Celluloid Co. v. Commissioner

CELLULOID COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Celluloid Co. v. Commissioner

Docket Nos. 8543, 19459.

United States Board of Tax Appeals

9 B.T.A. 989; 1927 BTA LEXIS 2474;

December 29, 1927, Promulgated

---

1. The claim of petitioner for the deduction of a loss for obsolescence of machinery, equipment and a portion of a building, in 1919, is not sustained. Amount of loss sustained in the year 1920 as a result of the discarding of certain machinery and equipment determined.

2. Where an inventory was originally taken at cost or market, whichever was lower, held that upon the discovery early in the succeeding year that it contained on the inventory date a large quantity of defective material it may be corrected to accord with the actual facts.

3. Where an accounts receivable account reflects the selling price of goods containing latent defects, held that it may not be reduced in the year in which the goods were sold by an amount representing the original selling price of such of the defective goods as were returned in the succeeding year, even though such amount could have been very closely approximated in the year of sale.

R. Kemp Slaughter, Esq., and H. C. Bickford, Esq., for the petitioner.

M. N. Fisher, Esq., for the respondent.

---

SMITH

This proceeding is for the redetermination of income taxes for the calendar years 1918, 1919, and 1920. The petitioner filed two appeals, one covering the years 1918 and 1919 and the other covering the year 1920. On motion made and granted the two appeals were consolidated for trial and decision. The Commissioner asserts that for 1918 there was an overassessment of $1,023.58; that for 1919 there is a deficiency of $65,749.54; and that for 1920 there is a deficiency of $23,512.41. The petitioner alleges that the Commissioner erred in that he failed (1) to allow as a deduction from gross income for each of the years 1919 and 1920 an amount sufficient to cover losses due to obsolescence and loss of useful value of structure and machinery; (2) to adjust the value of the closing inventory for the year 1920 on account of defective goods contained therein; and (3) to adjust the accounts receivable account as at December 31, 1920, on account of billings to customers contained therein covering defective goods which were returned after the close of the taxable year.

FINDINGS OF FACT.

Petitioner is a New Jersey corporation with its principal office in New York City. Its manufacturing plant, covering about 28 acres of land, is located in Newark, N.J., where it manufactures celluloid in the form of rods, sheets, and tubes, finished articles manufactured therefrom, and the base for photographic film. The enterprise is divided into departments, among which are the Roll Celluloid Department, Converting Department, Acid Department, and Specialty Department.

The date of acquisition, cost, percentage of depreciation reserve from date of the erection to January 1, 1919, amount of depreciation from date of acquisition to January 1, 1919, and net book value on January 1, 1919, of a portion of a building and certain machinery which were abandoned by petitioner are shown in what is hereinafter referred to as Table No. 1, as follows:

TABLE No. 1. - Building No. 42
ROLL CELLULOID DEPARTMENT
Description		Date of
		acquisition
STRUCTURE
1. 1 brick and concrete building 25
feet wide, 75 feet long, 3 stories
high. Interior construction,
cellular type of concrete and tile
partitions arranged to allow a
separate room on each floor for
each wheel and auxiliary equip-
ment.
NOTE. - This structure constituted
a portion of the new addition to
film building No. 42 and erected
in the year 1909. The entire
building, addition and alterations
to the old building of which it
became a part, cost	$37,893.22
Deduct alterations and changes to
old building included in above total
cost	1,775.66
Net cost	36,117.56
Deduct portion of addition continued
in use and not affected on account
of building become obsolete, nine-
sixteenths cost	20,316.13
	15,801.43
Balance, cost of obsolete portion.		Dec. 20, 1909
MACHINERY
2. 3 film wheels, cast iron, 14 feet
diameter, 26-inch face, polished and
nickel plated with dryers, drives
and auxiliary equipment (wheels Nos.
9, 10, 11).		Dec. 16, 1909
3. 1 film wheel (wheel No. 12)		Mar. 16, 1910
2a. 1 film wheel, cast iron, 14 feet
diameter, 26-inch face, with drives
and auxiliary equipment (without
dryers wheel No. 8):
Cost complete	$3,933.85
Less dryer	1,345.28	Dec. 16, 1909
4. 5 wheel foundations, concrete,
(wheels Nos. 8, 9, 10, 11, 12).		Dec. 20, 1909
5. 1 Landis grinder, 24-inch stroke,
arranged special for grinding face
of film wheels.		Dec. 16, 1909
6. 1 portable plating tank for 20
inch wheels.		Dec. 16, 1909
7. 2 1,000-pound hand-power hoists		Dec. 16,1909
8. 1 500-pound bridge crane		Dec. 16, 1909
9. 1 exhaust system (42-A-36)		Dec. 31, 1918
10. 1 double-pipe water cooler
(42-D-3).		Mar. 25, 1915
11. 1 complete air washing apparatus
(for old 10-foot wheels Nos. 1 to 5,
and 14-foot wheels Nos. 7 to 12,
inclusive).		Dec. 16, 1909
12. 1 refrigerating apparatus and
connections.		Dec. 11, 1909
13. 1 film wheel, cast iron, 15 feet
diameter, 49-inch face, polished and
nickel plated (old No. 6).		Dec. 29, 1910
CONVERTING DEPARTMENT
MACHINERY
14. 14 Burroughs absorbing presses
hydraulic, upright style, 26 by 38
inches, 14-inch ram, 14-inch stroke:
11 at $790	$8,690.00
3	2,288.65	1909
15. 1 cracker mill, 20 by 55 inches,
power driven, iron frame, 4-inch
cracker roll	1909
16. Pad dryer:
2 60-inch fans and installation	$116.37
	116.36
2 steel pad dryers, 115 sections,
pockets, frame	2,875.00
And tracks	2,875.00
Racks and trays	45.00
Piping	2,057.17
Power wiring	40.49
Foundations	335.01
Shafting	87.50	1909
ACID DEPARTMENT
MACHINERY
17. 1 Downingtown beating engine
(220-A-1)		Dec. 8, 1915
18. 1 Miller duplex beating engine
and installing 2 beaters		Aug. 3, 1920
19. Carrier air washer system:
1 80-inch steel plate fan, belt
drive, 3 by 3 feet outlet, heating
coil, in 5 feet 4 inches by 5 feet 4
inches by 5 feet 4 inches galvanized
housing	$339.00
With ducts and connections	151.00
	60.37
4 consecutive entries	695.00	July 31, 1918
SPECIALTY DEPARTMENT
MACHINERY
20. 6 Burroughs semiautomatic
hydraulic presses, 8-inch, operating
at 2,800 pounds pressure		Apr. 19, 1917

