32 T.C. 390">*391 The Commissioner determined deficiencies in income tax and additions thereto for fraud under section 293(b), ² as follows:

The deficiencies are due to a number of adjustments to the income reported on the separate returns of the petitioners for the year 1947 (in which they each reported one-half of the community income) and on their joint return for 1948. Some of these adjustments were in petitioners' favor. For example, in his determination of the deficiencies for the year 1947, the Commissioner allowed petitioners a net operating loss deduction of $ 33,472.85 as a carryback from 1949.

The petitioners do not assign any error as to this adjustment which the Commissioner made in their favor for 1947. However, petitioners do have an assignment of error as to 1948 in which they allege the Commissioner erred in his "[failure] to allow petitioners a net operating loss carry-back from the year 1949 in the amount of $ 33,472.85." It will be noted that the amount of net operating loss carryback which the petitioners allege should be allowed for 1948 is the same as the Commissioner1959 U.S. Tax Ct. LEXIS 153">*156 has already allowed for 1947. 32 T.C. 390">*392 This matter is not argued by the parties in their briefs. Therefore, in a computation under Rule 50 this net operating loss of $ 33,472.85 from 1949 should be allowed for 1947 as the Commissioner has already allowed in his deficiency notice. No reason is given as to why it should be allowed for 1948 as the petitioners allege in their petition.

The only adjustments and questions still in issue are as follows:

(1) Whether the amount of $ 316,784.38 deducted by petitioners in 1947 as a foreign contract selling and servicing expense represents an ordinary and necessary business expense paid or incurred during that year.

(2) Whether the Commissioner properly allocated to the petitioners gross income purportedly earned by the Weatherford Spring Company of Venezuela in the amounts of $ 278,124.96 and $ 768,779.56 for the years 1947 and 1948, respectively, under the provisions of section 45.

(3) Whether any part of the deficiencies in Docket Nos. 62186 and 62188 is due to fraud with intent to evade tax.

FINDINGS OF FACT.

Some of the facts were orally stipulated at the hearing and were recorded in the transcript; they are incorporated herein by reference.

1959 U.S. Tax Ct. LEXIS 153">*157 Petitioners Jesse E. Hall, Sr., hereinafter referred to as Hall or petitioner, and Rhoda O. Hall, husband and wife, are residents of Weatherford, Texas. They filed individual income tax returns for the year 1947 on a community property basis and a joint return for the year 1948 with the now district director of internal revenue at Dallas, Texas. Petitioners' books and tax returns for both years reflected the accrual system of accounting.

Hall was born in 1891, married in 1910, and had four sons, viz, George, John, Elmer, and Jesse, Jr. (hereinafter referred to by their first names). From the time Hall finished high school until about 1915 he engaged in water well drilling around Weatherford. In 1915 he went to Yuma, Arizona, and worked in canal building there until about 1920, when he moved to California to work in the oil fields. He had various jobs connected with oil well drilling and for a good part of the time he was a drilling superintendent. He worked for certain oil companies and also drilled on his own account.

Besides his drilling activities Hall spent some of his time inventing and developing various pieces of equipment designed for use in the oil industry. In 1935, 1959 U.S. Tax Ct. LEXIS 153">*158 he started building a device called a spiral centralizer which was designed to be used in the cementing of oil wells. Around 1941, Hall started building a device known as a scratcher which was also designed to be used in cementing.

32 T.C. 390">*393 Cementing is a process whereby "[cement] is pumped into the hole, between the walls of the hole and outside of the casing. Upon hardening it keeps the pipe in the hole stationary and prevents leakage from or to other strata that have been drilled through." ³ The main problem involved in cementing is getting the cement to form a solid sheath. When the sheath is imperfect there is a possibility of leakage between formations and oil sometimes escapes to the surface outside the casing. Where the cement job is imperfect it has to be recemented, which is a costly operation.

The centralizer and scratcher developed by Hall were to be attached to the outside of the casing throughout the area of the casing which was to be1959 U.S. Tax Ct. LEXIS 153">*159 cemented. The purpose of the centralizer and the scratcher was to keep the casing in the center of the hole to loosen the mud and cutting from the wall of the hole so as to allow the cement to form a direct bond between the cement and the wall. When using these devices the pipe (casing) was supposed to be reciprocated, i.e., moved up and down.

Hall received a patent on the centralizer in 1941 and on the scratcher in 1954. In addition, by 1946 he had received 20 other patents on various other devices designed to be used in oil drilling and in the oil industry.

Prior to 1939 or 1940, Hall was manufacturing this equipment in California. However, about that time (1939-1940) the United States Government, in connection with the war, took over some of the facilities he was using and Hall ceased to make any equipment for about a year. Around 1941, Hall moved from California back to Weatherford, Texas. He resumed manufacturing the spiral centralizer, the scratcher, and other equipment in a portion of a building which housed a buckle manufacturer. In 1944, Hall purchased the entire building and used it as his plant. Hall operated his business as a sole proprietorship under the name 1959 U.S. Tax Ct. LEXIS 153">*160 of Weatherford Spring Co., hereinafter referred to as Weatherford Co.

During the early 1940's when Hall was manufacturing his equipment in Weatherford his operation was small. Although some of the centralizers which he sold were shipped to the purchasers by common carrier, Hall personally transported most of them to the purchaser by automobile.

