Wright Contracting Co. v. Commissioner ( 1961 )

Wright Contracting Company, Petitioner, v. Commissioner of Internal Revenue, Respondent

Wright Contracting Co. v. Commissioner

Docket No. 69144

United States Tax Court

36 T.C. 620; 1961 U.S. Tax Ct. LEXIS 117;

June 30, 1961, Filed

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Decision will be entered under Rule 50.

1. Accounting Method, Change in Method of Reporting Income. -- In accordance with the system of accounting regularly employed by petitioner in keeping its books throughout the taxable years, amounts of "retainage" withheld out of earnings for work done on long-term construction contracts were accrued by petitioner as income in the years the work was performed. Such system clearly reflected income and, further, was used by petitioner as its method of reporting income consistently since its incorporation in 1942. Held, petitioner may not change its method of reporting income contrary to the consistent system of keeping its books and without the prior consent of the Commissioner, since under facts of this case such change in system of accounting and reporting was equivalent to a change of method within meaning of section 39.412(c), Regs. 118.

2. Depreciation. -- Held, that the facts warrant a revision of petitioner's depreciation schedules by salvage value and the reasonable amount of the latter determined.

3. Branch Operation Losses. -- Petitioner was engaged in the general contracting business, and primarily on highways, streets, and airports classified as light construction. Throughout the base period petitioner, in an entirely new and different undertaking in its experience and as a member of a joint venture, owned a one-third proprietary interest in an operation for the construction of a large dam classified as heavy construction. Held, that the dam construction project, to the extent of petitioner's proprietary interest therein, was a "branch" operated by petitioner within the meaning of section 433(b)(18) and (19) of the 1939 Code, and that its average base period net income should be adjusted on account of the losses incurred in such branch operation.

Scott P. Crampton, Esq., J. Q. Davidson, Esq., and Tom B. Slade, Esq., for the petitioner.

George W. Calvert, Esq., for the respondent.

Kern, Judge. Bruce, J., concurs in the result.

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KERN

Respondent determined deficiencies in the income and excess profits taxes of petitioner for the fiscal years ended June 30, 1951 to 1954, inclusive, in the respective amounts of $ 56,054.75, $ 57,972.62, $ 155,128.53, and $ 358,471.13. By affirmative pleading in the alternative respondent claims an increase of $ 53,475.58 in the asserted deficiency for the fiscal year ended June 30, 1953. Petitioner claims overpayments for the fiscal years ended June 30, 1951 and 1952, in the respective amounts of $ 305,702.63 and $ 208,852.06.

The issues presented are:

(1) For each of the years involved whether the respondent erred in determining that certain amounts of "retainage" withheld from petitioner as a retained percentage of amounts due for work performed on long-term construction contracts should be included in income in the years the work was performed, in accordance with petitioner's system of accounting for all years involved, and also with its method of reporting income for the years up to and including the fiscal year ended June 30, 1953, or whether the inclusion of such retainage in income may be properly deferred for income tax purposes to subsequent years upon the final completion and acceptance of the work as contended by petitioner without first having obtained the consent of the Commissioner.

(2) For each of the years involved, and as affirmatively pleaded by respondent in the alternative if the first issue is decided adversely to his determination, whether petitioner's corrected net income as determined in the statutory notice of deficiency should be adjusted to reflect the net change between the amount of retainage at the beginning and end of each taxable year so that such corrected net income should be reduced for the fiscal years ended June 30, 1951, 1952, and 1954, only by the amounts of $ 265,762.19, $ 101,816.72, and $ 372,746.13, respectively, and should be increased by the amount of $ 76,393.70 for the fiscal year ended June 30, 1953, resulting in an alleged increased deficiency of $ 53,475.58 for the latter year. Further, in the alternative with respect to the fiscal year ended June 30, 1954, respondent affirmatively alleges that petitioner's contract with the City of Columbus, Georgia, was finally completed and accepted in that year so that the retainage of $ 158,462.12 on such contract should be included in income and reflected in the above-mentioned adjustment of net income for that year.

(3) For each of the years involved whether the respondent erroneously reduced, by a determined salvage value, the depreciation deductions claimed by petitioner for certain types of equipment based on rates which were previously agreed upon by the parties with respect to prior taxable years.

(4) For each of the years involved, and for the purpose of computing petitioner's excess profits credit, whether the respondent erroneously failed to allow petitioner the benefits of section 433(b)(18) and (19) of the 1939 Internal Revenue Code, as amended, for alleged branch operation losses sustained during petitioner's base period.

(5) For each of the years involved, and in the alternative if the fourth issue is decided adversely to petitioner, whether the respondent erroneously failed to allow petitioner the benefit of its industry rate of return under section 442(d) of the 1939 Internal Revenue Code in computing petitioner's excess profits credit and, if so, what were petitioner's total assets for the purposes of such computation.

(6) For the fiscal year ended June 30, 1953, whether the respondent erred in failing to allow petitioner the benefit of an alleged unused excess profits credit carryback in an amount not less than $ 217,554.45 from the fiscal year ended June 30, 1954.

FINDINGS OF FACT.

Some of the facts have been stipulated by the parties. We find them to be as stipulated and incorporate herein by this reference the primary stipulation, together with the exhibits attached thereto, and the supplemental stipulation.

Petitioner is a corporation organized under the laws of Georgia on July 1, 1942, and maintains its principal office at Columbus, Georgia. Petitioner is engaged in the general contracting business in which it has many long-term contracts, and keeps its books and files its tax returns on the accrual basis of accounting for the fiscal years ending June 30. Its income tax returns for taxable years involved herein were filed with the collector or director of internal revenue for the district of Georgia. The taxes reported to be due for those years and the amounts and dates of payments thereof are as set forth in detail in the stipulation.

