THOR POWER TOOL CO. v. COMMISSIONER
Legal provision: Internal Revenue Code
Argument of Mark H. Berens
Chief Justice Warren E. Burger: We'll hear arguments first this morning in 9 -- number 920, Thor Power Tool Company against the Commissioner of Internal Revenue.
Mr. Berens you may proceed whenever you are ready.
Mr. Mark H. Berens: Mr. Chief Justice, may it please the Court.
This case presents two issues under the Internal Revenue Code; the valuation of excess inventory and the calculation of bad debts by the reserve method formula.
Both issues which are separate seem to be of high frequency and inspire considerable amount of feeling among the taxpayers involved.
The principle one involves the valuation of excess inventory.
Chief Justice Warren E. Burger: I suppose it might be accurately added that they present infinite variations, is that not so?
Mr. Mark H. Berens: They certainly do Mr. Chief Justice.
The excess inventory issue is really a question of timing.
When may inventory that a taxpayer reasonably determines to be in excess of foreseeable demand, when may it be written down?
At the time he makes his determination or later when it is eventually scrapped as the Commissioner contends.
The importance of this issue is indicated by the filing of very thoughtful amicus briefs by the United States Chamber of Commerce and the National Association of Manufacturers.
The issue effects all manufacturers on the lower of cost or market method as well as wholesalers and dealers who stock replacement parts.
This includes the automotive industry, farm equipment, machinery, electronics, electrical equipment of all sorts and good sound business sense requires these manufacturers and dealers to stock or really overstock spare parts if they have to serve their customers.
When the parts are first produced it is very difficult and sometimes impossible to predict exactly how much demand for a part based on its wearing ability, breakage etcetera and so they are intentionally overproduced by most manufacturers.
After the part has been in use after its main product has been in use for a while, it becomes evident that the part is overstocked and at this time generally accepted accounting principles require that the excess part, the excess quantity be marked down to a net realizable value.
And it is this requirement to clearly reflect financial accounting income that we submit should be parallelly determinative of taxable income.
Justice Harry A. Blackmun: Did your client dispose these excess parts at any time Mr. Berens?
Mr. Mark H. Berens: In the meantime did you say?
Justice Harry A. Blackmun: At any time.
Mr. Mark H. Berens: The excess parts in issue Mr. Justice Blackmun for 64% or 78% were disposed off by 1971.
Justice Harry A. Blackmun: Disposed off in what way?
Mr. Mark H. Berens: By scraping and this was by an exact tracing, Exhibit 17, I believe shows that.
I am going to dwell a little bit on the facts here, perhaps a little more than I should to get the proper perspective because while the facts are not in dispute, the parties interpret them quite differently.
At the end of 1964, Thor's new management determined that it's inventory was greatly overvalued.
After making a number of specific write downs it was confronted with the fact that it had 44,000 different items of inventory which comprised millions of pieces.
Most of these, 33000 different items were replacement parts and accessories, and they were held for the most part in quantities greatly exceeding foreseeable demand.
It was impractical to value these individually, and so management developed two procedures, statistically sound, fairly commonplace among manufacturers at the time to write down or determine how much should be written down.
The primary procedure was to compare an item by item basis, the quantities on hand with the actual sales Thor had made during 1964 or the production usage of the parts, and I stress item by item.
If there were no sales or use of that item they were written off as obsolete, a write off that the Commissioner accepted.
If there were some usage, but the amount at hand exceeded two years usage, then that portion in excess of two years was written off.
Amounts between one and two years were partially written off.
At some locations of Thor there was inadequate data on usage for the preceding year and so additional, not substitute, but additional percentage write downs were done for a limited number of limited categories of goods.
Thor's President testified that the write downs were solely intended to accurately reflect current inventory value at the end of 1964.
He stated that income tax effects were not even considered at that time.
The Tax Court, based on his testimony and that of several accounting experts found three specific things; that Thor's procedures for writing down the inventory and I am quoting, “the inventory in issue -- wrote down the inventory in issue to its estimate of current net realizable value,” and I stress current net realizable value.
The court also found that this was required by generally accepted accounting principles and it further found that this constituted a best accounting practice within the meaning of Section 471 of the Code to which I will return.
The findings of the court which were not disputed by the Court of Appeals nor by the Commissioner, were fully supported by the testimony of six expert accountants, five of whom were preeminent in the field of accountancy.
They testified that general accepted accounting principles require the excess inventory to be written down to clearly reflect financial income.
They stated that the use of a formula of this sort was essential as a practical matter and that it was commonplace.
They specifically testified that both procedures, that is the formula and the supplementary percentage write downs conformed to generally accepted accounting principles.
They testified that the write down was reasonable in amount and this was based on a hindsight basis including the degree of scraping and finally they testified that they would have withheld certification at the end of 1964 had Thor not written down the inventory as it had.
They further testified that if Thor had not written it down, but had waited until it was scrapped to write it down, financial income would have been distorted both in 1964 and in the later year or years when it was scrapped.
I want to stress, that the testimony and the findings of the court stated that this was an estimated current loss in existence at the end of 1964.
It was not a provision for a future loss.
Now throughout respondent's brief, the write down is characterized as an anticipation of or a reserve for a future loss, this we submit is contrary to the record.
Thor's write down is authorized, we submit, by two sections of the court; Section 446 which basically provides that taxable income shall be computed under the method of accounting the taxpayer uses in keeping his books, provided it clearly reflects income, but more directly governing is Section 471 which is the key section on inventory accounting.
It imposes two conjunctive requirements, binding on both the taxpayer and the Commissioner that inventory accounting must confirm first as nearly as maybe to the best accounting practice in the trade or business and secondly as most clearly reflecting the income.
Now the Tax Court found that Thor met the first requirement, conformance to the best accounting practice.
The testimony of the experts which said that if Thor had waited to scrap it, it would not have confirmed to a best accounting practice, means that the Commissioner's scrapping method cannot meet the first requirement of Section 471.
