Court Opinion

ID: 4621249
Source: CourtListenerOpinion
Date Created: 2020-11-21 02:44:17.911397+00
Date Added: 2024-06-11T07:55:58.807446
License: Public Domain

KAHUKU PLANTATION COMPANT, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.  MCBRYDE SUGAR COMPANY, LTD., PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.Kahuku Plantation Co. v. CommissionerDocket Nos. 99916, 101307.United States Board of Tax Appeals43 B.T.A. 784; 1941 BTA LEXIS 1452; February 28, 1941, Promulgated *1452  Prior to 1936 the petitioners kept their books of account and made their income tax returns upon the crop basis of reporting income.  From the gross sales of sugar during the year was deducted the cost of producing the sugar, including indirect expenses, such as property taxes and overhead, charged to the crop.  In 1936 the petitioners requested the permission of the respondent to change their methods of accounting and reporting and to be permitted to deduct from the gross income of each year the full amount of indirect expenses incurred in that year whether relating to the crop harvested during the year, or to crops to be harvested during the succeeding two years, instead of the amount of such indirect expenses charged to the crop harvested during the year.  The respondent granted the request upon the condition that the petitioners "exclude from deductions for the year of change and subsequent years the indirect charges which have been deferred under the method of allocating such costs to crops in process." This condition was accepted by the petitioners.  Under such condition the petitioners excluded from the deductions of 1936 the indirect expenses allocated to the crop harvested*1453  and sold in 1936, but did not exclude such expenses allocable to certain sugar carried over from 1935 under a marketing quota agreement with the Secretary of Agriculture.  Held, that the petitioners are not entitled to deduct from the gross income of 1936 the indirect expenses allocable to the sugar on hand at December 31, 1935, which was sold in 1936.  Montgomery E. Winn, Esq., R. A. Vitousek, Esq., and Thomas P. Goodbody, Esq., for the petitioners.  T. M. Mather, Esq., for the respondent.  SMITH *784  These proceedings, consolidated for hearing, involve income tax deficiencies for 1936 of $7,577.45 against the Kahuku Plantation Co. and $1,356.28 against the McBryde Sugar Co., Ltd.  The only issue *785  for our determination, which is common to both proceedings, is the cost basis to be used in determining the gain or loss on the sale in 1936 of sugar which the petitioners carried over from their 1935 crops in an "emergency reserve" set up under agreement with the Secretary of Agriculture.  Other issues raised in the pleadings were conceded by the respondent at the hearing.  FINDINGS OF FACT.  The petitioners are corporations organized*1454  under the laws of the Territory of Hawaii, engaged in the operation of large sugar cane plantations in the Hawaiian Islands and the manufacture of raw sugar.  Their principal office is in Honolulu and they filed their income tax returns with the collector at Honolulu.  The production of a mature crop of sugar cane in the Hawaiian Islands requires three years.  The cane is planted in the first year, fertilized and cultivated in the second year, and harvested in the third year.  Thus, there are three distinct crops in process in each year.  For many years prior to 1936 the petitioners, in common with other sugar producers in Hawaii, kept their books of account and made their income tax returns on the so-called "crop basis", charging to each crop all of the expenses incurred in its production, both "direct" and "indirect" expenses, and applying the sum total of such expenses against the selling price in the year when the crop was sold.  The difference between those amounts was the gain or loss on the crop which the petitioners reported in their income tax returns.  This method of accounting and of reporting income was approved by the Commissioner.  The direct expenses of each crop*1455  consisted of the cost of plowing, preparing, planting, cultivating, irrigating, fertilizing, etc., while the indirect expenses were such as camp sanitation, hospital maintenance, repairs, camp fuel, legal expenses, forestry maintenance, property taxes, workmen's compensation, insurance, industrial welfare, agricultural research, camp police, day nurseries, interpreters, and office salaries.  The indirect expenses were distributed or allocated to the three crops in process on thesame basis as the direct expenses attributable to each crop; that is, on the basis of the actual labor hours required on each separate crop.  During 1935 the petitioners, as well as other sugar cane growers in Hawaii, entered into "Sugarcane Production Adjustment Contracts" with the Secretary of Agriculture under authority of the Jones-Costgan Sugar Act.  Under the terms of those contracts the petitioners agreed to limit their sales of raw sugar for consumption during 1935 to certain fixed market quotas and to manufacture an additional amount *786  of not less than 9 percent of their base production to be held in an "emergency reserve." For 1935 Kahuku's total crop of sugar amounted to approximately*1456  20,148 tons.  Of that amount 18,414.76 tons were sold in 1935 and 1,733.435 tons were allocated to and held in the emergency reserve.  