4 T.C. 1033">*1034 This is a proceeding for the redetermination of a deficiency of $ 3,256.86 in petitioner's excess profits tax for the taxable year ended May 31, 1941. By an amended answer the respondent affirmatively claims an increased deficiency of $ 2,060.95 in petitioner's excess profits tax liability for that year.

The deficiency results in part from four adjustments to petitioner's excess profits net income computed under the invested capital method as disclosed by its return, and in part by adjusting petitioner's average borrowed1945 U.S. Tax Ct. LEXIS 198">*200 invested capital from $ 342,035 as reported to $ 128,580, which difference of $ 213,455 the respondent labeled "(a) Adjustment for open letters of credit," which he explained in a statement attached to the deficiency notice as follows:

(a) Open letters of credit are not borrowed capital as defined in section 719 of the Internal Revenue Code and consequently are not part of invested capital.

Petitioner does not contest the four adjustments to its excess profits net income, but by appropriate assignments of error it does contest the adjustment to its average borrowed invested capital.

The claim for an increased deficiency of $ 2,060.95 is based upon the respondent's affirmative allegation that petitioner's average borrowed invested capital should be further reduced from $ 128,580, as determined in the deficiency notice, to $ 28,181.20, which difference of $ 100,398.80 the respondent labeled "(a) Adjustment for acceptances payable," which he explained in a schedule attached to the amended answer as follows:

1945 U.S. Tax Ct. LEXIS 198">*201 In its reply, petitioner prays for the relief asked for in its petition and also that this Court determine that the increased deficiency claimed in the amended answer is erroneous.

4 T.C. 1033">*1035 FINDINGS OF FACT.

Most of the facts have been stipulated. The stipulation and the exhibits thereto are incorporated herein by reference.

Petitioner is a New York corporation incorporated in 1921, with its principal place of business in New York City. Petitioner's corporation income, declared value excess profits, and defense tax return and its excess profits tax return for the fiscal year ended May 31, 1941, were timely filed with the collector of internal revenue for the second district of New York. In its excess profits tax return petitioner computed its excess profits credit under the invested capital method. Petitioner maintains its books and files its returns on the accrual method of accounting.

Prior to, during, and subsequent to the fiscal year ended May 31, 1941, petitioner was engaged in the business of selling nuts and dried fruits at wholesale. About half of petitioner's purchases during the taxable year were made from foreign sources, principally from India and Brazil. These1945 U.S. Tax Ct. LEXIS 198">*202 foreign purchases must be made from seasonal crops at seasonal periods, and must be adequate for petitioner's needs during the entire year. Consequently, petitioner is required to maintain a large inventory. Petitioner does not sell its purchases short; all merchandise is purchased for use as its regular stock in trade. Shipments from Brazil usually take 3 to 4 weeks to arrive and those from India from 45 to 60 days.

All such foreign purchases were financed by means of bankers' irrevocable commercial letters of credit, hereinafter sometimes referred to as "letters of credit." Each such purchase was preceded by the execution of a formal contract of sale and each such contract of sale required petitioner to procure a letter of credit in favor of the seller. No letters of credit are issued for petitioner's account which do not involve such a prior contract of sale. During the period involved petitioner made purchases aggregating $ 1,980,184.26, of which approximately $ 1,000,000 were foreign purchases so financed.

During the taxable year five New York banks approved the extension to petitioner of lines of credit in maximum amounts as follows:

1945 U.S. Tax Ct. LEXIS 198">*203 A "line of credit" is an indication by a bank to its customer that it will make available to the customer a stipulated amount of credit. 4 T.C. 1033">*1036 This indication is not a binding commitment on the part of the bank, being subject to the continuance of the customer's financial position.

