American Cigar Co. v. Commissioner

AMERICAN CIGAR CO., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

American Cigar Co. v. Commissioner

Docket No. 16229.

United States Board of Tax Appeals

21 B.T.A. 464; 1930 BTA LEXIS 1842;

November 29, 1930, Promulgated

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">*1842 1. The amount of earned surplus for the years 1918 to 1920 which resulted from a profitable transaction of 1902 determined.

2. The petitioner advanced money to a debtor corporation with which that corporation paid interest on its bonds to the petitioner and others who owned the bonds. Held that the Commissioner did not err in including the amount of the interest due on the bonds owned by the petitioner in the petitioner's gross income, and, further, that the amount of this interest should not be deducted as debts ascertained to be worthless and charged off.

3. Where, at the time an interest payment on these bonds became due, there was no reasonable expectation of receiving it, and where the expectations were the same at the end of the year, the petitioner need not include the bond interest in its income.

4. Where the fair market value of certain stock at the time acquired by the petitioner is not shown, we can not say that the Commissioner erred in determining the effect of the acquisition of this stock upon invested capital.

5. If a company places a price upon tobacco which is higher than cost, and at the end of the year inventories the tobacco at this price, ">*1843 the difference between the inventory figure and cost does not represent earnings which should be reflected in invested capital.

6. The undepreciated cost of certain structures and the undepreciated March 1, 1913, value of other structures may be deducted as a loss where it appears that in the taxable year the structures became utterly worthless due to a necessary change in operations.

7. Where a taxpayer with sufficient surplus purchases its own stock originally issued for cash at par, by giving its note therefor, a reduction in its invested capital in the amount of the note results. The same reduction in invested capital would result if the corporation gave its note without at the same time acquiring its stock or some asset.

8. The petitioner advanced money to certain individuals. In 1918 the individuals were unable to repay the money and the petitioner was required to accept certain property in complete settlement of its claim against the individuals. The petitioner is entitled to deduct the difference between the value of the property and the money which it advanced.

9. The petitioner is entitled to deduct dividends received from a foreign corporation which was">*1844 taxable upon its net income under Title II of the Revenue Act of 1918.

10. The Commissioner did not err in disallowing deductions and in reducing invested capital on account of excise taxes which accrued in prior years but which were not paid until the taxable year.

11. Russel Wheel & Foundry Co.,3 B.T.A. 1168">3 B.T.A. 1168, followed.

12. The net addition to a reserve for cash discounts is not a proper deduction from gross income under section 234(a)(1), but the amount of cash discounts actually allowed is a proper deduction.

Thomas G. Haight, Esq., Robert H. Montgomery, Esq., J. Marvin Haynes, Esq., James O. Wynn, Esq., and William Diebold, Esq., for the petitioner.

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MURDOCK

">*465 John D. Foley, Esq., and Lloyd W. Creason, Esq., for the respondent.

The Commissioner determined deficiencies in the income and profits taxes of the petitioner for the years and in the amounts as follows:

1918	$222,596.54
1919	78,524.00
1920	81,454.21
1921	18,391.96
Total	400,966.71

The petitioner claims overpayments of its taxes for the following years and in the following amounts:

1918	$201,303.87
1919	27,414.04
1920	177,044.75
1921	8,899.22
Total	414,661.88

">*1845 The deficiencies are based on the consolidated net income and invested capital of the petitioner and certain other corporations, including the Cuban Land & Leaf Tobacco Co. and for the years 1919, 1920, and 1921 the Luis Marx Tobacco Co.

">*466 The petitioner alleges that the Commissioner erred:

1. In not including in invested capital for the years 1918, 1919, and 1920 the earned surplus, amounting to $11,015,992.60, arising out of the exchange of the stock of H. de Cabanas y Carbajal for cash and for stock and bonds of the Havana Tobacco Co., and out of the subsequent sale of a portion of the Havana Tobacco Co. stock.

2. (a) By including in gross income, for the years and in the amounts set out below, interest owed to the petitioner by the Havana Tobacco Co., whereas the said Havana Tobacco Co. was insolvent and unable to pay said interest:

1918	$222,645.83
1919	222,250.00
1920	226,344.44
1921	214,387.50

(b - In the alternative. ) In including in gross income for 1921 the sum of $118,450, which was the amount of interest owed by the Havana Tobacco Co. for the period from June 1, 1921, to November 30, 1921.

(c - In the alternative.">*1846 ) In not allowing as deductions from gross income in the years and in the amounts set forth in paragraph 2(a), debts owed to the petitioner by the Havana Tobacco Co. which were ascertained to be worthless and charged off in those years.

(d - In the alternative. ) In not including in invested capital for the years 1918, 1919, and 1920 the sum of $1,946,170.12, the amount of the accrued interest receivable on the bonds of the Havana Tobacco Co. as of December 31, 1917.

3. (a) In including in gross income for the years and in the amounts set out below, interest owed to the petitioner by J. S. Murias & Co., whereas the said J. S. Murias & Co. was insolvent and unable to pay said interest:

1918	$24,854.75
1919	27,974.16
1920	31,648.23
1921	41,940.89

(b - In the alternative. ) In disallowing as deductions from gross income for the years and in the amounts set forth in paragraph 3(a), debts owed to the petitioner by J. S. Murias & Co. which were ascertained to be worthless and charged off in those years.

(c - In the alternative. ) In not including in invested capital for the years 1918, 1919, and 1920 the sum of $184,085.49, the amount of the">*1847 accrued interest receivable on the notes of J. S. Murias & Co. as of December 31, 1917.

4. In not including in invested capital for the years 1918, 1919, and 1920 the amount of $160,000, being a portion of the cost to ">*467 the Cuban Land & Leaf Tobacco Co. of the stock of the Luis Marx Tobacco Co.

5. In not including in invested capital for the years 1918, 1919, and 1920 the sum of $62,751.82, being that portion of the earned surplus or undivided profits of the Cuban Land & Leaf Tobacco Co. which was represented by the credit balance in the "Leaf Adjustment Account" of said company on December 31, 1917.

6. In disallowing a deduction of $54,199.76 from gross income for the year 1920 as a reasonable amount for the obsolescence of buildings used in the taxpayer's trade or business.

7. (a) In reducing invested capital on account of certain shares of the petitioner's stock acquired from the American Tobacco Co. for delivery to two of the petitioner's employees, in the years and amounts as follows:

1918	$240,000
1919	180,000
1920	120,000

(b - In the alternative. ) In including in invested capital for the year 1918 only $45,369.86, and for">*1848 the year 1919 only $43,857.53, on account of the alleged issue, on the first day of March of each of said years, of 600 shares of the petitioner's stock of the par value of $60,000 to two of its employees, instead of that proportion of the par value of said shares which the number of days between March 1 and December 31 in each of said of said years bore to the total number of days in said years, or $50,301.37.

(c - In the alternative. ) In not including in invested capital for 1920, on account of the alleged issue on March 1, 1920, of 600 shares of the petitioner's stock of the par value of $60,000 to two of its employees, the sum of $50,163.94, being that proportion of the par value which the number of days between March 1, 1920, and December 31, 1920, bore to the total number of days in 1920.

8. (a) In disallowing as a deduction from gross income for the year 1918 a loss amounting to $20,513.74 sustained in that year upon the exchange of certain promissory notes for stock of the Beach Cigar Co., and not compensated for by insurance or otherwise.

(b - In the alternative. ) In not allowing as a deduction from gross income for the year 1918 debts amounting to $20,513.74">*1849 owed by E. E. Beach, Frank W. Beach, and H. R. Grant, which debts were ascertained to be worthless and charged off in that year.

9. In not allowing as a deduction from gross income for the year 1919 the amount of $12,622.43 which was received as dividends from Henry Clay and Bock & Co., Ltd., a corporation which during 1919 was taxable under Title II of the Revenue Act of 1918 upon its net income.

">*468 10. (a) In disallowing, as a deduction from gross income for 1918, taxes paid in that year on account of additional assessments of corporation excise taxes for the years 1909 to 1912, both inclusive, and on account of additional assessments of income taxes for the years 1914 and 1915.

(b) In deducting from invested capital for the year 1918, taxes amounting to $11,374.90 paid in that year on account of additional assessments of corporation excise taxes for the years 1909 to 1912, both inclusive, and on account of additional assessments of income taxes for the years 1914 to 1916, both inclusive.

(c - In the alternative. ) In deducting the full amount of said taxes from invested capital for 1918 instead of that proportion thereof, amounting to $903.76, which the">*1850 number of days between the date of the notice and demand for the payment of said taxes and December 31, 1918, bore to the total number of days in 1918.

11. In deducting from invested capital, in the years and amounts as follows, the amounts of Federal income and profits taxes alleged to have been due for the years 1917, 1918, and 1919:

1918	$100,961.21
1919	327,093.83
1920	148,019.15

12. In deducting from gross income the additions to a reserve for cash discounts in the years and amounts as follows:

1918	$451,078.71
1919	456,126.00
1920	604,599.03
1921	499,401.04

instead of the amounts of cash discount actually allowed to its customers in those years as follows:

1918	$456,174.97
1919	447,537.70
1920	611,410.55
1921	509,086.00

At the hearing the respondent was granted leave to amend his answer to allege (1) that the Commissioner erroneously allowed as deductions from the petitioner's gross income the amount of the accrued interest on the Havana Tobacco Co. notes as a loss sustained or as a bad debt ascertained to be worthless and charged off in the years and amounts as follows:

1918	$389,740.44
1919	415,343.42
1920	432,000.79
1921	450,951.87

">*1851 ">*469 (2) that the Commissioner erroneously included in the invested capital of the petitioner the sum of $50,000, or any other amount, on account of the acquisition of the stock of the Luis Marx Tobacco Co.

FINDINGS OF FACT.

1. The petitioner was incorporated under the laws of New Jersey in 1901. It has its principal office in New York City. Its books and accounts have been kept at all times on an accrual basis and for the calendar year.

The American Tobacco Co. was organized in 1890. Each year thereafter it sold a large part of the world's annual supply of cigarettes and smoking tobacco. Its business expanded rapidly, and at the beginning of the twentieth century it and its subsidiaries sold about 80 per cent of the cigarettes and smoking tobacco, about 75 per cent of the plug tobacco, and about 90 per cent of the snuff consumed in the United States. It also made large sales and conducted a successful business in England, Canada, Australia, China, and Japan. The American Tobacco Co. and the other companies associated with it had been very successful and had realized large profits.

