Pacific Vegetable Oil Corp. v. Commissioner , 26 T.C. 1 ( 1956 )

Pacific Vegetable Oil Corporation, Petitioner, v. Commissioner of Internal Revenue, Respondent

Pacific Vegetable Oil Corp. v. Commissioner

Docket No. 50344

United States Tax Court

26 T.C. 1; 1956 U.S. Tax Ct. LEXIS 224;

April 5, 1956, Filed

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Decision will be entered for the respondent.

1. Held, the revision effected by petitioner in 1949 to reflect contract sales accounts under which 95 per cent payments had been made in 1949 and for which contingent adjustments might be made in 1950 upon the determination in 1950 of certain facts constituted a change in its accrual method of accounting for which prior consent of the Commissioner was required. Held, further, that respondent's action in rejecting the change and his requirement that the method of accounting employed by petitioner prior to 1949 be continued, is not proven to be arbitrary or an abuse of the Commissioner's discretion.

2. Petitioner owned 2,094 shares of common stock, out of 5,182 shares, the only class of issued stock of Western Vegetable Oils Co. In 1949, Western acquired for cash 1,346 shares of stock owned by petitioner, and, also, all of the stock owned by some stockholders. All of the stock acquired was canceled and retired by Western. Held, the distribution of Western in cancellation of stock held by petitioner was not essentially equivalent to the distribution of a taxable dividend within the meaning of section 115(g) of the 1939 Code but was taxable as provided in section 115(c).

Dudley F. Miller, Esq., for the petitioner.

Edward H. Boyle, Esq., for the respondent.

Harron, Judge.

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HARRON

The Commissioner determined a deficiency in income tax for the year 1949 in the amount of $ 148,867.81. The petitioner concedes that some of the Commissioner's adjustments are correct so that there is a deficiency of about $ 35,907.31. The remaining deficiency of $ 112,960.50 is in dispute. There are two issues to be decided, as follows:

(1) Whether the petitioner's adoption, in 1949, of a new system of accounting for sales of copra which were in transit at the end of the year so as to include in gross income only 95 per cent of the contract price and to carry in a reserve for future, contingent adjustments in contract price 5 per cent, constituted a change in petitioner's accrual method of accounting which required prior consent of the Commissioner.

(2) Whether a cash distribution in 1949 to petitioner by another corporation in cancellation and redemption of part of the stock held by petitioner is essentially equivalent to the distribution of a taxable dividend within the meaning of section 115(g) of the 1939 Code, or was a distribution in partial liquidation taxable as provided in section 115(c).

FINDINGS OF FACT.

The petitioner filed its return for 1949 with the collector of internal revenue for the first district of California in San Francisco.

Issue 1.

Petitioner is a California corporation having its principal place of business in San Francisco. It keeps its books and makes its income tax returns on an accrual method of accounting and on the basis of a calendar year.

Petitioner is engaged in the business of manufacturing, processing, handling, and dealing in vegetable oil raw materials and vegetable oils in the United States and elsewhere in the world. One raw material in which it deals is copra, the meat of coconuts, from which coconut oil is manufactured. As part of its business operations, petitioner purchases copra rather extensively. Some of the copra which petitioner buys, it imports into the United States for the purpose of crushing into oil. The issue in this proceeding does not relate to such purchases. Petitioner purchases a large quantity of copra in the Philippine Islands and sells and ships such purchases to purchasers in Europe, Latin America, and elsewhere. Those purchases do not enter the United States. The issue to be decided relates to these purchases and sales of copra.

Prior to shipment, in the producing areas in the Philippine Islands, copra, the raw material, is removed from the coconut shell and is either sun dried, smoke dried, or kiln dried. During shipment there is usually loss of moisture and a resulting loss of weight of the copra, but sometimes there is a taking on of moisture if there is sweating and condensation of moisture in the hold of a ship, or there may be but a slight change in the weight of the bulk copra during transit to the point of delivery. This condition has given rise to a practice in the trade of comparing the weight of bulk copra at the time of unloading at the destination of the shipment with the weight at the time of loading at the point from which copra is shipped. The weight of copra at the point of destination is called the landed weight or outturn weight.

During 1949, and in prior years, petitioner sold and shipped large quantities of copra from the Philippines to buyers in Europe, Latin America, and other places outside the United States. The following contract is typical of the form of contract which petitioner and its customers used during 1949 and prior years:

COPRA SALES CONTRACT
Clause	This contract is subject to the published Trading Rules of the
paramount:	National Institute of Oilseed Products adopted and now in force,
	which rules are hereby made a part hereof to the same extent as
	if set forth in full herein, except insofar as such Rules conflict
	with any of the following terms of this Contract, in which event
	the said following terms shall govern. Any dispute arising under
	or resulting from this contract or under modification thereof
	shall be settled by Arbitration in accordance with the Rules of
	the National Institute of Oilseed Products in effect at the
	contract date.
Buyer:	H. M. F. Faure & Co., Ltd., London, E. C. 3, England.
Seller:	Pacific Vegetable Oil Corporation, San Francisco, California.
Commodity:	Philippine Copra.
Quantity:	Five hundred and fifty (550) long tons of 2,240-lbs. per ton; 5%
	more or less.
Quality:	Rule 100. The clause pertaining to moisture does not apply.
Packing:	In bulk.
Shipment:	August/September, 1951. Seller's vessel.
Weights	Certified landed weights. Sellers reserve the right to have their
analysis &	representatives present at time of discharge. Cost of weighing
sampling:	for buyer's account. Analysis by an independent Cebu or Manila
	laboratory of official samples taken at time of loading shall be
	final. Cost of sampling and analysis to be borne by seller.
	Rules 40, and 102 of the National Institute of Oilseed Products
	do not apply.
Insurance:	Marine, usual W. A. 3% terms, warehouse to warehouse, for
	110% of invoice value based upon ship weights, to be arranged
	and paid for by Seller. War Risk Insurance in excess of
	one-half percent for buyer's account.
Price:	Two hundred and fourteen dollars ($ 214.00) U. S. Dollars per
	ton of 2,240-lbs., C. I. F. ROTTERDAM.
Payment:	By Sight Draft against first presentation of shipping documents,
	for 95% of invoice value. Final settlement to be made when
	outturn weights established. Bank collecting charges for seller's
	account.
Taxes:	Any tax or other governmental charge hereafter imposed by
	any governmental authority upon the production, sale and/or
	shipment of goods sold hereunder shall be for buyer's account.
Force	Per Rule 56 of the Rules of the National Institute of Oilseed
majeure:	Products.
Special	Buyer guarantees that Import Permits are in hand.
conditions:	This contract shall be deemed to be made and performed in
	California and is to be governed by the laws thereof.
	Both buyer and seller hereby certify that they are familiar with
	and have access to copies of the published Trading Rules of
	the National Institute of Oilseed Products adopted and now in
	force.