On May 12, 1953, petitioner filed a claim for refund for the fiscal year ended June 30, 1951, claiming the benefit of losses from branch operations under section 433(b)(18) and (19) of the Internal Revenue Code of 1939, as amended. On March 14, 1955, petitioner filed claims (Form 843) for refunds for the fiscal years ended June 30, 1951 and 1952, stating that for those years its returns treated amounts of retained percentages on contracts as income in the years in which the work was performed and that the claims for refund treated such retainage as income in the year in which the work was finished and finally accepted by the contracting authority. On March 15, 1955, petitioner filed an application for tentative carryback adjustment on account of unused excess profits credit from the fiscal year ended June 30, 1954, to the preceding taxable year ended June 30, 1953.

Petitioner's charter authorized it to carry on a general engineering and contracting business including, inter alia, the designing and construction of buildings, highways, bridges, piers, docks, waterworks, and all iron, steel, wood, masonry, and earth constructions. Petitioner's charter further authorized it to become a member of, or be financially interested in, any partnership, joint venture, association, firm, agency, or corporation engaged in any business in which petitioner was authorized to engage. In carrying on its general contracting business petitioner's principal line of work is on highways, streets, sewerlines, airports, grading, drainage, and paving. In such work petitioner moves earth, makes fills, grubs trees, and lays asphalt and concrete. Petitioner contracts for work primarily in the various Southeastern States. It generally has from 30 to 40 different jobs within a year and several jobs in process at the same time. Petitioner sets up a temporary field office at the site of each of its construction projects outside of Columbus, Georgia. Petitioner participated in joint ventures with two other corporations in the building of two dams, one across the Cumberland River in Kentucky, and the other across the Dan and Roanoke Rivers in Virginia.

Many of the long-term contracts under which the petitioner was engaged during the years involved provided that as the work progressed the petitioner was to be paid at certain times for the work actually done and based on the contract unit prices and, further, that out of such progress payments a certain percentage could be retained by the party for whom the work was done until the completion and final acceptance of the entire work covered by the contract. The retainage was withheld from amounts due petitioner for work performed in order to insure the proper performance and completion of the contract in accordance with prescribed standards.

The following provision is representative of a provision found in the long-term contracts under which petitioner performed work for various subdivisions and agencies of the United States Government:

7. Payments to Contractors. -- (a) Unless otherwise provided in the specifications, progress payments will be made as the work progresses at the end of each calendar month, or as soon thereafter as practicable, or at more frequent intervals as determined by the contracting officer, on estimates approved by the contracting officer. In preparing estimates the material delivered on the site and preparatory work done may be taken into consideration.

(b) In making such progress payments there shall be retained 10 per cent on the estimated amount until final completion and acceptance of all work covered by the contract: PROVIDED, however, That the contracting officer, at any time after 50 per cent of the work has been completed, if he finds that satisfactory progress is being made, may make any of the remaining progress payments in full: And provided further, That on completion and acceptance of each separate building, vessel, public work, or other division of the contract, on which the price is stated separately in the contract, payment may be made in full, including retained percentages thereon, less authorized deductions.

(c) All material and work covered by progress payments made shall thereupon become the sole property of the Government, but this provision shall not be construed as relieving the contractor from the sole responsibility for all materials and work upon which payments have been made or the restoration of any damaged work, or as a waiver of the right of the Government to require the fulfillment of all of the terms of the contract.

(d) Upon completion and acceptance of all work required hereunder, the amount due the contractor under this contract will be paid upon the presentation of a properly executed and duly certified voucher therefor, after the contractor shall have furnished the Government with a release, if required, of all claims against the Government arising under and by virtue of this contract, other than such claims, if any, as may be specifically excepted by the contractor from the operation of the release in stated amounts to be set forth therein. If the contractor's claim to amounts payable under the contract has been assigned under the Assignment of Claims Act of 1940, 54 Stat. 1029 (41 U.S.C. Sec. 15), a release may also be required of the assignee at the option of the contracting officer.

The petitioner's contracts with various State governments and subdivisions thereof and with cities and municipalities contained provisions essentially similar to those quoted above providing for the contracting governmental body to withhold a percentage of work progress payments until completion and final acceptance of the entire work covered by the contract.

The petitioner had amounts of retainage on long-term contracts at the end of each of the fiscal years ended June 30, 1945, to June 30, 1954, inclusive, as follows:

Fiscal year	Amount of
ended June 30 --	retainage
1945	$ 163,871.74
1946	151,963.69
1947	268,822.38
1948	213,783.89
1949	255,040.56
1950	244,557.72
1951	510,319.91
1952	612,136.63
1953	535,742.91
1954	1,066,951.18

The petitioner, from its incorporation through the fiscal year ended June 30, 1954, accrued on its books and records the amounts retained from earnings on long-term contracts as income in the year the work was performed. Petitioner deducted its overhead expenses and direct expenses in connection with its long-term contracts as the expenses accrued. It treated the retained amounts as accounts receivable at their face value and any retainage petitioner failed to collect was charged off. The same firm of certified public accountants has prepared petitioner's income tax returns since its incorporation in 1942, and in connection therewith has made an annual audit of petitioner's books since about 1945 or 1946. This system of accounting, when consistently followed, adequately and accurately reflected petitioner's income.

On its Federal tax returns from incorporation in 1942 through its fiscal year ended June 30, 1953, the petitioner reported amounts retained from earnings on long-term contracts as income in the year the work was performed. Further, petitioner's income tax returns for years prior to and including the fiscal year ended June 30, 1950, were closed on that same basis of accounting.

On its tax return for the fiscal year ended June 30, 1954, the petitioner did not report amounts retained during that year from its earnings on long-term contracts for work performed during the year. The petitioner has never received permission from the Commissioner of Internal Revenue to change its method of reporting income from long-term contracts.

