American Liberty Pipe Line Co.
v.
Comm'r of Internal Revenue

This case is not covered by Casetext's citator
Tax Court of the United States.Jun 29, 1943
2 T.C. 309 (U.S.T.C. 1943)

Docket No. 108918.

1943-06-29

AMERICAN LIBERTY PIPE LINE CO., PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.

Harry C. Weeks, Esq., C. G. Clinton, Esq., and George H. Abbott, C.P.A., for the petitioner. Donald P. Moyers, Esq., for the respondent.


1. On November 21, 1935, prior to incorporation of petitioner on December 27, 1935, two of the three promoters addressed a letter to a bank in reference to the purchase by it of bonds subsequently to be issued by petitioner. By letter dated December 13, 1935, the bank advised the promoters it would undertake to place the proposed bond issue at par, subject to the prior performance of certain stipulations and conditions set out in the bank's letter. These conditions precedent were complied with on June 18, 1936, on which date petitioner executed the bonds or notes, and received the proceeds of the loan. Held, (1) the correspondence mentioned did not constitute a written contract executed prior to May 1, 1936; (2) assignments of portions of the proceeds of the contingent loan to pay for materials and services ordered by or in behalf of petitioner did not constitute ratification or adoption of the agreement with the bank by petitioner; and (3) petitioner is not thereby entitled to any credit in computing surtax on undistributed profits under section 26(c)(2) of the Revenue Act of 1936.

2. In its income tax return for the fiscal year ended November 30, 1936, which was its first return, petitioner stated that its inventories were valued at cost. A similar statement appeared on its return for 1937, and its inventories for those years were in fact valued at cost. Held, petitioner was not entitled to change such basis to cost or market, whichever was lower, for the taxable year 1938, without first having obtained permission from the Commissioner. Lenox Clothes Shops, Inc., 45 B.T.A. 1122, 1127, followed. Harry C. Weeks, Esq., C. G. Clinton, Esq., and George H. Abbott, C.P.A., for the petitioner. Donald P. Moyers, Esq., for the respondent.

Respondent determined deficiencies in petitioner's income tax liability for the fiscal years ended November 30, 1937 and 1938, in the amounts of $109,023.16 and $69,504.08, respectively. A number of issues raised by the pleadings were settled by stipulations of the parties at the hearing and will be given effect upon final settlement under Rule 50. The two issues submitted for decision are (1) whether petitioner is entitled, under section 26(c)(2) of the Revenue Act of 1936, quoted infra, to any credit in computing surtax on undistributed profits because of the provisions of a written contract executed by petitioner prior to May 1, 1936, dealing with disposition of its earnings and profits of the taxable years; and (2) whether petitioner is entitled to a reduction of inventories for 1938 which would result from a change in the method of reporting inventories from cost to cost or market, whichever was lower.

FINDINGS OF FACT.

Petitioner is a Delaware corporation, with its principal place of business in Dallas, Texas. The income tax returns for the taxable years were filed with the collector of internal revenue for the second district of Texas. Petitioner kept its books and records on an accrual basis, and on the basis of a fiscal year ended November 30.

The American Liberty Oil Co., a Delaware corporation, was organized in 1932, and, beginning in 1934, was owned and controlled by three individuals, Toddie L. Wynne, C. W. Murchison, and Dudley S. Golding. At all times material here these individuals owned, operated, and controlled this corporation, except for a period of a few months subsequent to March 1938. During that month Golding was killed in an airplane accident, and his interest in the company was purchased by Wynne and Murchison in the latter part of 1938 or early part of 1939. The principal business of the American Liberty Oil Co. was the production of crude oil, largely confined to the East Texas Field.

The American Liberty interest, embracing the American Liberty Oil Co. and its three stockholders, in 1935 had acquired the ownership of or were interested in various pipe lines or oil-gathering systems. These systems were operated under the names of the following companies:

Channel Transport & Marketing Co., a Delaware corporation, organized about 1933, was a 100 percent owned subsidiary which operated from the Conroe Field, about 40 miles north of the Houston ship channel, a deep water outlet. This company had a gathering system in the Conroe Field and a trunk line to the ship channel.

