*239 Decisions will be entered under Rule 50.
Excess Profits Tax -- Section 722 (b) (4) -- Change in Character of Business. -- Petitioner, in the operation of its radio broadcasting station, installed a new type antenna which resulted in improved station coverage. Held, petitioner changed the character of its business and a constructive average base period net income has been determined.
*1551 The Commissioner disallowed petitioner's applications for relief under section 722 for the fiscal years ended July 31, 1941, through 1946.
The only question to be decided is whether the Commissioner erred in denying relief to the petitioner. The issues presented*240 for decision are:
(1) Did petitioner change the character of its business within the meaning of section 722 (b) (4) by the installation of a vertical radiator-type antenna; and (2) is petitioner entitled to relief under section 722 (b) (4)?
The proceedings were consolidated for hearing.
FINDINGS OF FACT.
Some of the facts have been stipulated and are so found.
Petitioner was originally incorporated under the laws of the State of Texas in 1911, and in 1933 it adopted its present name, Southland Industries, Inc.
Petitioner filed income and declared value excess-profits tax returns and excess profits tax returns for the fiscal years ended July 31, 1941, 1942, 1943, 1944, 1945, and 1946 with the collector of internal revenue for the first district of Texas, at Dallas.
Petitioner's excess profits tax liability for each of the fiscal years ended July 31, 1941, 1942, 1943, 1944, 1945, and 1946, as finally determined without the application of section 722, is: $ 8,901.31; *1552 $ 58,850.12; $ 130,589.53; $ 196,973.58; $ 241,904.90 and $ 90,827.39, respectively. Petitioner filed timely application for relief under section 722 for each of the years before us.
For the period from August*241 1, 1934, to July 31, 1946, petitioner kept its books and reported its income for Federal tax purposes on an accrual basis. Petitioner is, and has been, located at all times material to these proceedings at 1031 Navaro Street, San Antonio, Texas.
On September 25, 1922, petitioner entered the radio field with a 500 watt station broadcasting from San Antonio, Texas, under the call letters WOAI. In 1925 the power of petitioner's radio station was increased to 5,000 watts. In 1928 WOAI became affiliated with the National Broadcasting Company (hereinafter sometimes referred to as NBC). In 1930 petitioner was granted a license to increase its power to 50,000 watts on a clear channel, and it has continued to operate as a 50,000 watt clear channel station.
In 1930 petitioner erected a T-type antenna near Selma, Texas, which is about 18 miles from San Antonio. This antenna was equipped with two 300-foot towers about 750 feet apart. Midway between these two towers an antenna was suspended. From the date of original installation this antenna operated unsatisfactorily and as a consequence petitioner's trade area, southwest Texas, was not properly served.
For the purpose of improving its*242 service, petitioner, between 1932 and 1935, had three reputable engineers make surveys and studies of the antenna. These studies indicated that the antenna was only 40 per cent efficient. During this period, the engineers made various recommendations for minor changes in the antenna. These recommended changes were adopted but they did not produce the desired beneficial result.
In 1935, Jack DeWitt, a recognized radio consulting engineer and now president of Station WSM, a 50,000 watt clear channel station in Nashville, Tennessee, made an inspection and survey of petitioner's antenna. He recommended that an entirely new, single vertical radiator antenna be installed.
In May 1937 petitioner asked NBC for information about an article appearing in a publication issued by the Radio Corporation of America. This article discussed the recent installation of a "slightly more than one-half wave length single vertical radiator antenna" at NBC's Station WJZ. This type of antenna was a relatively recent development in the radio industry and was not in general use. Petitioner also sought the advice of NBC's engineers as to the advisability of installing this new antenna at Station WOAI. *243 These engineers suggested that the new antenna be installed, and that it should increase the effective radiated power by approximately 80 per cent.
Petitioner was uncertain of the efficacy of this new antenna, for in the past it had received other recommendations and had expended *1553 money and effort for its present antenna, with little or no additional broadcast coverage. However, in view of the recent success of Station WJZ, petitioner decided to erect the new antenna.