In the statutory notice of deficiency and with respect to the fiscal years ended June 30, 1951, 1952, and 1953, the respondent determined petitioner's tax liability on the basis of including in income the retainage on long-term contracts in the year the work was performed, i.e., the same basis as petitioner reported. With respect to the fiscal year ended June 30, 1954, the respondent increased petitioner's reported gross income by including the amount of $ 531,208.25 as representing the difference between the $ 1,066,951.18 retainage at the end of the year over the amount of retainage at the beginning of the year. Respondent determined that such amount of retainage on work performed in that year was properly includible in income of petitioner on the accrual basis. Respondent further determined that petitioner should continue to use the method of reporting which it had consistently used on its books for all years and also on its tax returns for taxable years prior to the fiscal year ended June 30, 1954.

The parties herein are agreed that the above-mentioned amounts of retainage at the end of the fiscal years ended June 30, 1945, to June 30, 1953, inclusive, and $ 908,489.06 of the amount of retainage at June 30, 1954, were on various contracts as to each of which the entire contract had not been finally accepted at the end of those years, respectively.

The above-mentioned $ 1,066,951.18 retainage at June 30, 1954, included the amount of $ 158,462.12 representing retainage withheld by the City of Columbus, Georgia, on a contract between petitioner and that City. Petitioner did not report such $ 158,462.12 retainage in income on its Federal income tax return for the fiscal year ended June 30, 1954.

Petitioner's contract with the City of Columbus was entered into on June 10, 1953, for the improvement of certain designated streets and called for a contract price of approximately $ 333,603.85 based on a unit-bid price for estimated quantities of various types of work to be performed and materials to be used pursuant to the plans and specifications. The City reserved the right to increase or decrease the quantities of materials to be used or work to be performed at any time prior to final completion and acceptance of the work covered by the contract. The contract provided for certain retainage by the City out of work-progress payments to petitioner based upon periodic estimates by the city engineer of the amount of work done and the value thereof at the time of the estimate. The contract provided that final payment of the entire sum found to be due thereunder would be made after the "final estimate is made and approved by the City." Such final estimate and approval for payment constituted the City's final acceptance of the work covered by the contract. An amendment to the standard form of the contract with respect to payment further provided that the City was entitled to delay the payment of 50 percent of the contract price for a period of 5 months after completion pending the issuance and sale of certain street improvement bonds and, further, that the beginning of such 5-month period would be "the date of final acceptance of the work covered by this contract in its entirety."

During the petitioner's fiscal year ended June 30, 1954, the city engineer submitted five estimates which were approved for payments in various amounts. The "Estimate No. 5" was submitted on June 7, 1954, and was approved by the city manager on the same date for payment of the sum of $ 8,116.97 leaving the retained unpaid amount of $ 158,462.12 which was 50 percent of the total amount due petitioner for work completed to that date. The asphalt surface on the last of the streets covered by the contract was completed on April 20, 1954, and the last work performed by petitioner under the contract (a minimal matter involving the raising of two manhole covers) was done on June 28 and 29, 1954. The "Estimate No. 5 & final" on petitioner's contract was submitted by the city engineer on December 15, 1954, and was approved by the city manager on December 27, 1954, for payment of the sum of $ 158,462.12 as the final payment of the entire sum found to be due petitioner under its contract with the City of Columbus.

In connection with its construction work the petitioner acquired several hundred pieces of various types of equipment such as automobiles, trucks, trailers, bulldozers, power shovels, scrapers, tractors, rollers, concrete and asphalt plants, mixers, bins, spreaders, compressors, cranes, etc. During the war years and up through the fiscal year ended June 30, 1950, petitioner's equipment was used for longer hours per day and for harder work than was customary and repair parts were hard to obtain, all of which shortened the normal lives of its various pieces of equipment. The proper depreciation allowance on petitioner's equipment was a matter of controversy between the parties in determining the income tax liability of petitioner for years prior to the years involved herein. Such controversy involved the questions of whether petitioner's various pieces of equipment should be assigned shorter lives than the averages set out in Treasury Department Bulletin F, and whether petitioner should be required to set up salvage value thereon.

The above-mentioned depreciation dispute was referred to the Engineering and Valuation Section of the Internal Revenue Service which made a report and recommendation which assigned useful lives for various pieces of equipment acquired prior to January 1, 1946, and Bulletin F rates for all acquisitions after that date on the straight line method and in accordance with the taxpayer's experience. That report made no specific mention of salvage values. On the basis of that report the petitioner's depreciation deductions were finally settled, together with all other issues then involved, with respect to its tax liability for the fiscal years ended June 30, 1943, to June 30, 1950, inclusive. The petitioner anticipated that the agreed basis for determining depreciation would be applicable for a reasonable number of years subsequent to June 30, 1950.

In its Federal income tax returns for the taxable years involved herein the petitioner computed deductions for depreciation of its equipment on the straight line unit method of applying the life to the cost of each piece of equipment, respectively, and without setting up any salvage values. In general, petitioner applied the useful lives agreed upon for the prior years on similar types of equipment except for deviations as to the estimated lives of some items, such as a motor patrol, a shovel, and both light and heavy tractors. The equipment involved for the taxable years embraced many items acquired both prior and subsequent to June 30, 1950. They were primarily similar types of equipment but the items acquired after June 30, 1950, were improved and more expensive models of increased capacity and capable of doing more work.

Petitioner always tried to keep its equipment in the best of repair. As a general rule petitioner maintained and used its equipment so long as it remained workable for its purposes. Thereafter, and depending upon the type of equipment, some items had only scrap metal value while there was a market for other items which had some remaining value and useful life in the hands of farmers, smaller contractors, equipment dealers, municipalities, and counties.