H. M. F. Faure & Co., Ltd.,

(Buyer)

Pacific Vegetable Oil Corporation

(Seller)

Thru: Zimmerman Alderson Carr Co., SF SFZ-3888.

Under a copra sales contract, such as the one set forth above, the quantity covered by the contract is the number of tons specified in the contract (550 long tons, in the above contract), "5% more or less," which latter clause constitutes the provision for determining the landed, or outturn, weight; and the invoice value is the amount of the contract weight times the stated price per ton. For example, under the above contract, the invoice value was $ 117,700. The contract-invoice weight is called the shipped weight. Also, under the copra sales contract which petitioner used, the initial payment of the buyer was 95 per cent of the invoice value, which amount was paid under a sight draft before the shipment reached its destination, and the final settlement was made after the unloading of the shipment and the determination of the outturn, or landed weight. Under the above contract, the initial 95 per cent payment amounted to $ 111,815, and after the unloading of the shipment, if the outturn weight was more than 95 per cent of the shipped weight, i. e., weight at the time of shipment, the buyer would then pay petitioner the balance of the amount due over and above the initial 95 per cent payment. Or, if the outturn weight proved to be less than 95 per cent of the shipped weight, petitioner would make a refund to the buyer of the part of the initial payment which proved to be excessive. This custom of adjusting the final payment for a shipment on the basis of the outturn, or landed, weight gives rise to the description, "selling on a landed weight basis." Since the determination of the landed weight cannot be made until transit is completed, the final payment by the buyer is not made until about 60 days after the date of shipment.

Another way of describing the custom of selling on a landed weight basis is that the invoice price, which is computed at the time of the shipment, is adjusted at the end of transit, upon delivery, to the landed weight value, at which time the seller either collects an additional payment from, or makes a refund out of the initial payment to, the buyer.

The initial payments to petitioner under its executed sales contracts were brought about in the following way: Soon after shipment, the bill of lading, the invoice, and other papers were mailed to a bank together with a sight draft for 95 per cent of the invoice price. Such papers were received and the sight draft was paid by the buyer before the shipment of copra arrived at its destination.

Many of petitioner's shipments of copra are received and the landed weights are determined during and before the end of the year in which shipment is made. The record in this proceeding does not show the volume or amounts of such sales.

Some of petitioner's shipments of copra begin during October and November, but either they do not reach their destination before the end of the year, or the landed weights are not determined before the end of the year. (The issue in this proceeding relates to such shipments and the contracts therefor.) Instead, the deliveries are made, or the landed weights are determined after the close of the year in which transit starts. Usually the landed weights of such shipments are determined in the year next following the year of the shipment. With respect to such shipments, petitioner may receive and in many instances does receive the initial 95 per cent payment under the copra sales contract before the end of the year in which transit of the shipment began, and the final adjustments in the amounts of the contract price are made in the next succeeding year.

During the taxable year 1949, chiefly during the months of October, November, and December, petitioner made shipments from the Philippine Islands to buyers outside the United States under the type of copra sales contract set forth above, with respect to which the landed weights were not determined until after December 31, 1949. The contracts were executed by petitioner and the respective buyers in 1949. The total amount of the invoice prices set forth in these contracts was $ 3,520,633.45. All or some of the buyers paid, in 1949, 95 per cent of the invoice prices under sight drafts which accompanied the bills of lading, invoices, and other papers, which initial contract payments amounted to $ 3,361,377.29. The record does not show precisely whether all of the foregoing 95 per cent payments were received by petitioner before the end of 1949. The balance of the total sum of the invoice amounts, i. e., 5 per cent, amounted to $ 159,256.16. For some reason not explained in the record, two of the copra sales contracts included in the above total sums were not settled during 1950, the total invoice amounts of which were $ 124,191.59. The rest of the 1949 contracts for the late 1949 shipments totaling $ 3,396,441.86 were settled in 1950. The adjusted total amount of these contracts, which was computed after the landed weights of the shipments had been determined in 1950, was $ 3,248,694.93.

With respect to the above late 1949 copra sales contracts totaling $ 3,396,441.86, invoice value, the initial 95 per cent payments amounted to $ 3,238,334.87, all or part of which was received by petitioner in 1949. When the landed weight of each shipment involved under these contracts was determined in 1950, two of the shipments had a landed weight of more than the invoice price, and others had a landed weight of more than the 95 per cent of shipped weight, but less than the full shipped weight. The consignees of such shipments made additional payments to petitioner in 1950, over and above their respective initial 95 per cent payments, and these additional payments amounted to $ 54,186.35. On the other hand, of the remainder of the shipments, each had a landed weight of less than 95 per cent of the shipped weight, so that petitioner made refunds to individual consignees of part of the initial 95 per cent payments, and these refunds amounted to $ 43,826.29. The net amount of the additional payments received by petitioner in 1950, under the late 1949 sales contracts, was, therefore, $ 10,360.06.

The following schedule shows, with respect to the year-end copra sales contracts executed in 1949 on which buyers made additional payments totaling $ 54,186.35 above the 95 per cent of invoice prices, both the excess of the invoice prices over and above the adjusted prices based on landed weights, and the excess of the adjusted price based on landed weights above the invoice price based on shipped weights. In one instance the invoice price and the landed weight price was the same. The schedule sets forth year-end shipments to 12 buyers out of year-end shipments to a total of 17 buyers. That is to say, there were shipments, not shown below, to only 5 buyers in which the price based on landed weights amounted to less than 95 per cent of the invoice prices based on shipped weights with respect to which petitioner made refunds totaling $ 43,826.29:

Invoice price	Price based on	Excess of invoice	Excess of
	landed wt.	price	landed wt.
$ 10,749.36	$ 10,652.77	$ 96.59
32,250.00	31,596.83	653.17
88,650.00	88,059.20	590.80
95,750.00	93,221.63	2,528.37
92,400.00	92,400.00
92,800.00	89,468.11	3,331.89
59,700.00	57,266.23	2,433.77
537,500.00	516,598.22	20,901.78
421,395.00	408,915.00	12,480.00
285,067.50	285,101.14		$ 33.64
190,000.00	190,013.49		13.49
180,000.00	172,800.00	7,200.00
$ 2,086,261.86	$ 2,036,092.62	$ 50,261.37	$ 47.13

Prior to the calendar year 1949, petitioner, under its accrual method of accounting, debited accounts receivable and credited sales income with the entire amount (100 per cent) of the invoice price of each copra sales contract executed during a calendar year, the invoice price being based on the total shipped weight shown in each bill of lading. Later, when the landed weight of the copra shipped under each sales contract was determined, the petitioner deducted, as an expense, from sales income the dollar amount per contract of the loss in weight which had occurred during transit, i. e., the dollar amount of the difference between landed weight and shipped weight, if any.