Before the new antenna could be erected, petitioner had to procure formal approval from the Federal Communications Commission and the Bureau of Air Commerce. On July 6, 1937, petitioner requested such approval, and on August 20, 1937, the Federal Communications Commission authorized the erection of the new antenna. Authorization was also received from the Bureau of Air Commerce. A request to install a new antenna, as compared to a request for power increase, presents fewer practical difficulties for the applicant when seeking an authorization from the Federal Communications Commission.
Before going forward with the erection of the newly designed antenna in September 1937, petitioner employed A. Earl Cullum, *244 Jr., to review the series of studies that had been made by other engineers and to make an independent recommendation for the improvement of the station's output. Cullum was a qualified consulting radio engineer with extensive theoretical and practical experience in the radio field. He was of the opinion that a slightly more than one-half wave length single vertical radiator antenna would provide good results to petitioner. He also recommended to petitioner an improvement in the ground system which would include 120 radials of copper wire approximately 400 feet long extending out from a square ground screen of copper mesh 48 feet by 48 feet located immediately under the antenna.
On December 25, 1937, the new vertical radiator antenna with the ground system was completed and put into operation.
At the time the antenna was installed petitioner was required to purchase five additional acres of ground in order that it could have sufficient space to provide for the enlarged ground system, and an area for one of the anchors for the new antenna.
The cost of the new antenna was approximately $ 13,000. However, this amount does not include the cost of the additional land, nor the payments*245 for the services of an engineer who supervised the erection and made the tests after the erection. The total value of petitioner's assets as of June 30, 1937, was $ 735,408.79, but this included more than $ 450,000 in investments other than the broadcasting station.
Theoretical studies had been made of vertical antennas as early as 1924. The type antenna erected by petitioner was, however, something new in practical use. Prior to December 25, 1937, no radio station in Texas, or even in the Southwest, had erected a slightly more than one-half wave length single uniform cross-section vertical radiator antenna. Petitioner was not the first, but it was one of the early stations in the United States to erect both the half wave *1554 length design and the uniform cross-section design vertical radiator antenna. Even as late as 1940 less than 10 per cent of the radio stations in the United States had erected half wave length antennas, and less than 50 per cent of 50 kilowatt stations in the United States had installed half wave length antennas prior to 1940.
After the installation of its new antenna, petitioner again employed Cullum to test the efficiency of the new antenna. The*246 measurements taken by Cullum showed that during the early part of 1938 the efficiency of the ray emitted by the new antenna was essentially the same as the theoretical maximum. When the petitioner supplied the new antenna with 50,000 watts of power, 50,000 watts, less a small loss, was effectively radiated from the new antenna.
The new antenna structure improved the ground service area of petitioner's coverage during daytime operation. It also substantially improved the nighttime fade-free area which was served by petitioner.
A comparison of the populations and areas served by the old and the new antenna shows the following increases in population and area served with the new antenna:
| Daytime Operation | ||
| Area | ||
| Contour | Population | (Sq. miles) |
| 50 KW of power with old antenna | 916,040 | 36,200 |
| 50 KW of power with new antenna | 1,279,440 | 48,000 |
| Coverage gained | 363,400 | 11,800 |
| Nighttime Operation | ||
| 50 KW of power with old antenna | 588,596 | 12,700 |
| 50 KW of power with new antenna | 1,077,489 | 45,750 |
| Coverage gained | 488,893 | 33,050 |
Petitioner, with the old antenna, could have secured the same daytime coverage increase as it secured with the new antenna if it had increased*247 its power output from 50,000 watts to 125,000 watts.
In January 1938 petitioner conducted a mailing survey to determine its coverage. It made a series of free mail offers on various programs during the day and night, offering a different item at each broadcast time. Based on a survey of the items requested, the petitioner could determine the time and distance of its coverage. It computed its potential circulation by the method then being used by NBC to compute coverage by means of mail response. In 1938 the average number of 3.9 persons composed a radio home. Petitioner's potential composite daytime and nighttime circulation, based on the survey in 1938, was 1,583,763 persons.
