Conford, Gaulkin and Kilkenny. The opinion of the court was delivered by Conford, S.j.a.d.
In this appeal R. H. Macy & Co., Inc. ("Macy" hereinafter) seeks a review of a decision of the Division of Tax Appeals rejecting its complaints against revision by the Division of Taxation of its reported net worth for purposes of the Corporation Business Tax Act (N.J.S.A. 54:10A-1 et seq.) for the privilege years 1956, 1957 and 1958 (base years ending December 31, 1955, 1956 and 1957, respectively). The resulting deficiency assessments for the respective years in question were $4,816.79, $6,524.09 and $7,167.03.
The statute referred to is a corporation franchise tax act, enacted by L. 1945, c. 162, and applicable both to foreign corporations transacting business in this State, like Macy, and domestic corporations. Basically, it imposes a tax measured by a low rate against the taxpayer's book net worth. The act contains allocation formulae for corporations which maintain regular places of business outside New Jersey, but no problem is presented with relation thereto in this case.
The reassessments by the Division of Taxation disputed in this case involve three items: (a) a substitution of "Fifo" in the place of "Lifo" costs (both terms are explained hereinafter) in determination of inventory values; (b) a revision downward of bad debt reserves; and (c) a disallowance of
deduction for debt owing from a wholly-owned subsidiary, Garden State Plaza Corporation, a New Jersey corporation. Incidental to the dispute over revision of inventory valuations is the alternative contention of Macy that if its Lifo-based inventory valuations are to be revised, there should at the same time be deducted from its net book valuations certain claims listed as assets in its books for refunds of federal income taxes based upon the asserted right to use the Lifo method for income tax purposes for six income tax years preceding 1947.
Certain other attacks upon the action of the Division of Taxation and upon the tax statute, only incidentally affecting the meritorious questions mentioned above, have been made by Macy. All of these matters are considered in the course of this opinion.
Macy's franchise taxes were required to be assessed upon the basis of its books as of the end of a calendar or fiscal year. N.J.S.A. 54:10A-4(d). For the tax years, here in question, 1956, 1957 and 1958, Macy's books reflected merchandise inventories, at the close of the pertinent fiscal years, as follows: July 30, 1955, $41,376,258; July 28, 1956, $47,926,103; and August 3, 1957, $55,340,189. However, Macy's annual reports (not its tax returns), in showing these figures under "Current Assets," and describing them as "Merchandise inventories at Lifo cost, as determined under the retail inventory method, which is less than market," appended footnotes which stated that the said figures were, respectively, $11,893,487, $12,517,651, and $13,277,806 "less than they would have been if the first-in, first-out principle had been applied in determining cost." The "first-in, first-out principle" mentioned is commonly described as Fifo, by contrast with Lifo, meaning the "last-in, first-out principle."
These terms, according to the expert proofs in this case and standard accounting texts, have the following meanings. Inventory [77 NJSuper Page 161] costs are determined periodically in merchandising businesses for two principal purposes: (1) reflection of merchandise inventory as an asset on the balance sheet as of a given date; and (2) reflection of profits or net income during specific earnings periods, since closing inventories are instrumental in determining cost-of-goods-sold expense of both the current and subsequent earnings periods to be matched against revenues of such periods. However, where large quantities of items are bought and sold by a business during an accounting period it is not feasible to price inventory at the actual historical cost of each item. But since the prices paid for the merchandise in various lots of specific categories are known, the cost of closing inventories is frequently determined by artificial but convenient assumptions as to relation of identity of goods sold and goods remaining to goods purchased. One such assumption is Fifo, another, Lifo. Fifo assumes that the goods first purchased were first sold; Lifo, that the goods last purchased were first sold. From a balance sheet standpoint, Fifo has the advantage of attributing more recent costs to the closing inventory on hand, thereby affording a more realistic picture of current asset values; from an income or profit reflection standpoint, however, Lifo has the advantage of matching current revenues with current costs, thereby furnishing a more accurate picture of true business earnings or losses, as distinguished from market appreciation or depreciation of inventory values, during the earnings periods in question. Accounting theorists who favor the Lifo method describe it as based not on presumptions as to the flow of goods but rather as to the flow of costs. Where costs are stable over the respective periods involved, the stated advantages do not materialize. See Amory and Hardee, Materials on Accounting (3 d ed. Herwitz and Trautman 1959), pp. 176-178, 193-211; Finney and Miller, Principles of Accounting (4 th ed. 1951), pp. 360-368; Hills, Law of Accounting and Financial Statements (1957), pp. 191-192; Wixon and Cox, Principles of Accounting (1961), pp. 687-691; R. H. Macy & Co. Inc. v. United States of America , 255 F.2d 884 (2 Cir. , 1958),
cert. denied 358 U.S. 880, 79 S. Ct. 119, 3 L. Ed. 2 d 110 (1958). The use of the Lifo system can result in current inventories reflecting "values" in terms of costs incurred years earlier. Wixon and Cox, op. cit., supra , at p. 691.
There are other systems for pricing inventory recognized as acceptable from the standpoint of sound accounting principles, such as average cost, weighted average cost and specific identification, but these do not bear upon the issues herein. Two other matters discussed in the evidence in this case also appear not to be directly material to determination of the precise issue before the court. The first is that inventory costs, within the Lifo principle, are arrived at by Macy by the "retail inventory method"; the second, that all sound inventory accounting, including Macy's method, aims to reflect "cost or market, whichever is lower."
In the letter of reassessment from the Corporation Tax Bureau of the Division of Taxation to the taxpayer readjusting the values for the years in question, the treatment of inventory is explained as follows: "Inventory reserve is disallowed inasmuch as the Bureau deems inventory values to be the most recent cost to the date of the Balance Sheet." The readjustment made was to substitute the Fifo figures as shown in the footnotes of the annual reports for the Lifo figures shown on the balance sheets. The representative of the Bureau testified that the determination was that the Fifo valuations were "a closer approximation of the fair value of the inventories."
Resolution of the dispute here presented requires construction of the statute. N.J.S.A. 54:10A-5 imposes a franchise tax computed upon that portion of the "entire net worth" of the corporation allocable to this State multiplied by the applicable rates. N.J.S.A. 54:10A-4 defines "net worth" as follows:
"(d) 'Net worth' shall mean the aggregate of the values disclosed by the books of the corporation for (1) issued and outstanding capital stock, (2) paid-in or capital surplus, (3) earned surplus and undivided profits, (4) surplus reserves which can reasonably be
expected to accrue to holders or owners of equitable shares, not including reasonable valuation reserves, such as reserves for depreciation or obsolescence or depletion, and (5) the amount of all indebtedness owing directly or indirectly to holders of 10% or more of the aggregate outstanding shares of the taxpayer's capital stock of all classes, as of the close of a calendar or fiscal year. However, if in the opinion of the commissioner, the corporation's books do not disclose fair valuations the commissioner may make a reasonable determination of the net worth which, in his opinion, would reflect the fair value of the assets carried on the books of the corporation, in accordance with sound accounting principles, and such determination shall be used as net worth for the purpose of this act."
The act was changed in certain respects, effective beginning with the year 1959, L. 1958, c. 63, but the definition of "net worth" was not altered.
Since merchandise inventory is an asset entering into the aggregate of components (1) through (4) of the foregoing listed constituents of "net worth," Macy does not contend that a lawful redetermination of inventory would not result in a proper recomputation of the tax base. But it does challenge the lawfulness of the redetermination of inventory here made.
Expert accountancy testimony on both sides at the hearing before the Division of Tax Appeals was in agreement that both Fifo and Lifo were accepted methods of determining inventory costs for a retail merchandising business such as Macy's, "in accordance with sound accounting principles." The expert for the State testified that under the Lifo method the inventory is valued "at the costs that were prevalent at the time that the Lifo cycle commenced, which would be in the most distant past * * *. They would be the ancient or former costs rather than the current costs." In essence, the expert for the taxpayer was in agreement as to this. In the opinion of the State's expert the determination of the taxing authorities to utilize the Fifo valuations in this case was a "reasonable determination reflecting the fair value of the inventory assets carried on the books of the corporation," and one "in accordance with sound accounting principles."
The opinion of Macy's expert was that "there is only one balance sheet in accordance with sound accounting principles"
for a particular corporation, and, in the case of Macy for the years involved, those were the statements submitted to the Division of Taxation under certification by the corporation's auditors. He explained that the footnote references in the annual reports to Fifo costs were "to help financial analysts to compare businesses." He testified that "mechanically, because of the way you compute Lifo, you do know what Fifo is."
In sustaining the position of the Division of Taxation, the opinion of the Division of Tax Appeals states:
"No witness has testified that the determination of respondent is not fair value. Indeed, the witnesses all agree that Fifo method more closely approximates market value than the Lifo method. Market value usually is deemed to be fair value."
Macy formulates its argument on this appeal by assuming that the reassessment by the Division of Taxation is based on the foregoing expression of rationale by the Division of Tax Appeals, i.e. , that it equates "fair value" of inventory with "market value." It then attacks that equation by contending, on the basis of legislative history, that the Legislature did not intend to permit the Tax Division Director to use market value as a basis for establishing "fair valuations" of the assets "in accordance with sound accounting principles."
But the flaw in this attack is that the evidence shows that the Corporation Tax Bureau of the Tax Division did not purport to revalue inventory on a "market value" basis, but rather, as indicated above, on the basis of Macy-supplied Fifo figures determined to be preferable because representing "the most recent cost to the date of the Balance Sheet" (emphasis added). For reasons to be stated hereinafter, it is our view that the intent of the act is to require whatever "fair valuations" are arrived at by the Director to be consistent with sound accounting principles, and that such principles would preclude raising balance sheet inventory costs , whether Lifo or Fifo, to market value. So far as the opinion of the Division of Tax Appeals implies the contrary, we disagree with it.
(Distinguish the correctness in accounting theory of reducing inventory costs to market, as noted above.)
Thus, the real issue presented is whether the statute permits the Tax Division Director to revise a taxpayer's inventory asset valuations for franchise tax purposes from Lifo to Fifo costs in such circumstances as here shown, or whether the taxpayer's decision to operate on a Lifo basis for general accounting purposes compels the Director ...