When the petitioner was organized in 1901, the American Tobacco Co. owned 35">*1852 per cent of its stock, the Continental Tobacco Co. associated with the American Tobacco Co. owned 35 per cent of the stock, and various individuals, more or less closely connected with the same interests, owned the remaining 35 per cent. As part consideration for its stock, the American Tobacco Co. turned over to the petitioner a substantial cheroot and "little cigar" business. The petitioner immediately acquired or absorbed three leading cigar companies manufacturing such well-known brands of domestic cigars as Cremo, George W. Childs, Principe de Gale, and Preferentia. It soon became the largest domestic cigar manufacturer in the United States. It had bright prospects for a successful business career. In the latter part of 1901 it decided to enter the Havana or Cuban cigar business. Some time in the latter part of 1901 or early in 1902 it concluded negotiations with the owner of the Cabanas factories, producing under that name a full line of high grade Havana cigars, as a result of which a New Jersey corporation known as H. de Cabanas y Carbajal (hereinafter referred to as the Cabanas Co.) was organized; the petitioner paid $1,500,000 in cash for the stock of this corporation; ">*1853 and the corporation then purchased for $1,500,000 the Cabanas business, brands and property.

The attention of other leading manufacturers of Havana cigars was attracted by the American Tobacco Co. interests thus entering ">*470 the Havana cigar field. Shortly thereafter, these manufacturers negotiated with the petitioner for a consolidation of their interests in the Havana cigar business. The Havana Commercial Co. first acquired all of the stock of Henry Clay and Bock & Co., Ltd. (hereinafter referred to as the Bock Co.). The Bock Co. in turn owned the Havana Cigar & Tobacco Factories, Ltd. These companies owned valuable properties, manufactured the leading brands of Cuban cigars - including Carolina Perfecto, Bock Panatella, Henry Clay, Corona, Flor de Cuba and Cabanas, had substantially 90 per cent of the export tobacco business in Cuba, and a large Cuban domestic cigar and cigarette business. In bringing about the consolidation, those interested urged that, if these valuable properties and plants were placed under the successful management of the American Tobacco Co. large oeprating economies could be affected, great profits realized, and the financing and marketing">*1854 facilities of the American Tobacco Co. would be available to the combination. A reciprocity treaty with Cuba was then being discussed, under which import duties on Cuban products would be reduced.

To effect the consolidation, the Havana Tobacco Co. (hereinafter referred to as the Havanna Co.) was organized under the laws of New Jersey in 1902. It had, as its first board of directors, a number of well-known successful business men and financiers, many of whom were members of the board of directors of the American Tobacco Co., familiar with its management and responsible for its success. The Havana Co. had authority to issue $10,000,000 par value 20-year, 5 per cent bonds, $5,000,000 par value preferred stock, and $30,000,000 par value common stock.

On May 28, 1902, Samuel B. Lawrence, acting as a "dummy," made the following offer to the board of directors of the Havana Co.:

I hereby offer to transfer or cause to be transferred to your Company the entire Capital Stock of H. de Cabanas y Carbajal, the note of the Havana Commercial Company for $2,000,000, secured by the pledge of at least a majority of the shares of Henry Clay and Bock & Company, limited, and at least two-thirds">*1855 of each class of the outstanding shares of capital stock of Havana Commercial Company (being two-thirds of 60,000 shares of Preferred and of 125,000 shares of Common Stock), and to provide you with the sum of Two million dollars ($2,000,000), in cash, all in return for $7,500,000 in 5% Twenty-Year Gold Bonds of your Company, to be part of an authorized issue of $10,000,000 and all of the shares of your Capital Stock (except eighteen (18) shares of Common Stock), and eighteen hundred dollars ($1,800) in cash and the assumption of a contingent liability of not exceeding $250,000 to L. Carbajal to be hereafter ascertained and discharged by Havana Tobacco Companyy and of an assumption of not exceeding $50,000 for expenses in the reorganization of the Havana Commercial Company.

I further agree that in case this offer is accepted I will within sixty days thereafter cause to be transferred to your Company the remaining shares of Capital Stock of the Havana Commercial Company, or to the extent that I ">*471 shall fail to do so, shall deposit with the Guaranty Trust Company of New York, subject to your order, shares of stock of your Company to the extent of -

I. 60 shares of Preferred">*1856 Stock and 40 shares of Common Stock for each One hundred shares of Preferred Stock of the Havana Commercial Company not so transferred; and

II. 40 shares of the Common Stock of your Company for each One hundred shares of the Common Stock of the Havana Commercial Company not so transferred.

I further agree that if this offer is accepted I will within thirty days thereafter discharge and pay or acquire and transfer, or cause to be acquired and transferred, to your Company as you may from time to time direct, all the debts of the Havana Commercial Company in excess of $2,212,000 exclusive of its indebtedness on the note aforesaid, of its indebtedness to its employees in Cuba which I guarantee shall not exceed $90,000, and of its debts incurred in the usual and ordinary conduct of its business since May 1st, 1902.

On May 29, 1902, the board of directors of the Havana Co. accepted the above offer and on the same day $5,000,000 par value of the 5 per cent noncumulative preferred stock, $7,500,000 par value of the 20-year, 5 per cent gold bonds, and $29,998,200 par value of the common stock of the company and $1,800 in cash were delivered to and deposited with a trustee with whom">*1857 41,221 shares of the preferred stock and 93,628 shares of the common stock of the Havana Commercial Co., and 15,000 shares of stock of the Cabanas Co. were also deposited. All the bonds and stock to be delivered to Lawrence were then delivered to Lawrence.

The petitioner thus transferred all of its stock in the Cabanas Co. to the Havana Co. and received from the latter $3,500,000 par value of the bonds, $19,998,200 par value of the common stock of the Havana Co., and $1,800 in cash. Thereafter, it sold certain of these shares of the Havana Co. stock as follows:

Date of sale	Shares sold	Amount
February, 1903	10,000	$525,950.00
August, 1903	500	25,737.50
September, 1906	1 22,700	473,405.10
Total	33,200	1,025,092.60

The securities of the Havana Co. were sold on the "curb," but were not listed on the New York Stock Exchange. The first sales of the common stock of the Havana Co. were as follows:

Date of sale	Shares	Price per
	sold	share
June 4, 1902	20	50 1/2
June 5, 1902	100	50
June 9, 1902	100	51
July 12, 1902	120	48

">*472 There were no more sales of this stock until September, ">*1858 1902. From the date of the exchange, up to the first of March, 1903, 51,795 shares of this stock were sold at prices ranging from 41 1/2 to 59 3/4.

The first sale of the preferred stock took place on October 10, 1902, when 12 shares were sold at 66. From that time, to the last of February, 1903, 20,209 shares of this stock were sold at prices ranging from 63 to 68. From the date of the exchange, up to the first of March, 1903, "bid" and "asked" prices for these stocks had the following range:

	Lowest	Highest	Lowest	Highest
	bid	bid	asked	asked
Common stock	40	55	43	56
Preferred stock	60	68	63	75

There were no reported sales of or quotations on the bonds.

On or about the day of the exchange, the Havana Commercial Co. common stock was selling at 20. On or about the day of the exchange, Havana Commercial Co. common stock was quoted at 20 "bid" and 21 "asked" and Havana Commercial Co. preferred stock was quoted at 60 1/2 "bid" and 62 "asked."

The petitioner realized a profit on the exchange of its Cabanas Co. stock for cash and securities of the Havana Co. Of this profit $9,907,092.60 remained as earned surplus of the petitioner">*1859 during the years 1918 to 1920, inclusive.

The Commissioner in his computation of the petitioner's invested capital for the years 1918 to 1920, inclusive, has refused to recognize a profit of $11,015,992, or any part thereof, claimed to have been realized from the exchange of the Cabanas stock for cash and the securities of the Havana Co., and the subsequent sales of some of the Havana Co. stock.

2. The Havana Co. started its activities in 1902 with exceptionally fine prospects and did well for a while. But the manufacturing and merchandising methods of the American Tobacco Co. which had proven highly successful in other fields were quite unsuccessful when applied to the Cuban cigar business. Men familiar with the American leaf tobacco and cigarette business replaced many of those who had formerly managed the Cuban factories. These new managers made many costly errors in the conduct of the business, due to their lack of familiarity with conditions necessary to the production of Cuban cigars. The consumers began to believe that the cigars had lost their distinctive merits and were more or less justified in this belief. Havana cigars had formerly been imported and distributed">*1860 through American firms which sent purchasers to Cuba. The ">*473 Havana Co. distributed its own product in the United States in order to eliminate the profits theretofore made by importers. The American importers retaliated as early as 1903 by bringing out new brands which they were able to sell successfully because of well established relations with their customers and with producers in Cuba. This competition materially reduced the sales of the Havana Co. brands. As the result of an increase in duties on Cuban cigars, the sale of popular sizes in large quantities was made more difficult.

By 1909 the general financial condition of the Havana Co. was bad. Its only source of income was dividends on the stock of its subsidiary companies, and these dividends were insufficient to pay the interest on its bonds. In order to keep the Havana Co. going, and because the American Tobacco interests were loath to allow the Havana Co. to go into a receivership, the petitioner advanced money from time to time to the Havana Co. to enable it to meet its operating expenses and pay the interest on its bonds.