The centralizer and scratcher were not generally accepted by the oil industry as useful tools in cementing. Many of the persons connected with drilling objected to placing objects on the outside of the casing because they felt that such objects would increase the chance of the pipe's sticking. Therefore Hall, in connection with the sale of his products, offered free engineering service and free 32 T.C. 390">*394 advice on cementing problems and advertised to that effect. He tried to be personally present when an initial purchase was being installed so that he could show the purchaser the correct method of cementing when his equipment was being used. Hall realized that without proper use his equipment was valueless. In addition to being present when an initial purchase was installed he would actually do the cementing to demonstrate proper usage. 1959 U.S. Tax Ct. LEXIS 153">*161 In addition to the engineering service offered, Weatherford Co. sent written instructions concerning the use of Weatherford Co. equipment with all purchases.

Weatherford Co.'s sales increased steadily ($ 17,000 in 1942, $ 28,000 in 1943, $ 102,000 in 1944, $ 118,000 in 1945, and $ 238,000 in 1946). Hall could not personally attend to all of the work himself. Hall's son Jesse, Jr., helped him at the plant and he (Hall) trained his son John to help him run oil wells. His other two sons worked for Superior Oil Company as assistant superintendents engaged in oil well drilling, Elmer in Louisiana and George in California.

Foreign sales during 1944 and 1945 were negligible and in 1946 they totaled $ 8,138. During 1944 and 1945, Weatherford Co.'s foreign sales were handled by Roland Smith under a contract which provided that Weatherford Co. pay Smith a 40 per cent commission on all sales outside the United States. On January 1, 1946, a new contract was entered into calling for a 20 per cent commission to Smith on all foreign sales.

In the latter part of 1944, Gulf Oil Corporation, hereinafter referred to as Gulf, assigned one of its employees, A. J. Teplitz, a chemical engineer, to1959 U.S. Tax Ct. LEXIS 153">*162 make a thorough study of oil well cementing. Gulf had been experiencing an increasing number of cementing failures. Hall's son had contacted Teplitz and in the spring of 1946 Hall called upon him to discuss the possible use of Weatherford Co.'s spiral centralizer and scratcher by Gulf in cementing. As a result of the meeting, Teplitz decided to have Hall run some equipment in oil wells in southern Louisiana, which was the most troublesome and costly area that Gulf had at the time.

Hall ran about 6 or 7 wells in the area with success. They were the first wells where Gulf obtained good production immediately upon completion of the wells. After the work in southern Louisiana was completed, Hall, accompanied by Teplitz, ran wells for Gulf in Texas, northern Louisiana, and Mississippi.

Teplitz and W. E. Hassebroek of the Halliburton Oil Well Cementing Co. prepared and presented a technical paper entitled "An Investigation of Oil Well Cementing." The paper was later published in "The Petroleum Engineer" reference annual for 1946 and was reprinted and circulated by Weatherford Co. as advertising. The paper, in part, described the cementing procedures used by Hall on the Gulf wells 1959 U.S. Tax Ct. LEXIS 153">*163 in Louisiana and concluded, inter alia, that:

32 T.C. 390">*395 2. The experiments performed in the course if this investigation have shown that extensive channeling of cement occurs in the ordinary procedure of casing cementation, and indicate that this condition is responsible for most of the failures encountered.

3. By properly equipping the casing with scratchers and centralizing devices, reciprocating the pipe while placing the cement, and speeding up the rate of pumping, it has been possible to practically eliminate channeling and thus greatly increase the proportion of successful casing settings.

In the latter part of 1946, Teplitz contacted Hall about going to Venezuela to try his equipment on some wells owned by Mene Grande Oil Company, hereinafter called Mene Grande, a subsidiary of Gulf, which had been experiencing considerable cementing difficulties. Teplitz and Hall flew to Venezuela taking some Weatherford Co. equipment with them. Hall, accompanied by Smith, his foreign representative, and Teplitz, ran some of the Mene Grande wells in both western and eastern Venezuela. These tests were successful.

As a result of these tests Teplitz and Hall worked out an approved method1959 U.S. Tax Ct. LEXIS 153">*164 for using the Weatherford Co. centralizers and scratchers. This program mainly dealt with the number of scratchers and centralizers to be used and their position on the casing.

After the tests Mene Grande determined that the Weatherford Co. centralizers and scratchers should be used. Around March 18-20, 1947, W. F. Boyd, an employee of Mene Grande at San Tome, Venezuela, with the assistance of Smith, determined the amount of Weatherford Co. equipment that Mene Grande would need through June 30, 1948. As a result of these determinations the following orders were placed with Weatherford Co.:

Under the terms of these orders, as well as under the terms of all sales made by Weatherford Co., Hall was not required to run the scratchers1959 U.S. Tax Ct. LEXIS 153">*165 and centralizers into the well. However, in accordance with the custom of Weatherford Co., it was contemplated that Weatherford Co. would have persons available to offer technical advice in connection with cementing problems that arose.

Hall notified Jesse, Jr., of the large orders and told him to acquire a new plant site and start building a plant large enough to accommodate the sudden increase in business. Hall also induced Elmer to leave his position with Superior Oil Co. and come to Venezuela to replace him.

32 T.C. 390">*396 Elmer quit on or about April 15, 1947, and arrived in Venezuela shortly thereafter. After spending a few days with Elmer instructing him, but not actually running any of the Weatherford Co. equipment into the wells, Hall returned to the United States. Elmer had very little prior experience in using Weatherford Co. equipment but was an experienced drilling man. Before leaving Hall told Elmer that it was imperative that they have a company down in Venezuela because it was necessary to incorporate there in order to properly carry on the business. He felt that the same reason which caused other foreign businesses to carry on their operations in Venezuela by incorporating1959 U.S. Tax Ct. LEXIS 153">*166 subsidiaries in Venezuela also applied to his own business operations in Venezuela. In connection therewith he contacted Manuel Matienzo, a Venezuelan lawyer.

