Fulton Bag & Cotton Mills v. Commissioner

Fulton Bag & Cotton Mills, Petitioner, v. Commissioner of Internal Revenue, Respondent Fulton Bag & Cotton Mills v. Commissioner Docket Nos. 43796, 48383 United States Tax Court 22 T.C. 1044; 1954 U.S. Tax Ct. LEXIS 125; August 11, 1954, Filed August 11, 1954, Filed *125 Decision in Docket No. 43796 will be entered under Rule 50. Decision in Docket No. 48383 will be entered for the respondent. Held, petitioner's transactions in cotton futures contracts during the years involved were directly related to its business of manufacture and sale of cotton bags; were entered into by petitioner for the sole purpose of providing insurance against the possibility of market decline in the value of its inventory of raw cotton, of goods in process, and of finished goods unsold; and constituted hedging transactions rather than speculation. The losses sustained by petitioner as a result thereof are deductible in full as ordinary losses or as cost of goods sold. Norman D. Cann, Esq., and Bernard J. Long, Esq., for the petitioner. Newman A. Townsend,*126 Jr., Esq., and H. E. Kelly, Esq., for the respondent. Van Fossan, Judge. VAN FOSSAN *1044 Respondent determined deficiencies in income and excess profits taxes of petitioner as follows: Fiscal year Docket No. ended Tax Deficiency November 30 43796 [1946] Income $ 46,027.78 Excess profits 4,110.20 [1947] Income 143,591.76 48383 [1948] Income 6,359.77 [1949] Income 5,805.59 Petitioner has acquiesced in certain of the adjustments made by respondent in his determinations. The controversy in Docket No. 43796 involves the question of whether the losses sustained by petitioner from transactions in cotton futures during its fiscal years ended November 30, 1946, and November 30, 1947, respectively, are deductible as ordinary losses or as cost of goods sold. Respondent disallowed the deduction of such losses as ordinary losses or as cost of goods sold, but having determined that they represented capital losses allowed petitioner *1045 a carry-over to its fiscal years ended November 30, 1948, and November 30, 1949. In its original petition to this Court, which petition was docketed as No. 43796, petitioner sought review only as to the fiscal years*127 ended November 30, 1946, and November 30, 1947. As a protective measure, respondent then made a second and alternative determination as to petitioner's fiscal years ended November 30, 1948, and November 30, 1949, which determination is inconsistent with his first in that respondent therein takes the opposite view and disallows the capital loss carry-overs previously allowed. This second determination forms the basis for the petition in Docket No. 48383. The parties are in agreement that if the losses involved are allowable as ordinary losses or as cost of goods sold in fiscal years 1946 and 1947, no capital loss carry-overs are allowable to fiscal years 1948 and 1949; or, conversely, if such losses represent capital losses and respondent's original determination in Docket No. 43796 is sustained, then and in that event, his determination in Docket No. 48383 will be reversed. FINDINGS OF FACT. The stipulation of facts filed by the parties with the exhibits attached thereto, is, by this reference, made a part of these findings. The petitioner is Fulton Bag & Cotton Mills, a corporation organized under the laws of the State of Georgia. Petitioner keeps its records and files its returns*128 on the basis of a fiscal year ended November 30. The returns for the years here involved were filed with the collector of internal revenue for the district of Georgia. Petitioner is engaged in the manufacture and sale of a wide variety of paper, burlap, and botton bags. Its principal office and its cotton mills are located at Atlanta, Georgia. It has seven additional bag factories at New Orleans, Louisiana; Dallas, Texas; Los Angeles, California; Denver, Colorado; Kansas City, Kansas; St. Louis, Missouri; and Minneapolis, Minnesota. The petitioner has a purchasing office in New York, New York. It also has warehouses in Phoenix, Arizona; Winter Haven, Florida; and Memphis, Tennessee. Petitioner manufactures the major portion of the cotton cloth which it uses to make its bags and other products. In addition, it purchases some cotton goods for the manufacture of its bags. For the taxable years ended November 30, 1946, to November 30, 1949, inclusive, petitioner's inventories of raw cotton and the cotton content of its goods in process and finished goods which it manufactures were maintained on the last-in, first-out, or so-called Lifo method, pursuant to section 22 (d) of the *129 Internal Revenue Code. The purchased cotton goods inventories were maintained on the first-in, first-out, or Fifo inventory method. The petitioner's inventories of raw cotton and cotton content of its goods in process and finished goods which were maintained on the *1046 Lifo inventory method for income tax purposes totaled 45,702 bales at November 30, 1945, and 47,448 bales at November 30, 1946. The cost per pound at