The following statement shows the net advances made by the petitioner to the">*1861 Havana Co. and its subsidiaries prior to January 1, 1918, and the advances and repayments made during the years under consideration:

January 1, 1918, net advances to Havana Tobacco
Co. and its subsidiaries (including
$4,516,623.20 advanced to pay interest)		$11,640,123.20
Advances:
1918	$2,048,000.00
1919	787,000.00
1920	2,723,500.00
1921	3,129,000.00
		8,687,500.00
Total		20,327,623.20
Repayments:
1918	1,169,500.00
1919	1,135,000.00
1920	2,056,000.00
1921	2,495,500.00
		6,856,000.00
Balance due December 31, 1921		13,471,623.20

The income of the Havana Co. was not sufficient to pay the interest upon its outstanding notes and bonds in any year between 1908 and 1921. Its annual deficits during these years were as follows:

1908	$542,080.40
1909	520,288.47
1910	620,198.27
1911	570,192.16
1912	567,485.89
1913	309,955.55
1914	469,980.05
1915	$439,153.63
1916	243,056.91
1917	447,060.28
1918	549,469.13
1919	265,442.14
1920	204,290.29
1921	803,152.56

">*474 The following consolidated balance sheet reflects the condition of the Havana Co. and its subsidiary companies on December 31 of">*1862 each year of the years under consideration, as shown by the books of the companies:

	1918	1919	1920	1921
Assets
Cash	$60,940.78	$94,172.57	$47,693.99	$71,392.75
Notes and accounts
receivable, less
reserves for
bad debts	437,295.38	491,200.31	572,130.84	284,496.81
Inventories:
Mfg. stock, leaf
tobacco, and
operating
supplies	2,824,536.55	3,033,956.95	3,283,279.87	3,855,568.25
Investments:
Stock in foreign
corporations	2,810,691.96	2,810,691.96	2,810,691.96	2,810,691.96
Stock in domestic
corporations	100.00	100.00	100.00	100.00
Deferred charges	15,304.99	29,961.80	27,805.53	22,080.55
Capital assets:
Real estate and
buildings	669,051.68	666,451.68	668,451.68	731,176.30
Machinery and
equipment	298,318.61	278,349.76	406,085.00	411,594.38
Furniture and
fixtures	11,499.63	10,568.42	10,577.25	10,727.87
Delivery equipment	46,006.61	46,554.46	49,993.76	59,048.35
	1,024,876.53	1,001,924.32	1,133,107.69	1,212,546.90
Less reserves for
depreciation	239,666.89	237,488.79	233,766.01	275,706.70
	785,209.64	764,435.53	899,341.68	936,840.20
Good will,
trade-marks,
etc	19,688,284.11	19,688,284.11	19,688,284.11	19,688,284.11
	26,622,363.41	26,912,803.23	27,329,327.98	27,669,454.63
Liabilities
Notes payable	8,164,500.00	8,074,000.00	7,962,500.00	9,290,500.00
Accounts payable	1,597,821.72	2,073,260.57	2,603,297.71	2,797,788.18
Deferred credits	1,694.98	9,546.23	46,792.21	43,061.68
20-year 5 per
cent gold
bonds	7,500,000.00	7,500,000.00	7,500,000.00	7,500,000.00
Capital stock:
Preferred
(less stock
in treasury)	4,703,800.00	4,703,800.00	4,703,800.00	4,703,800.00
Common
(less stock in
treasury)	29,790,940.60	29,790,940.60	29,790,940.60	29,790,940.60
Minority stock
(preferred
and common)	472,000.00	472,000.00	472,000.00	472,000.00
Deficit (red)	25,608,393.89	25,710,744.17	25,750,022.54	26,928,635.83
	26,622,363.41	26,912,803.23	27,329,327.98	27,669,454.63

">*1863 The petitioner owned $3,500,000 par value of the bonds of the Havana Co. on which interest was due as follows:

Accrued Jan. 1, 1908, to Dec. 31, 1917	$1,946,170.12
1918	222,645.83
1919	222,250.00
1920	227,066.67
1921	214,387.50

All of these amounts were in fact paid to the petitioner out of funds advanced by it to the Havana Co., except that the petitioner did not receive interest on these bonds due December 1, 1921, in the amount of $118,450. In December, 1921, the petitioner refused to advance any more funds to the Havana Co. and a default occurred in the interest on the bonds.

Some years later, the Havana Co. was reorganized under a different name. The petitioner received 108,000 shares of the common stock of no par value and $1,500,000 par value of the bonds of the new company in lieu of its bond and stock holdings in and the principal ">*475 and interest of loans advanced to the Havana Co. The advances made by the petitioner to the Havana Co. were considered in fixing the amount of bonds and stock obtained by the petitioner in the new company. After 1908 the officers of the petitioner directed that the interest payments received on the">*1864 bonds of the Havana Co. should not be treated as income, but should be carried into an "interest suspense account." They did this because they believed that the advancements would never be repaid by the Havana Co., and because the petitioner was required to advance the money necessary to pay the interest on the bonds and was reimbursed in part only by its share of the interest. The petitioner did not report the amount of interest thus received in its income-tax returns.

The Commissioner included the amount of interest due for each year, as set forth above, in the petitioner's income for those respective years, but did not include the amount of the accumulated interest receivable on these bonds on December 31, 1917, as an asset in his computation of the petitioner's invested capital for the years 1918 to 1920, inclusive.

3. The petitioner owned all of the stock of J. S. Murias & Co. (hereinafter referred to as the Murias Co.) a New Jersey corporation operated as a subsidiary of the Havana Co. It has now been dissolved. A number of years ago it opened cigar factories in various parts of Cuba under agreements with Cubans living in the vicinity of the various factories that the">*1865 company would operate the factories and employ a certain number of people for a given number of years provided the Cubans would subscribe funds for the erection of the buildings. By 1910 the business of this company was an apparent failure, but the petitioner advanced money to keep it going rather than break faith with the Cuban people who had subscribed money.

The following balance sheet reflects the condition of the Murias Co. as of December 31 in each of the years under consideration, as shown by the books of the company.

1918 1919
Assets
Cash		$2,960.23	$1,837.28
Notes and accounts receivable		24,773.43
Inventories:
Raw materials (finished) goods,
supplies, etc	$248,374.95		$283,854.15
Less reserve for depreciation	1,414.92		1,610.24
		246,960.03
Deferred charges:
Unexpired insurance and taxes		1,707.28
Capital assets:
Real estate	19,787.34		19,787.34
Machinery and fixtures	4,476.59		4,448.03
Office furniture and fixtures	907.68		907.68
Horses, vehicles, etc	1,449.04		1,449.04
	26,620.65		26,592.09
Less reserve for depreciation	4,039.57		4,381.86
		22,581.08
Good will		600,000.00
		898,982.05
Liabilities
Capital stock		750,000.00
Bills payable		432,500.00
Deferred credits
Accounts payable		68,246.55
Deficit (red)		351,764.50
		898,982.05

">*1866 ">*477 Large sums were advanced by the petitioner to the Murias Co. on short-term, interest-bearing notes. Neither principal nor interest on these notes has been paid, and in 1923 the amount of the accumulated principal and interest was charged off the petitioner's books. Beginning in 1910 the petitioner entered the interest due on these notes in an account entitled "interest in suspense." It never reported this interest as income because it knew the hopeless financial condition of the Murias Co. and never expected to receive the interest. The Commissioner has included the interest due on these notes in the petitioner's income for the various years as follows:

1918	$24,854.75
1919	27,974.16
1920	31,648.23
1921	41,940.89

He has not included the accrued interest receivable on these notes on December 31, 1917, in the amount of $184,085.49 as an asset in his computation of the petitioner's invested capital for the years 1918 to 1920, inclusive.

4. The petitioner at all times material hereto, owned all of the stock of the Cuban Land & Leaf Tobacco Co. (hereinafter referred to as the Cuban Co.), and filed with it consolidated returns.

On April 21, 1906, Luis">*1867 Marx owned several tobacco plantations in Cuba, and on that day he and the petitioner entered into a contract which provided in part as follows:

You [Marx] value this plantation at four hundred thousand dollars ($400,000.) and you are raising on them annually fine crops of fine tobacco. We propose to you that you continue upon the terms hereinafter stated, the operation of such farms, and that each year after the present, that is, beginning with the crop of 1907, and including the crops of 1908, 1909, 1910 and 1911, you submit for examination each of said crops when it is ready for marketing, to the Cuban Land & Leaf Tobacco Company; the Cuban Land & Leaf Tobacco Company shall value each of said crops according to market prices for similar tobacco then ruling in the Island of Cuba. * * *

* * *

* * * the Cuban Land & Leaf Tobacco Company shall, and we hereby guarantee that it will, purchase each of said crops within thirty (30) days after its market value has been arrived at and shall pay therefor the said market value; the said crop to be delivered by you in Cuba. The whole of said purchase price shall not, however, be paid to you, but there shall be paid to you in cash">*1868 upon delivery, an amount equal to your actual cost of producing the same, including labor cost, cost of fertilizing material, canvas, cost of replacing or repairing depreciated or worn out farming utensils, and keeping and replacing of houses, livestock, the payment of any taxes, assessments, insurance or other charges upon the said land or crops, and all disbusements and outlays of whatever kind as may be actually made by you for and in connection with the production of the crop, and such as you have in the past been accustomed to make, and including also the sum of twenty four thousand dollars ($24,000.) annually, the same being in lieu of interest on the amount ">*478 invested in the farms, to wit, four hundred thousand dollars ($400,000) and the further sum of six thousand dollars ($6,000) annually in lieu of interest on one hundred thousand dollars ($100,000.), which is assumed to be your average investment in the farms in addition to the value of the land * * *. Any excess of the said market value of the said tobacco so to be paid by the Cuban Land & Leaf Tobacco Company, over and above the said cost and items of interest arrived at as aforesaid, shall not be paid to you, ">*1869 but shall immediately upon delivery of each of said crops be paid by the Cuban Land and Leaf Tobacco Company in cash to some individual or corporation, to be agreed upon between us, subject to the joint check of you and said Cuban Land & Leaf Tobacco Company. The said moneys so deposited and which we hereinafter shall call "the trust fund" shall receive interest from the depositary.

At any time within three months after the final delivery of the crop of 1907, or the crop of 1908, or the crop of 1909, or he crop of 1910, or the crop of 1911, the Cuban Land & Leaf Tobacco Company shall have the right to buy from you said farms at the price of four hundred thousand dollars ($400,000.) plus any amount expended by you in or for the production of the next succeeding crop, to be determined in the manner above provided for ascertaining cost, the said four hundred thousand dollars ($400,000.) plus the said amount of cost as aforesaid, shall be without interest, and upon the payment thereof to you in cash by the Cuban Land & Leaf Tobacco Company, you shall execute a good and sufficient deed to convey an absolute and unencumbered title, according to the laws of Cuba to the said lands to the">*1870 said Cuban Land & Leaf Tobacco Company, or to any person or corporation whom it nominates in writing, with full warranties of titles against liens and encumbrances. Said conveyance shall also include and convey all livestock, utensils and all other personalty, buildings and other property of the said farms, and without any additional consideration. If the said Cuban Land & Leaf Tobacco Company exercises its right and option hereunder, and makes said payment and acquires the said land, it shall thereupon be and become entitled to the whole of the trust fund up to that time accumulated. Within three months after the final delivery of the third crop hereunder, to wit, the crop of 1909, or within a like period after the final delivery of the fifth crop hereunder, to wit, the crop of 1911, the said Cuban Land & Leaf Tobacco Company shall have the right to notify you in writing that it does not desire to make such purchase and, thereupon, you shall become entitled to the whole of the said trust fund then accumulated and all future crops after 1909 until the crop of 1911 inclusive shall be paid for in cash on delivery, at the market value. * * * If in any year the market value of the">*1871 crop is not equal to the cost of its production, including interest charges as aforesaid, it shall be the duty of the Cuban Land & Leaf Tobacco Company to pay only such value, without respect to such cost, the trust, fund, as hereinbefore provided, securing nothing from that year's crop. You are in such event to be reimbursed immediately after delivery of such crop the difference between cost, including interest as aforesaid, and what you receive from the Cuban Land & Leaf Tobacco Company, only out of said trust fund as theretofore or thereafter accumulated hereunder, having no claim against us or the Cuban Land & Leaf Tobacco Company for such deficiency; it being our purpose and intent that the trust fund shall represent the net profits for the whole period.