In June 1947, some serious cementing problems had arisen in Venezuela and Gulf was very much concerned. Hall visited Gulf's Pittsburgh office concerning this matter and then flew to Venezuela to try to solve the problems. Hall felt that he could not continue to go back and forth between Venezuela and the United States and decided that the operation in Venezuela must be put on a permanent basis. Hall was also interested in obtaining someone to help Elmer. On the recommendation of a Mene Grande official he contacted James Berry, who had recently submitted his resignation effective September 1947 from his position as a drilling superintendent with Shell Oil Co. in Venezuela. Hall and Elmer approached Berry and discussed with him the possibility of his coming to work for Weatherford Co. Berry was interested in the Weatherford Co. products but was not interested in working for a salary. He wanted to go into business on his own.

After a few days of talks and negotiations it was decided to form a Venezuelan corporation. On1959 U.S. Tax Ct. LEXIS 153">*167 July 8, 1947, Weatherford Spring Company of Venezuela, C.A., hereinafter referred to as Spring Co., was incorporated in Venezuela with a capital contribution of about $ 8,000 (United States money). This amount was paid in by Hall. According to the records of this corporation the stockholders and the shares held by each during the periods shown were as follows:

Elmer became president and treasurer and Berry became vice president and secretary.

On July 14, 1947, the following letter was sent to Spring Co. by Hall and was accepted by Elmer on behalf of Spring Co.:

This will serve to confirm my verbal offer to you to act as sole representatives and distributors for all foreign countries, including Venezuela, of all the oil-well 32 T.C. 390">*397 equipment and other articles now or hereafter manufactured by me under the trade-name of "Weatherford", subject to the following terms and conditions:

(1) I agree to1959 U.S. Tax Ct. LEXIS 153">*168 sell to you at cost plus ten percent (10%) F.O.B. Weatherford, Texas, any and all oil-well equipment and other articles now or hereafter manufactured by my company, including any and all foreign orders at present pending, payment to be made by you at Weatherford upon presentation to your bank of the respective bills of lading.

(2) I further agree to permit you to use any and all of my catalogued patents and patents pending for the period of one year from the date hereof, and to assist you in the prosecution or defense of any law suits that may arise by reason of infringements upon said patents.

(3) In consideration of the above, you will take care of the installation and service of said equipment in Venezuela and in any other countries in which you may operate under this agreement, and will provide the necessary plant facilities and adequate personnel to take care of said services. You will also assume the obligation which I now have towards Mr. Roland E. Smith, at present acting as my foreign representative, which obligation consists of the payment of a twenty percent (20%) commission on all foreign orders and will terminate on December 31, 1947.

(4) The duration of the present 1959 U.S. Tax Ct. LEXIS 153">*169 agreement will be one year reckoned from the date hereof, extendable by mutual consent for successive periods of one year each.

If the above conditions are satisfactory, kindly sign the enclosed duplicate of this letter as evidence of your acceptance.

Hall returned to Weatherford on July 28, 1947. Pursuant to Hall's request, Jesse, Jr., and Odie Gilbert, Weatherford Co.'s shop superintendent, made a study of manufacturing costs to determine the unit cost for the purposes of the contract with Spring Co. They arrived at unit cost for scratchers ranging from 33 cents per unit for 2 7/8-inch to $ 1.53 for a 20-inch scratcher and for spiral centralizers ranging from $ 1.57 per unit for a 4-inch to $ 3.55 for a 20-inch centralizer.

A cutoff date of August 7, 1947, was used to determine which foreign sales should be credited to Spring Co. All foreign sales prior to that date were handled as sales of Weatherford Co. and foreign sales after that date were handled as sales of Spring Co. on the cost plus 10 per cent basis. Hall then had Patty, Jesse Jr.'s wife and Weatherford Co.'s bookkeeper, determine the foreign sales made by Weatherford Co. from January 1, 1947, to August 7, 1947. Patty1959 U.S. Tax Ct. LEXIS 153">*170 determined such foreign sales to be as follows:

32 T.C. 390">*398 The proceeds from these foreign sales were all deposited in the bank account of Weatherford Co. with the exception of checks in the amounts of $ 670.36, $ 5,323.72, and $ 8,728.28 which were deposited in the bank account of Spring Co. in Weatherford.

Patty then determined the contents of the above foreign sales and applied the unit prices previously determined to arrive at the manufacturing cost of the items sold. To this unit she added 10 per cent. Her computation was as follows (condensed):

1959 U.S. Tax Ct. LEXIS 153">*171 This amount, $ 25,518.41, was subtracted from the total foreign sales of $ 342,302.79 and the balance of $ 316,784.38 was charged on Weatherford Co.'s books as a "Foreign contract selling and servicing expense" and credited to Spring Co. as an account payable. Hall instructed that this entry be made in order to reimburse Spring Co. for the subsequent servicing of equipment sold prior to August 7, 1947, to the extent necessary for servicing equipment not already serviced prior to August 7, 1947.

This amount of $ 316,784.38 was deducted by Hall (and his wife) on his 1947 return as an ordinary and necessary business expense of Weatherford Co. The respondent in his notices of deficiency disallowed the entire deduction claimed for "Foreign contract selling and servicing" in the amount of $ 316,784.38 and explained such disallowance as follows:

(a) It is held that the $ 316,784.38 deducted by you as foreign contract and selling expenses, covering a purported charge by Weatherford Spring Company of Venezuela, does not represent an ordinary and necessary business expense as required by Section 23(a) of the 1939 Internal Revenue Code. The above-mentioned company was incorporated in Venezuela1959 U.S. Tax Ct. LEXIS 153">*172 on July 8, 1947. The $ 316,784.38 deduction represents the difference between the total amount of all merchandise invoiced to customers in foreign countries from January 1, 1947 to August 7, 1947, and your manufacturing costs plus ten percent.

