EXHIBIT B MEMORANDUM TO ACCOMPANY AGREEMENTS UNDER SECTION 606 OF THE REVENUE ACT OF 1928, IN THE CASE OF THE CUBAN-AMERICAN SUGAR CO. AND ITS AFFILIATED COMPANIES IN RESPECT OF INCOME AND PROFITS TAXES FOR THE FISCAL YEARS ENDED SEPTEMBER 30, 1918, AND SEPTEMBER 30, 1919 Closing agreements under section 606 of the Revenue Act of 1928 have been signed for the fiscal years ended September 30, 1918, and September 30, 1919, by the President and Secretary of the Cuban-American Sugar Co. and its affiliated companies designated to act on behalf of the affiliated group, for the fiscal years 1918 and 1919. The agreements were obtained by the office of the Assistant General Counsel for the Bureau of Internal Revenue after a reconsideration of the case resulted in a settlement whereby it was agreed to allow the taxpayers a further overpayment of $101,788.63 for the fiscal year ended September 30, 1918. The result of the reconsideration of the case has been reported to the Joint Committee on Internal Revenue Taxation. The Cuban-American Sugar Co. was organized in 1906 and immediately thereafter acquired the outstanding capital stock of the Chaparra Sugar Co., the Tinguara Sugar Co., the Cuban Sugar Refining Co., the Unidad Sugar Co., and the Mercedita Sugar Co. In May 1908 the Cuban-American Sugar Co. acquired the capital stock and bonds of the Colonial Sugars Co., in the year 1909 it acquired the capital stock of the San Manuel Sugar Co., and in the year 1910 the Chaparra Railroad Co. was formed and its capital stock acquired. In 1916 the Chaparra Light & Power Co. was organized and its capital stock was also acquired. Most of the companies in the affiliated group were engaged in the growing and production of raw sugar. In addition to the growing of sugarcane with the assistance of their own hired labor, the taxpayers entered into contracts with local planters for the growing of sugarcane. The taxpayers financed to a large extent the operations of the local planters. Loans would be extended from time to time in increasing amounts with the progress of each crop until a maximum was reached at harvest time. To finance their crops and those of the local planters the taxpayers made extensive borrowings during each growing season. The gross income of the taxpayers was derived primarily from the growing and production of raw sugar. Other income was derived from interest and rentals. The principal deductions claimed were for ordinary and necessary expenses, repairs, interest, taxes, depreciation, and amortization of war facilities. The taxpayers reported in the consolidated income tax return filed on Form 1120 for the fiscal year ended September 30, 1918, a total net income of $8,553,455.32, invested capital of $34,469,537.73 and tax liability of $3,138,966.74. However, Forms 1031 and 1103 previously filed for the fiscal year 1918, under the provisions of the Revenue Act of 1917, disclosed a tax liability of $1,690,259.15, which was assessed on Form 1031, but not taken into consideration when the assessment of $3,138,966.74 was made on Form 1120. Therefore, a duplicate assessment of $1,690,259.15 was made for the fiscal year 1918. In the consolidated return filed for the fiscal year ended September 30, 1919, the taxpayers reported a net income of $11,417,846.40, invested capital of $43,314,732.77 and a total tax liability of $2,580,803.81 after deducting a foreign tax credit of $1,308,189.79. The tax liability shown on the return was not assessed, however, as there had previously been assessed on a tentative return a tax in the amount of $2,700,000. A field investigation of the taxpayers' books and records for the fiscal year 1918 resulted in the determination of a consolidated net income of $8,352,287.40 and invested capital of $29,884,749.49 as shown in Bureau letter dated December 1, 1921. The field investigation for the fiscal year 1919 resulted in the determination of a consolidated net income of $11,263,414.90 and invested capital of $33,432,676.32, as reflected in Bureau letter dated December 1, 1921. The Audit Review Division of the Bureau, after consideration of the protests filed by the taxpayers and recommendations of the Bureau engineers relative to depreciation and amortization of war facilities, determined the correct consolidated net income for the fiscal year 1918 to be $7,997,019.66, and the correct consolidated invested capital to be $29,988,661.58, as shown in Bureau 60-day letter dated February 14, 1930. The Audit Review Division determined the correct consolidated net income for the fiscal year ended September 30, 1919, to be $10,779,377.78 and invested capital to be $33,593,415.64, as set forth in Bureau 60-day letter dated December 27, 1929. The