* * *

Second: You are to enter into the employ of the Cuban Land & Leaf Tobacco Company and devote such time and attention in a managerial of ">*479 other administrative capacity to its affairs, except so far as your attention is reasonably necessary to the conduct of said farms hereinbefore mentioned. The time and attention which you are to devote to the affairs of the Cuban Land & Leaf Tobacco Company and to">*1872 your farms are to be controlled by your judgment for the necessity thereof, and whenever in your judgment your personal services are not required, you are privileged to absent yourself from the Island of Cuba. You are to be paid by the Cuban Land & Leaf Tobacco Company an annual salary of twenty thousand dollars ($20,000.) payable in equal monthly installments, which payments we guarantee; * * *

On April 27, 1909, the accumulations in the trust fund mentioned in the above contract amounted to a little more than $210,000. On that day the Cuban Co. entered into a new contract with Marx which provided for the cancellation of the contract of April 21, 1906. In this new contract the parties agreed that a joint stock company should be formed under the laws of New Jersey with the name of "Luis Marx Tobacco Company" having capital stock, all of one class, of the par value of $190,000. It further provided that Marx should convey to the new company his plantations, together with all personal property thereon, and that he should receive $210,000 of the trust fund and one-half of the stock of the new company, and should convey the remaining one-half of the stock of the new company to the">*1873 Cuban Co. and should turn over to the new company whatever amount there was in the trust fund in excess of $210,000. The conract also contained a provision that Marx should enter the service of the new company, take general control and management, and, in consideration of his services, receive annually 25 per cent of the net profits, of which amount he was to keep 15 per cent and divide the remaining 10 per cent among the employees as he saw fit.

This new agreement was carried out in accordance with its terms, and the Cuban Co. received the stock of the Luis Marx Tobacco Co. of the par value of $95,000, which it set up on its books at $1 a share. At some time undisclosed by the record, the amount at which this stock was set up on the books of the Cuban Co. was increased to $50,000.

In his computation of the consolidated invested capital of the petitioner and its subsidiaries for the year 1918, the Commissioner has used $50,000 to represent this stock among the assets of the affiliated group.

On or about December 11, 1918, the Cuban Co. purchased the other half of the capital stock of the Luis Marx Tobacco Co. for $20,000. For 1919, 1920, and 1921 the petitioner, the Cuban">*1874 Co. and the Marx Co. filed consolidated returns.

In computing the invested capital of the consolidated group for 1919 and 1920, the Commissioner used $70,000 to represent the stock of the Marx Co.

">*480 5. In 1916 the total cost of leaf tobacco to the Cuban Co. was $69,842 less than the total amount of the market value of this tobacco placed upon it by the manager of the leaf department.

The company reported this difference as income for 1916. Thereafter, during the years here involved, it was carried as an asset of the company, subject only to a reduction of $7,090.18 in 1917, leaving a balance of $62,751.82. The balance was carried in "Leaf adjustment account." The respondent eliminated the amount of this balance from surplus in his computation of the consolidated invested capital of the petitioner and its subsidiaries for 1918, 1919, and 1920. In explanation of his action he stated:

The leaf adjustment account is merely a valuation reserve and not a surplus reserve. It should be offset against the inventory account as the inventory account contains appreciation over cost to the extent of this leaf adjustment account.

6. The Cuban Co. owned in fee a large">*1875 acreage of tobacco land in Cuba. It was engaged in cultivating these farms and raising and buying tobacco. On its tobacco plantations the Cuban Co. erected barns, sheds, shacks for laborers, and posts and poles for fences and shade. During the time that the land was cultivated these structures were kept in good condition by frequent inspection and repair. The expense of the repairs was charged to the cost of the crop in each year. Cuban tobacco farms some times become nonproductive after years of cultivation, due to the fact that the top soil either washes away or becomes sour. The policy of the Cuban Co. was to discontinue the use of such farms when convinced that they were no longer profitable because of the excessive expense of fertilizing such worn out land. The structures on such farms were useless after the farms were no longer cultivated. The Cuban Co. had found from experience that it was unprofitable to attempt to tear them down or remove them. They had no salvage value. In 1920 the Cuban Co. permanently discontinued cultivation of farms on which there were certain structures. The cost of these structures, less depreciation at the rate of 3 per cent per annum up">*1876 to the time of abandonment, was $54,199.76. Some of the structures had been acquired before March 1, 1913, but the value of such structures on March 1, 1913, was no less than their cost less depreciation at 3 per cent to March 1, 1913. The following table shows the type of structure, the date acquired, ">*481 the depreciation charged off to December 31, 1920, and the amount of the deduction claimed:

Structures	Date	Cost	Depreciation	Loss due to
	erected		to	abandon-
			Dec. 31, 1920	ment
Packing house	1905	$32,060.69	$13,542.41	$18,518.28
Dwellings	1904	1,290.89
Fences	1904	2,754.96
Dwellings	1905	2,572.75
Tobacco barn	1905	250.00
Fences	1905	4,134.37
Reo Seco shed	1905	113.64
Dwellings	1906	727.27	8,098.58	14,043.69
Tobacco barns	1907	3,818.17
Dwellings	1907	1,181.82
Fences	1908	740.75
Dwellings	1909	1,981.91
Tobacco barns	1910	712.11
Wooden bridge	1910	454.55
Dwellings	1912	1,409.08
Do	1913	1,336.81	280.73	1,056.08
Do	1914	2,229.29	401.27	1,828.02
Tobacco barns	1915	17,583.56	2,637.53	14,946.03
Dwellings	1915	2,987.86	448.18	2,539.68
Do	1917	1,393.38	125.40	1,267.98
Total		79,733.86	25,534.10	54,199.76

">*1877

Mar. 1, 1913, value of structures acquired prior to that date	$42,723.89
Cost of structures acquired since Mar. 1, 1913	25,530.90
	68,254.79
Depreciation to Dec. 31, 1920	14,055.03
Loss claimed Dec. 31, 1920, account of abandonment	54,199.76

In 1920 the Cuban Co. charged off the cost of these structures and in the consolidated return for that year a deduction in the amount of $56,717.45 was claimed on account of the obsolescence of these structures. The respondent has disallowed the claimed deduction.

7. For a number of years prior to 1916 Richard M. C. Glenn and Anthony Schneider had been employed by Seidenberg & Co., a New Jersey corporation, engaged in the manufacture and sale of cigars as a subsidiary of the petitioner. Glenn was in charge of the sales department and Schneider was in charge of the manufacturing. Both men were capable executives and valuable to Seidenberg & Co. These men contemplated entering business for themselves in 1916, and in order to retain their services, the president of Seidenberg & Co. conducted negotiations with them, which culminated in two contracts under date of March 1, 1916, wherein Glenn and Schneider agreed to">*1878 remain in the company's employ for a period of five years. Each contract provided inter alia:

* * * In lieu of additional salary to him [Glenn or Schneider] for said five years' service and the service hoped for and expected by party of the first part after the termination of said five years, party of the first part hereby conditionally assigns to party of the second part [Glenn or Schneider] an equitable ownership in fifteen hundred (1500) shares of the common stock of American Cigar Company out of three thousand (3000) shares of said ">*482 stock this day equitably acquired by party of the first part. The conditions affecting this equitable assignment are as follows: Party of the second part shall be entitled to receive and enjoy all dividends declared and paid from the date hereof on all of said fifteen hundred (1500) shares, and immediately upon the receipt of dividends by the record holder of the said stock party of the first part will cause the same to be transmitted to party of the second part; on March 1, 1917, [also 1918, 1919, 1920 and 1921] party of the first part will transfer or cause to be transferred to party of the second part * * * three hundred">*1879 (300) shares, and deliver the certificate therefor * * *. The obligation on party of the first part to pay or cause to be paid to party of the second part all dividends paid on the undelivered portion of the One Hundred Fifty Thousand Dollars ($150,000.) of stock hereby conditionally assigned, shall extend not only to ordinary dividends, but to any distribution, whether of money, property, stock or rights that the common stockholders of American Cigar Company become entitled to, and shall apply to all stock undelivered at the time such right accrues. * * *

On March 1, 1916, Seidenberg & Co. purchased from the American Tobacco Co. 3,000 shares of the common stock of the American Cigar Co. at par, in order to carry out the above mentioned contracts with Glenn and Schneider. In this connection the president of Seidenberg & Co. wrote a letter to the American Tobacco Co. on March 1, 1916, which was as follows:

We are this day buying from you three thousand (3,000) shares of the common stock of American Cigar Company at par, with interest from February 1, 1916, the date of the payment of the last dividend. As you are aware through conferences between Mr. Sylvester and Mr. Hill, this">*1880 purchase is in order to make deliveries in accordance with contracts dated March 1, 1916, between ourselves and Messrs. R. M. C. Glenn and Anthony Schneider, and our notes are so given that they become payable in principal as stock is to be delivered by us to Messrs. Glenn and Schneider.

This letter is written not only to express our appreciation of your making the sale, but also to say to you that if for any reason we do not make deliveries as contemplated by these contracts, then we are to return all of the stock that is undelivered, upon the cancellation pro tanto of our notes. In other words, you are selling us the stock for the purpose of aiding us to enter into and carry out the contracts, and you do not desire us to have the stock, nor do we desire to take it from you on any other basis or for any other reason.

