*157 Decision will be entered for the respondent.
Before 1937, petitioner produced cylinder-grinding machines which it sold to automobile repair shops. In 1937 it began making a new product, garden tractors, which it sold to Montgomery Ward. This constituted a change in the character of petitioner's business during the base period under section 722(b)(4). In its contract with Montgomery Ward it agreed to attempt to make improvements in the garden tractor. In 1939, it produced a riding tractor, which was sold at a loss in 1939, and a new type of garden tractor with front attachments, which was sold in 1940. In 1940, petitioner also produced fence controllers. Held: (1) The production of fence controllers in 1940 was not the result of a commitment prior to January 1, 1940. (2) Petitioner failed to establish a constructive average base period net income that would provide an excess profits credit larger than that available without the application of section 722.
*164 The Commissioner denied petitioner's claims under sections 722(a) and 722(b)(4) of the 1939 Code for relief from excess profits taxes imposed for the calendar years 1941-1945, inclusive. The petitioner has made claims for refunds of excess profits taxes in the amounts *165 of $ 4,732.93, $ 59,436.97, $ 54,405.86, $ 13,829.24, and $ 5,667.96 for the years 1941, 1942, 1943, 1944, and 1945, respectively. The only issue for decision is whether the Commissioner erred in rejecting those claims.
FINDINGS OF FACT.
Some of the facts have been stipulated. Such facts are found as stipulated.
The petitioner, a corporation organized under the laws of Wisconsin on May 11, 1922, and having its principal place of business in Port Washington, Wisconsin, filed its excess profits tax returns for the taxable years 1941 through 1945 with the collector of internal*159 revenue for the district of Wisconsin. It keeps its books and files its returns for calendar years on an accrual basis.
In his determination of the petitioner's excess profits taxes for the years 1941-1945, inclusive, the respondent computed petitioner's excess profits tax credit on the basis of invested capital pursuant to the provisions of section 714. Such credit, so computed, for each of the taxable years is as follows:
| Year | Invested capital excess profits tax credit |
| 1941 | $ 15,798,64 |
| 1942 | 14,318.27 |
| 1943 | 14,106.92 |
| 1944 | 16,482.44 |
| 1945 | 19,389.15 |
The petitioner's base period consists of the years 1936-1939, inclusive.
Petitioner's excess profits tax net income without reference to section 722, using petitioner's income tax returns for the years 1936 through 1939 as subsequently adjusted by a revenue agent's report and making the adjustments required by section 711, is computed to be as follows:
| Year | Excess profits net income (or loss) |
| 1936 | $ 285.25 |
| 1937 | (19,864.60) |
| 1938 | (9,953.57) |
| 1939 | (25,196.29) |
Prior to January 1, 1937, the petitioner manufactured only equipment for rebuilding internal combustion engines, which equipment was sold through*160 jobbers or directly to automobile repair shops.
The original stockholders of petitioner were Jackson B. Kemper, Francis Bloodgood, Jr., Wheeler P. Bloodgood, and W. J. Niederkorn. Each held 60 shares of the original issue of petitioner's common stock. Petitioner's first president was Jackson B. Kemper who held that office until his death in 1931. Clarence B. Hill, president of a bank in Port Washington, succeeded Kemper as president. W. *166 J. Niederkorn became president in 1934. Before becoming president, Niederkorn at all times had been the general manager, and he held the office of vice president in 1922 and 1923, and secretary and treasurer from 1924 through 1933. At the beginning of the base period, petitioner's officers and directors were:
W. J. Niederkorn, president, director.
Francis Bloodgood, Jr., vice president, director.
L. A. Laubenstein, secretary-treasurer, director.
J. C. Grieveldinger, director.
Louella G. Kemper, director.
Kemper held in excess of two-thirds of petitioner's common stock as of December 31, 1928, and thereafter until his death; and after his death, his estate maintained the same stock ownership control of petitioner until 1934. From*161 1934 to December 29, 1936, Louella G. Kemper, the widow of Kemper, held a little over 50 per cent of the common stock of petitioner. She died on January 2, 1937, and title to her stock in petitioner then passed to the First Wisconsin Trust Company of Milwaukee under a testamentary trust created under her will.
In 1937, Eric W. Passmore acquired 61 shares of the common stock of petitioner, and in June 1937 he began to participate in the management of petitioner. Also, in 1937 Francis Bloodgood, Jr., for the first time, began to take an active part in the management of petitioner.
In November 1938, Clarence B. Hill purchased the stock of petitioner held in the Louella G. Kemper trust pursuant to an agreement with Niederkorn and Passmore which provided for the eventual division of the stock among the three of them. In 1938, there was a division of such stock under the agreement and thereafter Hill held 186 shares, Niederkorn held 207 shares, and Passmore held 207 shares, and they continued to own such numbers of shares of common stock during the remainder of petitioner's base period.
Upon its incorporation in 1922, petitioner owned the patents to a machine designed to rebore and grind*162 the cylinders of internal combustion machines used on automobiles and tractors, which machines were manufactured by petitioner and sold to automobile repair shops which used them to recondition wornout engines. From 1922 up to 1937, petitioner enlarged its line of products to include piston grinders, valve grinders, and connecting rod reboring machines, all of which were sold to petitioner's regular customers. Petitioner continued in the above-described business until 1946 when it sold its motor building machine and equipment business to the Waterbury Tool Company.
During the base period years, petitioner's plant was located in a rented, 2-story and basement, concrete building having about 10,000 *167 square feet on each floor. In 1936 petitioner occupied 15,000 square feet, and by 1939 it occupied the entire building, about 30,000 square feet. Petitioner's manufacturing facilities consisted primarily of a machine shop with the necessary machinery to machine castings and steel parts. The principal machinery used in the machine shops in 1939 included about 7 lathes, 2 turret lathes, 3 milling machines, 1 radial drill press, 3 small drill presses, 2 gear harbors, 1 power hacksaw, *163 3 punch presses, and about 4 electric welding machines. Petitioner employed from 35 to 40 people in 1936.
In about 1936, automobile manufacturers began selling factory rebuilt engines to automobile owners as replacements for their wornout engines. This greatly reduced the business of reconditioning and rebuilding internal combustion engines conducted by automobile repair shops, and, in turn, the demand of such customers for the products manufactured by petitioner was greatly reduced. Because of declining sales, petitioner's managers, Bloodgood and Niederkorn, concluded that petitioner either must be liquidated or develop new business through the manufacture and sale of new products, and they began to survey ways for obtaining new products to manufacture.
Garden Tractors.
Gilson-Bolens Manufacturing Company in Port Washington, where petitioner's plant is located, in 1935, manufactured garden tractors, known as the conventional type, and attachments. They have 2 wheels, a motor of from 5/8 to 5 horsepower, and drag attachments attached at the rear. The operator guides the tractor, walking behind. The attachments included a cultivator, plow, harrow, and seeder such as are used*164 on large farm tractors. Gilson-Bolens engaged the Oliver Farm Equipment Company to assemble the tractors.
In 1935, Montgomery Ward entered into a contract with Gilson-Bolens for conventional garden tractors and attachments.
Early in 1937, Gilson-Bolens engaged the petitioner to make certain parts for the tractors.
Montgomery Ward became dissatisfied with its arrangements with Gilson-Bolens. However, Montgomery Ward believed that there was a demand for a small type of garden tractors; that it could develop a new market for them; and that it could become an important dealer. The smaller conventional garden tractors were then being used by commercial truck and flower producers, and for general garden work and lawn mowing. In about May 1937, Montgomery Ward began looking for a new manufacturer and asked Forrest V. Donald, an engineer and designer associated with Gilson-Bolens, to help in the search. At about the same time, the petitioner was in *168 search of a new item to manufacture. Donald had discussions with petitioner's president, Niederkorn, and its production manager, Grieveldinger. Niederkorn, soon after, began negotiations with Montgomery Ward for a contract to supply*165 it with garden tractors and attachments. By a letter dated May 24, 1937, the petitioner made certain proposals to Montgomery Ward which would cover a 3-year period. Petitioner proposed that it would employ Donald to work on improvements of the tractors, to develop new models, and to assist in instructing Montgomery Ward's branch managers in the operations of the tractors. Petitioner suggested that it might be able to obtain a license agreement from the owner of the patents covering the tractors which had been made by Gilson-Bolens. By a letter dated May 28, 1937, Montgomery Ward indicated its acceptance of petitioner's proposal, subject to certain conditions.
It was agreed that the initial production of petitioner would be the same conventional garden tractor which Gilson-Bolens had produced. That tractor was covered by a patent owned by Gilson-Bolens. Donald and Harry Bolens also had rights in the patent. Niederkorn negotiated with the above parties and he personally obtained a nonexclusive license to make certain models of the tractors covered by the patent for which he agreed to pay royalities.
Next, Niederkorn presented the proposed arrangements to petitioner's board of*166 directors for approval. He proposed assigning his nonexclusive license agreement to petitioner; that he should remain president and general manager at his then salary of $ 6,000 per year; that he would personally guarantee a loan of from $ 75,000 to $ 100,000 to be obtained by petitioner to finance changing over to the manufacture of garden tractors; and that petitioner, in return, should pay him 10 per cent of petitioner's gross sales to Montgomery Ward.