Prior to and during the taxable years involved herein the petitioner retained a substantial number of automobiles, trucks, and pieces of equipment which had been fully depreciated. The petitioner's tax returns for the years prior to and for the taxable years involved herein show substantial capital gains realized from sales of various types of equipment at prices in excess of the depreciated cost basis thereof, and the total of such gains for each of the taxable years in question was as follows:

Fiscal year ended June 30 --	Sale price	Depreciated	Gain
		basis
1951	$ 8,720.55	$ 4,307.05	$ 4,413.50
1952	93,992.60	35,805.73	58,186.87
1953	49,570.54	16,975.21	32,595.33
1954	69,273.69	32,578.57	36,695.12

In determining the deficiencies involved herein the respondent disallowed depreciation for the fiscal years and in the amounts, respectively, as follows:

Fiscal year	Depreciation
ended June 30 --	disallowed
1951	$ 64,585.89
1952	63,797.93
1953	58,733.55
1954	66,107.08

Substantially all of the changes in depreciation made by the respondent result from- his determination that the salvage value of petitioner's automobiles, trucks, and other equipment was 15 percent of their basis. The fair and reasonable salvage values are 10 percent of the basis for petitioner's automobiles and trucks, and 5 percent of the basis for petitioner's other equipment.

With respect to each of the taxable years involved herein the respondent made adjustments in the reported capital gains on items of equipment sold, in the respective years, so as to reflect the changes made on the depreciation allowed by him.

During petitioner's fiscal years ended June 30, 1946 through 1951, it was a member of a joint venture known as the Jones-Wright Company, which was organized and began business on or about February 25, 1946. The Jones-Wright Company was awarded a contract for the construction of a large dam across the Cumberland River near Somerset, Kentucky, for a contract price of approximately $ 18 million. This dam, known as the Wolf Creek Dam, is one of the largest built by the United States Engineers, and created a reservoir which is one of the 10 largest in the world. The petitioner had a full one-third interest in this joint venture and the other member thereof was the J. A. Jones Construction Company. Prior to 1946 neither of those companies had ever built a dam. The joint venture was to terminate after completion of the dam. The petitioner sold its interest in the Jones-Wright joint venture during petitioner's fiscal year ended June 30, 1951.

The Jones-Wright joint venture established its principal office and place of business at the damsite where all the books and records relating to the project were maintained. The books of the joint venture were kept on the percentage-of-completion method of accounting and by fiscal years ending June 30. It filed partnership returns of income on Treasury Department Form 1065. Other than in connection with the Jones-Wright joint venture project petitioner had no work or office in Kentucky during the period involved.

The Wolf Creek Dam project required the use of large 10-yard concrete mixers, a cableway suspended from towers across the damsite and having 2-inch cables capable of carrying an 8-yard bucket of concrete, a great quantity of steel forms for the placement of concrete, and heavy Euclid equipment for loading and dumping large quantities of dirt for excavations and fills. Such heavy construction equipment is not ordinarily used on the type of highway and street construction work usually engaged in by petitioner.

The Wolf Creek Dam project required the construction of cofferdams to divert the river and presented various construction and engineering problems quite different from petitioner's prior experience. No one in the employ of either partner had had prior experience in the building of a dam. Both the petitioner and the J. A. Jones Construction Company sent keymen and foremen to the damsite to work on the project. As a full partner in the overall venture the petitioner actually participated in the dirt and rock excavation work and participated in an advisory capacity on the entire project. The joint venture found it necessary to use union labor at the Wolf Creek project, at times employing from 700 to 800 men with a weekly payroll as high as $ 74,000, and throughout the project it had difficult labor relations. The project was closed down by strikes for 14 days in 1947, for 41 days in 1948, and 88 consecutive days in 1950. The project was also closed down for periods of 6 days in 1947, 4 days in 1948, 7 days in 1949, and 19 days in 1950 during high water and flash floods. The petitioner did not use organized labor and never experienced a strike on its highway and street construction work.

The Standard Industrial Classification Manual, Major Group 16, as a whole embraces general contractors engaged in the construction of various types of engineering projects other than buildings, and then provides for subgroups classifying light and heavy construction, respectively. Group No. 161, Industry No. 1611, embraces general contractors primarily engaged in construction work, such as highways, streets, highway bridges, parking areas, airports, and light construction sewage and waterworks. Group No. 162, Industry No. 1621, embraces general contractors primarily engaged in the construction of heavy projects, such as railroads, heavy construction sewers and water mains, heavy foundations, tunnels, elevated highways, viaducts, dams, reservoirs, etc. The Wolf Creek Dam project is classified as heavy construction under the above subgroup No. 162. The usual type of highway, street, sewage, and airport construction work of the petitioner is classified as light construction under the above subgroup No. 161.

The Wolf Creek Dam project of the Jones-Wright joint venture sustained very substantial losses due to a combination of circumstances. Neither of the participating joint venturers had ever built a dam before and costly mistakes were made. The poor labor relations in general, the turnover of labor, and the actual strikes caused costly delays in the progress of the construction work. The periods of high water and flash floods caused damage to cofferdams, foundations, and other construction work which resulted in costly delays and repairs.

The petitioner's share of the losses of the Jones-Wright joint venture was in the amounts and for the fiscal years, respectively, as follows:

Fiscal year	Petitioner's
ended June 30 --	share of loss
1946	($ 77,073.21)
1947	(356,907.30)
1948	(31,422.21)
1949	(233,639.31)
1950	(184,373.88)
1951	(45,120.39)

These losses reduced the petitioner's net income from its other work during the fiscal years ended June 30, 1946, to June 30, 1951, inclusive, and thereby reduced petitioner's average base period net income. The petitioner's share of these losses during its statutory base period exceeded 15 percent of its aggregate excess profits net income during such base period.

On May 12, 1953, petitioner filed a claim for refund (Form 843) stating that in determining its excess profits credit for its fiscal year ended June 30, 1951, under section 433(b)(18) and (19) of the Internal Revenue Code of 1939, as amended, petitioner was entitled to exclude from its base period earnings the losses which it sustained on the Jones-Wright joint venture. This claim has not been allowed by respondent. In its tax returns for the fiscal years ended June 30, 1952, 1953, and 1954, petitioner computed its excess profits credit under the aforesaid statute by adding back to its base period earnings the losses sustained on the Jones-Wright joint venture. In the statutory notice of deficiency the respondent determined that petitioner was not entitled to use section 433(b)(18) and (19), supra, in computing its excess profits credit for any of the years involved in this proceeding.