It cannot be a best accounting practice.
Justice John Paul Stevens: May I ask just one question?
You have twice used the phrase a best accounting practice.
I take it it's understood that there is not a single best accounting practice?
Mr. Mark H. Berens: No, Mr. Justice Stevens, and I am quite aware of that from the (Inaudible) decision that there maybe more than one best accounting practice.
Justice John Paul Stevens: Yeah, but an unusual use of the word best, but it really means an acceptable or --
Mr. Mark H. Berens: Yes.
The statute actually says 'the', but I think it is normally read as meaning 'a' and I sometimes use them interchangeably, but I agree with you.
Justice John Paul Stevens: Right, but I just wanted to be sure I wasn't misunderstanding it.
Mr. Mark H. Berens: The question then resolves did Thor's method clearly reflect income, under both Section 446 and 471? And we believe the test under both is identical.
Perhaps the best way of getting at that troublesome question is to relate the two methods to each other, and it seems a fair way of approaching it, because there seems to be no there logical point of time when the write down could occur than one of the other of these, the one side when the taxpayer reasonably determines it should be written down or later when it's scraped.
I cannot think of any other point of time that it could be used as a test.
Now, from this viewpoint, perhaps the best way of approaching is to look at the Commissioner's scrapping method.
Does it clearly reflect income?
Now, from a financial accounting viewpoint it doesn't, as was established, but beyond that, the Commissioner basically contends that to clearly reflect income you should overstate your inventory by not writing unsalable goods down to their net realizable value, and that you should hold this overstatement in the inventory for a year or two or more until whenever you eventually scrap it.
Now the layman would not view an overstatement of inventory to clearly reflect income, because the higher the inventory you stated, the higher the income is reported.
The Commissioner's view makes an assumption here, not only that it was a future loss but tied in that, and it's in both the lower court's opinions and in the brief of the respondent, is that inventory losses do not occur until they are realized.
Now, we submit and I use a strong word that this is a radical argument, it is never to our research been advanced in some 60 years.
The administrative history outlined at length in our reply brief is completely to the contrary, starting with TBR 48 issued in around 1919.
There are no cases that hold realization of losses of inventory are required for, and I should emphasize for a taxpayer using the lower of cost or market method for a cost taxpayer that is a different question.
And in particular, I cite the discussion in Space Controls 322 F.2d 147 and 148 which outlines the history of the realization issue in inventory accounting.
Justice Byron R. White: What do you -- you say the taxpayer writes the inventory down to net realizable cost?
Mr. Mark H. Berens: Yes.
Justice Byron R. White: What is a net realizable cost?
Are you going to get to that?
Is that different than what you think the scrap value will be?
Mr. Mark H. Berens: No in the Thor's case it was specifically an estimate of scrap value.
Justice Byron R. White: And why is the inventory held rather than scrapped at that time?
Mr. Mark H. Berens: Because on an individual item basis Mr. Justice White it is --
Justice Byron R. White: You can make a mistake.
Mr. Mark H. Berens: -- it is unknown, it is clear that Thor may have underestimated one of the 44,000 items and overestimated the other.
Justice Byron R. White: Do you have some experience in that regard as to what percentage of the inventory that Thor would like to write down later proves to be salable and that it has a value?
Mr. Mark H. Berens: In 1971, when Arthur Anderson was first engaged as Thor's accountants, this from the record, they did a first-time-through special test of the inventory write downs of this excess system, and they found, for the -- using the exact system and that the company used and doing very extensive sampling, they found in 1970 that the write down -- I am not speaking of the 1964 but in 1970 it was about, if I recall it correctly, about 5% too low, and in 1971 --
Justice Byron R. White: So 5% of the items were taken back in ordinary sales, is that it?
Mr. Mark H. Berens: They should have written off more than they did.
Justice Byron R. White: Oh I see.
Mr. Mark H. Berens: The write down was too little, a low is misleading there, too little and again in 1971 it was too little by a larger degree.
In other words, Thor's formula was on the conservative side.
The testimony of Mr. Beldock --
Justice Byron R. White: Nevertheless -- even so there would have been isolated or recurring instances of inventory that was written down that nevertheless was sold?
Mr. Mark H. Berens: Absolutely, absolutely and at that time to the extent that it was sold, that it already have been written taxable income in the later year would have been increased.
Justice Byron R. White: By the difference between its net realizable value and the sales price?
Mr. Mark H. Berens: Yes, yes.
Justice Byron R. White: Things are segregated so you know which inventory you are --
Mr. Mark H. Berens: No they are not segregated and I volunteer the observation that while it was stated in both lower courts' opinions neither state -- neither cited any authority for segregation and we could find none.
Justice Byron R. White: What happens if an item that's been written down is sold at the same -- at what it used to be sold for?
How do you -- you just put that amount in your gross income?
Mr. Mark H. Berens: Yes, Your Honor, that's exactly what is done.
Let me stress that this is a statistical system for which -- for any particular item may not work.
In fact I will go as far as to say it's unlikely to be accurate and that's the very need for it because it can't be accurate for one item.
It is accurate because there is 44,000 items.
As all of the experts testified, a formula system like this is statistically sound, if it's properly conceived, and while every item could be wrong, in the aggregate it is right.
And I would like to analogize here to the retail sales method where the same problem exists for a department store, where there are sometimes hundreds of thousands of items priced at retail value and when they take inventory, they use average mark-up formulas in reverse to mark them down to cost.
This is exactly the same statistical system, and I should interrupt myself to say that, that is specifically approved by the retail sales method regulations that this is the same statistical premises upon which the write down by Thor is based.
Now I also stress that even on an overall statistical basis, it is not accurate.
We do not contend it is perfectly accurate, but I harken to the Cohan rule promulgated by Judge Leonard Hand in 1930 where he said, most important things can't be exactly accurate and that the tax law has to be practical and as long as it is reasonably accurate, this is all that the law requires.
Justice Byron R. White: Ultimately your write down is going to be adjusted, isn't it?