The Federal Pipe Line Co., a Delaware corporation organized about 1933, also operated an oil-gathering system in the Conroe Field, which tied into the system of the Channel Transport & Marketing Co.

The International Pipe Line Co., a Texas corporation organized in 1932, was acquired by the American Liberty Oil Co. in 1934. It operated an oil-gathering system in the East Texas Field, and served certain properties owned by the American Liberty Oil Co.

The Associated Pipe Line Co., a Texas corporation, operated an oil-gathering system in the East Texas Field and was acquired by the American Liberty Oil Co. in 1935.

The Liberty Pipe Line Co. operated an 18-inch trunk line system which started in the East Texas Field and ran about 40 miles to the south. The American Liberty Oil Co. purchased the physical properties of this company in 1935, but not its stock.

In 1935 Murchison, Golding, and Wynne conceived the idea of unifying these gathering systems above mentioned and constructing a new trunk line of about 160 miles to fill in the gap between the south end of the Liberty Pipe Line trunk and the Conroe Field system so as to complete a line from the East Texas Field to deep water facilities at Houston. It was necessary to obtain outside assistance in financing the project to complete control of the gathering systems and to construct a new connecting line.

The matter was taken up with the Republic National Bank & -rust Co. of Dallas, Texas, hereinafter called the bank, through its president, Fred L. Florence, and, after oral discussions with reference to the issuance of pipe line bonds and other related matters, a letter dated November 5, 1935, was addressed to Florence, as president of the bank, signed by Toddie L. Wynne. In this letter it was stated that the pipe line to be constructed would be owned by a Delaware corporation to be known as the American Liberty Pipe Line Co.; that the proposed mortgage on the completed pipe line would aggregate $1,250,000 first mortgage 6 percent two-year notes, payable quarterly out of three-fourths of the net earnings, with the first payment to be made six months after the pipe line began operations. The remainder of the net earnings was to be used for extensions or improvements to the pipe line system, any amount of such remainder not so used to be applied to liquidation of the bonds.

It was further stated in the letter of November 5, 1935, that, in order to pay the owners of pipe lines then in existence which would form a part of the completed system, it would be necessary to issue approximately $1,500,000 of preferred 5 percent cumulative stock with the provision that no payments would be made thereon, even of interest, until after the bonds had been retired. The following statement, among others, was also contained in this letter:

As you have been advised, this is not a promotion proposition where a part of the bond money will have to be taken and paid for as the work progresses, but the bond money will be available only after the line has been fully completed and ready for operation.

Another letter signed by Toddie L. Wynne and C. W. Murchison under date of November 21, 1935, was addressed to the bank, reciting in detail the terms and conditions of the proposed bond issue. This letter contained further statements pertinent here, as follows:

In order to build this additional mileage of pipe line, it is necessary for Mr. Murchison and his associates to get some financing on the pipe line system now owned and to be constructed. What they propose to do is this:

Organize a new pipe line company to be known as the American Liberty Pipe Line Company, same to be a Delaware corporation with the following capital:

1st. 1,000 shares no par common stock.

2nd. Issue of 5% Cumulative Preferred Stock covering value of their pipe line properties now owned as ascertained by the engineer.

The present owners of the pipe lines now in existence will accept 65% preferred stock in payment of the properties they turn over and convey to the new corporation. * * *

It is estimated by the engineer in his report * * * that it will require $1,355,000 in cash to build the additional pipe line, of which $80,000 of the proposed improvements can be deferred * * * Murchison and his associates propose to create a first mortgage on the lines they convey to the new corporation and on the additional lines to be built by the new corporation, in the sum of $1,250,000, to be evidenced by notes bearing date as of the date of completion of the new construction, to be due two years after date. These notes will be secured by first and superior lien on all of the pipe line properties now constructed and to be constructed and to be further secured by three-fourths of the net earnings of the Pipe Line Company; the notes to bear interest from date at the rate of 6%, interest payable quarterly. * * * No part of the money to be raised by this note issue is to be delivered to the Trustee until the line has been completed and ready for operation, and thereupon the notes are to be executed and delivered, the money paid in and with this money the bills of the contractor and the Company furnishing the pipe will be paid.