On March 15, 1955, the petitioner filed an "Application for Tentative Carry-Back Adjustment" (Form 1139), in which it claimed that an alleged unused excess profits credit of $ 217,554.45 from its fiscal year ended June 30, 1954, should be applied to its fiscal year ended June 30, 1953. As a result of this application the petitioner, on May 20, 1955, received a tentative refund of $ 65,266.33 of taxes for the fiscal year ended June 30, 1953. In the statutory notice of deficiency the respondent determined that petitioner did not have any unused excess profits credit which could be carried back to the fiscal year ended June 30, 1953.

In addition to its participation in the Jones-Wright joint venture and during the latter part of its base period the petitioner had a 15-percent interest in another joint venture known as the Jones-Tompkins-Wright Company. This latter joint venture was organized and began business on or about April 17, 1948, to build a dam just below the confluence of the Dan and Roanoke Rivers in Virginia, which was known generally as the Bugs Island Dam. This dam was smaller than the Wolf Creek Dam. The Jones-Tompkins-Wright joint venture filed Federal partnership returns of income on Treasury Department Forms 1065.

Excluding any assets or equity the petitioner had in the Jones-Wright and Jones-Tompkins-Wright joint ventures, it had total assets at the end of the fiscal years ended June 30, 1946 through 1950, as shown in column 2, after the deduction of inadmissible assets as shown in column 3, as follows:

	Column 2.
Column 1.	Petitioner's	Column 3.
Fiscal year ended June 30 --	total assets (excluding	Inadmissible
	joint	assets
	ventures)
1946	$ 1,606,754.20	(1)
1947	1,358,651.15	(1)
1948	1,372,353.43	$ 5,000
1949	1,483,711.29	11,750
1950	2,332,909.45	11,750

The petitioner's share of the total assets of the Jones-Wright and the Jones-Tompkins-Wright joint ventures at the end of the fiscal years ended June 30, 1946 through 1950, as shown in column 2, and also the petitioner's equity in those joint ventures at the end of those years, as shown in column 3, were as follows:

	Column 2.	Column 3.
Column 1.	Petitioner's	Petitioner's
Fiscal year ended June 30 --	share of total	equity in joint
	assets of joint	ventures
	ventures
1946	$ 600,499.65	$ 8,712.87
1947	999,925.21	(107,000.68)
1948	1,092,326.02	(90,514.53)
1949	1,090,340.18	(30,633.19)
1950	1,147,754.06	(213,621.97)

The petitioner's statutory base period industry rate of return is 11.6 percent. For the purposes of section 442(d), I.R.C. 1939, the interest paid or incurred by petitioner during the fiscal years ended June 30, 1946 through 1950, was in the amounts and for the years as follows:

Year ended
June 30 --	Amount
1946	$ 849.80
1947	6,855.79
1948	7,497.79
1949	13,098.66
1950	39,110.35

On its Federal tax return for the fiscal year ended June 30, 1951, the petitioner applied for the benefits of section 442(d), I.R.C. 1939, and computed its excess profits credit under that section. On its tax returns for the subsequent fiscal years ended June 30, 1952, 1953, and 1954, the petitioner computed its excess profits credit under section 433(b)(18) and (19), I.R.C. 1939, and petitioner did not file an application for the benefits of section 442(d) in computing its excess profits credit for those fiscal years. In his deficiency notice the respondent computed petitioner's excess profits credit based on income under section 435(e), I.R.C. 1939, for each of the fiscal years ended June 30, 1951, 1952, 1953, and 1954.

OPINION.

The first issue presents the question of whether the amounts withheld from petitioner as a retained percentage of its earnings for work performed on long-term construction contracts should be included in petitioner's income in the years the work was performed, pursuant to the consistent and long-established system or practice of petitioner's accounting and reporting of such earnings and as determined by respondent, or whether the inclusion of such retainage in income should be deferred to subsequent years upon the final completion and acceptance of the work, even though this change was made by petitioner in its system or practice of accounting for such earnings subsequent to the last taxable year and the Commissioner has never been asked for his consent to such change pursuant to the pertinent regulations.

The applicable statutory provisions are sections 41 and 42 of the Internal Revenue Code of 1939. ¹Section 41 provides that the net income shall be computed upon the basis of the taxpayer's annual accounting period "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer" but if that method does not clearly reflect the income then "the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income." Section 42 provides that all items of gross income shall be included in income under the method of accounting permitted under section 41. The statute invests the Commissioner with broad administrative discretion to determine the question of the method of accounting which does clearly reflect the income, and the well-established rule is that the courts may not overturn the Commissioner's determination of that question unless the evidence clearly shows an abuse of his discretion. Schram v. United States, 118 F.2d 541">118 F. 2d 541; Advertisers Exchange, Inc., 25 T.C. 1086">25 T.C. 1086, affirmed per curiam 240 F. 2d 958.

Section 39.41-2(c) of Regulations 118, the pertinent portions of which are set out in the margin, ² requires that 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. The regulation requires the timely filing of an application for permission to change accompanied by a statement specifying the classes of items which would be treated differently as a result of the proposed change, and further states that permission to change the method of accounting will not be granted unless the taxpayer and the Commissioner agree to the terms and conditions under which the proposed change will be effected. One of the obvious reasons for this regulation is to prevent distortions of income which might result in an adverse effect upon the revenues. The cited regulation has the purpose of requiring consistency in the method of accounting for tax purposes and the courts have long approved the respondent's refusal to permit a change in a taxpayer's consistently used method of accounting without his prior consent. See Michael Drazen, 34 T.C. 1070">34 T.C. 1070, and the numerous authorities cited therein.