McBryde's total crop for 1935 was approximately 23,016 tons, of which 21,622 tons were sold and 1,394.82 tons were retained in the emergency reserve.  In closing their books for 1935 the petitioners inventoried the sugar retained in the emergency reserve at the close of the year at cost of production, which was less than the market value at that time.  The cost of production was arrived at by allocating to the reserve sugar a portion of the total cost of the entire 1935 crop, including both the direct and indirect expenses allocable thereto which had accumulated over the three-year production period.  Kahuku's 1,733.435 tons of emergency reserve sugar were inventoried at $88,977.22 and McBryde's 1,394.82 tons at $65,378.93.  Those amounts were taken up in petitioners' 1935 income while all of the expenses, both direct and indirect, which had been charged against the entire 1935 crop, including the sugar sold as well as that held in the emergency reserve, were taken up as deductions.  Prior to December 31, 1935, all of the petitioners' emergency*1457  reserve sugar had either been delivered to or was in transit to the California & Hawaiian Sugar Refining Corporation, Ltd., at Crockett, Port of San Francisco, California, where it was to be held in bond to prevent Its being processed or sold for consumption in the continental United States, under an arrangement made with the Agricultural Adjustment Administration.  The petitioners had received partial payments on some of those shipments.  In their income tax returns for 1935 the petitioners reported all of the proceeds from the sale of sugar in that year and also reported as "Other Income" the above amounts of inventories of sugar retained in the emergency reserve.  Also, in their 1935 returns they claimed the deduction of all of the expenses, both direct and indirect, attributable to the entire 1935 crop.  A controversy arose between the petitioners and the Commissioner as to the method of inventorying the emergency reserve sugar, the Commissioner contending that it should be inventoried at market value on December 31, 1935, instead of on the cost of production basis used by the petitioners.  The petitioners' 1935 returns were finally audited without any change in respect of*1458  the inventories in question, that is, the inventories of sugar held in the emergency reserve were taken up in income at cost (including indirect expenses) as reported in the returns.  *787  On February 1, 1936, the petitioners applied to the Commissioner for permission to change their method of accounting to the extent of charging all of the indirect expenses such as property taxes, camp sanitation, hospital maintenance, etc., on the annual accrual basis in the year when such expenses were paid or incurred, rather than on the crop basis.  On July 17, 1936, the Commissioner replied to this request in part as follows: Permission will be granted each of the taxpayers above named to change the method of allocating expenses to the respective crops under the crop basis of reporting income so as to take indirect charges on an annual basis as accrued instead of being allocated to the crops in process, provided the taxpayers express their willingness to exclude from deductions for the year of change and subsequent years the indirect charges which have been deferred under the method of allocating such costs to crops in process, and to confine the deductions for indirect charges for*1459  the year of change and subsequent years to those actually accruing within the given taxable year, excluding any deductions previously claimed in prior years.  The taxpayers must, after making the change, report such deductions consistently with the method of accounting employed.  The petitioners agreed to the conditions set forth in the Commissioner's letter of July 17, 1936, and on August 28, 1936, permission for the petitioners to make the proposed change was granted by the Commissioner.  Under their modified accounting system the petitioners in December 1936 wrote off, by a charge to surplus, all of the indirect expenses which had been allocated to the 1936 and 1937 crops in process prior to January 1, 1936.  For Kahuku the total amount so written off was $175,616.49, of which amount $139,295.91 had been charged to the 1936 crop and $36,320.58 to the 1937 crop.  The total amount written off by McBryde was $269,792.28 of which $188,276.70 had been charged to the 1936 crop and $81,515.58 to the 1937 crop.  In further compliance with the conditions upon which permission for the accounting change was granted, the petitioners in computing their profits on the 1936 crop deducted*1460  all of the direct expenses which had been charged to that crop in 1934, 1935, and 1936, and in addition thereto all of the indirect expenses paid or incurred during that year, a portion of which under the old method of accounting would have been allocated to the 1937 and 1938 crops.  In 1936 the petitioners sold all of the sugar produced in that year as well as the emergency reserve sugar brought over from 1935, the quota restriction having been removed by the ruling of the Supreme Court in 1936 that the Agricultural Adjustment Act was unconstitutional.  