The treasurer of the American Tobacco Co. wrote a letter on April 3, 1916, to Seidenberg & Co., as follows:

You have to-day handed me your five notes, each for $60,000.00 and dated March 1, 1916, each note bearing interest from February 1, 1916, at the rate of six per cent. (6%) per annum, interest payable semi-annually on August 1 and February 1; first note">*1881 being due one year after date; and second, two years after date; the third, three years after date; the fourth, four years after date, and the fifth, five years after date; each note having attached a certificate for six hundred (600) shares of the common stock of the American Cigar Company as collateral; the notes being given to this Company for three thousand (3,000) shares of American Cigar Company common stock purchased by your company, as stated in your letter of March 1, 1916, the receipt of which is also hereby acknowledged.

">*483 From and after March 1, 1916, until the dates upon which stock certificates were actually delivered to Glenn and Schneider under this contract, these men each received from time to time the equivalent of all dividends declared upon 1,500 shares of the stock of the American Cigar Co. When it received the notes of Seidenberg & Co., the American Tobacco Co. attached them to the stock certificates and retained possession of both. As each note became due and was paid, it released a corresponding portion of the stock for delivery to Glenn and Schneider. The interest on the notes was paid. In 1917 Seidenberg & Co. was dissolved, and the petitioner, ">*1882 on August 31, 1917, acquired all of the assets and assumed the liabilities of that company, including its obligations on the contracts with Glenn and Schneider. These men continued in the petitioner's service.

On or about the first day of March in each of the years 1918, 1919, and 1920 the petitioner paid $60,000 to the American Tobacco Co. on one of the notes above mentioned and received certificates for 600 shares of its stock, which it immediately delivered to Glenn and Schneider.

The American Tobacco Co. held certificates for stock in the American Cigar Co. which had been purchased as above set forth in the following amounts on the following dates:

	Shares
January 1, 1918	2,400
January 1, 1919	1,800
January 1, 1920	1,200

The Commissioner excluded the following amounts in the computation of the petitioner's invested capital for the years 1918, 1919, and 1920 as of the beginning of each year on account of this stock:

1918	$240,000
1919	180,000
1920	120,000

He then included in the petitioner's invested capital for the years 1918 and 1919 on account of the alleged issuance of part of this stock to Glenn and Schneider during each">*1883 year, the amounts set forth below:

1918	$45,369.86
1919	43,857.53

8. In 1916 the petitioner, for the purpose of establishing a distributing agency for its cigars in the State of Texas, entered into the following agreement with Elmer C. Beach:

AMERICAN CIGAR COMPANY,

New York, N.Y.

GENTLEMEN: I am anxious to engage in the business of jobbing or selling at wholesale cigars (with a possibility of a small cigarette and tobacco business) ">*484 in Dallas, Texas. I have no financial means which I desire to embark in the enterprise, and my conferences with you have revealed to me the fact that you desire for yourself and your subsidiary companies distributing facilities in Dallas, Texas, and the territory that would naturally, and as has been agreed upon, be served by a well organized Dallas cigar jobber. These conferences have led to an agreement which I hereby state:

I will proceed immediately to the formation of a corporation under the laws of the State of Texas, with an authorized capital of One Hundred Thousand Dollars ($100,000) at par, all stock of one class; the corporation is to be organized by some Texas counsel employed by me, but the papers">*1884 shall be subject to the inspection and criticism of your counsel. As soon as the corporation is organized, it shall issue to me for cash at par Fifty Thousand Dollars ($50,000) of the stock, and thereafter shall issue to me or such of my associates as I nominate, for cash at par, if and as the needs of the business require, the other Fifty Thousand Dollars ($50,000) of stock authorized at the time of the incorporation of the company but not immediately issued. Although this stock shall be issued to me and/or my nominated associates as aforesaid, the money to pay for such stock shall be furnished by you upon non-negotiable notes given by me and/or my nomiated associates, covering the amount of cash advanced, due one day after date, and bearing interest at the rate of six per centum (6%) per annum from the time you advance the money, interest payable semi-annually. However these notes may be drawn, it is understood that they shall not constitute personal obligations of the makers thereof, except to the extent of the interest of such makers in the stock of the company to be organized, and the stock as it is from time to time issued shall be deposited with you as collateral and the">*1885 sole collateral security to the said notes. The business of cigar jobbing or wholesaling shall be carried on to the best ability of myself and my associates under my management, and my salary, payable monthly, as a part of the expense of the business, shall be at the rate of Six Thousand Dollars ($6,000) per year; the profits of the business shall be, in a properly legal way, devoted primarily to the payment of the interest as it accrues on the said note or notes, and if and when in your judgment the interests of the business justifies, all excess profits shall be used, in a proper legal way, to the reduction of the principal of the said indebtedness to you. When such indebtedness is so wiped out, principal and interest, then the stock shall belong to me and/or my nominated associates, and the certificates representing such shall be delivered. Pending your investment of any amount, the business may be wound up by you upon my death, or upon my failure within thirty (30) days after your written demand to relieve you of the entire investment, principal and interest, and to that end I and my nominated business associates will facilitate you in every way; you having the right to transfer">*1886 into your own name or the name of your nominees all the stock so held by you, and the right to demand the resignation or co-operation of any of the then directors or officers.

Pending any investment by you as aforesaid, that is, until all principal and interest is paid, in consideration of your making the sole cash investment and releasing all claims on said notes against my general estate or the general estate of my nominated associates, it is understood that the said jobbing house while managed by me shall be conducted along the lines of your advice, with books and accounts to be kept as you direct and subject to inspection by your auditors, for the purpose of distributing the cigars in the territory of aforesaid manufactured by you or your subsidiary companies; I believe that with the whole line of all types and superior quality made by you and your subsidiaries, ">*485 a success can be made of the said house as a prosperous jobber of cigars, but at any rate, I know that during the continuance of the arrangement I will receive the Six Thousand Dollars ($6,000.) a year, which I deem reasonable compensation for my time and efforts. It is understood, however, that the jobbing">*1887 business so to be conducted is to have from you and your subsidiary manufacturing companies ordinary prices and terms such as obtain among jobbers generally, and said jobbing house shall sell cigars only of your production or the production of a subsidiary company. At any time the covenants set out in this paragraph may be terminated by me and/or my nominated associates by our relieving you of the entire investment, principal and interest, hereinbefore provided to be made by you.

If the foregoing correctly states the arrangement between us, please so denote below in duplicate, and no more formal paper will be needed to evidence the agreement; notes hereafter executed shall be deemed conditioned on this arrangement.

Very truly yours,

(Signed) ELMER E. BEACH.

The foregoing correctly states the agreement between us.

AMERICAN CIGAR COMPANY.

(Signed) By A. L. SYLVESTER, President.

In accordance with the terms of this contract, the petitioner advanced a total of $100,000 and accepted the notes of Beach and his associates as shown below:

July 1, 1916 (E. E. Beach)	$40,000
Oct. 26, 1916 (E. E. Beach)	10,000
Dec. 6, 1916 (E. E. Beach)	10,000
Jan. 17, 1917 (E. E. Beach)	10,000
Feb. 10, 1917 (E. E. Beach)	10,000
March 1, 1917 (E. E. Beach)	10,000
July 1, 1916 (Frank W. Beach)	5,000
July 1, 1916 (H. R. Grant)	5,000

">*1888 These notes were secured by a pledge of the stock of the Beach Cigar Co. of the par value of $100,000 which had been issued to Beach and his associates. The business of the Beach Cigar Co. was conducted at a loss during each year of its existence.

On December 28, 1918, the petitioner, in accordance with the contract, demanded to be relieved of its investment, whereupon Beach and his associates agreed that the stock should be transferred to the petitioner and that their interests and liabilities should cease. The stock was thereafter transferred to nominees of the petitioner. The petitioner then took an inventory of the property of the Beach Cigar Co. and ordered that $20,513.74 be charged off the petitioner's books as a loss on its advances to the Beach Cigar Co.

The following balance sheet reflects the condition of the Beach Cigar Co. on December 31, 1918, as shown by its books:

ASSETS
Cash (deficit)		$4,844.11
Bills receivable	$1,074.24
Accounts receivable	58,380.30
United States bonds	2,500.00
	61,954.54
Less funds	460.67
		61,493.87
Furniture and fixtures	2,880.71
Automobile	565.55
	3,446.26
Less funds	928.00
		2,518.26
Manufactured stock	61,749.49
Supplies	542.59
		62,292.08
Deferred expense account:
Unexpired insurance		432.32
Total		121,852.42
LIABILITIES
Capital stock		100,000.00
Accounts payable		39,535.27
Deferred credits		2,830.89
Surplus (deficit)		20,513.74
		121,852.42

">*1889 ">*486 The assets are shown at cost in the above balance sheet, except that the amounts shown opposite furniture and fixtures and automobiles represent the cost less depreciation. The manufactured stock was of recent manufacture and merchantable.

The following entry was made on the petitioner's journal under date of December 31, 1918:

LOSS ON LOANS
To Prov. for loss on loans		$20,513.74
For Loss on Loans to E. E. Beach, F. W. Beach and
H. R. Grant, aggregating	$100,000.00
it having been agreed to accept the collaterals
One Thousand (1000) shares of stock in Beach
Cigar Co., in settlement. The value of said stock
Dec. 31, 1918, being worth only book value	79,486.26
		20,513.74

The following entry was made on the petitioner's journal under date of January, 1919:

SUNDRIES
To Bills Receivable		$100,000.00
For 1000 Shares of Beach Cigar Co., accepted in
settlement of notes of -
E. E. Beach	$90,000.00
F. W. Beach	5,000.00
H. R. Grant	5,000.00
	100,000.00

Said stock having a book value of 79,486.26. The name of said Beach Cigar Co., was subsequently changed to Central Cigar Company.

Stock in Central Cigar Co., For
1000 shs. at 79.48626 per sh		79,486.26
Provision for Loss on Loans:
For loss arising out of above mentioned Loans	100,000.00
For value stock received in settlement	79,486.26
		20,513.74

">*1890 ">*487 The fair market value of the 1,000 shares of Beach Cigar Co. stock on December 31, 1918, was not more than $79,486.26.

On January 9, 1919, the name of the Beach Cigar Co. was changed to the Central Cigar Co. and the stock formerly held by Beach and his nominees was canceled and new stock certificates issued to the nominees of the petitioner.

The respondent has disallowed the deduction of $20,513.74 as a loss from this transaction.