which these inventories were valued under the Lifo method was substantially below the price at which spot cotton was selling in October and November of 1946. In the fall of 1946, petitioner's management became concerned as to the amount of cotton which the company held at the risk of the market, including raw cotton and the cotton content of goods in process, finished goods, and purchased goods. There was a feeling within the management in October 1946, that the current market price of cotton was too high, had reached a level where there was little likelihood of its advancing further, and that it probably would decline. The cotton content of the company's products varies. In general, it is equal to approximately one-half of the cost of the finished product. *130 As a result, there is a varying relationship between the selling price of the finished product and the market price of raw cotton. In fixing the selling price of its products, the company maintained branch price lists, showing the prices at which the various lines of products would be charged to the company's branch houses. These price lists are modified from time to time to reflect major changes in the market. The branches mark up the list prices an average of from 15 to 18 per cent upon sale to the public. Because of their views as to the market price of cotton, petitioner's management was of the opinion that with approximately 45,000 bales at market risk, its position was precarious and that it had entirely too much at risk. It was decided to hedge by entering into cotton futures contracts as the only practical method, in the opinion of its management, to protect petitioner against market decline. Cotton futures contracts entered into on the cotton exchanges are contracts for the purchase and sale of cotton for delivery during a future delivery month. The contracts are in units of 50,000 pounds, which is 100 bales, and are for basis middling grade, 15/16-inch staple cotton, *131 with delivery to be made at certain designated places. Delivery may be made in certain grades and staples other than basis middling grade, 15/16-inch staple, with a corresponding adjustment of the purchase price. Grades below low middling are not tenderable under the contracts. In order to satisfy the terms of the contract, a party who has entered into a futures contract of sale may make delivery or he may purchase an offsetting contract through a broker on the exchange. Delivery notices are issued on the 16th and delivery must be made by the 25th of the delivery month called for under the contract. Petitioner never considered making actual delivery of cotton on any of its futures contracts. It is customary within the industry to satisfy or close out a cotton futures contract by buying an offsetting contract in lieu of making actual delivery. *1047 During the period from October 11, 1946, to November 21, 1946, petitioner, through its brokers, entered into futures contracts of sale of cotton for the delivery months of May and July 1947 on the New York and New Orleans Cotton Exchanges in the amount of 21,400 bales. Of the contracts totaling 21,400 bales, 11,200 bales thereof*132 represented futures contracts which were sold concurrently with the purchase of a like amount of actual or spot cotton. The remaining 10,200 bales were contracts which the petitioner, beginning on October 23 and continuing through November 8, placed with its brokers at the rate of 1,000 bales per day. The contracts were sold in accordance with petitioner's instructions except where the exchange closed on certain days after price fluctuations reached the permissive limit under Federal statutes and the regulations of the exchanges. It was the intention of petitioner's management at the time it started selling the cotton futures contracts to reduce the amount of cotton held at market risk to approximately 20,000 to 22,000 bales. During the period the cotton futures contracts were outstanding, petitioner maintained a running record of its net long position known as the cotton condition statement. This statement showed, in terms of bales of cotton, the raw cotton in warehouses and the cotton equivalent or content of goods in process and finished goods, as of October 12, less the futures contracts outstanding on that date. The net long position on October 12 was 45,227 bales. For *133 the succeeding days on which statements were made, there were added to the previous day's balance the cotton and cotton goods purchased on that day, and there were subtracted sales of finished products and sales of futures contracts. When, during the period, cotton futures contracts were closed out, the number of bales of the contracts closed out was added to the net long position. The resulting balances showed the company's net long position and represented the amount of cotton which the company held at market risk on that particular date. By the sale of the 21,400 bales of futures contracts petitioner reduced its net long position to approximately 23,000 bales. During the period in which the cotton