
    381 F. 2d 389
    GRANT OIL TOOL COMPANY v. THE UNITED STATES
    [No. 35-64.
    Decided July 20, 1967]
    
      
      Stuart T. Peeler, for plaintiff. David W. Richmond, attorney of record. Joseph, D. Peeler, Richard A. Gadbois and Musicle, Peeler and Garrett, of counsel.
    
      Philip R. Miller, with whom was Assistant Attorney General Mitchell Rogovin, for defendant. E. Alan Moorehouse, of counsel.
    Before Cowen, Chief Judge, Laramore, Dureee, Davis, Collins, Skelton, and Nichols, Judges.
    
   Nichols, Judge,

delivered the opinion of the court:

This is a suit for refund of corporation income tax deficiencies and interest assessed by defendant and paid by plaintiff for the calendar years 1956,1957, and 1958, in the amount of $56,810.01, plus interest as provided by law. Claims for refund were timely filed and denied, and the same basis for recovery was asserted therein as alleged in this timely action. Determination of the amount of recovery, if any, is reserved for further proceedings.

Plaintiff is a California corporation, with principal place of business at Los Angeles, engaged in the business of manufacturing, renting, and selling of specialized oil well drilling tools to oil well drillers. The tools consist of bodies which have a useful life of several years and may be used in the drilling of many wells, and attachable parts which are attached to the bodies and generally wear out in the drilling of one well. In the course of drilling, plaintiff’s tools were sometimes irretrievably lost in the drill holes, or damaged beyond repair by negligence of the driller, or permanently misplaced by the driller, in which event the driller was required to make an agreed payment to plaintiff for the tool bodies. The question presented is whether on these contractual payments for the loss of the 'bodies of these tools, plaintiff was entitled to capital gains treatment pursuant to § 1231 of the Internal Revenue Code of 1954, 26 U.S.C. 1231 (1964) , or whether the gain realized therefrom was ordinary income as determined by the Commissioner of Internal Revenue.

Section 1231 provides for long-term capital gains treatment of gains from the compulsory or involuntary conversion (as a result of destruction in whole or in part) of property subject to an allowance for depreciation which has been bold by the taxpayer for more than 6 months and which has been used in taxpayer’s trade or business. However, the property cannot be inventory or property held primarily for sale in the ordinary course of taxpayer’s trade or business.

Plaintiff manufactures its oil well drilling tools from raw steel of high quality at its plant in Los Angeles, California, with the use of gun drilling machines, milling machines and lathes. In the typical tool, the body is a precisely machined cylinder from 6 to 11 inches in diameter, from 5 to 8 feet in length, weighing 800 pounds, with the overall cost averaging $1 per pound. Pockets or depressions are cut into the exterior of the body to accommodate attachable parts consisting of cutter blades, pins, bushings, and lock plates, weighing 40 to 50 pounds, with an overall cost of about $75. Plaintiff manufactures the cutters, but purchases the other parts. These parts are not interchangeable with those manufactured by any competitor. However, .the parts and body are designed to be used as a single tool, and neither the parts nor the body can be used without the other.

Plaintiff’s tools perform special functions in rotary well drilling. In such drilling, the drill bit is at the end of a series of pipe lengths known as the drill stem. As the stem is rotated from above, the bit loses its gauge, and the drill hole is reduced in diameter. Plaintiff’s tool is attached between two lengths of pipe in the drill stem above the bit, and the attached cutters ream the hole to a larger diameter than provided by the bit. Plaintiff’s tools are also placed at varying distances above the bit to stabilize the drill stem and maintain straight drilling.

Plaintiff’s tool bodies have a useful life which varies from 6 months to several years, depending on the type of body, the circumstances of its use, and frequency of use. The average useful life of the bodies is from 2 to 5 years. The attachable parts wear out regularly and usually are replaced several times in one drilling operation. The principal causes of body wear are: (1) The force of drilling fluid pumped into the drill stem under high pressure, and (2) necessary shortening by plaintiff of a tool body to provide joints and thread thereon to match those of a particular drill stem, with repeated rethreading resulting in the body being too short to be used.

In the course of rotary oil well drilling, the drill stem sometimes breaks, leaving a portion of the drill stem with specialized tools like those of plaintiff at the bottom of the hole. Depending upon the economics of the situation, the drilling contractor either abandons the hole, attempts to retrieve the severed portion of the drill stem by use of specialized tools in a fishing operation, or engages in whipstocking, that is, plugs the hole to the point of break and drills around and permanently abandons the severed portion of the drill stem and its attached tools. All decisions and all actions taken in the case of a severed drill stem with plaintiff’s tools attached are those of the driller, and plaintiff has no voice or control over the retrieval or abandonment of its tools. To the driller, the agreed value of plaintiff’s tool is usually of little consequence compared to the cost of the rest of the drilling operation.

Plaintiff maintains branch offices in oil producing areas of the United States and Canada. It faces heavy competition in its business, and normally its employees are competing with representatives of from 6 to 18 competitors to secure the use of its tools by a driller. Drilling contractors consider the quality and adaptability of a given tool to the particular job, the price to be charged for its use, and the services to be rendered by the supplying company.

Plaintiff makes infrequent domestic sales (United States and Canada) of its tool bodies and attachable parts, and some foreign sales. The tools sold, both foreign and domestic, are specially manufactured by plaintiff to conform to the specifications of the purchasers after receipt of orders, and are not supplied from any stocks maintained by plaintiff. None of the tools used by plaintiff in its domestic rental business was ever sold foreign or domestic.

While plaintiff’s tool bodies on hand rose from 1,869 to 2,900 during the 3 years in issue, and while plaintiff manufactured an average of 651 of such bodies per year during that period, plaintiff made domestic sales only at the yearly average of 9, and foreign sales averaging 100 annually.

