1957 U.S. Tax Ct. LEXIS 269">*269 Decision will be entered under Rule 50.
Excess Profits Tax -- Sec. 722 Relief -- Constructive Average Base Period Net Income. -- The record does not justify a finding of an amount of constructive average base period net income in excess of that allowed by the Commissioner.
27 T.C. 740">*740 This proceeding is based upon claims for excess profits tax relief for the years 1942 to 1945, inclusive, which have been denied in part. The taxable years are those ending June 30, 1942 through 1945. The years 1941 and 1946 are involved by reason of claims for a carryover of unused excess profits credit from 1941 to 1942 and 1943 and a carryback from 1946 to 1944 and 1945. The findings of fact are substantially those made by the commissioner of this Court who heard the evidence.
FINDINGS OF FACT.
The stipulated facts are incorporated herein by this reference.
The petitioner was organized under the laws of Oklahoma, December 12, 1912, to engage in the business of manufacturing oil field specialty items. It was organized under the name of1957 U.S. Tax Ct. LEXIS 269">*270 the Oil Well Improvements Company. In 1945 it changed its name to Orbit Valve Company. The petitioner's returns for the years involved, the fiscal years ended June 30, 1942 to 1945, inclusive, were filed with the collector of internal revenue for the district of Oklahoma.
During the base period, the years June 30, 1937, to June 30, 1940, inclusive, the petitioner had issued and outstanding 1,897 shares of capital stock of which 669 shares were held by Alf G. Heggem, 621 shares by Ed D. Ligon, and 600 shares by W. O. Ligon.
Prior to the base period, the petitioner's principal products were "control heads" and "oil savers," manufactured under exclusive license agreements covering patents issued to Heggem.
Control heads and oil savers were used in connection with the drilling of oil wells by the cable tool method. Their function was to divert the flow of waste liquids from a well during drilling operations to a nearby pit. The waste liquids create a fire hazard and unsafe working conditions if allowed to flow over the working equipment and the floor of the rig. Through its patent rights, the petitioner had a virtual monopoly on the manufacture and sale of these control heads and1957 U.S. Tax Ct. LEXIS 269">*271 oil savers for several years. The patents on the control head expired in 1932 and on the oil saver in 1933. During 27 T.C. 740">*741 the life of the patents several successful infringement suits were brought by the petitioner against other manufacturers. The petitioner has continued to manufacture both the control heads and oil savers up to the present time.
During the 1930's, throughout the oil industry, the rotary-type drill largely displaced the cable tool drill, especially for deep-well boring. Cable tools were still used for some of the shallow low-pressure wells, for finishing off wells drilled to the oil sands with rotary rigs, and for cleaning out producing wells. A survey made by the Oil Weekly in August 1937 showed that about 55 per cent of the rigs then in use were of the rotary type and 45 per cent of the cable tool type. By 1940 the percentage of rotary rigs had increased to 59.5 per cent.
Realizing that it was losing its market for its cable tool accessories, the petitioner turned to valves and controls for use with rotary rigs and on producing wells. In 1933 it began experiments with a drilling valve described as a wedge-type valve. A drilling valve is one that the 1957 U.S. Tax Ct. LEXIS 269">*272 drill can work through while the well is being bored. Its purpose is to control the flow of oil or gas during the drilling and after the drill has been removed from the hole. In gas wells, and sometimes in oil wells where high pressure is encountered, it is left in place when the well is completed. The petitioner manufactured a number of these valves and put them on the market in 1935 but they proved unsuccessful and had to be abandoned. The petitioner then began manufacturing a gear-operated drilling valve on which Heggem had been doing experimental work and on which he held patents. This was put on the market in 1936 and was successful.
In 1937 the petitioner began producing another valve known as the O. S. & Y. valve. This was a small, high-pressure valve, made in sizes from 2 to 4 inches, to withstand pressure up to 10,000 pounds per square inch. The O. S. & Y. valves were used in the control installations on a producing well, known in the trade as a "Christmas tree." The name had its origin in the odd appearance of the control assembly with its numerous valves and "gadgets." Its sole function is to control the flow of oil or gas from a producing well. Both the drilling1957 U.S. Tax Ct. LEXIS 269">*273 valves and the O. S. & Y. valves were for use on flowing wells only.
With respect to the development and manufacture of the above-described products, the parties have stipulated that:
petitioner has established that there was a difference in the products or services furnished, within the meaning of Section 722 (b) (4) of the Internal Revenue Code of 1939, by the introduction in February, 1936, of a gear operated drilling valve and the introduction in February, 1937, of an Outside Screw and Yoke (O. S. & Y.) valve, and that the average base period net income was an inadequate standard of normal earnings.
27 T.C. 740">*742 In introducing its new type valves to the trade, the petitioner sold a number of them on a trial basis to be paid for only if they proved satisfactory, and in some instances gave them to the producers. Generally, the oil industry was slow to make changes and would accept new products only after thorough tests under varying conditions.
Drilling valves and O. S. & Y. valves were the petitioner's principal products throughout the base period. During the war years, when the petitioner could not get sufficient materials for full production of these valves, it manufactured 1957 U.S. Tax Ct. LEXIS 269">*274 other products under war contracts.
The petitioner's products were sold through the oil field supply stores and the petitioner had regular salesmen or field representatives who called on the producers and store operators and other potential buyers.
The following table shows the petitioner's sales by products for the fiscal years ended June 30, 1937, to June 30, 1940, 1 inclusive:
| 1937 | 1938 | 1939 | 1940 | |
| O. S. & Y. valves | $ 2,960.82 | $ 60,647.93 | $ 59,314.30 | $ 126,505.28 |
| Drilling valves | 90,054.63 | 62,570.23 | 64,280.09 | 97,405.13 |
| Valve repairs | 287.73 | 1,137.62 | 1,008.92 | |
| Total valve sales | $ 93,015.45 | $ 123,505.89 | $ 124,732.01 | $ 224,919.33 |
| Control heads, oil savers, | ||||
| oil saver rubbers, etc | 101,952.36 | 93,351.83 | 63,143.45 | 46,391.98 |
The following is a comparative statement of the petitioner's sales, gross income, expenses, and net income (or loss), 1957 U.S. Tax Ct. LEXIS 269">*275 for the fiscal years ended June 30, 1922, to June 30, 1940, inclusive:
| Year | Sales | Gross | Expenses | Net income |
| income | (or loss) | |||
| 1922 | $ 224,997.31 | $ 88,922.26 | $ 53,248.32 | $ 35,673.94 |
| 1923 | 225,758.21 | 134,429.74 | 62,699.64 | 71,730.10 |
| 1924 | 136,075.30 | 90,973.38 | 93,638.11 | (2,664.73) |
| 1925 | 187,079.19 | 91,119.76 | 90,663.37 | 456.39 |
| 1926 | 254,346.64 | 133,220.84 | 103,201.24 | 30,019.60 |
| 1927 | 473,278.73 | 296,656.59 | 98,501.97 | 198,154.62 |
| 1928 | 197,992.11 | 118,392.61 | 95,407.26 | 22,985.35 |
| 1929 | 262,878.44 | 149,895.09 | 103,932.56 | 45,962.53 |
| 1930 | 289,531.59 | 203,783.06 | 157,822.91 | 45,960.15 |
| 1931 | 82,840.25 | 42,852.80 | 51,931.75 | (9,078.95) |
| 1932 | 35,805.69 | 13,160.93 | 21,920.36 | (8,759.43) |
| 1933 | 37,544.37 | 14,703.70 | 22,981.83 | (8,278.13) |
| 1934 | 71,406.35 | 29,433.31 | 28,534.75 | 898.56 |
| 1935 | 87,468.82 | 39,789.41 | 43,040.97 | (3,251.56) |
| 1036 | 105,297.71 | 35,763.87 | 43,562.56 | (7,798.69) |
| 1937 | 194,967.81 | 67,951.61 | 54,464.02 | 13,487.59 |
| 1938 | 216,857.72 | 81,383.70 | 78,661.96 | 2,721.74 |
| 1939 | 187,875.46 | 70,571.03 | 76,785.98 | (6,214.95) |
| 1940 | 271,311.31 | 97,782.84 | 87,187.86 | 10,594.98 |
27 T.C. 740">*743 The number of oil and gas wells drilled in the United States during1957 U.S. Tax Ct. LEXIS 269">*276 the years 1936 to 1939, inclusive, was as follows:
| Oil | Gas | Total | Index | |
| 1936 | 18,704 | 2,375 | 21,079 | 106.65 |
| 1937 | 23,115 | 2,732 | 25,847 | 130.78 |
| 1938 | 19,106 | 2,143 | 21,249 | 107.51 |
| 1939 | 17,734 | 2,030 | 19,764 | 100.00 |
The petitioner's excess profits net income; excess profits credit, based on a constructive average base period income of $ 23,100; excess profits credit, based on invested capital; and excess profits tax liability for the taxable years involved, as determined by the Commissioner in his notice of partial allowance of the petitioner's claims, are as follows:
| Excess profits | Excess profits | |||
| Taxable year | Excess profits | credit based | credit based | Excess profits |
| ending June 30 | net income | on income | on invested | tax liability |
| capital | ||||
| 1942 | $ 36,929.14 | $ 21,945.00 | $ 16,360.28 | $ 3,494.45 |
| 1943 | 80,930.61 | 21,945.00 | 17,666.80 | 46,287.14 |
| 1944 | 128,356.07 | 21,945.00 | 20,118.15 | 89,549.34 |
| 1945 | 201,944.10 | 21,948.97 | 23,034.26 | 136,780.65 |
OPINION.
The Commissioner of Internal Revenue has made a partial allowance of the petitioner's claims for relief under section 722 (b) (4) by reason of a change in the character of its business, based1957 U.S. Tax Ct. LEXIS 269">*277 upon a constructive average base period net income of $ 23,100. The petitioner, in its brief, has reduced its claim for constructive average base period net income to $ 69,187.43. The only question for decision is the amount of constructive average base period net income.
The partial allowance by the Commissioner was based upon a change in the character of the business resulting from the introduction of drilling and O. S. & Y. valves. The Commissioner argues in his brief that a normal level of earnings on the drilling valves had been reached by the end of the base period, the sales of other products were declining throughout the base period, and although the earnings on the sales of O. S. & Y. valves had not reached a normal level by the end of the base period the earnings of the entire business had reached a normal level at that time and there is no basis for the application of the push-back rule. The decline of the petitioner's sales of products other than valves during the base period was due to the gradual replacement of cable tool drills with rotary-type drills and was not affected perceptibly by the introduction during the base period of the valves here in question.
27 T.C. 740">*744 1957 U.S. Tax Ct. LEXIS 269">*278 The petitioner had a loss of about $ 6,200 in 1 base period year, and it had earnings of about $ 26,800 for the other 3 base period years. The constructive average base period net income allowed by the Commissioner is several times the actual earnings for the base period years, and the evidence falls short of convincing this Court that the constructive average base period net income allowed by the Commissioner was less than a fair and just amount to represent normal earnings of this petitioner. The record as a whole fails to indicate that the actual sales of the drilling valves during the base period years had not reached a normal level under the prevailing market conditions by the end of the base period. It is reasonable to believe, however, that the sales of O. S. & Y. valves had not reached their normal level by the end of that period. The constructive average base period net income determined by the Commissioner makes sufficient allowance for these conditions. The petitioner is entitled to a carry over of any unused excess profits credit from 1941 to 1942 and 1943 and a carryback from 1946 to 1944 and 1945 based upon the constructive average base period net income allowed1957 U.S. Tax Ct. LEXIS 269">*279 by the Commissioner.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. The stipulated figures relate to calendar years but are broken down as between the first and last 6 months of each year as shown in the table.↩