Fort Howard Paper Co. v. Comm.

Decision will be entered under Rule 50.

William A. Cromartie and Douglas L. Barnes, for the petitioner.

Robert M. Burns and John L. Pedrick, for the respondent.

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Respondent determined a deficiency in the amount of 212,354.52 in the Federal income tax of petitioner for the taxable year ended December 31, 1961. After concessions and agreements with respect to various adjustments raised by the deficiency notice, the issues remaining are: (1) Whether the additional examination of petitioner's records and the issuance of a deficiency notice thereunder were improper under section 7605; ¹ (2) whether respondent's determination was arbitrary and unreasonable and therefore should be disregarded, or alternatively not be accorded the usual presumption of correctness; and (3) if such determination is not to be disregarded, whether petitioner utilized the proper method of accounting for the cost of "self-constructed assets."

FINDINGS OF FACT Some of the facts are stipulated and are found accordingly.

Petitioner Fort Howard Paper Co. (sometimes hereafter referred to as Fort Howard) is a Wisconsin corporation with its principal offices in Green Bay, Wis., at the time of the filing of the petition herein. Petitioner timely filed its Federal income tax return for the calendar year 1961 on the accrual basis with the district director of internal revenue in Milwaukee, Wis.

Fort Howard is a manufacturer of paper and paper products. During the period 1953 through 1961, petitioner's gross sales ranged from approximately 15 million to 30 million. In 1961, the Fort Howard product line consisted exclusively of manufactured sanitary papers, such as paper towels, napkins, and tissues. Nearly 975 different items, including various grades and sizes of paper products, were manufactured. Six large paper-making machines were in operation at the plant. Petitioner also operated pulpers and equipment for the processing of dried pulp into a usable state for the paper machines. In addition, petitioner used certain machinery to convert logs into groundwood pulp and to process scrap paper and similar products into pulp ingredients when they could be appropriately used in the final product.

Petitioner operated its own fleet of motor vehicles and over 80 forklift trucks and towmotors. In addition, the company produced its own

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electric power from coal-operated steam generators, having in 1961 a maximum capacity of approximately 20,000 kilowatts. In 1961, petitioner purchased no electric power from sources outside the plant, with the exception of small amounts used in warehouses not directly connected with the main plant.

For many years prior to and including 1961, petitioner's plant was operated on a full 24-hour basis, usually for 13 days in each 2 weeks. Occasionally, the plant would be shut down because of repairs, or during a special "shut down" period of 2 weeks (once a year) when many employees were on vacation and only "skeleton" crews were on duty. To operate at this level, three full production crews were maintained in 1961 for each paper-making machine.

In 1961, approximately 1,100 persons were employed by petitioner, 190 to 200 of whom were repair and maintenance personnel in nonsupervisory capacities. Included in the repair and maintenance personnel were skilled mechanics and repairmen, carpenters, electricians, machinists, millwrights, and pipefitters. Petitioner also maintained and operated in its plant "repair shops," which were capable of handling most machine and plant repairs. Most of the employees on the repair and maintenance crews worked on the day shift (7 a.m.-3:30 p.m.) with smaller crews available on the evening (3 p.m.-11 p.m.) and midnight shifts (11 p.m.-7 a.m.). In order to keep the plant in continuous operation, all repair and maintenance personnel were subject to call at any time for emergency work.

At least as far back as 1939 and up to and including 1961, the Fort Howard management followed a policy of using its maintenance and repair personnel from time to time in the renovation of its buildings and the construction and installation of assets having useful lives of more than 1 year (hereinafter referred to as self-construction projects or self-constructed assets). To avoid having any "slack," "idle," or "loss" time, repair and maintenance personnel were used only during their spare time, when they could be so employed without disturbing normal operations. Such personnel were not diverted from regular repair or maintenance projects to work on self-construction projects. No special tools or machinery were acquired for use by such personnel in connection with such activities. Projects were often planned a year or more in advance of actual construction, but completion was sometimes delayed several years because work was done only on a "fill-in" basis.

Since the time of its inception (1919), Fort Howard management followed a policy of determining the size of its repair and maintenance staff on the basis of the need for continuous operation of the regular producing equipment. During peak periods of maintenance, it was often necessary to supplement the repair and maintenance force with

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anywhere from 25 to 75 employees borrowed from the manufacturing (producing) departments.