During the years in issue, plaintiff’s gross receipts from the tool bodies and parts were $6,827,833.50. Of this sum, 23.30 percent, or $1,584,285.62, were receipts derived from the tool bodies, as follows:

Tools-lost-in-bole charges- $252,310.44
Body rental charges- 1,114,694.17
Sales of tool bodies:
Foreign_ 192,139.91
(Domestic_ 25,141.10
Total_ 1,584,285.62

The tools-lost-in-hole charges were thus 15.98 percent of the total tool body receipts, and 3.70 percent of plaintiff’s total receipts on both the tool bodies and parts.

Plaintiff maintained no inventory of tool bodies at its principal place of business in Los Angeles, but did keep on hand there a supply of parts. The solicitation of rentals of tool bodies and parts by drilling contractors is done by plaintiff’s branch office employees in the field. Plaintiff supplies tool bodies and parts to its branch offices only on requisitions from branch managers who maintain a supply based on their best estimates of local rental demands. Plaintiff’s employees do not solicit sales because plaintiff desires to maintain strict quality standards in the use of its tools and because it can obtain more revenue from leasing its tools. Drillers in the domestic market do not seek to make purchases because it would be uneconomical for them to maintain a stock of tools of the various types and sizes needed in various drilling operations. Plaintiff’s practice of renting its tools and charging for their use in the domestic market is traditional and customary in the industry. No competitor employs a different arrangement. Renting is not practiced in the foreign market because overseas drilling operations are usually major projects carried on by large oil companies which standardize their operations to minimize the problem of long lines of supply, and foreign drillers prefer to purchase specialized tools which can be repeatedly used by them.

In the domestic market, the tool bodies remain the property of the plaintiff, except for the infrequent domestic sales above-mentioned, and plaintiff requires their return at the conclusion of their use. The drillers are charged for the tools according to a price list published by plaintiff, with a flat fee charged for each set of attachable parts used, and with the charge for the use of the body being on a per well, per day, or per month basis. Plaintiff’s employees pick up the bodies and parts from the driller after their use. The used parts are examined and some reused. The unusable parts are scrapped, as are any bodies which have become worn or excessively shortened. Neither the parts nor the bodies are paid for by the driller until they are used, and there is no charge unless there is use. The charges for the parts and bodies are segregated on the invoice presented to the driller. Due to competition in some areas, no charge is made for use of a body in about 10 to 15 percent of plaintiff’s transactions. A charge is always made for use of the parts.

If the driller is unable to return plaintiff’s tool bodies because they have been lost in the drill hole or because they have been misplaced or because they have been damaged beyond repair by negligence of the driller, plaintiff requires the driller to reimburse it for such tools in accordance with the following clause of plaintiff’s rental agreement:

Eental equipment remains the property of the Grant Oil Tool Company and shall be delivered to them on demand. If lost or damaged beyond repair, user will be charged at sale price of new equipment.

The driller is charged the amount set forth in plaintiff’s charge schedule for tools-lost-in-hole, which is the same as the selling price of new tool bodies sold in the foreign market. No adjustment is made for the age or condition of the tool body. No additional charge is made for parts not returned or damaged beyond repair.

In its accounting records and federal income tax returns, plaintiff treated as ordinary income, receipts from the use (per well, per day, or per month) of tool bodies, from the use of parts, from the sales foreign and domestic of bodies and parts, and from the scrap sales of bodies and parts. In such records and returns, plaintiff did not treat its tool bodies held for rental as inventory items but as depreciable property used in its trade or business, creating a separate asset and reserve account for each body, identified by serial number marking, and recovering its cost thereof through annual depreciation allowances.

Such treatment was never questioned by the Internal Eevenue Service on audit of plaintiff’s income tax returns for taxable years prior to 1956. Plaintiff’s estimates of the average useful lives of its tool bodies contemplated, that, on the average ’basis, such bodies would be used until they were worn out. These estimates were allowed by the Internal Revenue Service for depreciation purposes for the years in suit. Bach of the tool bodies concerned in the present action was held by plaintiff for more than 6 months prior to being lost in a drill hole, damaged beyond repair, or permanently misplaced by a driller. The number of tools damaged beyond repair and permanently misplaced is relatively insignificant compared to the amount lost in holes.

The recognized gains on the dispositions of such tool bodies exceeded plaintiff’s recognized losses during the years concerned from sales, exchanges, and involuntary conversions of property used in its trade or business, by the entire amount of such gains. To account for such bodies, plaintiff treated the excess of the payments received from the drillers for such losses over plaintiff’s adjusted basis in such bodies as long-term capital gains.

The hazardous nature of the oil well drilling business is such that it can be reasonably expected that some tools will be lost in the hole. Obviously, plaintiff’s chances of losing tools are increased the more they are employed, but not necessarily in proportion to the increase in the amount of footage drilled. Losses follow a random pattern. They seem to increase in relation to certain geographical areas, types of wells, and specific tools, but there is no way to predict how often, when, or at what depth tools will be lost. Plaintiff lost 95 tools in the hole in 1956,146 in 1957, and in the years 1958 through 1960, there was a successive decline in such losses from 141 to 120 to 102, even though plaintiff’s tools on hand steadily increased from 1,869 at the beginning of 1956 to 3,026 at the end of 1960.

The literal language of § 1231, so far as it is applicable herein, requires, as a prerequisite to capital gains treatment, that plaintiff’s tool bodies be used in its trade or business, that they be subject to the allowance for depreciation, that they be held for more than 6 months prior to their disposition by way of sale, exchange or involuntary conversion, and that they not be property of a kind which would properly be includable in the taxpayer’s inventory if on hand at the close of the taxable year or property that would be held by the taxpayer primarily for sale to its customers in the ordinary course of its trade or business. In addition, the basic condition of § 1231 for capital gains treatment is that the recognized gains on the qualifying dispositions of the property in question must exceed the recognized losses therefrom. In the instant case, all the prerequisites are met, and the taxpayer’s gain did exceed its losses, and by the entire amount of such gains.