With respect to copra sales contracts executed in 1948, and debited and credited as above described, the deductions made on petitioner's books in 1949 for the dollar amount of loss in weight during transit, computed with respect to invoice prices, amounted to $ 18,679.91.

In its income tax return for 1948, petitioner reported income from sales of copra in accordance with the above-described method of accounting for copra sales.

At the beginning of 1949, petitioner believed that the method of accounting for its copra sales, described above, resulted in an overstatement, at the time of making shipments, of the sales income ultimately realized from shipments in which there was a loss of weight during shipment. Therefore, beginning with the calendar year 1949, the taxable year, petitioner adopted another method of accounting for sales of copra made under copra sales contracts executed during 1949. Under this new practice, petitioner debited accounts receivable, only, with the entire amount (100 per cent) of the invoice price of each copra sales contract executed in 1949; petitioner credited sales income with 95 per cent of the invoice price, the amount payable by the buyer at about the time of shipment under a contract; petitioner credited the remaining 5 per cent of the invoice price to an account entitled "Reserve For Outturn Settlements."

It has been stipulated that: "Upon receipt of actual landed weights upon delivery and weighing of each cargo at destination, petitioner made an adjusting entry upon its books, eliminating the reserve applicable to the particular shipment, crediting sales income for any additional amount collected, and charging sales income for any amount refundable to buyer as a result of the landed weight being less than the 95 per cent of invoice value collected at time of shipment. As of December 31, 1949 said reserve for shipments of copra in transit and shipments upon which delivered weights had not then been determined, amounted to $ 159,256.16, representing said balance of 5% of invoice value of such shipments not collected or adjusted by December 31, 1949. Landed weights were received on all [sic] of said shipments during 1950 and only $ 10,360.06 of said $ 159,256.16 became collectible, reflecting a loss in weight in transit of 4.31% [net] on the total of all said shipments. Appropriate adjusting entries were then made in 1950 resulting in an additional credit to sales income of $ 10,360.06 [net] and the elimination of said reserve of $ 159,256.16."

In its income tax return for the taxable year 1949, petitioner reported income from sales of copra in accordance with the new method of accounting for copra sales which it adopted at the beginning of 1949.

Petitioner did not request or secure the consent of the Commissioner to change its method of accounting for income from sales of copra before computing its income for 1949 upon such new method.

In determining the deficiency for the taxable year 1949, the Commissioner included in petitioner's taxable income $ 159,256.16, and he gave the following explanation in the statement attached to the statutory deficiency notice:

(a) On your return a deduction was taken in the amount of $ 159,256.16 offsetting gain reported on sales of copra in the taxable year which were in transit at December 31, 1949. Information furnished by you is to the effect that the amount of $ 159,256.16 was credited to a reserve to provide for the settlement of contracts covering copra shipments in transit at December 31, 1949. Under these contracts total amounts due on sales shipments were subject to adjustment for possible cargo shrinkage sustained in shipment. In the following year 1950, the shipments were adjusted on arrival, and you made settlement allowances covering the shipments in question which amounted in the aggregate to a sum less than $ 159,256.16 deducted in the taxable year.

In years prior to 1949 you followed the accounting method of entering on your books the full invoice prices for shipments made as gross income realized. If shrinkage allowances were made to customers in the same or a subsequent year, such allowances were charged as expense when made. In your Federal income tax returns you reported gross income and sales allowance expense in the same manner as the entries in your books.

It is accordingly held that income was properly reflected by the method of accounting followed by you in years prior to 1949 with regard to shipments of copra in transit; that charges in 1949 to provide for a reserve against shipments in transit at December 31, 1949 represented a change in method of accounting for which you did not secure permission from the Commissioner of Internal Revenue.

It is further held that the liabilities to make allowances to customers for shrinkage of shipments at December 31, 1949 represented contingent liabilities not definitely accrued in the taxable year and therefore not deductible until the liabilities therefor were definitely ascertained. The deduction of $ 159,256.16 is therefore disallowed.

Issue 2.

Western Vegetable Oils Company, Incorporated, hereinafter called Western, is a California corporation having its principal place of business in San Francisco. The corporation was organized in 1935. It carried on a business of producing vegetable oils from copra and other vegetable-oil producing materials, and of selling the oil and the by-products in the United States. As of March 31, 1954, it discontinued its copra crushing operations because of unfavorable economic conditions in the copra crushing industry.

The outstanding stock of Western consisted of common stock only.

Prior to 1949, Western purchased 698 shares of its stock from the Bank of California, as trustee under the will of R. Carl Eddy, Jr., deceased, and 280 shares of its stock from J. H. Thies. It held these shares of stock, 978 shares, as treasury stock at the beginning and during part of 1949.

At the beginning of 1949, there were outstanding 5,182 shares of Western's stock, and such outstanding stock was held, in various amounts, by 10 stockholders, including the petitioner who held 2,094 shares, or 40.4091 per cent of the outstanding shares. Western's outstanding stock at the beginning of 1949 was held as follows:

	No. of
Stockholders	shares	Percentages
Pacific Vegetable Oil Corporation	2,094	40.4091
A. A. Schumann	1,252	24.1605
S. L. Jones & Co. (transferred to W. A. Dow, a shareholder
and officer of S. L. Jones & Co. on June 28, 1949)	900	17.3680
R. J. Boomer	250	4.8244
D. S. Burness	178	3.4350
Muriel Burness	178	3.4350
Estate of P. C. Denroche, deceased	140	2.7016
Thos. A. Allan	140	2.7016
Paul A. Schumann	25	.4824
F. Nelson	25	.4824
Total	5,182	100.0000

At various times during 1949, beginning in April, Western received offers from some of its stockholders to sell their common stock to Western, and Western accepted the offers at duly called meetings of its board of directors.