Mr. Mark H. Berens: It's going to be adjusted on a --
Justice Byron R. White: When you scrap it, when you scrap it?
Mr. Mark H. Berens: Or when it's eventually all sold.
Say that you completely --
Justice Byron R. White: Suppose it's scrapped and suppose you get out of it more than you thought you would?
Mr. Mark H. Berens: Then that's suggested too, the scraping revenues go into gross income.
Justice Byron R. White: And if you get less, what about that?
Mr. Mark H. Berens: Then you -- through the write off system you get an additional loss at that time.
Justice Byron R. White: So, eventually things turn out accurately?
Mr. Mark H. Berens: It rolls through, but I would like to stress Mr. Justice White, both when it's scraped and when it is sold, either disposal eventually catches up.
Justice Harry A. Blackmun: Mr. Berens your time is going on, but sometime before you sit down you have a response to the argument that the inventory evaluation procedure was a change in accounting method, the Government makes this, and I would like to get your response to it?
Mr. Mark H. Berens: Yes.
Justice Harry A. Blackmun: At your convenience just before you sit down.
Mr. Mark H. Berens: I suppose it would be -- would you prefer Mr. Justice Blackmun to give it now, I was going to save it for a rebuttal time but I would be glad to respond.
Justice Harry A. Blackmun: It's alright, but just so you catch it sometime.
Mr. Mark H. Berens: May be I better in case I lose my rebuttal time.
We submit that this is, and again I use a strong term a 'non issue' in reality.
Apart from the fact that the Commissioner had the burden of proof and the we do not believe met that burden.
There are three requirements for a change of accounting method within the meaning of 446(e) of the code, and the principal one is that, income escapes tax because of the change or that there is double deduction or in this case a double increase in cost of goods sold and either actually or potentially.
And as we explain it at length in our reply brief there is no possibility by Thor's procedures that any income could have escaped or a double reduction.
We secondly point out that change of method is a specific term meaning a change of the basis of valuation which was the lower of cost or market which was not changed, or a change in a inventory method such as from FIFO to LIFO or to change a cost accounting method which Thor also did not change.
It does not reach down into the component techniques of calculation within the basis of valuation, and within the method used.
Also in 1964 the regulations made this clear, and as we point out in our brief, it was only the later amendments of 1970 where the regulations stretched, we believe the statutory standard, to try to define change of method to include a change of a component of the method and we do not believe that as we said in our brief that that regulation applies to 1964 and in fact we argue that it goes beyond the statutory intention.
Justice Lewis F. Powell: Are you saying that the taxpayer has used consistently the lower of cost or market method for valuing inventories?
Mr. Mark H. Berens: Yes, and the record is clear on that Mr. Justice Powell.
Justice Lewis F. Powell: Right and when you use the term net realizable value that's not inconsistent with the cost or market method?
Mr. Mark H. Berens: As we conceive it based on generally accepted accounting principles, it is part of the lower of cost or market system.
It does not meet the specific requirements of or as interpreted by the Commissioner of the market regulation, the lower of cost or market.
I misstated that.
The Commissioner argues it does not meet the definitions within the lower of cost or market method of the regulations.
As our brief points out we submit that if they are interpreted to fulfill the statutory intent, that is to constitute a best accounting practice that they do authorize this type of write down.
Justice Harry A. Blackmun: I want to be sure incidentally Mr. Berens, do I correctly understand that you are not attacking specifically any of the regulations involved here?
Mr. Mark H. Berens: No Mr. Justice Blackmun, we cannot attack them because they are an omission.
They don't deal explicitly with the problem.
We say this application, if they are interpreted to preclude this type of a write down we object to that, but we do not say that any provision of the regulation is invalid and I stress because it's --
Justice Byron R. White: But you say -- you just talked about an interpretation of the regulation with which you disagree?
Mr. Mark H. Berens: Yes the Commissioner's interpretation of the regulations we believe is improper, but the regulations are not invalid.
They are basically silent on the write down of --
Justice Byron R. White: But you think the interpretation of that particular regulation is contrary to the statute?
Mr. Mark H. Berens: Yes.
Justice Byron R. White: Yes.
Justice John Paul Stevens: I am sorry Mister Berens when you say you took the position the regulation was, or was not contrary to the statute?
Mr. Mark H. Berens: No, the regulation -- you expressed it in a different way Mr. Justice Stevens it makes it -- I'll have to answer it a little differently.
The regulation as far as it goes is not contrary to the statute.
The regulation we concede is silent on the write down of excess inventory.
Justice John Paul Stevens: Well is 1471.4 silent on it?
I thought it allowed the write down of excess inventory if there was extraordinary circumstance that produced the excess and I thought you then argued about whether or not there was an extraordinary circumstance from the Tax Court?
Mr. Mark H. Berens: We never argued that there was an extraordinary circumstance, that was from the Tax Court's opinion.
We argued and we argue here and I have not stated this very well that if you -- that the language of -4 dealing with the write down of market construed broadly where it says if normal conditions of the market do not exist, that you may use the best available evidence.
We say that that covers excess inventory while at the same time conceding that excess inventory is not specifically provided for by name in that regulation.
We also parallelly argue that under the --
Justice John Paul Stevens: I want to stay with that for just a moment.
I guess I was wrong in using the word extraordinary.
It's, where there abnormal market circumstance or something like it --
Mr. Mark H. Berens: Yes, yes.
Justice John Paul Stevens: And you contend that the existence of an excess inventory -- do you contend there were abnormal market circumstances in your case?
Mr. Mark H. Berens: We contend that there is inherent abnormality in the market for replacements parts, that there is not a normal pricing effect of supply and demand as was testified both by Mr. --
Justice John Paul Stevens: But the answer the Court of Appeals gave as I remember was, you regularly produce in excess, because this is the normal way you do business but that nevertheless is abnormal?
Mr. Mark H. Berens: The market does not operate in the normal way for replacement parts.
We think the Court of Appeals is misapplying this concept in that point.