principal decreases in the reported net income for the fiscal year 1918 were an additional allowance for amortization of war facilities in the amount of $218,050.63, and a deduction for Cuban excise tax based on production in the amount of $369,079.04. There were several other minor decreases and increases in the reported net income but the net result of such adjustments was to increase reported net income by the amount of $30,694.31. The net decrease of $638,468.62 in the reported net income for the fiscal year 1919 is more than accounted for by deductions for amortization of war facilities in the amount of $435,711.84 and Cuban excise tax in the amount of $412,736.84. Cuban excise tax was claimed on the returns filed for the fiscal years 1918 and 1919 as a foreign tax credit, but was disallowed as a credit, since it represented a tax on production, and allowed as a deduction from gross income. Numerous large adjustments were made in the reported invested capitals for the fiscal years 1918 and 1919, the two principal decreases being the disallowance of good will in excess of $4,300,000 for each year, and a paid-in surplus of over $3,450,000 for the fiscal year 1919. The taxpayers filed petitions with the United States Board of Tax Appeals and the file was referred to the former special advisory committee for its consideration. It was the contention of the taxpayers that their profits taxes for the fiscal years 1918 and 1919 should be computed under the provisions of section 210 of the Revenue Act of 1917 and sections 327 and 328 of the Revenue Act of 1918. The former special advisory committee in a 41 page memorandum, approved by the Commissioner on September 27, 1932, recommended as an acceptable basis of settlement, that there be added to invested capital as determined in the Bureau 60-day letters, the lump sum of $11,000,000. No changes were made in the net incomes as reflected in the 60-day letters. As a result of the recommendation of the former special advisory committee, deficiencies and overassessments for the fiscal years 1918 and 1919 were determined as follows: Fiscal year ended Sept. 30, 1918: The Cuban-American Sugar Co--- Do.... The Cuban Sugar Refining Co., subsidiary. The Chaparra Sugar Co., subsidiary The Tinguaro Sugar Co., subsidiary. Colonial Sugars Co., subsidiary... Chaparra Light & Power Co., subsidiary. Chaparra Railroad Co., subsidiary- Over assessment $2, 190, 151. 02 135, 451. 10 19, 663. 43 2, 198. 65 179. 22 10, 064. 08 809. 68 Deficiency $3, 972. 72 784. 49 1, 766. 79 186. 66 The overassessments as above indicated were reported to the Joint Committee on Internal Revenue Taxation under date of September 15, 1932, but in the report it was stated that $157,391.38 of the overassessment for the fiscal year 1918 in favor of the Cuban-American Sugar Co. was barred by the statute of limitations and that only $2,032,759.64 of the overassessment determined for the fiscal year 1918 was allowable. All of the foregoing overassessments represented abatements except $292,146.67 for the fiscal year 1918 and $16,254.91 for the fiscal year 1919. Under date of December 15, 1932, a stipulation was filed with the United States Board of Tax Appeals for the fiscal year 1918, which disclosed an unpaid assessment to be abated in the amount of $1,898,004.35 and an overpayment of tax in the amount of $292,146.67. Since the Board of Tax Appeals did not at that time have jurisdiction to determine whether an overpayment of tax was barred by the statute of limitations, but had jurisdiction to determine only the amount of any overpayment of tax, no attempt was made to set forth in the stipulation the amount of the overpayment held to be barred from allowance. The decision of the Board of Tax Appeals was entered December 16, 1932, and reads in part as follows: "Ordered and decided: That the following is a correct statement of the Federal income and profits tax liability of the petitioner for the fiscal year ended September 30, 1918. Total tax assessed.. $4, 829, 225. 89 2, 931, 221. 54 Unpaid assessment to be abated__ 1, 898, 004. 35 Correct tax liability.. $2,639, 074. 87 2, 931, 221. 54 Overpayment. -- 292, 146. 