At all times material herein the petitioner has been engaged in the general contracting business and has maintained its books and records on the accrual basis of accounting. Under its long-term construction contracts and at specified times as the work progressed the petitioner had earnings for the work actually done and received the approved progress payments less a retained percentage which was withheld until the final completion and acceptance of the entire work covered by the contract. Under the method of accounting regularly employed by petitioner in keeping its books prior to and throughout the taxable years involved herein the petitioner accrued the amounts retained from earnings on long-term contracts as income in the year the work was performed. It treated the retained amounts as accounts receivable at their face value and subsequently charged off any portion thereof it failed to collect. The petitioner deducted its overhead expenses and direct expenses in connection with its long-term contracts as such expenses accrued. Prior to and during the taxable years petitioner's books were audited annually by a firm of certified public accountants which prepared its tax returns.

On its Federal tax returns from incorporation in 1942 through its fiscal year ended June 30, 1953, the petitioner consistently reported amounts retained from earnings on long-term contracts as income in the year the work was performed, which was in accordance with the method of accounting regularly employed in keeping its books. In the statutory notice of deficiency with respect to the fiscal years ended June 30, 1951, 1952, and 1953, the respondent accepted the petitioner's returns as correctly reporting as income the retainage on work done in each of those years.

On its tax return for the fiscal year ended June 30, 1954, contrary to the regular method of keeping its books throughout that year and without permission from respondent to change its method of reporting income, the petitioner did not include in income the amounts of retainage withheld from its earnings on long-term construction contracts for work performed during that taxable year. In his notice of deficiency, with respect to the fiscal year ended June 30, 1954, respondent included in gross income the increased amount of retainage due petitioner at the end of the year over the retainage at the beginning of the year. Further, the respondent determined that such retainage was properly includible in the income of petitioner on the accrual basis and that petitioner should continue to use the method of reporting income which it had consistently used for all prior years in accordance with the method regularly employed in keeping its books.

The respondent contends that his determination on the first issue should be sustained for the reasons that petitioner's income for all of the taxable years has been computed, in the deficiency notice, in accordance with the method of accounting regularly employed by petitioner in keeping its books as required by section 41, supra, and that petitioner failed to obtain permission to change its method of accounting in computing its income for tax purposes as required by section 39.41-2(c) of Regulations 118, supra. Respondent further contends that petitioner's method of accounting consistently used in keeping its books over a long period of years clearly reflects its income for tax purposes, whereas the proposed changes in the return for the fiscal year 1954 and now sought retroactively for the prior fiscal years 1951, 1952, and 1953, would result in a distortion of taxable income for each of those years unless appropriate adjustments are made with respect to items which would be duplicated or entirely omitted because of the proposed change.

The petitioner contends that the provision of the above-cited regulation, prohibiting a change in a taxpayer's method of accounting without prior consent, is not applicable because here there is no question of petitioner making any change from its accrual basis of accounting, but only the question of correcting an alleged erroneous accrual of the withheld retainage as income in each of the taxable years. Petitioner argues that its right to such retainage did not become fixed until the final completion and acceptance of the work in subsequent years at which time it would become properly accruable as income, citing Charles F. Dally, 20 T.C. 894">20 T.C. 894, affirmed on other issues 227 F.2d 724">227 F. 2d 724, certiorari denied 351 U.S. 908">351 U.S. 908, and United States v. Harmon, 205 F.2d 919">205 F. 2d 919.

In this case, unlike the cases cited by petitioner, the taxpayer had consistently followed a long-established system or practice of accounting on its books and reporting for taxation (except for the last taxable year) the so-called retainage, which, when followed, adequately and accurately reflected its income, and the taxpayer itself made a change in this system or practice with regard to reporting such earnings for the last taxable year, ³ which had substantial adverse effects upon the revenues and made such change without the prior consent of the Commissioner.

The question here is not whether the change would be proper. We may grant the propriety of the change (necessarily requiring considerable adjustments not made by the petitioner). ⁴ However, this question, in our opinion, would only be pertinent for our consideration here if it were raised before us after a request by petitioner for such change had been refused by the Commissioner.

The precise question for our determination on this issue is whether the change here involved is one which is subject to the provisions of section 39.41-2(c) of Regulations 118. Here the change was much more substantial and had a much more adverse effect on the revenues than the change involved in Advertisers Enchange, Inc., supra. On the authority of that case, we hold that the change in petitioner's system or practice of accounting and reporting the so-called retainages here involved and so consistently followed for so many years was so substantial with such adverse effects upon the revenues as to constitute a change in the method of accounting employed by petitioner within the meaning of the cited regulation and thus may not be made without first applying to the Commissioner for his permission. See Commissioner v. O. Liquidating Corporation, 292 F.2d 225">292 F. 2d 225.

Having decided the first issue in favor of respondent, the respondent's alternative contentions become moot.

The next issue for consideration is whether the respondent erroneously reduced, by a determined salvage value, the depreciation deduction claimed by petitioner for each of the taxable years on its various types of equipment based on rates which were previously agreed upon by the parties with respect to prior taxable years.

The record discloses that the parties herein engaged in a long drawn-out dispute regarding depreciation allowances for years prior to the taxable years in question and that such depreciation dispute, along with other questions involved, was settled on a basis on which petitioner's tax liabilities for the fiscal years ended June 30, 1943 through 1950, were closed. Petitioner cites Revenue Rulings 90 and 91, 1 C.B. 43">1953-1 C.B. 43-44, which announced a "policy" of the Internal Revenue Service generally not to disturb claimed depreciation deductions unless there was a clear and convincing basis for a change and such policy was pronounced for the purpose of reducing controversies. Petitioner contends that respondent should be required to follow his policy pronouncement in the absence of any clear and convincing basis for again revising the petitioner's depreciation schedules. Further, the petitioner contends that in the settlement for the prior years the parties agreed to depreciation rates which in effect resulted in an alleged "built-in" salvage value. However that may be, the short answer to petitioner's contention is that even a determination of the allowance of a deduction in prior years, much less the pronouncement of a general policy, does not preclude the respondent's disallowance of a claimed similar deduction for subsequent years. Cumberland Portland Cement Co., 29 T.C. 1185">29 T.C. 1185, and Michel M. Segal, 36 T.C. 148">36 T.C. 148.

