transferred to Building 220 but has never been used since 1920. The Miller duplex beating engine and the Carrier airwasher *996 system were left intact. The former was a comparatively new engine acquired in 1920 at a cost of $12,737.22. It and the Carrier air-washer system were partially dismantled but the machines are intact.
The six Burroughs semiautomatic hydraulic presses (item 20, Table 1) were never used for anything except experimental purposes. They have not been moved from where they were installed in the summer of 1920.
The principal commodity manufactured by the petitioner is celluloid. In manufacturing celluloid, tissue paper is treated with a mixture of nitric and sulphuric acids resulting in the formation of cellulose*2486 nitrate, which is also known as pyroxylin. This pyroxylin, after washing to remove traces of acid, is ground and dried. It is then treated with a plasticizing agent, together with alcohol and other solvents, and by a process of kneading, rolling, compressing and seasoning if finally is converted into celluloid. The foundation of the industry of celluloid manufacturing is based on the use of camphor as the plasticizing agent.
Camphor is not produced in this country. The bulk of it comes from Japan where the camphor trade is a governmental monopoly. In order to avoid the Japanese monopoly over camphor the petitioner had been endeavoring for a number of years to secure a substitute therefor or to produce it in this country. Its efforts to produce it here having proved abortive, the petitioner's chief chemist endeavored to develop certain foreign patents governing a substitute for camphor which petitioner had purchased prior to 1919. Finally in 1919 Lindsay, the chief chemist, pronounced the substitute a perfect one. This substitute - tricresylphosphate - was arbitrarily assigned the name "N" in accordance with the system of nomenclature employed by petitioner in the development*2487 of formulas.
In April, 1919, the company started extensive use of the "N" and gradually increased its use until orders were issued by the management to manufacture 80 per cent of the total product with the "N." Until August, 1919, the substitute was used entirely in the dark shades of celluloid, such as the black and tortoise sheel products upon which discoloration would have little effect. When the management issued orders to use the "N" material in 80 per cent of the product, the superintendent of the manufacturing department strenuously objected to the vice president, claiming that it was not suitable for use in the lighter shades. The chemical department, under Lindsay, maintained it was perfect, however, and the management ordered the superintendent to proceed with its use. During that time an imitation ivory was the principal product of the petitioner. This "ivory" had a delicate color, which the petitioner's competitors *997 found hard to imitate and, as a result, the company enjoyed a good business in camphor ivory. The color of such imitation ivory was highly important so that a slight discoloration would cause it to be unsuitable for sale.
Upon the insistence*2488 of the chemical department the manufacturing department commenced the use of "N" material in the manufacture of ivory during 1919. This use of "N" material gradually increased until the latter part of the year when trouble with discoloration caused a practical suspension in its use. However, in the spring of 1920, after improvements in the method of refining the "N," its use was resumed and gradually increased. During this period the superintendent continually objected to its use, but the management sustained the chemist, Lindsay, in his contention that the defects had been remedied. During the latter part of 1920 the customers of the company complained about its product, particularly the ivory, and began to return the goods in large quantities because of discoloration and brittleness, which made them unfit for use. These returns of defective goods were so great that they overflowed the stock rooms.
At the end of the year 1920 the company had in its stock room a large inventory of finished sheets of celluloid. Due to the large quantity the taking of inventory was commenced in October, and as the quantity of goods in each vault of the stock room was determined the vault was*2489 locked and a careful check on outgoing goods was kept thereafter until the end of the year. In this way the quantity of the inventory was determined by December 31, and promptly reported to the accounting department, where the costs were determined and applied. The inventory, as at the end of 1920, so taken and priced, totaling $4,829,127, was entered on the books of the petitioner and used in its tax returns for 1920 and 1921.
Included in the goods in the stock room was a large quantity of sheets in cases. These cases were not opened when the inventory was originally taken, but were inventoried according to case numbers and packing tickets. All goods in the cases were included in the inventory as first-class finished goods and were so classified some months before when inspected in the seasoning room.
Early in January, 1921, the large amount of defective goods refused and returned by customers caused the management to conclude that the inventory contained a large quantity of defective goods which were unsalable. Some of the material returned was not recognized as the material which had been shipped. It had become brown. It was, therefore, decided to open up the cases, *2490 inspect and reclassify the sheets.
On January 12, 1921, the superintendent wrote a memorandum to the stock room foreman instructing him to proceed with the reclassification *998 of the sheet celluloid stock. This reclassification was entirely of goods contained in the inventory at the end of 1920. During this reclassification large quantities of sheets were taken out of the cases and found to be so defective that they were sent to the scrap house "by truck loads." On February 10, 1921, the superintendent wrote the vice president, telling him that 395,556 pounds of scrap had accumulated, whereas the company's scrap house was built to hold only 200,000 pounds, and requested permission to dispose of it.