TABLE No. 1. - Building No. 42
ROLL CELLULOID DEPARTMENT
Actual cost
Each	Total	Percentage of de-	Amount of deprecia-	Net book
		preciation reserve	tion from date of	value Jan.
		from date of erec-	erection to Jan. 1,	1, 1919
		tion to Jan. 1, 1919	1919
	$15,801.43	44.00	$6,952.62	$8,848.81
$3,933.85	11,801.55	75.63	8,925.52	2,876.03
	3,858.19	69.63	2,686.46	1,171.73
	2,588.57	75.63	1,957.74	630.83
94.47	472.35	75.63	357.24	115.11
	1,348.10	75.63	1,019.57	328.53
	226.02	75.63	170.94	55.08
229.60	459.20	75.63	347.29	111.91
	196.53	75.63	148.64	47.89
	83.72	9.63	8.06	75.66
	1,711.67	35.63	609.87	1,101.80
	9,279.56	75.63	7,018.13	2,261.43
	2,425.64	75.63	1,834.51	591.13
	8,067.67	69.63	5,617.52	2,450.15
CONVERTING DEPARTMENT
	$10,978.65	75.63	$8,303.25	$2,675.40
470.00	75.63	355.46	114.54
	8,548.82	75.63	6,465.47	2,083.35
ACID DEPARTMENT
	$4,500.00	65.27	$2,937.15	$1,562.85
	12,737.22			1 12,737.22
	1,285.37	19.27	247.69	1,037.68
SPECIALTY DEPARTMENT
	$2,400.00	19.63	$471.12	$1,928.88

The manufacture of photographic film base or support is carried on in the Roll Celluloid Department, and in the manufacture thereof nitrate of cellulose is dissolved to form a mass which, after filtration and other treatment to get it into proper condition, has the color and consistency of stiff honey. The mass is then allowed to fall into a trough-shaped hopper mounted at the top of a large wheel which revolves at a slow speed. After the wheel has made one revolution, the partly dried material is stripped off, allowed to dry, and then spooled up.

Each of these wheels extends through three stories of the building in which they are located, weighs approximately 13 tons, and is finished in place by expensive plating apparatus. The surfaces of the wheels are copper plated, then nickel plated, and then brought to a mirror-like finish. Their accuracy must be within 2/000 of an inch.

In Building No. 42, Roll Celluloid Department, there were five film wheels 14 feet in diameter with a 26-inch face, which were installed in the year 1909 and one "Jumbo wheel" 15 feet in diameter with a 49-inch face which was installed in the year 1910 in order to increase the capacity of the plant and at the same time to reduce the cost as well as to improve the process of manufacturing film. (Items 2, 3, and 2a and item 13, Table No. 1.) As a further step forward, five more wheels of a later design and 16 feet in diameter were installed in 1911, and five additional 16-foot wheels with improvements in the design of the wheel structure were installed in 1914.