The regular goods you can move them if they are slow moving by lowering the price.
With replacement parts there is essentially no elasticity of demand.
You cannot lower the price and move them.
So although you have produced them intentionally, you still -- if you could be perfect you would produce exactly the right amount that's eventually needed, but you can't and so you produce intentionally the excess.
That production site is not what makes it extraordinary, what makes it -- I don't want to use the word extraordinary, what makes it an abnormal situation is the nature of the goods, the replacement parts.
Justice John Paul Stevens: Wouldn't your reasoning apply to any goods which a manufacturer makes expecting not to be able to sell 100% of his production?
Mr. Mark H. Berens: I would say it would and it certainly would apply to the retailer who buys quantities of goods some of which he knows are going to turn out to be obsolete and unsellable, which ones he doesn't know, but the lower of cost or market system is designed to handle that situation.
The two of the most important decisions of this court in the area of tax accounting, the Kansas City Structural Steel which condemned, one of them being Kansas City Structural Steel, which condemned the taxpayer's base stock method because it misrepresented the facts.
It merged the inventory results of one year with that of another, and that method is designed to do that.
Really that objection that this Court found to that method we think applies to the scraping method.
It delays recognizing a loss that has occurred to some year after it has really occurred and in that sense it misrepresents the facts.
In a case that I embarrassingly must admit was not cited in our briefs, United States -- Cartridge versus United States, the decision of this Court and we overlooked it until two days ago, Volume 284.
There was --
Justice William J. Brennan: (Inaudible)
Mr. Mark H. Berens: I think 269 Mr. Justice Brennan.
There a ammunitions manufacturer at the end of World War I was terminated by the government.
He-- in 1918 he immediately wrote down his inventory to salvage value of about $230,000.
While settlement negotiations were going on, the Commissioner contended that the write down should be postponed until the eventual payments by the government became known which occurred in 1921 or 1922, and the total payments amounted to $730,000, a difference of 500,000.
This Court in an unanimous opinion at that time stressed, and the taxpayer was on the lower of cost or market, stressed that the annual accounting period applied inventory as events happened, and that the taxpayer was entitled to write it down as he saw the situation in 1918, 230,000.
Even though there was a prospect of later recovery which indeed occurred, this should be taken into income in the later year as it became a closed event.
I think Mr. Justice White this is quite parallel to the line of questions you were addressing to me earlier.
Justice Byron R. White: Well how did you run into 284 US.
You just didn't stumble on in this --
Mr. Mark H. Berens: Well we were reading some of the cases in respondent's brief and one sharp pre-Commissioner said it was bound by US Cartridge and that's the first time that it had crossed apparently anyone's eye in our office.
Justice Byron R. White: But maybe an associate was working for a partnership?[Attempt to Laughter]
Mr. Mark H. Berens: I wish she would have found it earlier.
I see my time is up and I have not even touched the Bad-Debt issue.
Chief Justice Warren E. Burger: You've covered that in your brief though --
Mr. Mark H. Berens: We will have to stand (Voice Overlap)
Mr. Chief Justice.
Argument of Stuart A. Smith
Chief Justice Warren E. Burger: Very well.
Mr. Stuart A. Smith: Mr. Chief Justice, may it please the Court.
In the government view there is a fundamental issue at stake in this case which is familiar to all of us, I think in computing our tax liability and that is that a deductible loss can only be established by a closed and completed transaction fixed by identifiable events and not by fluctuations in value.
We all know this to be the case.
We buy share of stock or house that goes up in value or down in value.
Those paper loses, so to speak, are irrelevant in computing our current tax liability, and only when we sell or exchange or otherwise dispose off the asset does the loss become fixed.
Well this case involves inventories somewhat technical in nature, the same principle applies, because inventories really are simply a device of computing the cost of goods sold that is basis and thereby measuring a given year's income within the annual accounting system which is central to our tax system.
The Court recognized this much in the Catto decision, in Volume 384 U.S., where it said, the general and long-standing rule for all taxpayers, whether they used the cash or accrual method of accounting, is that costs incurred in the acquisition of inventory may not be currently deducted, but must be deferred until the year of sale, when the accumulated costs may be set off against the proceeds of sale.
In that particular case a portion of the regulations at issue here were under scrutiny, that is 1.471-6 as they applied to livestock raisers.
Here, we are principally concerned with -2 and -4 of 1.71 and I think that with the Court's indulgence, the best way to explain the Commissioner's position is to look at the details of these regulations because these regulations have been around since 1922.
They were promulgated pursuant to an express statutory command of Section 471, which is essentially the same now as it was back in the Revenue Act of 1918, and they are essentially the same.
If you read the old cases and you look at the footnotes, Article 1582 is virtually the same as these regulations set out in our appendix.
Now the new management of Thor Power came in in 1964 and made three large scale reductions to its closing 1964 inventory, and by doing that, it increased its cost of goods sold and thereby decreased its taxable income.
There was a $2,750,000 write-down of closing inventory to reflect items that were scrapped as obsolete.
There was also a $245,000 write-down to reflect some spare parts stock of unsuccessful products, and shortly thereafter, these parts were sold at reduced prices.
The Commissioner did not question these two write-downs and they are not involved in this case.
Why because in our view, there was an identifiable event that established a closed and completed transaction, that is the scrapping or the reduction of the price of the spare parts.
Now here, we have a $926,000 write-down which is essentially an amalgam of three other write-downs, but I don't think we have to go into the nature of those three other write-downs.
We essentially have $926,000 deduction which in our view is qualitatively different from those other two write-downs.
This write-down was based on the fact that the taxpayer had estimates that this inventory was in excess of a year's demand of its customers.
Now I think the important thing to point out at the very beginning is why this was the case.
This taxpayer like all manufacturers, manufactured machinery, and had a stock of spare parts.
