1952 U.S. Tax Ct. LEXIS 195">*195 Decision will be entered for the respondent.
1. Held, petitioner was not committed prior to January 1, 1940, to a course of action which resulted in the erection by a landlord of a new warehouse to be leased to petitioner and which when occupied in February 1941 by petitioner resulted in more efficient operation of its business and in increased earnings. Petitioner has not proved a commitment qualifying ground under section 722 (b) (4) of the Internal Revenue Code.
2. Petitioner in 1939, changed its method of operation as to transportation by selling its hauling trucks to another corporation and having an agreement with such corporation that it would thereafter transport petitioner's products for it. The evidence shows that this change did not result in increased earnings for petitioner but, on the contrary, decreased petitioner's earnings. Held, this change was not a qualifying operating change within the provisions of section 722 (b) (4) of the Internal Revenue Code.
18 T.C. 267">*268 The Commissioner has determined certain overassessments and deficiencies for petitioner for the calendar years 1943 and 1944, which are described in the deficiency notice as follows:
You are advised that the determination of your tax liability for the taxable years ended December 31, 1943 and 1944 disclose [sic] a deficiency of $ 179.53 and an overassessment of $ 3,082.93, respectively, in income taxes and deficiencies of $ 18.63 and $ 357.01 in declared value excess-profits taxes for the respective years, while the determination of your excess profits tax liability for the years ended December 31, 1943 and 1944 discloses deficiencies of $ 10,453.16 and $ 8,315.07, respectively, * * *
The deficiencies in excess profits taxes thus determined represent the portions of petitioner's liability for excess profits taxes as shown on petitioner's1952 U.S. Tax Ct. LEXIS 195">*197 excess profits tax returns for the respective years, the payments of which were deferred by petitioner under the provisions of section 710 (a) (5) of the Code. The deficiency notice also determined:
After careful consideration of your applications for relief under Section 722 of the Internal Revenue Code, filed July 10, 1944 and September 9, 1947 (amended claim) for the year 1943 and July 14, 1945 for the year 1944, it has been determined that you have not established your right to the relief requested in your applications.
The petitioner assigns no errors as to the determination of the deficiencies as such but does assign numerous errors designated from A to J, inclusive, as to respondent's refusal to grant relief under section 722, I. R. C. These assignments of error as we interpret them adequately raise but two issues. They are:
1. Was petitioner committed prior to January 1, 1940, to an increase in the capacity of its business through the acquisition or occupancy of a new warehouse adjacent to a railroad freight siding to which it moved its fruit and produce operations in February 1941.
2. Did the formation of a separate corporation which acquired title to petitioner's long-haul1952 U.S. Tax Ct. LEXIS 195">*198 trucks in 1939, and concurrently agreed to transport produce for petitioner on a contract basis, or any other base period change in its transportation methods, effect a substantial change in the character of petitioner's business or have the effect of increasing its normal level of earnings.
The stipulated facts and exhibits made a part thereof are included herein by reference.
18 T.C. 267">*269 FINDINGS OF FACT.
The stipulated facts are so found.
Petitioner, the successor to a partnership, was incorporated as the Central Produce Company under the laws of the State of Tennessee on February 15, 1935. At the time of incorporation petitioner had an authorized capital of 52 shares of preferred stock ($ 100 par value) and 30 shares of no par value common stock.
Petitioner filed its Federal tax returns for the taxable years ended December 31, 1943 and 1944, with the collector of internal revenue, Nashville, Tennessee.
Petitioner was organized according to the terms of its charter for the purpose of buying, selling, and dealing in the products of the farm, orchard, and garden in Tennessee or in any other state, or in buying, selling, and dealing with any other articles which were deemed necessary1952 U.S. Tax Ct. LEXIS 195">*199 for the successful operation of the business of the corporation and to do all things essential, necessary or incidental thereto.
Issue 1 -- Commitment to the Rental of a New and Improved Warehouse.