On October 15, 1919, the manager of the Roll Celluloid Department made a report to the president of the company in which he recommended the installation of five additional 16-foot wheels, and the subsequent removal of the 14-foot wheels and the utilization of the space occupied by the 14-foot wheels together with the locker room and the refrigerating room for the installation of more 16-foot wheels. This report contemplated a total project of 26 wheels, which was within the physical capacity of the area covered by the building. Plans were begun at or prior to the time of the report for the carrying out of the recommendations embodied therein, and on December 2, 1919, the president of the corporation authorized the installation of the five 16-foot wheels. This authorization also stated that the company did not contemplate any further increases of plant for the production of roll celluloid on the premises then occupied by the Roll Celluloid Department and directed that the plans for the manufacture of roll celluloid would be developed accordingly. Only that portion of the recommendation of October 15, 1919, providing for the installation of five 16-foot wheels was carried out.

After the installation in 1911 of the five original 16-foot wheels the five 14-foot wheels installed in 1909 were held in reserve and were used only spasmodically in the peak of business, up until February, 1920, when structural changes completely threw the 14-foot wheels out of service. They could not be used after that time. Wheels Nos. 9, 10, and 12 produced film in the week ended February 8, 1920, and shortly after that date the floor of that portion of the structure in which they were housed was raised and the complementary spooling apparatus was removed.

During the period of construction and installation of the five new wheels, which began early in 1920 and which continued for about 13 months, the five 14-foot wheels installed in 1909 were not available for emergency work, the floor level having been moved up 36 inches and the applicances for spooling film having been thrown out. Wheels 8, 9, 10, 11 and 12 (items 2, 3, and 2a, Table No. 1) were still standing on their original bearings, but they had been stripped of their driving equipment. The Jumbo wheel (item 13, Table No. 1) was last used in the fall of 1920. It was abandoned at that time for the manufacture of film and was scrapped in the spring of 1921.

Because of the question of fire hazard it was the practice of petitioner to install these film wheels in separate wells, divided originally by fire walls and fire doors, so that for all practical purposes each wheel was enclosed in its own building. There was a common roof and common outside walls, but all separated by partitions, and in the earlier designs, wooden floors. Subsequently the wheels were housed in a fire-proof building, using concrete floors on which to place the dryer over the wheel proper, the wheels themselves being installed through three levels of slat flooring. The lower portion of the wheels was in the basement, the pedestal and bearings on an intermediate floor, the hopper on the third floor, and the drier on a separate floor.

Originally the finished product was removed from the wheels through the fire wall into the main central bay of the building, where it was spooled up, but with the installation of the Jumbo wheel the operation of spooling up the film was carried on in the room containing the wheel so that the man who turned the hopper also attended to the spooling of the film. This arrangement was also employed with respect to the operation of the 16-foot wheels. With respect to the operation of the 14-foot wheels the finished product was spooled up in the central bay of Building No. 42 so that when structural changes were made in that building all of the spooling appliances had to be torn out and transferred to the rooms containing the wheels and the wheels became useless for the manufacture of film.

The building known as Building No. 42 formed the original structure of the Roll Celluloid Department. Originally it consisted of two bays, one of the cellular type containing six cells housing film wheels. The other bay was used for taking care of the solvents in the preparation of the honey-like syrup known as "dope" and for the spooling and packing of the film. The 14-foot wheels installed in 1909 were placed in a similar group of cells on the south side of the middle bay. These cells were of the same general type of structure as the cells housing the original wheels, except that they were fire proof, the floors being constructed of concrete instead of wood. In 1911 Building No. 42 was extended west to an adjoining street so that thereafter the structure ran from street to street and provided space for 10 machines, a group of five cells on each of the upper bays and the central bay, as before, but the floor level of the central portion was at a different level, a difference of 36 inches. At that time five wheels were installed on the southern side, and in 1914 five wheels were installed on the north side. The original wheels that were on the north face of the older portion were left there, but the doors were closed. They were left because it was cheaper and easier to leave them there than to take them out. At that time the petitioner was using the 14-foot wheels installed in 1909 and the five wheels installed in 1911.

The manager of the roll celluloid department recommended to the president of the company on October 15, 1919, that the five 14-foot wheels be torn out and that the space occupied by them be used for five new 16-foot wheels. This recommendation was not adopted. The 14-foot wheels were not torn out. They were allowed to remain in the portion of the building built to house them. This represented seven-sixteenths of the total building. No use has been made of the portion of the building in question since 1920. The five 14-foot wheels (items 2, 3, and 2a, Table 1) had no value whatsoever from the date their use was discontinued in 1920. The same is true of the Jumbo wheel (item 13, Table 1), the use of which was also discontinued in 1920.