67" Under date of March 15, 1933, a certificate of overassessment in favor of the Cuban-American Sugar Co. in the amount of $2,032,759.64 was scheduled for allowance for the fiscal year 1918. The face of the certificate showed the total overassessment to be $2,190,151.02 and that $157,391.38 was barred by the statute of limitations, leaving $2,032.759.64 as the allowable overassessment. Under date of March 28, 1933, the taxpayers' representative, David A. Buckley, Jr., addressed a letter to the Bureau in connection with the overpayment of $157,391.38 which was held to be barred from allowance in the settlement recommendation prepared by the special advisory committee and requested that, in view of the Supreme Court decisions in the case of United States v. Factors and Finance Company (268 U. S. 89) and other cases involving the sufficiency of claims, the taxpayers' blanket claim for refund for the fiscal year 1918 be given further consideration. Under date of May 23, 1933, an informal conference was held with Mr. Lawrence P. Mattingly (associated with Mr. Buckley) in the office of Mr. Joseph K. Moyer, chairman, special advisory committee, at which time he was advised by the Bureau representatives that the case was purely a settlement case for the years 1918, 1919, and 1920, and that the fact that $157,391.38 of the overpayment for 1918 was barred from allowance was part of the inducement leading to the allowance of certain other adjustments in the settlement of the case. Mr. Mattingly stated that he did not realize that the case had been handled in that manner and requested that the conference be adjourned until he had an opportunity to confer with Mr. Buckley. Nothing further was heard from Mr. Mattingly until August 8, 1933, when he addressed a letter to the Bureau in which he made application for the reconsideration of the decision, holding that the sum of $157,391.38 was barred by the statute of limitations for the fiscal year ended September 30, 1918. The application for reconsideration was based upon the decision of the Supreme Court in the case of United States v. Memphis Cotton Oil Company) 298 U. S. 62), which was decided subsequent to the settlement in the instant case. The taxpayers' blanket claim for refund of $1, or such greater amount as is legally refundable, in which no grounds for the refund are stated, was filed March 14, 1924. The claim was filed within 5 years from the due date of returns filed for the fiscal year 1918 under the provisions of the Revenue Act of 1918. Waivers were filed April 1, 1924, and December 30, 1924, which extended the time for filing claims for 1918 to April 1, 1926 (section 284 (g), Revenue Act of 1926). The taxpayers' blanket claim for refund for 1918 stated no ground for refund, but prior to the filing of the refund claim the taxpayers had filed their application for special assessment, and in the briefs and protests filed subsequent to the refund claim the taxpayers made reference to the abatement and refund claims on file and set forth reasons why the profits taxes should be computed under the specialassessment provisions of the Revenue Acts of 1917 and 1918. However, in the settlement of the case by the special advisory committee, special assessment was denied and a lump-sum addition of $11,000,000 was made to the invested capital previously determined. The addition of $11,000,000 consisted, for the most part, of the value of the various items which the taxpayers' claimed as constituting abnormal conditions in their invested capital and giving rise to their claim that the excess-profits taxes be computed under the special-assessment provisions of the Revenue Acts of 1917 and 1918. It appears that in the numerous conferences held before the special advisory committee, Mr. Buckley, the taxpayers' representative, always considered the amount of $157,391.38 for the year 1918 to be barred from allowance and his computations relative to settlement of the case were always based upon the net amount the taxpayer would be required to pay the Government and in such computations the amount of $157,391.38 was eliminated as barred. There is nothing in the file to indicate, however, that the taxpayers' representative waived the right to contest the sufficiency of the claim filed for 1918. Furthermore, when the case was under consideration in this office, Mr. Buckley raised the question as to whether or not the blanket claim for refund was sufficient to allow the tota overpayment for the fiscal year 1918, and was advised that there was considerable doubt as to whether the amounts of $134,755.29 for 1918 and $16,254.91 for 1919 were properly allowable under section 284 (c), Revenue Act of 1926, due to the decision in the case of First National Bank of Kansas City, Missouri, v. United States, 66 Fed. (2d) 536, but that in view of the fact that the case was a settlement case and the above amounts had been agreed upon as proper allowances, no objection would be raised to the allowance of those amounts, since they had been considered as allowable in arriving at the tax liability for the fiscal years 1918, 1919 and 1920, which the taxpayers were willing to pay as a settlement for the years involved. It was the contention of the taxpayers' representative, that the overpayment