Before L. HAND, AUGUSTUS N. HAND, and CHASE, Circuit Judges.
Both the taxpayer and the Commissioner appeal from orders assessing deficiencies in income tax, assessed against the taxpayer for the years 1928 and 1929; and denying the taxpayer's claims of overpayment. The taxpayer's appeal, which is the more important, involves four points: First, whether the Tax Court erred in refusing to allow any deduction for depreciation upon certain contracts for the sale of alcohol which were purchased by the taxpayer in the year 1929, and expiring on December 31st of that year: second, whether it erred in refusing to allow depreciation for wear and tear upon drums in which industrial alcohol was sold by the taxpayer in the years 1928 and 1929: third, whether a gain in the taxpayer's sale of shares of stock in a company, known as the Agni Motor Fuel Company, should have been included in 1929, or in 1930: fourth, whether the Tax Court erred in appraising losses in the taxpayer's equipment during the year 1929. The Commissioner's appeal is from an allowance to the taxpayer for payments made to the wholly owned subsidiary or an affiliate. As there are in effect five separate appeals, it will be simpler to consider them as though they were such, stating the facts in each and then discussing their legal effect.
Depreciation Upon Contracts Bought.
In 1929 the taxpayer purchased substantially all the assets of another distilling company - the Kentucky Alcohol Company - and assumed its liabilities. Among the assets so purchased were 214 contracts already made by the Kentucky Company with customers, or brokers, or jobbers, for the delivery of industrial alcohol before the end of the year. Each contract required the buyer to accept no more than a specified maximum, but no less than a specified minimum, number of wine gallons; and on June 15, as of which date the sale was concluded, the undelivered maximum was 8,794,464 gallons, and the undelivered minimum was 7,545,122 gallons. The contract prices were at, or a little under, the market prices at the time the contracts were made, and the parties expected that the buyers would accept about 7,500,000 gallons. Most of the contracts provided that the prices were to be "firm and uncancellable, without any protection against decline in prices"; but in several instances, the taxpayer, like the Kentucky Company before it, did not force upon the buyer even the minimum which he had promised to take, and in some instances it sold to him at a reduced price. The customer was expected to take the minimum; or, if that was in excess of his requirements, he was still expected to take at least his requirements; but, if the enforcement of the contract would result in his being obliged to carry over an excess stock, to be later disposed of at forced prices, that was thought undesirable, as the seller might lose him as a customer. Of the buyers under these contracts, a little over one-third continued to buy of the taxpayer in 1932; and these bought in the aggregate nearly fifty per cent as much as the total sales in 1929. The jobbers and brokers of the Kentucky Company in 1929 were operating in twelve cities; in 1932 they continued to operate in six of these.
The Tax Court found that in nineteen contracts the prices were guaranteed to be no higher than the prices offered by the Kentucky Company's competitors in 1929; and that in one instance, the purchaser was guaranteed against any decline in price. It also found that the contracts "as a practical matter * * * were regarded under the apparently universal custom of the industry, not as contracts for unqualified quantities and at unchangeable prices, but as the recognized method of booking orders for future deliveries." Again: "The significance of the contracts lies not in whether or not they were legally enforceable, but in whether the petitioner can be regarded as having acquired them with any idea that they would be enforced, or that their enforceability, if any, had value for it, or that this quality contributed in any substantial degree to the value of the business for which the purchase price was paid, so that any significant sum could be attributed to it." Again: The contracts "are to be treated as of no different consequence than" (sic) "unfilled customer's orders in other lines of business." The books did not disclose any depreciation account for the contracts; nor did such an item appear in the return for 1929. The Tax Court held that the contracts contributed a value to the assets analogous to that of good will, and could not, therefore, be exhausted; for this reason it denied the deduction.
If we limit our consideration to a single contract of sale, there are only two inducements which will lead to its purchase: (1) it may have been made at a higher price than the market price at the time when the assignee buys it; (2) if it has not, it may cost the assignee something in time and money to secure an equivalent contract at the market price. The first inducement could not have existed in the case at bar because, although it does not positively appear that the market prices on June 15th, 1929, were no higher than the contract prices, it is fairly to be inferred from testimony quoted below that there was nothing beyond normal profit in the contract at that time. Indeed, more than half the gallonage had just been contracted for in May and June. We do not forget that there was a profit of twenty cents per gallon in the contracts, but that is irrelevant if twenty cents was the usual profit upon sales at market prices. As to the second reason, there was evidence that it had cost the Kentucky Company more than $252,000 to secure the contracts, and while the Tax Court need not have accepted that figure, it refused to consider the issue at all, and that would have been an error, if the amount were relevant. It would have been relevant, if all that the taxpayer got when it bought the contracts was the right to "put" to the buyers the actual gallonage covered by them: i.e. if their only value had been in those particular sales. This might also be true, even though, as the Tax Court found, the contracts were not intended to be enforced as they read, but were to be softened, so to speak, both in quantity and in price, provided that the buyers bought up to their requirements. It would then have been necessary to find to spend to get payer would have had to spend to get equivalent contracts, and possibly the Kentucky Company's expense would have been a proper measure.