Now economically, it doesn't make sense and the counsel, I think, agreed and the testimonies to this effect as well, it doesn't make sense to manufacture a machine and then destroy the dyes or the tools and then when your customers who have this machine needs spare parts five years down the road to retool for those spare parts, so all the spare parts are made at once, and they are made pursuant to some estimate of what you think how long machine will be in circulation.
Now this is described as excess inventory, but I want to stress the fact it's not excess in the sense of farmer having a warehouse of oranges that are going to rot, or it's kind of glut on the market, it's a storehouse of goods which is in a excess of what you think you can sale for one year.
That doesn't mean that --
Chief Justice Warren E. Burger: Mr. Smith, I assume you would agree that no manufacturer can perfectly or with perfect accuracy estimate the amount of spare parts he is going to need --
Mr. Stuart A. Smith: Absolutely Your Honor, I think this was a --
Chief Justice Warren E. Burger: He must be high on some parts and if he has had bad staff work, he is going to be low perhaps on some others?
Mr. Stuart A. Smith: Asolutely Mr. Chief Justice and I think it was perfectly reasonable business sense, and I think it goes to the point that Mr. Justice Stevens explored with counsel earlier, and that is, this was not an abnormal situation.
This was quite a normal situation and in fact on page 51 of our brief, we quote the testimony of Thor's President who conceded that, “any business which is involved in the manufacture and sale of products inevitably must have access inventory.”
So I think that we don't dispute that fact.
Point I simply want to make is that this was not a glut of goods that had no utility.
It was simply a stock of goods that was in excess of the year's demand.
So what did the taxpayer do?
He said well, okay --
Chief Justice Warren E. Burger: Which might turn out to be excess at some point?
Mr. Stuart A. Smith: Might turn out to be excess at one point, and that's basically our point, because at some point is not at the end of 1964.
The tax system works on an annual accounting system.
At the end of 1964, these things were simply estimates and the Commissioner's regulations which I would like to now turn to, do not provide, in fact they explicitly prohibit the reduction of inventories based on these kind of estimates.
If there is one principle that underlines all of these regulations and has done so for 6o years, is that inventory adjustments must turn on objectively verifiable date and not estimates.
Justice John Paul Stevens: Can I ask you sort of fundamental question about your view on the statute and the regulation?
They argue in effect that there is an omission in the regulation.
They have argued alternatively that they complied with the regulations and also that the regulations are defective by not providing for this particular problem.
Is it your position that reading 471 which is their central section, that where it says such taxpayer on such basis as a secretary or his delegate may prescribe so forth and so on, that they must confirm to a regulation by the secretary authorizing the particular procedure they are using, then there is no room for --
Mr. Stuart A. Smith: Absolutely, absolutely.
Justice John Paul Stevens: You say if there is not a regulation authorizing it they are through?
Mr. Stuart A. Smith: Exactly, exactly, exactly.
They alternatively argued that the regulations are silent and somehow they should be allowed to sneak through so to speak, but we say no.
In fact the regulations in our view explicitly prohibit these write downs 1.471-2 (f) 1, 2 and 3, if I may burden the Court with all these number.
Justice John Paul Stevens: You have burdened the Court of Appeals with those. [Attempt to Laughter]
Justice Harry A. Blackmun: Mr. Smith, in this connection was 2 (f) argued to the courts below?
Mr. Stuart A. Smith: Absolutely, I believe so.
Isn't that the case?
Yes, yes, yes.
Justice Harry A. Blackmun: Are you sure of that?
Mr. Stuart A. Smith: Yes, I think the Court of Appeals had the benefit of -- in fact there is a good deal with acquisitions in the petitioners' brief about post -- appellate counsel's post talk justifications but while that maybe complementary, I may view that as personally complimentary, I think basically all of these considerations were put to the Court of Appeals including the change of accounting method argument as well.
Anyway, with that in mind I would like to turn to the regulations because I think that they justify, they not only justify they differentiated treatment by the Commissioner of these three write downs, but they required and they had required it since 1922.
Now the taxpayer's argument pretty much principally rests on the notion that there accountants told them that this was an acceptable accounting practice.
Justice Byron R. White: You just say these regulations prohibited, are you going to --
Mr. Stuart A. Smith: Yes, I'm going to explain them.
I am not just going to leave that statement hanging unsupported.
Justice Lewis F. Powell: Mr. Smith --
Mr. Stuart A. Smith: Yes sir.
Justice Lewis F. Powell: -- before you go on, didn't the Tax Court find that generally accepted accounting practice required what was done by this taxpayer, and that the SEC also would have required it in a registration statement?
Mr. Stuart A. Smith: There may well be at the SEC might require.
In fact it may well be that all sorts of bodies or statutes may require such things and that the account -- well I mean, our basic point is that accountants are concerned with projecting data to a reader in a way that doesn't really take into account measuring taxable income.
I think a prospective investor might want to know that Thor Power Tool had a feeling that it wasn't going to be able to sell all these things.
Down the road at some point it may have to get rid off them and it maybe worthless and that may affect his decision to buy a bond or share of stock or whatever.
But Commissioner of Internal Revenue was interested in measuring taxable income, and I feel that's quite a different matter.
And the fact that there might be such other requirements by the accountants or by other governmental agencies, I think is quite beside the point for purposes of determining whether --
Justice Lewis F. Powell: What promoted my question was, not that I was suggesting there may never be a variation in between tax requirements and accounting requirements.
It was your suggestion as I understood it that the taxpayer had sort of more less pulled this out because it wanted it and that they were not in accord with general accepted accounting practice or with what other governmental agencies required?
Mr. Stuart A. Smith: Oh, no, I didn't mean to suggest that.
Although, I think to fill out the story, the chronology is important as well.
I mean, this wasn't the situation where the accountants came in, and insisted on this method.
It was sort of quite the opposite management.
Justice Lewis F. Powell: I thought they wouldn't have said without testimony.
Mr. Stuart A. Smith: Well, there was testimony to that effect.
But all I want to point out is that management made the write-down and then asked the accountants for an opinion as to it's validity, and in fact the record indicates and we sort of quoted in our briefs, the accountant's opinion was --
Chief Justice Warren E. Burger: What page?
Mr. Stuart A. Smith: Page 8, I mean it's a standard -- it was a standard caveat that the accountants kept appending to their opinions.
It said “while the inventories reserves provided the best the current judgment of the company's management, it it's not possible to evaluate these reserves applied to ultimate disposition of the inventories involved.”
In other words -- I mean I think it's conceded this is an estimate and our point simply is while that maybe a perfectly reasonable thing for an accountant to do, the Commissioner of Internal Revenue regulations specifically prohibit those kind of estimates.
Justice Potter Stewart: But my brother Powell's question was, it went to what the Tax Court found?
Mr. Stuart A. Smith: I think the Tax Court did find that they --
Justice Potter Stewart: Did find that and that's in conformity with the Section 446 of the law enacted by Congress?
Mr. Stuart A. Smith: Well, it's in conformity with one requirement of Section 446.
Justice Byron R. White: Why do you think they should give away?
Mr. Stuart A. Smith: Well, I don't think --
Justice Byron R. White: If the Tax Court finds that the accountants won't certify as -- they wouldn't certify, if the taxpayer uses your method, then how can it possibly be in accord with best accounting practices?
Mr. Stuart A. Smith: Well Mr. Justice White, if I may just answer your question in a slightly different way.
I don't think there is a choice here that you have to say, are we going to -- which requirement has to -- there are two requirements.
There is a requirement that it conformed to the best accounting practice, there is also a requirement that it clearly reflects income.
I don't think there's any dispute here that this was an accepted --
Justice Potter Stewart: And the Tax Court found that it did both?
Mr. Stuart A. Smith: The Tax Court did not find it.
I think the Tax Court found that it clearly reflected financial income.
I think, that what counsel has said here this morning, but we're talking about whether it clearly reflected taxable income and I think that the answer to that question necessarily has to be made by reference to the Commissioner's detailed regulations.
Justice John Paul Stevens: You say that your method; the method that you insist on would be accepted in the accounting field --
Mr. Stuart A. Smith: May not be,may not be.
Justice John Paul Stevens: Well, if it isn't then this statute isn't satisfied either?
Mr. Stuart A. Smith: Well, then I must say I can -- I think it's true as Mr. Justice Stevens indicated, there is no one -- I don't think in this area there is one accounting method --
Justice Byron R. White: But you answered Mr. Justice Powell that there was a finding that – or at least a testimony that accountants would not have accepted any other basis?
Mr. Stuart A. Smith: I think that's right, there was testimony to that effect.
But the point is, the Commissioner of Internal Revenue --
Justice John Paul Stevens: Mr. Smith let me get something straight?
Mr. Stuart A. Smith: Yes, sure.
Justice John Paul Stevens: Earlier your opponent and I had a colloquy in which we agreed there could be more than one best accounting method.
Now, as I understand it, the SEC, for SEC purposes, they had required disclosure to the fact that the inventory on the book should be somewhat larger than its real value.
Mr. Stuart A. Smith: Right.
Justice John Paul Stevens: Say not unlike a case where you might have a piece of real estate, that's on its book showed one figure but there is a reason to believe its market values is much lower.
I assume the accountants wouldn't certify unless there was disclosure of the fact that there is great difference market value and the other.
That would necessarily mean of course you could take a deduction --
Mr. Stuart A. Smith: Exactly I think if there was a disclosure.
Justice John Paul Stevens: But, let me get to the heart of the thing.
Is there however any finding one way or another on the question whether accounting in conformity with the Commissioner's regulations would be or would not be a best method of accounting, an acceptable method?
Mr. Stuart A. Smith: There is no such finding in that regard.
Justice John Paul Stevens: Is there a testimony by the experts that they put on the stand that that would not be an acceptable method?
Mr. Stuart A. Smith: No, I think the testimony simply said that the taxpayer's method would be a good method of accounting.
Justice John Paul Stevens: It would be unacceptable.
Mr. Stuart A. Smith: Yeah, I think the way – perhaps the resolve this in a procedural sort of way, I mean it never quite frankly occurred to me, but if the statute requires these two things and the taxpayers has the burden of proof in the Tax Court, and it's the taxpayer's job to demonstrate that, its claimed reduction is proper and if it doesn't meet both tests then the deficiency is approved.
Justice John Paul Stevens: In a way I think your argument may be that the taxpayer is really challenging the regulation and requiring a method of accounting that's not a best method of accounting within the meaning of the statute, even though it's been on the books for some 40 years or something?
Mr. Stuart A. Smith: Well, I don't want to confront the accounting testimony.
I don't think I have to.
Justice Byron R. White: No (Inaudible).
Mr. Stuart A. Smith: [Attempt to Laughter] I don't think I have to do that.
Justice Lewis F. Powell: Mr. Smith, one thing that makes me keep coming back and taking your time is, that you refer to testimony and of course that's filed.
But I started over with the point and I finally found the sentence in the Tax Court's opinion, that says this is on page 8-19 of the petition of certiorari, five lines from the bottom, it says “a write down of inventory for excessive stock in this case was not merely desirable for accounting purposes, it was required in order to produce a certified balance sheet.
Now I would say, I don't think that decides a case.
I am just trying to --
Mr. Stuart A. Smith: I think you are right.
I think it's right --
Justice Lewis F. Powell: I am trying to make clear that this taxpayer --
Mr. Stuart A. Smith: This method of accounting was perfectly -- the Tax Court goes on to say –-
Justice Lewis F. Powell: It's required?
Mr. Stuart A. Smith: What?
Justice Lewis F. Powell: The Tax Court said it was required [Attempt to Laughter] not just --
Mr. Stuart A. Smith: Yes, but then the Tax Court went on to say Mr. Justice --
Chief Justice Warren E. Burger: It still leaves the second rule --
Mr. Stuart A. Smith: Yes exactly.