In April of 1949, the executor of the estate of P. C. Denroche, deceased, advised Western of its desire to sell 140 shares to Western, and asked for bids. Western's directors were authorized to offer the executor $ 120 per share. The executor accepted the offer, and Western purchased the 140 shares on April 30, 1949, for $ 120 per share. The stock was held as treasury stock by Western until after October 18, 1949.

During October 1949, Western received offers from other stockholders to sell their Western stock to Western for $ 220 per share, as follows:

		Shares
Pacific Vegetable Oil Corp		1,346
Thomas A. Allan	(all)	140
D. S. Burness	(all)	178
Muriel Burness	(all)	178
Paul A. Schumann	(all)	25
F. Nelson	(all)	25
Total		1,892

These offers to sell were accepted and the purchases for $ 220 per share were authorized at meetings of Western's board of directors on October 18, 1949, and October 26, 1949, and the stock was purchased by Western on dates in October and November 1949 following the directors' meetings.

As of December 31, 1948, the book value of Western's common stock was $ 220 per share.

At the meeting of Western's directors on October 18, 1949, a resolution was adopted to purchase the stock of Pacific Vegetable Oil Corporation, petitioner, and of Allan, in which it was stated that the earned surplus of Western was sufficient to enable the purchases and that it was deemed to be to the best interests of Western to purchase the stock. Statements to the same effect appear in the resolutions which were adopted at the directors' meeting on October 26, 1949, when authorization was given to purchase the stock of D. S. Burness, Muriel Burness, Paul A. Schumann, and Nelson.

At the directors' meeting on October 18, 1949, a resolution was adopted authorizing the retirement and cancellation of the 698 shares which had been purchased from the trustee under the will of R. Carl Eddy, Jr., the 280 shares which had been purchased from J. H. Thies, and the 140 shares which had been purchased from the estate of Percy C. Denroche, all of which had been held after the purchases as treasury stock. At the same meeting a resolution was adopted authorizing the retirement and cancellation of the stock to be purchased from Pacific Vegetable Oil Corporation and Thomas A. Allan. At the directors' meeting on October 26, 1949, a resolution was adopted authorizing the retirement and cancellation of the stock to be purchased from F. Nelson, Paul A. Schumann, D. S. Burness, and Muriel Burness.

Accordingly, before the end of 1949, Western retired and canceled 978 shares of stock it had purchased before 1949 and held as treasury stock, and it purchased, retired, and canceled 2,032 shares of the 5,182 shares which were outstanding at the beginning of 1949. Therefore, at the end of 1949, there were 3,150 shares of its stock outstanding of the 5,182 shares which had been outstanding at the beginning of the year.

The stock which was outstanding at the end of 1949 was held by 4 stockholders, Pacific Vegetable Oil Corporation, W. A. Dow, R. J. Boomer, and A. A. Schumann in the amounts set forth below. During 1949, 6 stockholders sold all of their stock holdings to Western, and petitioner sold 1,346 shares out of its 2,094. The stockholders at the end of 1949, and the percentage of the outstanding stock of Western held by each, were as follows:

	No. of
Stockholder	shares	Percentage
A. A. Schumann	1,252	39.75
W. A. Dow	900	28.57
Pacific Veg. Oil	748	23.74
R. J. Boomer	250	7.94
	3,150	100.00

Western paid to the stockholders from whom it purchased stock during 1949, the total amount of $ 433,040 for their stock, as follows:

Estate of P. C. Denroche	$ 16,800
Thos. A. Allan	30,800
Pacific Veg. Oil	296,120
D. S. Burness	39,160
M. Burness	39,160
F. Nelson	5,500
P. A. Schumann	5,500
	$ 433,040

Western paid $ 220 per share to each of the above-named stockholders, except to the estate of P. C. Denroche to whom Western paid $ 120 per share.

At a meeting of Western's directors on January 4, 1950, the directors considered offers by W. A. Dow (900 shares) and R. J. Boomer (250 shares) to sell all of their stock to Western, 1,150 shares, at $ 220 per share. A resolution was adopted authorizing acceptance of these offers by Western, and the retirement and cancellation of the 1,150 shares upon purchase thereof. After Western purchased and retired the above stock, 2,000 shares remained outstanding of which A. A. Schumann held 1,252 shares, and petitioner held 748 shares.

On or about February 17, 1950, petitioner purchased from A. A. Schumann 252 shares of Western's stock at a price of $ 220 per share. Thereafter, petitioner and A. A. Schumann each owned 1,000 shares (50 per cent each). Petitioner's purpose in purchasing 252 shares from A. A. Schumann was to equalize the number of shares held by each.

On or about October 24, 1949, after petitioner sold 1,346 shares of Western stock to Western, petitioner's remaining stock, 748 shares, then represented 20.1 per cent of Western's outstanding stock. On or about January 10, 1950, after Western bought the stock of Dow and Boomer, petitioner's 748 shares represented 37.40 per cent of the then outstanding stock, and the 1,252 shares held by A. A. Schumann represented 62.60 per cent of the outstanding stock.

On August 16, 1949, Western declared a cash dividend of $ 10 per share to shareholders of record on August 17, 1949. This dividend was paid. On August 17, 1949, there were 5,042 shares outstanding so that the dividend which was paid amounted to $ 50,420.

At the end of 1948, Western's paid-in surplus was $ 69,090, and its earned surplus was $ 768,299.64. Western's accumulated earnings and profits exceeded, at all times, the payments it made in 1949 for stock which it acquired from various stockholders.

Western's net income before taxes, income taxes, and paid dividends for the years 1943 through 1947 were as follows:

	Net income
Year	before taxes	Income taxes	Paid dividends
1943	$ 51,119.43	$ 450.00	$ 39,060
1944	65,152.50	38,596.21	11,760
1945	75,656.05	44,020.86	10,364
1946	344,858.23	137,115.08	51,820
1947	1,069,837.49	407,179.51	103,640

Western's net income before taxes (or loss) for the years 1948 through 1953, was as follows:

	Net income
Year	before taxes
1948	$ 88,573.88
1949	358,814.71
1950	(121,440.87)
1951	106,037.90
1952	(32,403.36)
1953	(52,140.97)

Western declared and paid dividends in 1948 and 1949 in the amounts of $ 51,820, and $ 50,420, respectively. No dividends were paid in 1950.