9. In 1919 the petitioner received $12,622.43 as dividends on shares of stock it owned in the Bock Co., a British corporation engaged in the business of manufacturing and selling cigars and other tobacco products. During 1919 that company realized income from sources within the United States in excess of the deductions allowed it under the Revenue Act of 1918 and was taxed thereon.

The respondent has not allowed the amount of the dividends it received from the Bock Co. as a deduction from the petitioner's gross income for 1919.

10. Prior to December 2, 1918, the respondent assessed additional corporation excise taxes against the petitioner for the years and in the amounts as follows:

1909	$7,615.74
1910	1,713.82
1911	583.39
1912	965.37
	10,878.32

">*1891 Prior to December 2, 1918, the respondent assessed additional income taxes against the petitioner for the years and in the amounts as follows:

1914	$74.76
1915	139.72
1916	182.09

">*488 On or about December 2, 1918, the petitioner received a notice of and demand for such taxes, and on or about December 12, 1918, it paid the taxes.

The respondent has not allowed any deduction from gross income for the year 1918 for any of such taxes, but has deducted $11,374.90 on account thereof in the computation of the petitioner's invested capital for that year.

11. The respondent has deducted in the computation of the petitioner's invested capital for 1918, 1919, and 1920 the amounts of Federal income and profits taxes alleged to have been due for the years 1917, 1918, and 1919, respectively, as follows:

1918	$100,961.21
1919	327,093.83
1920	148,019.15

12. During the years 1918 to 1921, inclusive, the petitioner allowed its customers a cash discount of 2 per cent on their purchases under certain circumstances not disclosed by the record. It maintained on its books of account a reserve for these discounts and set up monthly in this account">*1892 2 per cent of its gross sales. At the end of each year, the reserve was adjusted to reduce it to the equivalent of 2 per cent of customer's accounts outstanding at that time and the difference was taken into profits through the income account. The net amounts credited to the reserve and the amounts of cash discounts actually allowed are as follows:

Year	Credited to	Discounts
	reserve	allowed
1918	$451,078.71	$456,174.97
1919	456,126.00	447,537.70
1920	604,599.03	611,410.55
1921	499,401.04	509,086.00

The respondent has allowed as a deduction from gross income in each of these years, the amount of the annual addition to the reserve.

OPINION.

MURDOCK: 1. Early in the year 1902 the petitioner purchased all of the stock of the Cabanas Co. for $1,500,000. It exchanged this stock about five months later for $1,800 in cash, $3,500,000 par value of the bonds, and $19,998,200 par value of the common stock of the Havana Tobacco Co. It computes a profit on this latter transaction as follows:

Received -
$3,500,000 par value of bonds worth 90	$3,150,000
$19,998,200 par value of stock worth 50	9,999,100
Cash	1,800
Total	13,150,900
Gave for the above -
Cabanas stock purchased at par	1,500,000
Profit	11,650,900

">*1893 ">*489 It claims that this profit, reduced by subsequent sales of the stock to $11,015,992.60, was a part of its earned surplus during the years 1918 to 1920, inclusive.

The respondent contends that the petitioner realized no profit from this transaction because the stock and bonds received were worth no more than $1,500,000, the cost of the Cabanas stock. He computed invested capital without including any part of this alleged profit in the petitioner's earned surplus. However, there is evidence before us that the fair market value of the securities received by the petitioner exceeded $1,500,000 and this evidence overcomes the presumption of correctness which attaches to the Commissioner's determination. Cf. Christensen Machine Co.,18 B.T.A. 256">18 B.T.A. 256; Citrus Soap Co. of California v. Lucas, 42 Fed.(2d) 372. Thus, the fact that the petitioner realized a profit has been established, and our question is to determine the amount of such profit which remained as earned surplus during the years 1918 to 1920, inclusive.

The petitioner points to the fine prospects of the new company, to the array of successful men back of it, and to the sales">*1894 of the Havana Tobacco Co. common stock at $50, and up, about the time of the exchange to prove that its fair market value was at least $50 a share. It also argues that this value is shown by the fact that Havana Commercial common, 2 1/2 shares of which were exchangeable under the plan of consolidation for one share of Havana Tobacco Co. common, was selling at $20 on the day of the exchange. Similarly, 100 shares of Havana Commercial preferred, for which $61 was bid and $63 asked, were exchangeable for 60 shares of preferred and 40 shares of common of Havana Tobacco Co. stock, therefore, Havana Tobacco Co. common was worth $50, allowing $70 as the value of its preferred.

There were no sales of the bonds of the Havana Tobacco Co. at or about the time of the exchange. No "bid and asked" prices for these bonds are available. The petitioner called an expert witness to prove that their fair market value was about 90. This was a proper method of proof, as we had no special knowledge of the probable value of these bonds. Heiner v. Crosby, 24 Fed.(2d) 191; ">*1895 Boggs & Buhl, Inc. v. Commissioner, 34 Fed.(2d) 859. This man ">*490 told why he thought these bonds would have sold readily at 90. He was well qualified to express an opinion, his reasoning is persuasive, his testimony was not weakened upon cross-examination, and not only was there no proof of a contradictory nature, but his opinion is supported by other evidence that the bonds were valuable. Therefore his opinion is entitled to weight. Boggs & Buhl, Inc. v. Commissioner, supra.

There were no sales of large blocks of Havana Tobacco Co. common at or reasonably near the date of the exchange, but such sales as there were indicate that the value of this stock was between $41 and $60 a share. There were no peculiar circumstances connected with these sales so far as we know.

We have tried to determine the petitioner's earned surplus as accurately as possible from a careful study of all of the evidence presented. Where necessary, we have borne down heavily upon the petitioner whose duty it was to prove a larger profit, if larger profit there was. ">*1896 George M. Cohan v. Commissioner, 39 Fed.(2d) 540. Our conclusion is that, of the original profit, $9,907,092.60 remained as earned surplus in the years 1918 to 1920, inclusive. Cf. Conley Tin Foil Corporation,17 B.T.A. 65">17 B.T.A. 65; Ralph Andrew Applegate, Executor,10 B.T.A. 705">10 B.T.A. 705; Walter A. Edwards,10 B.T.A. 39">10 B.T.A. 39; Marshall Field, Glore, Ward & Co.,16 B.T.A. 1299">16 B.T.A. 1299; Wilber National Bank of Oneonta, N.Y., Executor,17 B.T.A. 654">17 B.T.A. 654; Simplex Engineering Co.,17 B.T.A. 504">17 B.T.A. 504. This amount should be included in the petitioner's earned surplus in computing its invested capital for these years.

2. The petitioner alleges that the respondent erred in including in its gross income the amount of bond interest owed it by the Havana Tobacco Co., which company was insolvent and unable to pay this interest. As an alternative, it alleges that the Commissioner erred in not allowing the amounts of these interest payments due in each of the years to be deducted in the respective years as debts ascertained to be worthless and charged off. These allegations, in view of the facts, require a somewhat">*1897 complicated discussion.

We do not know of any decided case which is directly in point. The case has some points in common with the case of Great Northern Railway Co.,8 B.T.A. 225">8 B.T.A. 225, but in several important details the two cases are different. One difference, although not the only one, is that in the present case the petitioner actually received the interest. It is true that it loaned the money to the Havana Co. with which the latter paid the interest. But the petitioner, by this method of its own choosing, materially changed its relations with the Havana Co. It surrendered the coupons on the bonds and received the interest therefor, and at the same time it became a creditor of the Havana Co. in ">*491 the amount of its advances, which advances were secured by interest bearing notes. As has frequently been said, tax liability must be determined by what was done as opposed to what might have been done, and it makes no difference that the petitioner might have advanced only the money to pay the interest on bonds held by others and left its coupons uncut. Cf. ">*1898 Nixon v. Lucas, 42 Fed.(2d) 833. If it had done that, this case would be one step nearer the Great Northern Railway Co. case, supra.

The petitioner kept its books and reported its income on an accrual basis. Apparently, it accrued the interest on these bonds on its books, but it did so in a special way by means of an "interest suspense account." The financial situation of the Havana Tobacco Co. was very bad. Nevertheless, the petitioner received its interest. Furthermore, it had a valid claim to the amount of the interest and the interest was a proper accrual as it became due. The president of the Havana Tobacco Co. testified that the men back of the American Tobacco Co. were very proud of the fact that they had never brought out a failure; they were loath to allow the Havana Tobacco Co. to get into the hands of a receiver; and they wanted him to make every possible effort to bring the company out of its difficulties. He further testified that he did not have any hope of being successful, but he thought if he could keep it going as a live proposition, then, if it ever had to be reorganized, "it was going to be far better as a capital investment than">*1899 throwing it overboard, which subsequently turned out to be the case." In view of this testimony and other circumstances of the case, including the fact that, when the Havana Tobacco Co. was finally reorganized, the petitioner received securities on the basis of all of the unpaid principal and interest which the Havana Co. owed it, we can not say that the Commissioner erred in including the amount of interest due in the petitioner's gross income for the various years, except as explained hereafter. We need not decide whether the petitioner would have been in a better position had it claimed that the amount of its advances to the Havana Tobacco Co. had become worthless and should be deducted as bad debts, for it did not so allege, and the proof here does not cover such a point.

The petitioner is in no better position as to its alternative allegation that the amounts which it received as interest should be deducted as debts ascertained to be worthless and charged off. As we have said, the amounts were actually paid and they no longer represented a debt. Having been paid, they could not be ascertained to be worthless. Therefore, it is not necessary to consider whether the circumstances">*1900 of the "interest suspense account" constitute a sufficient charge off.

The Commissioner has also included in the petitioner's income for 1921 the interest, amounting to $118,450, due on the bonds on or ">*492 about December 1, 1921. The Havana Tobacco Co. defaulted as to this interest and the petitioner never received it. In view of the financial condition of the Havana Tobacco Co. at the time this interest became due, which condition was known to the petitioner and remained unchanged at the end of the year, the amount of this interest should not have been included in the petitioner's income for that year. The Commissioner required the petitioner to report the interest on its advances evidenced by notes, but allowed a bad debt deduction to exactly offset the amount of this interest which was never received. In explanation he stated in his deficiency notice:

This office holds that as there appears to be no reasonable expectation of the American Cigar Company receiving the interest on the notes of the Havana Tobacco Company, due to the latter company's financial condition, the interest on the advances should be allowed as a bad debt in the same year in which reported as">*1901 income. The amount allowed as a bad debt has been added to your taxable income under Item (a) above.