futures contracts were sold, there was a substantial decline in the market price of cotton. The futures contracts were sold at prices ranging from a high of approximately 37 1/2 cents per pound to a low of approximately 26 1/2 cents per pound. During the last half of November there was a recovery in the price of July contracts to around 27 to 28 cents. On November 26, 1946, petitioner closed out 300 bales, and on November 29, 500 bales, of its futures contracts, by the purchase of*134 offsetting contracts. These transactions resulted in a loss of $ 9,446.04. The 800 bales of futures contracts were closed out upon the sales of finished goods made on November 22, 25, and 27, in the amount of 802 bales and maintained the company's net long position at a level *1048 of approximately 22,500 bales. From November 29, 1946, to January 15, 1947, no futures contracts were closed and petitioner's net long position declined from approximately 22,500 bales on November 29, 1946, to approximately 21,500 bales on January 15, 1947. During the same period, the price of July contracts had fluctuated from 28.4 cents per pound on November 30, 1946, to a high of 31.4 cents on December 26, 1946, and back to 28.4 cents on January 15, 1947. On January 16 and 17, 1947, petitioner closed out 5,000 bales of its futures contracts by the purchase of offsetting contracts. These transactions resulted in a net gain of $ 163,625. The closeout of the 5,000 bales of futures raised the petitioner's net long position to approximately 26,000 bales on January 17. Its position was again reduced to approximately 22,500 bales by actual sales of finished goods by January 31. On May 28, 1947, *135 petitioner closed out 600 bales of its futures contracts by the purchase of offsetting contracts. These transactions resulted in a net loss of $ 22,229.06. The 600 bales of futures were closed out concurrently with the sale of a like amount of raw cotton on the same day. During the period from January 15, 1947, to May 29, 1947, the price of July contracts advanced from approximately 28 cents to approximately 34 cents per pound. The price of July contracts continued to rise during June and was around 36 3/4 cents on June 19. From January 18, 1947, through May 26, 1947, the petitioner had 15,600 bales of futures contracts outstanding. It purchased no offsetting futures contracts during this period. From May 29, 1947, to June 18, 1947, it had 15,000 bales of futures contracts outstanding. It purchased no offsetting futures contracts during this period. The futures contracts for 15,000 bales which petitioner had outstanding on June 18 were all for the delivery month of July. Petitioner would have had to deliver actual cotton in satisfaction of these contracts or alternatively it would have had to purchase an equivalent amount of contracts during July to offset those outstanding. *136 If it had desired to continue its position in the futures market, it could have purchased July contracts and sold contracts for the delivery month of December or some other future month. During the period from June 19, 1947, to July 7, 1947, petitioner closed out the remaining 15,000 bales of its futures contracts by the purchase of offsetting contracts. These transactions resulted in a net loss of $ 533,931.47. The total net loss for the fiscal year ended November 30, 1947, was as follows: Loss on 600 bales May 28, 1947 $ 22,229.06 Loss on 15,000 bales June 19 to July 7, 1947 533,931.47 556,160.53 Less gain on 5,000 bales January 16 and 17, 1947 163,625.00 Net loss for fiscal year 1947 $ 392,535.53 *1049 At all times during the period during which the cotton futures contracts were outstanding, petitioner had on hand actual raw cotton in bales in excess of the cotton futures contracts outstanding. The following schedule shows petitioner's cotton inventory, outstanding cotton futures sold, net long position, and the price of July futures on the various dates indicated: Cotton in warehouse, Prices of Date cotton in Outstanding July process, futures Net long futures and (Sold) position (Per lb.) finished goods Oct. 12, 1946 46,427 1,200 45,227 Oct. 25, 1946 42,326 8,200 34,126 $ 0.3140 Nov. 1, 1946 40,959 12,000 28,959 0.3000 Nov. 4, 1946 42,623 15,000 27,623 0.3007 Nov. 8, 1946 40,756 17,400 23,356 0.2812 Nov. 15, 1946 41,139 18,400 22,739 0.2860 Nov. 19, 1946 43,081 20,400 22,681 0.2850 Nov. 21, 1946 43,994 21,400 22,594 0.2755 Nov. 25, 1946 43,562 21,100 22,462 0.2835 Nov. 29, 1946 43,239 20,600 22,639 0.2862 Dec. 6, 1946 43,100 20,600 22,500 0.2835 Dec. 20, 1946 42,447 20,600 21,847 0.3080 Jan. 16, 1947 42,024 17,600 24,424 0.2839 Jan. 17, 1947 41,692 15,600 26,092 0.2853 Feb. 4, 1947 37,713 15,600 22,113 0.2939 Feb. 25, 1947 33,783 15,600 18,183 0.3121 Mar. 7, 1947 31,832 15,600 16,232 0.3174 Mar. 25, 1947 31,357 15,600 15,757 0.3371 Apr. 9, 1947 31,705 15,600 16,105 0.3289 Apr. 23, 1947 33,306 15,600 17,706 0.3403 May 2, 1947 32,621 15,600 17,021 0.3359 May 20, 1947 31,367 15,600 15,767 0.3443 June 4, 1947 29,264 15,000 14,264 0.3472 June 18, 1947 27,886 15,000 