Petitioner prepared a brochure announcing that the new antenna had been built and that the station service area had been increased. This brochure was sent to prospective advertisers and advertising agencies throughout the United States to stimulate new business.
*1555 Petitioner could not raise the network rates which were charged by NBC for use of WOAI facilities; NBC alone controlled these rates. Petitioner could raise the rates which it charged local and non-network national advertisers at any*248 time at its own discretion and without the approval of an outside body. However, good business practice in the radio industry required a close relationship between the charges for network, non-network, and local time.
Under the terms of petitioner's contract with NBC, dated February 24, 1937, it was provided in rider 2 as follows:
In the event that the transmitter location, power or frequency of your station is changed, or any other major improvement in equipment is made, at any time during the term of this contract so that your station is more valuable to NBC as a network outlet, we agree at your request to resurvey your station's coverage six months after any such change and to increase your network station rate if such increase is justified by our method for the determination of network station rates then in general use.
A radio station which served an area where there had been a population increase was also eligible for a rate increase.
In April 1938 petitioner, pursuant to rider 2 of its contract with NBC, requested an increase in its advertising rate from $ 260 per unit hour to $ 320 per unit hour. The basis of this request was that the petitioner had increased its coverage*249 by installing a new antenna. Pursuant to the contract, petitioner requested that NBC make a study of its coverage and grant the rate increase. With the request petitioner forwarded to NBC its own survey of its potential coverage.
NBC, upon receipt of petitioner's request and the supporting material, asked its statistical department to make an analysis of the local mail received by petitioner, together with the network mail, to determine whether or not a rate increase was justified. Petitioner, during the remainder of 1938, continued to urge NBC to increase its hourly rate above the prevailing rate of $ 260 per unit hour.
On December 21, 1938, the statistical department of NBC completed its analysis of petitioner's estimated daytime circulation. It found that during the daytime petitioner had an estimated circulation of 288,067 radio families. This analysis was based on a count of mail received for the years 1936, 1937, and the first three months of 1938. The estimated daytime listening audience of petitioner was 1,123,461 persons.
On January 6, 1939, the statistical department of NBC completed its final analysis of petitioner's estimated nighttime circulation. It found that*250 during nighttime petitioner had an estimated circulation of 457,806 radio families. The estimated nighttime listening audience of petitioner was 1,788,433 persons.
In February 1939 NBC granted petitioner an increase in its unit rate from $ 260 per unit hour to $ 300 per unit hour. By agreement *1556 the effective date of the rate increase was to be later in the year. On October 1, 1939, this increase was made effective.
It has always been the general policy of NBC in announcing rate changes not to make increases or decreases in rates for one station at a time. It announces as few rate changes a year as possible to reduce to a minimum the budget and bookkeeping problems of advertisers and affiliates.
Radio time which is sold for a station by a network is known as network time. National non-network time is sold to advertisers for an individual station or a group of stations. Network time is competitive with national non-network time since the salesmen for network time and national non-network time sell to the same advertisers.
Local time is sold to local advertisers whose market is limited to the immediate area of a station and who have their principal offices in the state. *251 The purchasers of this time are not actually buying a station's entire coverage because the coverage area beyond their markets is valueless to them.
The rates charged by petitioner during the base period for each of its most favorable hours were as follows:
| January 1, 1936, to December 31, 1940 | |||
| Network (NBC) | National (non-network) | ||
| New | New | ||
| Date of change | rate | Date of change | rate |
| In effect | In effect | ||
| Jan. 1, 1936 | $ 200 | Jan. 1, 1936 | $ 250 |
| June 29, 1937 | 260 | July 1, 1937 | 275 |
| Oct. 1, 1939 | 300 | Nov. 1, 1939 | 300 |
| January 1, 1936, to December 31, 1940 | |||
| Local | Texas quality network | ||
| New | New | ||
| Date of change | rate | Date of change | rate |
| In effect | In effect | ||
| Jan. 1, 1936 | $ 150 | Jan. 1, 1936 | $ 150 |
| Aug. 15, 1937 | 175 | Aug. 15, 1937 | 175 |
| Nov. 1, 1939 | 180 | Nov. 1, 1939 | 180 |
Petitioner did not increase its national non-network rate beyond $ 275 per hour earlier than November 1, 1939.
During the base period and beyond, the broadcasting industry with respect to network, national non-network and local time maintained a policy which protected continuing advertisers against price increases. Under this policy a radio advertiser was*252 protected against a rate increase for a period of one year after the rate increase was announced. For continuing advertisers the rate increases made by NBC and the petitioner on October 1, 1939, and November 1, 1939, did not become fully effective until October 1, 1940, and November 1, 1940, respectively.
However, it was a standard condition of the contracts which petitioner had with its advertisers for the period from April 11, 1935, through October 3, 1939, that the contract could be terminated by either party by giving the other two weeks notice unless it was otherwise stipulated on the face of the contract. These contracts also *1557 provided that if during the life of the contract petitioner gave a lower rate, the lower rate would apply to the contract. There was no provision concerning what would happen in the event the hourly rates of the radio station were raised during the life of the contract.
The following tables indicate petitioner's net income for the base period years and for the years before us:
| Base period years | |
| Taxable year ended | Net income |
| July 31, 1937 | $ 161,601.57 |
| July 31, 1938 | 173,133.80 |
| July 31, 1939 | 180,743.43 |
| July 31, 1940 | 197,582.77 |
| Excess profits tax years | |
| Taxable year ended | Net income |
| July 31, 1941 | $ 257,863.55 |
| July 31, 1942 | 318,825.64 |
| July 31, 1943 | 338,101.23 |
| July 31, 1944 | 420,907.36 |
| July 31, 1945 | 477,780.50 |
| July 31, 1946 | 458,829.30 |
*253 Petitioner's total commercial clock hours sold for the fiscal years ended July 31, 1936, through July 31, 1940, inclusive, were as follows:
| Year ended | Number of |
| July 31 | hours |
| 1936 | 2,507.29 |
| 1937 | 2,926.30 |
| 1938 | 2,986.27 |
| 1939 | 3,038.67 |
| 1940 | 3,091.91 |
The number of national non-network, local and Texas Quality Network (TQN) announcements for the fiscal years ended July 31, 1936, through July 31, 1940, inclusive, were as follows:
| Year ended | Number of |
| July 31 | announcements |
| 1936 | 11,577 |
| 1937 | 13,473 |
| 1938 | 13,805 |
| 1939 | 14,612 |
| 1940 | 17,600 |
Petitioner's total program and announcement revenue before deducting agency commissions for the fiscal years ended July 31, 1936, to July 31, 1940, inclusive, was as follows:
| Year ended | |
| July 31 | Revenue |
| 1936 | $ 270,911.57 |
| 1937 | 334,346.35 |
| 1938 | 400,456.33 |
| 1939 | 425,309.94 |
| 1940 | 456,735.28 |
During the month of December 1939, petitioner did not receive the full benefit of the rate increases which became effective for network time on October 1, 1939, and national non-network, local and TQN time on November 1, 1939. Continuing advertisers who were receiving a full year rate protection had not yet begun to pay*254 for their advertising at the new rates. If all invoices for network, national *1558 non-network, local and TQN time had been billed at the new rates for the month of December 1939, including allowance for normal discounts, petitioner's broadcasting revenue from such billings would have been increased from $ 33,583.15 to $ 37,356.48.
The installation by petitioner of a slightly more than one-half wave length uniform cross-section vertical radiator antenna during the base period was a change in the character of its business within the meaning of section 722 (b) (4) of the Internal Revenue Code.
Petitioner's income by December 31, 1939, did not reach the level of earnings it would have reached if the new antenna had been erected two years earlier because of the time lag in the effect of the rate increases.
Petitioner's average base period net income computed without the benefit of section 722 of the Code is an inadequate standard of normal earnings.