At a meeting on June 24, 1937, petitioner's directors accepted Niederkorn's proposals; they ratified and approved the tentative letter agreement of May 28, 1937, between petitioner and Montgomery Ward; and they authorized petitioner's officers to take the necessary steps to carry out the agreement. Petitioner's officers then, in the latter part of May or June 1937, entered into a formal 3-year contract for the period from July 1, 1937, to June 30, 1940, under which, except for exports to foreign countries, petitioner agreed to manufacture garden tractors exclusively for Montgomery Ward, to meet its requirements, and the latter agreed to purchase all of its requirements from petitioner. The petitioner, designated the seller, agreed, *167 inter alia, as follows:
agrees promptly to make improvements in, and wherever practical to promptly adopt and use new available inventions and other progressive developments in the method of designing and manufacturing garden tractors, and attachments *169 and tools relating thereto, either or both of which may be calculated to reduce production costs and to improve the utility or quality of the merchandise manufactured for Buyer hereunder. * * * Seller further agrees to maintain an adequate field research and engineering staff in order to learn of and develop new improvements in merchandise to be sold to Buyer hereunder.
As part of the 3-year contract, Montgomery Ward issued a blanket order for the first year period ending June 30, 1938, showing specific quantities and prices and indicating that shipments were to be made weekly at a specific rate unless it directed to the contrary. This blanket order was for 500 5/8-horsepower tractors with tool carriage and cultivator, 1,905 larger size tractors, 170 lawnmower hitches, 170 seeders, 100 harrows, 1,300 cultivators for 1-horsepower and over tractors, 1,050 plows, and 150 riding carts, plus approximately 10,000 replacement*168 or repair parts for the attachments. The contract also provided that the seller should furnish and make available to the buyer evidence satisfactory to the buyer, including any pertinent books and records of the seller which the buyer might require in order to substantiate any demand by the seller for an increase in prices, or in order to assist the buyer in reaching an agreement with the seller upon prices for any new or different items of merchandise to be manufactured by the seller for the buyer. Petitioner also agreed to accept the return of any merchandise containing defects in materials or workmanship, and to credit the billing price of such merchandise to Montgomery Ward. The contract provided that Montgomery Ward would furnish the engines and tires to be used in the assembly of garden tractors and that the selling price to Montgomery Ward would not include any profit or cost with respect to the material cost of such engines and tires.
The nonexclusive license agreement between Niederkorn and Gilson-Bolens, the assignment of the license by Niederkorn to petitioner, the contracts between petitioner and Montgomery Ward, and the employment of Donald by petitioner were all events*169 which transpired at or about the same time in May of 1937, and each step was dependent upon the others. At some time after June 24, 1937, and as part of the total arrangements, there was an agreement between Niederkorn, Bloodgood, and Passmore that the 10 per cent commission on sales to Montgomery Ward to be paid to Niederkorn would be divided between Niederkorn, Bloodgood, and Passmore, in the ratio of 40-30-30, respectively. Bloodgood died in the fall of 1937, but a share of such commission was paid in his name in 1938. In 1939, the commission was divided equally between Niederkorn and Passmore. Clarence Hill, in consideration of the fact that he did not participate in such commissions, was paid a salary of $ 5,000. The actual division of the 10 per cent commissions was as follows: *170
| 1937 | 1938 | 1939 | |
| W. J. Niederkorn | $ 223.04 | $ 5,040.42 | $ 8,039.73 |
| E. W. Passmore | 167.29 | 3,898.63 | 8,039.73 |
| H. H. Bloodgood | 167.29 | 3,425.27 | |
| 557.62 | 12,364.32 | 16,079.46 |
On petitioner's income tax returns, Niederkorn's and Passmore's commissions were included in compensation of officers. It was understood by the parties involved that these amounts, except Niederkorn's*170 salary of $ 6,000, were to be received by them in lieu of other compensation for their services to petitioner.
Petitioner began immediately, around June 24, 1937, to make necessary changes to adapt its productive facilities to the manufacture of garden tractors and attachments. Donald, who was then employed by petitioner, was the engineer in charge of making the changeover. He began in June 1937 to do the designing and engineering work on the line of products which petitioner had contracted to manufacture. The products were similar to the line of tractors and attachments which had been produced by Gilson-Bolens for Montgomery Ward.
Montgomery Ward's 1937 catalog advertised a 5/8-horsepower tractor as power for truck gardens, florists, golf courses, lawn mowing, gardens, and other jobs, and ideal for large homes and estates. The larger horsepower tractors were generally sold to commercial gardeners or truck farmers. Montgomery Ward learned from its experience with the Gilson-Bolens tractors that it was selling smaller size tractors than the industry in general was selling, but Montgomery Ward did not feel that it yet had the best products for exploiting what it believed was a *171 new market for small garden tractors.
Under the 1937 contract of Montgomery Ward with the petitioner, it was contemplated that garden tractors and attachments would be ready for sale during the 1938 selling season, but it was necessary to have pictures of the line of products ready for Montgomery Ward's catalog by July 1937 and, therefore, the initial line of products of the petitioner had to be similar to that manufactured by Gilson-Bolens for Montgomery Ward.
Petitioner manufactured and shipped to Montgomery Ward 57 garden tractors and some attachments during 1937. It soon was evident that Montgomery Ward would not be able to sell all of the tractors and attachments which it had anticipated. Petitioner realized a loss on its operations in 1937. In July 1938, petitioner realized that sales would have to be increased considerably in order to avoid loss for the year 1938.
*171 On May 26, 1939, R. S. Stevens and Bernard F. Cook of Montgomery Ward suggested that the petitioner should be allowed to secure additional outlets in the United States for its tractors rather than continue to manufacture exclusively for Montgomery Ward. Accordingly, on July 30, 1939, Montgomery Ward approved*172 a change in its contract which permitted petitioner to sell tractors to dealers, jobbers, and distributors, but not to any other mail-order houses, at prices which would be at least 15 per cent higher than prices to Montgomery Ward. This change was made with the understanding that Montgomery Ward was to benefit fully from savings which would follow from lower costs and reduced overhead. The change in the contract was made because petitioner was losing money. Montgomery Ward's officials did not know, however, that petitioner's officers were receiving a commission of 10 per cent of petitioner's sales to Montgomery Ward. If Montgomery Ward's officials had known of the commissions, they would have disapproved the arrangement because they object to insiders' commissions. Montgomery Ward also indicated willingness to purchase other products to increase petitioner's sales.
Petitioner shipped to Montgomery Ward and billed it for 1,705 garden tractors in 1938, and 1,561 in 1939. In the fall of 1939, Montgomery Ward gave petitioner a paid stock order for 820 tractors (635 1-horsepower with a cultivator, and 185 3-horsepower without attachments), but these tractors were not shipped by *173 petitioner in 1939. Nevertheless, petitioner's books showed that it sold the 820 tractors in 1939, as its books showed sales of 2,381 units, which included the 820, as follows: 1 hp., 1,918; 2 hp., 3; 3 hp., 197; 5 hp., 250; 8 hp., 13; total, 2,381. In addition, petitioner's export sales of garden tractors in 1938 were 101 units, and in 1939, 38 units. Petitioner's actual shipments of tractors in 1938 and 1939 totaled 1,806, and 1,599, respectively, exclusive of blanket orders for delivery after the end of 1938 and 1939. The following schedule lists the classes of garden tractors actually shipped to Montgomery Ward in 1938 and 1939, and the export sales:
| Shipped to Montgomery Ward | 1938 | 1939 |
| Horsepower | ||
| 5/8 | 581 | 0 |
| 1 | 0 | 1,283 |
| 2 | 0 | 3 |
| 3 | 0 | 12 |
| 5 | 0 | 250 |
| 8 | 0 | 13 |
| 1 and 2 1 | 825 | 0 |
| 3 and 5 1 | 299 | 0 |
| Subtotal | 1,705 | 1,561 |
| Export sales | 101 | 38 |
| Total | 1,806 | 1,599 |
*172 Montgomery Ward gave petitioner a blanket order in 1937 for the 1938 selling season, an order in 1938 for the 1939 season, and an order in 1939 for the 1940 season as follows:
| Type | 6/16/37 for | 12/2/38 for | 8/28/39 for |
| 1938 season | 1939 season | 1940 season | |
| Horsepower | |||
| 5/8 1 | 500 | 0 | 0 |
| 1 1 | 0 | 385 | 635 |
| 1 | 100 | 0 | 0 |
| 2 | 1,140 | 0 | 0 |
| 3 | 150 | 0 | 185 |
| 5 | 565 | 200 | 0 |
| 8 | 0 | 200 | 0 |
| 2,455 | 785 | 820 |
The retail buyers of garden tractors often buy additional attachments for tractors. Thus, it was normal that the ratio of tractor attachment sales to tractor sales would increase during the first few years of a seller's experience in the garden tractor field.