Where, as here, at the time the interest became due there was no reasonable expectation of receiving it, to exclude the amount from income seems more proper than to include it and then allow it as a bad debt. 8 B.T.A. 225">Great Northern Railway Co., supra;Sowers Manufacturing Co.,16 B.T.A. 268">16 B.T.A. 268; Thorne, Neal & Co.,13 B.T.A. 490">13 B.T.A. 490; Northwestern Improvement Co.,14 B.T.A. 79">14 B.T.A. 79; Turner Falls Power & Electric Co.,15 B.T.A. 983">15 B.T.A. 983; La Salle Cement Co.,15 B.T.A. 1127">15 B.T.A. 1127; Wankinco Bog Co.,16 B.T.A. 386">16 B.T.A. 386; Corn Exchange Bank v. United States, 37 Fed.(2d) 34. However, the net result is the same in either case. The respondent, by amendment to his answer, alleged that he erred in allowing the interest on the notes of the Havana Tobacco Co. to be deducted. For the same reasons that we have given above relating to the interest on the bonds due December 1, 1921, we think that the deficiency should not be increased as now claimed by the respondent.

">*1902 As another alternative, the petitioner contends that if the interest was income to it, the amount of the accrued interest receivable on the bonds as of December 31, 1917, should be included in its surplus during the years 1918 to 1920, inclusive, for invested capital purposes. This contention is well taken. Cf. Schmoller & Mueller Piano Co.,1 B.T.A. 498">1 B.T.A. 498; National Grocer Co.,1 B.T.A. 688">1 B.T.A. 688; Pacific Coast Redwood Co.,5 B.T.A. 423">5 B.T.A. 423; Gould Coupler Co.,5 B.T.A. 499">5 B.T.A. 499; Willcuts v. Milton Dairy Co.,275 U.S. 215">275 U.S. 215; La Belle Iron Works v. United States,256 U.S. 377">256 U.S. 377.

3. The interest due on the advances to the Murias Co. is in the same category as that interest on the Havana Co. bonds due December 1, 1921, which was never paid. This interest was not taxable income to the petitioner, because at the time it became due there was no reasonable expectation of receiving it. The petitioner fully ">*493 realized this fact, but made the advances regardless of it, for sufficient reasons. ">*1903 8 B.T.A. 225">Great Northern Railway Co., supra;16 B.T.A. 268">Sowers Manufacturing Co., supra;Corn Exchange Bank v. United States, supra, and other cases already cited. We need not consider the petitioner's alternative contentions on this point, as our decision is for the petitioner on the main contention.

4. The petitioner contends that during 1918 it or its subsidiary owned one-half of 95 shares of the capital stock of Luis Marx Tobacco Co., which cost it $210,000, and that this amount, instead of $50,000, should be used in the computation of invested capital for each year. The respondent now claims that he erred in the use of $50,000 in this computation. In 1906 the petitioner and Marx entered into a contract under which the petitioner or its subsidiary was to buy, at market prices, the tobacco raised on Marx's land. An amount representing what would otherwise be the net profit to Marx from the sale of his tobacco was placed in a trust fund. At certain times the petitioner could buy the land from Marx at $400,000 and secure also the amount then in the trust fund. Otherwise, Marx eventually was to receive the trust fund representing his net profits. ">*1904 In 1909, when the contract had yet several years to run, and when the trust fund amounted to about $210,000, the old contract was conceled and a new one was entered into. As a result, a new corporation was organized and Marx transferred his land to it, received the trust fund, retained one-half of the stock of the new corporation, and secured a contract of employment. The petitioner or its subsidiary gave up its rights under the old contract and received one-half of the stock of the new corporation. Its rights under the old contract had cost it nothing, since it had merely paid the market price for its tobacco, but might have been valuable at the time they were given up. When it received the stock, the peitioner realized a profit equal to the fair market value of the stock received. This stock was an asset which could, and properly should, have been entered on the subsidiary's books at its fair market value, and an increase in surplus in this amount would have resulted. This surplus, subject to the limitations on inadmissibles, should be used in computing invested capital for 1918. The stock was entered on the books of the subsidiary at $50,000, and the respondent used this">*1905 amount in computing invested capital for 1918.

The petitioner argues that in 1909, under the first contract, it could have acquired land worth $400,000 and other property for $190,000 (since it would get the trust fund upon purchasing the property for $400,000) and therefore, as it got only one-half of the stock, this stock cost it $210,000. Even if this were correct, the petitioner's claim for increased invested capital would not be ">*494 established thereby. In this connection it may not be improper to point out that the same alleged facts support the argument that, since the only assets of the new corporation were the plantations, one-half the stock would be worth no more than one-half the value of the plantations; in 1909 the petitioner could have had the plantations for $190,000 net, but it did not care to give this amount; therefore, the value of this property was not as great as $190,000, and one-half of the value of the land, which would be some indication of the value of one-half the stock, was not as great as $95,000, perhaps no more than $50,000, the amount at which the stock was entered on the books of the subsidiary.

The value of the property conveyed to">*1906 the Marx Tobacco Co. is not established by the evidence. In fact, no effort was made to prove this value. But what is most important, the evidence does not establish that the fair market value of this stock in 1909 was other than $50,000. As to this issue we leave the parties as we found them.

5. The evidence in regard to the balance of $62,751.82 in the "Leaf Adjustment Account" of the Cuban Co. is not at all clear. Any deficiency or uncertainty in this evidence is to the petitioner's disadvantage, because the Commissioner's determination is presumed to be correct. He denied that the balance represented surplus, claiming that it was in effect an appreciation in inventory over cost.

Apparently, the Cuban Co. either purchased or raised some tobacco in 1916 at a certain cost. Its leaf manager put a price on it of its market value, which was higher than cost. What became of the tobacco we do not know. If the Cuban Co. kept it and at the end of the year inventoried it at more than cost, the difference between the inventory figure and cost would not represent earnings of the company. ">*1907 F. N. Johnson Co.,2 B.T.A. 256">2 B.T.A. 256; David Rodefer Oil Co.,11 B.T.A. 782">11 B.T.A. 782; Wickens Co.,16 B.T.A. 968">16 B.T.A. 968; United States v. Kemp, 12 Fed.(2d) 7; 25 Fed.(2d) 721; certiorari denied, 273 U.S. 703">273 U.S. 703. See also Lucas v. Kansas City Structural Steel Co.,281 U.S. 264">281 U.S. 264. The record does not show that the tobacco was ever disposed of at the price placed upon it by the leaf manager. We think the evidence tends to confirm the Commissioner, at least it does not prove him wrong.

6. The petitioner claims the right to duduct $54,199.76 for 1920 as a reasonable amount for the obsolescence of some buildings used in its trade or business. The respondent, in his brief, claims that there has been no showing that these structures had been abandoned and no proof of their fair market value on March 1, 1913. In our opinion the petitioner is entitled to deduct the amount as a loss ">*495 rather than as a reasonable amount for obsolescence. The testimony proves conclusively that these structures lost all value when the petitioner ceased to use the land on which they were situated, and there">*1908 was no way by sale, removal or otherwise that any benefit could be derived from them. There was testimony that the land would not regain its fertility for many years, if ever. In the meanwhile, the cheap structures here in question would be in ruins. This is not a case where the structures have merely lost useful value or are no longer useful to the petitioner, but is a case where they have become utterly worthless even though the petitioner continued to own the land. Cf. Marigold Garden Co.,6 B.T.A. 368">6 B.T.A. 368; Kilby Car & Foundry Co.,4 B.T.A. 1294">4 B.T.A. 1294; Multibestos Co.,6 B.T.A. 1060">6 B.T.A. 1060; Winter Garden Co.,10 B.T.A. 71">10 B.T.A. 71. The one-time president of the American Cigar Co., who had had many years of experience in the tobacco business in Cuba, had frequently inspected these properties, and had ordered that the cultivation of the farms be discontinued, testified that the value of the structures on March 1, 1913, was the same as the amount at which they were then carried on the books of the Cuban Co. We think they were worth at least the amount stated.

7. Invested capital is a statutory concept. ">*1909 Any question of invested capital must be studied with section 326 well in mind. 275 U.S. 215">Willcuts v. Milton Dairy Co., supra.If a taxpayer corporation purchases its own stock originally issued for cash at par, by giving its note therefor, a reduction in its invested capital in the amount of the note results. Cf. Fairmont & Cleveland Coal Co.,12 B.T.A. 1296">12 B.T.A. 1296; Clearfield Lumber Co.,3 B.T.A. 1282">3 B.T.A. 1282; National Tea Co.,17 B.T.A. 1222">17 B.T.A. 1222. As to such stock, there is no longer a stockholder, and consequently no one having anything risked in the business. The money formerly risked is no longer risked because the relation of the stockholder to the corporation has been terminated by the corporation returning some of its property in exchange for the stock. A note is a liability which is not reflected in invested capital. Where a corporation purchases its own stock by giving its own note therefor the note holder, the former stockholder, is in a new relation to the corporation, that of a creditor, a lender of money to the corporation. Borrowed money is not a part of invested capital. Without any change in assets, the corporation">*1910 has a new liability in the amount of the note, the par value of capital stock outstanding has been reduced by the amount of the par value of the stock purchased, and any difference between the amount of the note and the par value of the stock acquired is adjusted through surplus, if surplus is sufficient for the purpose. Cf. Hutchins Lumber & Storage Co.,4 B.T.A. 705">4 B.T.A. 705. The same reduction in invested capital would result ">*496 if the corporation gave its note without at the same time acquiring its stock or some asset, because in that case surplus would be reduced by the entire amount of the note.

In the present case when the petitioner assumed the liabilities of Seidenberg & Co., it assumed the liability on notes in the amount of $240,000. On January 1, 1918, these notes in this amount were a liability of the petitioner which, in accordance with its method of accounting, it would have to set up on its books as liabilities. Unless it at that time had an asset which would offset this total liability, its invested capital would be reduced as above demonstrated. The case of ">*1911 Cleveland Railway Co. v. Commissioner, 36 Fed.(2d) 347, is distinguishable. The question then is, Did it have any offsetting asset? If it owned the stock outright, such stock would not be an asset. If it did not own the stock, such stock would not be an asset. If there was anything else which would represent an offsetting asset, it has not been called to our attention and its cost or value as an asset has not been demonstrated or established. Thus, we need not trouble ourselves about the question of ownership of the stock, for the petitioner must fail in its contention in any event.