The obtaining of lines of credit entailed the submission of financial data to the banks, but did not involve the execution by petitioner of any bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust. Petitioner could exhaust its line of credit by any one of the following methods: Borrowing on its own notes and acceptances; discounting its customers' notes and acceptances; having the bank issue letters of credit on petitioner's application; and by the banks' acceptance of drafts drawn pursuant to such letters of credit. Petitioner could use any one of these means of financing, but the total amount involved therein could at no time exceed the line of credit extended to petitioner by the respective bank.

In each foreign purchase a contract of sale was first made in New York between petitioner as buyer and an agent for the foreign seller. Next, petitioner made1945 U.S. Tax Ct. LEXIS 198">*204 application, to a bank with which it has established a line of credit, for the issuance of a letter of credit by that bank to, and in favor of, the foreign seller, usually for 95 percent of the amount involved in the sale, and in accordance with the shipment, documentary, and payment terms specified in the contract of sale. Such applications were more or less uniform and set forth petitioner's obligation to the bank, assumed in consideration of the bank's issuance of the letter of credit. In such application, petitioner obligated itself to:

At any time and from time to time, on demand, to deliver, convey, transfer, or assign to you, as security for any and all of the obligations and/or liabilities of the undersigned, or any of us, hereunder, and also for any and all other obligations and/or liabilities, absolute or contingent, due or to become due, which are now, or may at any time hereafter, be owing by the undersigned, or any of us, to you, additional security of a value and character satisfactory to you or to make such cash payments as you may require.

Under such obligatory provison the bank may, and on occasion does, demand from its customer payment for the full amount of the1945 U.S. Tax Ct. LEXIS 198">*205 letter of credit prior to the bank's acceptance of drafts thereunder. The application also obligates petitioner to execute trust receipts to cover the documents and/or merchandise released to petitioner by the bank.

Immediately after the submission to the bank of the application and its approval by the bank, the bank issued a letter of credit in favor of the seller, in accordance with the specifications set forth in the application. The forms of letters of credit issued by the various banks have a practical uniformity. After issuance, the letter of credit was transmitted to the seller by one of the following methods:

4 T.C. 1033">*1037 (a) Letter of credit was cabled by the bank to the seller and a copy thereof mailed to the seller as confirmation; or

(b) Letter of credit was mailed by the bank directly to the seller; or

(c) Letter of credit was delivered to petitioner who, in turn, sent it to the seller or delivered it to the seller's agent in New York.

When the merchandise specified in the contract of sale was delivered by a seller to the carrier for shipment, a draft or drafts were drawn by the seller on the bank which had issued a letter of credit pursuant to the terms thereof, and1945 U.S. Tax Ct. LEXIS 198">*206 there were attached to such drafts documents such as bills of lading made to the order of the bank issuing the letter of credit, commercial and consular invoices, and weight certificates. The draft or drafts, together with these documents, were then negotiated by the seller with its own local bank. The seller's local bank in turn forwarded the draft or drafts, together with the various documents attached thereto, either directly or via its New York correspondent, to the bank which had issued the letter of credit. A majority of the letters of credit involved in the present proceeding provided for the drawing of ninety-day sight drafts. By reason of the use of airmail, it is customary for such documentary drafts to arrive in New York prior to the arrival of the merchandise.

When the draft was received by the New York bank which had issued the letter of credit, the bank stamped its acceptance upon the draft, and if it was other than a sight draft the bank returned the accepted draft to the bank which had presented the draft. The remaining documents were then sent to petitioner by the bank, together with the bank's notice of its acceptance of the draft or drafts, and in addition 1945 U.S. Tax Ct. LEXIS 198">*207 to such documents and notice the bank transmitted to petitioner a form of a trust receipt for execution by petitioner and return to the bank in accordance with the provisions of petitioner's application for the letter of credit. Petitioner then executed the trust receipt covering the documents and/or merchandise described in the bills of lading and accompanying documents, returned the trust receipt to the issuing bank, and retained the documents in order to take possession of the merchandise when it arrived. When the merchandise arrived petitioner was notified by the carrier, and custody of the merchandise was obtained by petitioner by presentation and surrender of the order bills of lading, the possession of which had been given to petitioner by the bank in accordance with the provisions of petitioner's application for the letter of credit. When the aforesaid documents were transmitted by the bank to petitioner no instrument other than the said trust receipt was executed by petitioner.