See . In their income tax returns for 1936 the petitioners reported the profits on the 1936 crop, computed by deducting from the proceeds of the sales of sugar in that year the direct expenses incident thereto *788  over the years 1934, 1935, and 1936, and all of the indirect expenses paid or incurred in that year in respect of the 1936, 1937, and 1938 crops.  These computations, as applied to the 1936 crop, were in accordance with the accounting plan agreed to by the Commissioner and are not questioned in these proceedings.  In computing their profit*1461  on the sales of the emergency reserve sugar broght over from 1935 the petitioners used as a cost basis the values at which this sugar had been inventoried at the close of 1935.  The respondent has determined, however, that the inventory values which were based on cost of production and included both the direct and indirect expenses allotted to the 1935 crop were not the correct bases; that under the agreement by which the petitioners were given permission to change their method of accounting the profits on the sale of the emergency reserve sugar carried over from 1935 must be computed in the same manner as the 1936 crop; that is, by eliminating from the cost all of the deferred indirect expenses which had been allocated to it.  This results in a reduction of $23,904.07 in the cost basis of Kahuku's emergency reserve sugar and of $17,909.49 in McBryde's, those being the respective amounts of such indirect expenses.  OPINION.  SMITH: The question presented is the correct interpretation of the respondent's letter of July 17, 1936, permitting a modification of the crop basis of reporting taxable income.  The respondent contends that his letter meant that for 1936 and subsequent years*1462  the petitioners were not to deduct from gross income under the new accounting system any indirect expenses except those which were incurred during the taxable year.  The petitioners, on the other hand, contend that the conditions of the letter did not require them to exclude from the deductions of 1936 the indirect expenses incurred and paid in years prior to 1936 in connection with the production of sugar which they had on hand at December 31, 1935.  They were not able to sell that sugar in 1935 by reason of the quota provisions of the Agricultural Adjustment Act.  The argument of the petitioners is that this sugar was not a part of the "crops in process" referred to in the respondent's letter of July 17, 1936.  They point out that this sugar on hand was inventoried in their accounts and in their returns for 1935 not at market, but at cost of production, including indirect expenses properly allocable to the sugar; and contend that in computing profits from the sale of that sugar in 1936 they should use as a basis the same inventory value as was shown by their books of account at December 31, 1936.  *789  In this connection it should be noted that the treatment of the carry-over*1463  sugar by the petitioners in 1935 had the effect of leaving the account for such sugar in suspense; in other words, the sugar was inventoried exactly at the cost of production, including the indirect expenses.  No gain or loss on the sugar was reflected in the accounting for 1935.  The accounting for profit or loss in respect of that sugar was deferred to 1936, the year in which it was sold.  It seems to us clear that the condition upon which the petitioners were permitted to modify their system of accounting and reporting was that for the year 1936 the petitioners should not receive the benefit of the deduction of any of the indirect expenses allocable to the sugar sold in 1936, except, of course, the total indirect expenses incurred in 1936.  The pertinent language of the letter of July 17, 1936, bearing upon this point is the proviso that "the taxpayers express their willingness to exclude from deductions for the year of change and subsequent years the indirect charges which have been deferred under the method of allocating such costs to crops in process." The indirect expenses pertaining to the sugar on hand at December 31, 1935, was in the case of the Kahuku Plantation Co. $23,904.07*1464  and in the case of the McBryde Sugar Co., Ltd., $17,909.49.  We think that these indirect expenses must be excluded from the deductions of 1936 as well as the other indirect expenses which had been charged on the books of account to the 1936 and 1937 crops which were charged off to profit and loss in 1936 in compliance with the condition of the permission to change.  The petitioners complain that under this construction of the respondent's letter they will never be allowed to deduct the indirect expenses pertaining to the carry-over sugar.  The respondent admits that this is so but insists that it was a condition of the grant of the permission for the petitioners to change their accounting method.  The petitioners admit that under the condition of the grant they forever lose the right to deduct the indirect expenses which had been incurred and paid in years prior to 1936 which they had charged to the 1936 and 1937 crops, the amounts being $175,616.49 in the case of the Kahuku Plantation Co. and $269,792.28 in the case of the McBryde Sugar Co., Ltd.  We can see no good reason why the indirect expenses allocable to the carry-over sugar should not be given the same treatment.  It*1465  seems to us that a fair interpretation of the respondent's letter requires such a conclusion.  The respondent's action upon the point involved is approved.  Decisions will be entered under Rule 50.