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to itself as dealing in grain or in cotton, rules generally applicable to merchandising are inadequate to afford the protection and proper application of the income tax law to which grain and cotton dealers are entitled.

Considering the tremendous volume and importance of the grain trade, the vital part that it plays in the subsistence of the people, the enormous bank credits without which the business cannot be maintained, and the disastrous consequences that will result to dealers, as well as consumers and producers, from any course of action that will seriously disturb the proper and efficient functioning of the business, it is obvious that extreme care must be taken not to embarrass the steady operation of the rather complicated and extended system by which grain is moved from farm to terminals, mills, and ocean vessels, not to jeopard the food supply of millions of people, not to imperil the credit which makes the continuance of the business possible, and not to ruin by unjust, inequitable, and erroneous methods of taxation (or of determining the taxable income) the thousands of business men whose genius and enterprise have built up the largest single industry in the United States.

It is, accordingly, respectfully suggested that the clearly established accounting practice followed in this peculiar business should be recognized and approved by the Bureau, and that all contracts for the purchase or sale of grain in the future, outstanding at date of inventory, should be required to be included as assets or liabilities of a taxpayer at the market at close of business on that day, in computing taxable income for the fiscal year then ended.

(EXHIBIT B.)

This memorandum is submitted. following a hearing held in the Treasury building on April 7, 1921, before the Committee on Appeals and Review. It has been prepared at the request of the Committee, and attempts to set out in very brief form the outstanding facts and our contentions with reference thereto.

(1) The grain trade occupies a unique position in the commerce of this country and is conducted in accordance with methods in many respects peculiar to the trade, which have been demonstrated by long experience to be the only ones which solve the complicated problem incident to the purchase and marketing of grain. The products dealt in are peculiarly liquid, inasmuch as the business methods universally employed provide a definite daily market, and the commodities and the contracts relating to the commodities may be converted into money at an exact stated value at any minute of any business day throughout the year.

The practice of hedging or selling against grain purchases for the purpose of protecting the owner from fluctuations in the markets, or buying against sales of grain for future delivery in order to assure the seller of the actual grain with which to fulfill its contracts when they mature, is a long-established practice of the grain business, recognized as sound in principle, as well as necessary in order to avoid serious speculative risk.

(2) The practices referred to are distinctly not speculative transactions. The transactions here referred to are only brought into being for the purpose of avoiding speculative risks. The dealer's profit is the legitimate merchandising profit which he makes as the compensation for his skill as a salesman and contact with the markets. His operations depend upon his credit and it is well known that there is no quicker way for a dealer to ruin his credit than for him to fail to protect himself against market fluctuation. It is, of course, true that if a man has securities, he can borrow money on them and speculate with it, but banks who lend on the grain as security, do not lend on this basis to those who do not hedge.

These transactions have been repeatedly upheld by the courts as entirely legal, and the transactions which are entered into in connection with the hedges have been decided to be valid and binding contracts on both parties. Bibb v. Allen, 149 U. S. 41. The same case emphasizes the fact that the current rules governing transactions enter into and form a part of the contracts of sale. In Clews v. Jamieson, 182 U. S. 461, 489, the court said, "and the fact that at the time of making a contract for future delivery the party binding himself to sell has not the goods in his possession, and has no means of obtaining them for delivery, otherwise than by purchasing them for delivery after the contract is made, does not invalidate the contract."