The bank received compensation from petitioner in connection with a letter of credit transaction as follows: (a) Time drafts are usually 4 T.C. 1033">*1038 charged for at the rate of one-eighth of 1 percent1945 U.S. Tax Ct. LEXIS 198">*208 per month on the face amount of the draft (thus, a 90-day acceptance is charged for at the rate of three-eighths of 1 percent of the amount thereof); (b) sight drafts are usually charged for at the rate of one-eighth of 1 percent of the face amount of the draft; and (c) if the credit is not drawn against, petitioner is obligated to pay a charge for its issuance. In some cases it is customary to charge for the time during which the letter of credit is outstanding and undrawn against.

The letters of credit by their terms indicate that they are issued for petitioner's account. The drafts drawn thereunder are also accepted by the bank for petitioner's account, and all such accepted drafts refer to the number of the letter of credit under which they are drawn. Generally, the practice has grown up of eliminating reference on the draft to the name of the person for whose account the draft is drawn and accepted, and of substituting for such name the number of the letter of credit. This practice prevents other banks in whose hands acceptances may find their way, via the bill market, from learning of the names of the issuing bank's letter of credit customers.

The engagement of a bank that1945 U.S. Tax Ct. LEXIS 198">*209 issues a letter of credit such as those issued in the instant proceeding runs to the drawer or bona fide holder of drafts drawn against the respective bank in accordance with the terms of the letter of credit. Once a letter of credit is issued and delivered, the bank is obligated to fulfill the commitments contained therein, regardless of the customer's credit standing in the meantime.

When customers in the United States make purchases from foreign sources of commodities such as are involved in the present proceeding they invariably use the method of letters of credit, and this is done regardless of the cash or other position of the purchaser at the time of the purchase. The use of letters of credit for purchases of merchandise from foreign sources is required by the terms of petitioner's purchase contracts.

When a letter of credit is issued by some banks it is entered on the records of such banks as a contingent liability of the customer. Some banks, however, carry letters of credit as an asset and as a corresponding liability on their published financial statements. None of the banks with which petitioner transacted business during the year involved showed letters of credit 1945 U.S. Tax Ct. LEXIS 198">*210 as a liability on their published statements. They were carried as a contingent asset and a contingent liability on the books of said banks. On petitioner's own balance sheets for the taxable year and all prior years bankers' letters of credit were not shown as a liability. In years subsequent to the taxable year they were so shown.

Petitioner's balance sheets as of the beginning and end of the taxable year were as follows: 4 T.C. 1033">*1039

The banks usually have on hand funds belonging to the customers sufficient to cover all drafts drawn on letters of credit on the due dates of1945 U.S. Tax Ct. LEXIS 198">*211 such drafts, and it is an unusual and disturbing situation when that is not the case.

Letters of credit are at times issued against which no drafts are drawn or against which drafts in amounts less than the face amounts of the letters of credit are drawn.

It was possible for petitioner to convert the goods purchased by it into cash prior to the due dates of the drafts drawn against letters of credit issued by the banks with which it transacted business, but this was very seldom done.