Five wheel foundations, one Landis grinder, one portable plating tank, two hand-power hoists, one double-pipe water cooler, one complete air-washing apparatus and one refrigerating apparatus (items 4, 5, 6, 7, 8, 9, 10, 11 and 12, Table 1) are units pertaining to the wheels and structure, the use of which was discontinued in 1920. They were discarded in 1920 at the same time that the wheels were discarded and they had only a scrap value at that date.

Due to a change in the process of manufacturing celluloid, 14 Burroughs Hydraulic Absorbing Presses, one cracker mill and one pad drier (items 14, 15 and 16, Table 1) were also discarded in 1920. They were dismantled and placed in the cellar. They were junked - not even sold for scrap, and had no value at the time they were discarded.

The use of the Downingtown beating engine, the Miller duplex beating engine, and the Carrier air-washer system items 17, 18 and 19, Table 1) was discontinued in 1920. The Downingtown beating engine was transferred to Building 220 but has never been used since 1920. The Miller duplex beating engine and the Carrier airwasher system were left intact. The former was a comparatively new engine acquired in 1920 at a cost of $12,737.22. It and the Carrier air-washer system were partially dismantled but the machines are intact.

The six Burroughs semiautomatic hydraulic presses (item 20, Table 1) were never used for anything except experimental purposes. They have not been moved from where they were installed in the summer of 1920.

The principal commodity manufactured by the petitioner is celluloid. In manufacturing celluloid, tissue paper is treated with a mixture of nitric and sulphuric acids resulting in the formation of cellulose nitrate, which is also known as pyroxylin. This pyroxylin, after washing to remove traces of acid, is ground and dried. It is then treated with a plasticizing agent, together with alcohol and other solvents, and by a process of kneading, rolling, compressing and seasoning if finally is converted into celluloid. The foundation of the industry of celluloid manufacturing is based on the use of camphor as the plasticizing agent.

Camphor is not produced in this country. The bulk of it comes from Japan where the camphor trade is a governmental monopoly. In order to avoid the Japanese monopoly over camphor the petitioner had been endeavoring for a number of years to secure a substitute therefor or to produce it in this country. Its efforts to produce it here having proved abortive, the petitioner's chief chemist endeavored to develop certain foreign patents governing a substitute for camphor which petitioner had purchased prior to 1919. Finally in 1919 Lindsay, the chief chemist, pronounced the substitute a perfect one. This substitute - tricresylphosphate - was arbitrarily assigned the name "N" in accordance with the system of nomenclature employed by petitioner in the development of formulas.

In April, 1919, the company started extensive use of the "N" and gradually increased its use until orders were issued by the management to manufacture 80 per cent of the total product with the "N." Until August, 1919, the substitute was used entirely in the dark shades of celluloid, such as the black and tortoise sheel products upon which discoloration would have little effect. When the management issued orders to use the "N" material in 80 per cent of the product, the superintendent of the manufacturing department strenuously objected to the vice president, claiming that it was not suitable for use in the lighter shades. The chemical department, under Lindsay, maintained it was perfect, however, and the management ordered the superintendent to proceed with its use. During that time an imitation ivory was the principal product of the petitioner. This "ivory" had a delicate color, which the petitioner's competitors found hard to imitate and, as a result, the company enjoyed a good business in camphor ivory. The color of such imitation ivory was highly important so that a slight discoloration would cause it to be unsuitable for sale.

Upon the insistence of the chemical department the manufacturing department commenced the use of "N" material in the manufacture of ivory during 1919. This use of "N" material gradually increased until the latter part of the year when trouble with discoloration caused a practical suspension in its use. However, in the spring of 1920, after improvements in the method of refining the "N," its use was resumed and gradually increased. During this period the superintendent continually objected to its use, but the management sustained the chemist, Lindsay, in his contention that the defects had been remedied. During the latter part of 1920 the customers of the company complained about its product, particularly the ivory, and began to return the goods in large quantities because of discoloration and brittleness, which made them unfit for use. These returns of defective goods were so great that they overflowed the stock rooms.

At the end of the year 1920 the company had in its stock room a large inventory of finished sheets of celluloid. Due to the large quantity the taking of inventory was commenced in October, and as the quantity of goods in each vault of the stock room was determined the vault was locked and a careful check on outgoing goods was kept thereafter until the end of the year. In this way the quantity of the inventory was determined by December 31, and promptly reported to the accounting department, where the costs were determined and applied. The inventory, as at the end of 1920, so taken and priced, totaling $4,829,127, was entered on the books of the petitioner and used in its tax returns for 1920 and 1921.