Under an agreement between Hall and K. A. Wright dated September 15, 1944, concerning patent rights Hall agreed to pay Wright a royalty of 2 1/2 per cent of the sales price on the equipment. On the foreign sales of Weatherford Co. for the period January 1 through August 7, 1947, Weatherford Co. paid Roland Smith a commission of 20 per cent.

32 T.C. 390">*399 Neither Hall nor Berry nor any other Spring Co. employee during the years involved visited any foreign country except Venezuela on Spring Co. business. A substantial amount of the equipment sold by Weatherford Co. to customers in Venezuela prior to August 7, 1947, had been used and serviced prior to that time.

No part of the $ 316,784.38 represented a selling expense to Weatherford Co.; however, $ 22,500 of the $ 316,784.38 represents a reasonable accrual in 1947 for servicing expense for equipment sold to foreign purchasers prior to August 7, 1947, but still unused by purchasers at that date. 1959 U.S. Tax Ct. LEXIS 153">*173 The amount of $ 22,500 represents an ordinary and necessary business expense of Weatherford Co. incurred during 1947. The amount is deductible in computing the income of Weatherford Co. (and of Hall and Rhoda).

Gulf had been informed by Hall that a new company was being formed in Venezuela. By letter dated September 3, 1947, Weatherford Co., by Jesse, Jr., notified Gulf of the formation of Spring Co. and that Gulf's unfilled orders would be filled by Spring Co. rather than Weatherford Co. Later Weatherford Co., by Hall, stated that it had shipped some of the unfilled orders to itself in Venezuela and that the unfilled orders would be delivered from Venezuela. After considerable correspondence all of the unfilled orders were filled by Spring Co. Other foreign purchasers with unfilled orders were also notified that Spring Co. would fill their orders.

Elmer and Berry each were to draw a $ 1,000 per month salary from Spring Co. Elmer started drawing his salary about July 1947 but Berry did not begin drawing a salary until September 1947 when he terminated his employment with Shell Oil Co.

Spring Co. opened a bank account in Weatherford, Texas, on August 11, 1947. Elmer could sign1959 U.S. Tax Ct. LEXIS 153">*174 checks drawn on the account but they had to be countersigned and approved by Hall.

In September 1947, Hall hired Harriet Tucker, hereinafter referred to as Harriet, an old friend of the Hall family from Fort Worth who had some general business experience, to take care of the Spring Co. office in Weatherford. The office was set up in one room in the building where Hall's office was. She set up a book to reflect cash receipts and disbursements. Harriet was also authorized to sign checks on the Spring Co. bank account but they also had to be approved by Hall.

There was an asset account carried on Weatherford Co.'s books entitled "Weatherford Spring Company of Venezuela Cash." This account reflected the bank account of Spring Co. in the Weatherford, Texas, bank and was closed out on Hall's books on June 30, 1948.

In September 1947, Hall wrote Smith as follows:

32 T.C. 390">*400 This is to notify you that we are terminating the agreement entered into on the 1st day of January, 1946, wherein Weatherford Spring Company appointed Roland E. Smith Agent and Export Representative.

As your services are not satisfactory, the agreement shall terminate on 90 days following the receipt of this letter.

1959 U.S. Tax Ct. LEXIS 153">*175 Smith replied and requested the reasons why his services were unsatisfactory. Hall replied by letter dated October 9, 1947, stating, inter alia, that Smith had wholly failed to furnish men in the field to service Weatherford Co.'s equipment, that he failed to service the products himself, that Hall had to go to Venezuela in connection with servicing equipment at a cost of $ 17,000, that Hall had to send a technical engineer to Venezuela to service equipment for a period of 4 1/2 months at a cost of $ 9,000, and that the contract is instantly terminated rather than at the end of the 90-day period.

In the fall of 1947, Elmer and Berry came from Venezuela to Weatherford for about a month. Berry was given some special training in cementing on some oil wells in Texas. On October 9, 1947, a new agreement was entered into between Hall and Spring Co. which provided, inter alia, that:

(1) Hall agrees to appoint Spring Co. as representative and distributor for all foreign countries of all products manufactured by Weatherford Co.

(2) Hall agrees to supply Spring Co. with his equipment at manufacturing cost plus 10 per cent and Spring Co. agrees to maintain sufficient stock in its1959 U.S. Tax Ct. LEXIS 153">*176 warehouse.

(3) Hall shall furnish advertising and sales information and shall keep Spring Co. informed of technical changes.

(4) Spring Co. must furnish sufficiently skilled personnel to properly service equipment sold and either party may cancel on 30 days' notice.

(5) Hall agrees to refer to Spring Co. all inquiries from foreign countries which in Hall's opinion can be advantageously handled by Spring Co. but Spring Co. will inform Hall if an order results.

(6) Hall agrees to assign to Spring Co. all patent rights covering the countries in which Spring Co. represents Hall and Spring Co. agrees to protect those rights.

(7) Spring Co. agrees to bear the cost of servicing and installing Weatherford Co. equipment in any country in which it may operate.

While in the United States, Elmer and Berry sent out notices to the trade advising of the existence of Spring Co.

Prior to the formation of Spring Co. when a foreign order was received by Weatherford Co. a file was made on the purchase order. The bookkeeper would then prepare a shipping order, a copy of which was forwarded to the plant and they would start production of the 32 T.C. 390">*401 equipment ordered. When the equipment was produced1959 U.S. Tax Ct. LEXIS 153">*177 the customer would be advised the shipment was ready. If shipping instructions had not been received, they were requested. The equipment was then shipped to the purchaser as instructed. When the delivery tickets came back with the bills of lading, an invoice was made and forwarded to the purchaser. A copy of the invoice was retained in the account receivable binder until it was paid. After the formation of Spring Co., when a foreign order was received in Weatherford, it would be handed to the Spring Co. employee, who would then prepare a purchase order and submit it to Weatherford Co. Upon receipt of the purchase order the same procedure as outlined above would be followed by Weatherford Co., except the ultimate purchaser was invoiced by Spring Co. Weatherford Co. would crate the order for export and it would be shipped to the purchaser. The employee of Spring Co. was furnished a list of the prices by Weatherford Co. reflecting the prices she was to show on invoices from Spring Co. to the foreign purchaser and the prices to show on purchase orders placed with Weatherford Co.

Spring Co. had no books in Venezuela during the years 1947 and 1948. Jack Etter, who became Weatherford1959 U.S. Tax Ct. LEXIS 153">*178 Co.'s office manager in 1948, went to Venezuela to set up books for Spring Co. in 1948. He was, however, forced to return to the United States prior to the completion of his task due to a revolution.

Spring Co., by Elmer, filed a statement dated March 2, 1948, with the Venezuelan income tax authorities in lieu of an income tax return stating, inter alia, that Spring Co.:

has had no profits or benefits of any kind from its formation date up to December 31, 1947.

I must add that this Company is still in its formation period and that up to now has only had expenses incurred in due to the investments in this country.

Prior to the August 7, 1947, cutoff date Weatherford Co. was selling Hall's products to the foreign trade at the prices shown below, less 5 per cent export discount and plus a 2 1/2 per cent boxing charge. Subsequent to this cutoff date the same merchandise was being billed to the purchasers by Spring Co. from its Weatherford office at the prices previously used by Hall in his sales to foreign customers.

The following schedule, which is representative of the entire line, shows the prices charged foreign purchasers by Weatherford Co. prior to the cutoff date. The 1959 U.S. Tax Ct. LEXIS 153">*179 same prices were charged foreign customers by Spring Co. after the cutoff date. The schedule also shows the prices charged Spring Co. by Weatherford Co. after the cutoff date. 32 T.C. 390">*402

1959 U.S. Tax Ct. LEXIS 153">*180 As stated previously, Weatherford Co. offered free service on all of its sales where the purchasers felt they needed it. However, written instruction regarding its use was included with the orders.

According to the 1947 catalog of Weatherford Co. its manufactured products were guaranteed against defects in materials and workmanship. While recommending the presence of a Weatherford Co. man on the first few jobs, the catalog, on page 6, under the heading "Terms and Conditions of Sale," states:

All quotations and sales are F.O.B. Weatherford, Texas, unless otherwise expressly stipulated. Our responsibility ceases upon delivery of bill of lading or dock receipt, invoice and supplementary documents to the customer or his agent, or upon delivery of the shipment to any common carrier.

During the years 1947 and 1948, quantities of Weatherford Co. equipment were sold and delivered to purchasers for use in Peru, Denmark, the Persian Gulf, Kuwait, Arabia, and Canada. During these years neither Weatherford Co. nor Spring Co. had representatives or servicemen in any of these locations with the exception of Kuwait. Hall's son, George, who worked for Weatherford Co., went to Kuwait for about1959 U.S. Tax Ct. LEXIS 153">*181 2 months in 1948 to service and sell equipment.

During the period here involved Elmer and Berry kept in frequent touch with Hall, exchanging technical information and clearing all business matters with him.

By letter dated December 11, 1947, in reply to a question as to the acceptability of payment for merchandise in pounds rather than dollars, Hall directed Elmer and Berry that he would advise them further after investigation as to whether or not "we could use the pounds, but if accepted, it will have to be taken on the financial ratio of a dollar value. * * * Whatever payment received, it must be equivalent to the American dollar; I will accept some Venezuelan money." Hall also instructed Elmer to buy certain property which Hall wanted, but instructed him to wait until payment was received from a Mene Grande order before making full payment for the property.

32 T.C. 390">*403 By letter dated June 9, 1948, Elmer wrote to his father stating that he had given a $ 1,000 check to a church in Caracas. Elmer stated: "If you don't think the contribution worthwhile, charge it to my personal account." In addition, he requested of his father "if possible please give me permission to build a house1959 U.S. Tax Ct. LEXIS 153">*182 at Anaco immediately as I am sick and tired of living in these co. camps." In this letter Elmer indicated that he was very busy in his area of Venezuela and suggested that his father put somebody, preferably his other brother, in charge of foreign operations so that he could cover the field and coordinate the operation.

In February 1948 Hall went to Venezuela. While there he told Elmer and Berry that he planned to sell Weatherford Co. to a new corporation in which his sons were interested. He also discussed the possibility of forming a second Venezuelan corporation to handle part of Spring Co.'s business so as to limit the liability under local law. Under this new setup the Venezuelan corporations were to loan money to the new corporation which was to buy the Weatherford Co. assets.

On June 18, 1948, the Midway Developing Co., hereinafter referred to as Midway Co., was chartered as a Puerto Rican corporation and was organized by Hall for selling Weatherford Co. to his sons. A memorandum inserted in the stock book by the incorporators stated that the 10 shares outstanding were beneficially and actually owned as follows:

1959 U.S. Tax Ct. LEXIS 153">*183 On September 14, 1948, 8 shares standing in the name of Walter L. Newsom, Jr., were converted into 1 share in his name and the other 7 shares into the name of Jesse, Jr. Of the total of 8 shares then so held in the name of Jesse, Jr., for directorship purposes only, 1 of such shares was considered as though issued to Etter and 1 as though issued to George. On September 24, 1948, a certificate for 79 newly subscribed shares was issued to Hall Development Company of Venezuela, C.A., hereinafter referred to as Hall Co., and a certificate for 1 newly subscribed share was issued to Elmer. No other changes or transfers of stock were reflected between September 24, 1948, and December 31, 1948.

On August 5, 1948, Hall Co. was incorporated in Venezuela to hold the licensing rights that Spring Co. had in the Weatherford Co. products in foreign countries and to own the warehouses for the Spring Co. inventories.

32 T.C. 390">*404 Around the middle of September 1948, Hall transferred the assets of Weatherford Co. to Midway Co. at Weatherford Co.'s book value (cost less depreciation). To effectuate the transfer the following checks were given:

1959 U.S. Tax Ct. LEXIS 153">*184 The checks totaling $ 520,450 from Midway to Hall were for the purchase price of Weatherford Co. The purchase price was based on Weatherford Co.'s book value (cost less depreciation).

Midway Co. was supposed to take over Weatherford Co.'s business immediately; however, it was unable to qualify to do business in Texas. On December 15, 1948, a new corporation was formed to take over the Weatherford Co. business. In the interim from the sale date in September to December 15, 1948, Hall continued to operate the factory properties in Weatherford and continued to handle all domestic sales as his own. On the advice of his bookkeeper and office manager, he reported on his income tax return all domestic sales and expenses as his own during that period.

After the purchase of Weatherford Co.'s assets, Midway Co. did make and record foreign sales to Spring Co. on the same basis (manufacturing cost plus 10 per cent) as Weatherford Co. had done previously. Midway Co. filed in 1950 a tax return in Puerto Rico for the short period in 1948 but, before its books could be established in proper form, all of its basic business records, i.e., invoices, canceled 32 T.C. 390">*405 checks, etc., were destroyed1959 U.S. Tax Ct. LEXIS 153">*185 by fire at Weatherford in the office of a certified public accountant who prepared the 1948 Puerto Rican return and who was to establish a set of books for Midway Co.

The books of Weatherford Co. show its sales to be as follows:

The above listed foreign sales include sales by Weatherford Co. to Spring Co. directly and through Midway Co. at manufacturing cost plus 10 per cent.

The respondent, in his notices of deficiency, added to petitioners' income the amounts of $ 278,124.96 and $ 768,779.56 for the years 1947 and 1948, respectively. The adjustment for 1947 is explained as follows:

(b) Under Section 45 of the 1939 Internal Revenue Code, income purportedly earned by Weatherford Spring Company of Venezuela, in the year 1947 subsequent to the period covered in adjustment (a) above, is allocated to you. Computation of the $ 278,124.96 adjustment follows:

1959 U.S. Tax Ct. LEXIS 153">*186 The adjustment for 1948 is explained as follows:

(a) Under Section 45 of the 1939 Internal Revenue Code, income purportedly earned by Weatherford Spring Company of Venezuela and Midway Developing Company during the year 1948 are allocated to you. Computation of the $ 768,779.56 adjustment follows:

In determining the above amounts to be allocated to Hall, the respondent took each item of equipment sold by Weatherford Co. to Spring Co. and Midway Co. and applied the catalog price. From 32 T.C. 390">*406 the amount so determined he deducted "cost plus 10%" which represents the "amount reported" as sales proceeds on these sales by Weatherford Co. and also deducted 20 per cent of the catalog price to represent the selling and servicing expense in connection with the sale to the ultimate purchaser.

Hall owned or controlled, directly or indirectly, 1959 U.S. Tax Ct. LEXIS 153">*187 Weatherford Co. and Spring Co. during 1947 and 1948. The allocations of the Commissioner as contained in his notices of deficiency are necessary to clearly reflect the income of Hall for 1947 and 1948.

No part of the deficiencies for either of the years 1947 and 1948 in Docket Nos. 62186 and 62188 is due to fraud with intent to evade tax.

OPINION.

The questions involved herein are: (1) Whether petitioner is entitled to a deduction of $ 316,784.38 as an ordinary and necessary business expense incurred in 1947, and (2) whether the Commissioner properly allocated to petitioner under section 45 the amounts of $ 278,124.96 and $ 768,779.56 for the years 1947 and 1948, respectively. There is also a question of fraud but that will be discussed last.

The facts relating to the first two questions are somewhat similar and will be set out to the extent necessary to an understanding of the issues. Hall, who spent most of his life connected with the water and oil well drilling industry, developed and manufactured certain equipment, viz, spiral centralizers and scratchers, designed to facilitate the cementing of oil wells. In 1946, after a few years of slowly but steadily increasing sales, 1959 U.S. Tax Ct. LEXIS 153">*188 he was able to prove the worth of his products and methods to Gulf by successfully cementing a number of difficult wells in Louisiana. In that year his sales of about $ 230,000 more than doubled his 1945 sales. In 1947, Gulf invited him to Venezuela to try his products there. Again his products and methods were successful on some difficult wells. Mene Grande, Gulf's subsidiary in Venezuela, placed orders for his equipment amounting to over $ 500,000.

Although not required to do so by the terms of his sales, Hall offered free service to purchasers. He sent instructions regarding the proper use of the equipment along with all orders, but he recommended having one of his men present the first few times the equipment was used. His equipment and methods were not generally accepted so it was advantageous and sometimes necessary to have his men instruct in its proper usage.

