H. Elkan & Co. v. Commissioner

H. Elkan & Co., Petitioner, v. Commissioner of Internal Revenue, Respondent H. Elkan & Co. v. Commissioner Docket No. 109559 United States Tax Court 2 T.C. 597; 1943 U.S. Tax Ct. LEXIS 78; August 24, 1943, Promulgated *78 Decision will be entered under Rule 50. "Unrealized profits" by hide dealer from open futures contracts on the Commodity Exchange can not be used to offset "unrealized losses" as indicated by the inventory taken at market price, on the basis of "cost or market, whichever is lower." Harry D. Orr, Jr., Esq., and Jay C. Halls, Esq., for the petitioner. John D. Kiley, Esq., David Altman, Esq., and Harold H. Hart, Esq., for the respondent. Turner, Judge. TURNER *597 The respondent has determined deficiencies in income and excess profits taxes for the year 1937 against the petitioner in the amounts of $ 48,379.45 and $ 4,497.20, respectively. The issue presented by the pleadings is whether in respect of certain contracts for the future delivery of hides previously sold by petitioner, which contracts were still open at December 31, 1937, there should be included in petitioner's income for 1937 an amount equal to the margin of the profit indicated by the market price of such contracts at December 31 of that year, or, to put it differently, the amount representing the difference between the price for which the contracts had been sold and the amount which would*79 have been required to make covering purchases thereon at December 31, 1937. FINDINGS OF FACT. The petitioner is an Illinois corporation, with its principal office in Chicago. It filed its income and excess profits tax returns for the calendar year 1937 with the collector of internal revenue for the first collection district of Illinois. The petitioner has been engaged in the business of dealing in hides and skins for more than 70 years. Hides and skins are bought primarily from packers, butchers, and collectors of farmers' and butchers' hides. They are sold primarily to tanners. All during the year 1937 petitioner had on hand a physical inventory of hides. It included all hides to which petitioner had title. They were kept in petitioner's own warehouse and in public warehouses. *598 The petitioner has been a member of the Commodity Exchange, Inc., of New York City, and a member of its clearing house since its organization in 1928 or 1929. During the same period it has regularly engaged in the purchase and sale of contracts for the future delivery of hides on the said exchange. A contract of hides, as that term is used on the exchange, covers approximately 40,000 pounds*80 of hides, with a variation of from 38,000 to 42,000 pounds allowable. Certain standard grades of hides are acceptable for delivery, such as native cow hides, packer cow hides, and packer and native hides. Other grades of hides such as branded cow and steer hides, South American hides, and standard South American packer hides are also acceptable for delivery, subject to various price differentials. To be eligible for delivery on the exchange, the hides must have been properly selected, salted, and stored for a period of time in the packer's cellar and then shipped in an unbroken shipment from the original packer's cellar to a warehouse licensed by the exchange, and if found to be acceptable for delivery, a certificate to that effect is issued. By reason of these requirements, none of the hides owned by the petitioner and kept in its own warehouse are eligible for future delivery on the exchange. At or prior to the delivery date under any futures contract, the exchange would publish a list indicating what type of hides were then available for delivery and delivery under any contract might be made in any of the hides above described as being acceptable for delivery. The petitioner's*81 purchases and sales of futures contracts were prompted by any of various considerations. If there was a possibility or probability that its physical inventory of hides might be depleted unduly, the petitioner was enabled to assure itself of an adequate inventory to meet its future needs through the purchase of futures contracts, and many of its purchases on the exchange were prompted by that consideration. If before the delivery date under the contract so purchased the petitioner was able to acquire by direct purchase an adequate supply of hides of the character and grade required to meet its customers' demands, it would ordinarily sell the futures contracts previously acquired; otherwise, it would take delivery of the hides themselves. At other times when its supply of hides was more than adequate to meet the needs of its customers, it might, if the market was right, sell contracts for future delivery of hides on the exchange. In such cases the sale of futures contracts could be availed of, and to some extent did serve to, protect petitioner from subsequent loss on its physical inventory in the event of a falling market. None of the petitioner's contracts for the future delivery*82 of hides on the exchange were, however, or could be, listed against any particular hides in petitioner's inventory or against any particular