We have found as a fact that on or about the first day of March in each of the years 1918, 1919, and 1920 the petitioner delivered 600 shares of its stock to Glenn and Schneider, and that on account thereof, the Commissioner included in the petitioner's invested capital, for the years 1918 and 1919, $45,369.86 and $43,857.53. We do not know what amount, if any, he included for the year 1920. The petitioner contends as an alternative, that for each of these three years about $50,000 should have been included in its invested capital on account of the delivery of these shares">*1912 of stock, the exact amount to be determined by taking that proportion of $60,000 which the number of days in the year after the day on which the stock was delivered bears to the total number of days in the year. In order to sustain this contention, in view of our holding that the amount originally paid in for this stock is no longer a part of invested capital, it was encumbent upon the petitioner to prove facts which would bring the case within some certain provision of section 326, and enable a proper computation of invested capital to be made under that provision. These facts have not been established and we will not disturb the Commissioner's determination on this point.

8. The petitioner contends that it sustained a deductible loss of $20,513.74 when, at the end of the year 1918, upon the transfer to it of all of the stock of the Beech Cigar Co. of the then fair market value of not more than $79,486.26, it canceled certain promissory notes, on which it had advanced $100,000. It also makes an alternative ">*497 contention, that if the amount was not a loss, it was a debt ascertained to be worthless and charged off within the year. In the decision of this case it is">*1913 not necessary to determine whether or not a debt resulted from this transaction. If it was a debt, the principle laid down in Steele Cotton Mill Co.,1 B.T.A. 299">1 B.T.A. 299, does not apply because here we do not have a situation where a part of a debt was written off as worthless and the other part maintained on the books of the taxpayer as having a value. On the contrary, all the means of collecting the debt of $100,000 were exhausted, the debt was canceled, the petitioner was in the possession of stock worth not more than $79,486.26, and it charged off the balance of the $100,000. This entitles it to a deduction under section 234(a)(5). On the other hand, if the debt provisions of the statute are not applicable, then under the loss provision, since the transaction was closed in the year 1918, the petitioner lost the difference between the amount of the money advanced and the value of the stock which it secured. Cf. Farmers' & Merchants' Bank of Nocona, Tex.,10 B.T.A. 709">10 B.T.A. 709; Turner Falls Power & Electric Co.,15 B.T.A. 983">15 B.T.A. 983.

9. In 1919 the petitioner received dividends amounting to $12,622.43 from the Bock Co., a foreign corporation. ">*1914 It claims a deduction of this amount from its gross income under section 234(a)(6) of the Revenue Act of 1918, which permits the deduction of "amounts received as dividends from a corporation which is taxable under this title upon its net income."

"Net income" is defined in section 232 of the 1918 Act as "the gross income as defined in section 233 less the deductions allowed by section 234." Section 233(b) provides that:

In the case of a foreign corporation gross income includes only the gross income from sources within the United States, including the interest on bonds, notes, or other interest bearing obligations of residents, corporate or otherwise, dividends from resident corporations, and including all amounts received (although paid under a contract for the sale of goods or otherwise) representing profit on the manufacture and disposition of goods within the United States.

The respondent's answer admits that the Bock Co. realized income from sources within the United States, that certain deductions were allowed, and that a tax was paid on the excess of its income over the deductions allowed. By applying the provisions of sections 233, 234, and 232 of the 1918 Act to">*1915 the Bock Co., we find that the Bock Co. was taxed upon its "net income."

The Commissioner, in explaining his action, mentioned section 234(a)(6) of the Revenue Act of 1921 as authority for what he had done. This section is quite different from the same section of the Revenue Act of 1918 which applies here. The amount of the dividends in question should be deducted from the petitioner's gross ">*498 income for the year 1918. To the same effect see T.B.M. 21, C.B. No. 1, p. 160, and O.D. 383, C.B. No. 2, p. 159.

10. The petitioner claims that it should be allowed to deduct from its gross income for 1918 the amount of additional corporation excise taxes for the years 1909 to 1912, inclusive, which it paid in the latter year, and perhaps it claims also the right to deduct additional income taxes for the years 1914 to 1916, inclusive, which it paid in the year 1918. It further contends that its surplus as of the beginning of the year 1918 should not have been reduced on account of these additional taxes.

Section 234(a)(3) of the Revenue Act of 1918 allows the deduction of "Taxes paid or accrued within the taxable year imposed (a) by the authority of the United States, ">*1916 except income, war-profits and excess-profits taxes." Thus, the additional income taxes for the years 1914 to 1916, inclusive, are clearly not deductible. The petitioner kept its books upon an accrual basis, and the question as to the excise taxes depends upon whether or not these taxes accrued within the year 1918.

In United States v. Anderson,269 U.S. 422">269 U.S. 422, at page 441, the Supreme Court of the United States stated:

Only a word need be said with reference to the contention that the tax upon munitions manufactured and sold in 1916 did not accrue until 1917. In a technical legal sense it may be argued that a tax does not accrue until it has been assessed and become due; but it is also true that in advance of the assessment of a tax, all the events occur which fix the amount of the tax and determine the liability of the taxpayer to pay it. It this respect, for the purposes of accounting and of ascertaining true income for a given accounting period, the munitions tax here in question did not stand on any different footing than other accrued expenses appearing on appellee's books. In the economic and bookkeeping sense with which the statute and Treasury decision">*1917 were concerned, the taxes had accrued. It should be noted that Section 13(d) makes no use of the words "accrue" or "accrual" but merely provides for a return upon the basis upon which the taxpayer's accounts are kept, if it reflects income - which is precisely the return insisted upon by the Government. We do not think that the Treasury decision contemplated a return on any other basis when it used the terms "accrued" and "accrual" and provided for the deduction by the taxpayer of items "accrued on their books."

Under this decision the petitioner's contention that the taxes here in controversy could not have accrued prior to the year 1918, since they were not assessed against it until that time, must fail. All of the events which fixed the amount of this tax and determined the liability of the taxpayer to pay occurred prior to the year 1918. The taxes, therefore, accrued prior to the year 1918. The situation is not changed by the fact that the statute of limitations on refunds for prior years will prevent the taxpayer from getting any deduction on account of the these additional taxes. See ">*1918 United States Trust Co. of New York,13 B.T.A. 1074">13 B.T.A. 1074; Ernest M. Bull, Executor,7 B.T.A. 993">7 B.T.A. 993; ">*499 Kossar & Co.,16 B.T.A. 952">16 B.T.A. 952. Cf. Petaluma & Santa Rosa Railroad Co.,11 B.T.A. 541">11 B.T.A. 541.

Since these taxes accrued in prior years, they were liabilities of the company at the beginning of the year 1918. We therefore approve the respondent's action in disallowing the deductions and in reducing invested capital.

11. The petitioner claims that the respondent erred in reducing its invested capital for the years 1918, 1919, and 1920 by the amounts of Federal income and profits taxes alleged to have been due for the years 1917, 1918, and 1919. This point is disposed of by the provisions of section 1207 of the Revenue Act of 1926, which sustains the determination of the respondent. Russel Wheel & Foundry Co.,3 B.T.A. 1168">3 B.T.A. 1168.

12. The last question relates to the proper method of deducting cash discounts. We have not been informed as to the exact circumstances or conditions under which the petitioner allowed the cash discounts in question. The witness once referred, probably inadvertently, to the">*1919 discount as a trade discount, but from the entire record we are satisfied that it is not a trade discount. The two are different and different results may follow. A trade discount is the difference between a seller's list prices for his goods and the amount at which he sells those goods to the trade. A cash discount has a very definite meaning also. It is a deduction from the price at which the goods are billed to the purchaser which the seller allows for settlement of the bill within a certain stated time. When goods are sold subject to a trade discount, the seller knows positively that the customer's remittance will not include the amount of the trade discount. The situation in regard to a cash discount is entirely different, in that at the time of the sale, and until the expiration of the specified period thereafter, or until settlement, the seller does not know the extent, if any, to which the purchaser will take advantage of a cash discount.

Cash discounts may be deducted as ordinary and necessary expenses under section 234(a)(1) of the Revenue Acts of 1918 and 1921. But the question remains as to whether the net addition to a reserve for cash discounts is the proper">*1920 deduction for any taxpayer using an accrual system, or whether the cash discount actually allowed for any year is the proper amount to deduct. Reserves for liabilities which at the end of the year are still contingent are not deductible even under an accrual system, because all of the events necessary to fix the taxpayer's liability and the amount thereof have not happened. 269 U.S. 422">United States v. Anderson, supra.See also William J. Ostheimer,1 B.T.A. 18">1 B.T.A. 18; Uvalde Co.,1 B.T.A. 932">1 B.T.A. 932.

On the authority of its earlier decisions the Board decided in M. I. Stewart & Co.,2 B.T.A. 737">2 B.T.A. 737, that reserves for cash discounts ">*500 are not proper deductions for one on the accrual basis. This was obviously correct for both the fact and the amount of liability are uncertain at the end of the year and, therefore, nothing is accrued. As the result of this last decision, the Commissioner issued G.C.M 1342, published in C.B. VI-1, p. 7, stating that reserves for cash discounts were not deductible, but that cash discounts actually allowed during the year were proper deductions. ">*1921 In Jackson Casket Manufacturing Co.,7 B.T.A. 1190">7 B.T.A. 1190, and in Landesman-Hirschheimer Co.,15 B.T.A. 64">15 B.T.A. 64; affd., 44 Fed.(2d) 521, the Board followed its previous decision and held that cash discounts actually allowed should be deducted rather than the net additions to a reserve for cash discounts. However, in National Straw Works,16 B.T.A. 463">16 B.T.A. 463, the Board allowed a reserve for cash discounts to be deducted. This latter case, in so far as it holds that an addition to a reserve for cash discounts is a proper deduction, is overruled. The case of J. B. Jemison,18 B.T.A. 399">18 B.T.A. 399, is distinguishable on its facts. We hold that the petitioner in the present case is not entitled to deduct the net addition to a reserve for cash discounts for each respective year, but is entitled to deduct the cash discounts actually allowed in each respective year.

Reviewed by the Board.

Judgment will be entered under Rule 50.

TRUSSELL dissents.

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Footnotes

• 1. Sold at 20.8545. ↩