At the time of petitioner's incorporation its place of business was located at 530 Third Avenue, North, at the southwest corner of Third Avenue and Locust Street. Previous to its move to 530 Third Avenue, North, the predecessor partnership had been located at 600, 602, and 604 Third Avenue, North, Nashville, Tennessee.
After the partnership had moved to 530 Third Avenue, North, it continued to rent on a month to month basis units formerly occupied by it, and this action was perpetuated by petitioner upon its incorporation. Both petitioner and predecessor partnership from time to time made active use of these buildings and at other times sublet these units to other parties.
On several occasions during the period 1936-1939, Hoyt Strother, secretary and treasurer of petitioner, had discussed with the president and the secretary of Standard Candy Company (sometimes hereinafter referred to as Standard) the possibility of that concern's building a warehouse for the petitioner on the property1952 U.S. Tax Ct. LEXIS 195">*200 owned by Standard adjacent to the railroad at Third Avenue and Locust Street. However, these discussions did not result in a firm commitment and the petitioner obtained for its efforts the mere promise that it would receive first consideration in any decision to build on that location made by Standard. Early in 1940, petitioner again approached the secretary of Standard for the purpose of negotiating an agreement of the type previously sought. As a result of these discussions, Standard engaged the services of an engineering firm for the specific purpose 18 T.C. 267">*270 of obtaining an estimate of the cost of construction for a building of the type desired by petitioner. The estimate of cost thus obtained was for the sum of $ 21,438. Upon receipt of this estimate negotiations reached a stalemate and were subsequently broken off because Standard was unwilling to make so large an investment for the rent petitioner was willing to pay. Likewise, petitioner did not feel that it was in a position to bind itself to a lease which involved the payment of rent so high that it removed assurance of a profitable operation arising from the increased facilities.
In July 1940, Hoyt Strother, in his1952 U.S. Tax Ct. LEXIS 195">*201 capacity as secretary of petitioner, was directed to again contact Standard for the same general purpose that had been the subject of prior discussions, namely, to negotiate with and enter into a rental contract with Standard for a warehouse to be erected by Standard at the previously discussed location, if such a contract beneficial to Central Produce Company could be made.
As a result of these later discussions certain revisions were made in the original plans for the building and a new estimate for the cost of construction involving the aforesaid modifications was obtained on October 5, 1940, which fixed the cost of construction at approximately $ 17,500. Because of the lower cost of construction arising out of the second estimate Standard was willing to decrease its rental demands somewhat to a point where petitioner and Standard were able to reach a basis for an agreement. As a consequence of this agreement, on November 9, 1940, Standard entered into a contract with the Nicholson Construction Company to erect a warehouse for the use of the petitioner. A permit to demolish the old buildings was issued on November 11, 1940. Standard and petitioner entered into a lease contract1952 U.S. Tax Ct. LEXIS 195">*202 for the use of the new building which was to be constructed on November 16, 1940. The new building was completed on February 15, 1941, and petitioner moved into it shortly after it was completed.
Petitioner was not committed prior to January 1, 1940, to an increase in capacity of its business through the acquisition or occupancy of the new warehouse building which it contracted to lease in November of 1940.
Issue 2 -- Change in Method of Transportation.
As far back as 1935, petitioner was employing both truck and rail facilities to move its produce to market. Because of the employment of these two separate and distinct methods of transportation and because the experience of the officers of petitioner had been limited almost entirely to trucking operations, in the Fall of 1936 or the Spring of 1937, the petitioner employed a so called perishable man. Previously this man had been employed for a period of 11 years by a railroad as a perishable agent whose principal duty was the inspection 18 T.C. 267">*271 of railroad shipments for the purpose of discovering possible breakage or damage suffered by the produce in transit. Petitioner utilized his services to buy and receive carload lots1952 U.S. Tax Ct. LEXIS 195">*203 and to take care of freight and freight rates in general.
At the annual stockholders' meeting of petitioner held July 4, 1939, it was reported that the petitioner had lost money during the preceding year and this loss was attributed to leakage arising from the manner in which the business was being operated. It was agreed that at least a portion of this leakage arose from the fact that petitioner was using its own trucks to haul produce. Therefore, a policy was adopted to seek other mediums of transportation and to eliminate long hauls of produce by the company itself.