The owners of these properties, in behalf of the corporation to be formed, offer you these notes described above at par. * * *

I will appreciate very much if you will let me have a reply in writing with reference to this matter at your earliest convenience.

Under date of December 13, 1935, the bank, acting by and through the chairman of its executive committee, addressed a letter to C. W. Murchison and Toddie Lee Wynne, in reply to the letter of November 21, 1935, above referred to, in which it was stated that, subject to the understandings recited therein, the bank would ‘place this First Mortgage 6% Note issue at the face amount thereof, as and when the following stipulations and conditions mentioned included inspection and approval of the properties as to condition and value; investigation and approval of contracts for the transporting of oil; examination and approval of titles to all properties owned and to be acquired by the American Liberty Pipe Line Co., and the assignment of all contracts for the purchase, sale, and transportation of oil as additional collateral to secure the first mortgage 6 per cent note issue. Additional stipulations were as follows:

(9) That the issuance and purchase and sale of said notes is to take place as soon as practical after the completion of the whole of the pipe line construction program contemplated hereunder and its acceptance by us; but it is understood and agreed that in no event shall we be obligated in any wise hereunder unless such construction shall have been fully and finally completed and presented to us for acceptance on or before June 30, 1936, and failure to so complete and present on or before said date shall render this commitment null and void; and,

(10) That the First Mortgage 6% Notes shall be dated as of the date of our acceptance of the project; * * *

On the last page of the letter from the bank dated December 13, 1935, appeared the following notation:

ACCEPTED:

(Sgd.) C. W. MURCHISON

TODDIE L. WYNNE

By letter dated December 26, 1935, the American Liberty Oil Co. made application to the bank for a loan of $200,000, upon a note to be executed by the oil company and endorsed by the partnership of Golding & Murchison. The loan was to be due and payable on or before May 1, 1936, with interest at 6 percent per annum. As additional security for the payment of the loan, it was agreed that there should be assigned to the bank proceeds from the commitment of December 13, 1935, in an amount sufficient to pay such note and interest at maturity. This loan was sought for the purpose of buying either the stock or properties of the Associated Pipe Line Co. On December 28, 1935, the bank entered on its collateral record the following notation:

Collateral agreement dated 12/28/35 pledging $200,000 of the proceeds of a loan for $1,250,000 to be placed for American Liberty Pipe Line Company as per our commitment dated 12/13/35, as and if such proceeds become available.

On December 27, 1935, the American Liberty Pipe Line Co., petitioner herein, was incorporated under the laws of Delaware, with an authorized capital stock consisting of 15,000 shares of preferred of a par value of $100 and 1,000 shares no par value common stock. None of petitioner's capital stock was issued until about April 1, 1936. On January 16, 1936, petitioner obtained a permit to do business in Texas.

The charter of petitioner was secured through a corporation service by which the incorporators were furnished; thereafter, at the original meeting of the incorporators on December 27, 1935, Murchison, Golding, and Wynne were elected directors of the corporation. On December 31, 1935, the first meeting of the board of directors was held, at which meeting Golding was elected president of the corporation, Murchison and Wynne were elected vice presidents, and D. R. Zachry was elected secretary and treasurer.

On January 8, 1936, C. W. Murchison and Toddie L. Wynne addressed a letter to the National Supply Co., Pittsburgh, Pennsylvania, in which reference was made to an order given on that date ‘by the American Liberty Pipe Line Company‘ for 74 miles of eight-inch pipe and three complete pump stations, and in this letter there was assigned to the National Supply Co. by Murchison and Wynne a sufficient amount of the ‘purchase letter and commitment‘ of the bank above mentioned to cover the cost of such pipe and pump stations; also an assignment covering an amount of approximately $61,000 owing to the National Supply Co. by the American Liberty Oil Co. Payment of the specified amounts was guaranteed by the American Liberty Oil Co. in the event the commitment of the bank was not fulfilled.