Faced with large Venezuelan orders, Hall had to return to the United States. However, to have a service and sales representative in Venezuela, he induced his son Elmer to leave his job with an oil company in April 1947 to come to Venezuela to take over.

32 T.C. 390">*407 Hall and Elmer considered setting up a permanent 1959 U.S. Tax Ct. LEXIS 153">*189 organization in Venezuela but delayed any action. In June 1947, serious cementing troubles brought Hall back to Venezuela. At that time he decided to form a Venezuelan corporation and also to secure help for Elmer. Berry, an experienced driller, who had just resigned his position with Shell Oil Co. in Venezuela, was contacted and offered a job. Berry was interested in Hall's products but wanted to go into business on his own. After negotiations, Spring Co., a Venezuelan corporation, was formed with Elmer as president and Berry as vice president. Hall contributed the original capital of about $ 8,000 and 248 of the 250 shares were transferred from the original incorporators to him. Elmer and Berry each had 1 share in his name. The 248 shares thus transferred to Hall remained in his name until February 16, 1948. Thereafter, 247 shares remained in Hall's name until August 16, 1948.

An agreement was entered into providing that Spring Co. would handle all foreign sales of Hall and that Hall would sell his products to Spring Co. at "cost plus 10%." However, "cost plus 10%" under Hall's computation was less than 10 per cent of Hall's list price. On the other hand, Hall usually only1959 U.S. Tax Ct. LEXIS 153">*190 gave a maximum of 20 per cent of list price for other parties who did selling and servicing for him.

On all foreign sales made by Hall prior to August 7, 1947, Hall made a calculation that he owed Spring Co. the sales price less "cost plus 10%" on the theory that this was a reimbursement to Spring Co. for servicing this equipment. All unfilled foreign orders at August 7, 1947, and all foreign orders after that date were treated as handled by Spring Co. After the so-called "cutoff" date, Hall charged Spring Co. "cost plus 10%" and Spring Co. charged the ultimate purchaser at Hall's regular list price.

The first item in question is the amount which Hall determined that he owed Spring Co. as selling and servicing expense for all foreign sales made by him prior to August 7, 1947. This amounted to $ 316,784.38 and Hall deducted this amount as an ordinary and necessary business expense in 1947. The Commissioner has disallowed it in its entirety. He stated the reasons for this disallowance in his deficiency notice. Regarding this item, we agree with the respondent that it does not represent an ordinary and necessary business expense incurred in 1947 except in small part as hereinafter1959 U.S. Tax Ct. LEXIS 153">*191 set out. Although the petitioner argues that a liability in this amount was incurred as a result of an arm's-length transaction with an unrelated party, the record shows that this was a transaction between related parties and, therefore, must be closely scrutinized (see issue 2, infra). And under close scrutiny it is evident that the claimed deduction does not meet the requirements of section 23(a)(1)(A).

32 T.C. 390">*408 Although Spring Co. and Hall had a written agreement regarding their relationship, this item, which is substantial in amount, is not mentioned. Although the amount was recorded on Hall's books the amount was nowhere mentioned in any of Spring Co.'s records. We are not even convinced that either Elmer or Berry understood what this amount represented in 1947.

The total foreign sales from January 1, 1947, to August 7, 1947, of $ 342,302.79 had already been made by Hall; therefore, no portion of this amount can be considered a selling expense. About $ 42,000 of these sales was made to purchasers in which Spring Co. did not have any personnel or servicing facilities. Of the remaining sales of about $ 300,000 to purchasers in Venezuela, the record indicates a substantial1959 U.S. Tax Ct. LEXIS 153">*192 portion of the equipment thus sold had already been delivered and used prior to August 7, 1947, and, therefore, did not need any servicing.

Under these circumstances and other circumstances shown in the record, the $ 316,784.38 which, in our opinion is clearly unreasonable in amount, represented neither an ordinary nor a necessary business expense accrual in 1947, except as to a comparatively small part thereof. It does appear that some portion of this amount should be allowed as a deduction to cover the cost of servicing some of the equipment which would require servicing in Venezuela. This amount should be based on the amount of equipment sold in Venezuela prior to August 7, 1947, which was still unused at that time. Since we do not know with exactness the amount of unused equipment at that time, we have used our best judgment and have made an estimate. After a careful consideration of the evidence, we have computed the proper accrual which petitioner should be allowed for servicing the unused equipment, as follows:

1959 U.S. Tax Ct. LEXIS 153">*193 The amount of $ 22,500 represents an ordinary and necessary business expense incurred in Hall's business during 1947. Cf. Cohan v. Commissioner, 39 F.2d 540 (C.A. 2, 1930). Accordingly, that amount is deductible in 1947 in lieu of the claimed amount of $ 316,784.38.

Regarding the second issue, i.e., the sales after August 7, 1947, the Commissioner determined that the full list price on all items sold by Weatherford Co. to Spring Co., less 20 per cent for selling and 32 T.C. 390">*409 servicing, should be treated as Hall's income. From this amount the Commissioner deducted the amount reported by Hall on these sales, i.e., cost plus 10 per cent. The question here is whether the Commissioner acted properly under section 45 which provides:

SEC. 45. ALLOCATION OF INCOME AND DEDUCTIONS.

In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Commissioner is authorized to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among1959 U.S. Tax Ct. LEXIS 153">*194 such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

The petitioner argues that his sole proprietorship, Weatherford Co. and Spring Co. were not owned or controlled directly or indirectly by the same interests, i.e., Hall argues that he had no interest in Spring Co. and that it was an altogether independent business corporation.

On the question of ownership practically all of Spring Co.'s shares were held in Hall's name from the time it was organized in July 1947 until August 1948, when the shares were transferred to his son Elmer's name. Petitioner argues that despite the record ownership the shares of Spring Co. were at all times relevant owned by Berry and Elmer equally, and that this division of ownership was the result of arm's-length negotiations involving Hall, Elmer, and Berry immediately prior to the formation of Spring Co.

We do not doubt that Berry had some interest in Spring Co. in addition to a straight salary arrangement but on the record here we have been unable to find that1959 U.S. Tax Ct. LEXIS 153">*195 Berry owned one-half of the Spring Co. stock. In addition to the record ownership of the stock Hall contributed the entire paid-in capital of Spring Co. The so-called agreement purportedly giving Berry one-half of the Spring Co. stock was not embodied in writing despite the "arm's-length" negotiations preceding it and despite the fact that the contract between Hall and Spring Co. was in writing. Considering all the evidence in the record, we have been unable to find that during the taxable years the stock of Spring Co. was owned one-half by Elmer and one-half by Berry. However, regardless of the question of the ownership of the Spring Co. stock, we think the record is abundantly clear that Hall controlled Spring Co. during the taxable years. Section 29.45-1 of Regulations 111 provides:

Sec. 29.45-1. Determination of the Taxable Net Income of a Controlled Taxpayer. -- (a) Definitions. -- * * *

* * * *

(3) The term "controlled" includes any kind of control, direct or indirect, whether legally enforceable, and however exercisable or exercised. It is the 32 T.C. 390">*410 reality of the control which is decisive, not its form or the mode of its exercise. A presumption of 1959 U.S. Tax Ct. LEXIS 153">*196 control arises if income or deductions have been arbitrarily shifted.

In this case it seems to us that the evidence shows that gross income has been arbitrarily shifted from Hall personally to Spring Co. Hall usually paid a 20 per cent commission to unrelated third parties for both selling and servicing. Cf. Asiatic Petroleum Co. (Delaware) Ltd., 31 B.T.A. 1152">31 B.T.A. 1152 (1935), affd. (C.A. 2, 1935) 79 F.2d 234, certiorari denied 296 U.S. 645">296 U.S. 645 (1935). The "cost plus 10%" contract with Spring Co. resulted in effect in a commission of over 90 per cent to Spring Co. for both selling and servicing. Furthermore, Spring Co. did not have selling or servicing facilities in any foreign countries except Venezuela. The fact that George, one of Hall's sons, went to Kuwait in 1948 to service equipment only shows that Hall regarded the whole operation as his because George worked for Hall rather than Spring Co.

In addition to the arbitrary shifting of income, the record is replete with instances of Hall's completely controlling and dominating Spring Co. The cash in the bank account of Spring Co. in Weatherford, 1959 U.S. Tax Ct. LEXIS 153">*197 Texas, in which most of the proceeds of Spring Co.'s sales were deposited, was available and was used by Hall. Berry was not even authorized to draw on the account and all checks had to be authorized by Hall. The many letters in the record that passed between the parties during the time in question clearly indicate to us that Hall was in complete control of Spring Co.

We think it clear from all the facts and circumstances that Hall owned or controlled directly or indirectly Spring Co. within the meaning of section 45. And the Commissioner, who has considerable discretion under that section, see National Securities Corp. v. Commissioner, 137 F.2d 600, affirming 46 B.T.A. 562">46 B.T.A. 562, certiorari denied 320 U.S. 794">320 U.S. 794, acted properly so as to clearly reflect the income of Hall and Spring Co. Indeed, the record indicates that the allocation reflects Hall's income as if he had been dealing with unrelated third parties. That, of course, is the purpose of the statute. Cf. Asiatic Petroleum Co. (31 B.T.A. 1152">Delaware) Ltd., supra.Accordingly, we uphold the determination of the 1959 U.S. Tax Ct. LEXIS 153">*198 Commissioner under section 45 for the years 1947 and 1948.

The final question is whether any part of the deficiencies is due to fraud with intent to evade tax. On this issue the burden of proof is upon the Commissioner, section 1112. Respondent has not introduced any direct evidence showing a fraudulent intent. Fraud, however, is rarely proved by direct evidence. It is usually inferred from circumstances. But, as has been held in many cases including some of the Supreme Court, the circumstances upon which a finding of fraud can be based must be both clear and convincing.

32 T.C. 390">*411 Here, the circumstantial evidence upon which the Commissioner relies, in our judgment, neither clearly nor convincingly indicates fraud. Clearly nothing fraudulent can be inferred from the formation of the Spring Co. in Venezuela; it is not unusual for an American company to have a foreign entity handle foreign business. For example, in the instant case we have the fact brought to our attention that Gulf, a well-known United States corporation, operated in Venezuela through a subsidiary, Mene Grande Oil Company. And although the contract between Hall and Spring Co. was not at arm's length, as we have1959 U.S. Tax Ct. LEXIS 153">*199 endeavored to point out, and did not result in a clear reflection of income, there is no indication that Hall was willfully attempting to evade, rather than avoid, taxes. On the contrary, the record convinces us that he reported what he thought was legally due. The fact that it turns out that we have held that the Commissioner has properly applied section 45 in the instant case does not mean that we think the Commissioner has established fraud. As already stated, we think he has not done so. Accordingly, we think that no part of Hall's deficiency was due to fraud with intent to evade tax and we have so found. The Commissioner's addition to tax under section 293(b) is not sustained.

Decision will be entered under Rule 50.