sale or purchase of actual hides. At other times the petitioner bought and sold futures contracts for the purpose *599 of realizing a profit through trading, in the same manner as it did through transactions in the physical hides themselves. Over the years the price of hides as quoted on the exchange has fluctuated widely. During the latter part of 1937, the trend of prices was definitely downward. This trend began at midyear and reserved itself at the end of March or the first of April 1938. The petitioner's physical inventory at December 31, 1936, was valued at $ 1,000,446.27, based on cost, the market value being slightly higher. Its physical inventory at December 31, 1937, based on cost, was valued at $ 924,051.15 and, based on market prices, was valued at $ 702,296.09. The petitioners' books of account were kept on the accrual basis of accounting. During the year 1937, and for more than thirty-five years prior thereto, petitioner had followed the practice on inventorying its actual hides on hand at the end of the calendar year, *83 on the basis of cost or market, whichever was lower. During all the years that Federal income tax returns have been required, petitioner has made its Federal income tax returns on the same basis. Hides covered by purchase contracts, other than futures contracts on the exchange, were not included in petitioner's inventory until title to such hides had passed to the petitioner and it had received an invoice for them. When actual hides were sold by petitioner to its customers, such hides were not removed from its inventory until title had passed to the purchaser and an invoice had been rendered. Petitioner could identify the hides in its inventory and ascribe thereto the cost or market price, whichever was lower. When petitioner made contracts either for the purchase of hides from packers or other producers or for the sale of hides to its customers, 30 to 60 days on the average elapsed between the time the contracts were made and the date of delivery. At the end of the year, if petitioner had open commitments for the purchase or sale of actual hides, no consideration was given to such transactions in determining its inventory as of the end of the year and no profit or loss was reflected*84 in the profit and loss account on its books or in its Federal income tax returns on account of such transactions until such time as the hides were taken into or removed from inventory. At the end of the year 1937 petitioner had substantial open commitments both to buy and to sell actual hides, and no consideration was given thereto in determining its closing inventory for the year 1937; likewise no profit or loss was reflected in its profit and loss account or in its Federal income tax return for 1937 in respect of such open commitments. No profit or loss was reflected in the profit and loss account on petitioner's books or in its income tax returns in connection with the purchase or sale of contracts for the future delivery of hides on the exchange until such contracts had *600 been closed out by making or taking delivery of actual hides, or by the sale or purchase, as the case might have been, of a contract for future delivery of hides of the same delivery date. For the year 1937, and for many years prior thereto, petitioner's income tax returns were prepared and filed on this basis, and no objection has ever been raised by respondent with respect to the method of reporting*85 profit or loss in connection with transactions in contracts for the future delivery of hides on the exchange. At the end of the year 1937 petitioner had in its inventory approximately 7,728,996 pounds of hides. At the end of the year 1937 petitioner had sold on the exchange 73 March contracts for the future delivery of hides, representing 2,920,000 pounds of hides, and, because of the declining price of hides in the latter part of 1937, petitioner had an unrealized profit at the end of the year in the amount of $ 153,656, representing the difference between $ 444,488, the price at which the contracts for hides had been sold, and $ 290,832, the quoted market price thereof at the end of the year. At the end of 1937 petitioner had sold on the exchange 22 September contracts for the future delivery of hides, representing 880,000 pounds of hides, for which it had an unrealized loss of $ 8,816, representing the difference between the price at which the contracts for hides had been sold and the quoted market price thereof at the end of the year. In addition, at the end of 1937 the petitioner had purchased on the exchange 54 June contracts for the future delivery of hides, representing 2,160,000*86 pounds of hides, for which it had an unrealized loss of $ 12,604, representing the difference between the price at which the contracts had been purchased and the quoted market price thereof at the end of the year. During the year 1937, petitioner had on hand a quantity of sheep skins, which were very perishable and which the petitioner was unable to sell. A contract was entered into with a wool processor for the pulling of the wool from the sheep skins, after which the skins were disposed