In our opinion the facts herein warrant a revision of petitioner's depreciation schedules in determining reasonable allowances under section 23(l)(1) of the Internal Revenue Code of 1939, which may be deducted in petitioner's returns for the taxable years. See Massey Motors v. United States, 364 U.S. 92">364 U.S. 92, and Hertz Corp. v. United States, 364 U.S. 122">364 U.S. 122.

Petitioner further contends that, if the Court reaches such a conclusion, then the respondent's determination of a flat 15-percent salvage value applied to automobiles, trucks, and other equipment is excessive. With this contention we agree and on the record herein conclude (and have so found as a fact) that the fair and reasonable salvage values are 10 percent of the basis for petitioner's automobiles and trucks, and 5 percent of the basis for petitioner's other equipment. Appropriate adjustments will be made in the computation under Rule 50.

We will next consider the question, for the purpose of computing petitioner's excess profits credit for each of the years involved, whether the respondent erroneously failed to allow petitioner the benefits of section 433(b) (18) and (19) of the Internal Revenue Code of 1939, as amended, ⁵ for alleged branch operation losses sustained during petitioner's base period.

In computing the excess profits credit provided for by section 435(a) of the 1939 Code it is necessary to determine the average base period net income. Section 433(b), supra, provides that for the purpose of computing the average base period net income the excess profits net income for any taxable year shall be the normal tax net income increased or decreased by certain specified adjustments. These adjustments permit an appropriate comparison between the taxpayer's base period experience and its income for the taxable years by requiring the removal of certain abnormalities. Included among these adjustments is the one provided for by section 433(b) (18) and (19), supra, relating to base period losses from branch operations, provided all of the therein enumerated prerequisites are met. Mid-Southern Foundation, 28 T.C. 918">28 T.C. 918, 931, affirmed on other issues 262 F.2d 134">262 F. 2d 134, certiorari denied 359 U.S. 991">359 U.S. 991, and Kimble Glass Co., 35 T.C. 1238">35 T.C. 1238.

In the instant case the petitioner contends that the factual circumstances herein meet all of the statutory prerequisites while respondent contends that they fail to do so in several respects. In considering the evidentiary facts bearing upon this issue and the conclusions to be drawn therefrom, we take note of what was said in Burford-Toothaker Tractor Co. v. United States, 262 F. 2d 891, involving other sections of the Korean War Excess Profits Tax Act, but equally applicable here. In reversing 158 F. Supp. 429">158 F. Supp. 429 the Court of Appeals for the Fifth Circuit, in effect, held that the trial court overemphasized single facts in unrealistic disregard of the practical nature of the operations involved and was, therefore, too narrow in its factual conclusions in relation to the intent of the statute, and stated in part:

This approach [by this District Court] is both highly unrealistic in the frame of this record and is an impermissible inoculation of the administrative process with the metaphysical subjective imponderables in Old Section 722 which Congress rejected as unworkable and unfair when, for the Korean Excess Profits Tax Bill, an automatic objective formula was prescribed. * * *

* * * *

Congress did not mean to write into this objective formula any legal casuistry. It was dealing with the very practical matter of taxes in practical day-to-day business operations. * * *

In Halpin v. Collis Company, 243 F. 2d 698 (affirming in part and reversing in part the judgment of the United States District Court, Southern District Iowa, Aug. 6, 1956), one of the issues involved the question of whether the taxpayer's camera unit or division was a "branch" as defined by section 433(b)(18), supra, and on appeal the issue boiled down to whether the camera unit was operated in a "separate place" from the taxpayer's other business. The camera unit was located on the premises of the main plant 600 feet from the general offices and in a building which had been partitioned off from the rest of the plant. The camera unit had its own separate entrance, facilities, machinery, employees, office, and records. The court said that there was nothing either in the statute or Regulations 130, section 40-433(b)-4, which requires that a branch be separated from the main plant by a substantial geographical distance and that the issue of whether the camera unit was operated at a "separate place" from the taxpayer's other business is a question of fact. Upon a consideration of all the evidence the court sustained the trial court's finding that "the camera unit was operated at a separate place and was physically separated from all of the taxpayer's other manufacturing facilities," and also sustained its conclusion that the camera unit was a "branch" within the meaning of section 433(b) (18) and (19), supra.

In the instant case the respondent states that his position on this issue is twofold -- first, that section 433(b)(18), supra, was not meant to cover joint venture operations such as the Jones-Wright Company, but, if so, then second, that the Jones-Wright joint venture operation was not a "branch" within the meaning of that section because it fails to meet all of the statutory requirements.

In regard to his first position respondent contends that "Congress meant to cover only those branch operations which were 100 per cent owned by one corporation and did not mean to cover partnerships and joint ventures carried on by two or more corporations." However, there is nothing either in the statute or the Regulations 130, as amended by T.D. 6076 by adding section 40.433(b)-4, which requires that a branch operation be wholly owned by the taxpayer and the issue presents a question of fact as to whether the Jones-Wright joint venture of constructing the Wolf Creek Dam project, to the extent of petitioner's participation therein, constituted a "unit or subdivision" of the petitioner's business. Cf. Halpin v. Collis Company, supra. The petitioner owned a one-third proprietary interest and was an active participant in the entire dam construction project. As a practical business operation its one-third share of the losses from that construction project was just as much a loss to it as if it had been a sole owner. From a practical point of view it is immaterial and, in our opinion, in no way inconsistent with the intent of the statute that petitioner's proprietary interest in the operation was less than 100 percent. We conclude, and so hold, that to the extent of petitioner's proprietary interest therein the Wolf Creek Dam project constituted a "unit or subdivision of the taxpayer's business" within the meaning of the term "branch" as defined in section 433(b)(18), supra.

