14 T.C. 695">*696 Respondent has determined deficiencies in income taxes, declared value excess profits taxes and excess profits taxes for the calendar years 1941, 1942, and 1943, in the total1950 U.S. Tax Ct. LEXIS 211">*212 amount of $ 30,731.74. Three issues are presented:

(a) The correctness of the disallowance of depreciation on machinery for each of the taxable years.

(b) Was petitioner a member of a controlled group within the meaning of section 713 (g) (5) of the Internal Revenue Code?

(c) If respondent is sustained in his disallowance of depreciation under the first issue, and the net income of the petitioner is thereby increased, is it entitled to deduct, in computing net taxable income, additional income taxes which might be due the State of North Carolina as a result of the increase in its net income?

The proceeding was submitted upon a stipulation of facts and certain testimony and exhibits presented at the hearing. The stipulated facts are so found.

FINDINGS OF FACT.

The petitioner is a corporation, organized in 1934 under the laws of Delaware, with office and principal place of business at Morganton, North Carolina. At all times material herein it was engaged in the manufacture and sale of women's full fashioned hosiery. Its tax returns for the periods involved were filed with the collector of internal revenue for the district of North Carolina. Petitioner is successor to a North Carolina1950 U.S. Tax Ct. LEXIS 211">*213 corporation of the same name which started business in 1927. Petitioner, upon its organization, acquired the assets of this North Carolina corporation, and the basis of those assets to petitioner for the purposes of depreciation was their adjusted basis to the North Carolina corporation. The accounting records of the North Carolina corporation and of the petitioner included one general account known as the "machinery account," and one general account called "second-hand machinery." These machinery accounts were made up of the balances from several subsidiary accounts, which subsidiary accounts were labeled as hereinafter set forth in the following schedule. During the years 1927 to 1932, inclusive, the North Carolina corporation acquired various kinds of new and used machinery and equipment. The cost of the equipment so purchased is reflected in the various subsidiary accounts, as follows: 14 T.C. 695">*697

1950 U.S. Tax Ct. LEXIS 211">*214 The bulk of the machinery and equipment purchased during the years 1927 to 1932, inclusive, consisted of knitting machines known in the trade as "leggers" and "footers." The original cost of the various items of equipment carried in petitioner's second-hand accounts, which had been acquired prior to January 1, 1933, is set out in a schedule included in the stipulation of facts and consequently need not be set out in detail here. This schedule also shows the type of machinery, gauge and section, quantity purchased, and date of purchase; also petitioner's unrecovered cost of that equipment as of January 1, 1941, petitioner's estimate as to remaining useful life used in computing its deductions for depreciation on its tax returns for the years here involved, and the estimated remaining useful life as determined by the respondent in his notice of deficiency.

In the full fashioned hosiery industry the term "section" when used in reference to a knitting machine means a unit of the machine which produces one stocking. Thus, the number of "sections" in the machine would indicate the number of stockings which could be knitted at one time. The term "gauge" refers to the fineness of the fabric1950 U.S. Tax Ct. LEXIS 211">*215 -- the higher the gauge, the finer the fabric.

In 1935 petitioner and respondent agreed upon a formula for the purpose of computing depreciation on the machinery and equipment and other items contained in petitioner's 2 machinery accounts. Pursuant to that formula, it was agreed that the useful life of any new equipment was 15 years from the date of acquisition, and the useful life of any used equipment was 12 years from the date of acquisition. These useful lives were composite lives and were applicable to all items of machinery and equipment, including those acquired after January 1, 1933, which were reflected in the 18 subsidiary accounts which made up petitioner's 2 machinery accounts.

14 T.C. 695">*698 During the taxable years 1936 to 1940, inclusive, petitioner computed depreciation on all of its machinery and equipment at the agreed composite rate of 15 years for new equipment and 12 years for secondhand equipment, and claimed deductions on its Federal tax returns accordingly. These deductions were allowed by respondent without change. The 1935 agreement between petitioner and respondent for the application of a life of 15 years for new and 12 years for used machinery and equipment1950 U.S. Tax Ct. LEXIS 211">*216 was not a formal agreement in writing and was not an agreement binding the respondent to accept the rate there provided if conditions in future years changed to the extent that the life of the machinery and equipment as so agreed was shown to be improper for such future years and that a reasonable allowance for depreciation should be computed on a longer or shorter period.