of. Being still unable to sell the wool, petitioner sold four May and June contracts for the future delivery of wool on the exchange, a standard wool contract amounting to 5,000 pounds of wool. At the end of the year 1937 the wool contracts were still open, and petitioner had an unrealized loss on account thereof in the amount of $ 1,600, representing the difference between the price at which the contracts had been sold and the quoted market price thereof at the end of the year. The four wool contracts were the only contracts for the future delivery of commodities, other than hides, ever entered into by petitioner. No part of the unrealized profits or losses from any of the said contracts for*87 the future delivery of hides or wool on the exchange *601 which were open at the end of the year 1937 were taken into petitioner's profit and loss account nor reported in petitioner's income tax return for the year 1937. The profit or loss on all contracts for the future delivery of hides on the exchange that were actually closed out during 1937 was reported in petitioner's income tax return for said year. All contracts for the future delivery of hides and wool on the exchange that were open at the end of 1937 were closed out during the year 1938. In recomputing petitioner's net income for the year 1937, respondent, in his notice of deficiency, has not given any effect to petitioner's unrealized losses in the total amount of $ 23,020 resulting from petitioner's transactions on the exchange in contracts for the future delivery of hides and wool. In dealing in contracts for the future delivery of hides on the exchange, it was necessary to put up original margin of $ 600 per contract. As the market price of the contracts fluctuated, the rules of the exchange required that clearing members should draw down the excess margin in case of a favorable fluctuation and should put up*88 additional margin in case of an unfavorable fluctuation, so that the original margin of $ 600 was always maintained. The $ 600 margin was retained by the clearing house until the contract was closed. Petitioner carried on its books an account entitled "Variation Margin Account," which reflected the amount of excess margin drawn down from the exchange or the amount of additional margin put up, whichever was the case. The contracts for future delivery were not affected by the margin adjustments and remained open either until they were closed out by a corresponding sale or purchase of a contract for the same delivery date, or by actual delivery. Petitioner did not credit the daily margin adjustments to its profit and loss account, and no effect was given to such adjustments until a particular contract for the delivery of hides was closed out, at which time the profit or loss, whichever was the case, was credited or charged to petitioner's profit and loss account on its books. On December 31, 1937, the "Variation Margin Account" showed the "net unrealized profits" to be $ 130,493.13, which said item was not reported as income in petitioner's income tax return for 1937. In its income*89 tax returns for the years 1937 and 1938, petitioner reported sales of hides in the amounts of $ 20,886,689.58 and $ 13,462,608.67, respectively. It reported net income for those years in the amounts of $ 127,433.84 and $ 114,967.81, respectively. As a result of the adjustments made by respondent, petitioner's net income for 1937 was determined to be $ 281,135.14 and for the year 1938, a loss of $ 28,929.66. OPINION. At December 31, 1937, petitioner was obligated under 73 contracts for March delivery of hides. The said contracts *602 had been sold during the taxable year and, on the basis of market prices existing at December 31, 1937, could have been closed on that date at a profit to the petitioner of $ 153,656. They were not closed until some time in 1938, but in determining the deficiency herein, the respondent has included as income to the petitioner in 1937 the gain which would have been realized if the contracts had been closed on December 31. Such action is explained in his deficiency notice as follows: (a) Your method of accounting, by deducting unrealized losses in your inventories through pricing them at cost or market whichever is lower, and not including unrealized*90 gains on open short sales contracts in income at the end of the year, does not reflect correct income. The income reported on your 1937 income tax return is, therefore, adjusted under section 22 (c) of the Revenue Act of 1936 by allowing unrealized losses to be deducted through the pricing of inventories at cost or market whichever is lower, and including in income unrealized gains on all short sales at the end of the year. Generally speaking, appreciation in the value of property, or, to state it differently, unrealized profit thereon, is not taxable. The gain or profit must be realized. Eisner v. Macomber, 252 U.S. 189; Merchants Loan & Trust Co. v. Smietanka, 255 U.S. 509; Lucas v. North Texas Lumber Co., 281 U.S. 11. Also as a general proposition, we think it may be safely said that in the case of a short sale no profit or loss is realized or sustained "until by the covering purchase the obligation of the short sale is discharged." Robert W. Bingham, 27 B. T. A. 186. See also H. S. Richardson, 42 B. T. A. 830;*91 Arthur S. Kleeman, 35 B. T. A. 17; Frances Bartow Farr, Executrix, 33 B. T. A. 557. In the instant case, the transactions in question were short sales of futures contracts, not closed until the following year, and the $ 153,656 added to income was the amount of gain which would have been realized if the contracts had been closed on the last day of the taxable year, and not only has the respondent in his determination of the deficiencies herein classified the said item of $ 153,656 as unrealized profit, but in his answer he has admitted the truth of an allegation to that effect in the petition. If therefore the respondent is to prevail, justification for his determination must be found as an exception to or outside the general propositions stated. Section 22 (c) of the Revenue Act of 1936, 1 the act here applicable, supplies or permits one exception to the general rule that only realized gains and losses are to be taken into account in determining the income of a taxpayer, and it was under that section that the respondent determined that the $ 153,656 of unrealized profits on the 73 short sales, as *603 of December*92 31, 1937, should be taken into income to offset the unrealized loss on the physical hide inventory. That section permits the use of inventories in determining income, but provides that both the use and basis for taking inventories shall be as prescribed by the respondent with the approval of the Secretary of the Treasury. In his regulations, article 22 (c)-1 of Regulations 94, the respondent has provided that "inventories at the beginning and end of each taxable year are necessary in every case in which the production, purchase, or sale of merchandise is an income-producing*93 factor. * * * Merchandise should be included in the inventory only if title thereto is vested in the taxpayer. Accordingly, the seller should include in his inventory goods under contract for sale but not yet segregated and applied to the contract and goods out upon consignment, but should exclude from inventory goods sold, title to which has passed to the purchaser. A purchaser should include in inventory merchandise purchased, title to which has passed to him, although such merchandise is in transit or for other reasons has not been reduced to physical possession, but should not include goods ordered for future delivery, transfer of title to which has not been effected." In article 22 (c)-2, it is provided that the inventory used "must conform as nearly as may be to the best accounting practice in the trade or business, and * * * must clearly reflect the income." One basis of valuation acknowledged by the regulation for taking inventories is cost or market whichever is lower. The respondent argues that the petitioner's dealings in futures were hedges and, as such, a form of insurance against loss on its physical inventories, and that he is accordingly justified, under section*94 23 (f) of the act, 2*96 in applying the profit on the 73 short sales herein to offset the unrealized loss reflected by petitioner's closing inventory. He also relies on section 41 of the statute 3 as authority for his action herein. Considering the structure of the statute and the fact that section 23 (f) appears as one part of that section providing for deductions against gross income, while inventories are used as one step in determining the *604 amount of gross income, namely, for the purpose of determining the cost of goods sold, there would seem to be good ground for concluding that the insurance referred to in section 23 (f) has to do with the determination of the amount, if any, of realized losses allowable as deductions from gross income and has no application or part in the determination of gross income. Whatever the theorizing, however, the practical effect of the respondent's action in offsetting the unrealized profit on the 73 short sales against the unrealized loss on hides actually on hand was exactly the same as if the petitioner's method of inventories had been changed from cost or market, whichever was lower, to market, by including the 73 short sales contracts*95 as if they were hides purchased at December 31, 1937, prices but having a market value on that date, for inventory purposes, equal to the prices at which the contracts had previously been sold. Obviously the treatment for inventory purposes of contractual obligations for the future delivery of hides not then owned, as hides currently owned, would be in direct conflict with the requirement in article 22 (c)-1 above that only merchandise the title to which is vested in the taxpayer may be included in inventory. Further, it would seem that if the respondent is sound in his view that petitioner's dealings in futures constituted a form of insurance against unrealized losses in petitioner's physical inventory, there is palpable error in his determination of the amount of such insurance available at December 31, 1937, in that he has taken into account only those transactions