Before MCLAUGHLIN, STALEY and HASTIE, Circuit Judges.
The Commissioner of Internal Revenue has petitioned for a review of two decisions of the Tax Court.*fn1 The principal issue presented is whether Section 45 of the Internal Revenue Code, 26 U.S.C.A. § 45, authorizes the Commissioner to combine the net income of three corporations with that of taxpayer where all are owned by the same interests. We are in accord with the Tax Court's conclusion that Section 45 was erroneously applied.
Between 1941 and 1944, taxpayer was engaged in the manufacture and sale of fans and blowers under the name of Chelsea Fan & Blower Co., Inc.*fn2 During this period the sole stockholders, officers, and directors of taxpayer were William J. Lohman, Sr., who held 50% of the common stock outstanding, and his two sons, Eugene W. and William J., Jr., each of whom held 25%.
In 1944 the three Lohmans, after consultations with their attorney, decided to separate taxpayer's manufacturing functions from its sales. The new plan was carried out by forming a sales corporation in each of three states: Missouri, Georgia, and New Jersey. These new corporations bore the respective names Chelsea Fan and Blower Company of Missouri, Chelsea Fan & Blower Company of Georgia, and Chelsea Fan and Blower Co., Inc. Each of the sales companies issued 1200 shares of stock at $1 a share, which was subscribed to in equal amounts by each of the three Lohmans. As in the case of taxpayer, the three Lohmans constituted the Board of Directors of each of the sales companies during the taxable years involved. At the same time, the taxpayer changed its name to Chelsea Products, Incorporated, and thereafter confined its activities principally to manufacturing.
Prior to the creation of the new corporate structure in 1944, taxpayer had sold its products through its officers and through "manufacturer's agents." Taxpayer had entered into contractual arrangements with these agents whereby they were paid commissions of about 10% on sales. After July 11, 1944, taxpayer no longer employed these manufacturer's agents. On that date the sales companies were designated exclusive agents, each company being assigned a different area of the country, and they in turn proceeded to employ sales agents. The arrangements between taxpayer and the sales companies were formalized by written agreements entered into between taxpayer and each sales company. These agreements, signed by William J. Lohman as president of taxpayer and Eugene W. Lohman as vice president of the sales companies, provide that each sales company is to "employ a sufficient number of salesmen to properly canvass its territory" and is to be charged the list price less 50% and 25%. The former discount was the standard one given by those in the industry to wholesale jobbers and was passed on to the wholesale jobbers who bought the products. The 25% discount, the Tax Court found, includes the 10% commission normally paid to the agent, thus leaving 15% for the operation of the business of the sales companies.
Although the Missouri and Georgia companies had mailing addresses in their respective states of incorporation, neither had an office there. Each of the sales companies maintained its office in New Jersey at 1206 South Grove Street, Irvington - the same address which had been occupied by taxpayer. Each of the companies had separate books and records and separate bank accounts. The records of the sales companies were kept by the same bookkeeper who kept taxpayer's books and were audited by an outside accounting firm.
During the taxable years involved, all the fans and blowers sold by the sales companies were manufactured by taxpayer. A sales agent, upon receiving an order, would send it to Irvington, N.J., to the sales company which employed him. The order was then turned over to taxpayer which shipped the merchandise directly to the customer and invoiced the sales company. The latter, in turn, submitted an invoice to the customer and received payment from him.
The business reasons which prompted the organization of the sales companies are set forth in the record. The attorney whom the Lohmans consulted in 1944 testified that he had advised them that taxpayer's tort liability arising from accidents in the use of the fans could thereby be "minimized." The record also reveals that the Lohmans had intended that the sales companies establish assembly plants in several states in order to reduce freight costs. Further, the Lohmans believed that sales, especially in the South, would be increased if promoted by a local firm.
The Commissioner determined that there was a deficiency of $110.58 in taxpayer's income tax liability and $37,091.85 in its excess profits tax liability for the year 1944. He also determined that there was a deficiency of $165.62 in its income tax liability and $25,519.13 in its excess profits tax liability for the year 1945. In arriving at these deficiencies, the Commissioner allocated the net income of the three sales companies to that of taxpayer. The latter then sought a redetermination before the Tax Court. The Tax Court found that each sales company was a business enterprise separate and distinct from taxpayer and that no part of the income of the sales companies constituted income to it. Moreover, that Court determined that the principal purpose for the organization of the sales companies was to carry on business and not to aid taxpayer in evading or avoiding Federal income or excess profits taxes. The Tax Court, five judges dissenting, held that the Commissioner's action was not authorized.
The Commissioner asserts that he acted within the broad discretionary power conferred upon him by Section 45, which section reads: "Allocation of income and deductions. In any case of two or more organizations, trades, or businesses * * * owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses." (Italics supplied.)
Section 45 has been a part of our Revenue Laws since 1928.*fn3 It is in some sense an offspring of Section 240(f)*fn4 of the Revenue Act of 1926, which gave the Commissioner the right to consolidate the accounts of businesses controlled by the same interests where he finds it necessary to make an accurate distribution of profits and deductions.*fn5 Section 240(f) was a part of the Consolidated Returns section of the 1926 Act. In drafting the new Section 45, important changes were made and, significantly enough, the offspring became a new section, separate and apart from the Consolidated Returns section.
Section 45 grants to the Commissioner power to allocate "gross income, deductions, credits, or allowances". There is no mention of authority to disregard completely the corporate entity by combining the net income of controlled corporations. The plain language of Section 45 must prevail.
The scope and purpose of Section 45 is clearly set forth in the Treasury Regulations. Treasury Regulation 111, § 29.45-1 (b) states: "The purpose of section 45 is to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer, by determining, according to the standard of an uncontrolled taxpayer, the true net income from the property and business of a controlled taxpayer. * * * The standard to be applied in every case is that of an uncontrolled taxpayer dealing at arm's length with another uncontrolled taxpayer. * * It is not intended (except in the case of the computation of consolidated net income under a consolidated return) to effect in any case such a distribution, apportionment, or allocation of gross income, deductions, credits, or allowances, or any item of gross income deductions, credits, or allowances, as would produce a result equivalent to a computation of consolidated net income under section 141." The Report of ...