In filing its excess profits tax return for the year in question, petitioner, under section 719 of the Internal Revenue Code, added by section 201 of the Second Revenue Act of 1940, claimed an average borrowed capital of $ 684,070 and an average borrowed invested capital of 50 percent of that amount, or $ 342,035. In a rider attached to the return, it explained these amounts as follows:

This corporation carries on a very active business with five banks to which it has obligations in notes, acceptances, irrevocable credits, etc., with constantly changing balances. The daily balances in each bank have been extended and accumulated into a total of $ 249,685,575.00, or an average balance for 365 days of1945 U.S. Tax Ct. LEXIS 198">*212 $ 684,070.00. The detail covers several hundred items and would be too voluminous to be made a part of this return. * * *

The above total daily balances of $ 249,685,575 (now stipulated to total $ 250,086,957) are made up of four different types of claimed borrowed capital, as follows:

4 T.C. 1033">*1040 In the deficiency notice the respondent determined that type (1) did not constitute borrowed capital under code section 719 (a) (1). He therefore excluded this type from petitioner's claimed average borrowed invested capital, but did not disturb petitioner's claim as to the other three types.

In the amended answer the respondent affirmatively alleges that type (2), as shown in the preceding schedule, should also be excluded from petitioner's claimed average borrowed 1945 U.S. Tax Ct. LEXIS 198">*213 invested capital. The parties have stipulated that "None of the items used in computing the total of $ 73,291,127 aforesaid are included in computing the total of $ 156,943,307" and that types (3) and (4), as shown in the preceding schedule, "are not in dispute, those items having been allowed by the Commissioner in his computation of petitioner's average borrowed capital."

The banks' outstanding irrevocable commercial letters of credit issued pursuant to petitioner's applications therefor during the fiscal year ended May 31, 1941, do not represent outstanding indebtedness of the petitioner which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust.

The banks' accepted drafts, accepted under the said letters of credit for the account of the petitioner, do represent outstanding indebtedness of the petitioner which is evidenced by bills of exchange.

OPINION.

The questions presented involve petitioner's excess profits tax liability for the fiscal year ended May 31, 1941, under subchapter E of chapter 2 of the Internal Revenue Code, added by Title II, section 201, of the Second Revenue Act of 1940 as amended.

Under code section1945 U.S. Tax Ct. LEXIS 198">*214 712, petitioner, in its return, elected to compute its excess profits credit under code section 714, under which section "The excess profits credit * * * shall be an amount equal to 8 per centum of the taxpayer's invested capital for the taxable year, determined under section 715." Code section 715 provides that "the invested capital for any taxable year shall be the average invested capital for such year, determined under section 716," which, under section 716, "shall be the aggregate of the daily invested capital for each day of such taxable year, divided by the number of days in such taxable year." Code section 717 provides that "The daily invested capital for any day of the taxable year shall be the sum of the equity invested capital for such day plus the borrowed invested capital for such day determined under section 719."

The controversy here concerns only petitioner's average borrowed invested capital for the fiscal year ended May 31, 1941. The material 4 T.C. 1033">*1041 provisions of code section 719 are set forth in the margin. ¹1945 U.S. Tax Ct. LEXIS 198">*215 The material provisions of Regulations 112 are also set forth in the margin. ²

In its return petitioner claimed an average borrowed invested capital for the taxable year of $ 342,035. This amount was based upon the total daily balances of $ 1945 U.S. Tax Ct. LEXIS 198">*216 249,685,575 set out in our findings, which latter amount was made up of the four different types of claimed borrowed capital also set out in our findings. In the deficiency notice the respondent determined that type (1), namely, "Banks' outstanding letters of credit issued pursuant to petitioner's applications aforesaid" in the total amount of approximately $ 155,822,150 (now stipulated to total $ 156,943,307), did not constitute borrowed capital, and, that, therefore, $ 213,455 (50 percent of $ 155,822,150 divided by 365) should be excluded from petitioner's claimed average borrowed invested capital of $ 342,035. The pleadings placed in issue the correctness of this adjustment by the respondent. It is clear, therefore, that the first question presented is whether petitioner is entitled to include in the computation of its average borrowed invested capital under section 719 the outstanding irrevocable commercial letters of credit issued by the banks pursuant to petitioner's applications for such letters of credit. In other words, the question is not limited to the effect of the applications alone, but includes the effect of the granting of the applications and the issuance of 1945 U.S. Tax Ct. LEXIS 198">*217 the letters of credit themselves.