in futures contracts which as of that date reflected a profit and has failed to take into account both short and long transactions in respect of which the market had gone against the petitioner. The respondent seeks to justify his action above by comparing the dealings of petitioner with those of cotton and grain dealers and by calling attention to certain of his own rulings which, in their case, permit adjustments somewhat similar to those made by him in determining the deficiencies here. 4*97 There are several distinctions, however, between the situations dealt with in the case of cotton and grain dealers were to bring all elements, including futures contracts, whether shown in S. M. 5693 and G. C. M. 17322, wherein it appears that the accounting practice consistently followed by the cotton and grain dealers was to bring all elements, including futures contracts, whether long or short, and the physical items on hand to market at the close of the year and not to cost or market, whichever was lower, as did the petitioner. In approving, in the case of cotton and grain dealers, the application of unrealized gains and losses in futures contracts against unrealized gains and losses disclosed by physical inventories, taken in *605 every instance at the market, it was held that such "dealers should incorporate in their balance sheets at the close of the taxable year at market such open futures contracts to which they are parties as are hedges against actual spot or cash transactions or against forward sales or purchases, as the case may be; provided, that no purely speculative transactions in futures not offset by actual spot or cash transactions*98 or concurrent forward purchases or sales may be so included or taken into the taxpayer's account in any manner until such transactions are actually closed by liquidation." First, it is to be noted that the petitioner took its physical inventory not at market, as the cotton and grain dealers did, but at cost or market, whichever was lower, and the respondent has at no time made any claim that the petitioner's basis for taking inventory should be changed. Secondly, petitioner's transactions in futures contracts were not against "actual spot or cash transactions or against forward sales or purchases." It is true that in some instances a short sale may have operated as insurance against loss on surplus physical inventories, but there were no matched transactions nor *99 the earmarking of such sales against any specified hides or lots of hides, and, as stated in G. C. M. 17322, supra, "it is impossible to ascertain the extent to which gains or losses on open hedges should be reflected in income at the close of the accounting period to offset or nullify the profits or losses in inventory due to market fluctuations where the inventory is taken at cost or market, whichever is lower." In G. C. M. 17322, supra, the General Counsel ruled, in the case of a textile manufacturer which consistently based its inventory of cotton on cost or market, whichever was lower, as did the petitioner, that "The general accounting practice generally in use in that industry reflects gains and losses from hedging transactions only to the extent realized by those closed out within the accounting period. Separately considered, that treatment of such items is correct, for, as indicated above, the losses are not incurred expense and the gains are not accrued income, as the case may be, until the hedges are closed out." While as noted above the short sales of futures contracts did in some instances have the effect of a hedge against loss in physical*100 inventories on hand, such result was general and incidental when considered in connection with the petitioner's operations as a whole. To a large extent, purchases of futures contracts were made not because of anticipated fluctuations in the market, but for the purpose of assuring the petitioner of a sufficient supply of hides of the grade and quality desired and needed to meet the demands of its customers in the future. It also appears that one motive for dealing in hide futures was the hope of realizing a profit through such trading, just as in transactions in the physical hides themselves. It is thus apparent that the case of the petitioner is distinguishable from and not comparable *606 to that of the cotton and grain dealers dealt with in the above rulings. We find no basis in the statute, the decisions of the courts, or the regulations or rulings of the respondent himself to sustain his action in including in the petitioner's income for 1937 the unrealized profit on the 73 short sales of futures contracts, and petitioner's claim of error is accordingly sustained. Under the rules of the Commodity Exchange, the deposit of $ 600 as margin was required on each and every *101 futures contract bought or sold. Adjustments giving effect to market fluctuations were made at the close of each business day in the account of each "clearing member" and such members were required to put up additional margin or draw down excess margin, as the case might be, so as to maintain the margin on each contract at $ 600. Such