The store managers and clerks of Montgomery Ward were experienced in selling soft goods and were unacquainted with garden tractors and the attachments. Therefore, Montgomery Ward carried on a sales training program to promote sales of garden tractors. It was necessary to instruct clerks about how to demonstrate and handle the tractors and attachments. Also, Montgomery Ward contracted with petitioner to allow Donald to instruct store managers. In 1938 and 1939, Donald worked extensively on such instruction and sales promotion. He visited stores of Montgomery Ward throughout the country. Such work was not completed in 1939.
After obtaining Montgomery Ward's permission in July 1939 to sell directly to domestic dealers, petitioner immediately began to develop its own dealer organization in the United States. Although some dealers were obtained during the year, it was expected that at least 18 months*175 would be required to develop an organization to the point where it would contribute materially to an increase in petitioner's volume of sales.
Riding Tractor.
During 1938, Montgomery Ward had persuaded petitioner and Donald to undertake to develop a small riding tractor. Donald was skeptical but he proceeded to design an 8-horsepower riding tractor and several attachments such as a sickle bar, a cultivator, a plow, a spring tooth harrow, a disc harrow, and a seeder.
By an order dated December 2, 1938, Montgomery Ward ordered 200 riding tractors. Petitioner delivered slightly more than 100, plus attachments. The riding tractors were a failure. There was *173 a great deal of breakdown in the hands of purchasers, due in part to use in work for which the riding tractor was not intended. The tractors were taken back from customers, and were returned to petitioner in the spring of 1939. Almost all of the riding tractors and attachments were returned to petitioner. Petitioner stopped all production of them which was in progress and was obliged to scrap some of the materials. Only a small amount of the materials could be converted for use in the conventional walking-type *176 tractor. The petitioner sustained a loss in 1939 of about $ 12,800 as a result of the returns of riding tractors and the scrapping of materials.
Petitioner's business and Montgomery Ward's sales of tractors were hurt by the failure of the riding tractor. Montgomery Ward's only order for tractors in the fall of 1939 was a paid stock order for 635 1-horsepower tractors with a cultivator and 185 3-horsepower tractors without attachments.
Quick-Hitch Tractor.
Montgomery Ward, in 1937, had discussed with Donald a plan for designing a new type of garden tractor which would be lighter than the conventional garden tractor and would use front-hitch attachments which would mow grass and cut weeds as well as serve as a cultivator for a small garden. Donald had the idea for such new design which was described as an all-purpose, quick-hitch garden tractor. The development of the unsuccessful riding tractor and its problems delayed Donald's work on the quick-hitch tractor so that production thereof could not be started in the fall of 1939 and pictures thereof could not be included in Montgomery Ward's catalog for the spring of 1940.
In 1940, petitioner began the first manufacture of the *177 all-purpose, quick-hitch tractor and attachments, and those items were offered by Montgomery Ward for delivery in 1941. The first quick-hitch tractor which was put on the market carried the trade name, "Cultimower." It was a 1-wheel, light weight, 3/4-horsepower tractor. It employed a patented front-hitching device which enabled the user to interchange its attachments in 1 minute's time. The 1-wheel tractor is not used today.
The all-purpose, quick-hitch tractor introduced for the first time into the garden tractor field a lawnmower attachment which converted the tractor into an actual power mower. The Cultimower furnished power and also drove the cutting blades of the mower attachment at a high speed; it was designed for attachment to a cultivator, or a sickle-type mower, or a regular lawnmower.
In determining the prices which petitioner charged Montgomery Ward for garden tractors and attachments, Niederkorn would obtain *174 from Grieveldinger an estimate of the cost of materials and direct labor which entered into the manufacture of the various tractors and attachments sold to Montgomery Ward. Niederkorn then estimated the overhead attributable to the manufacture of such*178 products by a rule of thumb based on the assumption that factory burden would be equal to the cost of direct labor used in manufacturing; he then added the costs of material and direct labor to obtain his total estimated cost of the products. He then divided the estimated cost by three and added the resulting amount to the cost in order to obtain the price to charge Montgomery Ward. Such pricing formula, it was believed, would give petitioner an estimated gross profit of 25 per cent on its sales of garden tractors and attachments to Montgomery Ward. The pricing formula was not rigidly applied to each product. At times a price would have to be cut in order to meet a competitor's price. However, when the price of one item was cut, the price of another item was adjusted upwards in order to keep, if possible, the overall gross profit of petitioner at about 25 per cent.
The petitioner's net sales, cost of sales, gross profit, and the percentage of gross profit to net sales for garden tractors for each of the years 1937, 1938, and 1939, and the aggregate for the 3 years were as follows:
| Gross profit | ||||
| Years | Net sales | Cost of sales | Gross profit | percentage |
| and net sales | ||||
| 1937 | $ 8,201 | $ 5,742 | $ 2,459 | 30.0 |
| 1938 | 149,105 | 108,882 | 40,223 | 27.0 |
| 1939 | 168,949 | 151,798 | 17,151 | 10.2 |
| Aggregate 1937, | ||||
| 1938, and 1939 | 326,255 | 266,422 | 59,833 | 18.3 |
*179 If the $ 12,800 riding tractor loss were to be eliminated, petitioner's gross profit for 1939 would have been $ 29,951, or 17.7 per cent of net sales of $ 168,949. If the assumed inventory loss of $ 4,031.99 were also to be eliminated from the 1939 gross profit, the gross profit would be $ 32,983, or 20.1 per cent of 1939 sales. The following table shows how the foregoing figures would be computed:
| Gross profit after | Gross profit after additional | ||||
| adjusting loss from | adjustment from | ||||
| Garden | riding tractor | assumed inventory loss | |||
| Years | tractor | ||||
| net sales | |||||
| Amount | Per cent to | Amount | Per cent to | ||
| net sales | net sales | ||||
| 1937 | $ 8,201 | $ 2,459 | 30.0 | $ 2,459 | 30.0 |
| 1938 | 149,105 | 40,223 | 27.0 | 40,223 | 27.0 |
| 1939 | 168,949 | 29,951 | 17.7 | 33,983 | 20.1 |
| Total | 326,255 | 72,633 | 22.1 | 76,665 | 23.5 |
*175 Petitioner's normal gross profit on sales of tractors and attachments to Montgomery Ward, excluding the riding tractor loss, averaged 22.1 per cent of its net sales for the period from June 1937 through December 31, 1939.
The entry of Sears, Roebuck and Company and Montgomery Ward into the garden tractor field in the middle 1930's *180 marked the first attempts to gain a mass distribution of garden tractors. Because of the small size of the industry in these early years, the efforts of a company having the distribution which Montgomery Ward had was expected to have a major effect on such market. In the years 1937 to 1939, inclusive, Montgomery Ward's position in the garden tractor field was 0.6 per cent; 17.7 per cent; and 16.3 per cent, respectively. The table below indicates the growth of Montgomery Ward as compared to the industry as a whole:
| Petitioner's | Industry | Per cent | |
| Year | shipments to | shipments, | Montgomery |
| Montgomery | units | Ward to | |
| Ward units | industry | ||
| 1937 | 57 | 10,218 | 0.6 |
| 1938 | 1,705 | 9,633 | 17.7 |
| 1939 | 1,561 | 9,599 | 16.3 |
The following table shows, for the years 1922 through 1931, and 1935 through 1939, the number of garden tractors produced by manufacturers in the United States, the number shipped, and the value in dollars:
| Shipments | |||
| Year | Number | ||
| produced | |||
| Number | Value | ||
| 1922 | 898 | 1,109 | $ 187,766 |
| 1923 | 2,682 | 2,696 | 546,487 |
| 1924 | 2,505 | 2,400 | 330,535 |
| 1925 | 3,456 | 3,407 | 508,612 |
| 1926 | 3,921 | 3,906 | 572,209 |
| 1927 | 5,591 | 4,928 | 721,369 |
| 1928 | 4,465 | 4,237 | 786,602 |
| 1929 | 5,895 | 5,314 | 839,177 |
| 1930 | 6,161 | 5,003 | 938,192 |
| 1931 | 2,675 | 2,673 | 585,377 |
| 1935 | 4,273 | 4,254 | 810,325 |
| 1936 | 5,939 | 5,981 | 1,110,095 |
| 1937 | 10,716 | 10,218 | 1,539,903 |
| 1938 | 9,949 | 9,633 | 1,332,014 |
| 1939 | 9,777 | 9,599 | 1,423,818 |
*181 In 1939, Montgomery Ward generally had their stores in smaller towns. On the other hand, Sears, Roebuck and Company generally had their stores in towns over 50,000 population. In towns with a population of 30,000 or more, there are found suburban customers, and they increase where towns are larger.
In 1939, there was not the demand for a suburban-type garden tractor that exists today.
Sears, Roebuck and Company had sold garden tractors at least since 1925. Their tractors were manufactured in Sears' wholly *176 owned factory, David Bradley. However, Sears' purchasing of tractors from its wholly owned factory did not differ materially from buying from an outside source.
Sears had approximately 20 per cent of the garden tractor market in 1939. Sears did not have a quick-hitch in 1939 on its garden tractors for front-mounted attachments similar to the one developed by petitioner for 1941 sale.