On January 10, 1936, a contract was entered into between petitioner, referred to therein as the company, and the Fredell Construction Co., referred to as contractor, for construction of a pipe line approximately 105 miles in length, to serve as the connecting link between the various oil-collecting systems. The contract provided that upon completion and acceptance of the line the contractor would be paid $50,000 in American Liberty Pipe Line Co. two-year 6 percent first mortgage bonds at par, and the balance due in cash; also that immediately upon execution of the contract the company would assign to the contractor, subject to completion and acceptance of the line, a portion of the commitment of the bank, hereinbefore mentioned, of $50,000 in bonds and $105,000 in cash, any balance due by either party to be paid in cash upon consummation of the transaction. By letter dated January 10, 1936, addressed to the Fredell Construction Co., Murchison and Wynne assigned to the company a portion of the bank's commitment of December 13, 1935, sufficient to make payment of the sums due under the provisions of the construction contract, including $50,000 in bonds.

On January 9, 1936, the Oil Well Supply Co. of Dallas, Texas, accepted an order from the American Liberty Pipe Line Co. for 36 miles of pipe, to be of stated specifications, and by letter dated January 15, 1936, C. W. Murchison and Toddie L. Wynne assigned as collateral security to the Oil Well Supply Co., out of the bank's purchase letter and commitment, an amount sufficient to pay for the pipe, estimated at approximately $152,000. On January 21, 1936, the Oil Well Supply Co. by letter notified the bank of such assignment, and on January 29, 1936, the bank by letter acknowledged receipt of the notice.

On March 31, 1936, the board of directors of petitioner held a special meeting, at which a resolution was adopted approving a certain plan and agreement of reorganization of the American Liberty Oil Co., which provided that effective on April 1, 1936, the latter company should transfer to petitioner corporation the pipe lines, properties, and equipment acquired by purchase from the Liberty Pipe Line Co., solely in exchange for stock of petitioner as follows: 896 shares of no par value common stock, and $401,000 par value (being 4,010 $100 par value shares) of 5 percent cumulative nonvoting preferred stock. The shares of stock referred to in the above resolution were issued on April 1, 1936. Prior to that date no capital had been paid in to petitioner, and none of its authorized capital stock had been issued.

On April 23, 1936, a special meeting of the stockholders of petitioner was held, at which a resolution was adopted approving a plan and agreement of reorganization, to be effective as of June 1, 1936, by way of a merger or consolidation into petitioner of the Associated Pipe Line Co., International Pipe Line Co., Channel Transport & Marketing Co., and Federal Pipe Line Co., all Delaware corporations. The plan provided that all of the companies, other than petitioner, should transfer to petitioner all of their assets and liabilities in exchange for specified numbers of shares of petitioner's common and preferred stock. The stock was issued on June 1, 1936, as provided in the resolution, and the transfers of assets and liabilities were effected on the same date.

On May 4, 1936, the consulting engineer employed by the bank reported that construction of the pipe line was approximately 95 percent completed on May 2, 1936, and thereafter, on May 30, 1936, the engineer reported that the project was completed.

Under date of June 11, 1936, petitioner corporation addressed a letter to the bank in which reference was made to the bank's commitment of December 13, 1935, to purchase petitioner's first mortgage notes in the amount of $1,250,000, subject to certain contingencies to be performed before the purchase of the notes was to be completed, and the bank was advised that such contingencies had been performed.

A meeting of the board of directors of petitioner was held on June 18, 1936, at which a resolution was adopted approving, both as to form and substance, a proposed form of deed of trust and chattel mortgage to the bank, as trustee, dated June 18, 1936, to secure payment of the two-year notes of the corporation in the aggregate principal sum of $1,250,000, and also the proposed form of such notes. The officers of the corporation were authorized and directed to execute all necessary instruments in that connection, and at a meeting of the stockholders held on the same date, the action of the directors was ratified, approved, and adopted. The deed of trust and notes were duly executed on June 18, 1936. The proceeds of the loan were on the same date deposited to the credit of petitioner, and checks were issued to the various parties in accordance with the assignments hereinbefore mentioned.