deposits and withdrawals by the petitioner were entered on its books in an account entitled "Variation Margin Account." This account was in the nature of a suspense account and no amounts were closed from it into profit and loss until the various futures transactions were closed on the exchange and the profit or loss from the purchase or sale of the particular contract or contracts was actually realized. When the contracts were so closed on the exchange, any profit or loss therefrom standing in the suspense account was closed into the petitioner's profit and loss account. At December 31, 1937, the "Variation Margin Account" disclosed a net balance in favor of petitioner, in the amount of $ 130,493.12. On brief and in the alternative, the respondent for the first time contends that this net balance represents income actually realized by the petitioner*102 in 1937 on its futures transactions which remained open at the close of the year and that the said amount should be included in petitioner's income in determining the controversy herein. The respondent's determination, as indicated by his notice of deficiency, included only the unrealized profit as of the close of the taxable year on 73 of the futures contracts which had been sold by petitioner during the taxable year and which remained open at the end of the year. The rationale of the determination was that these short sales were directly related to the physical inventories and that under section 22 (c), supra, of the statute, which governs the use of inventories in determining income, it was proper to offset the unrealized profit on short sales of futures contracts against any unrealized losses indicated by the physical inventories. The questions of both law and fact raised by the alternative contention are basically different from the questions raised by the respondent's determination and pleadings herein. The claim now advanced relates to all futures contracts and neither the petitioner's inventories nor the basis or method of taking them is in any way involved. It assumes*103 as a factual basis that there was during *607 the year a net of excess margin withdrawn over margin deposited and concludes that such net withdrawals constituted realized income, under Brown v. Helvering, 291 U.S. 193, and North American Oil Consolidated v. Burnet, 286 U.S. 417, even though the futures transactions did not in and of themselves become completed transactions on which gain or loss might be computed until they were closed. If the respondent desired to charge the petitioner with liability based on the claim now made, two courses were open to him: first, through his determination of the deficiencies herein, and, second, by affirmative allegation in his answer. He has taken neither course, and may not prevail on an issue which, under the statute and our rules of procedure, is not properly before us. Furthermore, even though the issue had been properly and timely raised by the respondent in his answer, we should not on the record before us be able to resolve the issue in his favor. In such case, the burden of proof would have been on him, and, even though we assume the correctness of his premise*104 that a net of margin withdrawals over total margin deposits would, under the cases cited, constitute realized income, the record would not justify a conclusion of fact that the $ 130,493.13 net balance shown in the "Variation Margin Account" was the true net of such withdrawals, since we should be unable to conclude without further evidence that the original margin of $ 600 deposited on each futures contract was entered in the "Variation Margin Account" and taken into account in computing the net balance in question; and for the further reason that there is some indication in the testimony that the net balance shown in the account did include or may have included withdrawals by the petitioner on the contracts of various of its customers for whom it dealt. Decision will be entered under Rule 50. Footnotes 1. SEC. 22. GROSS INCOME. * * * * (c) Inventories. -- Whenever in the opinion of the Commissioner the use of inventories is necessary in order clearly to determine the income of any taxpayer, inventories shall be taken by such taxpayer upon such basis as the Commissioner, with the approval of the Secretary, may prescribe as conforming as nearly as may be to the best accounting practice in the trade or business and as most clearly reflecting the income.↩ 2. SEC. 23. DEDUCTIONS FROM GROSS INCOME. * * * * (f) Losses by Corporations. -- In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.↩ 3. SEC. 41. GENERAL RULE. The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer's annual accounting period is other than a fiscal year as defined in section 48 or if the taxpayer has no annual accounting period or does not keep books, the net income shall be computed on the basis of the calendar year. (For use of inventories, see section 22 (c).)↩ 4. A. R. M. 100 (1920), C. B. No. 3, p. 66; A. R. M. 135 (1921), C. B. No. 5, p. 67; S. M. 5693 (1927), C. B. V-2, p. 20; G. C. M. 17322 (1936), C. B. XV-2, p. 151; G. C. M. 18383↩, C. B. 1937-2, p. 244.