Self-construction work performed by repair and maintenance personnel was the subject of a written description and was designated a "project." Examples of such "projects" included the following (as recorded from petitioner's record of Jobs in Progress -- 1961):

 Date opened   Job No.

Petitioner maintained on its books and records an account identified as Construction in Progress. A separate record sheet was prepared for each self-construction project. All direct labor and direct materials employed on each project were accumulated in the "Construction in Progress" account prior to the time that the particular project was completed and placed into service. No indirect costs (i.e., overhead)

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were so accumulated. No part of the costs of the drafting department was capitalized as a cost of self-construction. Not until a project was completed was it determined whether the applicable labor and materials were to be charged to expense or to be capitalized. Petitioner consistently followed the foregoing method for a least 35 years.

For at least the period from 1939 through 1961, Fort Howard followed the practice of allocating a portion of its overhead in determining the cost of goods which it produced and sold. For this purpose, the company's cost accounting procedures included a "grade-costing" system which was used to arrive at an average cost per ton for each grade of paper produced. All direct charges for labor and material used in each of the 29 producing departments were charged directly to such departments. Indirect expenses were also distributed to the producing departments, or to three basic service classifications identified as "mill services," "building services," and "steam and power." The company did not consider certain "fringe benefit" items (including bonuses, profit-sharing distributions to employees, group insurance, and personnel, cafeteria, and first aid expense) to represent proper elements of the cost of goods. Instead of being allocated to inventory, these items were always currently expensed.

Fort Howard tax returns were audited by agents of the respondent for each of the years 1928 to 1961. For almost all of these years, including 1961, the agents who made the examinations were aware that petitioner, in determining the costs applicable to its self-construction projects, capitalized the direct labor and direct materials involved, but did not allocate any overhead thereto. During the period 1928 to 1961, the accounting for costs in the determination of overhead, and the allocation thereof to cost of goods produced and sold, was also subject to review by these agents. Both Agent Evans (examiner from 1928 to 1938) and Agent Baeb (examiner from 1942 to 1961) reviewed the petitioner's practices in determining the costs to be attributed to self-constructed assets and decided that the method employed was proper under the circumstances because of the consistent use of such method by petitioner over a period of many years. During the course of the foregoing audits (including the year involved herein), respondent's agents themselves frequently adopted this method by utilizing petitioner's computation of costs, i.e., only direct labor and materials, as the measure of the amount of deducted repairs which they required to be capitalized; they included no overhead in the capitalized amount.

Petitioner's return for the year 1961 was initially audited by Agent Baeb. He was assigned to the office of the district director of internal revenue, Milwaukee, Wis. Some time after Baeb had completed his initial audit, the Internal Revenue Service received a complaint that certain irregularities involving the official conduct of respondent's agent had occurred in the prior examination of the tax returns of

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petitioner. Pursuant to this complaint, Agent Slotnick of the Chicago district office was assigned to investigate these purported irregularities and to examine petitioner's 1963 income tax return. Slotnick's examination established that none of the purported irregularities had occurred and that the complaint was without substance, but he nevertheless felt that certain adjustments should probably be made, not only in the 1963 return but in the returns for prior years.

Upon returning to the Chicago office, Slotnick prepared a memorandum requesting authorization to reopen the taxpayer's returns for the years 1961 and 1962. This request was approved by John W. Hungeling, Acting Assistant Regional Commissioner -- Audit, on February 1, 1965, and a notice of reexamination, dated February 1, 1965, and signed by the Regional Commissioner for the Midwest Region, was sent to petitioner. Thereafter, Agent Slotnick commenced his examination of petitioner's 1961 return. Engineer Revenue Agent Lawrence M. Kenney was assigned to work with Slotnick and spent 6 days at petitioner's plant between February 18, 1965, and February 26, 1965. Having been advised that he was confronted with a problem of determining "overhead," Kenney familiarized himself with the list of "Jobs in Progress -- 1961" and personally observed the physical facilities in the plant. Kenney had made no visit to the plant in 1961. No official written report was prepared by Kenney with respect to the year 1961 until April 12, 1965. Agent Slotnick's report upon reexamination was dated March 5, 1965. The principal proposed adjustment to petitioner's 1961 income was the allocation of 408,374.08 of "overhead expenses" to the capitalized cost of self-constructed assets.

The basic approach followed by Agent Slotnick in making his determination of how much overhead to capitalize was (1) to determine the particular departments and persons connected with self-construction projects in 1961; (2) to determine the total costs connected with each of these departments and persons; (3) to determine what percentage of these costs were allocable to self-construction projects; and (4) to determine the amount of supervision costs allocable to each department involved in such projects.

In determining which departments and persons were involved in the self-construction projects and the extent of such involvement, Slotnick relied on the following: (1) A single inspection of petitioner's plant; (2) discussions with petitioner's assistant treasurer which were not reduced to writing; (3) his own general experience as a certified public accountant and an Internal Revenue agent; (4) the reading of a cost accounting text in the Green Bay Public Library, which text specifically dealt with the method of allocating mill service departments to the producing departments of a factory; and (5) consultations with Agent Kenney and information furnished by him which formed the basis of his report dated April 12, 1965.

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Petitioner was generally cooperative during the reexamination of its 1961 return, furnishing such records and information as were available, upon request by Slotnick. At the time he conducted his examination, Slotnick was aware that self-construction activities had taken place and that petitioner's records contained detailed information with respect to each such project. He did not, however, avail himself of such information. Nor did he attempt to ascertain from petitioner's records the extent to which personnel of any one of the specific departments actually participated in self-construction work.

In capitalizing "overhead" in the amount of 408,374.08 for the year 1961, respondent did not reduce petitioner's inventory at December 31, 1961, by that portion of said "overhead" which had been allocated to inventory valuation by petitioner in determining its cost of goods sold. The parties have stipulated that, whatever the decision of the Court with regard to other issues in this case, petitioner's inventories at December 31, 1961 (and on Jan. 1, 1962), will be as shown on the 1961 return (namely, 1,359,698.17).

On its corporate income tax return for the calendar year 1961, petitioner showed taxable income of 5,102,651.76, cost of goods sold of 16,887,948.60, fixed assets of 24,736,046.84, and depreciation of 1,516,573.28. Petitioner's total computed income tax for 1961 was 2,644,698.10. ULTIMATE FINDING OF FACT

Petitioner's method of accounting for self-constructed assets clearly reflected its income. OPINION

The core issue herein involves the question of how petitioner should treat overhead expenses in determining the cost of self-constructed assets for tax purposes. Respondent contends that portions of such expenses should be capitalized and added to the cost basis of the assets. Petitioner asserts that it should be entitled to continue its past practice of capitalizing only direct labor and materials costs without allocation of overhead.

Petitioner is a large manufacturer of a great variety of paper and paper products. To a marked degree, its operations are self-sufficient, e.g., it produces the bulk of its own power. For many years prior to and including the taxable year involved herein, petitioner operated on a 24-hour basis, usually for 13 days in each of 2 weeks. During 1961, it employed 1,100 persons at its plant, of whom 190 to 200 persons were repair and maintenance personnel, including mechanics, carpenters, electricians, millwrights, and pipefitters. Such personnel worked throughout the 24-hour daily cycle, the majority of them on the day shift. All were subject to call at any time for emergency work.

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At least as far back as 1939, petitioner followed a policy of using repair and maintenance personnel during their spare time in the construction, renovation, and repair of fixed assets used by petitioner in its manufacturing operations. At no time were such personnel diverted from regular repair and maintenance activities to work on such self-constructed assets.

At all times the size of petitioner's repair and maintenance staff was determined exclusively by its need for the continuous operation of its regular producing equipment. No special tools or machinery were acquired for use by such personnel in their activities on self-constructed assets. Respondent does not contend that petitioner maintained a larger than necessary repair and maintenance staff as a cover for its self-construction activities, and, indeed, there is no evidence in the record before us to support any such conclusion.

For 35 years or more, petitioner capitalized only the direct labor and materials charges directly attributable to self-constructed assets. No portion of expenditures in overhead categories (such as fuel, supplies, oil, grease and waste, insurance, bonuses and vacation pay, profit-sharing, cafeteria, and first aid) was capitalized. Some of such overhead was allocated to inventory; the balance was expensed on petitioner's books and deducted as ordinary and necessary business expenses on its Federal income tax returns. Throughout the years, respondent was well aware of petitioner's practice in this regard. Not only did respondent not object, but, in several instances where respondent's agents determined that certain expenditures for repairs should be capitalized, they also included in the capitalized amount only direct labor and material costs.

In January 1965, an investigation and an audit of petitioner's 1963 return was commenced by an agent specially designated by respondent's Chicago office for reasons wholly unrelated to the issue involved herein. During the course of that audit, it was determined that a portion of overhead expenses should be capitalized. As a consequence, respondent decided to invoke the provisions of section 7605 and reopened petitioner's 1961 return, which had previously been closed on audit. On March 12, 1965, just prior to the expiration of the 3-year period of limitations, the deficiency notice involved herein was issued.

It is against the foregoing background that we consider the core issue confronting us. In so doing, we note that we are not faced with questions involving: The proper annual period in which an item of income or expense should be accounted for taxwise; the propriety of the cash versus accrual basis of accounting; the validity of a change of a method of accounting at the instance of the taxpayer; a dichotomy between the basis on which a taxpayer's books and records are kept and that on which his tax returns are filed; or the standards, for tax

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and regulatory purposes, imposed upon a public utility. In the instant case, the items involved concededly accrued in 1961, and the question before us is how they should be treated in that year.

Respondent's thrust herein is predicated on two sections of the Internal Revenue Code. He first urges that overhead is a capital expenditure within the contemplation of section 263. ² Secondly, he asserts that the accounting method utilized and characterized by petitioner as the "incremental cost" method is in fact the "prime cost" method and does not conform to generally accepted accounting principles. Respondent then claims that the requirement of "clearly reflect income" in section 446 ³ and the regulations thereunder demands the use of the "full absorption cost" method. ⁴ Petitioner counterattacks with the proposition that its method has been consistently used over a period of many years with the knowledge, and indeed the approval, of respondent and that the method is in accordance with generally accepted accounting principles. For the reasons hereinafter stated, we agree with petitioner.

We reject as without merit respondent's contention that section 263 of the Code is in and of itself dispositive of the issue before us. By requiring the capitalization of amounts "paid out for new buildings or for permanent improvements or betterments made to increase the value of any property," such section begs the very question we are asked to answer. We are satisfied that, under the circumstances involved herein, sections 263 and 446 are inextricably intertwined. A contrary view would encase the general provisions of section 263 with an inflexibility and sterility neither mandated to carry out the intent of

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Congress nor required for the effective discharge of respondent's revenue-collecting responsibilities. Accordingly, we turn to a determination as to whether petitioner's method of accounting "clearly reflects income" pursuant to the provisions of section 446.

Several broad theses are applicable in such a determination. Income must be reflected with as much accuracy as recognized methods of accounting permit. Caldwell v. Commissioner, 202 F. 2d 112 (C.A. 2, 1953), affirming on this issue a Memorandum Opinion of this Court. Respondent is given broad discretion in determining whether a particular method of accounting clearly reflects income and a heavy burden is imposed upon the taxpayer to overcome a determination by respondent in this area. Commissioner v. Hansen, 360 U.S. 446 (1959); Photo-Sonics, Inc., 42 T.C. 926, 933 (1964), affd. 357 F. 2d 656 (C.A. 9, 1966); Michael Drazen, 34 T.C. 1070 (1960). Even though a particular method may be in accordance with generally accepted accounting principles, it may not so clearly reflect income as to be binding upon the Commissioner. Schlude v. Commissioner, 367 U.S. 911 (1961); American Automobile Assn. v. United States, 367 U.S. 687 (1961). Moreover, mere failure of the Commissioner previously to object to the taxpayer's accounting method will not stop him from later challenging it. Niles Bement Pond Co. v. United States, 281 U.S. 357, 362 (1930); Hotel Kingkade, 12 T.C. 561 (1949), affd. 180 F. 2d 310 (C.A. 10, 1950). Finally it has been recognized that consistency of application is an important consideration and may be entitled to considerable weight. Photo-Sonics, Inc., supra at 935; cf. Advertisers Exchange, Inc., 25 T.C. 1086 (1956), affirmed per curiam 240 F. 2d 958 (C.A. 2, 1957). But consistency standing alone is not sufficient to satisfy the taxpayer's burden. Photo-Sonics, Inc., supra at 935; Ezo Products Co., 37 T.C. 385, 391 (1961); V. T. H. Bien, 20 T.C. 49 (1953). Indeed, it will be disregarded where an erroneous method of accounting has been used. Photo-Sonics, Inc., supra; D. Loveman & Son Export Corporation, 34 T.C. 776 (1960), affd. 296 F. 2d 732 (C.A. 6, 1961), certiorari denied 369 U.S. 860 (1962).

In the final analysis, we must apply the foregoing theses in light of the particular facts and circumstances of each case with reference to the particular business involved, the particular method employed, and the specific item at issue. Sam. W. Emerson Co., 37 T.C. 1063 (1962). We move to this task mindful of the desirability of avoiding judgments dependent upon "(subtle) accounting nuances" (see Boyton v. Pedrick, 136 F. Supp. 888, 891 (S.D.N.Y. 1954), affirmed per curiam 228 F. 2d 745 (C.A. 2, 1955)) and aware that in many situations in this area exact calculations may be neither practical nor necessary (cf. E. W. Bliss Co. v. United States, 224 F. Supp. 374 (N.D. Ohio 1963), affd. 351 F. 2d 449 (C.A. 6, 1965)).

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At this point, it is useful to recall the salient facts regarding petitioner's policy with respect to self-constructed assets. Petitioner did not in any way augment its personnel to construct these assets. It relied entirely on its repair and maintenance staff to do this work and then only during "slack" or "idle" time, so that the normal flow of production activities was in no way affected. Thus, petitioner's policy achieved a "double duty" objective. In a very real sense, petitioner killed two birds with one stone. There is nothing in the record before us which indicates that there was any increase in overhead costs which could be directly identified with the self-constructed assets. ⁵

We were favored with considerable expert testimony on the propriety of the method of accounting used by this petitioner with respect to self-constructed assets. The testimony was clear and convincing and is supported by our extensive review of accounting authorities. Finney & Miller, Principles of Accounting -- Intermediate 292-294 (1965); Hendirksen, Accounting Theory 302-304 (1965); Karrenbrock and Simons, Intermediate Accounting 413 (4th ed. 1964); Kohler, A Dictionary for Accountants 85, 217-218 (3d ed. 1963); Meigs, Johnson, Keller, Intermediate Accounting 509-511 (1963); Holmes, Maynard, Edwards, Meier, Intermediate Accounting 365 (1958).

These authorities and the testimony of the experts herein clearly indicate that both the "incremental cost" method as applied by this petitioner and the "full absorption cost" method urged by respondent are acceptable. This is in marked contrast to the attitude with respect to allocating a portion of overhead to inventory, where failure to do so is specifically designated an erroneous method of accounting. American Institute of Certified Public Accountants, Bull. No. 43, Restatement and Revision of Accounting Research Bulletins 29 (1961).

This factor, namely, the utilization of an erroneous method of accounting, is what deprives Dearborn Gage Co., 48 T.C. 190 (1967), and Photo-Sonics, Inc., supra, heavily relied upon by respondent, of any precedential value herein. We recognize that superficially it would seem to follow that, if a portion of overhead costs is properly allocable to inventory, the same procedure should be followed with respect to self-constructed assets. But the distinctions between the two situations are real. In the first place, they are, as we have noted, treated differently by the accounting authorities. Secondly, since 1918 the respondent has required by regulation that overhead costs be included in inventory. See Photo-Sonics, Inc., supra at 934. No such requirement has

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been imposed with respect to self-constructed assets, nor did any of respondent's representatives, who testified at the trial, know of any other general policy or rule which contained any such guidance for revenue agents. Indeed, respondent's own acceptance from time to time of direct labor and material costs without overhead as the measure of the amount of repairs, which this petitioner deducted and respondent required to be capitalized, indicates that no such policy or rule, exists. Thirdly, meaningful standards for measuring inventory overhead costs are usually available. On the other hand, it is often impracticable or even impossible to develop the detailed documentation necessary to support a rational allocation of overhead to self-constructed assets, particularly in a case such as this, where literally dozens of miscellaneous projects were involved.

Respondent also relies heavily on Ben Perlmutter, 44 T.C. 382 (1965), affirmed on other issues 373 F. 2d 45 (C.A. 10, 1967), and Variety Construction Co., T.C. Memo. 1962-257. We think these cases are inapposite. The "overhead" costs involved were directly identified with the constructed buildings and therefore properly should have been taken into account. Moreover, in Perlmutter, it appears that the taxpayer conceded that some allocation of overhead was proper and that the sole dispute was as to the measure of the allocation. See 44 T.C. at 404. In any event, in both of these cases, the taxpayer's very business was the construction of fixed assets, i.e., buildings, and its personnel was employed for that very purpose. This is a far cry from the situation involved herein, where a large manufacturing concern engages in self-construction activities not at the expense of normal operating time but as a fill-in for slack periods.

Under all the circumstances herein, we hold that petitioner has satisfied its heavy burden and has convinced us that it employed a generally accepted method of accounting which "clearly reflects its income." Sam W. Emerson Co., 37 T.C. 1063 (1962); Klein Chocolate Co., 36 T.C. 142 (1961); Geometric Stamping Co., 26 T.C. 301 (1956). In so doing, we neither hold nor imply that, under all circumstances, a taxpayer has a right to choose between alternative generally accepted methods of accounting or that respondent may not, under some circumstances, require a taxpayer to accept his determination as to a preferred selection among such alternatives. We hold merely that where a taxpayer, in a complicated area such as is involved herein, has over a long period of time consistently applied a generally accepted accounting method (which is considered "clearly to reflect" income by competent professional authority and is not specifically in derogation of any provision of the Internal Revenue Code) and where this method has been frequently applied by respondent in making adjustments to the taxable income of the same taxpayer (as distinguished from respondent's mere failure to object to its use by such taxpayer), the taxpayer's choice of

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method will not be disturbed. Photo-Sonics, Inc. v. Commissioner, 357 F. 2d 656, 658 fn. 1 (C.A. 9, 1966). See also Report of Commissioner of U.S. Court of Claims in McNeil Machine & Engineering Co. v. United States (Mar. 29, 1967), 1967-7 C.C.H. Fed. Tax Rep. par. 8173, 1967-6 P.-H. Fed. Taxes par. 58,036.

We now turn to petitioner's treatment of two particular items in the calculation of the cost of its self-construction projects. Petitioner did not capitalize an allocable portion of certain fringe benefit items -- i.e., vacation, profit-sharing, group insurance, bonus, cafeteria, and first aid. Neither did petitioner capitalize any of the costs of its drafting department, although such department admittedly prepared plans for some of the self-construction projects.

Since the primary question before us is the propriety of petitioner's accounting method, we deem it entirely within our province to determine whether petitioner has correctly applied such method as to particular items. In so doing, we may raise and dispose of contested issues related to the application of petitioner's method even though such issues were not specifically pleaded, particularly where, as here, the parties are not unduly surprised and are given ample opportunity to argue such issues on brief. Certainly there should be no question as to the propriety of such a course of action where, as here, the issues were clearly raised during the course of the trial and there was specific testimony directed to such issues. Cf. J. T. Slocomb Co. v. Commissioner, 334 F. 2d 269, 273 (C.A. 2, 1964), affirming 38 T.C. 752 (1962); Friednash v. Commissioner, 209 F. 2d 601 (C.A. 9, 1954); Hilbert S. Bair, 16 T.C. 90, 98 (1951), affd. 199 F. 2d 589 (C.A. 2, 1952); see 9 Mertens, Law of Federal Income Taxation (Zimet rev. 1961), sec. 50.46.

On the basis of the expert testimony given at trial and our review of relevant accounting authorities, we are satisfied that this petitioner should not be required to capitalize either the fringe items or the costs of its drafting department.

With respect to the fringe items, some of these expenditures, such as profit-sharing, bonus, and group insurance, were essentially discretionary in nature and, in any event, were not planned, fixed charges. Others, such as vacation time, cafeteria, and first aid, were not directly identified with the self-constructed assets. Thus, this petitioner's treatment of such expenditures fits the normal accounting categorization of these items as period costs of an administrative character.

A more difficult problem is raised with regard to the drafting department. At first glance, it would seem that the labor cost of the personnel of this department should be charged to the self-constructed assets. In theory, at least, the person who draws the plans for a machine would seem to be making as direct a contribution as the person

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who actually builds the machine, and the cost of his labor would therefore appear to be directly traceable to the machine itself.

"Direct" labor, however, refers to that labor which is obviously related to and conveniently traceable to specific assets. "Indirect" labor refers to labor which may be attributable to particular assets, but which is not considered feasible to measure and charge thereto. These labor costs are generally considered part of the general pool of factory "overhead." See Horngren, Cost Accounting -- A Managerial Emphasis 22 (2d ed. 1967); Gillespie, Cost Accounting and Control 160 (1957). We think that the drafting department of a manufacturing concern, such as petitioner, reasonably falls within the category of "indirect labor." We are satisfied that not all of the self-constructed assets required blueprints, drawings, or the like. We also note that there is often a significant time lag between the planning of the construction of such assets and the actual consummation of construction. Moreover, some of these projects may very well be "scrapped" in the interim. In essence, the activities of petitioner's drafting personnel were conglomerate in nature, as distinguished from those of the repair and maintenance personnel, where there was a clear dichotomy between the "slack" or "idle" time which they devoted to self-constructed assets and the time which they devoted to their normal functions.

Nor do we think a portion of the labor costs of the drafting department should be considered as a variable overhead cost and therefore required to be capitalized under the "incremental cost" method utilized by this petitioner. We have found that the operations of this department were geared to petitioner's production requirements. Here again, respondent does not contend that the size of the drafting department was larger than necessary for this purpose and was therefore a cover for its self-construction activities. Nor is there any evidence in the record herein indicating that such was the case. The drafting department, like the repair and maintenance staff, performed a "double duty" function.

Finally, we are constrained again to note that, on the frequent occasions when respondent required repair items tobe capitalized rather than deducted, his agents themselves adopted petitioner's computation of the cost thereof, although they were fully aware that no portion of the expenditures for fringe items or the labor costs of the drafting department were included and although it seems clear that such elements must have been involved in some of the repairs.

Without enunciating any general rule applicable in all cases, we hold that this petitioner has satisfied its burden and that its treatment of fringe items and the labor costs of its drafting department as overhead not allocable to self-constructed assets was entirely proper.

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As a consequence of the foregoing holdings, we do not reach the additional issues involved herein, namely: (1) The alleged irregularity of a second examination of petitioner's books and records under section 7605(b) and the issuance thereunder of the within notice of deficiency; (2) the claim that the deficiency notice itself was arbitrary and unreasonable and therefore invalid, or at the very least not entitled to the presumption of correctness; ⁶ (3) the correct computations of overhead expenses of various of petitioner's departments; and (4) the application of section 481 to certain proposed adjustments.

To reflect other concessions of the parties,

Decision will be entered under Rule 50.

² SEC. 263. CAPITAL EXPENDITURES. (a) General Rule. -- No deduction shall be allowed for --

(1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. * * *

³ SEC. 446. GENERAL RULE FOR METHODS OF ACCOUNTING.

(a) General Rule. -- Taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books.

(b) Exceptions. -- If no method of accounting has been regularly used by the taxpayer, or if the method used does not clearly reflect income, the computation of taxable income shall be made under such method as, in the opinion of the Secretary or his delegate, does clearly reflect income.

(c) Permissible Methods. -- Subject to the provisions of subsections (a) and (b), a taxpayer may compute taxable income under any of the following methods of accounting -- (1) the cash receipts and disbursements method; (2) an accrual method; (3) any other method permitted by this chapter; or

(4) any combination of the foregoing methods permitted under regulations prescribed by the Secretary or his delegate.

⁴ The "full absorption" cost method involves capitalizing direct costs of materials and labor plus an allocable portion of all overhead. The "prime cost" method involves capitalizing only direct materials and labor costs. The "incremental cost" method involves capitalizing direct labor and material costs plus that portion of overhead which can be directly identified with the self-construction project. Where construction ordinarily takes place only where regular facilities and personnel are not being fully utilized (i.e., during "slack" or "idle" time), there may be no overhead which can be directly identified with the project.

⁵ We are aware that there may well have been some overhead costs generally attributable to the self-constructed assets. But, under the "incremental costs" method, as we understand it, the overhead costs must be directly identified with those assets; general attribution is not enough. See fn. 4, supra. A good example of such unidentifiable overhead exists in the very case before us, where this petitioner generated its own electric power.

⁶ We are constrained to note, however, that, while the respondent's determination may not have been arbitrary and unreasonable as a matter of law, the revenue agent's calculations were for the most part made with little, if any, attempt to ascertain with even a modicum of accuracy the relevant underlying circumstances. We make this comment with a full realization of the time limitation under which the agent was operating. We also note that nothing in our references to petitioner's burden in our decision on the accounting issues should be construed as holding that such burden was in fact placed upon it in this case. We merely assumed, for purposes of decision, that respondent's determination was presumptively correct and that petitioner had the burden, indeed a heavy one, of overcoming it.