In the amended answer the respondent affirmatively alleged that he erred in not also determining that type (2), namely, "Banks' accepted drafts, under the said letters of credit" in the total amount of $ 73,291,127, 4 T.C. 1033">*1042 did not constitute borrowed capital, and, that, therefore, $ 100,398.80 (50 percent of $ 73,291,127 divided by 365) should also be excluded from petitioner's claimed average borrowed invested capital of $ 342,035. The second question presented is, therefore, whether the respondent did so err as he has alleged. The question is not limited to the effect of the trust receipts that were executed by petitioner upon the acceptance of the drafts by the banks.

We think the first question should be decided in favor of the respondent. Before we could hold that the letters of credit here involved constituted borrowed capital under code section 719, we would have to be of the opinion that such letters of credit represented "outstanding indebtedness * * * of the taxpayer which is evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust." We do not think the letters of credit here involved1945 U.S. Tax Ct. LEXIS 198">*218 come within that provision of the statute.

Petitioner contends (1) that the said letters of credit did represent outstanding indebtedness of the taxpayer; (2) that as such the letters of credit were in the nature of bonds, notes or bills of exchange; and (3) that if held to represent indebtedness of the taxpayer but not evidenced by any of the particular instruments specified in section 719, then the letters of credit were nevertheless includible within the scope of that section on the ground that the words "or any other written evidence of indebtedness" should in effect be read into section 719 (a) (1).

Did the letters of credit here involved represent outstanding indebtedness of the petitioner? We do not think they did. A letter of credit has been defined as "a letter whereby one person requests some other person to advance money or give credit to a third person, and promises to repay the same to the person making the advancement." Second Nat. Bank of Toledo v. Samuel & Sons, Inc., 12 Fed. (2d) 963; certiorari denied, 273 U.S. 720">273 U.S. 720. The letters of credit here involved were all irrevocable. The bank's obligation under1945 U.S. Tax Ct. LEXIS 198">*219 such letters of credit is absolute and unconditional and is unaffected by the terms of the contract between the buyer and seller. Laudisi v. American Exch. Nat. Bank, 239 N.Y. 234; 146 N.E. 347. The bank can not even, on the buyer's instructions, refuse to honor drafts drawn under such letters. Doelger v. Battery Park Nat. Bank, 201 A.D. 515; 194 N. Y. S. 582. Petitioner's obligation to the bank is to reimburse the latter for all payments made by the bank for petitioner's account. This obligation is also absolute and unconditional. Cf. Pan-American Bank & Trust Co. v. National City Bank, 6 Fed. (2d) 762; certiorari denied, 269 U.S. 554">269 U.S. 554. Under the contract between petitioner and the bank, the latter may demand that petitioner deposit with 4 T.C. 1033">*1043 the bank the full amount of the letter of credit prior to the bank's acceptance of any drafts drawn thereunder. Notwithstanding the definitiveness of these obligations of both the bank and petitioner, we do not think they represent an "indebtedness" 1945 U.S. Tax Ct. LEXIS 198">*220 as that term is used in section 719 until, at least, a draft has been drawn and accepted. As the Supreme Court said in Deputy v. DuPont, 308 U.S. 488">308 U.S. 488, "But although an indebtedness is an obligation, an obligation is not necessarily an 'indebtedness' * * *." The letters of credit are for a definite period, and if during this period no drafts are drawn against the bank, the petitioner will not be required to pay the bank any more than the charge the bank makes for its issuance. Petitioner's obligation under its contract with the bank may ripen into an indebtedness, but until it has done so we can not hold it to represent "outstanding indebtedness * * * of the taxpayer" as those words are used in section 719. During and prior to the taxable year petitioner did not carry the letters of credit on its books and in its financial statements as outstanding indebtedness. But that would not be controlling had it done so. It is substance that counts and not mere bookkeeping We hold against petitioner on its first contention.