The Tax Court went on to say, if you turn to page over -- “however the petition also showed that the method clearly reflects taxable income,” and our point is that he hasn't done that and the reason he hasn't done that, he hasn't conformed with the regulations.
I think although the counsels deny that he (Inaudible) the regulations, he really does because --
Justice William H. Rehnquist: You have to get to the regulations if you take 446 (b), entitled exceptions which I take it means there are exceptions to Section 446 (a).
One of the exceptions is, “or if the method used does not clearly reflect income.”
Mr. Stuart A. Smith: Right, then the secretary makes the computation.
Justice William H. Rehnquist: And that's the end of it, whether it conforms --
Mr. Stuart A. Smith: And that's what we have done.
Yeah, but I think, I think you have to get to the regulations only to determine whether it clearly reflects income because the regulations I think provide a detail panoply of rules as to what will meet the clearly reflect income standard.
Justice William H. Rehnquist: But even if it conforms to entirely proper accounting practice and even if the accounting professional would say, this is the only way to do it, if the Commissioner can properly determine that it does not clearly reflect income, you win I would think?
Mr. Stuart A. Smith: That's absolutely the case and the reason we win in our view is because this doesn't meet the requirements of the regulations yes.
I am sorry.
Justice Lewis F. Powell: May I follow up on Mr. Justice Rehnquist, a point with which I do not necessarily disagree.
Do you perceive that there is any sort of a presumption in favor of what a taxpayer does when it is in accord with general accepted accounting practice and moreover his balance sheet will be certified unless he does what was done.
Is there any sort of presumption that --
Mr. Stuart A. Smith: Well I don't think there is any presumption as such.
I would not characterize it as presumption, I would simply say it needs that one way --
Justice Lewis F. Powell: That can put the burden on a Commissioner to demonstrate why the taxpayer was wrong?
Mr. Stuart A. Smith: Oh no I don't think so.
I think the Commissioner --I think the taxpayer has a -- these are statutes in which the courts have traditionally characterized the taxpayer's burden as heavy one and the Commissioner's discretion is a broader one.
Justice Lewis F. Powell: Even in view of the conjunctive language in 471?
Mr. Stuart A. Smith: Yes.
I think that's right and I think to follow up on your point I think the taxpayer, and to get into the regulations, the taxpayer has plucked out a sentence out of the regulations which says here that the --
Justice William J. Brennan: What are you reading?
Mr. Stuart A. Smith: I am in 471-2 (b).
Justice William J. Brennan: Page?
Mr. Stuart A. Smith: Page 85, I am sorry, the appendix to our brief.
Inventory rules should give effect to trade customs which come within the scope of the best accounting practice and then down below it says an inventory that can be use under the best accounting practice in a balance sheet showing the financial position of the taxpayer can as a general rule be regarded as clearly reflecting income.
I think that's what the regulations provide, but I think that's it.
What that sentence -- the taxpayer would have that sentence stand as a kind of universal standard in derogation of the rest of these detailed rules that have existed for almost 60 years.
Justice Lewis F. Powell: Of course one starts with the statutory language and the regulations can rise no higher than that?
Mr. Stuart A. Smith: Sure.
Justice Lewis F. Powell: My question really was whether or not statue itself does not put the burden on the Commissioner in this type of situation where the taxpayer has met the first requirement of the statue?
Mr. Stuart A. Smith: No, I don't think it does Mr. Justice Powell.
In fact the portions of the code in which the -- I mean the general rule is that the taxpayer has the burden of proof of --
Justice Lewis F. Powell: I am familiar with that.
Mr. Stuart A. Smith: Yes, and I think that the portions of the code has a few sections which specifically put the burden of proof on the Commissioner in accumulated earnings tax case if the taxpayer files a statement of reasonable cause for accumulations then the Commissioner has the burden that's by statue, in a case where the Commissioner asserts the 50% fraud penalty, the Commissioner has the burden.
The Tax Court rules provide that when the Commissioner raises new matter by answer it has the burden.
I think that those are unusual circumstances and I think that the general rule has to apply here.
Simply qualifying under one provision, under one requirement of the statue I don't think shifts, you know, provides any shifting of burdens of proof.
Justice Lewis F. Powell: May I ask you just one more question and then I will be very quiet.
Mr. Stuart A. Smith: Sure.
Justice Lewis F. Powell: How does a taxpayer in a business that involves a substantial number of items comply with what I understand your point is and that is that there must be a realization of the loss estimated to exist in inventory before it maybe taken in the taxable year in question.
How does one comply, you have --
Mr. Stuart A. Smith: Well there are several ways.
In fact counsel adverted to one of them, scraping of goods but --
Justice Lewis F. Powell: Suppose you have a millions bits and pieces of inventory, you can't selectively scrap, perhaps you could, but you would still have a very large number of items that perhaps properly should be written down on a cost or market inventory basis.
What does one do?
Mr. Stuart A. Smith: Well what one does is look at the regulations which provide for a way of fixing the proper amount of the write down.
The regulations provide -- let me give two examples.
If you look at page 85-86, there is a provision for a write down for damaged or imperfect goods, goods that have been shopworn etcetera, and the regulations provide that they should be valued at bona fide selling prices less direct cost of disposition whether you are on the cost or lower cost to the market method.
And the regulations go on to say little further down, I suppose two-thirds the way down on page 86, “bona fide selling price means actual offering of goods during a period ending not later than 30 days after inventory day.”
And if I may drop down a few more, “actually the burden of proof will rest upon the taxpayer to show that such exceptional goods as are valued upon such selling prices come within the classification above and he shall maintain such records of the disposition of his goods, as will enable a verification.”
The regulations, the hallmark of the regulations,the touchstone, is independent means of verification.
Now going on to page 87, if I may, the lower of cost or market and this sort of in a way I would like the clear up what I think is a fundamental sort of misconception advanced by the counsel and that is, that somehow market means net realizable value.
Market and the lower cost of market doesn't mean net realizable value, it means replacement value.
