29 T.C. 409">*409 Respondent determined a deficiency in petitioner's income and excess profits tax for 1950 of $ 219,504.64. The deficiency, to the extent in issue, is based on respondent's1957 U.S. Tax Ct. LEXIS 26">*27 determination that there should be no disallowance of the deduction for vacation pay in 1949, a base year, in computing petitioner's excess profits tax credit for 1950 and 1951. The questions presented are (a) whether or not vacation pay constitutes a "class of deductions" as that term is used in section 433 (b) (9) of the Internal Revenue Code of 1939; and (b) whether any of the provisions of section 433 (b) (10), I. R. C. 1939, apply to bar petitioner from invoking the benefits of section 433 (b) (9), supra.

FINDINGS OF FACT.

Some of the facts have been stipulated and as so stipulated are incorporated herein by this reference.

Petitioner is a corporation engaged in the manufacture and sale of bakery products. It keeps its books and files its returns on an accrual basis and for calendar years. Its excess profits credit for the years 1950 and 1951 was computed according to the income method under section 435 of the Internal Revenue Code of 1939, in determining its excess profits tax liability for the years 1950 and 1951.

In the years prior to 1949, all individuals in the employ of the petitioner were eligible, either through company contracts with the bakers' union or through1957 U.S. Tax Ct. LEXIS 26">*28 company agreements with employees not covered by union contracts, to 1 week's vacation with pay after 1 year's continuous service with the company, 2 weeks' vacation with pay after 3 years of continuous service with the company, and 3 weeks' vacation with pay after 20 years of continuous service with the company.

29 T.C. 409">*410 The obligations of the company and the rights of the employees were not spelled out in sufficient detail under the agreements and contracts mentioned above, in that the employees were not entitled as of right to a vacation with pay in a subsequent year on account of services performed in the prior year. Instances arose which were not covered in the agreements or contracts and many cases had to be decided on their own facts. One reason for the change in 1949 in the vacation pay provision of the union contract (see infra) was to clear up the uncertainty and confusion under the pre-1949 contract provisions as to vacation pay.

In October 1949, petitioner entered into the new union contract covering about 51 per cent of its employees, which applied to 1949 and subsequent years. These contracts expressly provided for the first time that every union employee who1957 U.S. Tax Ct. LEXIS 26">*29 had completed at least 1 year's employment by the end of each year was entitled to 1 week's vacation with pay, and additional weeks with pay depending upon the length of time of such employment to the end of the year, provided the employee was on the payroll of the company through the last regularly scheduled working day of the completed year. Thus, an employee who had completed the necessary period of employment and was on the payroll as of the last regularly scheduled working day of a completed year, was, for the first time upon termination of employment on that date, entitled as of right and unconditionally to vacation pay for the subsequent year in the manner specified in the contract.

Upon execution of such union contracts in October 1949, the petitioner, by notices dated November 22, 1949, which were posted on conspicuous bulletin boards in all its manufacturing plants, bakeries, sales branches, and other locations, extended a similar right to all of its employees not covered by the 1949 union contract referred to above.

As a result of the change in the labor contracts in October 1949 and the agreement with the nonhourly rated employees (not covered by the labor contracts), 1957 U.S. Tax Ct. LEXIS 26">*30 the petitioner set up on its books at the end of 1949 an accrued liability for vacation expense for 1950 as well as the vacation expense actually paid for the year 1949. Respondent concedes that the said liability was properly accrued and raises no question with respect to the amounts actually paid for 1949.

In the company's annual report to its stockholders for the year 1949, the management called the attention of the stockholders to the doubling-up in vacation expense for 1949 because such a doubling-up 29 T.C. 409">*411 was considered by the management to be unusual and out of the ordinary. In the report the company refers to vacation pay as wages paid during vacations. It also refers to the item as vacation payments.

The petitioner filed a Federal income tax return for 1949 on Form 1120. On such return, the vacation expense attributable to the hourly rated employees (covered by the labor contract) was reported in the figure of $ 158,985,082.89 appearing as item 2 on such return (cost of goods sold); and in Schedule A on page 2 of such return, such expenses were included in the item of $ 50,797,025.64 opposite the caption "Salaries and Wages." The vacation expense attributable to the1957 U.S. Tax Ct. LEXIS 26">*31 nonhourly rated employees was partly in the item of $ 548,100 in item 16 captioned "Compensation of Officers" and partly in the item of $ 41,705,096.80 in item 17 captioned "Salaries and Wages (not deducted elsewhere)." This same practice was followed in the petitioner's income tax returns in the years prior to 1949 and for the years subsequent to 1949.