The 8-horsepower tractors, mentioned heretofore, were too heavy and difficult for satisfactory handling by Montgomery Ward's customers and most of those sold were returned to petitioner. Petitioner sold Montgomery Ward 124 of these tractors, and 111 were returned. Petitioner converted*182 the 111 tractors to the 5-horsepower model of the conventional tractor. On its books, the 111 returned tractors were "charged back" in the accounts relating to the 8-horsepower models; and in sales of the 5-horsepower models entries were made showing corresponding sales of 111 converted models.
Petitioner's accounts show sales in 1939 of 250 units of the 5-horsepower garden tractor. That figure includes the 111 unsatisfactory 8-horsepower models which were taken back and changed over into 5-horsepower models. Subtracting the remodeled units, there were 139 units of 5-horsepower tractors sold in 1939. Petitioner's records show an overstatement, in effect, of sales of the 5-horsepower models to the extent of 111 units.
It has been stated herein, supra, that Montgomery Ward's sales of garden tractors in 1939 proved to be fewer than expected and that in order to help petitioner, Montgomery Ward gave it a paid stock order for a total of 820 tractors dated August 28, 1939. Petitioner received payment of $ 37,515 under this order. That order was mailed on September 25, 1939, and was for 635 1-horsepower models at $ 36.50 each, and 185 3-horsepower models at $ 77.50 each. None *183 of the tractors covered by this order was completed by petitioner and delivered in 1939, although the order contemplated that they would be by the end of December. Since petitioner did not deliver any tractors in 1939 under this stock order, although it included Montgomery Ward's prepayment in the amounts of its 1939 sales, petitioner's actual sales in 1939 were overstated in the amounts of $ 23,177.50 and $ 14,337.50 for the 1-horsepower and 3-horsepower models, respectively. Also, petitioner's record of the numbers of units actually sold in 1939 was overstated by 635 and 185 units of the 1- and 3-horsepower models, respectively.
Petitioner's actual sales in 1939 as adjusted to correct the billings of the 635 1-horsepower tractors, and the 185 3-horsepower tractors on August 28, 1939, not shipped in 1939, and by the 111 5-horsepower tractors that resulted from reworking 111 8-horsepower tractors returned, were as follows: *177
| (1) 1 | (2) | (3) | (4) 2 | |
| Emergency | ||||
| paid stock | Actual 1939 | |||
| 1939 | order (included | Reworked 8 | sales corrected | |
| Actual sales | in sales but | horsepower | for abnormalities | |
| not completed | ||||
| at Dec. 31, | ||||
| 1939) | ||||
| Horsepower | ||||
| 1 | 1,918 | 635 | 0 | 1,283 |
| 2 | 3 | 0 | 0 | 3 |
| 3 | 197 | 185 | 0 | 12 |
| 5 | 250 | 0 | 111 | 139 |
| 8 | 13 | 0 | 0 | 13 |
| Total | 2,381 | 820 | 111 | 1,450 |
Expressed as percentage of the total unit sales of tractors, the 1-horsepower model represented 80.1 per cent of the total tractors billed to Montgomery Ward in 1939 (1,918 divided by 2,381). Expressed as a percentage of the total actual 1939 unit tractor sales, the 1-horsepower model represented 88.48 per cent of the total tractor sales (1,283 divided by 1,450).
The following tables show for the base period years 1936 through 1939 petitioner's profit and loss according to its audit reports and adjusted to show excess profits net income:
| 1936 | ||
| Garden tractors and attachments: | ||
| Net sales | ||
| Cost of material and labor: | ||
| Material | ||
| Labor | ||
| Motor rebuilding equipment: | ||
| Net sales | $ 118,847.29 | |
| Cost of material and labor | ||
| Material | $ 22,906.67 | |
| Labor | 18,811.38 | 41,718.05 |
| 77,129.24 | ||
| Total sales less cost of material and labor | 77,129.24 | |
| Manufacturing expenses | 25,408.39 | |
| Total gross profit all sales | 51,720.85 | |
| Selling and administrative expenses | 51,226.39 | |
| Operating income (or loss) | 494.46 | |
| Other charges: | ||
| Interest paid | 497.43 | |
| Discounts allowed | 939.48 | |
| Inventory of obsolete stock written off | ||
| Discount on notes receivable discounted | 4,649.57 | 6,086.48 |
| Less other income: | ||
| Interest and finance charges earned | 5,740.34 | |
| Profit on sale of fixed assets | ||
| Miscellaneous | 136.93 | 5,877.27 |
| Other charges -- net | 209.21 | |
| Taxable income (or loss) | 285.25 |
| 1937 | ||
| Garden tractors and attachments: | ||
| Net sales | $ 8,201.44 | |
| Cost of material and labor: | ||
| Material | $ 3,410.26 | |
| Labor | 1,082.10 | 4,492.36 |
| 3,709.08 | ||
| Motor rebuilding equipment: | ||
| Net sales | 79,665.19 | |
| Cost of material and labor: | ||
| Material | 16,298.68 | |
| Labor | 17,551.70 | 33,850.38 |
| 45,814.81 | ||
| Total sales less cost of material and labor | 49,523.89 | |
| Manufacturing expenses | 21,526.19 | |
| Total gross profit all sales | 27,997.70 | |
| Selling and administrative expenses | 30,724.73 | |
| Operating income (or loss) | (2,727.03) | |
| Other charges: | ||
| Interest paid | 1,729.85 | |
| Discounts allowed | 1,037.16 | |
| Inventory of obsolete stock written off | 16,022.78 | |
| Discount on notes receivable discounted | 18,789.79 | |
| Less other income: | ||
| Interest and finance charges earned | 1,592.07 | |
| Profit on sale of fixed assets | ||
| Miscellaneous | 60.15 | 1,652.22 |
| Other charges -- net | 17,137.57 | |
| Taxable income (or loss) | (19,864.60) |
| 1938 | ||
| Garden tractors and attachments: | ||
| Net sales | $ 149,104.81 | |
| Cost of material and labor: | ||
| Material | $ 62,533.71 | |
| Labor | 18,475.62 | 81,009.33 |
| 68,095.48 | ||
| Motor rebuilding equipment: | ||
| Net sales | 39,976.37 | |
| Cost of material and labor: | ||
| Material | 11,224.30 | |
| Labor | 11,400.40 | 22,624.70 |
| 17,351.67 | ||
| Dorr pumps: | ||
| Net sales | ||
| Cost of material and labor: | ||
| Material | ||
| Labor | ||
| Total sales less cost of material and labor | 85,447.15 | |
| Manufacturing expenses | 47,071.43 | |
| Total gross profit all sales | 38,375.72 | |
| Selling and administrative expenses | 45,630.99 | |
| Operating income (or loss) | (7,255.27) | |
| Other charges: | ||
| Interest paid | 3,068.39 | |
| Discounts allowed | 802.07 | |
| Inventory of obsolete stock written off | ||
| Discount on notes receivable discounted | 3,870.46 | |
| Less other income: | ||
| Interest and finance charges earned | 1,047.10 | |
| Profit on sale of fixed assets | ||
| Miscellaneous | 125.06 | 1,172.16 |
| Other charges -- net | 2,698.30 | |
| Taxable income (or loss) | (9,953.57) |
| 1939 1 | ||
| Garden tractors and attachments: | ||
| Net sales | $ 168,949.01 | |
| Cost of material and labor: | ||
| Material | $ 92,303.74 | |
| Labor | 28,169.13 | 120,472.87 |
| 48,476.14 | ||
| Motor rebuilding equipment: | ||
| Net sales | 41,773.69 | |
| Cost of material and labor: | ||
| Material | 12,039.52 | |
| Labor | 11,224.61 | 23,264.13 |
| 18,509.56 | ||
| Dorr pumps: | ||
| Net sales | 21,409.75 | |
| Cost of material and labor: | ||
| Material | 15,132.41 | |
| Labor | 3,497.43 | 18,629.84 |
| 2,779.91 | ||
| Total sales less cost of material and labor | 69,765.61 | |
| Manufacturing expenses | 46,932.26 | |
| Total gross profit all sales | 22,933.35 | |
| Selling and administrative expenses | 44,973.65 | |
| Operating income (or loss) | (22,140.30) | |
| Other charges: | ||
| Interest paid | 2,854.74 | |
| Discounts allowed | 640.53 | |
| Inventory of obsolete stock written off | ||
| Discount on notes receivable discounted | 3,495.27 | |
| Less other income: | ||
| Interest and finance charges earned | 352.81 | |
| Profit on sale of fixed assets | 47.51 | |
| Miscellaneous | 38.96 | 439.28 |
| Other charges -- net | 3,055.99 | |
| Taxable income (or loss) | (25,196.29) |
*187 *178 Petitioner's total selling expenses (in round figures), and the total amount of commissions paid to officers on garden tractor sales to Montgomery Ward in the years 1936-1939, inclusive, the commissions being included in selling and administrative expenses, were as follows:
| 1936 | 1937 | 1938 | 1939 | |
| Officers' commissions | 0 | $ 557 | $ 12,364 | $ 16,079 |
| Sales expenses | $ 31,147 | 12,865 | 23,198 | 22,137 |
Petitioner's total administrative expenses (in round figures), and the total amount of salaries paid to officers (including Niederkorn's salary) in the years 1936-1939, inclusive, were as follows:
| 1936 | 1937 | 1938 | 1939 | |
| All officers' salaries | $ 7,890 | $ 7,980 | $ 7,980 | $ 12,980 |
| Administrative expenses | 20,078 | 17,859 | 22,432 | 22,836 |
*179 Petitioner's net income or loss, adjusted by revenue agents' reports, compensation paid to officers of petitioner for the years 1936-1939, inclusive, as shown in petitioner's income tax returns (in round figures) were as follows:
| 1936 | 1937 | 1938 | 1939 | |
| Salary, Niederkorn 1 | $ 6,000 | $ 6,000 | $ 5,879 | $ 14,039 |
| Salary, other officers | 1,890 | 1,980 | 11,040 | 15,020 |
| Total officers' salaries | 7,890 | 7,980 | 16,919 | 29,059 |
| Net income (or loss) | 285 | (19,865) | (11,947) | (25,196) |
New Product Failures.