Petitioner made periodic payments to the trustee to apply on principal and interest due on its notes. These payments were computed on the basis of petitioner's monthly income, less cash outlays of current expenses, and were made under direction of the trustee's auditor in accordance with the provisions of the deed of trust dated June 18, 1936. In the fiscal year ended November 30, 1937, petitioner paid on the principal of its notes, as applied thereto by the trustee, the following amounts: March 31, 1937, $193,138.18; June 18, 1937, $129,649.11; September 18, 1937, $94,444.69; total, $417,231.98.

In the fiscal year ended November 30, 1938, petitioner paid on the principal of its notes, as applied thereto by the trustee, the following amounts: December 18, 1937, $189,098.67; March 18, 1938, $81,111.47; total $270,210.14.

As of May 1, 1938, petitioner refinanced its business through a new loan from the Bank of the Manhattan Co. in the amount of $1,500,000, secured by a deed of trust on its properties. This new loan called for monthly payments of $60,000, and recited that as of the date of execution of the second deed of trust there were outstanding notes of the June 18, 1936, issue in the amount of $319,091.12, and that the indebtedness represented by the loan of May 1, 1938, was in renewal and extension of the balance in that amount due on the notes originally in the aggregate sum of $1,250,000. In its fiscal year ended November 30, 1938, petitioner made three $60,000 payments on the principal of the new loan of $1,500,000.

Petitioner was not only engaged in the business of transporting oil, but also bought and sold crude oil, which latter was inventoried for tax and accounting purposes. The income tax return filed by petitioner for the fiscal year ended November 30, 1936, under ‘Valuation of Inventories,‘ contained the following question: ‘State whether the inventories at the beginning and end of the taxable year were valued at cost, or cost or market, whichever is lower. ‘ To which question the answer in typewriting was ‘Cost.‘ The return filed by petitioner for the fiscal year ended November 30, 1937, contained the same question upon the printed form, and the same typewritten answer.

At the close of petitioner's fiscal years 1936 and 1937, there was no difference between cost and market of the crude oil then on hand.

In October 1938 the market price of crude oil declined below the cost of the crude oil on hand as inventoried by petitioner. Petitioner continued to carry its inventories at cost, but in order to reflect the difference between market and cost, petitioner set up a reserve account against which it entered a credit when crude oil was actually sold, since such sale would be reflected in cost of the goods sold.

By the end of the fiscal year 1938 petitioner had absorbed all of the reserve in the manner described, except as to Rodessa crude on hand, for which there remained in the reserve account the sum of $34,473.69, and this amount was deducted at the close of the fiscal year 1938 as a ‘Reserve for Loss.‘ In its tax return for the fiscal year ended in 1938 petitioner indicated a change in the method of computing its inventory from cost, as used in prior years, to cost or market, whichever was lower.

OPINION.

HILL, Judge:

The first issue for decision here is whether petitioner is entitled to any credit in computing surtax on undistributed profits because of the provisions of a written contract executed by the corporation prior to May 1, 1936, dealing with the disposition of its earnings and profits of the taxable years, within section 26(c)(2) of the Revenue Act of 1936.

SEC. 26. CREDITS OF CORPORATIONS.In the case of a corporation the following credits shall be allowed to the extent provided in the various sections imposing tax—(c) CONTRACTS RESTRICTING PAYMENT OF DIVIDENDS.—(2) DISPOSITION OF PROFITS OF TAXABLE YEAR.— An amount equal to the portion of the earnings and profits of the taxable year which is required (by a provision of a written contract executed by the corporation prior to May 1, 1936, which provision expressly deals with the disposition of earnings and profits of the taxable year) to be paid within the taxable year in discharge of a debt, or to be irrevocably set aside within the taxable year for the discharge of a debt; to the extent that such amount has been so paid or set aside. * * * As used in this paragraph, the word ‘debt‘ does not include a debt incurred after April 30, 1936.

