Canister Co. v. Commissioner

The Canister Company, Petitioner, v. Commissioner of Internal Revenue, Respondent Canister Co. v. Commissioner Docket No. 5895 United States Tax Court 7 T.C. 967; 1946 U.S. Tax Ct. LEXIS 57; October 16, 1946, Promulgated *57 Decision will be entered under Rule 50. Issue 1. -- Held, that advance payments by the Government to petitioner under contracts for the manufacture and delivery of machinery were not outstanding indebtedness evidenced by a bond within section 719 (a) (1) of the Internal Revenue Code and were properly excluded from borrowed capital for purposes of computing the excess profits credit under section 712 (a). Issue 2. -- Held, that a reasonable salary allowance for petitioner's president was the entire sum deducted. Thomas N. Tarleau, Esq., Sandow Holman, Esq., and Jacob Blecheisen, Esq., for the petitioner. Robert S. Garnett, Esq., and A. H. Monacelli, Esq., for the respondent. Harron, Judge. HARRON *967 The respondent has determined a deficiency in income tax for the year ended April 30, 1942, in the amount of $ 3,951.71; and deficiencies in excess profits tax for the years ended April 30, 1941, and April 30, 1942, in the respective amounts of $ 3,011.88 and $ 60,571.29. Petitioner has abandoned several of its allegations of error. Only two questions remain for decision, and both issues relate to petitioner's liability for income and excess profits*58 taxes for the fiscal year ended in 1942. The first question is whether petitioner, for the fiscal year ended April 30, 1942, has computed properly the amount of the excess profits credit allowed by section 712 (a) of the Internal Revenue Code, based upon invested capital, secs. 714, 715, 716, 717. The parties are agreed upon the amount of petitioner's equity invested capital, sec. 718. The issue arises out of conflicting contentions about petitioner's daily invested *968 capital, sec. 717. Petitioner included in its invested capital certain amounts which it claimed represented "borrowed invested capital," and which respondent determined did not constitute borrowed capital within the intent and meaning of section 719 (a) (1). Petitioner, as contractor, had contracts with the United States Government to manufacture for and sell to the Government certain machinery, under which contracts the Government made advance payments of the contract prices to facilitate petitioner's performance of its contracts. The question is whether these advance payments which were made by the Government were borrowed capital, as defined by section 719 (a) (1). Petitioner alleges that the advance*59 payments under the Government contracts represented outstanding indebtedness evidenced by a bond, and respondent denies this allegation. The second question is whether petitioner is entitled, under section 23 (a) (1) (A), to a deduction of $ 18,200 in computing its net income for the fiscal year ended April 30, 1942, as a reasonable allowance for the salary of its president. Respondent determined that $ 10,200 was reasonable compensation and disallowed $ 8,000 of the deduction. Petitioner filed its several returns with the collector for the fifth district of New Jersey. FINDINGS OF FACT. Petitioner, a New Jersey corporation, having its office at Phillipsburg, New Jersey, conducts a business made up of two divisions -- the designing and manufacture of fiber bodied, custom made containers for packaging dry and liquid products, and the designing and manufacture of automatic machinery for the loading and assembling of ammunitions and of special purpose machinery for commercial use. Petitioner keeps its books and reports income on the accrual method of accounting. The president and sole stockholder of petitioner is R. T. Garfein, who organized petitioner in 1924. Issue 1. -- On August*60 7, 1941, petitioner, as contractor, entered into a written contract with the Government of the United States for the manufacture and delivery by petitioner to the Navy Department of certain machinery for the loading of ammunition, for the total contract price of $ 1,866,235. The contract provided for payments of the contract price and for advances to the contractor to facilitate the performance of the contract, as follows: Article 8. Payments. -- The contractor shall be paid, upon the submission of properly certified invoices or vouchers, the prices stipulated herein for articles delivered and accepted or services rendered, less deductions, if any, as herein provided. Unless otherwise specified, payments will be made on partial deliveries *969 accepted by the Government when the amount due on such deliveries so warrants; or, when requested by the contractor, payments for accepted partial deliveries shall be made whenever such payments would equal or exceed either $ 1,000 or 50 per cent of the total amount of the contract. * * * * Advance Under the Authority of the Act of 28 June 1940. -- The Government agrees to advance to the contractor a sum not to exceed 30 per *61 cent of the contract price, * to facilitate the performance of the contract and the delivery of the automatic loading equipment. The funds required for this purpose will be advanced in one sum or from time to time, as requested by the contractor, provided that an advance shall be made at intervals of not less than fifteen days and only in sums and at times as required to meet payment obligations on these. The funds advanced will be liquidated by crediting 30 per cent of each payment becoming due under the contract to the advance until the full amount of the advance is liquidated. It is agreed that, in case of default by the contractor in the performance of this contract or the termination thereof, before liquidation of the advance due to causes of contractor's responsibility, the contractor shall refund to the Government upon demand a sum equal to the unliquidated advance, all other provisions of the contract and all rights of the Government to remain in full force and effect. A bond shall be furnished in a sum equal to 30 per cent of the total contract price guaranteeing the accounting for, or repayment, of the sum advanced, provided that in case of default by the contractor in the*62 performance of the contract or any termination thereof before liquidation of the advance due to causes of the contractor's responsibility, the contractor shall refund to the Government upon demand a sum equal to the unliquidated advance, all other provisions of the contract and all rights of the Government to remain in full force and effect; provided, further, that if the principal shall well and truly account for or repay the aforesaid advance payment in accordance with the terms of the contract or any modifications or agreements pertaining thereto that may have been or may subsequently be entered into, notice of such modifications to the surety being hereby waived, then the obligation under the bond to be void, otherwise to remain in full force and virtue. * * * * On August 7, 1941, the date of the execution of the contract, the Government advanced to petitioner $ 559,870.50, 30 per cent of the contract price of $ 1,886,235. On August 7, 1941 a "Performance Bond," Treasury Form No. *63 25 (Revised), in the penal sum of $ 559,900 was executed by petitioner as principal and United States Guarantee Co. as surety to the Government. The premium charged for the bond was $ 4,199.25. The bond recites, inter alia: The Condition of This Obligation Is Such, that whereas the principal entered into a certain contract, hereto attached, with the Government, dated August 7th, 1941, for Machinery, 20 Millimeter. am. per contract NOs-86604. *970 Whereas, provision is made under the contract to advance to the contractor funds in an amount equal to 30 per cent of the total contract price, subject to the stipulation that in case of default by the contractor in the performance of the contract, or any termination thereof before liquidation of the advance due to causes of contractor's responsibility, the contractor shall refund to the Government, upon demand, a sum equal to the unliquidated advance; provided, further, that in case the material covered by the said Contract NOs-86604 should not be manufactured and delivered by the principal in accordance with the provisions of the contract, and if the principal fails to reimburse the Government in the amount due in the sum or *64 sums paid by the Government to the principal, the surety on the bonds shall be liable to the Government for the amount thereof. Now Therefore, If the principal shall well and truly perform and fulfill all the undertakings, covenants, terms, conditions, and agreements of said contract during the original term of said contract and any extensions thereof that may be granted by the Government, with or without notice to the surety, and during the life of any guaranty required under the contract, and shall also well and truly perform and fulfill all the undertakings, covenants, terms, conditions and agreements of any and all duly authorized modifications of said contract that may hereafter be made, notice of which modifications to the surety being hereby waived, then, this obligation to be void; otherwise to remain in full force and virtue. * * * * The contract dated August 7, 1941, called for delivery of goods by petitioner "within 540 days after the date of the contract or order awarded on this bid." Petitioner did not make any deliveries under this contract during its fiscal year ended April 30, 1942. The contract dated August 7, 1941, provided for payment of 90 per cent of the contract*65 price of each item upon delivery, as follows: Ninety percent (90%) of the contract price of each item will be paid upon delivery of each item at its destination for installation. The final ten percent (10%) will be paid upon completion of installation, satisfactory test and acceptance of each item by the Government, including for the last item delivery by contractor of tracings of drawings, instructions, etc., required by contract specifications. A supplemental contract was executed by petitioner and the Government on March 2, 1942, for the manufacture and delivery of additional machinery for the contract price of $ 3,654,200. The Government agreed to advance to the contractor funds not to exceed 30 per cent of the contract price, under provisions in the agreement which are substantially the same as in the original contract of August 7, 1941, except that sums advanced under the supplemental contract were to be liquidated by crediting 35 per cent (instead of 30 per cent) of each payment becoming due under the contract to the advance until the full amount of the advance should be liquidated. On March 2, 1942, the Government advanced $ 1,098,260 to petitioner, which represented 30 *66 per cent of $ 3,654,200. And on March 2, 1942, petitioner, as principal, and certain corporations, as sureties, executed an "Advance Payment Bond" in the penal sum of $ 1,096,300: *971 * * * to save the Government harmless against any and all losses which may result from the failure of the Principal to liquidate or repay to the Government all or any portion of the advance payments so made; Now Therefore, if the advance payments so made are repaid to the Government or are liquidated by deductions from other payments due the Principal, or otherwise, in accordance with the terms of said contract, then this obligation to be void; otherwise to remain in full force and virtue. The machinery to be delivered under the supplementary contract was to be delivered by petitioner by February 28, 1943. Petitioner did not make any deliveries under the supplementary contract during the fiscal year ended April 30, 1942. Petitioner did not include in its gross income for the fiscal year ended April 30, 1942, any of the sums advanced by the Government under the original and the supplementary contracts; and respondent has not determined that any of such advance payments should have been included*67 in gross income. Issue 2. -- The business of petitioner is carried on in two divisions -- the fiber container designing and manufacturing division, and the machine designing and manufacturing division. Petitioner's president, R. T. Garfein, is the final authority in the management of all of the business, but each division has a chief, M. T. Cowell being in charge of the container division and Pasquale Di Cosmo being in charge of the machinery division. Both men are officers of petitioner. From 1937 through 1940, fiscal years, the salary of Garfein was $ 10,400 per year; Cowell's salary was $ 5,400 in 1941; and Di Cosmo's salary was $ 10,500. Salaries were increased for the fiscal year 1942 as follows: Garfein's salary was increased to $ 18,200; Cowell's to $ 7,100; and Di Cosmo's to $ 13,480. The increase in the salary of Garfein was made at the beginning of the 1942 fiscal year. The gross sales and net income of the business, before officer's salaries and taxes, for the fiscal years 1939, 1940, 1941, and 1942 were as follows: [1942] Sales, machinery division $ 81,769 $ 119,311 $ 189,842 $ 555,921 Sales, container division 285,699 423,577 538,486 860,945 Total gross sales 367,469 542,888 728,328 1,413,595 Net income before salaries and taxes 5,940 35,565 100,029 226,401 *68 The capital stock of petitioner is $ 250,000. The number of employees of petitioner during the years 1939 through 1942 was as follows: 1939, 147; 1940, 245; 1941, 262; 1942, 287. The fiber containers were sold to the Government and to corporations. About 70 per cent of sales of this division were to the Government and to the Picatinny Arsenal, in 1942, which purchased shell *972 containers. Commercial organizations purchased a variety of containers designed for their special products, which were designed and patented by petitioner. During the fiscal year 1942 new container designs were worked out which were sold in large quantities in later years. Garfein devoted a large part of his time to the designing of the new containers. Garfein negotiated all sales and made all sales of products of the fiber container division in the fiscal year 1942, except for $ 100,000 of sales which were made by one commission salesman, the only salesman employed by petitioner except Garfein. Garfein was responsible for fixing prices charged for containers and for purchasing raw materials. During the fiscal year 1942 the plant capacity of the container division was increased and $ 25,000 additional*69 machinery was purchased. The business of this division increased in 1942 by about $ 300,000. Hours of operations increased to a 2-shift day. The machinery division of the business increased in the fiscal year 1942 by $ 366,000. The division was enlarged in 1942 by the use of an additional building and an increase in personnel. Hours were increased in 1942 from 40 to 50 hours a week, and later to 60 hours for the day shift and 66 hours for the night shift. In 1942 this division went on a 2-shift basis. Most of the machinery produced in 1942 was sold to the War and Navy Departments. Garfein did all of the selling for this division, negotiated contracts, and fixed prices. Garfein controlled all purchases of raw materials and made the final decisions upon designs. During 1942 Garfein devoted all of his time to petitioner's business. His duties, hours, and services were increased. The salary of $ 18,200 was reasonable compensation for Garfein's services in the fiscal year of 1942. OPINION. Issue 1. -- The question under the first issue, whether the advance payments received in the taxable year under the original and supplementary contracts with the United States Government*70 constitute "borrowed capital" under the definition set forth in section 719 (a) (1) of the Internal Revenue Code, 1 requires a determination of whether there was an "indebtedness" of the petitioner "evidenced by a bond." The statute contains its own definition of indebtedness, and the facts must show that the situation of the taxpayer comes *973 within the definition. Journal Publishing Co., 3 T.C. 518, 522; Flint Nortown Theatre Co., 4 T.C. 536, 538. In construing the statute, we must follow the statutory definition of "borrowed capital." *71 The Congress restricted the definition of "borrowed capital" to an indebtedness evidenced by one of several stated documents which are written evidence of indebtedness. It has been held in the above cited cases that a narrow construction of the statute is required. The omission of a catch-all phrase, such as "any other written evidence of indebtedness," has been held to be of significance. In this case, the situation serves to illustrate the point that the first emphasis in the statutory definition is the existence of a debt, and there is the additional requirement that the debt must be evidenced by some prescribed type of written evidence of a debt. Thus we think the most apt general definition to refer to here to illustrate the definition contained in section 719 (a) (1) is as follows: A "bond" is but a written evidence of a debt, whether in the hands of the original payee, or in the hands of some other person by proper transfer * * *. A "debt" is a sum of money which is certainly, and at all events, payable as a debt, without regard to whether it is payable presently or at a future time. [Words and Phrases, Permanent Ed., vol. 5, p. 653.] The contracts in question called*72 for the payment of prices by the Government for articles delivered by the contractor. The contractor's obligation was to make and deliver the goods. The Government's obligation was to pay money for the goods, and that obligation included an agreement by the Government to pay not more than 30 per cent of the total contract price in advance. By the terms of the contract the payments with which we are concerned were advance payments under the contract, and not loans. The contractor, petitioner, made an agreement to guarantee an accounting for the sums advanced by the Government under a performance or advance payment bond, and the evident purpose was to keep the Government free from any loss on account of the advance payment. The guarantee of the contractor and the performance bond were part of the entire contract to make and deliver goods. If the contractor, petitioner, well and truly performed all of his undertakings under the contract to make and deliver goods, then the obligation under the bond to pay a "penal sum" to the Government would be void. Such guarantee to perform the contract or to pay a penal sum was not the giving of a "bond" to evidence an "indebtedness" as provided*73 in section 719 (a) (1), in our opinion. Petitioner relies upon the performance or advance payment bond as evidence of the existence of an indebtedness to the Government, in its contention that the advance payments constituted "borrowed capital." The argument fails to give due consideration to the fact that the giving of the performance bond *974 was part of the entire contract, and, while the bond was a separate document, it was only evidence of a penalty to be paid for failure to perform under the contract. We think the obligation of petitioner to perform under the contract and the giving of the performance bond were interrelated, and that the advance payments in question had no other character than payments on account of the contract purchase price, which were not to be returned to the Government unless goods for which the advance payments were consideration, were not delivered under the contract. While the advance payments could have taken on the character of sums repayable, in the event of the contractor's failure to perform his obligation to make and deliver goods, they were not ordinary loans, and, in our opinion, did not give rise to "outstanding indebtedness" as that*74 term is used in section 719 (a) (1). It is held, therefore, that respondent did not err in determining that no part of the advance payments was includible in invested capital as "borrowed capital." See West Construction Co., 7 T.C. 974. Issue 2. -- Respondent determined that $ 10,200 was a reasonable allowance for petitioner's president's salary for purposes of deductible business expense under section 23 (a) (1) (A), and he disallowed $ 8,000 of the deduction taken on the return. Such allowance was not only less than the salary paid in prior years, and allowed, $ 10,400, but did not provide compensation for the increased services of petitioner's president in the taxable year. It has been found as a fact that $ 18,200 is a reasonable allowance for the president's salary; and it is held that such amount is deductible. This determination is reversed. Decision will be entered under Rule 50. Footnotes *. On the signing of the contract.↩ 1. SEC. 719. BORROWED INVESTED CAPITAL. (a) Borrowed Capital. -- The borrowed capital for any day of any taxable year shall be determined as of the beginning of such day and shall be the sum of the following: (1) The amount of the outstanding indebtedness (not including interest) of the taxpayer which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust * * *↩