A typical example as to how the practice of hedging works is as follows: A grain merchant buys a quantity of wheat, finding it in different parts of the country-say, 100,000 bushels. In order to avoid the risk of market fluc

tuation while he is seeking a purchaser, he immediately sells on an exchange or board of trade a like 100,000 bushels for delivery at some future date. If he failed to take this precaution his banker would very likely cancel his line of credit. These transactions are practically simultaneous; if not exactly simultaneous, the hedging transaction follows at the earliest opportunity. They are so closely associated that in the trade they are considered as one transaction. The hedging part of the transaction operates to limit the transaction so that any apparent profit or loss in the transaction due to fluctuation is rendered apparent only, and the dealer's condition is stabilized by the quality of the transaction. If the dealer sees fit to sell the grain which he bought he has no further use for the hedge and immediately offsets it by buying 100,000 bushels for delivery at the same future time. It is evident that the sale of the grain forces him to close out the hedge; because, if he did not, the hedge itself, standing alone, would involve a risk of gain or loss according to the fluctuation of the market. It is the practice of the trade to close out the hedge after the other part of the transaction is closed. As stated above, the only purpose for which the hedge was entered into was to insure the merchant from a declining market and a resulting loss in his purchase. Such a loss is rendered impossible by reason of the fact that a changing price affecting his cash grain is closely reflected in a change in the market on sales for future delivery. Thus he is protected from the violent changes which occur in the market and insures to himself the enjoyment of the ordinary merchandising profit which it is his business to earn; say, one or two cents per bushel.

It will thus be seen that the balancing transaction which starts with the purchase of cash grain and a sale of future grain is only completed when both have been closed out. It is very clearly not a case of two isolated transactions-one a dealing in cash grain, the other a sale of future grain followed by a purchase of future grain which cancels it. The two deals balance each other.

A like balancing occurs in a situation where a dealer contracts to sell grain, which he has not on hand, for delivery at a port at some month in the future. To avoid risk incident to market fluctuation, he either purchases as a hedge cash grain and holds it for delivery, or purchases grain for future delivery with the idea of keeping the hedging transaction alive only long enough to serve its purpose-that is, of avoiding risks from market fluctuation.

The Federal Trade Commission has investigated and elaborately reported the practices involved in modern traffic in grain. Reference is made to the description of "Country Grain Marketing," Report of the Federal Trade Commission on the Grain Trade, pages 207, 210, 223, and "Future Trading Operations in Grain," volume 5, pages 17-18, 23-25, 28, 29, 44, and 50.

That the process of hedging is the reverse of speculative is attested by the report of the Federal Trade Commission, above referred to. Thus it defines hedging as "the method employed by many dealers in cash grain of protecting themselves against losses due to market fluctuations by executing with cash purchases and sales practically simultaneous future transactions upon the opposite side of the market." (Vol. I, page 207.)

So also, in discussing future operations in grain:

"It should be noted also that settlement and cancellation of future contracts prior to delivery is essential to the serviceability of the most important of the business uses of the future contract, namely, hedging.' Affording an opportunity for hedging-which is a device to enable a merchant or manufacturer to avoid certain commercial risks-is the principal economic service of future trading *. His (the hedger's) future contract enables him to avoid speculative risks in price **" (Vol. V, page 18.)

*

An important feature of these practices, as built up by experience, is the fact that a dealer who hedges by selling an amount of grain equal to the amount of his purchase not only enters into a contract to deliver the specified grain at a future date, but assumes a variety of other obligations which are just as binding on him as the obligation to deliver the grain.

Among these collateral undertakings which become binding on him he promises that in case the market on such future deliveries goes against him, showing a loss, he will pay in cash the amount of the loss, and that he will make this payment on demand. The enforcement of this obligation occurs thousands of times every day. It is to be noted that even at a time when the hedging transaction is still open, the dealer incurs an absolute obligation to pay over money, this obligation resting on the collateral promises which he made when

he entered into the sales for future delivery. The market having gone against him, the condition of his liability has become fixed, and he owes the money on demand. Although the time for delivery has not been reached the failure of the dealer to pay the debt created by this obligation is a breach of his contract just as much as if he failed to deliver at the time when delivery was promised. On the other hand, the contract which the dealer makes in working out his hedging arrangement, requires the other party to the transaction, in case the market goes against him, to pay, as a matter of binding agreement, the amount by which the market has gone against him. These obligations to pay are absolute and are therefore properly accruable on the books of the two parties. The well-known rules of exchanges, requiring daily settlement by members, emphasize the sharply defined nature of these daily settlements.

