Conford, Kilkenny and Lewis. The opinion of the court was delivered by Conford, S.j.a.d.
[87 NJSuper Page 3] This is an appeal by American Can Company ("American Can," or "taxpayer," hereinafter) from a judgment of the Division of Tax Appeals sustaining as valid a redetermination by the Corporation Tax Bureau of the State Division of Taxation, on behalf of the Director thereof, of taxpayer's franchise tax liability for the privilege year 1959 (as of December 31, 1958), incurred pursuant to the Corporation Business Tax Act (1945), N.J.S.A. 54:10A-1 et seq. Of the additional tax of $5,678.80 thus assessed, this appeal
involves only the sum of $4,215.57, which was attributable to the addition by the Director to the taxpayer's reported net worth of a $20,300,001 "reserve for deferred income taxes" (for the corporation and its covered subsidiaries), shown on the taxpayer's books as a liability. The action of the Corporation Tax Bureau was stated as follows: "Reserve for Deferred Income Taxes is deemed to be a surplus reserve and includible in net worth for franchise tax purposes."
The reserve in question arises from the following circumstances. As permitted by section 167(b) of the Internal Revenue Code of 1954 (and similar provisions of Canadian income tax laws), American Can and certain of its subsidiaries had, for income tax purposes only, been using accelerated methods of depreciation of machinery and equipment. At the same time, as permitted by the Internal Revenue Service (Rev. Rul. 59-389, 1959-2 Cum. Bull. 89), the company had used normal straight-line methods of depreciation for general reporting purposes on its books of account. In the normal course of events, and other factors being equal, accelerated depreciation for income tax purposes results in abnormal reductions of income taxes during the early portion of the depreciable life of an asset but in abnormal increases of such taxes in the later portion thereof because the asset then permits of less than normal depreciation in consequence of the excessive depreciation taken in the earlier period.
The uncontradicted expert accountancy testimony in this case is to the effect that a corporation taking accelerated depreciation for income tax purposes but at the same time straight-line depreciation for purposes of general reporting on its books of account, must, under generally accepted accounting practices, show a reserve on the liabilities side of the balance sheet for the presumptive deferred income taxes mentioned above. The reserve disputed in this case was such a reserve, set up on the liabilities side of the general books of account of American Can as of the close of the calendar year 1958 at the direction of Lybrand, Ross Brothers and
Montgomery, independent auditors of the corporation. It was calculated, as concededly normal accounting practice then required, by taking 52% of the total amount of difference between depreciation expense based upon accelerated depreciation and depreciation expense based upon straight-line depreciation, the 52% rate being the then current total income tax rate applicable to the corporation's net income. Walter R. Staub, partner of the Lybrand firm in charge of the American Can account, testified that such a reserve is necessary for "a fair matching of costs and revenues in accepted accounting principles"; that without it he could not have given a "clean opinion" on the audit, i.e., "without qualification as to acceptability of the accounting principles followed in their preparation"; and that the item cannot be included in net worth in the guise of a surplus reserve or otherwise without violation of such principles. He further testified that both the standards of the American Institute of Accountants and the regulations of the Securities and Exchange Commission require the exclusion of such an item from net worth in a corporate balance sheet, either by a reserve on the liability side, as on the instant American Can balance sheet, or by additional depreciation reserves on the asset side.
Arthur F. Wilkins, a certified public accountant associated with Haskins & Sells, testified essentially in support of the conclusions and opinions given by Staub. There was no contradiction of that testimony by either of the witnesses for the Director of the Division of Taxation. There can be not the slightest doubt of the correctness of the accounting principles enunciated by the taxpayer's witnesses, in terms of generally accepted accounting principles and practice, in relation to the specific treatment by American Can of the reserve for deferred income taxes on its December 31, 1958 balance sheet. See Accounting Research Bulletin No. 44 (Revised) of American Institute of Accountants (July 1958); Supplementary Letter of August 1959; Securities and Exchange Commission, Accounting
Series Release No. 85 (February 29, 1960);*fn1 Amory and Hardee, Materials on Accounting (3 d ed., Herwitz and Trautman 1959), pp. 261-270.
A representative of the Corporation Tax Bureau, not qualified as an accountant, explained its transfer of the American Can reserve for deferred taxes to net worth as a "surplus reserve" as follows: "The Bureau made the redetermination with what we feel is sound accounting, by merely considering the reserve as set up to be not a liability, not a true liability, and, at best, a contingent liability which will not be paid out within any immediate foreseeable future." The witness conceded on cross-examination that the State's treatment of the reserve was contrary to the policy of the American Institute of Accountants as formalized in its Accounting Research Bulletin No. 44 (Revised), supra.*fn2 The Institute's Supplementary Letter, supra, interpreting that Bulletin, states: "A provision in recognition of the deferral of income taxes, being
required for the proper determination of net income, should not at the same time result in a credit to earned surplus or to any other account included in the stockholders' equity section of the balance sheet." The Bulletin as a whole indicates that simultaneous use of accelerated depreciation for income tax purposes and straight line depreciation for ordinary financial reporting constitutes a typical situation requiring creation of the "provision in recognition of the deferral of income taxes" mentioned.
The argument in defense of the State's treatment of the disputed reserve for franchise tax purposes submitted on this appeal is essentially as follows. There was no fixed liability as of December 31, 1958 for the projected future income taxes supporting the deferral reserve. The fact or amount of such future taxes was conjectural and uncertain, depending upon such unknown factors as continuation unchanged of existing federal income tax laws and rates; the earning by the company of a net profit in future years; absence of later enlargement, by additions, of the company's depreciable plant, since such growth would postpone, perhaps indefinitely, the anticipated later loss of normal asset depreciation because accelerated depreciation on newly added plant would replace anticipated fall-off of depreciation on older assets (described as "rollover" by the taxpayer's experts); and the like. In the meantime, argues the State, the taxpayer has completely unrestricted use of the funds represented by the "reserve." Were the corporation to have liquidated on December 31, 1958, the whole reserve would be equity capital, free of any federal tax claim, and available for distribution to stockholders.
Resolution of the controversy before us calls for close attention to the statute, its history and rationale and the interpretive decisions.
N.J.S.A. 54:10A-5 imposes a state franchise tax computed upon that portion of the "entire net worth" of the corporation allocable to this State, multiplied by the applicable rates. ...