The sheets found to be defective included both "N" celluloid and camphor celluloid, the latter resulting from the fact that the pyroxylin base used in both had been chemically modified to adapt it to the use of the "N" plasticizer, and this modification of the base had an injurious effect on the camphor product as well as that produced by the use of "N."
The work of reinspecting and reclassifying the inventoried sheets extended over several months, during which time the*2491 company was making an issuance of preferred stock. The bankers who were handling the sale of stock for the company requested a firm of certified public accountants to examine and certify to the statement of profits for the preceding 10-year period and the balance sheet as at December 31, 1920, both of which had been prepared from the books. The accountants in the course of their examination discovered that during the months of November and December, 1920, approximately $170,000 worth of goods had been returned. This was more than the returns of a normal year which averaged about $12,000 per month. They further learned of the failure of the "N" as a camphor substitute and that large quantities of defective goods were in the inventories classified as first-grade product. The accountants refused to certify to the inventory figure of $4,829,147 which was entered on the books and used in the returns, and requested the vice president to write them a letter stating the quantity of defective goods included in the inventory as "firsts." On March 26, 1921, the vice president wrote the accountants stating as an estimate that there were 55,000 pounds of sheets listed "firsts" which should*2492 be scrapped, and 52,000 pounds more which should be listed as "seconds" instead of "firsts." On the basis of this letter and other information of a similar character the accountants reduced the inventory by $100,000 to $4,729.147, which figure was used by the bankers in the published prospectus instead of the figure of $4,829,147 shown by the books and the tax return.
Following this, on April 22, 1921, the superintendent rendered to the vice president of the company a final report of the reclassification of the sheets included in the inventory of December 31, 1920, as follows:
Ivory material Pounds "D" seconds Pounds ordinary seconds Pounds good material Good, pounds inspected: 57,515 X 19,000 12,000 26,515 44,753 C 11,500 9,500 23,753 Seconds, pounds inspected: 43,028 X 29,028 14,000 35,857 C 22,000 13,857 Miscellaneous Sheets Pounds "B" second sheets Ordinary second sheets Dis. second sheets Scrap sheets Salvage sheets Good sheets 36,863 X 55,204 8,276 4,272 227 14,528 1 9,559 2,614 C 7,382 55 5 221 2,333 *999
Material scrapped since first of year *2493 49,433 pounds "X" delivered to scrap house
529 pounds "C" delivered to scrap house
15,000 pounds "X" to be scrapped
All of the foregoing merchandise was classified by petitioner in its original inventory either as "firsts" or "seconds" and the inventory was then valued at cost or market, whichever was lower, as determined by petitioner's accounting department. Application of the same unit costs or market values to the merchandise contained in the inventory after reclassification resulted in reducing the price of the inventory as follows:
*2494Pounds Value Pounds Pounds Uniform Reduction Total reclassi- used in seconds scrap price in unit reduction fied inventory therein therein therefor price as used in the original inventory X firsts 57,515 $0.86 12,000 $0.60 $0.26 $3,120.00 .86 19,000 n1 .86 16,340.00 X seconds 43,028 .60 29,028 (.60 17,416.80 C firsts 41,753 1.00 9,500 .70 .30 2,850.00 1.00 11,500 ( ) 1.00 11,500.00 C seconds 35,857 .70 22,000 .45 .25 5,500.00 MISCELLANEOUS COLORS X shall 17,455 $0.92 1,769 $0.63 $0.29 $459.01 .92 183 n1 168.36 X white 13,576 .76 7,831 .54 .22 1,722.82 .76 2,134 n1 1,621.84 X black 8,806 .76 1,314 .54 .22 289.02 .76 11,196 n1 8,508.96 X amber 1,567 .85 135 .60 .25 34.75 X pearl 508 1.02 46 .71 .31 14.26 1.02 20 n1 20.40 X misc 2,143 .76 46 .54 .22 10.12 .76 106 80.56 C white 899 .85 96 .55 .26 24.96 C pearl 833 1.22 145 .85 .37 43.65 C pink 62 1/2 .96 1 .67 .29 .29 C shell 2,170 1.04 33 .72 .32 10.56 69,736.36 Lowest value: Scrapped X 64,433 .76 48,969.08 C 529 .76 ( ) 430.04 119,135.48 *1000 The petitioner consistently took its inventories on the basis of cost or market, whichever was lower.
The accountants who were employed by the underwriters of the proposed issue of preferred stock further refused to certify to the balance sheet taken from petitioner's books as at December 31, 1920. In the balance sheet which was certified by them both the accounts reseivable and the surplus shown on the balance sheet taken from the books were reduced in the amount of $100,000 to offset the approximate value of merchandise billed and shipped to various customers which, it was anticipated eventually would be returned. During the first four months of 1921 the value of the goods returned, compared with returns during the same period in the previous year, was as follows:
