# Texas Instruments v. Commissioner

> United States Tax Court · May 27, 1992 · 63 T.C.M. 3070

URL: https://www.frixlaw.com/law-library/cases/4612786

## Case

- **Full name:** TEXAS INSTRUMENTS INCORPORATED AND ITS CONSOLIDATED SUBSIDIARIES v. COMMISSIONER OF INTERNAL REVENUE
- **Court:** United States Tax Court
- **Decided:** May 27, 1992
- **Citations:** 63 T.C.M. 3070; 1992 T.C. Memo. 306; 1992 Tax Ct. Memo LEXIS 328
- **Precedential status:** Unpublished
- **Opinion:** Opinion
- **Judges:** COHEN
- **Cited by:** 4 later opinions in the Frix Law Library

## Citator (automated)

- No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases.
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/4612786

## Opinion text

TEXAS INSTRUMENTS INCORPORATED AND ITS CONSOLIDATED SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
Texas Instruments v. Commissioner
Docket No. 32707-88
United States Tax Court
T.C. Memo 1992-306 ; 1992 Tax Ct. Memo LEXIS 328 ; 63 T.C.M. (CCH) 3070 ;
May 27, 1992 , Filed
*328 Decision will be entered under Rule 155.
John S. Nolan , Alexander Zakupowsky, Jr. , Jean A. Pawlow , Robin L. Greenhouse , and Robert E. Liles, II , for petitioner.
Deborah A. Butler, John S. Repsis , and Gary D. Kallevang , for respondent.
COHEN
COHEN
TABLE OF CONTENTS
Issue 1: Long-Term Contract and Overhead Adjustments
FINDINGS OF FACT
Background
Overview of Petitioner's Accounting System
Costs Allocated Through Petitioner's 4000 and 6000 Series Accounts
Costs in Petitioner's 8000 Series Accounts
Casualty Loss
Profit in Asset Depreciation
Purchase Cash Discounts
Rework Labor and Scrap
Tax Treatment
OPINION
Completed Contract Rules
The Parties' Positions
Expert Testimony
Change in Method of Accounting
Respondent's Adjustments to Overhead Variances
Respondent's Affirmative Claim
Casualty Loss
PIA Depreciation
Purchase Cash Discounts
Rework Labor and Scrap
Issue 2: Petitioner's Rebate Programs
FINDINGS OF FACT
Rebate History
TI-59 Rebate Program
The Home Computer Rebate Program
The Learning Aids Rebate Program
The Speech Synthesizer Rebate Program
OPINION
Issue 3: Investment Tax Credit Issue
FINDINGS OF FACT
Waste Treatment Facilities
Drywall Partitions
*329 Miscellaneous Structures and Related Equipment
Floors
Window Walls
Ceilings
Air Conditioning
Plumbing
Emergency Doors
Fire Protection Systems
Security Fencing
Landscaping
Electrical Equipment
Category One
Category Two
Category Three
Category Four
OPINION
Waste Treatment Facilities
Drywall Partitions
Miscellaneous Structures and Related Equipment
Floors
Window Walls
Ceilings
Air Conditioning
Plumbing
Emergency Doors
Fire Protection Systems
Security Fencing
Landscaping
Electrical Equipment
Category One
Category Two
Category Three
Category Four
MEMORANDUM FINDINGS OF FACT AND OPINION
COHEN , Judge : Respondent determined deficiencies of $ 34,450,765, $ 172,714, and $ 39,777,526 in petitioner's Federal income tax for 1980, 1981, and 1982, respectively. In its petition, petitioner affirmatively asserted that it was entitled to overpayments of $ 2,530,408, $ 1,460,668, and $ 1,645,219 for 1980, 1981, and 1982, respectively. By Amendment to Answer, respondent set forth additional allegations to support respondent's claim that the correct deficiencies in petitioner's Federal income tax for 1980, 1981, and 1982 were $ 53,465,355, $ 2,099,681, and $ *330 53,221,461, respectively.
The issues discussed in this opinion are: (1) Whether petitioner's treatment of certain indirect costs and overhead variances under the long-term contract method of accounting set forth in section 1.451-3, Income Tax Regs. , was proper and whether petitioner is entitled to other related adjustments, (2) whether petitioner's treatment of its rebate programs under section 1.451-4, Income Tax Regs. , was proper, and (3) whether certain property used in petitioner's manufacturing operations was " section 38 property" eligible for the investment tax credit. A fourth issue has been separated and disposed of by separate opinion filed this date. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.
Some of the facts have been stipulated, and the stipulated facts are incorporated in our findings by this reference. Because the pretrial stipulation process in this case was not adequate, the Court suggested posttrial stipulation of agreed facts that could be incorporated in our opinion. Based on the evidence, which included 3,696 *331 pages of transcript and over 775 exhibits, the parties filed with the Court 188 pages covering over 410 joint proposed findings of fact with respect to the issues for decision in this opinion. The parties also requested in 79 pages of their briefs that we find an additional 320 facts. It is not reasonable to reproduce here all of the findings requested by the parties. We have therefore endeavored to set forth only those findings that are necessary to explain and to dispose of the issues for decision in this opinion. The other agreed facts are incorporated in our findings by this reference. For convenience, we have set forth below separately our findings of fact and opinion with respect to each issue.
Texas Instruments Incorporated (petitioner) was a publicly held corporation organized under the laws of Delaware with its principal place of business in Dallas, Texas. Petitioner was an accrual method taxpayer that employed other specialized accounting methods in reporting various items of income and expenses for Federal income tax purposes. Petitioner timely filed consolidated Federal income tax returns (Forms 1120) for the taxable years ended December 31, 1980, December 31, *332 1981, and December 31, 1982.
Issue 1: Long-Term Contract and Overhead Adjustments
FINDINGS OF FACT
Background
Petitioner's Equipment Group division (EG) contracted to manufacture equipment for various departments of the United States Government and some foreign governments. Eighty to eighty-five percent of the EG's business, in terms of value, was long-term contracts, and a majority of those contracts (over 2,000) were with the United States Government.
Prior to 1979, petitioner used the percentage of completion method of accounting for cost plus contracts and the accrual shipment method of accounting for fixed price contracts, with inventories valued at the lower of cost or replacement cost. In 1979, petitioner filed with respondent a Form 3115, Application for Change in Accounting Method, requesting permission to change its method of accounting for long-term contracts in the EG to the completed contract method. On January 4, 1980, respondent granted to petitioner permission to change to the completed contract method.
Overview of Petitioner's Accounting System
Petitioner maintained a uniform chart of accounts for financial planning and reporting purposes *333 that was organized in the following nine major account groups or series: Series Number Accounts
1000 Assets
2000 Liability and Stockholders Equity
3000 Revenue, Cost, and Adjustment
4000 Manufacturing Overhead
5000 Service Operations Expense
6000 Research and Engineering Overhead
7000 Marketing Expense
8000 General and Administrative
9000 Other Income and Deductions
Indirect costs were initially charged to the 4000, 5000, 6000, 7000, or 8000 series accounts, depending on the type of cost. Subsequent reclassifications were made to the initial account charges. Certain types of accounts, known as clearing accounts, were used to collect costs in one series and the costs were then charged to other accounts in other series to account for the use of a service or property. Petitioner charged direct labor and direct materials to its 1000 series accounts directly or through adjustments from other accounts.
At the beginning of each year, the EG developed overhead application rates for the 4000 and 6000 series accounts. The purpose of those rates was to charge to petitioner's long-term contracts certain indirect costs (overhead) by reference to actual direct labor costs charged *334 to those contracts. Petitioner set its overhead application rates high to motivate its managers and because it was petitioner's policy not to overstate its inventory.
To determine the overhead application rates, petitioner estimated the annual overhead costs expected to be incurred, aggregated the accounts into pools, and divided the expected dollars in each pool by the expected direct labor costs for that year. The total estimated costs of all the 4000 and 6000 pools were divided by the total of estimated direct manufacturing and engineering labor dollars, respectively, to derive the overhead application rates. Those rates were expressed as percentages.
By application of the manufacturing overhead rate, each dollar incurred for direct manufacturing labor resulted in an automatic charge (debit) of manufacturing overhead (4000 series account) to the same 1000 series account as the manufacturing direct labor dollar was charged. Similarly, by application of the engineering overhead rate, each dollar incurred for direct engineering labor resulted in an automatic charge of engineering overhead (6000 series account) to the same 1000 series account as the engineering direct labor dollar *335 was charged. Thus, through the overhead rates, costs in accounts and cost centers in the manufacturing and engineering pools (4000 and 6000 series accounts, respectively) were applied to and became a part of the costs of long-term contracts with manufacturing and engineering direct labor hours.
As each debit was made to a 1000 series account for application of the manufacturing and engineering overhead, a corresponding credit was made to account 4910 (manufacturing) or 6910 (engineering). This applied overhead was charged to project inventory and credited to accounts 4910 and 6910 at the standard overhead rates. Actual manufacturing and engineering overhead costs were charged to all other 4000 and 6000 series accounts, respectively.
If the credit balances in its 4910 and 6910 accounts at the end of each year exceeded the aggregate debit balances in its various 4000 and 6000 series accounts, the EG had charged more overhead to the 1000 series accounts than it had actually incurred (overapplied overhead). Conversely, if the aggregate debit balances in its various 4000 and 6000 series accounts at the end of each year exceeded the credit balances in its 4910 and 6910 accounts, the *336 EG had actually incurred more overhead than it had charged to the 1000 series accounts (underapplied overhead). The overapplied and underapplied overhead were referred to as variances, because they represented the variance between estimated costs and actual costs. Underapplied overhead decreased petitioner's income, and overapplied overhead increased petitioner's income.
The EG prepared journal entries each month in amounts equal to the net credit balances in its 4000 and 6000 series accounts and charged (debited) account 3931 (miscellaneous cost of sales) and credited account 1489 (inventory reserve account). The effect of these journal entries was to reserve in full all overapplied overhead without regard to the amount of overapplied overhead that should have been liquidated from inventories through cost of sales.
In 1980, the EG had overapplied overhead. Thus, it increased its costs of sales by that amount as a debit to account 3931 and a credit to account 1489. As inventory was liquidated, the reserve account was relieved because the overhead charge was keyed by inventory. In 1981 and 1982, the EG had underapplied overhead and no adjustments were booked, because petitioner *337 did not want to overstate its inventories. The overapplied and underapplied balances as reflected in 4000 and 6000 series accounts for those years were: (Overapplied)/UnderApplied Balances
1980 1981 1982
4000 accounts $ (5,100,101) $ 1,234,451 $ 286,574
6000 accounts 4,541,802 3,956,578 (215,692)
Net $ ( 558,299) $ 5,191,029 $ 70,882
The total actual overhead for 1980, 1981, and 1982 was $ 213,510,032, $ 239,370,860, and $ 275,488,837, respectively. The variances expressed as a percentage of the total actual overhead for 1980, 1981, and 1982 were (.261), 2.169, and .026, respectively.
Petitioner maintained organizational units called cost centers. Cost centers were an area of responsibility that contained accounts to collect the center's costs. Cost centers were groupings of employees that were segregated by resource type or organization. They were established for the management of particular functions or activities, which related to a "program" or "programs". The term "program" was used to refer to a particular contract or group of contracts.
Certain 8000 series accounts for ad valorem, sales, and use taxes were charged to long-term contracts. *338 Also, some research and development costs were included in contract costs through applied overhead while other research and development projects were charged to cost centers that contained 8000 series accounts. Group occupancy charges, i.e., depreciation, utilities, lease costs, etc., were also collected in 8000 series accounts. These costs were accumulated in cost centers and charged out on a square-foot basis to the various cost centers using the facilities. This was accomplished by crediting account 8975 for these cost centers and debiting the appropriate account for the cost center to which the cost was charged. If charged to a cost center that contained accounts in the 4000 or 6000 series, the costs would be charged to account 4975 or 6975, respectively, and allocated to long- term contracts through the applied overhead rate.
Costs Allocated Through Petitioner's 4000 and 6000 Series Accounts
Each cost center had managers and a clerical staff. There were typically one to three levels of management between cost centers and production workers. There were basically four levels of management within the EG (group, division, department, and supervisory). The group management *339 was the highest level of management within the EG.
A cost center generally billed its activities to accounts in the 4000 or 6000 series, as appropriate. The costs in these cost centers were the foundation for the overhead application rates. The costs of other cost centers were contained in the 7000 and 8000 series accounts and were not charged to the 1000 series accounts, and the cost of other inventoriable overhead was collected in the 5000 series accounts.
Some administrative cost centers performed management or administrative functions for the operation or support of program -- and project-type activities being conducted by the EG. Generally, where managers performed direct labor, their time was to be charged to 1000 series accounts and was not to be included in the balances of the cost centers. The administrative cost centers at issue had balances of $ 6,358,370, $ 6,690,883, and $ 7,665,578 for 1980, 1981, and 1982, respectively.
Cost centers were established for cost accounting operations throughout the EG. Clerks performed a variety of cost accounting functions in each cost center. The cost accounting cost centers at issue had balances of $ 1,787,553, $ 2,487,109, *340 and $ 2,875,794 for 1980, 1981, and 1982, respectively.
Petitioner also maintained a group of "packing and shipping" cost centers. These cost centers primarily were to design and engineer packing containers or materials for use by the EG packing and shipping operations. The costs in these cost centers included the cost of designing special packaging under particular contracts. When an employee worked on an item for a particular contract, his or her time was charged directly to a 1000 series account. The packing and shipping cost centers at issue had balances of $ 135,601, $ 182,643, and $ 225,551 for 1980, 1981, and 1982, respectively.
"Material handling" cost centers captured the costs of receiving incoming direct and indirect material at the warehouse dock, storing the material in the warehouse, moving it to the production floor, and planning and scheduling group inventory. Some of these accounts included the costs of compensation of stock handlers in the EG warehouses whose primary responsibility was handling materials eventually used in the performance of its contracts and the costs of packing, shipping, and stock handling of supplies. Other accounts included the costs *341 of demurrage for freight carrier trucks that petitioner could not unload and demurrage for gas containers owned by petitioner's gas suppliers while the containers were in petitioner's possession. The material handling cost centers at issue had balances of $ 13,492,013, $ 16,979,390, and $ 20,447,513 for 1980, 1981, and 1982, respectively.
Petitioner also maintained "research expense" cost centers. One group of cost centers was known as the Advanced Front-End Prototype Center (AFPC). The function of these cost centers was to develop manufacturing processes for the production of high-density, integrated circuits for eventual use in the EG products. Petitioner also maintained the Corporate Manufacturing Technology Center (CMTC) in its Corporate Research Development and Engineering Division to work on advanced technologies to assist in its manufacturing business. The costs charged by the CMTC for this research were captured in indirect work orders. The total balances of the cost centers associated with the AFPC and the work orders associated with the CMTC were $ 6,651,825, $ 9,379,657, and $ 11,306,503 for 1980, 1981, and 1982, respectively.
Petitioner collected the costs of "employee *342 benefits" in various 4000 and 6000 series accounts. The costs collected in these accounts included, for example, insurance premiums for workers' compensation, product liability, and personal liability for petitioner's employees, costs of memberships and dues, and severance pay upon separation of service in the event of a reduction in work force. The balances of the accounts in which these employee benefits were collected were $ 2,640,213, $ 3,150,266, and $ 3,981,992 for 1980, 1981, and 1982, respectively.
Petitioner also collected in various 4000 and 6000 series accounts "training costs". The costs collected in these accounts included, among others, salaries and wages of employees while enrolled in training courses, costs of producing training and personnel recruiting programs, and the costs of travel for employees while attending training courses. The balances of the accounts in which these costs were collected were $ 2,999,033, $ 2,815,608, and $ 3,765,183 for 1980, 1981, and 1982, respectively.
Petitioner also collected in various 4000 and 6000 series accounts "recruiting costs". The costs collected in these accounts included storage of an employee's household goods when *343 the employee relocated from one site to another, costs of relocating existing and new employees, and other related recruiting expenses. The balances of the accounts in which these costs were collected were $ 5,569,965, $ 3,303,267, and $ 6,589,005 for 1980, 1981, and 1982, respectively.
Petitioner also collected miscellaneous "marketing and selling expenses". These costs included, among others, the costs of marketing supplies, of attendance and exhibition at a convention or trade show, and of miscellaneous promotional activity. The balances of the various 4000 and 6000 series accounts in which these costs were collected were $ 22,413, $ 76,382, and $ 64,085 for 1980, 1981, and 1982, respectively.
Petitioner also collected "security services" costs, which included costs of installation, repair, and maintenance of security devices and special security services such as guards to watch areas experiencing special security problems. The balances of the various 4000 and 6000 series accounts in which these costs were collected were $ 33,919, $ 55,283, and $ 36,983 for 1980, 1981, and 1982, respectively.
Finally, petitioner recorded in a 4000 and 6000 series account the costs of "charitable *344 contributions". The balances in the accounts in which these costs were recorded were $ 20,300, ($ 8,824), and $ 72,420 for 1980, 1981, and 1982, respectively.
Costs in Petitioner's 8000 Series Accounts
Cost centers 450 through 456 contained accounts in the 8000 series. The costs of these cost centers were incurred for major moves and rearrangement, including the cost of occupying a new building or moving out of an old building, and building maintenance for the EG facilities at various sites. They were not allocated to petitioner's long-term contracts. These rearrangements were planned and controlled at the group level. The balances in these cost centers were $ 13,659,397, $ 12,839,095, and $ 14,810,947 for 1980, 1981, and 1982, respectively.
Cost centers 460 through 466 contained accounts in the 8000 series. The costs in these cost centers were incurred for mail, landscaping, cleaning, security, fire, and safety activities for the EG facilities at various sites and were not allocated to petitioner's long-term contracts. Where a specific contract required security of an extraordinary nature, the cost was charged directly to the contract. The balances in these cost *345 centers were $ 9,383,587, $ 10,711,242, and $ 10,740,929 for 1980, 1981, and 1982, respectively.
Cost centers 230, 231, 250, and 431 contained accounts in the 8000 series. Cost centers 230 and 431 collected costs that were incurred in the performance of the administration of Government contracts. Cost center 231 was known as the Office of Government Affairs. The costs of this cost center were incurred to perform the function of interfacing with Government contract personnel, which included negotiation of Government-approved overhead rates, cost accounting standards, and allowable independent research and development costs. The costs in cost center 250 were incurred to perform the function of providing offices and services to Government contract auditors and administrators. Costs in these cost centers were not allocated to petitioner's long-term contracts. The balances in these four cost centers were $ 3,118,232, $ 3,573,203, and $ 4,257,132 for 1980, 1981, and 1982, respectively.
Cost center 610 contained accounts in the 8000 series. The costs in this cost center were incurred in purchasing materials, equipment, supplies, and services for the EG and were not allocated to petitioner's *346 long-term contracts. The balances in this cost center were $ 3,363,227, $ 4,021,839, and $ 4,589,818 for 1980, 1981, and 1982, respectively.
In 1981, petitioner reclassified various expenses in cost centers 450 through 454, 460 through 464, and 610 to cost of sales for financial statement purposes. Petitioner also reclassified costs in some of these cost centers in 1980.
Casualty Loss
In November 1980, a number of gold "targets" and rods used in the manufacture of infrared systems were stolen from a stockroom. The estimated value of the stolen gold was $ 353,814.48, which was less than petitioner's basis in the property. Petitioner initially charged the cost of gold to a "common module holding account" (1000 series account), which collected the cost of producing a batch of items and divided the cost for the batch among the number of items produced. When the gold was stolen, petitioner replaced it and charged the common module holding account with the cost of the replacement gold.
Petitioner had two insurance policies to cover such thefts. One policy had a $ 100,000 deductible and one had a $ 50,000 deductible. As of January 27, 1981, petitioner had not determined *347 under which of those policies it would file a claim. In 1981, petitioner received insurance settlements in the total amount of $ 264,282.76.
Profit in Asset Depreciation
When the EG acquired a capital asset that was constructed either by the EG or another group, the asset was capitalized in petitioner's capital asset reporting system at its cost, plus an internal profit factor. Depreciation on these assets included depreciation on this internal profit factor, which was known as profit in asset (PIA) depreciation. The PIA adjustment related solely to intracompany transactions between groups or divisions of petitioner and was compiled to comply with Government cost accounting standards. In developing its overhead application rates for the manufacturing (4000) and engineering (6000) pools, petitioner used depreciation on the EG assets that included PIA depreciation. The depreciation charged to 4000 and 6000 series accounts included PIA depreciation. PIA depreciation attributable to its 4000 and 6000 pools was $ 2,831,167, $ 3,774,818, and $ 3,839,575 for 1980, 1981, and 1982, respectively.
In preparing its consolidated financial reports, petitioner eliminated all PIA depreciation. *348 In preparing its Federal income tax returns for the years in issue, petitioner used the consolidated financial income, which reflected the elimination of the PIA depreciation. Petitioner also made Schedule M adjustments to reflect the deferral of income and expense on the EG contracts under the completed contract method. Petitioner decreased book income by the amount of income included for contracts not completed during the year and increased book income by the amount of the cost of goods sold for such contracts. The amount of the cost of goods sold on incomplete contracts that increased income in the Schedule M adjustment included PIA depreciation. The Schedule M adjustments with respect to the EG contracts were based on amounts prior to elimination of PIA depreciation at the consolidated level.
Purchase Cash Discounts
When petitioner purchased material, it debited its inventory account and credited its accounts payable account for the full cost of the material. If petitioner paid the invoice within the discount period and was entitled to pay the discounted price, it debited the accounts payable account for the full price of the material, credited the cash account for *349 the discounted price, and credited account 3981 for the amount of the discount. This had the effect of increasing petitioner's income by the amount of the discount. Petitioner's income was decreased when the gross cost of goods purchased was deducted from income. The credit balances in account 3981 were $ 806,020, $ 501,177, and $ 454,711 for 1980, 1981, and 1982, respectively.
Rework Labor and Scrap
In the course of petitioner's manufacturing, nonconforming parts were identified by quality assurance personnel. These parts either had to be conformed to their specifications, returned to the vendor, or scrapped. Petitioner maintained a series of general work orders to identify the costs of bringing parts into conformity with specifications and to identify the costs of scrapped parts. The costs so identified were included in 1000 series accounts. The total amounts of the rework labor costs were $ 2,883,309, $ 1,853,534, and $ 3,329,363 for 1980, 1981, and 1982, respectively. Scrap material costs, net of income from the sale of scrap, were $ 903,043, $ 941,216, and $ 1,121,942 for 1980, 1981, and 1982, respectively.
Tax Treatment
For Federal income tax purposes, *350 petitioner did not make any Schedule M adjustments to account for its overhead variances. In its Federal income tax return for 1980, petitioner included in income the amount of its overhead variance (overapplied overhead). In its Federal income tax returns for 1981 and 1982, petitioner treated as a current expense the amount of its overhead variance (underapplied overhead).
During the course of the audit of petitioner's Federal income tax return for 1979, respondent's agent and petitioner discussed whether petitioner had properly accounted for its overhead variances for that year and whether petitioner had allocated to its long-term contracts certain amounts in its 4000 and 6000 series accounts that could have been deducted currently. Respondent's agent also sent to petitioner an Information Document Request (IDR) and requested documentation to support petitioner's treatment of amounts in its 7000, 8000, and 9000 series accounts as costs described in section 1.451-3(d)(5)(iii), Income Tax Regs.
During the course of the audit of petitioner's Federal income tax returns for 1980, 1981, and 1982, respondent sent to petitioner an IDR, which contained a computation of petitioner's *351 overhead variances for those years, and requested a copy of petitioner's program for allocating its indirect costs to long-term contracts. That IDR also listed twelve 8000 series accounts and requested records to support petitioner's position that those costs were not allocable to its long-term contracts. Petitioner provided responses as to six of those items by describing those accounts. Petitioner also responded that it had erroneously allocated to its long-term contracts "scrap" and "employee benefits" and that those costs were described in section 1.451-3(d)(5)(iii), Income Tax Regs.
Respondent issued at least 13 additional IDR's and requested information regarding petitioner's treatment of certain of its 8000 series accounts, including records and descriptions of those accounts. Respondent also requested, in six of those IDR's, information as to the allocation of its overhead, including any records and a program or procedures manual that petitioner used in allocating its overhead to its long-term contracts. On one occasion, petitioner responded that amounts in one of its 8000 series accounts were costs described in section 1.451-3(d)(5)(iii), Income Tax Regs. In response *352 to respondent's request for information to support petitioner's previous response that it had erroneously allocated "scrap" to its long-term contracts, petitioner stated that it would file an amended return.
In the statutory notice of deficiency, respondent determined that petitioner's treatment of its overhead variances was erroneous. Respondent allocated petitioner's overhead variances among work-in-progress, finished goods, and cost of goods sold and adjusted petitioner's taxable income accordingly.
In its petition, petitioner alleged that it was entitled to deduct in the years in issue certain amounts that it contended had previously been erroneously capitalized and deferred as costs to its long-term contracts under the completed contract method of accounting (petitioner's affirmative claim). These claims would decrease petitioner's taxable income as follows: Employee Benefits Rework Research and
Year and Other Costs and Scrap Development
1980 $ (28,640,000) $ (13,904,280) $ (5,174,000)
1981 (16,370,000) ( 5,475,979) (4,403,000)
1982 (25,491,000) ( 3,009,934) (5,840,000)
In an Amendment to Answer (respondent's affirmative claim), respondent asserted *353 that petitioner had included in its 8000 series accounts, and therefore deducted for Federal income tax purposes, certain general and administrative expenses that were incident to and necessary for the performance of its long-term contracts. Respondent asserted that petitioner was required to allocate those amounts to its long-term contracts. Respondent asserted increased deficiencies in petitioner's Federal income tax in the amounts of $ 19,014,590, $ 1,926,967, and $ 13,443,935 for 1980, 1981, and 1982, respectively.
OPINION
Completed Contract Rules
Section 1.451-3(d), Income Tax Regs. , in effect for 1980, 1981, and 1982, provided the following rules for the completed contract method of accounting: (d) Completed contract method . -- (1) In general . * * * under the completed contract method, gross income derived from long-term contracts must be reported by including the gross contract price of each contract in gross income for the taxable year in which such contract is completed * * *. All costs which are properly allocable to a long-term contract (determined pursuant to subparagraph (5) of this paragraph) must be deducted from gross income for the taxable *354 year in which the contract is completed. * * *
* * *
(5) In determining what costs are properly allocable to a long-term contract in the case of a taxpayer utilizing the completed contract method of accounting for tax purposes, the following rules shall apply:
(i) Direct material costs and direct labor costs must be treated as costs properly allocable to a long-term contract. * * *
(ii) The term "indirect costs" includes all costs (other than direct material costs and direct labor costs) which are incident to and necessary for the performance of particular long-term contracts. Indirect costs which must be allocated to long-term contracts include:
* * *
(iii) Costs which are not required to be included in costs attributable to a long-term contract include:
Costs in section 1.451-3(d)(5)(ii), Income Tax Regs. , included repair expenses and maintenance of equipment or facilities used in the performance of particular long-term contracts and administrative costs incurred in the performance of particular long-term contracts. Costs in section 1.451-3(d)(5)(iii), Income Tax Regs. , included marketing and selling expenses, distribution expenses, general and administrative expenses *355 attributable to the performance of services that benefitted the long-term contractor's activities as a whole, casualty losses, certain pension and profit-sharing contributions, and costs attributable to strikes, rework labor, scrap, and spoilage.
In 1982, the Department of the Treasury proposed to Congress a new system of accounting for long-term contracts and stated its intention "to amend the current completed contract regulations to require that most indirect costs (so-called period costs) be allocated to contracts rather than immediately expensed". Administration's Fiscal Year 1983 Economic Program: Hearings Before the House Committee on Ways and Means, 97th Cong., 2d Sess. (Part 1) 271 (1982) (statement of Hon. Donald T. Regan, Secretary of the Treasury). In the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248, sec. 229 (a)(3), 96 Stat. 324 , 493, Congress did not adopt the proposal of the Department of the Treasury but directed it to modify the regulations "properly [to] allocate all costs which directly benefit, or are incurred by reason of, the extended period long-term contract activities of the taxpayer." The regulations as amended, however, are applicable *356 only to contracts entered into after December 31, 1982. T.D. 8067 , 1986- 1 C.B. 218 , 219, 236-237 . We therefore apply the regulations quoted above. Except where otherwise noted below, petitioner bears the burden of proof. Rule 142(a).
The Parties' Positions
Petitioner's position is that it is entitled to deduct certain indirect costs that it collected in pools of costs in the 4000 and 6000 series accounts and allocated to its long-term contracts through the application of the overhead rates. These costs include those identified with the administrative, cost accounting, packing and shipping, material handling, and research expense cost centers, and the costs of employee benefits, training, recruiting, marketing and selling, security services, and charitable contributions described in our findings as the costs at issue. Petitioner argues that it was required to deduct these costs because they were described in section 1.451-3(d)(5)(iii), Income Tax Regs.
If the deduction of these costs constitutes a change in its method of accounting, petitioner contends that this change is not barred by section 446(e) . Petitioner argues that that change was initiated *357 by respondent, who changed petitioner's method of accounting for its overhead variances. Petitioner also contends that it is entitled to adjust its income to account properly for its casualty loss in 1980, its PIA depreciation, its purchase cash discounts, and its rework labor and scrap costs.
Respondent's position is that petitioner elected to capitalize and defer the indirect costs that it had allocated to its long-term contracts pursuant to section 1.451-3(d)(5)(ii), Income Tax Regs. Respondent contends that petitioner's attempt to deduct these costs constitutes a change in its method of accounting and that petitioner has not obtained consent for such a change. Respondent also argues that petitioner has not established that these costs are within the meaning of section 1.451-3(d)(5)(iii), Income Tax Regs. , that they were initially allocated to long-term contracts, or the amount of these costs actually incurred.
Respondent also contends that, in the notice of deficiency, she properly reallocated to petitioner's long-term contracts the overhead variances that it had previously included or deducted for Federal income tax purposes. Finally, respondent contends that some of the *358 expenses that petitioner included in its 8000 series accounts were required to be allocated to its long-term contracts pursuant to section 1.451-3(d)(5)(ii), Income Tax Regs.
Expert Testimony
Respondent offered the testimony and report of Edward B. Deakin (Deakin) in support of her position. The Court recognized Deakin as an expert in the fields of cost accounting and financial accounting. Deakin based his testimony and report on Generally Accepted Accounting Principles, standards promulgated by the Cost Accounting Standards Board, and other relevant accounting principles. Deakin concluded that petitioner's attempt to deduct costs in the 4000 and 6000 series accounts that it had allocated to its long-term contracts would constitute a change in method of accounting within the meaning of those accounting standards and principles. Deakin also concluded that respondent's adjustments to petitioner's overhead variances were the correction of an error and not a change in petitioner's method of accounting. Finally, he concluded that respondent's adjustments to certain costs in petitioner's 8000 series accounts were the correction of an error and not a change in petitioner's method *359 of accounting.
Change in Method of Accounting
As a threshold matter, we address respondent's contention that petitioner's attempt to deduct certain indirect costs constitutes a change in its method of accounting for those items. (For this purpose only, we assume that those costs were described in section 1.451-3(d)(5)(iii), Income Tax Regs. ) We then consider whether respondent's adjustments to petitioner's overhead variances and to certain indirect costs in petitioner's 8000 series accounts constitute changes in petitioner's method of accounting for those items.
Section 446(a) provides that "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." Section 446(b) , which is an exception to that general rule, provides that, "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, does clearly reflect income."
"The term 'method of accounting' includes not only the over-all method of accounting of the taxpayer but *360 also the accounting treatment of any item." Sec. 1.446-1(a)(1) , Income Tax Regs. Section 1.446-1(e)(ii), Income Tax Regs. , provides in part: (ii)( a ) A change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan. Although a method of accounting may exist under this definition without the necessity of a pattern of consistent treatment of an item, in most instances a method of accounting is not established for an item without such consistent treatment. A material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction. * * *
( b ) A change in method of accounting does not include correction of mathematical or posting errors, or errors in the computation of tax liability (such as errors in computation of the foreign tax credit, net operating loss, percentage depletion or investment credit). Also, a change in method of accounting does not include adjustment of any item of income or deduction which does not involve the proper time for the inclusion of the item of income or the taking *361 of a deduction. * * * A change in the method of accounting also does not include a change in treatment resulting from a change in underlying facts. On the other hand, for example, a correction to require depreciation in lieu of a deduction for the cost of a class of depreciable assets which had been consistently treated as an expense in the year of purchase involves the question of the proper timing of an item, and is to be treated as a change in method of accounting.
Each party urges an interpretation of section 1.451-3(d)(5), Income Tax Regs. , that, in effect, is dispositive as to this change in method of accounting issue. We do not place undue emphasis on Deakin's testimony and report, inasmuch as he was allowed only to testify as an expert in cost and financial accounting matters and not in tax accounting matters.
Respondent contends that, pursuant to section 1.451-3(d)(5)(iii), Income Tax Regs. , a taxpayer may either deduct costs described therein or capitalize and defer those costs by allocating them to its long-term contracts. Respondent argues that petitioner is therefore bound by its election to allocate those costs.
Petitioner contends that the deduction of costs *362 described in section 1.451-3(d)(5)(iii), Income Tax Regs. , is not a matter of choice between two permissible alternatives. Petitioner asserts that a taxpayer is prohibited from allocating such costs to its long-term contracts and is required to deduct them currently. Petitioner cites Standard Oil Co. (Indiana) v. Commissioner , 77 T.C. 349 (1981) , and argues that the current deduction of those costs "is merely the correction necessary to implement the method provided by the regulations" and is not a change in its method of accounting that requires the consent of the Commissioner. For the reasons discussed below, we reject petitioner's interpretation of section 1.451-3(d)(5), Income Tax Regs.
Petitioner's interpretation is not consistent with the apparent meaning of the regulation. Section 1.451-3(d)(1), Income Tax Regs. , which was the operative rule for the completed contract method, provided that all costs that were "properly allocable to" a long-term contract were required to be deducted in the taxable year in which the contract was completed. Section 1.451-3(d)(5), Income Tax Regs. , specified what costs were "properly allocable to" long-term contracts. *363 In contrast to certain direct costs, which "must" have been treated as costs "properly allocable to" a long-term contract, and to indirect costs described in subdivision (ii) (category (ii) costs), which "must" have been "allocated to long-term contracts", indirect costs described in subdivision (iii) (category (iii) costs) were "not required to be included in costs attributable to a long-term contract" and "may [have] been deducted currently". See McMaster v. Commissioner , 69 T.C. 952 , 954-955 (1978) . It does not follow that, because costs were "not required" to be included in costs "attributable to a long-term contract" and could have been deducted currently, they were prohibited from being treated as "costs properly allocable to" long-term contracts. The use of the permissive language in category (iii), in contrast to the mandatory language used in the first two categories, belies petitioner's contention that petitioner was required to deduct the costs described in section 1.451-3(d)(5)(iii), Income Tax Regs.
Petitioner also relies on section 1.451-3(a)(3), Income Tax Regs. , in support of its contention that category (iii) costs were required to be deducted. *364 That section provided: (3) The percentage of completion method and the completed contract method apply only to the accounting for income and expenses attributable to long-term contracts . [The term "expenses attributable to long-term contracts" means all direct labor costs and direct material costs (within the meaning of paragraph (d)(5)(i) or (6)(i) of this section), and all indirect costs except those described in paragraph (d)(5)(iii) or, in the case of extended period long-term contracts, paragraph (d)(6)(iii).] Other income and expense items, such as investment income or expenses not attributable to such contracts and costs incurred with respect to any guarantee, warranty, maintenance, or other service agreement relating to the subject matter of such contracts, shall be accounted for under a proper method of accounting . See section 446(c) and sec. 1.446-1(c) . [Emphasis supplied by petitioner.]
The bracketed portion of the quoted regulation was added by T.D. 8067 , 1986- 1 C.B. 218 , 222 , and does not apply to the years in issue. Petitioner, however, argues that the: new material merely codified the universal understanding of the *365 long-term contract regulation cost allocation rules from the time they were first issued in 1976 that costs described in Treas. Reg. sec. 1.451-3 (d)(5)(iii) were costs which were not allocated to long-term contracts. * * *
Petitioner relies principally on a sentence in the Notice of Proposed Rule Making for the new completed contract regulations, to the effect that the indirect cost allocation rules applicable to long-term contracts that are not extended period long-term contracts were unchanged, to support its contention that its interpretation was universally understood. See 48 Fed. Reg. 10703 (Mar. 14, 1983). We cannot conclude from this this petitioner's interpretation of the regulation in effect for 1980, 1981, and 1982 was universally understood.
Moreover, even were we to consider the effect of the new portion of that regulation, petitioner's interpretation of it is not the only plausible one. The new portion of the regulation could be construed to confirm that costs in the first two categories were required, but that category (iii) costs were not required, to be included as expenses attributable to long-term contracts. This interpretation is not inconsistent *366 with the statement of the Department of the Treasury ( supra p. 24 ), upon which petitioner relies, that its intention was to amend the regulations to require that certain costs be allocated to long-term contracts rather than expensed currently. Again, that the regulations as amended (and applicable to years after those in issue here) expanded the scope of costs that were required to be allocated to long-term contracts does not mean that those costs were required to be deducted for years prior to the effective date of the amended regulations.
We conclude that section 1.451-3(d)(5)(iii), Income Tax Regs. , was not mandatory and did not require that costs described therein not be allocated to long-term contracts but instead be deducted by an accrual method taxpayer. Petitioner was not prohibited from allocating to its long-term contracts certain costs in its 4000 and 6000 series accounts. Petitioner's treatment of those items for Federal income tax purposes was consistent for 1980, 1981, and 1982 and was consistent with how those items were treated on its books for those years. See Casey v. Commissioner , 38 T.C. 357 , 385-386 (1962) . It follows that petitioner's *367 treatment of those items was a "method of accounting" within the meaning of section 1.446-1(a)(1), Income Tax Regs.
In light of our conclusion, petitioner's reliance on Standard Oil Co. (Indiana) v. Commissioner , 77 T.C. 349 (1981) , is misplaced. There the taxpayer had elected to deduct intangible drilling costs (IDC), pursuant to section 1.612-4, Income Tax Regs. , but had capitalized and expensed over the lives of the assets certain IDC. We rejected respondent's assertion that the taxpayer's attempt to deduct that IDC in the taxable years at issue was a change in its method of accounting that required the Commissioner's consent because: If the election [to deduct IDC] is made, all IDC must be deducted. Petitioner's tardy assertion that the "other" costs in issue should have been deducted does not * * * constitute a discretionary choice that such costs should be deducted. It is a discovery that petitioner failed to deduct costs which, under the accounting method it has chosen, had to be deducted. [ Standard Oil Co. (Indiana) v. Commissioner , supra at 382-383 .]
In this case, petitioner had a choice either to deduct *368 or to allocate to its long-term contracts category (iii) costs. Compare, e.g., Thompson-King-Tate, Inc. v. United States , 296 F.2d 290 , 294 (6th Cir. 1961) . Its attempt now to deduct those costs is not a "correction of internal inconsistencies" or a "mistake of law" that affected the computation of a deduction, the correction of which is "'tantamount to a mathematical error.'" Standard Oil Co. (Indiana) v. Commissioner , supra at 383 (citing North Carolina Granite Corp. v. Commissioner , 43 T.C. 149 (1964)) . Also, petitioner was aware that these costs were potentially deductible, by its own admission, at least as of the time that it filed its Federal income tax return for 1979. Petitioner's attempt now to deduct such costs in 1980, 1981, and 1982 did not result from a " discovery " that it had failed to deduct those costs when it filed its returns for those years. Standard Oil Co. (Indiana) v. Commissioner , supra at 383 .
Petitioner's asserted "correction" of the allocation of those costs involves the proper time for the taking of a deduction and did not result from a "change in underlying *369 facts" within the meaning of section 1.446-1(e)(2)(ii)(b), Income Tax Regs. Compare ESCO Corp. v. United States , 750 F.2d 1466 , 1470 (9th Cir. 1985) (accrual method taxpayer's employment of more sophisticated forecasting methodology in estimating its accrued claims expenses not a change in method of accounting). Petitioner's attempt to deduct those costs is a change in its treatment of material items. We conclude that such a change in treatment constitutes a change in its method of accounting for those items within the meaning of section 1.446-1(e)(ii)(a), Income Tax Regs. See Wayne Bolt & Nut Co. v. Commissioner , 93 T.C. 500 , 510-511 (1989) . Our conclusion is not affected by the absence of an express provision in section 1.451-3(d)(5)(iii), Income Tax Regs. , that such a change was to be considered a change in method of accounting for those items. Compare sec. 1.471-11(c)(2)(ii), Income Tax Regs.
In contrast, as petitioner points out, respondent's adjustment in the Amendment to Answer to allocate to petitioner's long-term contracts certain costs in its 8000 series accounts "in effect embraces the holding in" Standard Oil Co. (Indiana) v. Commissioner , supra . *370 Petitioner did not have a "discretionary choice " as to whether they were to be deducted. Id. at 382 . Rather, those costs "must" have been "allocated to long-term contracts" pursuant to section 1.451-3(d)(5)(ii), Income Tax Regs. McMaster v. Commissioner , 69 T.C. at 955 . We therefore conclude that, to the extent that petitioner was required to allocate those costs to its long-term contracts to comply with the regulations, respondent's proposed adjustments would not constitute a change in petitioner's method of accounting for those items within the meaning of section 1.446-1(e)(ii), Income Tax Regs.
Respondent now concedes that her allocation to petitioner's long-term contracts of its overhead variances (contrary to her own expert's conclusion) was a change in petitioner's method of accounting. By reallocating the overhead variances to petitioner's long-term contracts, respondent affected the timing of those items and thus changed petitioner's treatment of material items.
We now consider whether petitioner's change in its method of accounting for the indirect costs in its affirmative claim is barred by section 446(e) . That section *371 provides that a taxpayer must secure the consent of the Commissioner before computing his taxable income under a new method of accounting. "It is not sufficient for a taxpayer merely to show the correctness of the new method; that fact alone cannot justify a change without the Commissioner's consent." Southern Pacific Transportation Co. v. Commissioner , 75 T.C. 497 , 681 (1980) (citing Wright Contracting Co. v. Commissioner , 316 F.2d 249 (5th Cir. 1963) , affg. 36 T.C. 620 (1961)) . We also explained in Southern Pacific Transportation Co. v. Commissioner , supra at 682: In addition, consent is required when a taxpayer, in a court proceeding, retroactively attempts to alter the manner in which he accounted for an item on his tax return. If the alteration constitutes a change in the taxpayer's method of accounting, the taxpayer cannot prevail if consent for the change has not been secured. Casey v. Commissioner , supra at 385-386 [ Casey v. Commissioner , 38 T.C. 357 (1962)] ; Cubic Corp. v. United States , an unreported case ( S.D Cal. 1974, 34 AFTR 2d 74 -5895, 74-2 USTC par. 9667), *372 affd. per curiam 541 F.2d 829 (9th Cir. 1976) .
In this case, petitioner did not request or obtain the consent of the Commissioner to deduct costs in its 4000 and 6000 series accounts. Petitioner contends, however, that its change in its method of accounting was initiated by respondent and that, under such circumstances, respondent cannot use section 446(e) as a "shield" to bar petitioner's changes. Petitioner argues that "This attempt to allow only those changes which increase TI's [petitioner's] taxable income violates basic principles of fairness". Petitioner relies principally on Commercial Security Bank v. Commissioner , 77 T.C. 145 (1981) , and Gus Blass Co. v. Commissioner , 9 T.C. 15 (1947) .
In Commercial Security Bank , the cash basis taxpayer sold all of its assets, subject to liabilities, in a liquidation pursuant to section 337. The taxpayer included all of its "accrued interest receivables" and deducted all of its "accrued business liabilities" on its final Federal income tax return. Respondent accepted the inclusion in income of the receivables but denied the taxpayer's deduction of the liabilities. We *373 rejected respondent's contention that to allow the deduction would have the "effect of" permitting the taxpayer to change its method of accounting without the prior consent of the Commissioner, because we had concluded that the taxpayer had "effectively paid" the accrued liabilities. Commercial Security Bank v. Commissioner , supra at 151 . Thus there was no change in the taxpayer's method of accounting. Petitioner, however, focuses on our statement that followed: Moreover, by requiring Orem to include "accrued interest receivables" in income, respondent has in effect put Orem on an accrual basis as to those items, and we think his reliance on a highly technical reading of his regulations to say that similar treatment should not be accorded to the "accrued business liabilities" is questionable. This observation is, we think, particularly applicable in the instant situation, where the items in question are, as far as this record reveals, not only of a character otherwise qualifying for deduction under sections 162 and 163 * * * but also appear to have been intimately related to the items of "accrued interest receivables." [ Id. at 151 .] *374
Petitioner argues that the items involved in this case are more "intimate" because "The legal issues involved in TI's claim and the Service's claim are the same, that is, whether the costs are required to be allocated to the contracts" or accounted for currently in income.
We recognize that the overhead variances, simply stated, are the difference between the actual overhead and the overhead costs collected in petitioner's 4000 and 6000 series accounts through the application of the overhead rates. The amount of the overhead variances is directly affected by the costs that were collected in the 4000 and 6000 series accounts. Inversely, however, the 4000 and 6000 series accounts are not directly affected by the reallocation of those overhead variances to petitioner's work-in-progress, finished goods, and cost of goods sold accounts. Thus, it is not a harsh result to allow respondent to reallocate the overhead variances and to preclude petitioner's adjustments to exclude certain costs from the overhead pools. Id. The "harsh" result is that respondent's reallocation of the overhead variances increases petitioner's taxable income in two of the years in issue, while petitioner's *375 changes would decrease its taxable income. Also, respondent's change in petitioner's method of accounting for its overhead variances is a change in petitioner's method of accounting for those items and not, as petitioner asserts, a change in its method of accounting for all of its overhead costs. We therefore decline to hold in this case that the asserted relationship between the overhead variances and the indirect costs that petitioner now seeks to deduct either (1) establishes that respondent initiated a change in petitioner's method of accounting for those costs or (2) negates petitioner's obligation to seek the permission of the Commissioner prior to changing its method of accounting for those costs.
Petitioner also relies on the events that transpired during the audits of its returns to support its position. Petitioner offered the IDR's, and its responses to those IDR's, that respondent issued to petitioner during the course of respondent's audits of petitioner's returns for 1979, 1980, 1981, and 1982. The Court received those documents into evidence solely to show the sequence of events for purposes of determining whether petitioner had adopted a method of accounting for, *376 and whether it had changed its method of accounting for, certain of the costs in its 4000 and 6000 series accounts that it had allocated to its long-term contracts.
Those documents suggest that whether petitioner's treatment on its Federal income tax returns of all of the costs at issue was proper was considered by both parties during the course of those audits. We cannot infer (or give any effect to the inference), however, that petitioner's obligation formally to seek the permission of the Commissioner to change its method of accounting for its category (iii) costs was abrogated because respondent was aware of and considered petitioner's treatment of these costs, whether raised initially by petitioner or only in response to respondent's inquiry into the treatment of those costs or other related costs. That respondent inquires into the taxpayer's treatment of an item on a return and subsequently makes an adjustment to an item that constitutes a change in the taxpayer's method of accounting does not open the door and allow the taxpayer to change its method of accounting for any "related" items.
The facts in Gus Blass Co. v. Commissioner , supra , are also *377 distinguishable from the facts in this case. In that case, the taxpayer was on the accrual method except that, with respect to installment sales, it annually posted to an unrealized profit account a percentage of its uncollected installment receivables at the end of the year. Respondent determined that the taxpayer's income from installment sales should be computed on the accrual method and disallowed the taxpayer's deduction for the increase in its unrealized profit account for that year. Pursuant to regulations in effect for that year, a taxpayer was required to include in income the balance in its unrealized profit account if it had applied for and was granted permission to change from the installment to the accrual method. Because that requirement applied whether the change was "made at the direction of the Commissioner or upon the application of the taxpayer", and because the change was directed by the Commissioner, we concluded that the taxpayer was not required to "secure formal permission to change in order to comply with the regulations." Gus Blass Co. v. Commissioner , 9 T.C. at 35 -36 . In this case, respondent did not require in the first instance *378 that petitioner change its method of accounting for its overhead costs.
In sum, if (as it contends) petitioner was unable to determine which of the category (iii) costs could be deducted on its 1979 return "because of time constraints existing when it received permission to use the completed contract method", it could have rectified the problem prior to the time that it filed the returns for 1980, 1981, and 1982. Thereafter, petitioner could have sought permission to change its method of accounting. See Rev. Proc. 80-51 , 1980- 2 C.B. 818 . Petitioner's attempt to deduct those costs constitutes a change in its method of accounting for those items. Not having sought the permission of the Commissioner to change its method of accounting for those items, petitioner cannot complain that "basic principles of fairness" are being violated. We therefore conclude that petitioner's attempt to deduct the indirect costs that petitioner contends were described in section 1.451-3(d)(5)(iii), Income Tax Regs. , is barred by section 446(e) .
Respondent's Adjustments to Overhead Variances
Respondent possesses broad discretion to determine whether a particular method *379 of accounting clearly reflects income and to require a change to a method that, in her opinion, does clearly reflect income. Capitol Federal Savings & Loan v. Commissioner , 96 T.C 204 , 209 (1991) . "Respondent's authority under section 446(b) reaches not only overall methods of accounting, but also a taxpayer's method of accounting for specific items of income and expense." Prabel v. Commissioner , 91 T.C. 1101 , 1112 (1988) , affd. 882 F.2d 820 (3d Cir. 1989) . In reviewing changes in accounting methods under section 446(b) , the taxpayer must establish that respondent abused her discretion. Prabel v. Commissioner , supra at 1112 . To satisfy that heavy burden, the taxpayer must show that respondent's adjustments under section 446(b) were clearly unlawful or plainly arbitrary. Thor Power Tool Co. v. Commissioner , 439 U.S. 522 , 532-533 (1979) (quoting Lucas v. Structural Steel Co. , 281 U.S. 264 , 271 (1930) , and Lucas v. American Code Co. , 280 U.S. 445 , 449 (1930)) ; Prabel v. Commissioner , supra at 1112 .
Where a taxpayer *380 demonstrates that the taxpayer's method of accounting clearly reflects income, respondent cannot require that taxpayer to change to a different method even if, in respondent's view, her method more clearly reflects income. Molsen v. Commissioner , 85 T.C. 485 , 498 (1985) . Whether the particular accounting method clearly reflects income is a question of fact. Coors v. Commissioner , 60 T.C. 368 , 394 (1973) , affd. 519 F.2d 1280 (10th Cir. 1975) . If the taxpayer's method of accounting is explicitly authorized by the Internal Revenue Code or by the regulations, respondent may not reject that method as not providing a clear reflection of income if the taxpayer has applied that method on a consistent basis. Hallmark Cards, Inc. v. Commissioner , 90 T.C. 26 , 31 (1988) . Also, if that method of accounting reflects a consistent application of generally accepted accounting principles, it will ordinarily be regarded as clearly reflecting income. Hallmark Cards, Inc. v. Commissioner , supra at 31 ; sec. 1.446-1(a)(2), Income Tax Regs. But see Thor Power Tool Co. v. Commissioner , supra at 539-540 . *381
Section 1.451-3(d)(6), Income Tax Regs. , authorized the use of burden rates to allocate indirect costs to long-term contracts but did not provide for the treatment of overhead variances. For Federal income tax purposes, petitioner included in income the amount of its overhead variance for 1980 and deducted the amount of its overhead variances for 1981 and 1982. In the notice of deficiency, respondent allocated those overhead variances among work-in-progress, finished goods, and cost of goods sold and adjusted petitioner's taxable income accordingly.
The full absorption inventory rules provided that a taxpayer was required to reallocate to its ending inventory variances unless "such variances are not significant in amount in relation to the taxpayer's total actual indirect production costs for the year". See sec. 1.471-11(d)(3)(ii), Income Tax Regs. Although the regulation did not specify what was "significant", a variance of less than 3 to 5 percent was generally considered insignificant. See 1 Schneider, Federal Income Taxation of Inventories, sec. 4.04[4][a], at 4-87 (1991). For 1980, 1981, and 1982, petitioner's overhead variances, expressed as a percentage of the total *382 actual overhead, were (0.261), 2.169, and 0.026, respectively. Thus, at least under the full absorption inventory rules, petitioner's overhead variances for the years in issue were not significant.
Deakin stated in his report that overhead variances must be adjusted to reflect actual costs for "taxes, and financial reporting purposes" but that, for financial reporting purposes, "these adjustments may be waived because they are deemed immaterial." He further explained that petitioner's overhead variances for 1980, 1981, and 1982 were deemed immaterial for financial reporting purposes by petitioner's external auditors. Thus petitioner's method of not reallocating its overhead variances to its long-term contracts was in accordance with generally accepted accounting principles.
Also, the purpose of the completed contract method of accounting is to account for the entire results of a contract at one time. National Contracting Co. v. Commissioner , 37 B.T.A. 689 , 702 (1938) , affd. 105 F.2d 488 (8th Cir. 1939) . "Income is recognized under this method for the taxable year in which the contract is finally completed and accepted, and deduction of costs *383 properly allocable to the contract is deferred until such time as the income is recognized." Peninsula Steel Products & Equip. Co. v. Commissioner , 78 T.C. 1029 , 1046 (1982) ; fn. ref. omitted. The variances in this case, as respondent acknowledges, were "not a separate type of cost" but were merely the difference between estimated and actual costs. Given the nature of the variances and that the use of burden rates that gave rise to the variances was authorized by section 1.451-3(d)(6), Income Tax Regs. , we conclude that petitioner's method of accounting for those variances was not inconsistent with the completed contract method of accounting, and our review of the record does "not reveal any significant distortions of income". Peninsula Steel Products & Equip. Co. v. Commissioner , supra at 1049 .
We recognize respondent's broad discretion in making adjustments under section 446(e) . In this case, however, petitioner's method of accounting for its overhead variances reflected consistent application of generally accepted accounting principles for financial reporting purposes for 1980, 1981, and 1982. Hallmark Cards, Inc. v. Commissioner , 90 T.C. at 31 ; *384 sec. 1.446-1(a)(2), Income Tax Regs. Further, the amounts of petitioner's variances were not significant under the full absorption inventory rules in effect for the years in issue. Finally, petitioner's method of accounting for those variances was not inconsistent with the completed contract method of accounting. That respondent's method of accounting for those variances may have more clearly reflected petitioner's income does not entitle her to change petitioner's method. Molsen v. Commissioner , 85 T.C. at 498 . On these facts, we conclude that petitioner's method of not reallocating its variances to its long-term contracts clearly reflected its income. Respondent abused her discretion in requiring petitioner to reallocate its overhead variances to its long-term contracts. Prabel v. Commissioner , 91 T.C. at 1112 .
Respondent's Affirmative Claim
In an Amendment to Answer, respondent asserted that petitioner included in its 8000 series accounts, and deducted for Federal income tax purposes, general and administrative expenses that were incident to and necessary for the performance of its long-term contracts. Respondent contends *385 that the costs included in various cost centers that contained 8000 series accounts were costs described in section 1.451-3(d)(5)(ii), Income Tax Regs. , and that petitioner was required to allocate such costs to its long-term contracts. Respondent has the burden of proof as to this issue. See Rule 142(a).
We explained in McMaster v. Commissioner , 69 T.C. 952 , 956 (1978) , that the "telling distinction" between the types of costs described in section 1.451-3(d)(5)(ii) and in section 1.451-3(d)(5)(iii), Income Tax Regs. , is one of degree. That is, category (ii) costs "relate to and benefit individual contracts", while category (iii) costs "benefit the business as a whole." Being a question of degree, the facts in this case do not support the conclusion that any of the costs in respondent's affirmative claim related to and benefited individual contracts and did not benefit petitioner's business as a whole.
Cost centers 450 through 456 collected costs that were incurred for major moves and rearrangement and building maintenance, and cost centers 460 through 466 collected costs that were incurred for landscaping, cleaning, security, fire, and safety activities. *386 That petitioner allocated to its long-term contracts group occupancy charges through accounts 4975 (manufacturing) and 6975 (engineering) suggests that those charges may have been related to individual contracts but does not establish, as respondent contends, that the costs in cost centers 450 through 456 and 460 through 466 were thus required to be allocated. Moreover, the types of costs that were collected in those cost centers were distinct from the group occupancy charges.
Respondent also argues that her position with respect to these cost centers is supported by their reclassification to costs of sales in 1981 for financial statement purposes and by Deakin's testimony that this reclassification showed that petitioner's "accountants believed that these costs were associated with their manufacturing or contract activities." The significance of this evidence, as it relates to the proper tax accounting treatment of costs in these cost centers, was not explained and is not apparent.
Respondent also contends that costs collected in cost centers 230 and 241, which were incurred in the administration of Government contracts, and in cost centers 231 and 250, which related to interfacing *387 with Government contract personnel and auditors, were administrative costs described in section 1.451-3(d)(5)(ii)(L), Income Tax Regs. These functions were "related" to the EG's contracts in the broad sense. That is, 80 to 85 percent of the EG's business was from long-term contracts, and a majority of those contracts (over 2,000) were with the United States Government. Thus respondent has not proved that the costs in those cost centers related to and benefitted individual contracts and did not relate to the EG's business (long-term contracts) as a whole. McMaster v. Commissioner , 69 T.C. at 956 . Similarly, respondent has not proved that the costs collected in cost center 610, which included costs of purchasing materials, equipment, supplies, and services for the EG, were incurred for and therefore related to and benefitted individual contracts.
Finally, respondent contends in a footnote in her brief that "other costs in the 8000 series accounts are required to be allocated." Throughout trial of this case, it was not clear to the Court (or to petitioner) exactly what other costs and cost centers were related to respondent's affirmative claim. This passing *388 reference in her brief has shed no light on this matter, and we decline to scrutinize the vast record in search of other costs that may fall within the broad net that respondent cast in her Amendment to Answer. We conclude that respondent has not satisfied her burden of proving that any of the costs in her affirmative claim were required to be allocated to petitioner's long-term contracts.
Casualty Loss
Section 165 generally allows a taxpayer to deduct losses arising from the theft of property in the year that the theft is discovered. Sec. 165(a), (e); sec. 1.165-1(d)(3), Income Tax Regs. Section 1.451-3(d)(5)(iii)(G), Income Tax Regs. , provided that section 165 losses were not required to be allocated to long-term contracts. The amount of the loss allowable as a deduction shall not exceed the taxpayer's adjusted basis in the property. Sec. 1.165-1(c)(1), Income Tax Regs.
A loss within the meaning of section 165 is allowed as a deduction only for the taxable year in which the loss is sustained. Sec. 1.165-1(d)(i), Income Tax Regs. Where there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the theft loss *389 with respect to which reimbursement may be received is sustained until it can be ascertained whether or not such reimbursement will be received. Sec. 1.165-1(d)(3), Income Tax Regs. The portion of the loss that is not covered by a claim for reimbursement with respect to which there is a reasonable prospect of recovery is sustained during the taxable year in which the theft occurred. Sec. 1.165-1(d)(2)(ii), Income Tax Regs. Thus a loss "may be sustained in a year following the year when the casualty actually occurred, particularly where there is insurance involved". Gale v. Commissioner , 41 T.C. 269 , 275 (1963) .
In this case, the theft, which was discovered in November 1980, was covered by two insurance policies. The value of the stolen gold was $ 353,814.48. As of the end of 1980, petitioner had not determined under which of those policies it would file a claim. Because one policy had a $ 100,000 deductible and one had a $ 50,000 deductible, we conclude that petitioner sustained a casualty loss of $ 50,000 deductible in 1980. In 1981, petitioner received insurance settlements in the total amount of $ 264,282.76. We therefore conclude that petitioner *390 sustained a casualty loss of $ 39,531.72 deductible in 1981 ($ 353,814.48 minus $ 264,282.76, less $ 50,000.00 deductible in 1980).
PIA Depreciation
Petitioner contends that it is necessary to reverse the amounts of PIA depreciation contained in its Schedule M adjustments in order correctly to state its income. PIA depreciation was charged to petitioner's 4000 and 6000 series accounts. In preparing its Federal income tax returns for the years in issue, petitioner used the consolidated financial income shown on its financial statements, which reflected the elimination of the PIA depreciation. Petitioner made Schedule M adjustments to reflect the deferral of income and expense on the EG contracts under the completed contract method.
The net effect of the Schedule M adjustments was that petitioner overstated its taxable income by the amount of PIA depreciation. Petitioner erroneously failed to eliminate the PIA depreciation prior to making the Schedule M adjustments, where it had been eliminated at the consolidated financial level, and the effect was to double-count the increase to taxable income resulting from this adjustment. Petitioner should be allowed to correct that *391 error. Respondent cites only section 1.1502-13(c)(1)(ii)(b), Income Tax Regs. , which allows members of a consolidated group to defer inter company profit on sales. That section is inapposite. The PIA depreciation in issue was depreciation on intra company transactions between groups or divisions of a single corporation.
Purchase Cash Discounts
Petitioner also contends that it should be allowed to deduct the amount of its purchase cash discounts to prevent the overstatement of the direct material costs allocated to its long-term contracts. In allocating its direct material costs to its long-term contracts, petitioner debited its inventory account and credited its accounts payable account for the full cost of the material. If petitioner paid the invoice within the discount period and was entitled to pay the discounted price, it debited the accounts payable account for the full price of the material, credited the cash account for the discounted price, and credited account 3981 for the amount of the discount. This had the effect of increasing petitioner's income by the amount of the discount. Its income was decreased, however, when the gross cost of goods purchased *392 was deducted from income.
Section 1.451-3(d)(5)(i), Income Tax Regs. , incorporated by reference section 1.471-3(b), Income Tax Regs. , to determine the elements of direct material costs. That section provides that cost means: (b) In the case of merchandise purchased since the beginning of the taxable year, the invoice price less trade or other discounts, except strictly cash discounts approximating a fair interest rate, which may be deducted or not at the option of the taxpayer, provided a consistent course is followed. * * * [Sec. 1.471-3(b), Income Tax Regs. ]
Whether a discount approximates a fair interest rate is to be determined based on all of the facts and circumstances. See Warfield-Pratt-Howell Co. v. Commissioner , 13 B.T.A. 305 , 310 (1928) .
We found no evidence in the record as to the terms of any discounts received by petitioner and there is no basis to conclude that the discounts it received did not approximate a fair interest rate. We therefore reject petitioner's tardy assertion that "conventional discounts received by TI on purchases" did not approximate a fair interest rate and would thus not fall within section 1.471-3(b), Income Tax *393 Regs.
Moreover, petitioner's treatment of that item for Federal income tax purposes was consistent for 1980, 1981, and 1982 and was consistent with how those items were treated on its books for those years. That treatment was a "method of accounting" within the meaning of section 1.446-1(a)(1), Income Tax Regs. Petitioner's attempt to alter its treatment of its purchase cash discounts has the effect of postponing the reporting of income and is a change in its treatment of a material item. That change in treatment constitutes a change in its method of accounting within the meaning of section 1.446-1(e)(ii)(a), Income Tax Regs. Because petitioner has not sought the permission of the Commissioner to effect this change, petitioner's claim is barred by section 446(e) .
Rework Labor and Scrap
Finally, petitioner contends that it should be entitled to deduct the costs identified as rework and labor. Petitioner argues that these costs, which were incurred to bring parts into conformity with specifications and to identify the costs of scrapped parts, are deductible under section 1.451-3(d)(5)(iii), Income Tax Regs. These costs were included in 1000 series accounts as direct material. *394 Like petitioner's treatment of purchase cash discounts, its treatment of these items was a "method of accounting" within the meaning of section 1.446-1(a)(1), Income Tax Regs. , and its attempt to alter its treatment of those items constitutes a change in its method of accounting within the meaning of section 1.446-1(e)(ii)(a), Income Tax Regs. Petitioner's claim on this issue is also barred by section 446(e) .
Issue 2: Petitioner's Rebate Programs
FINDINGS OF FACT
Rebate History
From 1976 through 1982, petitioner offered various rebate programs for some of its consumer products. For financial reporting purposes, petitioner generally accrued amounts that it expected to pay out to redeem rebate requests that it received. These accruals offset income from sales in the current accounting period. Amounts were usually accrued on a monthly basis but sometimes were not accrued until the last month of a quarter. Payments made subsequent to the accrual were charged to, and reduced, the balance of the account. Petitioner used two liability accounts, accounts 2349 and 2350, to record its liability for its rebate programs.
To determine the financial cost of a consumer rebate *395 program, petitioner estimated a "redemption rate" before it was initiated. The redemption rate was the expected number of rebate requests to be received and was expressed as a percentage of sales.
From August 23, 1976, to October 15, 1976, petitioner offered a consumer rebate on the SR-56 Scientific Calculator (the SR-56 rebate program). As of September 1976, petitioner had recorded $ 79,900 in account 2350 for the SR-56 rebate program. That amount was determined by anticipating, at the beginning of the program, the gross number of rebate requests to be redeemed and then subtracting from that figure the number of requests received at year-end. Petitioner recorded additional amounts during the accounting period and offset the account by payments, yielding a net balance of $ 710 in the account at the end of December 1976. On its Federal income tax return for 1976, petitioner deducted the amount paid in 1976 for SR-56 rebates, plus the $ 710 balance of account 2350. Petitioner did not reverse that balance on its Schedule M.
From August 15, 1977, to October 31, 1977, petitioner offered a consumer rebate on the TI-58 Programmable Calculator and the TI-59 Programmable Calculator *396 (the TI-58/59 rebate program). In 1977, petitioner recorded an amount in account 2349 for the TI-58/59 rebate program. That amount was determined by anticipating, at the beginning of the program, the gross number of rebate requests to be redeemed and then subtracting from that figure the number of rebate requests received at year-end, which yielded a year-end balance of $ 69,880. On its Federal income tax return for 1977, petitioner deducted the amount paid in 1977 for TI-58/59 rebates, plus the $ 69,800 balance of account 2349. Petitioner did not reverse that balance on its Schedule M.
TI-59 Rebate Program
From August 1, 1981, to December 31, 1981, petitioner offered a $ 20 consumer rebate on TI-59 Programmable Calculators purchased on or between those dates (the TI-59 rebate program). Pursuant to the terms of that program, consumers were eligible to receive the $ 20 rebate if the rebate request was postmarked by January 15, 1982, and if they submitted: (1) A sales receipt dated on or between August 1, 1981, and December 31, 1981, (2) a completed customer information card, and (3) a coupon.
Coupons for this rebate program were available in magazine and newspaper advertisements *397 and on counter cards and in flyers that were available in stores. The coupons were inducements for sales, and a consumer was not required to purchase a TI-59 calculator to obtain a coupon. These coupons, as well as those offered in conjunction with petitioner's other rebate programs described below, set forth the terms of the program and instructed the consumer to provide certain information.
Petitioner designed the TI-59 rebate program to ensure that the consumer actually purchased the TI-59 calculator. United Marketing Services (UMS) was an independent agent that petitioner employed to process rebate requests for the TI-59 rebate program. UMS conducted validity checks to ensure that consumers complied with the terms of that program. Petitioner would pay or advance to UMS sufficient money to allow UMS to process consumer rebates during a given period.
Petitioner calculated its 1981 total liability for the TI-59 rebate program, $ 108,299, by multiplying an estimate of total redemptions by the estimated costs of redeeming each rebate request and then subtracting from that figure amounts that petitioner had advanced to UMS. Petitioner had recorded $ 108,000 in account 2349 as *398 of December 31, 1981.
The estimate of total redemptions included the number of rebate requests that UMS had received as of January 6, 1982, 12,077, and the number of additional rebates that petitioner expected would be received 3,000. Different methods were used to arrive at that estimate. One method used a percentage of estimated total retail "take-away", which was the amount of product that was sold off a retailer's shelves in a given month. Another method involved tracking rebate requests and factoring in the average delay time between the date of purchase and the date that rebate requests were received.
As of January 6, 1982, petitioner had advanced $ 200,000 to UMS for the TI-59 rebate program. UMS had received 14,202 TI-59 rebate requests as of February 26, 1982, and had spent $ 250,300 for the TI-59 rebate program as of that date.
Petitioner did not deduct the $ 108,000 balance in account 2349 for the TI-59 rebate program on its Federal income tax return for 1981. In preparation of its 1981 Form 1120, petitioner prepared Schedule M #5-10 and reversed the $ 108,000 balance in account 2349, because that amount was not fixed and determinable. Petitioner deducted $ 308,299 *399 for the 1981 TI-59 rebate program on an amended Federal income tax return that it filed for 1981.
The Home Computer Rebate Program
From September 1, 1982, to January 31, 1983 (a date that was subsequently extended to April 15, 1983), petitioner offered a $ 100 consumer rebate on its home computers purchased by retail consumers on or between those dates (the home computer rebate program). Pursuant to the terms of that rebate program, consumers were eligible to receive the $ 100 rebate if the rebate request was postmarked by February 10, 1983 (a date that was subsequently extended to April 15, 1983), and if they submitted: (1) An original sales receipt, (2) a completed user information card, (3) a coupon, and (4) the words "Model PHC-004A DESC: 99/4A QTY 1" cut out from the home computer box (the proof of purchase).
Coupons for the home computer rebate program were available in magazine and newspaper advertisements and in stores. The coupons were inducements to sales, and a consumer was not required to purchase a home computer to obtain a coupon.
Petitioner designed the 1982 home computer rebate program to ensure that the consumer actually purchased the home computer. As *400 of April 5, 1983, petitioner did not have written procedures for processing home computer rebate requests. Where petitioner approved a rebate request without all of the required documentation, additional procedures were used to verify the validity of the claim.
For purposes of computing its book income from sales of the home computer, petitioner established a reserve for future redemptions. As of December 31, 1982, the home computer rebate liability, which was reflected in account 2350, was $ 21,642,400 (rounded to $ 21,643,000). That book reserve was computed by multiplying an estimate of total redemptions (including future redemptions) by the cost of redeeming each rebate request and then subtracting from that figure amounts petitioner had paid to consumers as of December 31, 1982. Petitioner multiplied the rebate cost per unit, $ 100, by the sum of the cumulative retail "take-away" and the ending inventory as of that date. Petitioner then multiplied an expected redemption rate of 80 percent by that amount to arrive at a gross liability as of December 31, 1982. The $ 100 home computer rebate program was petitioner's first program in which it offered a rebate on home computers. *401 Petitioner based the 80-percent redemption rate on past experience with rebate programs of smaller dollar amounts.
As of December 31, 1982, petitioner had received 114,500 home computer rebate requests. As of June 27, 1983, it had received 405,122 home computer rebate requests and issued 403,048 checks for a minimum of $ 100 each.
For Federal income tax purposes, petitioner prepared Schedule M #4-15 to adjust the home computer rebate reserve recorded in account 2350 to reflect its fixed and determinable liability, based on rebate coupons actually received as of December 31, 1982. Petitioner deducted $ 11,450,000 ($ 8,100,000 in rebate payments made through December 31, 1982, plus $ 3,350,000, as an accrued liability as of December 31, 1982) for the home computer rebate program on its 1982 return. On an amended Federal income tax return that petitioner filed for 1982 (1982 Form 1120X), petitioner deducted $ 29,742,400 ($ 8,100,000 paid plus $ 21,642,400) for the home computer rebate program.
The Learning Aids Rebate Program
From October 15, 1982, to January 31, 1983 (a date that was subsequently extended to May 31, 1983), petitioner offered a $ 15 consumer rebate on certain *402 talking learning aids purchased by retail customers on and between those dates. Petitioner also offered a $ 10 rebate on its Speak and Spell Compact and a $ 5 rebate on modules for the talking learning aids purchased by retail customers during that same period (collectively referred to as the learning aids rebate program). Pursuant to the terms of that rebate program, consumers were eligible to receive the rebate if the rebate request was postmarked by February 10, 1983 (a date that was subsequently extended to May 31, 1983), and if they submitted: (1) An original sales receipt, (2) a coupon, and (3) a proof of purchase from the product box or manual enclosed in the product box. A proof of purchase was the product name within a dotted bubble from the front panel of certain of the product boxes or the top right corner of the manual enclosed in certain of the other product boxes.
Coupons for the learning aids rebate program were available in magazine and newspaper advertisements and in stores. The coupons were inducements to sales, and a consumer was not required to purchase the product to receive a coupon.
Petitioner designed the learning aids rebate program to ensure that the *403 consumer actually purchased the learning aids. UMS processed rebate requests for this rebate program. In some cases, UMS gave consumers a rebate even if they failed to submit the proof of purchase. Typically, this involved a telephone discussion with or letter from the consumer and, in most instances, each case was discussed with one of petitioner's employees.
For purposes of computing its book income from sales of the learning aids, petitioner accrued $ 9,155,000 for the learning aids rebate program in account 2350. Petitioner reduced that liability by $ 1,545,344, the amount petitioner reimbursed UMS for learning aids rebates paid by UMS by the end of 1982. Petitioner's books reflected a $ 7,609,656 balance as an accrued liability for the learning aids rebate program as of December 31, 1982. That book reserve for future redemptions was computed, essentially, in the same manner as the reserve for the home computer rebate program. Petitioner based its expected redemption percentage on experience that it had with other similar rebate programs.
UMS issued a total of $ 9,783,214 in rebate checks for the learning aids rebate program.
For Federal income tax purposes, petitioner *404 prepared Schedule M #4-15 to adjust its learning aids rebate reserve recorded in account 2350 to reflect its fixed and determinable liability ($ 1,862,400), based on rebate coupons actually received by UMS as of December 31, 1982, but not yet paid. Petitioner deducted $ 3,407,400 ($ 1,545,000 in rebate payments made as of December 31, 1982, plus $ 1,862,400) for the learning aids rebate program on its 1982 Form 1120. Petitioner claimed as a deduction for 1982 the total of the learning aids rebates paid as of December 31, 1982, $ 1,545,344, plus the balance in account 2350 as of December 31, 1982, $ 7,609,656, on its 1982 Form 1120X.
The Speech Synthesizer Rebate Program
From September 1, 1982, through January 31, 1983, petitioner offered a consumer rebate in which customers who purchased six software command cartridges or two software albums for the home computer, on and between those dates, were entitled to a free speech synthesizer (speech synthesizer rebate program). Consumers did not have to purchase the home computer to receive the speech synthesizer.
Pursuant to the terms of that rebate program, consumers were eligible to receive the speech synthesizer if the rebate *405 request was postmarked by February 15, 1983, and if they submitted: (1) An original sales receipt, (2) a coupon, and (3) the end flaps with the number 1043601-1 from each command cartridge box. Coupons for the speech synthesizer rebate program were available in magazine and newspaper advertisements and in stores. The coupons were inducements to sales, and a consumer was not required to purchase software command cartridges or software albums to receive a coupon.
Petitioner designed the speech synthesizer rebate program to ensure that the consumer actually purchased the software packages. In a limited number of cases, consumers received a speech synthesizer even though they failed to comply with all of the terms of the speech synthesizer rebate program. The considered decision to grant the rebate request was based upon the consumer's explanation for the failure to submit all of the required documentation.
For purposes of computing its book income from sales of the software command cartridges and software albums, petitioner recorded $ 753,000 in account 2349 for the speech synthesizer rebate program. Based on revised ending inventory figures, petitioner, on June 20, 1983, estimated *406 that the December 31, 1982, liability for the speech synthesizer rebate program would be $ 680,800. That amount was computed by applying an estimated speech synthesizer redemption rate to the estimated number of home computer units expected to be redeemed. Petitioner subtracted the number of speech synthesizers shipped as of December 31, 1982, 24,100, to arrive at a net unit liability, 29,600. The net unit liability was multiplied by the estimated cost of the speech synthesizer, $ 23. The estimated speech synthesizer redemption rate was based, in part, on past rebate programs under which petitioner offered consumers a product. This program, however, was the first of its kind in that consumers were required to buy a number of or combination of products to qualify for the product rebate. As of June 27, 1983, petitioner had received 168,554 rebate requests and shipped 168,306 speech synthesizers.
Petitioner deducted $ 135,677 as an accrued liability for the speech synthesizer rebate program on its Federal income tax return for 1982. Petitioner claimed as a deduction the accrued liability for that program as of December 31, 1982, $ 753,000, on its 1982 Form 1120X. (Petitioner *407 now concedes that the proper amount was $ 680,800.)
In its petition, petitioner asserted that it was entitled to deduct the amounts paid for its 1981 and 1982 rebate programs, plus the year-end reserve balances for estimated future redemptions, as reported on its Forms 1120X for those years.
OPINION
Petitioner's position is that it has satisfied the requirements of section 1.451-4, Income Tax Regs. , and that it is therefore entitled to deduct the amounts claimed on its 1981 and 1982 Forms 1120X for its rebate programs. Respondent's position is that petitioner has not satisfied the requirements of that section. Respondent also contends that petitioner seeks to change its method of accounting with respect to the rebate programs and that permission to effect such a change was not requested or granted as required by section 446(e) .
Section 1.451-4(a)(1), Income Tax Regs. , provides, in part: If an accrual method taxpayer issues trading stamps or premium coupons with sales * * * and such stamps or coupons are redeemable by such taxpayer in merchandise, cash, or other property, the taxpayer should, in computing the income from such sales, subtract from gross receipts with respect *408 to sales of such stamps or coupons * * * an amount equal to --
(i) The cost to the taxpayer of merchandise, cash, and other property used for redemptions in the taxable year,
(ii) Plus the net addition to the provision for future redemptions during the taxable year (or less the net subtraction from the provision for future redemptions during the taxable year).
The purpose of that regulation is to match revenues with expenses incurred in generating those revenues, and taxpayers are entitled to a present deduction for only that portion of the stamps or coupons that will eventually be redeemed. See Mooney Aircraft, Inc. v. United States , 420 F.2d 400 , 411 (5th Cir. 1969) ; see also Rev. Rul. 78-212 , 1978- 1 C.B. 140 .
Respondent first contends that petitioner's coupons "were merely part of advertisements inducing potential customers to purchase petitioner's products" and were not issued "with sales" within the meaning of section 1.451-4, Income Tax Regs. Respondent cites Rev. Rul. 73-415 , 1973- 2 C.B. 154 , and Rev. Rul. 78-212 , supra . Revenue rulings are not substantive authority *409 but are merely a statement of the Commissioner's position with respect to a specific factual situation. Stark v. Commissioner , 86 T.C. 243 , 250-251 (1986) .
In Rev. Rul. 73-415 , supra , the taxpayer had distributed, through the mail or in periodicals, advertisements that entitled consumers to a reduction in the sales price of an article when the consumers presented the coupon at the time of purchase. Respondent determined that those "coupons were not issued with sales", because they were "distributed gratuitously to the general public as an inducement to purchase the taxpayer's products." Similarly, in Rev. Rul. 78-212 , supra , the taxpayer issued coupons that entitled consumers to a discount on the sales price of certain products that they would purchase in the future. Coupons that were issued in connection with an advertising campaign or in weekly newspaper advertisements were not issued with sales. In contrast, the taxpayer did issue with sales of its product coupons that appeared on the face of the package (on-pack) or were included in the package (in-pack). Respondent, however, determined that *410 these coupons were not "redeemable in cash, merchandise or other property" because an additional purchase of the retailer's product by the consumer was required. Rev. Rul. 78-212 , supra at 141 .
The facts on which the cited rulings were based are distinguishable from the facts in the instant case. Under the terms of petitioner's rebate programs, consumers were required to submit to petitioner a coupon that was available in magazine and newspaper advertisements and in stores. In each instance, that coupon set forth the terms of the rebate program and instructed the consumer to provide certain information. Under those terms, the consumer was required to submit to petitioner an original sales receipt and some additional type of proof of purchase. In the TI-59 and the home computer rebate programs, that proof of purchase was a customer information card, which was packaged with the product that the consumer purchased. In the home computer, the speech synthesizer, and the learning aids rebate programs, that proof of purchase was some part of the product box or, in the latter program, a corner of a manual enclosed in the product box. Petitioner required *411 such proofs of purchase in each of those programs to ensure that the consumer actually purchased the product. Thus, consumers were required to submit to petitioner an item that was issued "with sales" and, at least in the case of all of the rebate programs except the speech synthesizer rebate program, were not required to purchase an additional product to be entitled to the rebate.
Also, it is not dispositive in this case that the coupons that petitioner distributed were "inducements to sales". By their nature, rebate programs are designed to promote and increase the sale of a product. See Brown & Williamson Tobacco Corp. v. Commissioner , 16 T.C. 432 , 434 (1951) . Rather, the issue is whether the in-pack or on-pack proofs of purchase that petitioner issued with sales were "coupons" within the meaning of section 1.451-4, Income Tax Regs.
The in-pack and on-pack proofs of purchase that petitioner issued were similar to those in Rev. Rul. 78-212 , supra , which respondent determined were coupons within the meaning of section 1.451-4, Income Tax Regs. Although not defined in the regulation itself, the term "coupon" generally includes *412 "a token or certificate given with a purchase and redeemable in merchandise or cash" and "a trademark, wrapper, box top, or similar evidence of a purchase for which premium articles are given". Webster's Third New International Dictionary (1976). We conclude that the in-pack and on-pack proofs of purchase that petitioner issued with sales, which were required to be submitted to petitioner to entitle consumers to a rebate, were "coupons" within the meaning of section 1.451-4, Income Tax Regs.
Specifically with respect to the speech synthesizer rebate program, respondent also argues that that program was "conditional" because a consumer "was required to buy the TI Home Computer and six cartridges of software" to qualify for a speech synthesizer. Consumers were not required to purchase a home computer as part of that rebate program. Moreover, nothing in the regulation prohibits a taxpayer from requiring that a fixed number of coupons issued with sales be submitted to entitle the consumer to the rebate. See Brown & Williamson Tobacco Corp. v. Commissioner , supra at 434 .
Finally, respondent argues that petitioner did not follow the accounting method prescribed *413 in section 1.451-4, Income Tax Regs. , because petitioner gave rebates to consumers in certain instances where the consumer did not comply with all of the terms of a particular rebate program. Where such requests were granted, however, petitioner or UMS had taken measures to verify that the consumer had actually purchased the product. Petitioner's failure to require exacting compliance with the terms of its rebate programs in every instance did not preclude petitioner's right to use that method of accounting. See Brown & Williamson Tobacco Corp. v. Commissioner , supra at 435 ; Creamette Co. v. Commissioner , 37 B.T.A. 216 , 218 (1938) .
Respondent next contends that, even if petitioner is entitled to use that method of accounting, petitioner failed to establish the amount of the reserve for its rebate programs in accordance with the regulation.
The determination of the provision for future redemptions is computed by multiplying estimated future redemptions by the estimated average cost of redeeming each trading stamp or coupon. Sec. 1.451-4(b)(1)(i), Income Tax Regs. The term "estimated future redemptions" means the number of "trading *414 stamps or coupons outstanding as of the end of such year that it is reasonably estimated will ultimately be presented for redemption." Sec. 1.451-4(b)(1)(ii), Income Tax Regs. A taxpayer may use any method of determining the estimated future redemptions as long as that method is used consistently and "results in a reasonably accurate estimate of the stamps or coupons outstanding at the end of such year that will ultimately be presented for redemption". Sec. 1.451-4(c)(1)(i), Income Tax Regs. Whether the expected redemption is reasonable is a question of fact. See Brown & Williamson Tobacco Corp. v. Commissioner , supra at 444-445 ; Frontier Saving Stamps, Inc. v. United States , 6 AFTR 2d 5092 , 60-2 USTC par. 9654 (N.D. Tex. 1960).
Section 1.451-4(c)(2), Income Tax Regs. , provides: Normally, the estimated future redemptions of a taxpayer shall be determined on the basis of such taxpayer's prior redemption experience. However, if the taxpayer does not have sufficient redemption experience to make a reasonable determination of his "estimated future redemptions", or if because of a change in his mode of operation or other *415 relevant factors the determination cannot reasonably be made completely on the basis of the taxpayer's own experience, the experiences of similarly situated taxpayers may be used to establish an experience factor.
Respondent argues that petitioner does not have sufficient redemption experience because the home computer and the learning aids rebate programs were the "first of their type." Section 1.451-4(c)(2), Income Tax Regs. , however, does not require that a taxpayer demonstrate that its estimated future redemptions be based on its experience with an identical redemption program, only that it be based on "prior redemption experience."
Our task is only to determine if petitioner's estimates of its future redemptions were "reasonable." Petitioner estimated a redemption rate, the expected number of rebate requests to be received expressed as a percentage of sales, as part of the process of determining the financial cost of a consumer rebate program before it was initiated. The estimated redemption rates used in all of petitioner's rebate programs were based on petitioner's past experience with other rebate programs, as required by section 1.451-4(a), Income Tax Regs. We are *416 satisfied that the methods petitioner used in establishing those redemption rates were sound. Also, those rates are reasonable when viewed in light of the actual number of rebate requests received and the amounts paid in those rebate programs. We therefore conclude that petitioner has established that its provisions for future redemptions were reasonable and in accord with the requirements of section 1.451-4, Income Tax Regs.
In the alternative, respondent contends that petitioner seeks to change its method of accounting with respect to its rebate programs. Respondent asserts that petitioner accounted for its rebate programs for 1976, 1977, 1981, and 1982 under the accrual method of accounting and that petitioner is now seeking to change its method of accounting for a material item.
Petitioner computed its year-end book liability for its 1976 and 1977 rebate programs by determining, as of the beginning of the program, the gross number of rebate requests that it expected to redeem and then subtracting the number of rebate requests received at year-end. Because those rebate programs terminated prior to year-end, that liability that was booked may have also satisfied the all events *417 test. See sec. 1.446-1(c)(1)(ii), Income Tax Regs. What is determinative, however, is that petitioner's method of establishing that liability was consistent with the method provided in section 1.451-4, Income Tax Regs. , and was the same method that petitioner used to determine its year-end liability on its books and its income from sales for the rebate programs at issue. See sec. 1.446-1(e)(2)(ii)(b), Income Tax Regs.
For Federal income tax purposes for 1976 and 1977, petitioner deducted the year-end liability that it had computed under that method, in addition to the amounts that it had paid. For 1981 and 1982, petitioner erroneously failed to deduct for Federal income tax purposes the year-end reserves that it computed on its books for its 1981 and 1982 rebate programs. We conclude that petitioner's attempt to deduct those amounts is not a change in its method of accounting for its rebate programs. Compare, e.g., Casey v. Commissioner , 38 T.C. 357 , 384-385 (1962) .
Issue 3: Investment Tax Credit Issue
FINDINGS OF FACT
In the notice of deficiency, respondent made adjustments to investment tax credits (ITC) in the amount of $ 1,881,573. During trial *418 of this case, petitioner made substantial concessions, reducing the amount of the disputed ITC to approximately $ 1,260,000. The parties made further concessions in their briefs. There remain, however, over 200 assets with respect to which petitioner contends it is entitled to an ITC. These assets fall, generally, into 13 categories. Our findings with respect to the assets within each of these categories are set forth below. Unfortunately, this issue requires lengthy and detailed treatment. (The parties, the Court, and the public might better be served by submitting technical factual issues of this type to technically qualified arbitrators under Rule 124.) For the convenience of the parties, and to facilitate our analysis, we have identified each of these assets by a tag number that was generated in the course of petitioner's business and by reference to the location of the plant or facility with which each of those assets is associated.
Waste Treatment Facilities
Petitioner built two structures in which it housed equipment used in the waste treatment processing systems at Dallas (the Dallas facility) (asset 976683) and at S.W. Houston (the S.W. Houston facility) (assets *419 976248, 976249, 976250, 976262-1, and 976265-1). Waste treatment is an integral part of the manufacturing operations at those sites.
The 40- by 66- by 20-foot Dallas facility had a concrete floor, walls, and roof. The size of the facility was determined by laying out the various pieces of equipment necessary for the waste treatment processing system and creating an enclosure for such equipment. The walls were not constructed until some of the equipment was already in place. There were no restrooms, no windows, two pedestrian doors, and two cargo doors in a dock that was used for receiving chemicals and other supplies.
The Dallas facility had steel stairways and catwalks or grates that established five to six levels to provide access to the tanks and other pieces of equipment. The space between pieces of equipment was narrow and cramped, as were the catwalks and grates.
The Dallas facility was heated, but the walls and roof of the facility were not insulated and did not dissipate heat from the equipment or prevent condensation on the equipment. They protected the equipment from sun and rain.
The concrete floor had tiers and trenches and served as a containment vehicle in *420 the event untreated fluids flowed onto the floor. If metals were detected in the waste or rinse water stream, that stream was pumped onto the floor where it drained into a sump and was held until it was pumped into one of the two metal treatment streams treated within the facility. This was a critical function of the facility and the walls and doors aided in this function, although the doors did not have any special seals. The Dallas facility could contain 20,000 to 30,000 gallons of fluid. Spills have occurred and have been as deep as 16 to 17 inches. Equipment was installed on 6-inch concrete pads to protect the equipment from spills.
The waste treatment processing system in the Dallas facility was highly automated, but an operator had certain responsibilities, which included monitoring and activating certain processes and the filter press; maintaining an adequate supply of treatment chemicals and other reagents and periodically adding these chemicals to the batch processes; and performing occasional preventative maintenance. In 1982, these responsibilities dictated that an operator devote one-half of each shift in that facility.
As constructed, the Dallas facility did not *421 have an enclosed control room. An air-conditioned control room was subsequently built. It contained a desk and chair, personal computer, calculator, telephone, alarm clock, reference books, and bulletin board. A maintenance team from the manufacturing plant made a 5- to 10-minute walk-through of the waste treatment plant once a day and performed any maintenance tasks required.
Although similar systems were constructed to operate outdoors, the waste treatment system in the Dallas facility could not have been operated outdoors because of the possibility that freezing would disrupt the system. Petitioner used 50-percent caustic reagents, which freeze at temperatures between 55 and 60 degrees Fahrenheit, as neutralizing agents in this waste treatment process. With modifications and installation of additional equipment, the system could have been operated outdoors. Alternatively, petitioner could have installed a waste treatment processing system with heated lines and tanks that could tolerate outdoor conditions. In either event, part of the system, including the control room and the ultrafiltration equipment, would have had to have been indoors. Although it had conducted no formal *422 studies as to alternative uses, petitioner did not consider it feasible, in part because of the size of the facility and its construction, to use the facility for any other purpose.
Like the Dallas facility, petitioner constructed the S.W. Houston facility to house and to protect the waste treatment processing equipment and to contain spills. The 118- by 44- by 25-foot S.W. Houston facility had no windows, five pedestrian doors, and five roll-up type doors, two of which permitted the installation and removal (as required) of two large filter presses. The walls and the roof were not insulated and were not designed to allow heat to dissipate from the equipment or to prevent condensation on the equipment, but they sheltered the equipment and provided protection from freezing. Except for the control room and laboratory, the facility was not air conditioned.
In addition to the equipment and walkways to access the equipment, a dock used for receipt and storage of chemicals, a storage room for sulphur dioxide, and a small toilet room were located on the ground level. The spaces between the equipment, between the equipment and the walls, and on the catwalks were narrow.
The concrete *423 floor collected any spills in the containment pit, from which the spilled fluids were pumped back through the waste treatment processing system. The floor had sloping contours, which were approximately 4 inches in places, that led to floor drains that were connected to the spill containment pit. The walls and doors aided in this spill containment function in that they contained spills adequately to prevent any substantial amount of fluids from leaking outside the structure, although the doors did not have watertight seals. Equipment was installed on 3- to 4-inch concrete pads.
On the second level was a small air-conditioned room that contained the control room and a laboratory. Catwalks were used by the operator to examine the equipment and to add chemicals used in the processing system.
The processes for treating the two waste treatment streams at the S.W. Houston facility were highly automated and were operated by a programmable logic controller. This system was operated by one person working an 8-hour shift and was operated for two 8-hour shifts per day. In addition to programming the necessary commands into the controller, the operator's responsibilities included starting *424 the system, performing tests, operating the filter presses, monitoring certain fluid levels, performing minor maintenance, and adding chemicals to the equipment as required. Major maintenance was performed by a crew from the nearby manufacturing facilities.
The waste treatment processing system also included equipment located outside the facility itself. Petitioner did not experience any problems with freezing of this equipment.
The system in the S.W. Houston facility could have been operated outdoors with modifications such as the installation of heated lines and a different neutralizing agent. Petitioner used a slurried lime mixture, which was susceptible to freezing, as a neutralizing agent to treat the waste streams processed by this system. Most of the other equipment could have operated outdoors, but the control room and laboratory had to be located indoors. Because of the cost, petitioner did not consider it feasible to convert the facility for use for any purpose other than waste treatment.
Drywall Partitions
Petitioner used drywall partitions to construct "clean rooms", computer rooms, and rooms that were used to control noise or other factors. Employees regularly *425 worked in these enclosed areas.
Clean rooms were structures in which petitioner controlled the temperature and the humidity and limited the contamination to a process or product. These environmental controls were necessary for the manufacturing that was conducted within the rooms. The drywall did not possess any special or unique qualities that contributed to the cleanliness of the room. The filtering function was performed by the air-handling equipment that forced air through the room through high-efficiency particle filters in the ceiling and, in some cases, through perforations in the floor. A clean room could not be constructed without, at least, enclosing an area with walls, a ceiling, and a floor. These clean rooms varied in size from 1,400 to 49,000 square feet. The following assets included drywall used to construct clean rooms: Assets 976035-9 (Dallas-N. Building); 973992, 973992-1, 974233, 974334, 975488-2 (S.W. Houston); 973797 and 975467 (Sherman); and 973967 (Lewisville).
Petitioner constructed computer rooms in which it controlled the temperature and the humidity, which was necessary for the proper operation of the computer equipment. A computer room could not *426 be constructed without, at least, enclosing an area with walls, a ceiling, and a floor. Although the drywall confined the air, equipment located outside the structure controlled the temperature and humidity inside the structure. The following assets included drywall that formed the walls, or some of the walls, in computer rooms: Assets 976703 and 976705 (Dallas-S. Building); 973771, 974133, and 976034-4 (Forest Lane); and 2179168-1 (Johnson City).
At its Attleboro plant, petitioner used drywall to construct the buffing line room (asset 2039809), which was used to polish chrome. This drywall had a 2-inch sound blanket that aided in containing the noise and dust produced from the equipment used in the room. Petitioner also used drywall to construct the roller, stretcher, leveler room in Building 4 at Attleboro (asset 2039939-6). Air-handling equipment controlled the temperature in the room, which was necessary to maintain the dimensional tolerances of the metal processed in that room. The following assets included drywall that was used to construct structures to control noise or to provide protection from objects in manufacturing areas: Asset 974106 (Lewisville), asset 976038 *427 (Lewisville), and asset 2179115-2 (Johnson City). Petitioner constructed with drywall a structure to enclose telephone equipment at Lubbock (asset 975600). The telephone equipment required a temperature-controlled environment, and the drywall helped to contain the cooled air. The telephone equipment supported the entire Lubbock site.
The following assets included drywall that petitioner used to construct structures and to enclose areas, in part, for security reasons: Assets 974133, 973771, 976034-4, and 974026 (Forest Lane); 972804, 973669, 976214, and 976832 (Lewisville); 976652 (Colorado Springs); and 2179168-1 (Johnson City).
All of the drywall was gypsum board or Sheetrock and was screwed or nailed onto each side of metal studs and secured at the floor and ceiling or roof deck (except for asset 2039809, which was constructed on top of a 4-foot concrete wall). The drywall joints were bedded, taped, floated, and finished. In certain clean rooms, the drywall was sealed with an enamel and plastic covering on the interior to prevent the release of any particles in the room. The drywall was not installed to facilitate its removal, and drywall of this type was not generally reused *428 because the resulting damage and labor required upon removal made reuse uneconomical.
The structures constructed in part with drywall partitions were sometimes converted to other uses. In one instance, a portion of one of the computer rooms was left empty and another portion of the room was put to a different use.
Miscellaneous Structures and Related Equipment
Petitioner built a 25- by 30-foot metal structure to protect the main electrical switch gear for the Attleboro site (asset 2038151). It had steel walls, a steel roof, a flat concrete floor, no windows, two personnel doors, and one overhead door. The structure had minimal insulation and heating and was not air conditioned. The equipment in the facility occupied between 20 and 50 percent of the floor, and the unoccupied floor space was required for access to and removal of equipment. There were numerous 6-inch holes in the floor through which electrical cables passed. No employees were assigned to work in the structure, but a desk and a file cabinet were placed there.
Petitioner also built a structure (asset 973365) at Lewisville to protect water pumps. (Included in the costs associated with this asset were the *429 pumps, the water storage tank, a fuel oil tank, and a fuel oil containment pit.) The 250,000-gallon water tank and water pumps were part of the fir

[Text truncated at 120,000 characters. The full text is on the page linked above.]

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4612786. Public record. Not legal advice.