(3) The facts set out in the foregoing paragraphs are clearly reflected in the accounting practices universally followed in connection with grain trades. Statements filed in connection with this memorandum show that the practice of taking into account at the close of a taxable year all the accrued gains or losses, in connection with open transactions of the sort described, is universal, and is everywhere recognized, not only as the standard practice, but also as the only feasible method by which the accounts of the grain dealers can be made to reflect, on any reliable basis, the net income of grain dealers. Thus the accounting follows the fact, the effect of such payments being to bring the open trades to the market at the close of each day's business.

Statements of accountants, filed herewith, show

"In connection with the hearing held before the Committee on April 7, 1921, relative to the bringing into account of the accrued profit and loss on open trades and futures and the valuation of inventories, for the purpose of arriving at net income in the grain trade, we are of the opinion that the practice used in the trade of bringing all elements to market price at the date of closing, which has been in use for a long period of years, is the only practical method of arriving at a true and correct result of the operations." We have submitted statements by accountants and bankers showing not only that the method suggested by us is the only practice used in the trade, but is the only method which truly reflects the condition of the company and its net income. We attach an additional statement to the same effect with a specimen balance sheet, showing two ways in which the open trade may be taken into account, i. e., either through inventory or including accrued gains and losses as assets and liabilities. We also file a specimen wheat-inventory sheet, which shows how the open trades may be and are reported. You will see that this method serves to bring into check, or approximate check, the total number of bushels bought and the total number sold. The left-hand column of the sheet, called "wheat inventory," shows the number of bushels. Specimen journal entries are also attached, illustrating how these matters may appear in the journal.

These well-established accounting practices would alone seem to have a decisive effect on the question, since section 212 (b), Revenue Act of 1918, provides:

"The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal or calendar year, as the case may be), in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made upon such basis and in such manner as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer's annual accounting period is other than a fiscal year, as defined in section 200, or if the taxpayer has no annual accounting period, or does not keep books, the net income shall be computed on the basis of the calendar year."

This clearly establishes a prima facie presumption in favor of "the method of accounting regularly employed in keeping the books" of the taxpayer. Where the taxpayer has a regular accounting method the effect of this paragraph is that this method shall be followed by the Commissioner, unless the method employed does not clearly reflect the income." In this case we are dealing not only with the method regularly employed by a particular taxpayer, but with a method universally employed and recognized in the trade and considered as the only method which does, in fact, for any particular twelve months' period, truly reflect income for that period. The Bureau has before it, in cases now in process of audit, numerous instances in which the forcible separations of the primary trade from its balancing hedge has resulted in obviously

distorting income and losses; for example, such forcible separation frequently results in apparent large loss in one year and apparent large gains in another, when, in fact, by reason of the continued balancing, as outlined above, and the continual readjustment of accounts, the business at no time deviated very far from its normal course of a small profit or loss per bushel of grain. The method of hedging employed absolutely guaranteed the dealer against gains or losses on a large scale due to fluctuation in the market. The only correct method of reflecting the annual income of the business is one which reflects the fact that substantial losses from fluctuation have been eliminated. No method is correct, obviously, which indicates large losses or large gains due to market fluctuation in the case of a business that has effectively avoided any such gains or losses. The test being whether the method of accounting employed properly reflects the annual income or not, it seems perfectly plain that no method of reporting income which fails to take into account the open hedges, and the collateral obligations which go with them, is permissible, and that the only method possible is the one universally used, which we are now advocating.

The statement previously made, that to a substantial extent a dealer's credit with his bank depends on the consistency with which he protects himself against the possible losses due to market fluctuations, is substantiated by the statements filed, showing the policy generally followed by important banking institutions throughout the United States.

It is respectfully submitted that grain dealers who protect themselves by future transactions from market fluctuations, and whose accounts consistently reflect and take into account at the end of the taxable period accrued gains and losses in such future transactions, be permitted to make their returns on such basis.