Western's cash and earned surplus at December 31 of each of the years 1948 through 1953 amounted to the following:

		Earned
Year	Cash	surplus Dec. 31
1948	$ 448,201.72	$ 768,299.64
1949	238,503.21	503,756.80
1950	54,739.69	129,315.93
1951	84,466.05	233,223.71
1952	54,005.10	198,723.82
1953	48,277.30	142,854.72

The increases or decreases in Western's earned surplus for the years 1946 through 1950 were as follows:

	Earned surplus,
Year	increase (or decrease)
1946	$ 155,923.15
1947	558,104.56
1948	3,095.81
1949	(264,542.84)
1950	(374,440.87)

For the years 1948 through 1950, as of December 31 of each year, Western's gross sales, gross profit or loss, expenses, and net taxable income or loss were as follows:

		Gross profit	Business	Net taxable
Year	Gross sales	(or loss)	expenses	income (or loss)
1948	$ 5,617,486.61	$ 214,656.89	$ 164,308.51	$ 88,573.88
1949	4,672,896.09	467,787.70	116,865.38	358,814.71
1950	6,373,894.78	(11,829.73)	115,888.12	(121,440.87)
1951	6,551,529.94	200,610.82	94,973.52	106,037.90
1952	5,661,159.15	165,790.02	221,689.16	(32,403.36)
1953	6,164,545.29	121,955.34	225,784.28	(52,140.97)

Western carried on its oil manufacturing and copra crushing business from the beginning of its business in 1935 until approximately March 31, 1954. All plant and equipment owned and maintained by Western prior to 1949 continued to be owned and maintained by Western after 1949 to and including March 31, 1954.

The basis of 1,346 shares of Western stock, which Western acquired from petitioner in 1949, was $ 18,832, or about $ 13.99 per share.

In its income tax return for the year 1949, petitioner reported the sum of $ 296,120, which it received from Western upon its surrender of 1,346 shares of Western, as a dividend, and took a dividend credit, under section 26 (b) of the 1939 Code, of 85 per cent of the sum received, or $ 251,702, which left $ 44,418 as taxable income received in 1949 from the transaction.

The respondent determined that there was a partial liquidation of Western in 1949; that the petitioner erred in treating the transaction as a dividend; and that the $ 296,120 which petitioner received in exchange for 1,346 shares of stock of Western represented a recovery of the petitioner's cost or basis of the stock to the extent of $ 18,832, and that, accordingly, the petitioner realized capital gain in the amount of $ 277,288. Respondent's explanation in the statement attached to the deficiency notice is as follows:

(b) The amount of $ 296,120.00 received by you from the Western Vegetable Oils Company, Inc., in return for the surrender of 1346 shares of stock of that corporation was reported on your return as dividends, against which an income credit of 85% or $ 251,702.00 was claimed. Western Vegetable Oils Company, Inc., acquired these shares from you in accordance with a resolution of the directors authorizing the purchase at a price of $ 220.00 per share and subsequent cancellation thereof. This transaction was one of a series of such transactions whereby the corporation purchased 3042 shares out of a total of 5042 shares outstanding. All of the holdings of seven stockholders in the aggregate of 1696 shares were purchased and cancelled by the corporation. You retained 748 shares of the 2000 shares which remained outstanding.

You contend that your shares were redeemed and cancelled by the corporation at such time and in such manner as to make the proceeds received by you essentially equivalent to receipt of a taxable dividend under Section 115(g), I. R. C.

It is held that your gain from this transaction is taxable as long-term capital gain realized from the sale or other disposition of property in the amount calculated as follows:

Proceeds from 1346 shares	$ 296,120.00
Cost Basis of stock sold	18,832.00
Long-term capital gain	$ 277,288.00

Accordingly dividend income of $ 296,120.00 and the offsetting credit of $ 251,702.00 are eliminated from your net income and the long-term capital gain of $ 277,288.00 is substituted therefor.

All of the stipulated facts which have not been found herein are found as stipulated. All of the exhibits attached to the stipulation are incorporated herein by this reference.

With respect to copra sales in transit at the end of 1949, liabilities had not become fixed, before or at the end of 1949, and, therefore, had not been incurred, placing upon petitioner liabilities to reduce the charges for the copra in transit to any amounts less than the contract-invoice prices. The contract-invoice prices agreed to in 1949 were not inflated. The new system of accounting for copra sales in transit at the end of the year which petitioner adopted in 1949 constituted a change in its accrual method of accounting for which the Commissioner's prior consent was required.

The distribution of Western Vegetable Oils Company to petitioner in 1949, in exchange for 1,346 shares of Western's stock owned by petitioner, was a distribution in partial liquidation. The distribution to petitioner was in cancellation and redemption of part of Western's stock. The distribution and cancellation and redemption of the stock was not at such time and in such manner as to be in whole or in part essentially equivalent to the distribution of a taxable dividend.

OPINION.

Issue 1.

The petitioner keeps its books and reports its income on an accrual method of accounting. Prior to 1949, with respect to income from sales of copra under a standard copra sales contract, petitioner accrued the entire invoice amount of such contracts in the year of the contract and it did so with respect to its year-end contracts where copra was in transit and the landed weights thereof had not been determined prior to the end of the taxable year. The problem under this issue relates to contracts executed in the latter part of 1949 which we refer to as year-end contracts for convenience. The petitioner adopted a new system in 1949 of including in gross income only 95 per cent of the invoice amount of its year-end contracts. The petitioner takes the position that 95 per cent of invoice prices was paid before the end of 1949 on the sight drafts accompanying the bills of lading which were mailed to the banks of buyers and paid by the buyers before December 31, 1949. This appears to be the purport of an exhibit attached to the stipulation of facts. The petitioner contends that the new system adopted in 1949 is consistent with its accrual method of accounting, that it more clearly reflects annual income, that it corrects a previous error in its accrual method, and that the new system does not constitute a change in its accrual accounting method for which permission of the Commissioner was required under Regulations 111, section 29.41-2. ^{I-1 C. B. 87; North American Oil Consolidated v. Burnet, 286 U.S. 417">286 U.S. 417; Permanent Homes Land Co., 27 B. T. A. 147; Helvering v. Russian Finance & Construction Corporation, 77 F. 2d 324.Petitioner relies on Corn Exchange Bank v. United States, 34">37 F. 2d 34; and Great Northern Railway Co., 8 B. T. A. 225.}