Included in the goods in the stock room was a large quantity of sheets in cases. These cases were not opened when the inventory was originally taken, but were inventoried according to case numbers and packing tickets. All goods in the cases were included in the inventory as first-class finished goods and were so classified some months before when inspected in the seasoning room.

Early in January, 1921, the large amount of defective goods refused and returned by customers caused the management to conclude that the inventory contained a large quantity of defective goods which were unsalable. Some of the material returned was not recognized as the material which had been shipped. It had become brown. It was, therefore, decided to open up the cases, inspect and reclassify the sheets.

On January 12, 1921, the superintendent wrote a memorandum to the stock room foreman instructing him to proceed with the reclassification of the sheet celluloid stock. This reclassification was entirely of goods contained in the inventory at the end of 1920. During this reclassification large quantities of sheets were taken out of the cases and found to be so defective that they were sent to the scrap house "by truck loads." On February 10, 1921, the superintendent wrote the vice president, telling him that 395,556 pounds of scrap had accumulated, whereas the company's scrap house was built to hold only 200,000 pounds, and requested permission to dispose of it.

The sheets found to be defective included both "N" celluloid and camphor celluloid, the latter resulting from the fact that the pyroxylin base used in both had been chemically modified to adapt it to the use of the "N" plasticizer, and this modification of the base had an injurious effect on the camphor product as well as that produced by the use of "N."

The work of reinspecting and reclassifying the inventoried sheets extended over several months, during which time the company was making an issuance of preferred stock. The bankers who were handling the sale of stock for the company requested a firm of certified public accountants to examine and certify to the statement of profits for the preceding 10-year period and the balance sheet as at December 31, 1920, both of which had been prepared from the books. The accountants in the course of their examination discovered that during the months of November and December, 1920, approximately $170,000 worth of goods had been returned. This was more than the returns of a normal year which averaged about $12,000 per month. They further learned of the failure of the "N" as a camphor substitute and that large quantities of defective goods were in the inventories classified as first-grade product. The accountants refused to certify to the inventory figure of $4,829,147 which was entered on the books and used in the returns, and requested the vice president to write them a letter stating the quantity of defective goods included in the inventory as "firsts." On March 26, 1921, the vice president wrote the accountants stating as an estimate that there were 55,000 pounds of sheets listed "firsts" which should be scrapped, and 52,000 pounds more which should be listed as "seconds" instead of "firsts." On the basis of this letter and other information of a similar character the accountants reduced the inventory by $100,000 to $4,729.147, which figure was used by the bankers in the published prospectus instead of the figure of $4,829,147 shown by the books and the tax return.

Following this, on April 22, 1921, the superintendent rendered to the vice president of the company a final report of the reclassification of the sheets included in the inventory of December 31, 1920, as follows:

Ivory material
	Pounds "D" seconds	Pounds ordinary seconds	Pounds good material
Good, pounds inspected:
57,515 X	19,000	12,000	26,515
44,753 C	11,500	9,500	23,753
Seconds, pounds inspected:
43,028 X	29,028	14,000
35,857 C	22,000	13,857

Miscellaneous
Sheets	Pounds	"B" second sheets	Ordinary second sheets	Dis. second sheets	Scrap sheets	Salvage sheets	Good sheets
36,863 X	55,204	8,276	4,272	227	14,528	1	9,559
2,614 C	7,382		55	5	221		2,333

Material scrapped since first of year

49,433 pounds "X" delivered to scrap house

529 pounds "C" delivered to scrap house

15,000 pounds "X" to be scrapped

All of the foregoing merchandise was classified by petitioner in its original inventory either as "firsts" or "seconds" and the inventory was then valued at cost or market, whichever was lower, as determined by petitioner's accounting department. Application of the same unit costs or market values to the merchandise contained in the inventory after reclassification resulted in reducing the price of the inventory as follows:

	Pounds	Value	Pounds	Pounds	Uniform	Reduction	Total
	reclassi-	used in	seconds	scrap	price	in unit	reduction
	fied	inventory	therein	therein	therefor	price
					as used
					in the
					original
					inventory
X firsts	57,515	$0.86	12,000		$0.60	$0.26	$3,120.00
		.86		19,000	n1	.86	16,340.00
X seconds	43,028	.60		29,028	(1)	.60	17,416.80
C firsts	41,753	1.00	9,500		.70	.30	2,850.00
		1.00		11,500	(1)	1.00	11,500.00
C seconds	35,857	.70		22,000	.45	.25	5,500.00
MISCELLANEOUS COLORS
X shall	17,455	$0.92	1,769		$0.63	$0.29	$459.01
		.92		183	n1		168.36
X white	13,576	.76	7,831		.54	.22	1,722.82
		.76		2,134	n1		1,621.84
X black	8,806	.76	1,314		.54	.22	289.02
		.76		11,196	n1		8,508.96
X amber	1,567	.85	135		.60	.25	34.75
X pearl	508	1.02	46		.71	.31	14.26
		1.02		20	n1		20.40
X misc	2,143	.76	46		.54	.22	10.12
		.76		106			80.56
C white	899	.85	96		.55	.26	24.96
C pearl	833	1.22	145		.85	.37	43.65
C pink	62 1/2	.96	1		.67	.29	.29
C shell	2,170	1.04	33		.72	.32	10.56
							69,736.36
Lowest value:
Scrapped X	64,433	.76			1		48,969.08
C	529	.76			(1)		430.04
							119,135.48