The sum of $ 170,721 is a fair and just amount representing normal earnings to be used by petitioner as a constructive average base period net income for the purpose of computing its excess profits tax for the taxable year ended July*255 31, 1941, and $ 204,621 is a fair and just amount representing normal earnings to be used by petitioner as a constructive average base period net income for the purpose of computing its excess profits tax for the taxable years ended July 31, 1942, to July 31, 1946, inclusive.
OPINION.
The question presented is whether petitioner is entitled to relief from excess profits tax for the years before us under the provisions of section 722 (b) (4). Under the statute petitioner must establish (1) that the tax computed without the benefit of section 722 results in an excessive and discriminatory tax, and (2) a fair and just amount representing normal earnings to be used as a constructive average base period net income. Cf. East Texas Motor Freight Lines, 7 T. C. 579. In determining (2) above, no regard shall be had to events or conditions affecting petitioner, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939.
We shall first consider whether petitioner has established (1) above. Section 722 (b) (4), in so far as material to the instant case, provides that the excess profits tax imposed shall be considered*256 excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713:
(b) * * * if its average base period net income is an inadequate standard of normal earnings because --
* * * *
*1559 (4) the taxpayer, * * * during * * * the base period, * * * 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 * * *.
It further provides that "the term 'change in the character of the business' includes * * * a difference in the capacity for production or operation." The parties agree that the petitioner is entitled to use the excess profits credit on income pursuant to section 713.
Petitioner contends that the erection of a new antenna during the base period produced an increase in capacity for production which directly resulted in an increase in its income from advertising so as to bring it within the scope and intent of section 722 (b) (4).
A further contention of the petitioner is that the modernization of its studio facilities, and the installation of new recording equipment should be considered as changes under*257 the statute. Petitioner did not press the latter contention. It appears from the modicum of evidence that these changes were repairs such as cleaning and painting, with the addition of some modern transcribing equipment. Without further discussion, these changes are found not to be within the scope of section 722.
It is respondent's contention with regard to the installation of the new antenna in 1937 that such an installation was simply a type of technical development which was routine with radio broadcasting stations, and therefore did not constitute a change in the character of petitioner's business within the meaning of section 722 (b) (4). Respondent further contends that the erection of the new antenna did not directly result in an increase in petitioner's advertising income.
If petitioner had increased its power, which it could not do under Federal Communications Commission regulations, then the following section of Regulations 112 would be applicable:
(d) Commencement or change in character of business. --
* * * *
(3) * * * A radio broadcasting station increased its power during the base period, necessitating changes and expansion of the physical property of the station, *258 and thus enlarged the area it served. The station was thereby enabled to increase its volume of advertising and advertising rates. Such radio station is deemed to have effected a change in its capacity for production or operation. * * * [Section 35.722-3(d) (3), Regulations 112].
The petitioner "enlarged the area it served." Prior to the erection of the new antenna in 1937, tests indicated that while 50,000 watts of input power were being generated into the old antenna, petitioner's effective radiating power, that is, the power which listeners can hear, was only about 20,000 watts. The antenna was operating on an efficiency of only 40 per cent. Tests on the new antenna indicated an efficiency of approximately 100 per cent. This was equal to an increase *1560 in effective radiating power of 150 per cent. Therefore, while petitioner had no actual increase in capacity to generate power, it has tripled its effective power by the use of the new antenna. The increase in effective power provided an increase in nighttime coverage from 12,700 square miles to 45,750 square miles and doubled the population served. A similar improvement was also shown for daytime coverage.
To qualify*259 for relief petitioner must show that the erection of the new antenna was a change of substantial, of a permanent or lasting nature, and not of a routine character. See section 35.722-3(d), Regulations 112. We think that the record clearly indicates that petitioner made a substantial change. On a small plot of land purchased especially for the installation, petitioner erected an entirely new antenna and installed a ground webbing to go with the antenna. Petitioner was a pioneer when it erected this new antenna; it was the first such antenna in Texas, or even in the Southwest. It is not disputed that the new antenna employed recent technological improvements, but the use of technical knowledge for a part does not necessarily designate the whole as a mere technological improvement of a routine character.