To implement this policy decision petitioner entered into a sales contract with Central Transportation Company whereby petitioner sold to Central Transportation its long-haul trucks and there was embodied in the contract the additional proviso that Central Transportation agreed to haul all wares of the petitioner from such points as desired. Moreover, it was expressly stated in the contract that petitioner was entering into such an agreement because the cost of self-transportation of produce had resulted in a loss to the company, and that, therefore, the policy had been adopted to discontinue all company transportation1952 U.S. Tax Ct. LEXIS 195">*204 of produce and in the future to employ rail or contract trucking for the transportation of its produce. This contract was signed September 16, 1939.
On July 4, 1940, petitioner again held its annual stockholders' meeting and at this meeting the attention of the stockholders was directed to the fact that under the petitioner's present contract for hauling with Central Transportation Company the cost of transporting commodities to Nashville from elsewhere was excessive and to some extent responsible for the lack of profits shown by the company. It was suggested as an alternative that petitioner should lease the vehicles of Central Transportation Company and operate them, absorbing the entire cost of operations with the exception of repair and maintenance which would be provided by the Central Transportation Company. This plan was adopted and petitioner was authorized to enter into such an agreement with Central Transportation Company. Likewise, petitioner adopted as a matter of policy the more regular use in the future of railway facilities and other trucking concerns when advantageous.
After 1940, petitioner greatly increased its use of railway facilities in its business thereby1952 U.S. Tax Ct. LEXIS 195">*205 resulting in increased earnings. The operations under the contract which petitioner signed with Central Transportation Company on September 16, 1939, to which reference has been made above did not increase petitioner's earnings but, on the contrary, had the opposite result. The contract proved unprofitable to both 18 T.C. 267">*272 parties to the contract. It was not such a change in the operation of petitioner's business as entitled it to relief under the provisions of section 722 of the Code.
Petitioner's sales and net taxable income (loss) per returns as adjusted were as follows:
| Net taxable income | ||
| Year | Sales | as adjusted |
| 1936 | $ 749,887.25 | $ 4,943.64 |
| 1937 | 949,437.02 | 3,032.29 |
| 1938 | 1,050,326.42 | (1,214.57) |
| 1938 | 1,103,111.73 | 3,166.82 |
Petitioner's average base period net income for the years here in question calculated in accordance with section 713 (e) (1) of the Internal Revenue Code is $ 3,000.25.
OPINION.
Petitioner's assignments of error do not identify very clearly what statutory grounds it relies upon for relief under section 722 of the Code. However, we have set out in our preliminary statement the two issues we deemed to have been raised by the petition1952 U.S. Tax Ct. LEXIS 195">*206 in its assignments of error as grounds for relief under section 722. Evidently petitioner is relying upon grounds which it alleges fall within the provisions of section 722 (b) (4) of the Internal Revenue Code. 1
1952 U.S. Tax Ct. LEXIS 195">*207 18 T.C. 267">*273 Issue 1 -- Commitment to the Rental of a New and Improved Warehouse.
The evidence shows that in 1940, Standard Candy Company which had been petitioner's landlord of certain property for several years erected a new and much more commodious warehouse for petitioner than it had been using in prior years. The testimony also establishes that this new warehouse which was situated on the railroad tracks added very substantially to the efficiency of petitioner's operations and increased its earnings. Petitioner contends that Standard was committed to the erection of this warehouse prior to January 1, 1940, and that petitioner was committed prior to that date to rent it from Standard. If the facts substantiated this contention, then petitioner might well have ground for relief under section 722 (b) (4), I. R. C., the commitment provisions of section 722 (b) (4) assuming, of course, that other requirements of the statute are met. The proof, however, does not sustain petitioner as to this alleged commitment prior to January 1, 1940. H. L. Ray, secretary of Standard testified at the hearing as a witness for the petitioner. During the course of his testimony the following question1952 U.S. Tax Ct. LEXIS 195">*208 and answer occur:
By Mr. Jackson: [Attorney for petitioner]
Q. Mr. Ray, see if I am right. Did you say that several years before this building was built that the Standard Candy Company had agreed to build a building when they wanted it? Is that what you said?
A. No, we had not agreed to build any building. We had talked with Mr. Strother, or he with us several years about building a building, but we never did get together on it until the beginning of 1940.
Other testimony in the record is to the same effect. The upshot of this testimony is that petitioner and Standard had discussed the building of this warehouse for petitioner prior to January 1, 1940, but no agreement or definite commitment had been reached. It was in 1940 that the parties reached a definite agreement as to the erection of this warehouse for lease to petitioner. After the agreement was reached in 1940, Standard went ahead and erected the building and the lease of the building to petitioner was signed November 16, 1940. Petitioner began to occupy the building on or about February 15, 1941. Under these facts and circumstances, we hold that petitioner has not proved a commitment within the meaning of the language1952 U.S. Tax Ct. LEXIS 195">*209 used in section 722 (b) (4) wherein it says:
* * * Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, * * * shall be deemed to be a change on December 31, 1939, in the character of the business, * * *
It follows that petitioner is not entitled to any relief upon this ground.
18 T.C. 267">*274 Issue 2 -- Change in Method of Transportation.
The facts show that during the base period years prior to 1939 petitioner had used its own trucks to haul produce from places where it had been purchased. In 1939, a policy was adopted by the directors of petitioner to seek other mediums of transportation and to eliminate long hauls of produce by petitioner's own trucks. To implement this change in policy, petitioner entered into a sales contract with Central Transportation Company whereby petitioner sold to Central Transportation Company its long-haul trucks and there was embodied in the contract the proviso that Central Transportation Company agreed to haul all wares of petitioner from such points as desired. This1952 U.S. Tax Ct. LEXIS 195">*210 contract was signed September 16, 1939.
The change did not result in increased earnings for petitioner as it had expected but, on the contrary, had the reverse effect and in the following year another change was made which is described in our Findings of Fact. Apparently this second change in methods of transportation which took place in 1940 did result in increased earnings to petitioner but it took place in 1940 and is, therefore, not a ground for relief under section 722 (b) (4), no commitment to this course of action having been shown prior to January 1, 1940. In view of the fact that the facts show that the change in methods of transportation which the petitioner made in 1939 did not result in increased earnings but, on the contrary, resulted in a lower level of earnings, it would not be a qualifying factor for relief under section 722 (b) (4). The Bureau of Internal Revenue Bulletin contains the following discussion of the requirements for recognizing a change in character of business due to a change in operation or management so as to qualify a taxpayer for relief under section 722 (b) (4):
(1) A CHANGE IN THE OPERATION OR MANAGEMENT OF THE BUSINESS
To be entitled to relief1952 U.S. Tax Ct. LEXIS 195">*211 because of a change in the operation or management of the business, a taxpayer must demonstrate that the change is substantial as measured by two basic tests:
(i) The nature of the operations must be essentially different after the change from the nature of the operations prior to the change; and
(ii) There must be a higher level of earnings which is directly attributable to the change.
See, Bulletin on Section 722, page 48. Even if we assume that the change in transportation methods which petitioner put into effect in 1939 qualifies as a change under (i) above, it clearly does not qualify under (ii) above.We hold that under the facts and circumstances which attended and followed petitioner's change in transportation operations in 1939, such change does not qualify petitioner for relief under section 18 T.C. 267">*275 722 (b) (4). Petitioner has failed to establish that it is entitled to any relief under section 722 of the Internal Revenue Code with respect to the years 1943 and 1944.
Reviewed by the Special Division.
Decision will be entered for the respondent.
Footnotes
1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
* * * *
(b) Taxpayers Using Average Earnings Method. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because --
* * * *
(4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the purpose of this subparagraph, the term "change in the character of the business" includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, a difference in the ratio of nonborrowed capital to total capital, and the acquisition before January 1, 1940, of all or part of the assets of a competitor with the result that the competition of such competitor was eliminated or diminished. Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, or↩