The respondent has determined that the entire invoice amounts of the copra sales contracts which are involved under this issue are includible in gross income for 1949. His determination resulted in adding to income $ 159,256.16. The respondent determined that the accounting system used by petitioner prior to 1949, as it applied to copra shipments in transit under year-end contracts, properly reflected petitioner's income. He contends that the new system adopted by petitioner in 1949 represents a change in accounting method and that since petitioner did not request or obtain permission for a change in accounting method it was error for petitioner to omit 5 per cent of invoice prices, $ 159,256.16, from 1949 income. Respondent also determined that petitioner's liabilities to make allowances to buyers for loss in weight of copra while in transit were, as of December 31, contingent liabilities not definitely incurred or accrued in the taxable year, and, therefore, not deductible until such liabilities were definitely ascertained. Respondent contends, also, that the full amount of the invoice prices of copra in transit accrued before December 31, 1949. Respondent cites the following cases: Ross B. Hammond. Inc., 36 B. T. A. 497, affd. 97 F. 2d 54; Estate of L. W. Mallory, 44 B. T. A. 249; Berryman D. Fincannon, 216">2 T. C. 216, 220;Kahuku Plantation Co. v. Commissioner, 132 F. 2d 671, affirming 43 B. T. A. 784; Brown v. Helvering, 291 U.S. 193">291 U.S. 193; Crescent Cotton Co., 5 B. T. A. 850; and David J. Joseph Co. v. Commissioner, 136 F.2d 410">136 F. 2d 410.

Petitioner admittedly did not request or obtain permission to make a change in its method of accounting for income from copra sales contracts covering copra in transit. Regulations 111, section 29.41-2, and prior regulations to the same effect, have the purpose of promoting consistent accounting practice from year to year, thereby securing uniformity in the collection of the revenues. The regulation is reasonable and valid and compliance with it has been held to be mandatory. Ross B. Hammond, Inc. v. Commissioner, supra; Estate of L. W. Mallory, supra;St. Paul Union Depot Co. v. Commissioner, 123 F.2d 235">123 F. 2d 235; Berryman D. Fincannon, supra;Elmwood Corporation v. United States, 107 F. 2d 111.The Commissioner determined that petitioner, in the taxable year 1949, changed its method of accounting with respect to sales of copra in transit and the income therefrom. That determination is presumptively correct and the petitioner has the burden of proving it is erroneous. St. Paul Union Depot Co. v. Commissioner, supra, p. 240; Welch v. Helvering, 290 U.S. 111">290 U.S. 111.

One question under this issue is whether the petitioner in 1949 changed its method of accounting and basis for reporting income from sales where the shipment was in transit. As has been stated above, petitioner argues that its new system did not represent a change in accounting method. The petitioner has the burden of proving that it did not change its accounting method. The evidence under this issue consists chiefly of stipulated facts and two exhibits (1A, the sales contract form, and 2B, a schedule about invoice amounts, adjusted charges, and additional payments by buyers or refunds by petitioner). There is very little testimony. It is well to mention, preliminarily, a few matters about petitioner's evidence. Petitioner uses the term "shipped weights" rather loosely. That term means, as we understand, the quantity specified in a sales contract, such as 550 tons, or some other specified quantity; it does not mean extra tons which may be shipped by petitioner in an overweighting procedure for market advantage. When a shipment is overweighted at the place of shipment, the invoice amount is computed upon the weight specified in a contract, nevertheless. Another point which is not entirely clear is whether under the new system adopted in 1949, petitioner regarded as "accrued" before the end of the year, only the 95 per cent of invoice price payments represented by payment or acceptance before the end of the year of sight drafts for such amounts, or whether petitioner regarded such 95 per cent as "accrued" before the end of the year on the basis of an executed contract and shipment of copra regardless of whether a sight draft had been paid or accepted before the end of the year. Since petitioner has not made any point of these details, they do not affect our conclusions but we have observed that accuracy about them is to be desired, and petitioner's lack of accuracy, if material, serves only to indicate some inadequacies in petitioner's proof.

Prior to 1949, petitioner accrued in income of a taxable year the entire amount of invoice prices computed under sales contracts which had been executed in a taxable year and under which contracts shipment had been made. The contract specified a certain number of tons and the price per ton. The invoice price was the result of multiplying the specified number of tons by the specified price per ton. Also, prior to 1949, petitioner treated as an "expense" of a sale, in the year landed weight was determined for a shipment, the amount of the adjustment in the charge to the buyer. Such amount was the dollar value of the difference between the tons specified in the sales contract (shipped weight) and the tons determined upon a reweighing of the shipment at the end of transit (landed weight). Such "expense" was deducted in a year following the year for which invoice price was accrued, if the landed weight was determined after the end of the year of shipment under the sales contract. Also, prior to 1949, under the accounting method followed by petitioner, no "Reserve for Outturn Settlements" was carried on petitioner's books. We conclude that the new system adopted in 1949 constituted a change in petitioner's method of accounting. We are not satisfied that petitioner has shown that the new system did not represent a change in accounting method. We understand that under the new system, petitioner accrues as income in a taxable year, only the amounts which are paid by a buyer, rather than the amounts computed under the sales contract, i. e., the invoice price. That is to say, petitioner includes in income, first, 95 per cent of the invoice price, and in a later year, it includes any additional payments of the buyer made after landed weights are determined. Also, under this system petitioner will not treat as an expense, and deduct, the difference between invoice price and the adjusted price based on outturn weights. In our opinion, the accruing of 95 per cent, rather than 100 per cent, of invoice price, the setting up of a so-called reserve of 5 per cent for future adjustments, to be made after the close of a taxable year, and the abandonment of the method of taking as expense deductions the amount of adjustments in invoice price made after the taxable year, constitute a change in accounting method. Cf. Brown v. Helvering, supra.