Having decided contention (1) against petitioneer, it becomes unnecessary to decide the remaining contentions relative to the first1945 U.S. Tax Ct. LEXIS 198">*221 question. If, however, we are wrong in our holding that the letters of credit do not represent "outstanding indebtedness * * * of the taxpayer," then it is our opinion that such indebtedness, if it be indebtedness, is not evidenced by either a bond, note, or bill of exchange as petitioner contends under its second contention, and we have so found in our findings. Petitioner's third contention under the first question, that the phrase "or any other written evidence of indebtedness" should in effect be read into section 719 (a) (1), was considered by us and rejected in Journal Publishing Co., 3 T.C. 518, and Flint Nortown Theatre Co., 4 T.C. 536.

The second question raised by respondent by affirmative allegations in his answer presents a different situation. The question raised by these affirmative allegations is the legal effect of the drafts drawn under the letters of credit and accepted by the banks for petitioner's account. The respondent concedes that these acceptances qualify as bills of exchange. See I. T. 3481, Internal Revenue Cumulative Bulletin 1941-1, p. 274. He contends, however, in his brief that:

* 1945 U.S. Tax Ct. LEXIS 198">*222 * * A draft accepted by one of the banks with which petitioner transacted business became a bill of exchange, as to the bank, within the meaning of section 719 (a) (1) and would qualify as an indebtedness evidenced by a bill of exchange insofar as the bank is concerned. This does not mean that it would qualify as to the petitioner also. Certainly both the petitioner and the bank would not be 4 T.C. 1033">*1044 entitled to a borrowed invested capital credit on account of one purchase of merchandise or one accepted draft.

We think that, when these drafts were accepted and the bills of lading turned over to petitioner, petitioner became indebted for the merchandise to the full extent of the drafts drawn and accepted. At that point the letters of credit had, to the extent of the acceptances, ripened into an absolute indebtedness in the form of the acceptances. True, the bank was liable for the indebtedness, but so was petitioner. It had been contracted for petitioner's account and in a very true sense was petitioner's indebtedness. Petitioner was the one that ultimately had to pay.

We agree with the respondent to the extent that both the petitioner and the bank would not be entitled to a1945 U.S. Tax Ct. LEXIS 198">*223 borrowed invested capital credit on account of one purchase of merchandise or one accepted draft, but we think that under the applicable statute, printed above in the margin, petitioner is the one that is entitled to the credit. The amount owing on the accepted draft was petitioner's indebtedness. If the bank had failed to pay the accepted draft, petitioner would have been obligated to pay. Greenough v. Munroe, 53 Fed. (2d) 362; certiorari denied sub nom. Irving Trust Co. v. Oliver Straw Goods Corporation, 284 U.S. 672">284 U.S. 672. In fact the bank was entitled under its contract with petitioner to insist upon petitioner having sufficient funds on deposit with the bank to meet the accepted drafts as they became due.

In order to satisfy the statute it is not enough for the indebtedness to be the "outstanding indebtedness * * * of the taxpayer." It must also be "evidenced by a bond, note, bill of exchange, debenture, certificate of indebtedness, mortgage, or deed of trust." The respondent concedes that the acceptances here in question qualify as bills of exchange, but he argues that they were the banks' bills of exchange and1945 U.S. Tax Ct. LEXIS 198">*224 not petitioner's, and that this fact is fatal to petitioner's claim for a borrowed invested capital as far as these acceptances are concerned. We do not think that this conclusion follows. The statute requires that the indebtedness has to be the indebtedness "of the taxpayer," but it does not require that the specific type of instrument mentioned in the statute be that "of the taxpayer." All that the statute requires is that the outstanding indebtedness of the taxpayer be "evidenced by" one of the specific types of instruments.

We hold, therefore, that the respondent's claim for an increased deficiency should be and is denied.

A decision for the deficiency determined in the deficiency notice will be entered for the respondent.