When petitioner first commenced the manufacture of women's full fashioned hosiery in 1927 a great variety of machinery and equipment was necessary to make a complete stocking. In addition to the two basic machines, which were known as "leggers" and "footers," a great deal of auxiliary equipment was necessary. This auxiliary equipment included silk-throwing machinery, looping machines, seamers, boarding machinery, dyeing machinery, and tables and chairs. Many of the manufacturing operations were done by hand. The "footer" machines were an integral part of the manufacturing process at that time. The leg of the stocking was knitted on a "legger" machine, after which it was transferred by hand to the "footer" machine, where the foot was knitted to the leg of the stocking. The transferring process was a very difficult1950 U.S. Tax Ct. LEXIS 211">*217 and delicate operation. The principal machines used in the industry at that time were 43- and 45-gauge with 20 and 24 sections. There were a few 39-gauge machines with 18 sections.

Prior to 1941 petitioner used silk and some cotton in the manufacture of full fashioned hosiery. In 1941 petitioner used nylon, silk, and cotton, and some rayon in the latter part of the year. Silk was not available to petitioner or the industry as a whole after August, 1941. In 1942 and 1943 the only materials available were rayon and cotton. Nylon was not available for use in those years. In 1935, when the so-called formula was worked out for a 15-year useful life on new and a 12-year useful life on used machinery and equipment, petitioner was using silk and cotton in the manufacture of hosiery. In 1942 and 1943 there was some slight decline in the production of hosiery by petitioner, due principally to the scarcity of labor and materials.

During the years 1927 to 1943, inclusive, there was an increasing consumer demand for stockings of a finer gauge and sheerness. This demand required the industry to use higher gauge machines. While an acceptably sheer stocking could be made on a 45-gauge machine, 1950 U.S. Tax Ct. LEXIS 211">*218 it could not be produced on a 42-gauge machine. The 48-gauge stocking 14 T.C. 695">*699 was not popular with consumers. The 48-gauge machine was not popular with hosiery manufacturers for that reason. As a result very few machines of this gauge were made. The consumer trend in hosiery went rapidly from 45 gauge to 51 gauge. The 51-gauge machines became popular with hosiery manufacturers with the advent of nylon in 1939 and 1940. Petitioner had no 51-gauge machines. Women began to associate 51-gauge stockings with sheerness and fineness during World War II, when O. P. A. labeling regulations required the gauge of the stocking to be marked thereon. As a result, it was impractical for petitioner to try to make and sell hosiery of a coarser gauge.

Since 1927 there have been substantial and important improvements in the machinery used in the manufacture of women's full fashioned hosiery. In addition to the consumer trend requiring higher gauge machines, there were important developments and improvements in the machines used in the industry. The 48-gauge machine was not popular among hosiery manufacturers and was generally regarded as a mongrel gauge which was not needed. Knitting machinery1950 U.S. Tax Ct. LEXIS 211">*219 in vogue in 1940 was vastly different from the knitting machinery in vogue in 1927. In 1940, 26-section 45-gauge machines and 26-section 51-gauge machines were used. Machines were built with more sections, with the result that one operator, without additional effort, could knit more stockings. In addition to the increase in the number of sections, there was a decided trend toward increased automaticity. As a result, many of the manufacturing operations formerly done by hand were eliminated. The elimination of these manual operations enabled a worker to operate a machine with more sections, which meant increased production. These devices on the new model knitting machines enabled manufacturers to complete a stocking on one machine and eliminated the need and use of footing machines and the piece rates payable for this operation. Among these developments was the automatic welt turner, which became available in the industry in 1936 or 1937. At the same time came the automatic carrier changer. The three carrier tackle and subsequently the back rack tackle, or round heel attachment, were developed in 1938 or 1939. It was not considered practical or prudent to install these devices1950 U.S. Tax Ct. LEXIS 211">*220 on old machines. In the late 30's there was also introduced a circular knitting machine for the making of seamless hosiery, known as the "400 needle machine." This machine made a stocking comparable in fineness to a 51-gauge full fashioned stocking and was considered to be a real threat to the full fashioned hosiery industry.