Petitioner tried to enter into the manufacture of pumps and a milk tester but abandoned both in 1939. It made a few pumps in 1939 for the Dorr Manufacturing Company but learned that the undertaking would not be profitable. It employed the inventor of a milk tester, Emil Hansen, to develop that item, and began negotiations, in 1939, with Montgomery Ward for its sales. Montgomery Ward decided that the milk tester could not be merchandised. Therefore, petitioner gave up the milk tester promotion after expending at least $ 405.76, which was a loss.
Electric Fence Controllers.
Stanley G. Klumb, a resident of Milwaukee and an inventor, worked on inventions pertaining to an improved electric fence controller during the years 1934-1939 and filed applications for patents thereon on May 4, 1936, and January 30, 1939. His invention dealt with a mercury tube, the patentable part of a new model. He engaged in 1936 the services of Ira M. Jones, a Milwaukee patent lawyer, and became indebted to Jones for his services.
Klumb and Jones entered into a written agreement on October 16, 1939, their first agreement, by*189 which Klumb sold Jones an undivided one-fifth interest in the inventions of the patent applications and patents to be issued, in consideration for the cancellation of Klumb's debt to Jones and Jones' agreement to do certain work relating to prosecution of an interference action and other matters and to assume certain expenses. It was agreed that Jones' one-fifth interest would lie in royalties and profits derived from the sales of units or "the licensing of others to manufacture and sell said units," and that the parties would not grant any rights under the expected patents without the written consent of the other. There is in this agreement no determination or mention of the amount of any royalty to be paid to Klumb upon sales of units or the licensing of others *180 to make and sell units, and there is no mention of or reference to Simplicity Manufacturing Company.
Klumb made and sold, personally, some experimental models of his fence controller during the years 1934-1939. He built the models himself at home, and he was not employed at any other work during this period.
When the above agreement was executed, Jones expressed the opinion that some concern could become interested*190 in manufacturing the fence controllers, but at that time Jones did not mention any particular person or concern.
The electric fence controller of Klumb's invention comprised a tube, a condenser, and wiring. It is an electrical device which charges a wire in a wire fence with an electric current, contact with which deters animals from going through the fence. Some models are operated with a battery. One model is connected with an electricity line conducting an a.c. current.
The manufacture, or production, of the fence controller consists of assembling the component parts -- tubes, condensers, and wires -- into units and enclosing the units in whatever case or container might be suitable. In the production of units, a glassblower is employed to make vacuum tubes, but many of the parts are purchased from outside sources. Small tools are used in assembling a unit, such as pliers, screwdrivers, and soldering irons. Girls are employed at workbenches in the assembly work. An engineer and various men are also employed in the production and shipping work.
As of October 1939, Jones was well acquainted with petitioner's president, Niederkorn, as a professional adviser and friend; he had*191 done some work for him relating to garden tractors; and he knew of petitioner's production of tractors for Montgomery Ward.
At some time after October 16, 1939, but in 1939, Jones told Niederkorn about Klumb's fence controllers and Niederkorn expressed an interest in the possibility of interesting Montgomery Ward in taking them for sale. Niederkorn told Jones that if Montgomery Ward would undertake to purchase the fence controllers from Simplicity, after seeing samples and negotiating, Simplicity would enter into an agreement with Jones and Klumb to manufacture the fence controllers on a royalty basis. Niederkorn was not interested, however, in Simplicity's making them for sale to various dealers. His interest from the outset was conditioned upon Montgomery Ward's becoming interested in buying the fence controllers from Simplicity.
In order to market the fence controllers it was necessary to design a case to hold the working mechanism of a controller, as well as to enter into negotiations with Montgomery Ward about various matters, conditions, standards, and unit prices for various models, and *181 to develop sample models for Montgomery Ward's consideration. It was necessary, *192 also, to negotiate with Klumb for a license to make, use, and sell his inventions on a royalty basis.
R. S. Stevens is the manager of the farm equipment division of Montgomery Ward; Bernard F. Cook is a buying supervisor; and B. A. Kaefer is associated with Cook and Stevens in the same division.
Brook Stevens is an industrial designer in Milwaukee, having his own office, a design engineer, and staff. He had worked for Simplicity on designs of garden tractors.
At some time after entering into the first agreement with Jones on October 16, 1939, Klumb, at Jones' suggestion, took a fence controller to Simplicity's office to give Niederkorn a demonstration of its operation and to interest him in marketing the device. After that meeting with Niederkorn, it was Klumb's understanding that Simplicity was not then equipped to manufacture and did not have the personnel to handle an electrical device. Niederkorn proceeded with his consideration of the fence controller. He requested Brook Stevens to design and make a model of a case for a fence controller. Also, he contacted representatives of Montgomery Ward.
Montgomery Ward had been selling an electric fence controller manufactured by Northern*193 Signal Company from whom it made purchases in 1938, 1939, and 1940. For example, it purchased from Northern Signal in 1938, 14,599 units for $ 135,685; in 1939, 22,292 units for $ 198,726; and in 1940, 32,172 units for $ 230,691.
On February 26, 1940, Niederkorn sent a letter to Kaefer, of Montgomery Ward, regarding the Klumb fence controllers. This was Niederkorn's first written communication with Montgomery Ward on this subject. Niederkorn advised Kaefer about various features, advantages, and conditions; that the design was streamlined by Brook Stevens; that Jones had approved the construction after field operating tests; that approval of States having electric fence laws would be obtained; that the price would be lower or equal to what Montgomery Ward was then paying; and that the Klumb controllers might be advantageous after the end of Montgomery Ward's contract with Northern Signal. In this letter, Niederkorn did not suggest any unit prices.
As of February 26, 1940, Simplicity did not have a license to make and sell the Klumb fence controllers. It did not obtain such license until November 1, 1940, which was after Montgomery Ward gave Simplicity the first blanket order *194 on September 15, 1940.
On March 6, 1940, Niederkorn, for Simplicity, sent another letter to Kaefer submitting Simplicity's proposal to supply Montgomery Ward with four models at stated prices, three battery-operated *182 models, and one a.c. electric line model, all equipped with a flasher. Prior to this letter, Niederkorn and Jones, within the week, had conferred with Kaefer. Simplicity's proposal was conditioned upon the receipt of an order from Montgomery Ward by September 1, 1940, and Simplicity urged that an "early decision" be made by Montgomery Ward.
On April 4, 1940, petitioner sent its completed cost figures on certain models of electric fence controllers to Montgomery Ward and, again, requested a decision.
On April 19, 1940, R. S. Stevens of Montgomery Ward sent a letter to petitioner expressing Ward's interest in three models and setting forth several matters which represented Ward's conditions for placing an order for Ward's estimated requirements for 1941.
On April 23, 1940, petitioner, by letter, accepted the conditions previously prescribed by Montgomery Ward.
On April 23, 1940, Klumb entered into a written agreement with Jones which recited that Jones had alleged*195 that Simplicity Manufacturing Company was desirous of obtaining an exclusive license to make, use, and sell Klumb's inventions relating to electric fencing, and that Klumb desired to grant to Jones the right to license Simplicity subject to the payment of royalties to Klumb. Under this agreement, Klumb empowered Jones to grant Simplicity the sole and exclusive license to make, use, and sell any and all of Klumb's inventions in and to electric fencing and fence controllers, subject to certain terms and conditions including the royalty to be paid to Klumb on battery-operated sets of fencing called models A, B, and C, and on model D, a high line controller operated under a.c. current. It was provided, further, that if Simplicity should be unsuccessful in obtaining business from Montgomery Ward by October 1, 1940, the agreement would be terminated. Niederkorn was a witness to the execution of the agreement.
In July 1940, petitioner hired Klumb to assist in the work of petitioner relating to the fence controllers.
On September 15, 1940, Montgomery Ward gave petitioner a blanket order for 14,060 fence controllers of various specified models in the amount of $ 106,718.20.