The effect of the Commissioner's determination is to require that petitioner continue to use the accounting method consistently employed by petitioner in prior years. The Commissioner has determined that the method consistently followed before 1949 clearly and accurately reflected income. Secs. 41 and 42, I. R. C. 1939. The Commissioner's determination is within the broad administrative discretion accorded to him under the statute. See Brown v. Helvering, supra, where it was said, that, "It is not the province of the court to weigh and determine the relative merits of systems of accounting." The Commissioner's determination that petitioner shall continue to use the accounting method consistently followed unless his permission to change is given, is not to be disturbed unless an abuse of his wide administrative discretion is evident. Schram v. United States, 118 F. 2d 541; Shoong Inv. Co. v. Anglim, 45 F. Supp. 711">45 F. Supp. 711. We are unable to find that there has been an abuse of discretion as the following observations may serve to demonstrate.

The petitioner does not deny that upon the execution in 1949 of the copra sales contracts involved under this issue, contracts were formed in which a quantity of goods was specified, the price per ton was specified, the initial 95 per cent payment was based upon such quantity and price, otherwise known as the invoice price, and that the petitioner's right to receive payment of such price was fixed during 1949. Also, the petitioner takes the position that the 95 per cent of invoice price payments were received before the end of 1949. The petitioner does not deny that, accordingly, title to the shipments passed to the buyers upon their payment of sight drafts in the amount of 95 per cent and their receipt of bills of lading to which the sight drafts were attached, or that petitioner made technical delivery of the shipments to the buyers before the end of 1949 upon the payment of and acceptance by the buyers of the sight drafts. See 2 Williston, Sales (rev. ed.), sec. 289 and sec. 305. We think it is clear, that under the contracts in question, namely the year-end contracts where copra was in transit, the year 1949 was the year in which petitioner's right to receive payment for such sales became fixed, and that the amount of the payment was determined, as well. For example, if the shipment were lost at sea, the invoice price thereof was the amount petitioner had a right to recover, other things being equal. It is the right to receive income, not the actual receipt thereof that determines when it should be accrued and included in gross income. United States v. Harmon, 205 F.2d 919">205 F. 2d 919; Security Flour Mills Co. v. Commissioner, 321 U.S. 281">321 U.S. 281; Continental Tie & Lumber Co. v. United States, 286 U.S. 290">286 U.S. 290; Spring City Foundry Co. v. Commissioner, 292 U.S. 182">292 U.S. 182. Although adjustment might be made in the amount of the invoice price after determination of landed weight, this was, we believe, only part of and due to the seller's warranty, specific or implied, that it would deliver the quantity called for by the sales contract, and that if the quantity unloaded at the end of transit should be less, according to outturn weight, the buyer would not be charged for more goods than he received. As was stated in David J. Joseph Co. v. Commissioner, supra, page 411 --

In practically every contract of sale for merchandise there is an implied warranty of quality and quantity of the merchandise sold, for the breach of which the merchant would be liable to the buyer, but the breach would not develop prior to delivery, and the right to demand damages or a refund would not accrue until its discovery. * * *

The amounts of future adjustments in the invoice prices were contingent and liability for them did not accrue in the taxable year 1949. Crescent Cotton Co., supra.That they were contingent, not fixed, and not susceptible of an accurate estimate in 1949 is amply shown by the evidence before us. In one instance, upon adjustment in 1950 of the invoice price after determination of landed weight, the adjusted price was only $ 96.59 less than the invoice price; in another instance, it was $ 20,901.78 less than the invoice price; in two instances, the invoice price was less than the adjusted, landed-weight price; in one instance there was no adjustment in invoice price when landed weight was determined. However that may be, the contingency of having to make adjustments in invoice prices does not prevent the accrual of income in the year in which the right to income under the sales contracts became fixed. Brown v. Helvering, supra.

The petitioner has failed to show that the Commissioner has abused his administrative discretion in making the determination which has given rise to this issue. Furthermore, the petitioner has not produced evidence to show that in the copra selling business it is customary to accrue in the year sales contracts are made under which the shipment is in transit, only 95 per cent of the invoice price rather than 100 per cent. Cf. Pacific Grape Products Co. v. Commissioner, 219 F. 2d 862, reversing 17 T.C. 1097">17 T. C. 1097.

We think also that petitioner's action in effecting a new system of accounting for income from copra sales contracts where shipments were in transit, whereby it changed the manner of treating items of income and expense cannot be denominated as merely a technical correction of prior errors, or a mere change in "accounting practice," as petitioner chooses to call it. This was a substantial change which may have had some adverse effect upon the revenues, and, therefore, it clearly required the Commissioner's prior consent to the change. Curtis R. Andrews, 23 T.C. 1026">23 T. C. 1026.

The authorities cited by the petitioner have been considered. They are either inapplicable or distinguishable on their facts.

There are other points which, if discussed, would demonstrate further the errors in petitioner's general contentions. One, for example, is that the Internal Revenue Code makes specific provision for certain reserves, such as reserves for bad debts, and provides how such specific reserves may be treated for tax purposes. With these exceptions, the rule is that reserves may be deducted only in the year when they represent liabilities which have been incurred. Brown v. Helvering, supra.The reason underlying the rule is that a liability does not accrue while it remains contingent. It is clear that any liability of petitioner to reduce the contract-invoice price was, at the end of 1949, contingent. The record shows that petitioner sometimes overweighted shipments (without any change in the contract-invoice price) so as to make up for shrinkage and loss of weight in transit. When that was done, landed weights would equal or be close to the contract-invoice weight and price and, then, no or little adjustment downward of the contract-invoice price would be required. The evidence does not establish that the contract-invoice price was an inflated amount. Of course, if petitioner underweighted a shipment, shipping fewer tons than the contract specified, an adjustment downward of the contract-invoice price would be necessary when the consignee took possession of and reweighed the shipment. The record indicates that petitioner sometimes underweighted shipments when it believed that practice was advantageous because of the trend of the market prices of copra. But this practice was within petitioner's control. Also, it provides a possible explanation of why at times landed weights of shipments were more than normally less than the weights shipped per contracts.

In view of the conclusions we have reached, it is not necessary to discuss other aspects of the issue even though consideration has been given to them.

The Commissioner's determination is sustained. Berryman D. Fincannon, supra;Advertisers Exchange, Inc., 25 T. C. 1086.

Issue 2.