In 1939 the du Pont Co. introduced nylon yarn for use in making full fashioned hosiery. Hosiery manufacturers were not permitted 14 T.C. 695">*700 to use nylon on 42-gauge machines. It was the opinion of the du Pont Co. officials that the consumer received a much greater value in the 45-gauge and 51-gauge nylon stockings. The advent of nylon yarn vastly accelerated the use of the round heel attachment in the manufacture of women's full fashioned hosiery. As a result, the use of footing machinery was no longer necessary. Likewise, a substantial part of the auxiliary equipment formerly used was no longer used in the knitting of nylon stockings. This auxiliary equipment included silk-throwing machinery, skein winders, boarding machines, doublers, and twisters.

The introduction of nylon yarn in the hosiery industry had a very influential effect on a substantial part, 1950 U.S. Tax Ct. LEXIS 211">*221 if not all, of the machinery acquired by petitioner prior to January 1, 1933. Petitioner's 42-gauge equipment could not be operated on nylon. In view of the developments in the industry from 1935, petitioner's 42-gauge equipment was obsolete and rendered almost useless. Petitioner's footing machinery was unnecessary in the use of nylon, as was petitioner's silk-throwing machinery. Nylon stockings became so popular after their introduction that it was extremely difficult for petitioner to sell silk stockings. Within a year after nylon was first made available to petitioner, nylon stockings accounted for at least 20 per cent of its production.

The full fashioned hosiery industry is a hazardous one and, if a hosiery manufacturer wishes to stay in business, he must maintain a modern, up to date plant. Petitioner's president has had 35 years' experience in the hosiery business and was the first president of the Southern Hosiery Manufacturers' Association. During World War II he served with the Office of Price Administration and the War Production Board as a hosiery consultant. Petitioner's management is regarded in the industry as progressive and forward looking. When the depreciation1950 U.S. Tax Ct. LEXIS 211">*222 formula mentioned heretofore was worked out with the Bureau of Internal Revenue in 1935, petitioner's management considered that the useful lives there fixed were too long for prudent management because of the trend toward finer gauges, increased number of sections, and more automatic equipment.

Until nylon was introduced silk was the principal material used in the manufacture of stockings. In 1940 petitioner used silk, some cotton, and nylon in increasing quantities. Petitioner never made any substantial quantity of all-cotton stockings. During 1941 petitioner used some cotton, nylon, and silk, until silk was commandeered by the Government in August of that year. Nylon was frozen in February of 1942. During 1942 and 1943 petitioner used rayon and cotton, although it had never used rayon before. Order M-37, issued by the War Production Board, allocated rayon to the industry. The War Production Board prohibited the use of fine rayon on 42-gauge 14 T.C. 695">*701 equipment, giving preference to 45-gauge and higher gauge equipment in allocating fine yarn. The result was that the allocation of rayon restricted the use of 42-gauge equipment to the manufacture of service weight stockings. 1950 U.S. Tax Ct. LEXIS 211">*223 The finest denier that petitioner was allowed on 45- and 48-gauge equipment was 100-denier yarn. In 1942 and 1943 it was impossible to tell how long restrictions on materials would last. During 1941, 1942, and 1943, generally, there was a scarcity of available labor and materials which affected the petitioner, as it did the entire industry.

In January, 1942, the Bureau of Internal Revenue issued Revised Bulletin F, dealing with income tax depreciation and obsolescence. That bulletin states:

The composite life for the machinery of concerns spinning and weaving cotton, wool, or silk is approximately 25 years, and for those engaged in knitting the same materials 15 years. Rayon manufacturing machinery composite life is approximately 16 years.

Since January, 1940, petitioner has had in its employ a certified public accountant who assisted in the preparation of petitioner's tax returns and advised its officials on tax matters. The depreciation schedules which were attached to petitioner's tax returns for the calendar years here involved were prepared under his supervision and were reviewed by him with petitioner's president. During the taxable years here involved, petitioner's management1950 U.S. Tax Ct. LEXIS 211">*224 considered the possibility of claiming increased amounts for depreciation. They were prompted in this by the numerous improvements in full fashioned machinery, and particularly by the popularity of 51-gauge stockings, which petitioner could not make. After some discussion, it was decided that the agreement of 1935 was binding and that the useful lives previously fixed thereunder should be used.