On October 29, *196 1940, Klumb and Jones entered into another agreement. There was pending then an interference proceeding relating to one of Klumb's patent applications and Klumb was unable to finance continuance of the legal matters involved. Jones wanted to terminate all of his previous agreements with Klumb, and Klumb wanted to renegotiate an agreement with Jones to induce Jones to continue the prosecution of Klumb's patent applications and interference suit. Therefore, under the agreement of October 29, 1940 *183 Klumb granted Jones the exclusive and sole right and license to make, use, and sell his inventions in electric fencing and fence controllers, it being understood that Jones contemplated licensing Simplicity to manufacture four models of fence controllers, A, B, C, and D. Jones agreed to pay Klumb a specified royalty on only one model, the high line (model D) fence controller sold by Jones or a sublicensee.
On November 1, 1940, Jones, as the exclusive licensee, entered into a written sublicense agreement with petitioner granting petitioner an exclusive license to make, use, and sell the inventions covered by Klumb's patent applications pertaining to electric fencing and fence controllers*197 subject to the payment by petitioner to Jones of 5 per cent of its net sales price of all models of fence controllers, or parts thereof.
In the fall of 1940, petitioner arranged facilities for the production of the fence controllers on the third floor of its plant. Space which had been used for storage and some motor rebuilding equipment was cleared, cleaned out, and the floor was sanded. The use of the area was changed to a workshop for assembling fence controller units. Fifteen workbenches and a ventilating light fixture device were installed. No machines were used in the production of fence controllers. The cases in which the units were installed and practically all of the parts of the units were purchased from suppliers. Only small tools were used. Petitioner spent about $ 5,000 in the fall of 1940 to arrange a work area where the fence controllers were to be assembled. Petitioner hired 20 girls and 5 men to take care of production.
Petitioner started the production of the fence controllers in the latter part of 1940 for the 1941 requirements of Montgomery Ward.
Under the sublicense agreement of November 1, 1940, with Jones, the royalties to be paid by petitioner to Jones*198 were 5 per cent of its net sales of fence controllers. Under the license agreement from Klumb to Jones, dated October 29, 1940, the royalty to be paid to Klumb was 25 cents for each so-called high line controller, i.e., the controller operated on a.c. current from an electric line, with a stated minimum each year. Jones asked Klumb to waive the minimum amount of his royalties for 1941. Petitioner, as sublicensee, paid royalties to Jones. Jones, as the licensee, paid royalties to Klumb.
In a letter dated April 5, 1941, Jones advised Niederkorn that he wished to have Niederkorn share royalties with him, over and above the royalties due Klumb each year, as long as Simplicity was the sublicensee. Accordingly, petitioner paid royalties to Jones who, in turn, made payments to Klumb. Petitioner also paid royalties *184 to Niederkorn. Jones' letter to Niederkorn stated, in part, as follows:
Although during my negotiation of this contract no mention was made of the fact, I have felt all along that I would like to have you participate in royalties as long as Simplicity is the licensee, for I realize that you put forth considerable effort even though it was in the interests of the*199 company.
The following table sets forth the amounts of royalties received by Jones, Niederkorn, and Klumb during the years 1941-1946, inclusive:
| Year | Jones | Niederkorn | Klumb |
| 1941 | $ 6,347.54 | $ 5,116.52 | $ 1,231.00 |
| 1942 | 8,049.71 | 6,577.21 | 1,472.50 |
| 1943 | 6,874.67 | 4,732.66 | 2,142.00 |
| 1944 | 5,992.81 | 4,335.83 | 1,656.95 |
| 1945 | 4,531.09 | 3,108.44 | 1,422.65 |
| 1946 | 4,273.88 | 2,801.42 | 1,472.45 |
| 36,069.70 | 26,672.08 | 9,397.55 |
Montgomery Ward's purchases of fence controllers from Northern Signal Company and Simplicity, respectively, during the years 1938-1946, inclusive, were as follows:
| Northern Signal | Simplicity | |||
| Year | ||||
| Units | Amounts | Units | Amounts | |
| 1938 | 14,599 | $ 135,685 | (1) | (1) |
| 1939 | 22,292 | 198,726 | (1) | (1) |
| 1940 | 32,172 | 230,691 | (1) | (1) |
| 1941 | (1) | 1,178 | 31,077 | $ 229,592 |
| 1942 | 5,873 | 55,198 | 33,058 | 296,903 |
| 1943 | 7,104 | 76,799 | 21,692 | 261,727 |
| 1944 | 4,170 | 47,881 | 17,272 | 188,318 |
| 1945 | 6,620 | 76,362 | 14,497 | 148,023 |
| 1946 | 5,070 | 59,843 | 11,233 | 135,679 |
Petitioner was not committed prior to January 1, 1940, to a difference in products involving electric fence controllers which it produced in 1940. *200 Montgomery Ward had not agreed before the above date to purchase Klumb fence controllers from petitioner, and in the early part of 1940 it was still considering whether or not to give petitioner a contract for them.
Petitioner's commencement of the production of garden tractors in 1937 constituted a change in the character of its business.
Had petitioner commenced the manufacture of garden tractors and sold them to Montgomery Ward 2 years before it did so, it would have introduced the all-purpose, quick-hitch garden tractor in 1939.
If petitioner had commenced making garden tractors for Montgomery Ward 2 years before they were made, Montgomery Ward *185 nevertheless would have insisted on the production of the riding tractor, and because it proved to be a failure and a loss, petitioner's sales of other garden tractors would have been affected adversely.
Petitioner has not shown what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period.
OPINION.
It is undisputed that petitioner *201 is a taxpayer who is entitled to use the excess profits credit based on income, and that its manufacture of the conventional garden tractor in 1937, a new product, constituted a change in the character of its business during the base period within the meaning of section 722(b)(4) of the 1939 Code. 1
In 1939, petitioner obtained a release by Montgomery Ward from the restrictive provision in the 3-year contract whereby petitioner became free to develop its own dealer organization and to sell through its dealers its garden tractors and attachments under its own brand*202 name in the United States, in addition to selling them to Montgomery Ward. Late in 1940, petitioner began the manufacture of the Cultimower, the all-purpose, quick-hitch garden tractor, and new attachments. Also, late in 1940, petitioner began the production of electric fence controllers. The petitioner contends that its average base period net income is an inadequate standard of earnings. Its contention is based upon two premises, as follows:
(1) The first premise relates to petitioner's manufacture and sale of garden tractors. With respect thereto, petitioner relies upon the 2-year push-back rule contained in the second sentence of section 722(b)(4) 2 and claims (a) that it shall be deemed that it obtained the right to sell garden tractors in the United States under its own brand name through its own dealers and distributors 2 years before Montgomery Ward actually agreed to release petitioner from the exclusive restriction in its contract; and (b) that since the development of the Cultimower and the new attachments was one which clearly would have been expected to result from petitioner's *186 change to the garden tractor business in the ordinary course of such business, *203 it shall be deemed that it would have been manufacturing and selling the Cultimower with such new attachments as the lawnmower, cultivator, and sickle bar 2 years before it actually did, namely in the latter part of 1938.
(2) The second premise relates to petitioner's production of fence controllers, and with respect thereto petitioner relies upon the commitment rule contained in the fourth sentence of (b)(4), 3 contending that prior to January 1, 1940, it was committed to a course of action which resulted in the production of the fence controllers, which constituted a change in its capacity for production.
*204 Finally, petitioner contends that it has established that $ 131,885.33 would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period for the purpose of section 722(a).
The respondent's position is, briefly, as follows:
By virtue of the change in character of petitioner's business in 1937, represented by its manufacture of the conventional garden tractors and attachments, petitioner is entitled to assume that the change took place 2 years earlier. The respondent does not seriously dispute petitioner's contention that the development of the Cultimower, and new attachments, was a development which clearly would have been expected to result from the change to the garden tractor business, in the ordinary course of business. Accordingly, respondent does not seriously resist petitioner's claim that it is entitled to reconstruct Cultimower tractor sales in 1939.
However, the respondent argues that there was not a commitment prior to January 1, 1940, with respect to the fence controllers. Therefore, *205 the petitioner is not entitled to apply the 2-year pushback rule to the fence controllers in its attempt to reconstruct its base period net income.
Moreover, the respondent argues that the removal late in 1939 of Montgomery Ward's restriction on petitioner, to sell only to it in the United States, did not constitute a change in petitioner's capacity for production or operation, and even if it did, petitioner cannot derive any relief from this factor because if it were assumed that the restriction had been removed 2 years earlier, it would have resulted in either no additional sales or very small sales in 1939.
*187 Respondent contends, further, that petitioner has failed to establish validly a reconstruction of base period net income in the amount claimed, or in any amount which will provide a larger excess profits credit than has been allowed, and, therefore, some relief. In this respect, the respondent points out that if it is held that the petitioner is not entitled to reconstruct sales of and profits from fence controllers, then petitioner must remove about $ 30,000, attributed to that product, from its reconstruction. In addition, the respondent contends that for reasons*206 set forth hereinafter, petitioner's reconstruction is faulty and without foundation in respect to its elimination of an average amount of $ 66,000 of officers' commissions from expenses, and its elimination of the $ 12,800 loss on the riding tractors. Respondent asserts that petitioner's reconstruction of its unit sales of tractors, of unit prices of tractors, and of the percentage of profit from such sales are inflated and invalid. Under his criticism of petitioner's reconstruction of base period net income, it is the respondent's view (as we understand it) that the maximum amount which petitioner can validly reconstruct for its 1939 income (before making adjustments for the earlier years by use of an index) is around $ 8,500, which amount will not yield larger excess profits income credits for the excess profits years involved here than have been allowed.