Petitioner's total vacation expense for 1949 (included in items 2, 16, and 17 of the petitioner's 1949 income tax return as indicated above) was $ 5,975,279, and on audit by the Internal Revenue Service such amount was allowed in computing petitioner's net income for 1949. Of this amount, $ 2,960,028.89 constituted vacation expense actually paid in 1949, and the balance of $ 3,015,250.11 constituted an accrued liability on account of vacation pay as of December 31, 1949. The liability of $ 3,015,250.11 accrued in 1949 was under and pursuant to the aforesaid labor union contracts and the agreements with employees not covered by union contracts but was not actually paid in 1949.

In the years prior to 1949, the petitioner, for income tax purposes, was allowed only vacation expense actually paid in such prior years, and in all years 1957 U.S. Tax Ct. LEXIS 26">*32 after 1949, the petitioner has been allowed only vacation expense accrued as of December 31 in each of such years.

The following were the total amounts of vacation expense allowed for each of the following years on audit of petitioner's income tax returns for those years:

Vacation expense for 1949 exceeded 115 per cent of the average vacation expense deducted by petitioner in the prior 4 years.

29 T.C. 409">*412 The petitioner's net sales, gross income, net income, and excess profits net income per income tax returns after audit by respondent, for the years 1945 through 1951, were as follows:

1957 U.S. Tax Ct. LEXIS 26">*33 The progressive increase in the petitioner's gross income for the years 1945-1951 was due to the normal growth of the petitioner's business.

The increase in petitioner's vacation expense in 1949 was due to the fact that petitioner not only paid expenses for vacations taken in 1949 but also accrued a liability for 1950 vacation expense under the 1949 labor contract and the company agreement with respect to nonhourly workers conforming with that contract.

The new provision in the labor union contracts in 1949 with respect to vacation pay and the agreement by petitioner to make the same vacation allowance as to its other employees were not the cause of any increase in petitioner's gross income, nor were they a consequence of any increase in petitioner's gross income.

The increase in petitioner's vacation expense for 1949 did not cause a decrease in the amount of any other deduction in petitioner's base period.

The increase in petitioner's vacation expense for 1949 was not the result of a decrease in the amount of any other deduction in petitioner's base period.

The increase in petitioner's vacation expense for 1949 was not a consequence of a change at any time in the type of the business1957 U.S. Tax Ct. LEXIS 26">*34 engaged in by the taxpayer.

The increase in petitioner's vacation expense for 1949 was not a consequence of a change at any time in the manner of operation of petitioner's business, the size of the petitioner's business, or the condition of the petitioner's business.

There was no substantial change in the number of petitioner's employees during the years 1948, 1949, and 1950, although the trend was slightly downward.

In 1949, at the time of the change in the treatment of vacation expense in the labor contracts, the petitioner had no notice or knowledge of the possible enactment of an excess profits tax.

29 T.C. 409">*413 Because of the accrued liability for vacation pay arising out of the labor contract entered into in 1949 and petitioner's agreement to make the same vacation allowance to employees not covered by the labor contract, petitioner set up an accrual at the end of the current year rather than taking up the expense at the time of payment in the following year which had been the practice in years in which there had been no accrued liability.

There was no intrinsic difference in the nature and character of the vacation expense in respect of the hourly rated and the nonhourly rated1957 U.S. Tax Ct. LEXIS 26">*35 employees. In both instances the expense represented either payments actually made or payments accrued as of December 31.

The following practices have been consistently followed by the petitioner for many years both before, during, and after 1949. In the case of the hourly rated employees, the vacation payments and the accrued liability in respect of vacation pay appear on the petitioner's books in a separate account from the account covering the regular wages of such employees. Such account is captioned "Vacation Expense." In the case of the nonhourly rated employees, the vacation payments and the accrued liability in respect of vacation pay are included on the petitioner's books in the account captioned "Salaries and Wages." The term "hourly rated employees" embraces the petitioner's employees covered by the union contracts referred to above, which employees are directly engaged in the manufacture of petitioner's products; the term "nonhourly rated employees" covers employees not directly engaged in manufacturing, such as executives, salesmen, clerical staff, truck drivers, shipping clerks, and branch managers.