12,886 0.3683 June 20, 1947 27,704 7,200 20,504 0.3662 June 27, 1947 26,878 2,200 24,678 0.3753 June 30, 1947 26,210 1,700 24,510 0.3762 July 3, 1947 26,134 [200] 25,934 0.3720 July 9, 1947 24,738 [0] 24,738 0.3818 July 15, 1947 22,647 [0] 22,647 0.3898 *137 The petitioner purchased bales of spot cotton in its fiscal years ended November 30, 1946, and November 30, 1947, as follows: Fiscal year ended November 30 [1947] December [19] January 1,054 [100] February 9,400 March 7,800 5,100 April 9,800 2,800 May 1,201 [109] June [502] July 2,342 August September 6,000 1,750 October 5,200 10,520 November 6,553 1 14,575 Totals 49,871 34,954 *1050 In its manufacturing, petitioner normally uses about 50,000 bales of raw cotton a year. It normally buys cotton goods from other mills representing about 35,000 to 45,000 bales. Petitioner needs between 30,000 and 35,000 bales in the operation of its mills. Prior to the transactions in October and November 1946, the petitioner had traded in cotton futures only on isolated and infrequent occasions. It had not followed a practice of selling futures when it bought spot cotton. It had followed a practice of purchasing cotton on call. Under this method the petitioner agreed to purchase cotton from a shipper for delivery subject to the petitioner's*138 call, the price paid to be the price on the date of call. The shipper protects himself by hedging on the exchange. The petitioner has purchased a large amount of cotton on call since 1947 but has not dealt in futures contracts to any substantial extent. The petitioner claimed a deduction in the full amount of $ 9,446.04 on its income tax return for the fiscal year ended November 30, 1946, because of its loss on closing out futures contracts. The respondent disallowed the loss as an ordinary deduction and allowed the $ 9,446.04 as a capital loss in reduction of the capital gain realized by the petitioner in that year. The petitioner claimed the $ 392,535.53 loss on futures contracts in its fiscal year ended November 30, 1947, as a part of the cost of goods sold and deducted it from gross receipts in the computation of gross income. The respondent, in the notice of deficiency in Docket No. 43796, disallowed the loss as an ordinary loss and allowed $ 127,263.27 thereof as a capital loss for the fiscal year ended November 30, 1947. A capital loss carry-over to the fiscal year ended November 30, 1948, was allowed in the amount of $ 25,439.08, and a capital loss carry-over to the *139 fiscal year ended November 30, 1949, was allowed in the amount of $ 23,222.37. In addition to, and based upon, the foregoing, we make the following ultimate finding of fact: Petitioner's transactions in cotton futures contracts during the period here involved were directly related to its business of the manufacture and sale of cotton bags, and were entered into by petitioner for the sole purpose of providing insurance against the possibility of market decline in the value of its inventory of raw cotton, of goods in process, and of finished goods unsold. They constituted hedging transactions rather than speculation. OPINION. The question presented in Docket No. 43796 is whether the losses sustained by petitioner during its fiscal years ended November 30, 1946 and 1947, respectively, on its transactions in cotton futures are deductible in full as ordinary losses or as cost of goods sold. The parties are agreed that such question is to be answered in the *1051 affirmative, if, as contended by petitioner, the losses were a result of bona fide hedging operations; whereas, if such losses were sustained from speculating in cotton futures, they are deductible only as capital losses *140 as originally determined by respondent. This agreement is consistent with the rationale of such cases as Stewart Silk Corporation, 9 T. C. 174; Estate of Dorothy Makransky, 5 T. C. 397, affd. 154 F. 2d 59; Kenneth S. Battelle, 47 B. T. A. 117; Ben Grote, 41 B. T. A. 247; and Commissioner v. Farmers & Ginners Cotton Oil Co., 120 F. 2d 772, reversing 41 B. T. A. 1083, certiorari denied 314 U.S. 683. See also G. C. M. 17322, XV-2 C. B. 151. Petitioner's position is that its transactions in cotton futures contracts were directly related to its business of manufacture and sale of cotton bags; were entered into as a method of insuring itself against possible market decline in the value of its inventory of raw cotton, goods in process, and unsold finished goods; and that such transactions constituted true hedging transactions rather than speculation. Respondent argues, on brief, that petitioner had no risk against which to hedge*141 since it valued its inventory on the so-called Lifo method and intended the continued use of such method and the maintenance of a constant physical level of closing inventory each year; and that, ergo, petitioner's transactions in cotton futures were not true hedges, but to the contrary, were sheer speculation. Reduced to its essence, respondent's contention, as we understand it, is that any taxpayer regularly employing the so-called Lifo method, which taxpayer also intends to, and does, in fact, maintain a constant level of closing inventory each year, by reason thereof, stands no risk of ever sustaining a business loss caused by fluctuation of the market, and that any transactions by such a taxpayer in futures of the commodity in which it regularly deals must a fortiori be speculation. We agree neither with respondent's conclusion nor with the premise upon which it is based. The so-called Lifo method is merely an accounting procedure employed in computing the value of the closing inventory of a taxpayer for tax purposes. This method is designed to prevent the reflection and consequent recognition as profit of an appreciation in the value of merchandise during the taxable*142 year. Conversely, it likewise prevents such reflection and recognition of a depreciation therein. In application, where a taxpayer ends the year with the same level of inventory with which it began, the so-called Lifo method, it is true, would not reflect a loss, nor for that matter a gain, upon the user's books of account. But, it does not logically follow that a gain or loss may not, in fact, have actually been realized by such taxpayer. All of which is to say that the Lifo method is no guarantee against the hazards of business, and the use thereof does not, in and of itself, *1052 insure the user against the realization of an actual gain or loss. This is true, whether or not a constant level of inventory is maintained. The method of accounting employed by a taxpayer has no bearing whatever upon, and, in fact, is an irrelevant factor in determining whether certain transactions on the commodities market constitute a true hedge. See also G. C. M. 17322, supra. Moreover, this conclusion appears to be in accord with respondent's own recognition of the use of true hedges by a taxpayer which employs the Lifo method. See Regs. 111, sec. 29.22(d)-1. *143 Whether or not petitioner's transactions in cotton futures during the years before us constituted true hedges is a question of fact to be resolved from those appearing on the present record. The term "hedge" is elusive and incapable of being defined with exactness and precision, Kenneth S. Battelle, supra. The Court of Appeals for the Sixth Circuit in Commissioner v. Farmers & Ginners Cotton Oil Co., supra, gave as a broad definition thereof the following: A hedge is a form of price insurance; it is resorted to by business men to avoid the risk of changes in the market price of a commodity. The basic principle of hedging is the maintenance of an even or balanced market position. * * * But, as was pointed out in Kenneth S. Battelle, supra, at page 126: This description of hedging is not sufficiently detailed and exclusive to be used as a complete guide in all factual inquiries without the addition of such further necessary and material qualifications as the facts of the individual case require. Thus, although the maintenance of a balanced or even market position is contemplated and*144 constitutes the very essence of hedging, Stewart Silk Corporation, supra, nevertheless, a true hedge becomes nonetheless a true hedge because the futures transactions are not concurrent with spot transactions. G. C. M. 17322, supra. Nor is a true hedging transaction converted into a speculative one by the failure of the hedger to close out its futures contracts simultaneously with the sale of its spot goods. It is sufficient that such closeout transactions take place within a reasonable time following the elimination of the risk factor; and where, as here, the hedger closes out its futures contracts within the same taxable period as the sale of the spot goods takes place, we believe such closing transaction to be within a reasonable time. Furthermore, the fact that the taxpayer had never before or since entered into a hedging transaction is not conclusive of whether the ones in the taxable years under review constituted bona fide hedging or merely speculation. Cf. also Stewart Silk Corporation, supra. We have viewed the facts on the present record in light of the foregoing definition handed*145 down in the Farmers & Ginners Cotton Oil Co. case, making such "* * * further necessary and material qualifications * * *" as such facts require, see Kenneth S. Battelle, supra, *1053 and have concluded that the futures transactions entered into by petitioner during the fiscal years involved were true hedging operations to insure it against the risks of the cotton market. We have so found as a fact, and here hold, that the losses sustained by petitioner as a result thereof are deductible in full as ordinary losses or as cost of goods sold. In view of the stipulation of the parties set forth above, such holding renders consideration of the question presented in Docket No. 48383 unnecessary. Decision in Docket No. 43796 will be entered under Rule 50. Decision in Docket No. 48383 will be entered for the respondent. Footnotes 1. This item includes at least 10,000 bales represented by warehouse receipts which were sold in December 1947.↩