The Government makes three arguments, any one of which it claims entitles it to prevail in this case. It asserts that the receipt of the lost-in-hole charges did not constitute a sale, exchange or involuntary conversion; that the tool bodies were property “of a kind” that would properly be includable in the inventory of Grant Oil; and, relying heavily on Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955), it contends that the Supreme Court has established two cardinal principles which are controlling in this case: (1) That legislative intent requires that the exceptions from ordinary income taxation be strictly construed, and (2) that where the receipts are not the kind of gain for which Congress intended preferential treatment, capital gains treatment must be denied even though the transaction qualified under the literal language of the capital gains provisions. We treat each argument in the order in which they are previously set forth.

First: The Government has found it difficult to visualize how Grant Oil concludes that the receipts attributable to its lost-in-hole charges represent the proceeds of an “involuntary conversion.” We think the definition of that term, as contained in § 1231(a), clearly covers this case.

A “compulsory or involuntary conversion” under § 1231 (a) requires a lawful or tortious taking of property used in the taxpayer’s trade or business. Walter A. Henshaw, 23 T.C. 176 (1954) (acq.); Guy L. Waggoner, 15 T.C. 496 (1950) (acq.). See Commissioner v. Gillette Motor Transport, Inc., 364 U.S. 130, 135 (1960); 3B Mertens, Law of Federal In come Taxation, § 22.125 (Malone Rev. 1966). However, by express provision it also includes “destruction in whole or in part” of said property. This need not be a physical annihilation, for “destruction” can also mean “rendering the thing useless for the purpose for which it was intended.” Walter A. Henshaw, supra, at 182. In the case at bar, when the taxpayer’s tool bodies are lost in the drill hole they are no longer of any use or value to the taxpayer or the drilling contractor. In an economic sense they have been totally destroyed and this complete and unwanted destruction of taxpayer’s tool bodies is clearly within the definition of “involuntary conversion” as set forth in § 1231 (a). Fishing Tools, Inc. v. Usry, 232 F. Supp. 400 (E.D. La. 1964); Walter A. Henshaw, supra.

In speaking of those cases where the treatment of gain from the sale or exchange of depreciable business property resulted in an undue hardship to the taxpayer, the House Ways and Means Committee, in reporting on what is now § 1231, used as examples, among others, the cases “where the proceeds of insurance on destroyed property exceed the cost of the property” and “gain or loss resulting from the involuntary conversion of property into other property or money * * H.R. No. 2333, 77th Cong., 1st Sess., pp. 53-54 (1942-2 C.B. 372,415). In the case at bar the destruction of plaintiff’s tool bodies, in addition to being an involuntary conversion, is in a way analogous to an insured casualty loss. Had plaintiff insured its bodies for their replacement cost, upon the destruction thereof it would have received approximately the lost-in-hole charge it actually levied, as that charge was meant to provide the funds needed to replace the lost body. Here, instead of contracting with a private insurer, plaintiff, through the levy of the lost-in-hole charge, had the drilling contractors substitute for an insurer of its bodies.

We note that the losses of tool bodies in holes are occurrences that are remunerative to plaintiff, to the extent that the charge for such losses is the same as the selling price of similar new bodies sold in the foreign market, while more often than not, the lost bodies have been fully or partially depreciated on tbe plaintiff’s books. Though, plaintiff stands to profit by this arrangement, it “profits” only in the sense that it receives money it would not otherwise get. Testimony at the trial showed that most, if not all, of the lost-in-hole charge is used to cover the cost of producing a new tool body and the general and administrative expenses of Grant Oil connected with such production. See Fishing Tools, Inc., supra, at 402. However, this procedure was adopted by plaintiff to assure that drilling contractors would take every precaution to avoid abandonment of the tool bodies unless recovery thereof would, from the contractor’s viewpoint, be economically unfeasible. All decisions with respect to the course of action to be taken in case of a break in the drill stem (in which the tool body is contained) are made by the drilling contractor, and plaintiff has no voice in the matter. The decision as to whether to “fish” for the body, to abandon the hole, or to whipstock (plug the drill hole up to the point of the break in the stem and drill around the severed portion) is made by the driller based on the economics of each course of action. The fact that plaintiff’s tool is lost is of little consequence to the driller. The tool is of inconsequential value compared to the other costs of the driller’s operation. The procedure adopted by plaintiff is all that it could do to avoid the method of disposition in question.

The Government argues that the decision in Nehi Beverage Co., 16 T.C. 1114 (1951), precludes a finding of an involuntary conversion in this case. There a soft drink bottler and distributor, when the deposits on bottles exceeded the number of bottles in the hands of its retailers, transferred the surplus of deposits from a liability to an income account. The Tax Court held that the failure of the taxpayer’s retail dealers to return the bottles did not entitle the bottler to capital gains treatment on the deposits. The Tax Court said (at p. 1124) there was no involuntary conversion because Nehi Beverage, voluntarily, through the unilateral action of its board of directors, made the accounting entry to transfer the funds. We note that this transfer was done at an arbitrary time when the taxpayer was unable to tell whether the bottles had actually been, destroyed or were still in existence. Without commenting on the merits of the Tax Court’s approach to the facts before it, in the instant case Grant Oil’s action — the levy of the lost-in-hole charge — is taken only when the economic nonexistence of the tool bodies is a certainty; there is no arbitrariness about the time of its action.

Our decision in Philadelphia Quartz Co. v. United States, 179 Ct. Cl. 191, 374 F. 2d 512 (1967), establishes that a conversion does not lose its involuntary character because the owner of the property in question yields possession of it to bailees who he knows will fail to return his property in some instances. There, as is true here, the owner retained title and assessed loss charges sufficient to deter any attempt to purchase the property de facto through the simple means of omitting the return of it.

Second: § 1231(b) (1) (A) excludes from capital gains treatment, even though it is depreciable business property used in the taxpayer’s trade or business, “property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year.” The question here is whether Grant Oil’s tool bodies, which are produced by it in quantity as the end product of its manufacturing cycle, fall within that exclusionary language. The test to be applied in answering this question is not whether the property is included in inventory by the taxpayer but whether the property is “properly includible” in “the inventory.” Mary Alice Browning, 9 CCH Tax Ct. Mem. 1061, 1066 (1950). However, before we can apply this test we must know what “the inventory” of Grant Oil is. (Emphasis supplied.)

Inventory is, in its present context, simply stated, property that is held for sale. See Forrester v. Americas Oil Co., 66 Ga. App. 743, 745, 19 S.E. 2d 328, 330 (1942); MacFarland, Ayars & Stone, Accounting Fundamentals 200 (3d ed. 1957); 3 CCH 1967 Stand. Fed. Tax Eep. paragraph 2936.017; 2 P-H 1967 Fed. Tax Serv. paragraph 6550. The Treasury Regulations recognize this, for in defining “gross income” they focus their attention upon the cost of goods sold computation, in which the use of inventories is an integral part. By subtracting the cost of goods sold from gross sales the taxpayer arrives at its gross profits from sales. Thus, the use of inventories helps to determine sales income.

Of course, the definition of inventory to mean only property held for sale may not apply in another context. It may also mean, in appropriate context, “a list or schedule of property, containing a designation or description of each specific article.” Black, Law Dictionary (4th ed. 1951). However, we think this definition refers to the inventory a business would keep of its stamps or stationery supplies or that which an individual would keep of the books in his personal library. To be consistent with the scope and purpose of § 1231, “the inventory” it excludes must be that from which the taxpayer gets his normal sales profits. We are concerned in this case with Grant Oil’s domestic operations. In that sphere, excluding its sale of tool bodies when a contractor so demands, it does not solicit sales of bodies, it only rents them.

The tool bodies held for rental would be “properly includible” in the taxpayer’s financial statement under the heading “property, plant and equipment,” not in “inventory”: finished goods, work in process and raw materials. The rental tool bodies are not held for sale. They are relatively long-lived capital investments used in Grant Oil’s tool body rental and parts furnishing business. Even if Grant Oil were to have an inventory of its tool bodies held for sale, tool bodies held for rental would not be “properly includible” therein. Merchandise, to be “properly includible” in “the inventory” that § 1231 excludes, must be held for sale at a profit. Francisco Sugar Co. v. Commissioner, 47 F. 2d 555 (C.A. 2d, 1931).

Without specific discussion of the inventory question, it has been held that a taxpayer holding an item for retail sale as an everyday part of its operation may nse that same item in its business and, if that use is bona fide, the item will not be said to be primarily held for sale (a contention the Government does not make in this case) or properly includible in inventory. Lynch-Davidson Motors, Inc. v. Tomlinson, 172 F. Supp. 101 (S.D. Fla., 1958); Latimer-Looney Chevrolet, Inc., 19 T.C. 120 (1952) (Acq.); McCullough Transfer Co., 27 T.C. 822 (1957) (Nonacq.). We note that in none of these cases did the taxpayer itself produce the property in question. However, the important question, as our discussion of the Government’s third contention will illustrate, is not who produced the property but for what purpose was the property held ? In any event, the Internal Eevenue Service recognizes, as did Government counsel in oral argument, that a taxpayer can be the manufacturer of its own § 1231 assets. See Eev. Eul. 55-706,1955-2 C.B. 300; Eev. Eul. 62-141,1962-2 C.B. 182, superseding Eev. Eul. 55-706, as the latter applies to sales made before August 27,1962.

In the analogous area of auto sales dealers who take cars that would otherwise be held for sale by them and use them in their business as “company” cars, see, e.g., Lynch-Davidson Motors, Inc. and Latimer-Looney Chevrolet, Inc., supra, the Internal Eevenue Service has ruled that to overcome the presumption that all vehicles he acquires are held as stock in trade primarily for sale, the auto dealer must show that the vehicle in question was expressly acquired for, and actually devoted to, use in the dealer’s business (other than for “demonstration” purposes) and that he looles to normal depreciation in the ordinary course of operations to recover his cost (and not to the sales of the cars for the recovery of most or substantially all of his investment therein). Eev. Eul. 60-15, 1,960-1 C.B. 22, amplifying Eev. Eul. 54 — 222, 1954-1 C.B. 19. In the case at bar, Grant Oil created a separate asset and reserve account for each rental body used in its business, identified it by serial number marking, and recovered its cost through annual depreciation allowances. (Emphasis supplied).

Therefore, in accordance with the preceding discussion, the lost-in-hole charges derived from the involuntary conversions of rental tool bodies are not denied capital gains treatment by § 1231(b) (1) (A) or any other part of § 1231.

Third: The Government’s final argument, that relating to the applicability of the Gorn Products, supra, doctrine to § 1231 assets, has come before us before. See, e.g., E. I. du Pont de Nemours & Co. v. United States, 153 Ct. Cl. 274, 288 F. 2d 904 (1961) and Philadelphia Quartz Co., supra. We continue to question whether Gorn Products has any proper impact on § 1231. In any event, our decision herein, in adherence to our interpretation of the Gorn Products doctrine as expounded in du Pont, supra, (at p. 283-84, 288 F. 2d at 909) and Philadelphia Quartz, supra (179 Ct. Cl. at 196, 374 F. 2d at 515), is that the Government is not entitled to prevail.

Even if we were to apply the Corn Products, sUpra, doctrine in the situation here involved, the taxpayer would still be entitled to § 1281 treatment on its lost-in-hole charges. While both parties agree the receipts from actual rentals and sales made by Grant Oil would be ordinary income, it does not follow that the receipts from the involuntary conversions of the tool bodies held for rental would likewise constitute ordinary income. The ultimate question in determining the nature of such receipts is the purpose for which the tool bodies were held. E. I. du Pont de Nemours & Co., supra, 153 Ct. Cl. at 283, 288 F. 2d at 909; Philber Equipment Corp. v. Commissioner, 237 F. 2d 129, 131 (C.A. 3d, 1956); Fields v. Granquist, 134 F. Supp. 624, 626 (D. Ore., 1955); McCullough Transfer Co., supra, at 832. And, the final disposition of the property will only be decisive if the taxpayer’s business is operated with the final gains from such disposition being a determining business purpose. Philber Equipment Corp., supra, at 131-32. Grant Oil’s normal business is the rental of tool bodies and the parts attachable thereto, with sales of bodies being made only in reluctant response to demand of domestic drillers or in response to special foreign orders. The involuntary conversions of the rental bodies are not integral to this business nor are they at the core of it. They are unwanted occurrences which Grant Oil does all it can to avoid.

The defendant has filed a number of exceptions to the findings as submitted by the commissioner. All are in the nature of requests for amplification and do not raise any question as to the accuracy of the findings made. The plaintiff objects to virtually all the changes proposed. None of them, separately or together, would if made lead to a different conclusion than the one we arrive at. Pursuant to Pule 66, we presume the commissioner’s findings are correct, and we are shown nothing to establish the contrary. Therefore, the commissioner’s findings are not modified as requested.

In conclusion, we hold that the income from the lost-in-hole charges is entitled to capital gains treatment under § 1231, and that plaintiff is, accordingly, entitled to recover and judgment is entered for plaintiff. The amount of recovery will be determined pursuant to Pule 47(c) of the Pules of this court.

FINDINGS OF FACT

The court, having considered the evidence, the report of Trial Commissioner Poald Hogenson, and the briefs and arguments of counsel, makes findings of fact as follows:

1. This case is based on defendant’s denial of plaintiff’s timely claims for refund of assessed federal income tax deficiencies and interest paid by plaintiff for the calendar years 1956, 1957, and 1958. The same basis for recovery was asserted in such claims as alleged in this timely action. The question presented is whether contractual payments to plaintiff by oil well drilling contractors for the loss or destruction of certain of plaintiff’s tool bodies resulted in long-term capital gains pursuant to § 1231 of the Internal Pevenue Code of 1954, 26 U.S.C. 1231 (1964), or were ordinary income as determined by the Internal Pevenue Service. In its brief to the trial commissioner, defendant has withdrawn its further defense stated in its First Amended Answer pertaining to depreciation deductions on tool bodies.

2. Plaintiff is a California corporation with its principal office and place of business in Los Angeles, California. During the years in question, plaintiff was engaged in the manufacture, rental, and sale of various specialized oil well tools and related items.

3. Plaintiff manufactures its oil well drilling tools at its plant in Los Angeles, California. These tools generally consist of bodies and attachable parts. In a typical tool, the body is a steel cylinder from 6 to 11 inches in diameter and from 5 to 8 feet in length. The body weighs approximately 800 pounds and is precisely machined from raw steel of high quality in plaintiff’s plant, with the overall cost averaging about $1 per pound. Pockets or depressions are cut into the exterior of the body to accommodate the attachable parts. These attachable parts consist of cutter blades, pins, bushings, and lock plates, weighing 40 to 50 pounds, with an overall cost of about $75. While such items as bolts, pins, and lock washers are purchased, plaintiff manufactures the cutters. The parts are made to fit a certain type and size of body manufactured by plaintiff, and they are generally not interchangeable with attachable parts manufactured by another manufacturer. Thus, the parts and body are designed to be used together as a single tool. Neither the parts nor the bodies are of any use without the other.

4. Plaintiff manufactures its tool bodies only to fill specific orders. Except for some export and infrequent domestic sales, such orders come from plaintiff’s branch managers whose supply of bodies is based upon their best estimates of local rental demands. The average lead time on a body order is 60 days. During an average day 90 percent of the work orders in process in plaintiff’s plant will relate to parts being manufactured, and only 10 percent will involve bodies. A number of different machines, including gun drilling machines, milling machines, and lathes which are a permanent part of plaintiff’s manufacturing equipment are used in the manufacture of the bodies. In accordance with market demands, plaintiff manufactures 13 basic types of bodies and within each category makes 2 or 3 subtypes. Bodies within each subtype have 15 different kinds of joints, 8 basic thread sizes, and a range in diameter between 4 inches and 20 inches. There is also a variation in the type of steel used.

5. Plaintiff’s tools perform certain specialized functions in rotary oil well drilling. In such drilling, the drill bit is at the end of a series of pipe lengths of varying sizes known as the drill stem. This drill stem is rotated from above to accomplish the drilling function. As the well is being drilled, the drilling bit wears and loses its gauge, thus forming a hole of reduced diameter. Plaintiff’s tools are attached between two lengths of pipe in the drill stem above the drill bit, and the attached cutters act on the side of the hole to ream the hole to a larger diameter. A new drilling bit can thus replace a worn-out bit and go directly to the bottom of the hole. Without plaintiff’s tools, drilling with the new drilling bit would have to begin at the point where the hole was reduced in diameter due to the dulled drilling bit. Plaintiff’s tools are also placed at varying distances above the drilling bit to stabilize the drill stem and thus keep the hole drilling straight.

6. Ordinarily, plaintiff’s tools are used only for certain portions of the drilling operation, although it might be necessary for the driller to have them on hand throughout the drilling operation. The drilling of an oil well may take from several weeks to over a year, depending on the depth and drilling conditions.

7. Plaintiff’s tool bodies have a useful life which varies from 6 months to several years, depending upon the type of body and use and frequency of use. The average useful life of the bodies is from 2 to 5 years, while the attachable parts wear out regularly from the contact with the side of the hole, and generally must be replaced several times during the course of one drilling operation. In many wells 60 to 70 sets of cutters will be worn out in one drilling operation while attached to 4 bodies. The bodies wear out in time from the force of the drilling fluid which is pumped down into the drill stem under high pressure. It is sometimes necessary for plaintiff to rethread the ends of a tool body to match the thread of a particular drill stem, and this results in the body being made somewhat shorter. Eepeated rethreading eventually makes the body too short to be used.

8. Plaintiff’s bodies and parts are distributed to oil well drillers through branch offices located in oil producing areas in the United States and Canada. These branch offices usually have a manager and two or three field men. These employees solicit business from oil well drilling contractors. After an order is placed, plaintiff must either find a body having joints which match the joints of the drilling string of the drill stem, or machine and rethread the available body. Drill stem joints are not standard in the oil well drilling industry. The body is then dressed with the necessary attachable parts. A typical order would be four bodies and eight sets of component parts. Plaintiff’s employees deliver the bodies and attachable parts needed to drill a particular well to the well site. The employees visit the well several times a day to see how many sets of attachable parts are used and how many more are needed.

9. Plaintiff is in heavy competition with otlier reamer service companies. Normally, plaintiff’s employees are competing with representatives of from 6 to 18 competitors to secure the business of a driller. Drillers are specialists who normally make the decision as to which or whose tool is to be used. These drillers normally decide whether or not to use a particular service company’s tools by utilizing the following factors: (1) The quality and adaptability of the tool to the job at hand; (2) the price for use of the tool; and (8) the actual service rendered by the reamer service company.

10. At all times prior to loss or damage beyond repair, the bodies remain the property of the plaintiff, and plaintiff requires their return at the conclusion of their use. The drillers are charged for the tools according to a price list published by the plaintiff. The drillers are charged a flat fee for each set of attachable parts used. They are charged for the use of the body on a per well, per day, or per month basis. Plaintiff’s employees pick up the bodies and the attachable parts from the driller after they are used. The used attachable parts are examined and some of them may be reused. The unusable parts are scrapped, as are the bodies when they have become worn or shortened to the extent that they are no longer usable. Neither the attachable parts nor the bodies are paid for by the driller until after they are used. The charge for the bodies and for the attachable parts is segregated on the invoice presented to the driller. No charge is made for tools not used. A per well, per day, or per month charge is not made for the body in 10 to 15 percent of the transactions due to competition in some areas. However, in most areas the charge for body use is made. A charge is always made for use of the attachable parts.

11. Plaintiff’s arrangement with respect to nse of and payment for its bodies is traditional and customary in the industry. No competitor employs a different arrangement. Drillers do not want to buy the bodies because it is the nature of their business that drilling requirements change frequently. It would be uneconomical to maintain a stock of tools of the various types and sizes that might be needed in various drilling operations, and oil well drilling contractors do not undertake to do so.

12. Occasionally, plaintiff sells its tools to domestic purchasers when such purchasers insist upon buying them. These tools are specially made to the purchaser’s specifications and plaintiff does not fill the order out of its rental stock. Plaintiff never solicits sales, and specifically directs its employees not to solicit sales. Plaintiff prefers not to make such sales because it desires to maintain strict quality standards in each operation of its tools and because it believes it will obtain more revenue from leasing the tools. A stock of bodies of different types and sizes is maintained at each branch office according to anticipated rental demand. A supply of parts is kept in Los Angeles, and at the branch offices.

13. In the course of oil well drilling, the drill stem sometimes breaks, leaving the portion of the drill stem below the break and the tools attached thereto at the bottom of the hole. When this happens, the driller must either attempt to retrieve the severed portion of the drill stem by use of special tools known as fishing tools, abandon the hole, or plug the hole up to the point of the break and drill around the severed portion of the drill stem. This latter operation is known as whipstocking. If fishing operations are unsuccessful, the driller must either whipstock or abandon the hole, in which case the severed portion of the drill stem and the tools attached thereto are left in the hole. All decisions with respect to the course of action to be taken in case of a break in the drill stem are within the province of the driller, and plaintiff has no say. The decision as to whether to fish, how long to fish, to whipstock, or to abandon the hole is made by the driller based on the economics of each course of action. The fact that plaintiff’s tool is lost is of little consequence to the driller. The tool is of inconsequential value compared to the cost of the rest of the drilling operation. Plaintiff’s employees may be at the drill site and be aware that the break has occurred, but they have no authority with respect to what the driller will do and render no assistance in retrieving the severed portion of the drill stem.

14. The hazardous nature of the oil well drilling business is such that it can be reasonably expected that some tools will be lost in the hole. Plaintiff’s chances of losing tools are increased the more they are employed, but not necessarily in proportion to the increase in the amount of footage drilled. There is no way to predict the loss of an individual tool. The decision as to whether a particular tool is to be abandoned is completely within the control of the driller. Losses follow a random pattern. Plaintiff might go 2 or 3 months without losing a tool, and then suddenly lose 4 or 5 tools in 1 week. Certain geographical areas, types of wells, and specific tools seem to increase the possibility of loss of a tool, but there is no way to predict how often, when, or at what depth tools will be lost.

15. The number of tools plaintiff had on hand at the beginning of 1956 was 1,869 which increased to 2,900 by the end of 1958.

During the 3 years in issue, 1956-1958, plaintiff manufactured an average of 651 tool bodies per year, scrapped an average of 61, made foreign sales of an average of 100, made domestic sales of an average of 9, and lost an average of 127 in weU'holes.

Plaintiff lost 95 -tools in the hole in 1956,146 in 1957, and in the years 1958 through 1960, there was a successive decline in such losses from 141 to 120 to 102, even though plaintiff’s tools on hand steadily increased from 1,869 at the beginning of 1956 to 3,026 at the end of 1960.

16. Occasionally plaintiff’s tool bodies are misplaced by the driUer and are not available to be returned to plaintiff’s employees when they come to pick up the tools. The case where a body is permanently misplaced is rare and occurred only two times during the three years concerned. Occasionally plaintiff’s tool bodies are damaged beyond repair in the course of drilling operations. This also is an infrequent occurrence, and averaged only 8.3 bodies per year during the years concerned.

17. Occasionally tools are damaged by the driller, but not beyond repair. The driller returns the tools to the plaintiff who has them repaired. The driller is billed for the cost of the repairs.

18. If the driller is unable to return plaintiffs tool bodies because they have been lost in the drill hole or because they have been misplaced, plaintiff requires the driller to reimburse it for the tools in accordance with the following clause of plaintiff’s rental agreement:

Eental equipment remains the property of the Grant Oil Tool Company and shall be delivered to them on demand. If lost or damaged beyond repair, user will be charged at sale price of new equipment.

The driller is charged the amount set forth in plaintiff’s charge schedule for tools-lost-in-hole. The same charge is made if a tool body is damaged beyond repair in the course of drilling operations where the customer has been negligent or careless, 'Such as where the driller continued to use a reamer after the cutter blades had become dull, thus causing damage to the body. Whether a tool body is considered to have been damaged beyond repair or worn out through normal use is determined by plaintiff. No additional charge is made if the parts are not returned or damaged beyond repair. A lost tool charge is imposed by plaintiff only if the driller is unable to find the body after a thorough search, and in the event the body is later found, the driller is given full credit. Whether a body rental charge is made in addition to the tools-lost-in-hole charge depends on the competitive situation in the particular area and plaintiff’s relations with the particular customer. Plaintiff does not charge body rental for the period after a body becomes lost in the hole, regardless of the length of the fishing period, and, due to competitive factors, often does not charge body rental for the period of use prior to loss. In the usual case, however, plaintiff does charge body rental in addition to the loss charge.

19. Plaintiff’s charge for the bodies lost in the hole, damaged beyond repair, or misplaced by the driller, is the same as the selling price of similar new tools sold in the foreign market. Apart from the infrequent sales to the purchasers, payments for tool bodies lost in the hole, damaged beyond repair, or misplaced by the driller constitute the only circumstances during the years in question in which domestic customers paid plaintiff for the full value of such tool bodies. However, no adjustment is made in the tools-lost-in-hole charge for the age or condition of the tool.

20. The money received from the driller for the failure to return plaintiff’s tools is deposited in the normal course of the plaintiff’s business.

21. In its consistent accounting practice and on its federal income tax returns for the years concerned, plaintiff did not treat its tool bodies as inventory items but as depreciable property used in its trade or business, creating a separate asset and reserve account for each body, identified by serial number markings, and recovering its cost thereof through annual depreciation allowances. Such treatment was never questioned by the Internal Revenue Service on audit of plaintiff’s income tax returns for taxable years prior to 1956. Plaintiff’s estimates of the average useful lives of its tool bodies contemplated, that, on an average basis, such bodies would be used until they were worn out. These estimates were allowed by the Internal Revenue Service for depreciation purposes for the years in suit. Each of the tool bodies concerned in the present action was held by plaintiff for more than 6 months prior to being lost in a drill hole, damaged beyond repair, or permanently misplaced by a driller. The recognized gains on the dispositions of such tool bodies exceeded plaintiff’s recognized losses during the years concerned from sales, exchanges, and involuntary conversions of property used in its trade or business, by the entire amount of such gains.

22. To account for the instances where tool bodies which had been held by plaintiff for 6 months or more were lost in the hole, damaged beyond repair, or misplaced by the customer, plaintiff treated the excess of the payment received from the customer on account of such loss over plaintiff’s adjusted basis in such assets as long-term capital gain. Income from the furnishing of the attachable parts and from the per well, per day, or per month use of the tool bodies was treated as ordinary income, as were the proceeds from scrap sales of 'bodies and parts. The 'attachable parts were inventoried at cost and charged against income on an individual basis as they were lost or worn out.

23. Plaintiff sells tool bodies and parts similar to those described above in foreign markets. The economic conditions of the export market and the domestic market (United States and Canada) are entirely different. The domestic market is characterized by a large number of independent drilling contractors with little capital who must drill under a wide variety of drilling programs and conditions. Their drilling tool needs are unpredictable and they prefer to lease a given tool as the need arises. In contrast, in the export market there are relatively few drillers, many of whom are major oil companies. Because of long lines of supply, drilling programs are planned on a long term basis with standardized operations, in which the same drilling tools can be used over and over. Plaintiff does not believe it economically feasible to establish overseas rental branches, and foreign drillers desire to buy rather than rent drilling tools. None of the tool bodies used by plaintiff hi its domestic rental business was ever sold in the export market. All such export sales were made on the basis of manufacture of new tools to particular specifications after receipt of a specific export order. Income received from export sales was treated by plaintiff as ordinary income, as were the proceeds from the few domestic sales.

24. Plaintiff to some extent manufactured tools of types not involved in this case. Excluding such tools, plaintiff’s gross receipts for all of the 3 years here involved, 1956-1958, from the tool bodies and parts were the sum of $6,827,833.50. Of this total, 23.30 percent, or $1,584,285.62, represented the receipts derived from the tool bodies, as follows:

Tools-lost-in-hole charges_ $252,310.44
Body rental charges- 1,114, 694. IT
Sales of tool bodies:
Foreign_ 192,139.91
Domestic_ 25,141.10
Total 1, 584,285. 62

The tool-lost-in-hole receipts ($252,310.44) were thus 15.93 percent of the total tool body receipts of $1,584,285.62.

Thus, the tools-lost-in-hole receipts ($252,310.44) constituted 3.70 percent of plaintiff’s total receipts of $6,827,833.50.

25. For the 3 years in issue (1956-1958) plaintiff had total net income of $1,337,005.85, of which plaintiff’s gain on lost-in-hole tool bodies was $211,188.76, or 15.8 percent.

26. Proceeds from the sale of used tools which were sold for their scrap metal content were reported by plaintiff as miscellaneous ordinary income in the following amounts during the years in suit:

1956 - $464
1957 _ 371
1958 - 615

27. At all times concerned plaintiff kept its books of account and filed its federal income tax returns on the basis of a calendar year and the accrual method of accounting.

28. Plaintiff timely filed its federal income tax return for the calendar year 1956, showing thereon a liability of $241,491.88, all of which was paid by plaintiff within the time prescribed by law. Thereafter the Internal Revenue Service determined that there was a deficiency in plaintiff’s federal income taxes for that calendar year in the amount of $18,629.46, which amount, together with interest thereon in the amount of $3,779.94, was paid by plaintiff within the time prescribed by law. On September 24, 1962, plaintiff filed with the District Director of Internal Revenue for the Los Angeles District its claim for refund of taxes paid with respect to the calendar year of 1956, demanding refund of taxes in the amount of $13,506.65 plus interest. This claim for refund was denied by the District Director on April 22,1963.

29. Plaintiff timely filed its federal income tax return for the calendar year 1957, showing thereon a liability of $286,769.51, all of which was paid by plaintiff within the time prescribed by law. Thereafter the Internal Revenue Service determined that there was a deficiency in plaintiff’s federal income taxes for the calendar year 1957 in the amount of $30,946.46, which amount, together with interest thereon in the amount of $4,564, was paid by plaintiff within the time prescribed by law. On September 24, 1962, plaintiff filed with the District Director of Internal Eevenue for the Los Angeles District its claim for refund of taxes paid with respect to the calendar year 1957, demanding refund of taxes in the amount of $24,371.70 plus interest. This claim for refund was denied by the District Director on April 22,1963.

30. Plaintiff timely filed its federal income tax return for the calendar year 1958, showing thereon a liability of $94,127.28, all of which was paid by plaintiff within the time prescribed by law. Thereafter the Internal Eevenue Service determined that there was a deficiency in plaintiff’s federal income taxes for the calendar year 1958 in the amount of $30,641.40, which amount, together with interest thereon in the amount of $2,433.01, was paid by plaintiff within the time prescribed by law. On September 24, 1962, plaintiff filed with the District Director of Internal Eevenue for the Los Angeles District its claim for refund of taxes paid with respect to the calendar year 1958, demanding refund of taxes in the amount of $18,931.66 plus interest. This claim for refund was denied by the District Director on April 22,1963.

31. The above-mentioned deficiencies, to the extent involved in this suit, resulted from the treatment by the Internal Eevenue Service of plaintiff’s reported gain on charges for tools lost in the hole, damaged beyond repair by negligence of the driller, or permanently misplaced by the driller, as ordinary income rather than capital gain.

ULTIMATE FINDINGS OK FACT

32. Plaintiff’s pertinent tool bodies were used in its trade or business.

33. Such tool bodies were subject to the allowance of depreciation.

34. Such tool bodies were held for more than 6 months prior to disposition.

35. Such tool bodies were not inventory or property held for sale to customers in the ordinary course of plaintiff’s trade or business.

36. Such tool bodies were subjected to involuntary conversions.

37. Such, involuntary conversions and the gains derived therefrom were not an integral part of plaintiff’s trade or business.

38. The recognized gains from the involuntary conversions of such tool bodies exceeded in each of the taxable years involved, plaintiff’s recognized losses from sales, exchanges, and involuntary conversions of property used in its trade or business, by the entire amount of such gains.

CONCLUSION OF LAW

Upon the foregoing findings of fact and opinion, which are adopted by the court and made a part of the judgment herein, the court concludes as a matter of law that plaintiff is entitled to recover, and judgment is entered to that effect, with the determination of the amount of recovery reserved for further proceedings pursuant to Buie 47(c). 
      
      This case was referred to Trial Commissioner Roald Hogenson, with directions to make findings of fact and to recommend conclusions of law. The commissioner has done so in an opinion and report filed October 3, 1966. The court is in agreement with the findings of the commissioner. While we reach the result arrived at by the commissioner, we do so by a different route.
     
      
       In Its brief to the trial commissioner, defendant has withdrawn its further defense stated in its First Amended Answer pertaining to depreciation deductions on the tool bodies.
     
      
       § 1231. Property used in the trade or business and involuntary conversions.
      (a); ¡General rule. If, during the taxable year, the recognized gains on sales or exchanges of property used in the trade or business, plus the recognized gains from the compulsory or involuntary conversion (as a result of destruction in whole or in part, theft or seizure, or an exercise of the power of requisition or condemnation or the threat or imminence thereof) of property used in the trade or business and capital assets held for more than 6 months into other property or money, exceed the recognized losses from such sales, exchanges, and conversions, such gains and losses shall be considered as gains and losses from sales or exchanges of capital assets held for more than 6 months. If such gains do not exceed such losses, such gains and losses shall not be considered as gains and losses from sales or exchanges of capital assets. * * *
      * * * * *
      (b) Definition of property used in the trade or business. — For purposes of this section—
      (1) General rule. — The term “property used in the trade or business” means property used in the trade or business, of a character which is subject to the allowance for depreciation provided in section 167, held for more than 6 months, and real property used in the trade or business, held for more than 6 months, which is not—
      (A) property of a kind which would properly be includible in the inventory of the taxpayer if on hand at the close of the taxable year,
      (B) property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business, * * *
      * * * * *
     
      
       Section 1231 was amended for the years beginning after December 81, 1957, by Section 49, Technical Amendments Act of 1958, P.L. 85-866, 7® Stat. 1606, 1642, in respects not material here.
     
      
      Treasury Regulation § 1.61-3(a) (1967) states: “In a manufacturing, merchandising * * * business, ‘gross income’ means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. Gross income is determined without subtraction of * * * items not ordinarily used in computing cost of goods sold.” (Emphasis supplied.)
      Cost of goods sold is computed in the following manner: to inventory on hand at the beginning of the year is added the cost of purchases (be it of raw materials, work in process, or finished goods) made during the tax year in question. By subtracting closing inventory from that total cost of goods sold is reached.
     