The petitioner consistently took its inventories on the basis of cost or market, whichever was lower.

The accountants who were employed by the underwriters of the proposed issue of preferred stock further refused to certify to the balance sheet taken from petitioner's books as at December 31, 1920. In the balance sheet which was certified by them both the accounts reseivable and the surplus shown on the balance sheet taken from the books were reduced in the amount of $100,000 to offset the approximate value of merchandise billed and shipped to various customers which, it was anticipated eventually would be returned. During the first four months of 1921 the value of the goods returned, compared with returns during the same period in the previous year, was as follows:

	Returns in 1921	Returns in 1920
January	$53,162.83	$12,000
February	46,355.79	12,000
March	65,110.24	24,000
April	28,201.20	17,000
	192,830.06	1 65,000

Of the goods so returned in the first four months of 1921, amounting to $192,830.06, a total of $128,379.21 represented returns of inherently defective goods which had been included in sales account for 1920.

Subsequent to the taxable year and because of the failure of the camphor substitute "N," as indicated by the foregoing conditions, the petitioner discontinued its use and returned to the use of camphor.

OPINION.

SMITH: In Docket No. 8543, covering the years 1918 and 1919, the petition alleges errors on the part of the Commissioner as follows:

(4) The determination * * * is based on the following errors:

(a) The Commissioner of Internal Revenue failed to allow as a deduction from gross income the loss amounting to $41,711.57 claimed by taxpayer as obsolescence and loss of useful value on structure and machinery.

(b) The Commissioner failed to allow as a deduction from gross income a sufficient amount to reasonably cover the loss sustained by the company by reason of wear and tear and obsolescence.

In Docket No. 19459, covering the year 1920, the petition alleges errors as follows:

4. The determination * * * is based upon the following errors:

(a) The Commissioner failed to allow as a deduction an amount sufficient to cover the losses due to depreciation and to obsolescence and loss of useful value of structures and machinery.

(b) The amount used, in computing gross income, as the inventory as of December 31, 1920, was erroneous inasmuch as the amount included therein for certain goods hereinafter described was greatly in excess of the actual market value of such goods at that date.

(c) The total of sales used in computing gross income included billings to customers of large quantities of unmarketable goods manufactured by an experimental process, which was a failure, which goods the customers rejected and returned to the petitioner, so that the sales were never consummated and the assumed profit on the same never had any actual existence, and the cost of manufacture was almost or quite a total loss.

This petition further alleges that in lieu of a deduction on account of obsolescence of structure and machinery in the amount of $41,711.57 claimed in the petition filed for the years 1918 and 1919 (Docket No. 8543), there should be allowed as a deduction from gross income on account of obsolescence for the years 1919 and 1920 the sums of $20,420.71 and $5,877.82, respectively.

After the petitions were filed the petitioner prepared a statement (Table No. 1, supra ) showing the property on which a deduction for obsolescence is claimed, together with its date of acquisition, cost, percentage of depreciation reserve from date of erection to January 1, 1919, amount of depreciation from date of acquisition to January 1, 1919, and net book value on January 1, 1919. At the hearing counsel for the petitioner withdrew assignment of error (4)(b), Docket No. 8543, and stated that the above-mentioned statement set forth specifically and in detail the subject matter of allegations (4)(a) Docket No. 8543, and 4. (a) Docket No. 19459. He also asked that the various amounts claimed as deductions for obsolescence in the two petitions be subject to amendment so as to conform to the facts that would be introduced in evidence.

Counsel for the respondent stated that his understanding of petitioner's position with respect to claimed deductions on account of depreciation and obsolescence was that there should be deductions for 1919 and 1920 on account of obsolescence of property properly spread to the two years, and also that there should be allowed in one or both of the years losses on account of definite abandonment of property.