In regard to the question raised by respondent as to the lack of "permanency" of an operation to build one dam and then cease, the facts show that petitioner was a member of a joint venture which was awarded a contract for construction work of considerable magnitude, and in connection with that operation petitioner sustained substantial losses in each of the fiscal years ended June 30, 1946 to 1951, inclusive. This meets the terms of the statute which require only 2 or more years of operation of a unit or subdivision as a branch at a loss during the base period years.

In regard to the question raised by respondent as to whether the dam construction project was operated in a "separate place" from petitioner's other business, the facts clearly show that the operation had its own separate office and place of business, its own separate books and records, its own separate and locally hired employees, its own separate machinery and equipment of special types for the work to be done and, further, the project was physically and geographically separated from the petitioner's other primary business operations. This factual situation meets the statutory requirement. Cf. Halpin v. Collis Company, supra.

The next question raised by respondent is whether the dam operation "differed substantially" from petitioner's other business with respect to character of products or services. The facts show that the Wolf Creek Dam construction project is "of a type classifiable by the Standard Industrial Classification Manual * * * in a different subgroup of the taxpayer's major industry group than that in which its other business is so classifiable." Further, the facts clearly show that the Wolf Creek Dam project was an entirely new and different undertaking in the experience of petitioner and that the heavy construction of the dam, from foundation work to completed structure, differed substantially in material aspects of design, execution, and finished product from the petitioner's principal business of light construction of highways, streets, sewerlines, and airports. The factual circumstances herein meet this particular statutory requirement.

There is no question herein that the sum of petitioner's share of the net losses of the Wolf Creek Dam operation during the base period exceeded 15 percent of the aggregate excess profits net income of the petitioner during the base period.

Upon consideration of all the evidence herein, in relation to the terms of the cited statutory provisions and in the light of the cited cases, we conclude that the Wolf Creek Dam project, to the extent of petitioner's proprietary interest therein, was a "branch" operated by petitioner within the meaning of section 433(b) (18) and (19), supra, and that its base period net income should be adjusted on account of its losses incurred in such branch operation.

The above conclusion obviates the necessity of passing upon the alternative issue of whether petitioner is entitled to the benefit of its industry rate of return under section 442(d) of the 1939 Code and the further question of what constitutes petitioner's total assets for the purpose of such computation.

The question of the petitioner's unused excess profits credit carryback, if any, from the fiscal year ended June 30, 1954, will be determined in the recomputation under Rule 50.

Decision will be entered under Rule 50.

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Footnotes

• 1. None.↩

• 1. SEC. 41. GENERAL RULE.

  The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. * * *

  SEC. 42. PERIOD IN WHICH ITEMS OF GROSS INCOME INCLUDED.

  (a) General Rule. -- The amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41↩, any such amounts are to be properly accounted for as of a different period. * * *

• 2. Regulations 118.

  Sec. 39.41-2 Bases of computation and changes in accounting methods.

  (c) 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. * * * Application for permission to change the method of accounting employed and the basis upon which the return is made shall be filed within 90 days after the beginning of the taxable year to be covered by the return. The application shall be accompanied by a statement specifying the classes of items differently treated under the two methods and specifying all amounts which would be duplicated or entirely omitted as a result of the proposed change. Permission to change the method of accounting will not be granted unless the taxpayer and the Commissioner agree to the terms and conditions under which the change will be effected. * * *↩

• 3. As to this last taxable year it should be noted that the earnings represented by such retainages were reported for taxation according to one concept of accounting and yet were carried on its books on another.↩

• 4. But cf. Dingle-Clark Co., 26 T.C. 782↩.

• 5. SEC. 433. EXCESS PROFITS NET INCOME.

  (b) Taxable Years in Base Period. -- For the purposes of computing the average base period net income, the excess profits net income for any taxable year shall be the normal-tax net income, as defined in section 13(a)(2) as in effect for such taxable year, increased or decreased by the following adjustments * * *:

  * * * *

  (18) Adjustment for base period losses from branch operations. -- In the case of a taxpayer which during two or more such taxable years operated a branch at a loss, the excess profits net income for each such taxable year (determined without regard to this paragraph) shall be increased by the amount of the excess of such loss above the loss, if any, incurred by such branch during the taxable year for which the tax under this subchapter is being computed. As used in this paragraph, the term "branch" means a unit or subdivision of the taxpayer's business which was operated in a separate place from its other business and differed substantially from its other business with respect to character of products or services. A unit or subdivision of the taxpayer's business shall not be considered to differ substantially from the taxpayer's other business unless it is of a type classifiable by the Standard Industrial Classification Manual in a different major industry group or in a different subgroup of the taxpayer's major industry group than that in which its other business is so classifiable; Provided, however, That this paragraph shall not apply unless the sum of the net losses of such branch during the base period exceeded 15 per centum of the aggregate excess profits net income of the taxpayer during the base period. For the purposes of this paragraph, the aggregate excess profits net income of the taxpayer during the base period shall be the sum of its excess profits net income for all years in the base period, increased by the sum of the net losses of such branch during the base period.

  (19) Rules for application of paragraph (18). -- For the purposes of paragraph (18) --

  (A) A branch shall be deemed to have been operated at a loss during a taxable year if the portion of the deductions under section 23 for such year which is determined, under regulations prescribed by the Secretary, to be the portion thereof properly allocable to the operation of such branch exceeds the portion of the gross income during the taxable year which is determined under such regulations to be the portion thereof properly allocable to the operation of such branch; and the amount of the loss shall be an amount equal to such excess.

  (B) If the portion of the gross income determined to be properly allocable to the operation of the branch is a minus quantity, the amount of such excess shall be the sum of the deductions under section 23↩ determined to be properly allocable to the operation of the branch plus an amount equal to such minus quantity.