The issues to be decided are clear. The mere existence of a change in the character of business within (b)(4) is not enough to entitle petitioner to relief under section 722. "Petitioner must also prove that, because of such change, its actual average base period net income does not reflect the normal operation during the base*207 period of the business as changed, and it must also establish a fair and just amount representing normal base period earnings for the changed business." . Furthermore, in the last analysis, petitioner must prove and establish a constructive average base period net income of such size as to produce larger excess profits credits than have been allowed without the benefit of section 722. .
Petitioner is entitled to reconstruct for all developments which clearly would have been expected to result from the change in the character of petitioner's business in the usual course of business under base period conditions. The record shows that if petitioner had commenced manufacturing garden tractors 2 years earlier, in 1935, it would have made and sold the all-purpose, quick-hitch garden tractor (the Cultimower) and the new attachments for that tractor by 1939. Forrest V. Donald had conceived the idea of an all-purpose tractor with front-hitch attachments which would mow grass and cut weeds, as well as use a cultivator for a small garden, *188 *208 before petitioner and Montgomery Ward entered into their 1937 agreement. Donald believed that a demand for such tractor would be found readily and he had discussed his idea with Montgomery Ward. It was interested, and it was strongly in favor of petitioner's employing Donald so that he might develop his project. In its contract with Montgomery Ward (paragraph 5), petitioner agreed to make improvements and adopt progressive developments in the method of designing and manufacturing garden tractors and attachments. It was part of petitioner's early negotiations with Donald that he would work on developing his design of a new-type garden tractor with front attachments. In spite of Montgomery Ward's insistence upon Donald's development of the riding tractor, which proved to be a failure, Donald completed the designing and engineering work on the Cultimower in 1939, and we are satisfied that such work would have been completed earlier, in 1938, but for the delays occasioned by demands of Montgomery Ward. We think it is clear that the Cultimower was developed in the normal course of developing petitioner's garden tractor business and would have been produced 2 years earlier if the change*209 in the character of petitioner's business had occurred 2 years before the change took place. Cf. . Petitioner is entitled to reconstruct Cultimower sales in 1939.
With respect to the removal late in 1939 of Montgomery Ward's restriction upon petitioner's sales through its own dealers in the domestic market, we think it may be assumed in this case that such release, opening another source of sales to petitioner, constituted a qualifying change under (b)(4). .
The next question is whether there was a change in petitioner's capacity for production after January 1, 1940, as a result of a commitment prior to January 1, 1940, with respect to the production of fence controllers.
Petitioner's conversion in 1940 of part of a floor of its plant to facilities for the production of fence controllers represented a change in capacity for production. Petitioner converted unused space in its building into a production department with workbenches, test benches, some laboratory facilities, and other arrangements which enlarged its productive operations, constituted "a difference*210 in the capacity for production or operation" within the meaning of section 722(b)(4). Respondent does not question this aspect of the issue. See Regs. 112, sec. 35.722-3(d)(3). The more difficult question is whether the petitioner was committed to such change in 1939 within the meaning of (b)(4).
The record shows that the following steps were taken in 1940 which led to petitioner's installation in its building of a production *189 division for assembling fence controllers in the latter part of 1940:
(1) On February 26, 1940, petitioner's president advised Montgomery Ward in writing about the features of the Klumb fence controller, which it said it could manufacture and sell. No prices were quoted.
(2) Thereafter, there were discussions between B. A. Kaefer of Montgomery Ward and Niederkorn, in which Ira Jones participated.
(3) Petitioner's first written offer to supply Montgomery Ward with four models of controllers at a stated price, each, for each type was made in a letter dated March 6, 1940, to Kaefer; and this was a proposal inviting acceptance by Montgomery Ward. The prices stated in the offer were $ 9 for the deluxe a.c. electric current set; $ 9 for the deluxe battery*211 set; $ 5.50 for the standard battery set; and $ 4.50 for the special battery set, each price without a battery. In this letter, petitioner also advised Montgomery Ward as follows:
It is important to us that we have your early decision on this proposal so that we can proceed, without delay, with the engineering and redesigning of the various units and submit our lowest prices.
* * * *
P.S. We have arranged to ship you a Battery Set for your test and approval.
(4) About one month later, petitioner sent a letter dated April 4, 1940, to Kaefer saying that it had completed its "cost figures," and submitting a list of revised prices for five models as follows: $ 9.40 for the deluxe a.c. electric current set having contact operation; $ 9.25 for the deluxe d.c. electric current set having continuous operation; $ 8.25 for the deluxe battery set with a flasher; $ 5.20 for the standard battery set with a flasher; and $ 4.15 for the special battery set without a flasher, each price without a battery. Again, Montgomery Ward's decision was requested.
(5) On April 19, 1940, R. S. Stevens, manager, sent a letter to petitioner stating that he had reviewed the proposals of March 6 and April 4; *212 that Montgomery Ward would be interested at the start in only three models; that eight specifications should be met by petitioner, including a guarantee; that petitioner should submit samples of the products by September 1 for listing in the spring of 1941 catalog; and that "at the time samples of the finished products are received and O.K.'d in line with the above, we will place blanket order with you for our estimated 1941 requirements."
(6) Petitioner, on April 23, 1940, gave Montgomery Ward's Stevens a written acceptance of his proposals and conditions of April 19.
(7) On April 23, 1940, Klumb entered into his first written agreement licensing Jones to grant a license to anyone to make and sell *190 the Klumb fence controllers; for the first time Klumb's royalties were fixed; for the first time Simplicity was mentioned in a written license agreement as a licensee; and failure of Simplicity to obtain "the Montgomery Ward business for the year 1941 by the first day of October, 1940" was stated to be a condition for terminating Klumb's agreement with Jones. Prior to April 23, 1940, Klumb had not given Jones any written license to license petitioner or any other firm or person*213 to make, use, and sell the Klumb fence controllers, the written agreement of October 16, 1939, having been limited to an assignment and sale to Jones of a one-fifth interest in royalties which might be derived from the sale or licensing to others of Klumb's two patent applications in the future, no mention having been made of the amounts of Klumb's royalties or of any particular licensee.
(8) On July 5, 1940, Brook Stevens' office completed a drawing of a case for a model "C" fence controller to be made of 16-gauge auto-body steel, enameled.
(9) In July 1940, petitioner hired Klumb, as an employee in petitioner's shop, to work on fence controllers.
(10) On September 15, 1940, Montgomery Ward gave petitioner a blanket order for the purchase of 14,060 fence controllers, valued at $ 106,718.20, to cover Montgomery Ward's requirements from December 1940 through July 31, 1941, to conform to the specifications contained in its letter to petitioner of April 19, 1940. The order was signed by Kaefer. It covered various quantities of four models at the following prices, each: $ 9.95 for the deluxe a.c. electric current set; $ 9.05 for the deluxe d.c. electric current set; $ 5.65 for the "master" *214 battery set; and $ 4.85 for the "standard" battery set.
(11) On October 29, 1940, Klumb and Jones terminated "all previous agreements" and entered into a new agreement whereby Klumb granted Jones "the sole and exclusive right and license to make, have made, use and sell" Klumb's fence controller inventions; and the only royalty to be paid to Klumb was fixed at a stated amount for the sale of every "high line" controller and at a total minimum figure per year. In this agreement it was stated that Jones contemplated licensing Simplicity, and that Simplicity contemplated manufacturing three battery-operated and one high line (electric line) operated controllers, A, B, C, and D, the battery-operated controllers being not patented.
(12) On November 1, 1940, Jones executed with Simplicity the first written license agreement whereby Jones granted Simplicity an exclusive license to make, have made, use, and sell any and all of Klumb's inventions in electric fence controllers, it being understood *191 that Simplicity contemplated making at least four models, A, B, C, and D (as described in Jones' agreement of October 29, 1940, with Klumb), and Simplicity agreed to pay Jones 5 per cent*215 of its net sales.
The above facts show that as of February 26, 1940, petitioner was attempting to interest Montgomery Ward in considering buying electric fence controllers from petitioner by suggesting that it could furnish a better product at a lower price than Montgomery Ward was then obtaining from Northern Signal; that as of the above date, Klumb had not granted to Jones or petitioner a license to make, have made, use, and sell his fence controllers; that Montgomery Ward did not commit itself until April 19, 1940, to give petitioner a blanket order for controllers; and that it was not until April 23, 1940, that a contract came into existence whereby petitioner bound itself to make for and sell to Montgomery Ward the controllers, and that Klumb gave Jones a license to make and have made the controllers, upon the condition that Simplicity was to receive a sublicense and would obtain a contract from Montgomery Ward not later than October 1, 1940.