Having given due consideration to the statements appearing in the petitions and in the petitioner's brief, and having considered such allegations in the light of the position taken by counsel for both parties at the hearing, we take it that the issues before us are, (1) whether the petitioner is entitled to a deduction from gross income for each of the years 1919 and 1920 on account of losses due to obsolescence and loss of useful value of structure and machinery; (2) whether the value of the closing inventories for the year 1920 should be adjusted on account of defective goods contained therein; and (3) whether the accounts receivable account as of December 31, 1920, should be adjusted on account of billings to customers contained therein covering defective goods which were returned after the close of the taxable year.

The allegation of petitioner that the respondent erred in refusing to allow certain deductions for obsolescence being common to both of the appeals considered here, they were, on motion of the petitioner which was duly granted, consolidated and heard together. This issue, being the only one raised with respect to the year 1919, will be disposed of first. No issue was raised with respect to the year 1918 and the Commissioner having determined an overassessment for that year the Board is without jurisdiction of so much of the appeal as pertains thereto. , and .

Section 234(a) of the Revenue Act of 1918 provides:

That in computing the net income of a corporation subject to the tax imposed by section 230 there shall be allowed as deductions:

* * *

(4) Losses sustained during the taxable year and not compensated for by insurance or otherwise;

* * *

(7) A reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence.

The property covered by petitioner's claim consists of (1) machinery used in the manufacture of photographic film base, (2) machinery used in the manufacture of celluloid, and (3) a portion of the building in which the manufacture of film base is carried on. While neither the record nor petitioner's brief clearly sets forth upon which of the above-quoted provisions of the statute the petitioner bases its claim for a deduction for the year 1919, no evidence was presented to show that during that year it sustained losses within the meaning of subdivision (4), supra. On the contrary, the evidence is clear that there was no discarding or abandonment of the property in question during 1919. Consequently it is apparent that no deduction for the year 1919, based upon the provisions of section 234(a)(4) of the Revenue Act of 1918, would be allowable.

We conclude, therefore, that petitioner's claim for a deduction for the year 1919 is based upon the provisions of subdivision (7) of section 234(a) of the Revenue Act of 1918. This conclusion is supported by the introduction of testimony at the hearing to show (1) that plans were made in 1919 which would necessitate the abandonment in 1920 of the wheels installed in 1909 and 1910 for use in the menufacture of film base, together with certain complementary machinery; (2) that changes were made in the formula employed in the manufacture of celluloid in 1919 which would necessitate the abandonment in 1920 of the machinery used in making celluloid; and (3) that the plans made in 1919 for the abandonment in 1920 of a portion of the machinery used in making film base would also result in the abandonment of that part of the building in which such machinery was housed.

As a result of years of experimentation and development by the petitioner a type of machinery peculiarly adapted to the manufacture of film base was evolved. The first installation of such machinery was made in 1911 and as demand for film base increased subsequent installations of the same general type were made in 1914 and in 1920. While the recommendation of the superintendent of film manufacture, dated October 15, 1919, contemplated the removal of the wheels installed in 1909 and 1910, as well as the installation of additional wheels of the same type as those installed in 1911 and 1914, the president, under date of December 2, 1919, authorized only the installation of the additional wheels. He did not approve that portion of the recommendation relative to the removal of the wheels installed in 1909 and 1910.

The machinery in use prior to 1911 was either discarded or abandoned in 1920, so that to-day all film base is made by the use of machinery installed in 1911, 1914, and 1920. It is evident that long prior to 1919 the petitioner considered the type of machinery erected in 1911 was best suited to its needs and the superintendent of film manufacture testified that in his opinion the machinery installed in 1909 became obsolete in 1911 when the new type of machinery was erected.

Relative to the machinery used in the manufacture of celluloid, the testimony is clear that when the formula was changed in 1919 it became apparent that the use of a substitute in the place of camphor would necessitate the use of machinery different from that previously employed in making celluloid. It is equally clear, however, that a wide divergence existed in the opinions of various plant executives relative to the advisability of using the camphor substitute on a large scale. The management relied on the assurances of the chief chemist that the camphor substitute had been perfected, and ordered the superintendent of manufacture to employ the new formula to a large extent. The superintendent protested against the use of a substitute, claiming that its use would result in the production of an inferior product. Due to the fact that use of the substitute did result in the production of inferior celluloid its use was discontinued in the latter part of 1919, and it was not until the latter part of 1920 that the use of a substitute was resumed. Consequently, it does not appear that in 1919 the petitioner definitely knew that this machinery would be subsequently superseded by other machinery adapted to the manufacture of celluloid in which a substitute for camphor was used, or that the machinery in question became obsolete in that year.

While certain plans and changes affecting both the manufacture of film base and celluloid were made in 1919 which occasioned the abandonment in 1920 of certain machinery used therein, the evidence does not show that such machinery and that portion of the building in which it was housed became obsolete in 1919. Nor has the petitioner alleged that the respondent committed error in computing the allowance for exhaustion, wear and tear of its property with respect to the year 1919. No deduction, therefore, in a addition to that allowed by the respondent can be allowed for that year under the provisions of section 234(a)(7) of the Revenue Act of 1918.

The next question for determination is the amount of the loss, if any, deductible from gross income for the year 1920 as a result of the discarding of certain machinery and equipment. The evidence shows that the wheels had no value for any purpose whatever after they were dismantled in 1920. The evidence also shows that the machinery and equipment which was an integral part of the manufacture of film base connected with those wheels was also valueless at the date of abandonment in 1920. It also shows that the machinery left in the converting department (items 14, 15 and 16, Table 1) was valueless at the date discarded in 1920. Petitioner is entitled to deduct from the gross income of 1920 the depreciated cost of these assets. , and cases cited therein. Although the use of the machinery and equipment designated as items 17, 18, 19 and 20 (Table 1), was discontinued in 1920, the evidence does not show that these assets were valueless at that date. One witness testified that the Downingtown beating engine and the Miller duplex beating engine had a value of approximately $650 in 1927 and that the value in 1920 was not in excess of that amount. The latter engine was almost new. A discontinuance of the use of machinery alone does not prove a loss in respect of the machinery. Upon the evidence the claim of the petitioner for a loss deduction in respect of these assets is not sustained.

With respect to a loss of seven-sixteenths of the cost of the building in which the discarded film wheels were located, W. F. Crawford, a witness for petitioner, testified as follows:

Q. Mr. Crawford, you have testified that this property, this particular equipment and structures, too, because the structures were no longer of value, were abandoned February 8, 1920?

A. Yes.

Q. What do you consider was the value of these structures, and that equipment, as of February 8, when you permanently abandoned it?

A. For the purpose of making film those wheels were of no value. By cutting the building, ripping out partition walls and foundations and cutting larger openings in the outside wall, it would be possible to install the large wheels. That was contemplated as part of this project.

Q. Would the cost justify the expense?

A. That is an open question, because of the fact that concrete was used in part of the structure and was heavily reinforced. I am not sufficiently expert as a building designer to state whether or not it would pay, because of the handicaps that would be involved in getting these tremendously heavy machines in place through the side wall.

Q. So that substantially as they stand - even to-day they have no value?

A. They are of no value for the purpose for which they were erected.

Q. And since they occupy the structure, the structure is of no value; is that correct?

A. That is correct.

After carefully weighing this evidence we conclude that the use of this portion of the building for the purpose for which it was erected was terminated in 1920 and not that it became useless for all purposes and was abandoned in that year as valueless. The claim of petitioner for the deduction of this loss is likewise not sustained.

From the evidence submitted there can be little doubt that petitioner's inventory on December 31, 1920, contained a great quantity of defective material which had been erroneously classified as "firsts" and "seconds," resulting in an over-valuation of the inventory. Nor can there be much doubt that the reinspection of the material contained in the inventory together with the method employed in reclassifying it enabled the petitioner to determine the proper grade for each kind of material contained therein. Since the inventory had been originally valued at cost or market, whichever was lower, we are of the opinion that the petitioner was entitled to revalue it by assigning to the reclassified material the corresponding unit costs or market values employed in the original valuation, and that the deficiency for the year 1920 should be recomputed on the basis of the reclassified inventory. .

The third issue relates to the right of petitioner to reduce the amount of its accounts receivable account as of December 31, 1920, in the sum of $128,379.21. This amount was reflected in the accounts receivable account as at December 31, 1920, and represents the value of defective goods returned in the first four months of 1921 but which had been sold and delivered in the year 1920. The evidence shows that returns of defective goods, both in the latter part of 1920 and in the early part of 1921, were greatly disproportionate to normal returns for a like period in prior years, and a firm of certified public accountants estimated shortly after the close of the year 1920 that the accounts receivable account as at December 31, 1920, reflected approximately $100,000 worth of goods which, in all probability, would be returned.

The question as to the propriety of accruing a liability that is wholly anticipatory has been before us on numerous occasions and we have held that the accuracy with which the amount of the liability may be predetermined does not affect the question, which must be answered solely in the light of whether the liability is certain or contingent. In the instant case, as in the , none of the goods were returned in the taxable year. The decision in that case is controlling here and no reduction of the accounts receivable account as of December 31, 1920, may be allowed.

Reviewed by the Board.

Judgment will be entered on 15 days' notice, under Rule 50.

MURDOCK concurs in the result.

STERNHAGEN dissents in part.

PHILLIPS dissents on the first point.

---

Footnotes

• 1. Value, 1920. ↩

• 1. No value. ↩

• 1. Expressed in round numbers. ↩