If the taxpayer had meant to close up the business on December 31st, 1929, we should therefore have felt bound to reverse upon this point. But it was buying a going business which it expected to continue, and there was abundant evidence to support the findings of the Tax Court that one purpose - indeed, the primary purpose - was to insure a market, not only until the end of the year but for an indefinite time thereafter. In such an industry - for that matter, in any industry - continuity of sales is a condition of continued existence; once they stop, it is extremely hard, if not impossible, to start up the business again. Therefore the power to sell over the period immediately after the business is taken over, insuring as it does against such a break, has a value quite independent of any profit that may be got from those particular sales. There is no reason to suppose in the case at bar that the taxpayer would have paid anything whatever for the contracts if they had not contributed in this way to the continued existence of the business. Indeed, it was permissible for the Tax Court to find - though it did not do so - that the taxpayer expected no profit whatever from the contracts. At least, so its chairman of the board, Adams, appears to have thought. "We paid a million and a half dollars for contracts out of which we expected to make no profit, and we paid one million nine for everything else we got. Of course we got no profit in 1929. We expected when we agreed to pay a million and a half dollars for those contracts to get a benefit in future years, by reason of that particular payment that was all in the million and nine."
The industrial advantage so secured was not an exhaustible asset; it is of no importance that in three years less than half of the output for 1929 continued to be sold to buyers of that year. The contracts would have served their purpose had the personnel of the buyers completely changed, for it was only by keeping the business alive by a continuous market that its value was maintained at all. For this reason the Commissioner could safely have conceded that Adams's estimate of $1,500,000 as the price which he paid for the contracts was right; he was paying for what was a necessary condition upon any value to the plant as an industrial unit. The Tax Court was quite right therefore in assimilating the situation to the purchase of a newspaper with its list of subscribers; and in holding that the contracts were analogous to goodwill. It would have been mere surmise to suppose that the value contributed by them had in any degree disappeared on December 31st, 1929. Once more to quote Adams: "We agree to pay a million and a half dollars * * * to get a benefit in future years."
Depreciation of the Steel Drums.
The next item is for the depreciation of drums used to ship alcohol. Until the year 1932 whenever the taxpayer shipped alcohol it charged the buyer six dollars for the drum (a little more than its cost) which the buyer agreed to return in ninety days. If he did, he was credited with six dollars and the drum was used again, and so on until it became too worn out for further service, or the supply became too large. It was then sold, or junked, for whatever it would bring. The taxpayer between 1922 and 1929 did not keep any account on its books of gradual deterioration of these drums; nor did it claim any such deduction in its returns; it merely claimed a deduction of six dollars when the drum was finally scrapped or sold - charging itself with whatever was salved. It was not until November 1931 that it suggested any change and claimed an overpayment for 1928 and 1929, based upon a depreciation of the whole mass of drums, calculated upon a uniform deterioration over a stipulated life of ten years. The Commissioner denied this claim and the Tax Court affirmed his ruling.
Section 41 of the Revenue Act of 1928, 26 U.S.C.A. Int. Rev. Acts, page 363, directed a taxpayer's income to be computed "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but * * * if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the commissioner does clearly reflect the income." Article 322 of Regulations 74, which were promulgated for the Act of 1928, enacted that a taxpayer who wished to change his "method of accounting employed in keeping his books * * * should, before computing his income on such new basis for purposes of taxation, secure the consent of the Commissioner," for which he must apply "at least 30 days before the close of the period to be covered by the return." The taxpayer made no such application until nearly two years after the close of the second year - 1929 - and it is therefore impossible to see what standing it had to vary the "method of accounting regularly employed" by it. This has been the view taken in a number of decisions. Elmwood Corp. v. United States, 5 Cir., 107 F.2d 111; St. Paul Union Depot Co. v. Commissioner, 8 Cir., 123 F.2d 235; Franklin County Distilling Co. v. Commissioner, 6 Cir., 125 F.2d 800; Commissioner v. Saunders, 5 Cir., 131 F.2d 571.
But the claim is without merit anyway. There was no actual "realized" loss in a drum until it was scrapped; so far as appears, it served its purpose quite as well until then, though it would not fetch as much upon a sale. Nevertheless, it is quite true that the law does recognize depreciation not "realized," and treats it as a deductible loss, when in the jargon of the statute, not to do so will "distort," and not "clearly reflect," the income; by which we understand only that it will be more equitable to allow depreciation. In this case there is no persuasive evidence that annual depreciation would a priori have had such a result: certainly none conclusive enough to justify the Tax Court in overruling the Commissioner. In the end, if the taxpayer had carried out its method of deducting only scrapped or junked drums it would have recovered all its actual losses; the only question is as to whether the distribution of these losses by means of an annual deterioration allowance was so much fairer that the Commissioner had no discretion to refuse it. We do not think that it was. It is true that such an allowance over the years 1928 and 1929 would have been more than three times as great; and that for the years 1928 and 1929 it would have been more than twice as great. This is understandable. The records show only the drums on hand in 1922 at the Peoria plant and these were less than 4,000; but as the number of drums in that plant in 1928 and 1929 was about one half of all the taxpayer's drums, we may suppose that the total number of drums in 1922 was in the neighborhood of 8000. As this number had grown by 1928 and 1929 to over 180,000, there was an inevitable lag between an allowance based upon scrapped and sold drums and a depreciation allowance; indeed, the surprising thing is that more than 34,000 should have been scrapped or sold between 1922 and 1929. But we cannot see why - even if the Commissioner had had the power to allow a change - it was unfair to hold the taxpayer to a method chosen by it, and adapted in the end to allow it all its actual losses. It is not true that the annual loss would have no relation to the annual income. We should assume, at least after the system had been working for ten years, that the mass of drums on hand would always contain the same proportion of aged drums; if so, an increase in business in any year, ...