of $157,391.38 for 1918 was allowable under the decision in the case of the Memphis Cotton Oil Company, supra, which held that a claim for refund seasonably filed, but which fails to state the grounds upon which the refund is demanded, may be amended by specifying the grounds at any time before the claim in its original form has been finally rejected, though it be after the time when a wholly new claim would be barred by limitation. The taxpayers' representative orally advised this office, that in order to avoid the necessity of bringing suit for the recovery of the amount of $157,391.38 for the fiscal year 1918, the taxpayers would settle the matter on the basis of a further allowance of $118,043.54 for 1918, which represented 75 percent of the amount of $157,391.38, the amount held to be barred from allowance. He was advised that if the taxpayers would consent to decrease the above amount by $16,254.91, the overpayment allowed for 1919, as a basis of settlement, under the provisions of section 284 (c), Revenue Act of 1926, even though not technically allowable under that section, and accept a further allowance of $101,788.63 for the year 1918, that amount would be recommended for allowance if final closing agreements for 1918 and 1919, under the provisions of section 606, Revenue Act of 1928, were executed by the taxpayers. After communicating with the taxpayers he advised that the further allowance of $101,788.63 for 1918 was acceptable to the taxpayers and that they would sign final closing agreements for 1918 and 1919. The decision of the Board of Tax Appeals was entered on December 16, 1932, and has become final. Section 507 of the Revenue Act of 1928 provides that any overpayment determined by the Board of Tax Appeals shall when the decision has become final, be credited or refunded to the taxpayers, if the taxpayers' claim or petition to the Board was filed within the time perscribed for filing claims. All facts and evidence, upon which the adjustments made in the settlement of the case were based, were on file prior to the partial rejection of the taxpayers' claim on March 15, 1933, and this office after careful consideration of all factors involved was of the opinion, in view of the decision of the Supreme Court in the Case of the Memphis Cotton Oil Company, supra, and Mimeograph 4092, I. R. B. XII-47-6520, that no part of the total overassessment previously determined for the fiscal year 1918 was barred by the statute of limitations, and that should the taxpayers have been compelled to bring suit for the recovery of $157,391.38, they would have been successful in securing a judgment for the full amount, unless the Government had been successful in obtaining a set-off of $16,254.91, the overpayment allowed for the fiscal year 1919 under section 284 (c), Revenue Act of 1926, which was apparently barred from allowance at the time of the settlement, by the special advisory committee. but was approved by this office in order to carry out the settlement recommended The facts in the instant ease appear to be on all fours with the facts in the case of the Memphis Cotton Oil Company, supra, and in view of the decision in that case it is not believed that the taxpayers' claim could successfully be held to be insufficient. It appears that the only other defense the Government could raise in this case would be if it could show that notwithstanding the amount of the Overpayment set forth in the stipulation filed with the Board of Tax Appeals, there was an agreement on the part of the taxpayers whereby they consented to right an overpayment of $134,755.29 for the fiscal year 1918 and waive their However, the file contains no evidence of an intention on the part of the taxpayers Hight to the balance of the overpayment for 1918 in the amount of $157,391.38. fiscalive any of their rights to any portion of the overpayment determined for the year 1918. The taxpayers' representative signed an agreement to stipulate which set forth the income and invested capital adjustments that were to be made, and stated that all other issues were to be waived and no new issues raised. The agreement to stipulate makes no mention of any portion of an overpayment being barred from allowance, and the waiver of all other issues mentioned in the agreement could only refer to the issues pending before the Board of Tax Appeals, which did not include the sufficiency of any claim for refund. The stipulation filed with the Board conforms with the agreement to stipulate, and in filing the stipulation with the Board disclosing an overpayment of $292,146.67 for the fiscal year H. Repts., 79-1, vol. 1-25 1918, there is nothing to show that the Government was relying on anything other