Petitioner's claim, that it was committed in the latter part of 1939 to a course of action which was consummated after December 31, 1939, and which resulted in a change in its capacity for production or operation, is based upon the following*216 allegations and assertions with respect to what petitioner purportedly did before December 31, 1939; that it had commenced in 1938 to look for additional new products and volume of sales when it became evident that the sales of garden tractors were not as large as anticipated and desired; that it had expressed willingness in 1939 to Jones to make the fence controllers provided it could sell them to Montgomery Ward; that Jones orally had assured Niederkorn "in such manner as was considered a definite commitment" that petitioner would receive an exclusive license to manufacture, if petitioner were able to obtain a contract from Montgomery Ward; that Niederkorn began in 1939 "negotiating" with R. S. Stevens and Bernard Cook of Montgomery Ward for a contract; and that in 1939, petitioner contracted with Brook Stevens to have him design cases for the fence controllers for a lump sum of $ 750 for the completed job of making the design.
There are no items of written proof in support of the allegations of petitioner about what allegedly transpired in the latter part of 1939. Petitioner, with respect to such assertions, relies wholly on the testimony of Niederkorn, Jones, and Brook Stevens.
*217 Petitioner's theory about an oral agreement in 1939 with Jones is well described in some of Jones' testimony which is to the following *192 effect: That Jones and Niederkorn, in the latter part of 1939, had a tentative understanding that if Montgomery Ward would be interested in having Simplicity manufacture the electric fence controller, Simplicity would be interested in acquiring the license to make and sell the Klumb fence controller; that the best deal Jones could make at the time with Klumb was the agreement with him dated October 16, 1939; and that after that agreement with Klumb was made, Jones and Niederkorn had a gentlemen's agreement that Simplicity would "derive a license under the umbrella or cover of" the October 16, 1939, agreement between Jones and Klumb.
Niederkorn testified that in 1939 he told Jones "that Simplicity would make an agreement with him and Mr. Klumb to manufacture the electric fence controller of Klumb providing Montgomery Ward and Company would purchase it after we had submitted samples."
Cook, who was called by petitioner to testify about the garden tractors arrangements of Montgomery Ward, was not asked by petitioner to give any testimony about*218 the fence controller negotiations of Montgomery Ward; and R. S. Stevens was not called to give any testimony and no explanation was given for not calling him. There is nothing in the record to corroborate or substantiate Niederkorn's testimony that he had discussions in 1939 with Cook and R. S. Stevens of Montgomery Ward about the Klumb fence controllers, and that in 1939 they requested Niederkorn to submit samples of the controllers with prices. The unexplained absence of testimony of Stevens and Cook suggests that their testimony would not have been favorable to petitioner. . It must be recognized that Niederkorn was testifying from his recollection of circumstances in 1939, over 17 years before the trial of this case, and that his memory may have been less than precise and accurate in fixing his first discussions with Stevens and Cook as having taken place in the latter part of 1939 rather than soon after January 1, 1940. We are unable to give Niederkorn's uncorroborated testimony on this matter as much weight as petitioner desires. Furthermore, there is nothing in the record to *219 explain why petitioner did not send a letter to Montgomery Ward before February 26, 1940, covering the same generalities if, in fact, petitioner had spoken to Stevens and Cook in 1939 about the fence controllers. As far as Jones and Klumb were concerned, the same sort of generalities as were contained in the letter of February 26, 1940, could have been written to Montgomery Ward before December 31, 1939, and the fact that no such letter was written in 1939 to Montgomery Ward suggests that there may not have been any serious conversations in 1939, or none at all, with *193 Stevens and Cook. For example, if Niederkorn's recollection placing his first conversations with the above men in 1939 were accurate, there is no apparent reason why he would have delayed until February 26, 1940, to write to Montgomery Ward, there being nothing at all specific about the fence controllers, or making them, or pricing them in the February 16, 1940, letter.
Another effort of petitioner to support its claim that there was a commitment in 1939, is the alleged hiring of Brook Stevens and his firm of designers in 1939 to design a case for the controllers, but, again, there is little or no basis in *220 the record which would support a finding that such arrangement with Brook Stevens was made in 1939. Stevens testified that Niederkorn and Klumb came to his office in October 1939 to engage him to prepare engineering designs for a fence controller case and that Niederkorn was desirous of having this work done in connection with working out estimates of production costs in preparation for giving Montgomery Ward price quotations. Stevens stated that his design work could have extended over 6 months to the point of completion. However, Stevens testified entirely from his recollection and did not refresh his memory by referring to any office records, although he was given an opportunity to do so. He admitted that he and his assistants had been doing design work for the petitioner on garden tractors in 1939. Klumb, on the other hand, testified that the first time he met Niederkorn was in February 1940, when he took a fence controller to petitioner's office to give Niederkorn a demonstration of its operation and to discuss costs; and that the first time he met Brook Stevens was in July 1940, after Klumb accepted employment at petitioner's plant. Klumb was asked if he had gone to Stevens' *221 office with Niederkorn in 1939, and his answer was that he did not recall having done so. Niederkorn testified that he first contacted Stevens in the fall of 1939 about designing a case for a fence controller, but, again, he relied solely upon his recollection, and when asked how much time would be required to develop sample models of a fence controller unit before prices could be quoted to Montgomery Ward, his reply was, at least 90 days.
We are not satisfied that Brook Stevens and his office did any substantial work in 1939 on designing cases and estimating production costs for petitioner. The record shows that his office completed a drawing of a metal case on July 5, 1940. It appears that the 6 months' work which he estimated would be required may well have been done in the first 6 months of 1940, or that even if he gave Niederkorn some advice late in 1939, that probably did not involve any substantial amount of work at that time.
Klumb's testimony is in conflict with that of Stevens and Niederkorn. Klumb testified that he had made models of fence controllers *194 in his shop at home; that the first time he saw Niederkorn was in the early spring of 1940, around February; *222 that at that time there was a superficial discussion about production costs; and that he went to work for petitioner in the middle of July 1940 for the purpose of further developing battery-operated models and to assist in preparations for the production of fence controllers. There was no cross-examination of Klumb.
The petitioner did not quote any prices for fence controllers until March 6, 1940, which was after having conferences with representatives of Montgomery Ward; as of April 4, 1940, petitioner revised its first price quotations; and by April 19, 1940, it was the understanding of Montgomery Ward that petitioner's prices would be no higher than those submitted in its letter of April 4, and that petitioner's prices "must be competitive with other quotations" which Montgomery Ward might receive on comparable fence controller units.
Upon consideration of all of the evidence on this point, particularly Niederkorn's testimony that it would take about 3 months to prepare costs of controller units and prices to be quoted to Montgomery Ward, it appears that such work may have been and was begun by petitioner and its officers after December 31, 1939. Petitioner's substantially final*223 quotations of prices were completed around the first of April 1940. On the whole, there is no convincing proof that petitioner began any work before December 31, 1939, in any substantial way for fence controller production; it did not make any changes in its plant facilities preparatory to arranging for production until around July 1940.
Decision of the question does not depend upon whether or not petitioner could have withdrawn from its considerations about producing fence controllers prior to January 1, 1940, without substantial detriment to itself. Rather, the question is whether petitioner, before January 1, 1940, had made a substantial change in its position toward effecting the change in capacity, and had unequivocally established the intent to make the change within a reasonable period of time.
Upon the facts and circumstances, it is concluded that at the end of 1939 the petitioner was not committed to a course of action to increase its capacity for production or operation by the creation of facilities to produce fence controllers, which arrangements were made in 1940. Petitioner did not spend any money in 1939. All of its expenditures were made in 1940, when it paid*224 Brook Stevens $ 750 in October and $ 5,000 for converting space to a division for fence controller production, which apparently was done after Montgomery Ward had agreed in April to purchase controllers. Prior *195 to the end of 1939, petitioner had only a promotion idea for soliciting Montgomery Ward's fence controller business which, if obtained, would lead to its going into fence controller production in 1940. Prior to January 1, 1940, petitioner did not take any course of action or make any definitive change in position which unequivocally established a commitment actually to enlarge its production facilities at any particular time, if ever, for assembling fence controllers, or which unequivocally established an intent to make fence controllers within any particular time.
The discussions in 1939 between Niederkorn and Jones directly related to Niederkorn's first "selling" the idea of the superiority of the Klumb fence controllers to Montgomery Ward. Only if and when Niederkorn succeeded in that undertaking would petitioner receive a license to make them and commence to change its productive capacity. Niederkorn did not obtain any promise from Montgomery Ward in 1939 to*225 buy the Klumb controllers, and the record does not establish that any substantial advancement in that direction was made in 1939. Petitioner was not interested in making them for any other distributor or buyer. At the end of 1939, the possibility of petitioner's expanding its facilities for fence controller production was contingent and remote. Petitioner's intention to make a change in production facilities within a reasonable period of time was not unequivocal but was conditional and open to doubt prior to January 1, 1940.
It has been observed that a taxpayer's failure to make a contract during the base period for a change in capacity is not necessarily conclusive of the question of commitment, ; , provided there is proof that some definitive course of action was taken before 1940 through which the taxpayer changed its position so considerably as to have unequivocally committed itself to make the change in capacity for production. As we pointed out in ,*226 "something more than hope, desire, and expectation is needed to demonstrate a commitment under section 722(b)(4). A definite plan, together with action taken on the strength of such plan, must be shown." