FINDINGS OF FACT Some of the facts have been stipulated by the parties. Such stipulation and the exhibits attached thereto are incorporated herein by this reference. Rapid New York, petitioner in docket No. 6621-71, is a corporation organized in 1954 under the laws of the State of New York. It filed its corporate income tax returns on the accrual method of accounting for each of the taxable years 1964, 1965, and 1966 with the district director of internal revenue, Manhattan District, New York. At the time of the filing of the petition herein, Rapid New York's principal office was located at 1300 Herschell Street, Bronx, New York. James A. Viola (hereinafter referred to as Viola), petitioner in docket No. 6622-71, timely filed his Federal individual income tax returns for the taxable years 1964 and 1965 with the district director of internal revenue, Manhattan District, New York, using the cash method of accounting, At the time of the filing of the petition herein, his legal residence was Candlewood Lake, Brookfield, Conn. Petitioners in docket No. 6623-71 are Viola and his wife, Evelyn Viola, whom he married in 1966. They filed a timely joint Federal income tax return for the taxable year 1966 on the cash method of accounting with the district director of internal revenue, Manhattan District, New York. Their legal residence at the time of the filing of the petition herein was Candlewood Lake, Brookfield, Conn. Evelyn Viola is a petitioner herein only by virtue of having filed a joint return with her husband. In 1944, Viola established a sole proprietorship under the name of Rapid Electric Co. to engage in the manufacture and sale of lowvoltage or "electroplating" rectifiers. Rectifiers are electrical apparatus that convert alternating electrical current into direct electrical current. The rectifier operations were continued in the proprietorship form until January 1960, when its assets were transferred to Rapid New York, of which Viola was president and holder of all its outstanding stock. Since such time, Rapid New York has been continuously engaged in the manufacture and sale of rectifiers. Its plants were located in Bronx, New York, and in Brookfield, Conn., the latter being built in the late 1950's with the expectation that the entire operation could be moved there. Throughout the years in question, Rapid New York's employment level numbered approximately 150. During 1961 and 1962, the steadily increasing competition in the manufacture of low-voltage rectifiers was adversely affecting profits. As a consequence, Viola decided to expand the operations of Rapid New York to include high-voltage or "industrial" rectifiers of the 532-904-74-16 dry type, which though considerably more complex and sophisticated to produce, provided the opportunity for a higher profit margin. This decision was not without its risks, however, since the dry type of rectifier, as opposed to the commonly used oil-immersed type, had yet to be developed by any of the other rectifier manufacturers. The Brookfield, Conn., plant was chosen as the place to begin the operation since the facilities were better suited for the job. At the outset, Rapid New York encountered unexpected difficulties in perfecting the industrial rectifier. It also found itself faced with a sudden labor shortage in Brookfield which resulted in labor costs being 20 percent to 30 percent higher than those in the Bronx. The shortage prevented Rapid New York from consolidating its whole operation in Brookfield as originally planned. As a consequence, it had to operate two plants with a costly duplication of equipment and overhead. A combination of all these factors placed severe financial strain on the corporation. Such conditions continued to exist during the years in question, 1964 through 1966. On January 31, 1961, Viola formed Rapid Puerto Rico under the laws of Puerto Rico. He has been the owner of all its outstanding stock and its president since its inception. At all times pertinent herein, Rapid Puerto Rico has been engaged in the manufacture and sale of metal containers or cabinets which are used to house both low- and high-voltage rectifiers. The purpose in forming Rapid Puerto Rico was to provide Rapid New York with an assured and dependable supply of containers for its rectifiers. Prior to the creation of Rapid Puerto Rico, Rapid New York had experienced considerable difficulty in obtaining prompt delivery of containers from independent suppliers. Much of this difficulty was attributable to the inability of Rapid New York to make timely payments to the suppliers which, in turn, was caused by its tenuous financial condition during this period. The decision by Viola to locate its supplier in Puerto Rico was based on the greater profit potential afforded by labor costs which were 50 percent lower than in the United States, and the added incentives offered by the Puerto Rican Government, which included 18 months free rent for its operations, and the funds necessary to train the personnel and to ship the manufacturing equipment to Puerto Rico from the United States. In return for the commitments by the Puerto Rican Government, Rapid Puerto Rico agreed to hire 15 local employees at its inception and reach a level of 21 within 2 years. Beginning in 1962, Rapid Puerto Rico supplied all the needs of Rapid New York with respect to metal containers. The procedure Respondent has conceded since the prices charged for the containers were reasonable there is no basis for an adjustment under sec. 482. agreed upon by the two corporations for accounting for such sales was that Rapid Puerto Rico would set up an accounts receivable on its books for all amounts owed by Rapid New York by reason of such sales, against which would be credited any amounts expended by Rapid New York in purchasing raw materials on its behalf and any cash payments made against the account. A corresponding accounts payable was set up on the books of Rapid New York. This procedure was followed throughout the years in question. As of January 1, 1964, the opening balance due Rapid Puerto Rico from Rapid New York was $184,840.08. The following indicates the net increases to such account in each of the years in question: 1964 Sales from Rapid Puerto Rico to Rapid New York.. Raw materials purchased by Rapid New York for Total repayments... Net increase in the account__ 1965 Sales from Rapid Puerto Rico to Rapid New York.. Raw materials purchased by Rapid New York for Cash payments from Rapid New York to Rapid Total repayments___. Net increase in the account__ 1966 $182, 625: 06 $74, 692.50 17, 500.00 92, 192.50 90, 432. 56 $265, 095, 79 $77, 346. 39 24, 434. 85 101, 781. 24 163, 314, 55 Sales from Rapid Puerto Rico to Rapid New York... $311, 308. 97 The closing balance of the accounts receivable of Rapid Puerto Rico at the end of 1966 was $541,814.61. Rapid New York made its purchases of raw materials several times each year at the request of Rapid Puerto Rico. The raw materials were shipped directly down to Rapid Puerto Rico and used in its business. It periodically made cash payments whenever it could spare the money without jeopardizing its business and financial position. The payments did not correspond to any particular invoice or invoices received from Rapid Puerto Rico. Rapid New York had a taxable income of $18,113.94, $25,812.94, and $48,658.72, respectively, during the years 1964 through 1966. Its balance sheets for the end of such years reflected as current assets and current liabilities, the following: Rapid New York did not issue any notes or similar instruments of indebtedness to Rapid Puerto Rico with respect to any of the above balances owing. The additional working capital which became available to Rapid New York during such years as a result of Rapid Puerto Rico's extension of credit on its sales was principally used to build up its inventory. No portion of such additional working capital, however, nor any of its regular working capital, its assets, or the profits realized from its operations was used or disposed of in a way which was not related to its trade or business.* Rapid Puerto Rico continued to sell containers to Rapid New York on the same basis in the years 1967 through 1969. The total sales for such years amounted to $273,817.29, $248,107.58, and $206,399.84, respectively, while the respective cash payments and purchases of raw materials for such years totaled $196,235.49, $194,684.94, and $137,993.09. As of the end of 1969, its accounts receivable balance was $741,225.80. Rapid New York's purchases of containers from Rapid Puerto Rico accounted for 64 percent of its total sales in 1964 and 92 percent and 90 percent of its total sales respectively in 1965 and 1966. One incidental exception to this was bona fide loans of $8,602.37 and $235.78, made to Viola in 1964 and 1966, respectively. A certain part of purchases in 1965 and 1966 included amounts representing shipments of surplus containers which Rapid Puerto Rico held during each of those years." Rapid Puerto Rico treated these surplus shipments as sales on its books. The manufacture of surplus containers by Rapid Puerto Rico was necessary to meet its commitment to the Puerto Rican Government to maintain an employment level of at least 15 workers. The commitment was originally made in the expectation that a viable independent market for its containers could be established in the Caribbean. Its subsequent failure to develop such an outside market by 1965 created a situation where production capacity exceeded the demand." Nevertheless, in order to keep its employment commitment, it had to continue to make containers whether Rapid New York needed them or not. Its attempts to get the Puerto Rican Government to release it from its employment commitment were met only with demands that the incentives which it originally received be restored. Rapid Puerto Rico had accumulated earnings and profits of $149,894.06 as of January 1, 1964, and had current profits of $127,626.85, $110,844.92, and $171,986.79, respectively, during the taxable years 1964 through 1966. Neither Rapid New York nor Rapid Puerto Rico has paid a dividend since its inception. Respondent asserted deficiencies against Viola in 1964 and 1965 and against Viola and his wife in 1966 contending that the net increases in the accounts receivable of Rapid Puerto Rico for each of such years represented constructive dividends to Viola. During the taxable years 1964–66, Viola incurred the following travel and entertainment expenses: Rapid New York reimbursed Viola for the amounts so expended and claimed such amounts as deductions on its corporate returns for the years 1964 through 1966. It also claimed a deduction of $500 in each of such years as the cost of operating an automobile used by Viola. Respondent has disallowed all such claimed deductions except for $3 of travel and entertainment expense in 1964. "It was estimated by Viola that Rapid New York had a surplus of $150,000 of cabinets on hand at the end of 1966. "One of its largest potential customers, ITT Caribbean, discovered it could not use the containers as produced, but needed higher quality containers for its telephone equipment. |