At the hearing before the Committee on April 7 last the Committee was deeply impressed with the force of the arguments presented by counsel and with the seriousness of the situation that would unquestionably develop in the cotton and grain trades should the present practice of the Unit in denying to taxpayers the right of including in their balance sheets their liabilities or assets under these "hedges be confirmed and established as the recognized practice of the Bureau. The Committee admits all the contentions advanced by these taxpayers through their counsel, and it finds itself at no embarrassment in according the relief sought without doing violence to any ruling heretofore promulgated or to precedents established.

Attention is again invited to the fact that in drafting its Memorandum 100, the Committee was dealing solely with inventories, and therein disposed only of a proposition that had reached the Bureau from various sources, to include "hedges" as a part of the inventory; adding them thereto in cases of "future" purchases or deducting them therefrom in cases of "future" sales. This method of procedure was denied as being fundamentally erroneous in principle, but the opinion of the Committee was expressed only as to its effect upon the inventory.

From that opinion the Committee now finds no cause to deviate and holds it to be self-evident, without again referring to the legal questions involved, that any proposition to add to an inventory the value of a commodity the title to which is not at the time actually vested in the taxpayer, or to deduct from an inventory the value of a commodity the title to which may or may not be vested in the taxpayer but which is to be delivered only at some time in the future, cannot by any correct system of reasoning or logic be maintained.

But the cases now presented for consideration involve quite a different principle, and the proposition is not identical with, nor in fact in any degree parallel to, that discussed in Memorandum 100. Here we are dealing not with the value of a commodity purchased

to be received, or sold to be delivered, at some future date; but with firm contracts entered into in good faith for a consideration and enforceable under the law, the value of which (and consequently the profit or loss resulting therefrom) can be absolutely fixed and determined at any minute of any business day. To deny to these contracts, at any time during their life, Governmental recognition as actual liabilities or actual assets (as the case may be) would in the opinion of the Committee be futile, nor could such a contention be sustained in the courts where recognition has heretofore been fully accorded them.

For the foregoing reasons the Committee is convinced of the right of the taxpayer to set up on his books and incorporate in his balance sheet at the end of his taxable year, the liabilities or the assets which inhere at that precise moment in such contracts to which he is a party, and to include in his income account the profit or the loss due directly thereto; but this result should in no case be accomplished by adding to or deducting from the inventory the values of the commodity covered by such "future" contracts.

Therefore, the Committee holds: That dealers in cotton and grain and in such other commodities as are dealt in in a similar manner may, for the purpose of determining taxable income, incorporate in their balance sheets at the close of any taxable year, such open "future" contracts to which they are parties as are "hedges" against actual "spot" or cash transactions: Provided, That no purely speculative transactions in "futures not offset by actual " spot or cash transactions may be so included or taken into the taxpayer's account in any manner until such transactions are actually closed by liquidation: And provided further, That the values of the commodity covered by such open future" contracts shall not be added to nor deducted from the inventory of the taxpayer.

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SECTION 212, ARTICLE 23: Bases of computation.

48-21-1941 O. D. 1113

A taxpayer who had heretofore computed his income and filed his returns on the accrual basis changed his method of accounting to the cash receipts and disbursements basis on June 30, 1921, the close of his taxable year, and applied to the Commissioner for permission to compute his income in his return for the 1921 fiscal year on the cash basis.

Held, that inasmuch as the change in his method of accounting was not made until the close of the taxable year, permission to compute income in his return for 1921 on the cash receipts and disbursements basis is denied.

SECTION 212, ARTICLE 23: Bases of computation.

50-21-1971 O. D. 1133

A taxpayer who has properly filed his return on the cash receipts and disbursements basis can not be granted permission to amend it by stating that it is filed on an accrual basis, even though his cash receipts and disbursements were the same as his accrued income and deductions except as to the item taxes accrued to a foreign country.