In 1935 three individuals, Toddie L. Wynne, C. W. Murchison, and Dudley S. Golding, who were the sole stockholders of the American Liberty Oil Co., conceived the idea of unifying certain oil-gathering systems owned or controlled by their corporations and in that connection it was also proposed to acquire other properties and to construct certain additional pipe lines. In order to carry out the project it was necessary to borrow a considerable amount of money. The matter of a loan was taken up with a bank at Dallas, Texas, and, after oral discussion in reference to the issuance and sale of bonds, Wynne addressed a letter to the bank under date of November 5, 1935, outlining the proposed transaction. Under date of November 21, 1935, another letter was addressed to the bank by Wynne and Murchison, reciting in detail the terms and conditions of the proposed bond issue in the amount of $1,250,000, and requesting a reply from the bank in writing. By letter dated December 13, 1935, addressed to Murchison and Wynne, the bank stated that it would ‘place this First Mortgage 6% Note issue at the face amount thereof,‘ as and when certain stipulations and conditions set out therein had been fully met and complied with. One of the stipulations in the bank's letter was that in no event would the bank be obligated in anywise under its commitment unless the contemplated construction program was fully and finally completed and presented to the bank for acceptance on or before June 30, 1936. Murchison and Wynne noted their acceptance of the bank's proposal by signing their names at the bottom of the last page of the letter. This correspondence substantially constitutes the alleged written contract upon the basis of which petitioner claims the credits in controversy.

Petitioner asserts that it subsequently, but prior to May 1, 1936, ‘executed the written contract‘ by way of ratification and adoption. This contention will be further considered as a separate point hereinbelow. The first quest posed by the facts is whether the correspondence constituted a written contract executed prior to the date stated in the statute. We think it did not. By the plain and unambiguous language of the bank's letter the tentative commitment to place the bond issue was not to become effective, and the bank was not to be bound in anywise thereby, unless and until at some future date prior to June 30, 1936, the specified conditions precedent had been complied with. On June 18, 1936, compliance with those conditions was fully and finally completed, and thereupon the bank's tentative commitment became a definite obligation. On the same date, the mortgage and notes were executed by petitioner and the proceeds of the bond issue were paid over to it.

That all of the parties concerned understood and recognized that the bank's commitment was wholly prospective prior to performance of the specified conditions is clearly indicated by statements appearing in connection with orders placed for pipe and other materials, covered by assignments of proceeds of the proposed loan. In accepting such an assignment, the National Supply Co. required an additional guarantee of payment by the American Liberty Oil Co. in the event the commitment of the bank was not fulfilled. In the case of the Oil Well Supply Co., the assignment was designated as collateral security for payment of the amount to become due; and in the collateral agreement by which $200,000 of the proposed loan was pledged to the bank for the benefit of the American Liberty Oil Co., the bank's acceptance of the pledge was subject to the notation ‘as and if such proceeds become available.‘

It seems clear to us that, not only was the bank not bound by its conditional commitment prior to June 18, 1936, but neither was petitioner, nor its promoters, bound to perform the conditions. Petitioner argues that the contract was for the benefit of third persons, and that after assignments of the proceeds petitioner was definitely obligated to complete performance of the agreement. It is obvious, however, that petitioner would not have been so bound if it had discharged its obligations to the contractors out of funds from other sources, as it might have done without breaching any agreement with the bank.

The terms of the bank's letter of December 13, 1935, constituted an offer of an unilateral contract, and the acceptance by petitioner's promoters was merely an authentication of the terms of the offer. The contract was ‘executed,‘ within the meaning of that word as used in the statute, upon performance of the conditions precedent on June 18, 1936. Even if the agreement had been executed by petitioner, it would not have been a contract within the provisions of section 26(c)(2), supra, Bethlehem Silk Co. v. Commissioner, 124 Fed.(2d) 649, affirming 43 B.T.A. 515; Florence Cotton Mills, 44 B.T.A. 436; affd., 126 Fed.(2d) 1017; Morgan Manufacturing Co., 44 B.T.A. 691; affd., 124 Fed.(2d) 602.