In 1949, Western Vegetable Oils Company, Inc., had only one class of issued and outstanding stock, namely, common stock, and petitioner, 1 of 10 stockholders, owned 2,094 shares out of 5,182 shares, or 40.4 per cent of the stock. In October 1949, Western acquired, canceled, and retired 1,346 shares of the stock held by petitioner for which it paid $ 220 per share, or $ 296,120. It is agreed that, if material, petitioner's basis for the stock so acquired was $ 18,832, or about $ 13.99 per share. Since petitioner received $ 296,120, the long-term capital gain would be $ 277,288, if respondent's determination is correct.

Petitioner treated Western's distribution of $ 296,120 as dividends and took a dividend credit of 85 per cent under section 26 (b) of the 1939 Code, in the amount of $ 251,702, whereby $ 44,418 of the alleged dividend remained subject to tax.

The Commissioner's determination results in the elimination of $ 296,120 from dividend income of the petitioner and, correspondingly, elimination of a credit against dividend income of $ 251,702; and the inclusion of $ 277,288 in petitioner's net long-term capital gain. Petitioner did not have any net short-term capital loss in 1949 to offset against net long-term capital gain.

The petitioner contends that the distribution by Western in exchange for its stock was at such time and in such manner as to make the distribution and cancellation of the stock "essentially equivalent to the distribution of a taxable dividend" within the provisions of section 115 (g) (1) of the 1939 Code. The Commissioner maintains that the entire amount of the distribution must be treated as in payment for the stock under section 115 (c), and that none of the distribution was essentially equivalent to a taxable dividend. Respondent relies upon Regulations 111, section 25.115-9, the material part of which is as follows:

The question whether a distribution in connection with a cancellation or redemption of stock is essentially equivalent to the distribution of a taxable dividend depends upon the circumstances of each case. A cancellation or redemption by a corporation of a portion of its stock pro rata among all the shareholders will generally be considered as effecting a distribution essentially equivalent to a dividend distribution to the extent of the earnings and profits accumulated after February 28, 1913. On the other hand, a cancellation or redemption by a corporation of all of the stock of a particular shareholder, so that the shareholder ceases to be interested in the affairs of the corporation, does not effect a distribution of a taxable dividend. * * *

It is concluded that petitioner has failed to prove that the distribution to petitioner by Western in 1949 of $ 296,120 in exchange for 1,346 shares of Western's stock was at such time and in such manner as to make the distribution, and the cancellation and redemption of the stock, essentially equivalent to the distribution of a taxable dividend within the intendment of section 115 (g).

The facts show that after petitioner surrendered 1,346 shares of Western's stock, petitioner's relationship to Western was essentially changed. For example, after Western acquired, in April or May 1949, 140 shares of its stock from the estate of Denroche, petitioner's block of Western's stock, 2,094 shares, represented 41.5 per cent of the outstanding stock, 5,042 shares. After petitioner surrendered 1,346 shares, it retained 748, and, also, there remained 3,696 shares of Western's stock outstanding. Accordingly, petitioner's remaining 748 shares represented 20.1 per cent of Western's outstanding stock.

The distribution to petitioner was a distribution by Western "in complete cancellation or redemption of a part of its stock." Western canceled and retired the stock. Furthermore, the distribution to petitioner was one of a series by Western in complete cancellation and redemption of part of its stock. In 1949, Western received and accepted offers from six stockholders, in addition to petitioner, to surrender all of their stock which amounted to 686 shares. All of these transactions were bona fide, arm's-length transactions in which the surrendered stock was retired. Including the 1,346 shares which petitioner surrendered, 2,032 shares were canceled and retired by Western. In addition, Western retired 978 shares which it had acquired before 1949 and had held as treasury stock. There were, therefore, a series of distributions by Western in complete cancellation and retirement of stock, all of which stock constituted a portion of the outstanding stock. These distributions, of which the distribution to petitioner was one, come within the definition of partial liquidation set forth in section 115 (i). It has been stated that in order to be "a partial liquidation it is not necessary that the corporation be planning a cessation of business or be in the process of final liquidation," or that all of the outstanding stock be retired at once. Benjamin R. Britt, 40 B. T. A. 790, 796, 797, affd. 114 F. 2d 10; Commissioner v. Quackenbos, 78 F.2d 156">78 F. 2d 156; Commissioner v. Cordingley, 78 F. 2d 118; Salt Lake Hardware Co., 27 B. T. A. 482. Section 115 (i) "applies, not to a distribution in liquidation of the corporation or its business, but to a distribution in cancellation or redemption of a part of its stock," Hamilton Allport, 4 T.C. 401">4 T. C. 401, 403. The mere existence of sufficient earnings and profits to cover the acquisition of the stock does not automatically bring the transaction within the provisions of section 115 (g). Fred B. Snite, 10 T. C. 523, 531, affd. 177 F.2d 819">177 F. 2d 819.

We recognize that the net effect of the transaction is to be considered, Flanagan v. Helvering, 116 F. 2d 937, in determining whether section 115 (g) applies. In applying the "net effect" rule, we have observed that no one factor is controlling, Fred B. Snite, supra, and that all relevant factors must be considered in determining the net effect of the transactions. We have considered all of the factors which the evidence discloses. For example, Western had declared and paid dividends in each year, including 1949, since 1943. Also, the distribution which petitioner received upon the surrender of 1,346 shares of Western's stock, was not one of a pro rata distribution to all of Western's then existing stockholders. A. A. Schumann, Western's president, did not receive any such or comparable distribution. We are unable to find that the distribution received by petitioner was in any sense a substitute for regular dividends which otherwise would have been payable.

We note that the evidence submitted by petitioner is lacking in explanation for Western's series of distribution in retirement of stock. There is no testimony relating to these transactions.

Upon the record before us, it is our opinion that the various factors which are before us for consideration lead to the conclusion that the transaction in question whereby petitioner surrendered 1,346 shares of Western's stock, did not have the equivalence of a taxable dividend under section 115 (g). It is held that the distribution in question was a distribution in partial liquidation within the meaning of section 115 (i), and that it is taxable under the provisions of section 115 (c). The respondent's determination is sustained.

Decision will be entered for the respondent.

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Footnotes

• 1. Regulations 111.

  Sec. 29-41-2. Bases of Computation and Changes in Accounting Methods. -- * * *

  * * * *

  A taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner. For the purposes of this section, a change in the method of accounting employed in keeping books means any change in the accounting treatment of items of income or deductions, such as a change from cash receipts and disbursements method to the accrual method, or vice versa; * * *↩