Hourly rated and nonhourly rated employees of the company are urged1957 U.S. Tax Ct. LEXIS 26">*36 to take the full vacation to which they are entitled. When because of an emergency in the course of the petitioner's business an employee fails to take a vacation, the petitioner in its discretion sometimes makes additional payments to such employee as vacation pay.

Prior to 1953, hourly rated employees of the petitioner were paid their regular wages in cash. When such an employee left on a vacation he would receive cash covering his wages for the last payroll period prior to this departure and also cash covering his vacation pay in advance. The former payment was charged on the petitioner's books to the account covering regular wages, while the latter payment was charged to the account captioned "Vacation Expense." Beginning in 1953, hourly rated employees were paid their regular wages and vacation pay by check. Vacation payment is made in advance by a check separate from the check for regular wages. The check for vacation pay is not specifically designated as such, but the amount of the check is charged on the petitioner's books to vacation expense.

29 T.C. 409">*414 Employees in the nonhourly rated group have been paid their regular salaries by check for many years. On leaving for1957 U.S. Tax Ct. LEXIS 26">*37 his vacation, such an employee has the option of receiving a check in advance, covering both his salary up to the date of his departure and pay in respect to his vacation time. If he does not request his check at the time of his departure on vacation, he receives a check for his salary and vacation pay at the next regular payroll date. There is no designation on such check in either case as to which portion thereof is attributable to vacation pay.

For the purpose of Federal income tax, withholding, and social security tax withholding, the amounts withheld include amounts attributable to vacation pay. In the case of any employee who terminates his employment in a given year without having taken a vacation and receives vacation pay upon termination of such employment, such taxes are withheld on such vacation pay.

Petitioner's vacation expense constituted "a class of deductions" within the meaning of section 433 (b) (9) of the Internal Revenue Code of 1939.

Of the deficiency of $ 219,504.64 in income tax for 1950 determined by the notice of deficiency, the petitioner, pursuant to formal notice and demand, paid to the district director of internal revenue for the second New York district1957 U.S. Tax Ct. LEXIS 26">*38 on January 12, 1955, $ 218,504.64 with interest thereon of $ 49,738.24. Said payment was made subsequent to the filing of the petition in this Court.

OPINION.

The total amount of vacation pay for 1949 was in excess of 115 per cent of the average amount of vacation pay for the 4 previous taxable years. The amount was deducted by petitioner on its return for 1949 but not as a single, separate item. Vacation pay of hourly workers was included as a part of cost of goods sold and vacation pay of other workers was included as a part of wages, salaries, and officers' compensation. The questions we are to decide are (1) whether vacation pay is a "class" as that term is used in section 433 (b) (9) and (10) ¹ of the Internal Revenue Code of 1939; (2) whether vacation 29 T.C. 409">*415 pay is a "deduction" contemplated by section 433 (b) (9) and (10); and (3) whether any other provision of section 433 (b) (9) and (10) bars the disallowance of the deduction in computing excess profits net income.

1957 U.S. Tax Ct. LEXIS 26">*39 Section 433 (b) (9) enumerates certain specific classes and leaves to regulations prescribed by the Commissioner the enumeration of all other classes. Petitioner claims that vacation pay constitutes a class as that term is defined in the regulations. Section 40.433 (b)-3 (d) (2), Regs. 130, allows a taxpayer to group deductions in such classes other than those provided for in the statute "as are reasonable in a business of the type which the taxpayer conducts and are applicable in the light of the taxpayer's business experience and accounting practice."

Respondent argues that vacation pay is a part of wages and salaries; that it is not treated differently for tax purposes; that social security and withholding apply to vacation pay; that it is deducted as part of wages; that petitioner did not keep separate accounts with respect to nonhourly workers; and that payment to nonhourly workers was made in the same check as wages with no breakdown of the amount attributable to each. Petitioner argues that vacation pay is a separate class because it serves an objective differing from that of regular wages; because, in so doing, it performs a separate function; and because to hold otherwise1957 U.S. Tax Ct. LEXIS 26">*40 would allow an obvious distortion in its average base period net income, which result would thwart the remedial nature of the statute.