Prior to the erection of the new antenna petitioner had to secure the authorization of the Federal Communications Commission and the Bureau of Air Commerce. This tends to further support petitioner's contention that the change was of a substantial character. While no single factor itself proves that the change was of a major and substantial character, when we consider the testimony, *260 the tests and the plans prior to the erection, the antenna itself, and the resulting increase in coverage, there is no doubt in our minds that the change was substantial, and of a permanent and lasting nature.
Pursuant to its agreement with NBC wherein the petitioner could request a survey of its coverage after a major improvement was made, petitioner requested such a survey to determine if a rate increase was justified. In January 1939 the survey was completed. A month later, because of the increased coverage as shown by the survey, petitioner was granted an increase in its unit rate per hour. However, because of a trade practice, the increase was not made effective until October 1939. Respondent contends, since there was too great a time lag between the erection date and the date of the rate change, that the erection of the new antenna was not responsible for the rate increase. A vice president of NBC explained the cause for this time lag as follows:
It takes a considerable length of time for listeners to change their habits. They become accustomed to passing over a certain spot on the dial when inferior reception has been received. Gradually they begin to listen to that *261 station *1561 and eventually be counted as part of the circulation. It takes anywhere from six months to a year to accomplish that.
Other evidence indicates that because of the competition and trade practice WOAI could not raise its local rates for advertising until such time as it received a rate increase for network time. Because the petitioner has shown that the erection of the new antenna resulted in improved coverage, and that the rate increase was directly attributable to the improved coverage, we find that a higher level of earnings is directly attributable to the erection of the new antenna. Petitioner has shown "a change in the character of the business" within the contemplation of section 722(b)(4).
Generally, business experiences a time lag between the time that new operations are commenced, reflecting either the starting of a new business or of a business essentially different in character from an old business, and the attainment of a normal earning level. If all or a portion of this time lag occurs during the base period, the earnings during such period can not be said to represent normal average earnings. Section 35.722-3 (d), Regulations 112. Petitioner *262 received a rate increase in October 1939 and a month later increased its local and network rates so as to correspond to the network increase. However, under the trade rate policy these increases did not immediately improve petitioner's income. Under this policy a continuing advertiser was permitted to continue its broadcasts at the old rates for a period of 1 year beyond the date when the new rates became effective. Since the full effect of the rate increase would not be determined until some 12 months after the increase, an increase at the end of the base period could not possibly reflect the normal operations for the entire base period.
A provision of section 722 (b) (4) is as follows:
* * * 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. * * *
In light of this section of the Code and the evidence that it takes 12 months before the new rates can be applied to all advertisers, we think it necessarily*263 follows that as a matter of fact petitioner's business did not reach, by the end of the base period, the earning level which it would have reached if petitioner had made the change in character 2 years before it did.
On the entire record, we hold that petitioner has established that the tax computed without benefit of section 722 results in an excessive and discriminatory tax, and that its average base period net income is an inadequate standard of normal earnings.
*1562 In considering (2) above, what is a fair and just amount representing normal earnings to be used as the constructive average base period net income, we must evaluate an estimate of what earnings would have been under assumed circumstances. An absolute constructive net income is not available and is not expected.
Petitioner used the actual radio time sold in December 1939 as the basis of its reconstruction. Knowing the ratio of its income in December to the whole year, petitioner computed the yearly income. The 1939 yearly income was extended for the base period by the use of index numbers which the petitioner compiled. We do not accept these index numbers. The parties have stipulated statistical data from*264 which normal earnings for 1939 may be reconstructed. Some such reconstruction, subject to error as it probably is, must be used and has been used by the Court in arriving at a "fair and just amount to be used as constructive average base period net income." Cf. Victory Glass, Inc., 17 T. C. 381; Lamar Creamery Co., 8 T.C. 928">8 T. C. 928.
Decisions will be entered under Rule 50.