In computing depreciation charges for the taxable years, the effect of nylon yarn on petitioner's machinery and equipment was not considered, even though, within a year after it was first made available to petitioner, nylon stockings accounted for at least 20 per cent of petitioner's production. During the taxable years, petitioner maintained a uniform rate of production, and operating conditions remained comparatively stable except for material shortages and labor shortages. Petitioner maintained its machinery and equipment in good operating condition, but the repairs did not extend the useful life of any of its machinery.

For the taxable years petitioner computed depreciation on all of its machinery and equipment at the composite useful life of 15 years for new equipment and 12 years 1950 U.S. Tax Ct. LEXIS 211">*225 for second-hand or used equipment. In determining a portion of the deficiencies here in controversy, respondent adjusted the remaining useful life of a part of the machinery 14 T.C. 695">*702 and equipment carried in petitioner's 2 machinery accounts by determining that all items acquired prior to January 1, 1933, had a useful life expiring December 31, 1947. Petitioner's depreciation charges on machinery and equipment acquired subsequent to that time were not disturbed.

On December 31, 1939, petitioner had outstanding paid-in preferred stock amounting to $ 416,800. On October 31, 1941, petitioner acquired 2,106 shares of preferred stock of Huffman Full Fashioned Hosiery Mills, Inc., in exchange for 2,106 shares of preferred stock of petitioner of a par value of $ 100 per share. On the same date petitioner acquired 4,606 shares of common stock of Huffman Full Fashioned Hosiery Mills, Inc., in exchange for 460.6 shares of petitioner's common stock without par value. In each case the stock acquired was all of the outstanding stock of Huffman Full Fashioned Hosiery Mills, Inc. On October 1, 1942, all of petitioner's preferred stock, amounting to $ 627,400, was retired for cash. At all 1950 U.S. Tax Ct. LEXIS 211">*226 times material herein, Huffman Full Fashioned Hosiery Mills, Inc., had no subsidiary companies. With the exception of Huffman, petitioner had no subsidiary companies.

A finding of deficiencies in petitioner's Federal taxes in this proceeding will result in additional income taxes due the State of North Carolina by petitioner.

During the taxable year 1941 petitioner was a member of a controlled group of corporations for excess profits tax credit purposes within the definition of "controlled group" in section 713 (g) (5) of the Internal Revenue Code.

At the end of each of the taxable years, the composite, reasonably anticipated useful life of all of petitioner's machinery and equipment was not more than 15 years from the date of acquisition for new equipment and not more than 12 years for second-hand or used equipment.

OPINION.

The first issue is with respect to respondent's action in adjusting the petitioner's deduction for depreciation for the three years here involved by increasing the anticipated useful life of its machinery and equipment.

The record discloses that in 1935, after conference between the officers of petitioner and representatives of the respondent, a depreciation 1950 U.S. Tax Ct. LEXIS 211">*227 rate was fixed by agreement based upon a useful life of 15 years for new and 12 years for second-hand machinery and equipment. The petitioner carried upon its books two general accounts, one designated as "machinery account" and the other as "second-hand machinery." These machinery accounts were made up from a number of subsidiary accounts, petitioner's machinery and equipment being 14 T.C. 695">*703 of various types. Depreciation has always been taken upon a composite basis and was so continued under the agreement of 1935.

It is respondent's contention, upon brief, that petitioner's objection to the adjustment of its depreciation rates for the years 1941, 1942, and 1943 is based upon the premise that the agreement of 1935 was binding upon the respondent and that these agreed rates must be applied for the taxable years, irrespective of the conditions then actually existing. The record, however, does not support the respondent in this position. Petitioner does not take the position that the respondent is precluded from adjusting the rates for depreciation fixed under the 1935 agreement, if such rates as applied to the taxable years are, in fact, unreasonable. Its contention is that the1950 U.S. Tax Ct. LEXIS 211">*228 application of the agreed rates was proper for the years involved in the light of the conditions then known or reasonably to have been anticipated at the close of each of those years. It contends that these rates are shown to have been correct in the light of its experience in the hosiery business, taking into consideration conditions existing at the close of each of the taxable years, together with the conditions which could reasonably have then been anticipated. Petitioner charges that the contested adjustment in the rates to increase the probable useful life of portions of its machinery and equipment resulted from a determination by respondent made in 1946, three years after the close of the taxable period. It is argued that this determination was based, not upon conditions known or reasonably to have been anticipated at the close of each of these years, but upon conditions which arose during the course of the year, and that in making this determination the respondent used "hindsight" instead of "foresight."

Respondent does not dispute the rule that a reasonable rate for depreciation is to be determined upon the facts existing as of the close of the respective taxable year. 1950 U.S. Tax Ct. LEXIS 211">*229 Leonard Refineries, Inc., 11 T.C. 1000; Commissioner v. Mutual Fertilizer Co., 159 Fed. (2d) 470. Respondent insists, however, that his determination, although made subsequent to the three taxable years, was made in the light of conditions existing as of the close of those years.

We have examined the evidence carefully and think it definitely establishes that a drastic change in conditions facing the full fashioned hosiery business was in progress prior to the three taxable years. A large part of petitioner's machinery and equipment was used in the knitting of silk stockings. The advent of nylon, which became available to the trade in 1940, practically spelled the doom of the silk stocking industry. Nylon yarn was allocated by the du Pont Co., its sole manufacturer, for use on 45- and 51-gauge knitting machines. Petitioner had no 51-gauge machines and, although the only machines 14 T.C. 695">*704 it possessed suitable for the knitting of nylon yarn were those of 45-gauge, the manufacture of nylon stockings by petitioner in 1940, the first year nylon became available, accounted for the 20 per cent of its total production.

1950 U.S. Tax Ct. LEXIS 211">*230 Following the United States' entry into the war, both nylon and silk were frozen by the Government and thus became unavailable. Petitioner thereafter used rayon and a mixture of cotton and rayon. It has never made more than a small amount of all-cotton stockings.

The record shows that at the close of each of the taxable years petitioner's income tax schedules were made up by its accountant and discussed with petitioner's president. The question was raised on each occasion as to whether or not it should apply for an increase in its depreciation rates by reason of existing conditions, together with those which it could anticipate that it would have to meet. Respondent had, in January, 1942, issued his Revised Bulletin F, setting out a composite useful life of 15 years for silk-knitting machines, and petitioner's officers decided not to request an allowance for additional depreciation, but to continue the application of the agreed rate of 1935, although it was apparent that the facilities in the petitioner's machinery account used in the knitting of the silk were then practically obsolete.

Shortly prior to the taxable years, many improvements were made in knitting machines. The 1950 U.S. Tax Ct. LEXIS 211">*231 number of sections had been greatly increased. What was known as the "round heel" attachment had been developed and was being largely used. This attachment eliminated the need and use of "footer" machines. The leg of the stocking theretofore had to be knitted on a "legger" machine, after which it was transferred by hand to a "footer" machine, which knitted the foot onto the leg. The new device made the knitting of a stocking one operation instead of two. Another invention had been the circular knitting machine, which made a seamless stocking and was thought to be a very definite threat to the business equipped with machines of the earlier type.

Upon the record, we conclude that, at the end of each of the taxable years, the rate of depreciation theretofore applied was accurate and did not require revision. We hold that the depreciation claimed by petitioner for these years was a reasonable allowance therefor. The action of respondent in increasing the composite useful life of petitioner's machinery and equipment is disapproved.

The second issue involves the propriety of respondent's action in computing petitioner's invested capital credit for excess profits tax purposes by application1950 U.S. Tax Ct. LEXIS 211">*232 of section 713 (g) (5) of the Internal Revenue Code in its classification of petitioner as a member of a "controlled group." There is no dispute between the parties that this contested 14 T.C. 695">*705 action is correct if petitioner is in fact a member of a "controlled group" within the purview of the cited section.

Section 713 (g) (5) thus defines a "controlled group":

* * * As used in this paragraph, a controlled group means one or more chains of corporations connected through stock ownership with a common parent corporation if (i) more than 50 per centum of the total combined voting power of all classes of stock entitled to vote, or more than 50 per centum of the total value of shares of all classes of stock, of each of the corporations (except the common parent corporation) is owned directly by one or more of the other corporations and (ii) the common parent corporation owns directly more than 50 per centum of the total combined voting power of all classes of stock entitled to vote or more than 50 per centum of the total value of shares of all classes of stock, of at least one of the other corporations.

Here the corporate petitioner owned all of the issued and outstanding stock, both1950 U.S. Tax Ct. LEXIS 211">*233 common and preferred, of the Huffman Full Fashioned Hosiery Mills, Inc. It had no other subsidiary, nor did it have a parent corporation. The Huffman Full Fashioned Hosiery Mills, Inc., had no subsidiary. Petitioner argues that, under the quoted statutory definition of "controlled group," three corporations, at least, are necessary, while here the only subsidiary corporation owned by the parent is the Huffman Full Fashioned Hosiery Mills, Inc., and that the latter company is not a member of a chain of corporations controlled by a parent because a chain must necessarily have more than one link. The question here presented has never been raised before in any court, so far as we know. The quoted definition is rather confused. The legislative history of the section discloses only that it was the intention of Congress to apply the adjustment of invested capital as there set out to a corporation which was a member of a group controlled by stock ownership. The section of the code here in question was added by the Revenue Act of 1942. The report of the Committee on Ways and Means of the House of Representatives, which accompanied that bill, states:

This section is applicable to taxable1950 U.S. Tax Ct. LEXIS 211">*234 years beginning after December 31, 1941, and applies to any taxpayer which is a member of a controlled group and which owns stock in one or more corporations in such controlled group acquired after the beginning of the taxpayer's first taxable year under the excess profits tax. In general, it provides that such stock owned by the taxpayer on any day of the taxable year shall be a daily capital reduction for such day.

The Report of the Finance Committee of the Senate accompanying the bill in the Senate reads:

This section, which is identical with section 210 of the House bill, is applicable to taxable years beginning after December 31, 1941, and applies to any taxpayer which is a member of a controlled group and which owns stock in one or more corporations in such controlled group acquired after the beginning of the taxpayer's first taxable year under the excess profits tax. In general, it provides that such stock owned by the taxpayer on any day of the taxable year shall increase 14 T.C. 695">*706 the daily capital reduction for such day (or, if the taxpayer has made no previous distributions resulting in daily capital reduction, such stock owned by the taxpayer on such day shall be a1950 U.S. Tax Ct. LEXIS 211">*235 daily capital reduction for such day).

Respondent has, by his Regulations 112, section 35.713-2, interpreted the above definition of a "controlled group" to mean two or more corporations and to include a parent corporation owning the stock of one subsidiary, as is the present situation. The reason for and the purpose of the elimination of the cost of the stock of the subsidiary in the computation of daily invested capital would seem to be the prevention of a duplication of credit for what, in fact, is the same investment. This reason and purpose manifestly apply with equal force where the parent corporation had only one controlled subsidiary instead of two. We think under all the circumstances it is only reasonable to construe the meaning of the word "chain" as thus used by Congress to include the parent with the subsidiary. We therefore conclude that the quoted statutory definition of "controlled group" includes the present situation, where petitioner is unquestionably in control, through stock ownership, of the Huffman Full Fashioned Hosiery Mills, Inc. In this connection it seems significant that although such a condition is certainly not unique and probably has existed in1950 U.S. Tax Ct. LEXIS 211">*236 many cases, it appears that respondent's regulatory interpretation of this confused definition has not been questioned in any decided case.

We hold that petitioner was a member of a "controlled group" within the purview of section 713 (g), and sustain respondent in his contested adjustment of petitioner's daily invested capital in the computation of its credit for excess profits tax purposes.

The third issue becomes moot upon our decision of the first issue.

Decision will be entered under Rule 50.

Van Fossan, J., dissenting: I can not agree that two links constitute a chain and I therefore dissent on that issue.