Vacation pay is, of course, compensation, but is often controlled by special circumstances and subject to separate conditions (frequently as a result of negotiation of labor union contracts, sometimes wholly 29 T.C. 409">*416 voluntary). It may assume the character of a "fringe benefit." It sometimes develops from custom in a particular area or in a particular industrial group. From one perspective it may be characterized as an amount paid in recognition of prior services but covering periods during which the employee is not working as contrasted with periods in which services are performed. It may, in this respect, be deemed akin to pensions, sick pay, and severance pay. It may be an amount measured by longevity or in recognition of extraordinary services and paid as an inducement for future loyalty. And, of course, despite the more modern trend toward recognition of the need for vacations, and the desirability of having the employer make available the "wherewithal" in one form or another, there still exist employer-employee relationships where there1957 U.S. Tax Ct. LEXIS 26">*41 is no such recognition or implementation.

Somewhat similar problems have been presented to this Court under varying circumstances, both under section 433 (b) of the Korean War Excess Profits Tax Law and under section 711 (b) (1) (J) of the World War II counterpart. In Quaker Oats Co., 28 T.C. 626, we held that "[section] 711 (b) (1) (J) was intended to be, and is, a remedial statute." We think it obvious that the objective of section 433 (b) (9), as a relief measure, is substantially the same in principle as section 711 (b) (1) (J). The principle has evolved that in order to constitute a separate class the objective and purpose of the item in question must be different in character from other items of the same general category of deductions. Quaker Oats Co., supra.This principle must, of course, be applied to the facts of the particular case in accordance with the purpose of the statute. Thus, in Mine & Smelter Supply Co., 10 T.C. 1179 (1948), where stock bonuses were issued for the primary purpose of cementing the relationship and continued employment of the participants and for the1957 U.S. Tax Ct. LEXIS 26">*42 further purpose of partially rewarding them for past services, the bonuses were treated as a separate class from salaries.

Viewing the facts of the instant case in the light of the purpose of the statute and the general rule of interpretation as set forth above, we hold that vacation pay here constitutes a separate class. There is no fundamental difference in principle in treating vacation pay as a separate class than in according a separate classification to pensions as we did in Arrow-Hart & Hegemann Electric Co., 7 T.C. 1350, 1372-1375, holding that "they properly belong in a class separate and distinct from routine salaries." In the instant case, vacation pay was treated apart from regular wages in the contract with the union and in the agreement with employees not covered by the union contract. The fact that petitioner did not include it as a separate item in its tax returns is not of controlling significance. Arrow-Hart & Hegemann Electric Co., supra.As to accounting entries, vacation expenses, 29 T.C. 409">*417 both paid and accrued, for hourly rated employees appear in an account captioned "Vacation Expense" which 1957 U.S. Tax Ct. LEXIS 26">*43 was separate from the account covering the routine wages of said employees. It is true that in the case of nonhourly rated employees like payments and accruals are included in the account captioned "Salaries and Wages," but such vacation expense is ascertainable (and was ascertained for the purpose of this case, see stipulation, paragraphs 13, 15, and 16, and Exhibits 5-E and 6-F). Again it is our view that the use of hybrid methods, one for hourly rated and the other for nonhourly rated employees does not of itself bar relief. See Arrow-Hart & Hegemann Electric Co., supra.

Respondent argues that the change here was merely one of accounting procedure, having no other practical effect. Assuming, arguendo, that respondent's contention is factually correct, it would not appear that its effect would be to invoke any proscription of section 433 (b). See R. & J. Furniture Co., 20 T.C. 857, 870 (1953), remanded for further findings on another point (C. A. 6, 1955) 221 F.2d 795. We do not, however, agree that there was a mere change of accounting procedure. We think it is clear that there was1957 U.S. Tax Ct. LEXIS 26">*44 a substantial change and that, instead of a change in accounting procedure, petitioner merely reflected the 1949 circumstances on its books in a manner consistent with its accounting method which was consistently on an accrual basis.

Respondent argues further that if we hold (as we have, supra) that vacation pay is to be regarded as constituting a separate class under section 433 (b) (9), it is nevertheless not a "deduction" within the meaning of section 23, and therefore cannot be a deduction under section 433 (b). Respondent urges that petitioner is therefore barred from relief under the latter section. In arguing that vacation pay is not a section 23 deduction, respondent refers to the fact that a substantial part of the vacation pay (in substance, that part payable to hourly rated employees) was a part of cost of goods sold, and was taken into account as such in determining (reducing) gross income under section 22.

Section 23 provides, in part, as follows:

SEC. 23. DEDUCTIONS FROM GROSS INCOME.

In computing net income there shall be allowed as deductions:

(a) Expenses. --

(1) Trade or business expenses. --