than its legal rights; namely, the insufficiency of the refund claim as to $157,391.38 of the overpayment. In order to prove a settlement whereby the taxpayers agreed to waive their rights to $157,391.38 of the overpayment for 1918, it would be necessary to introduce oral evidence to that effect. This office has interviewed representatives of the former special advisory committee in connection with the settlement of the case, and it is not believed that the Government would be able to introduce evidence of a clear and convincing nature that there was a waiver by the taxpayers of their rights as to the overpayment of $157,391.38. The burden would be upon the Government to show that the stipulation filed with the Board of Tax Appeals did not represent the agreement of the parties, and it is the opinion of this office that such burden could not be met by clear and convincing evidence. Since the taxpayers were willing to settle the case for $101,788.63, which is $39,347.84 less than the amount it would undoubtedly recover if compelled to litigate the matter in the courts, and the Government was successful in securing the set-off of $16,254.91 for the fiscal year 1919, it is the opinion of this office that the further allowance of $101,788.63 for the fiscal year 1918 is decidedly to the advantage of the Government. This office accordingly, under date of December 27, 1933, recommended that a further overassessment of $101,788.63 be allowed for the fiscal year 1918. The recommendation of this office was approved by the Acting Commissioner on January 8, 1934, and the closing agreements covering the fiscal years 1918 and 1919 were received on July 5, 1934. The chairman of the Joint Committee on Internal Revenue Taxation has been advised that $101,788.63 of the amount of $157,391.38 previously held to be barred from allowance, was being allowed for the fiscal year 1918. The major issues in the case were: 1. Amortization of war facilities. 2. Cuban excise tax. 3. Special assessment. 4. Invested capital. 5. Statute of limitations. 1. Amortization of war facilities.—In the return filed on Form 1120 for the fiscal year 1918 an amortization deduction of $238.409.82 was claimed. The taxpayers later filed schedules claiming an amortization deduction of $1,280.227.43 on property which cost $5,261,891.82. The Bureau engineers' reports disclose that the taxpayers had property at a total cost of $3,788,891.85 on which it was entitled to an amortization deduction of $892,172.29. Of the total amortization allowance $676,161.80 was based upon lowered replacement costs and $216,010.49 was based on a value in use of one plant of 51 percent of cost. The amortization allowance based on replacement costs was the difference between actual cost of the property and the replacement costs as at March 3, 1924, depreciated during the war period. The value in use of 51 percent referred to above represented the sale or salvage value plus the post-war use which was found to be greater than the value in use computed on the basis of post-war production. The date of cessation of operation as a war facility was December 31, 1918, and the amortization allowance on costs of property used in war production were apportioned as outlined by the United States Board of Tax Appeals in its decision in the case of American-Hawaiian Steamship Company, 7 B.T. A. 13. The amortization allowance on costs of property not completed in time for war production was allowed as a deduction for the fiscal year ended September 30, 1919. The result of such apportionment was to allow an amortization deduction of $456,460.45 for the fiscal year 1918 and a deduction of $435,711.84 for the fiscal year 1919. Since an amortization deduction of $238,409.82 was claimed in the return for the fiscal year 1918, the result of the above-indicated allowances was to allow an additional amortization deduction of $218,050.63 for that year, and to allow an amortization deduction of $435,711.84 for the fiscal year 1919 inasmuch as no deduction for amortization was claimed in the return filed for that year. 2. Cuban excise tax.-The taxpayers in the return filed for the fiscal year 1918 claimed Cuban excise tax in the amount of $335,288.45 as a foreign tax credit, and in the return filed for the fiscal year 1919, Cuban excise tax in the amount of $412,736.84 was claimed as a foreign tax credit. Investigation disclosed that the tax in question represented a tax on production and was a proper deduction from gross income instead of a credit against the tax liabilities for the years in question. The correct Cuban excise tax for the fiscal year 1918 was $369,079.04 instead of $335,288.45 claimed as a credit, and in the audit of the return for that |