And the reason it means replacement value simply is because as I said earlier the whole process of inventories is to determine basis.
In another words, if you buys something for $100 and then two years down the road you find out that you can buy it for $50, well if the Commissioner will then say if you are on the lower of cost or market then if you went out and bought one today you would only pay $50 for it, we will allow you a $50 write down.
But again it has to be on the basis of independent verifiable data.
If I may ask the Court to look at one more of these detailed provisions on page 88 sub paragraph C on the lower of cost or market it says “where the inventory is valued on the basis of cost or market whichever is lower, the market value of each article on hand that the inventory date shall be compared.”
In another words, the Commissioner's regulation – I mean I think it's -- I don't think that it's incomprehensible to infer that there is tremendous amount of abuse in the keeping of inventories and the way the Commissioner has tried to set up these requirements for almost 60 years is to provide for independent verifiable evidence of inventory reduction.
Justice John Paul Stevens: Well Mr. Smith, one of the taxpayer came to the Tax Court or came to the Commissioner and said, look my net realizable value is scrap value, here is what I could get if I actually scraped it, and suppose you said well we agree with you that if you scrapped it right now, that is the net realizable value.
That amount would be the amount you say is the net realizable value and let's assume you agreed agreed with him, you still would let him write it down, would you?
Mr. Stuart A. Smith: Oh it has to be scrapped.
Justice John Paul Stevens: I know but you [Attempt to Laughter] --
Mr. Stuart A. Smith: In another words, what I am saying is that there are another --
Justice John Paul Stevens: Suppose he gets offers from people who are buying scrap and he comes in and says at page 86, he says I here have some bona fide offers for my inventory and scrap value?
Mr. Stuart A. Smith: If I may just modify your example in one respect.
Justice John Paul Stevens: Don't modify at all, take my example for a minute.
Mr. Stuart A. Smith: (Attempt to Laughter)Well, I would say that the write down would be permitted if the goods were damaged in perfect shopworn, unstylish or they are broken, lost --
Justice John Paul Stevens: So you just don't permit [Attempt to Laughter] on the page 86, don't permit writing down for just excess inventory.
Mr. Stuart A. Smith: Exactly, exactly and --
Justice John Paul Stevens: Well why did you cite that to us as an example of what the taxpayer could have done here?
Mr. Stuart A. Smith: Excuse me.
Justice Lewis F. Powell: Well you indicated he might have used this method on page 86?
Mr. Stuart A. Smith: I said if the goods were damaged or shopworn, it said, in other words what I am simply saying that these are detailed technical rules.
Justice Byron R. White: So tell me again now Mr. Smith, I asked you a while ago.
What specific provisions in these regulations is the -- prohibit what the taxpayer does?
Mr. Stuart A. Smith: Oh, certainly.
Justice Byron R. White: Certainly 86 doesn't now you have conceded?
Mr. Stuart A. Smith: Page 87.
Justice Byron R. White: So 86 is irrelevant.
Mr. Stuart A. Smith: Yes, well no.
Let's put it -- no, 86 is not irrelevant, 86 simply --
Justice Byron R. White: Well it doesn't cover this?
Mr. Stuart A. Smith: It refutes -- I mean it's relevant only because petitioner has claimed to come within it.
Justice Byron R. White: You said it was running with the prohibition on the equipment.
Mr. Stuart A. Smith: The prohibition is at the top of page 87, paragraphs 1, 2 and 3 “deducting from the inventory a reserve for price changes or an estimated depreciation in the value thereof,” and we set forth in great detail in our brief at pages 41 to 44 and cited a number of cases which incidentally antedate.
Justice Byron R. White: But is this the only provision you are saying?
Mr. Stuart A. Smith: No, two and three as well expressly prohibit.
We think that what the taxpayer did here on the basis of estimates is describe by each of those sub paragraphs.
He deducted from the inventory reserve for price changes or an estimated depreciation, in other words that these were estimates and not independently --
Justice Byron R. White: Is there anything else in the –
Mr. Stuart A. Smith: No, there is no expressed prohibition, everything else -- we have invoked the regulation in every other respect to refute the taxpayer's claim to the inventory right then.
In fact because the taxpayer's principle claim is that somehow this is lower of cost or market and we say simply it is misread market.
Justice John Paul Stevens: (Voice Overlap) allow them to write off any inventory of any item that had been unsold for at least a year?
Mr. Stuart A. Smith: Say that excuse me.
Justice William O. Douglas: There were some items on which there had been no sales for at least a year.
Did not the Commissioner permit them to write those off at 100% as obsolete?
Mr. Stuart A. Smith: There were were two, as I said earlier, there were two specific write downs, one of them for obsolete goods, you are right and the other one was for --
Justice John Paul Stevens: Wasn't the test of obsolescence no sales of the particular item for a year?
Mr. Stuart A. Smith: I think they were scrapped, they were scrapped as obsolete.
In other words, they met the scrapping requirement, the one that the taxpayer feels so unhappy about.
Justice John Paul Stevens: Do you know whether or not the Commissioner allowed write off for obsolescence merely on a showing that an item had not been sold for years?
Mr. Stuart A. Smith: I don't think there is anything in the record that indicates that and I would suggest that wouldn't meet the test of the regulations simply because something wasn't sold for a year, I don't think indicates that it's without utility or value to the taxpayer.
Justice Byron R. White: And under what part of the regulation was that particular write down for obsolescence permitted?
Mr. Stuart A. Smith: Permitted?
I would suggest to the Court, there is nothing in the regulations as such that permits a write down for obsolescence or scrapped as obsolescence, but that it seems to us that the statutory basis for that is Section 165 of the code which simply permits a loss when something becomes valueless like when you had a casualty and your house burns down.
Justice John Paul Stevens: Realized loss.
Mr. Stuart A. Smith: Yeah exactly, and it is of no value to you or whatever you can get for it.
I think my time has expired, if you have no further questions.
Chief Justice Warren E. Burger: Thank you gentlemen.
The case is submitted.