In the second place, the contract was not signed or executed by petitioner corporation. It is insistently argued by petitioner that its contract for material and the assignments in its behalf of portions of the proceeds of the bank's tentative commitment, in January 1936, constituted ratification and adoption of the contract by it in writing. It is to be noted that only one such contract was executed by petitioner, the others having been signed by the promoters, and in none of them are to be found any express words of ratification or adoption. In our opinion, the assignments amounted to no more than an effort on the part of petitioner to avail itself of benefits under the agreement with the bank. If the assignments could be said in any proper sense to have constituted ratification, such conclusion must rest upon farfetched inference, which is not enough to show execution of a written contract by the corporation within the intendment of the statute. And the fact that petitioner may have considered itself bound by the agreement and carried out its terms is unimportant. Kolor-Thru Corporation, 44 B.T.A. 1303; Schwabacher Hardware Co., 45 B.T.A. 699; Mastin Realty & Mining Co. v. Commissioner, 130 Fed.(2d) 1003. The attenuated distinctions on the facts which petitioner seeks to draw between the present proceeding and the cited decisions do not avail it in establishing its right to the claimed credits. Since the statute grants a special credit in the nature of a deduction, subject to precisely stated limitations, petitioner must be held to strict compliance with its terms. Helvering v. Ohio Leather Co., 317 U.S. 102.

Finally, petitioner's claim must be disallowed on still another ground. Section 26(c)(2) allows a credit equal to the portion of the earnings and profits which, in accordance with the other provisions, is required to be and is in fact paid within the taxable year in discharge of a ‘debt,‘ or irrevocably set aside within the taxable year for such purpose. It is further provided, however, that the word ‘debt‘ as used in the statute does not include a debt incurred after April 30, 1936.

Petitioner attempts to support its position by asserting that the mortgage notes executed by it on June 18, 1936, represented in part merely a renewal of the debts incurred by it in January 1936 for materials and services. We can not agree. The latter debts were fully discharged and satisfied out of the proceeds of the bank's loan, and a new debt, owing to another and different creditor, in a different amount, and upon entirely different terms and conditions, was incurred after April 30, 1936. It was in discharge of the debt incurred on June 18, 1936, that petitioner's earnings and profits of the taxable years were required to be and were paid.

On the first issue, respondent's determination is approved.

The second issue involves the question whether petitioner is entitled to change its method of valuing inventories of crude oil in the taxable year 1938 from the basis of cost, as used in the prior years, to cost or market, whichever was lower. In its income tax return for the fiscal year ended November 30, 1936, which was petitioner's first return, it was stated that the basis used was cost. The same statement was made in petitioner's return for the fiscal year 1937. In those years there was no difference between cost and market. In 1938 the price of crude oil declined below cost of the oil which petitioner had on hand. At the close of 1938 petitioner inventoried at cost, but set up a ‘reserve for loss‘ accounts to which is charged such difference. As oil was sold, the reserve account was credited, since the loss on sales would be reflected in the cost of goods sold. At the end of 1938 the balance of the reserve account amounted to $34,473.69, which respondent included in petitioner's income for that year as an understatement of inventory. Petitioner stated in its income tax return for 1938 that its inventories were valued at cost or market, whichever was lower.

The question now is whether petitioner made a binding election in its 1936 and 1937 returns to inventory at cost, which method it could not change in a subsequent year without permission of the Commissioner, which permission admittedly was not obtained.

Technically, of course, petitioner consistently valued its inventories at cost in all of the years mentioned, but the practical effect of its bookkeeping was to change to the lower of cost or market in 1938. Petitioner's contention on this point, briefly, is that it did not intend to exercise an election by the answers made in its earlier returns; that such answers merely stated a fact; and that, since there was no difference between cost and market in 1936 and 1937, there was no occasion for it to make an election in those years.

The question presented here was considered by us on substantially similar facts, and decided adversely to petitioner's contentions, in Lenox Clothes Shops, Inc., 45 B.T.A. 1122, 1127 (on appeal, C.C.A., 6th Cir.). Also compare Mother Lode Coalition Mines Co. v. Helvering, 317 U.S. 222.

On the second issue, respondent is affirmed.

Decision will be entered under Rule 50.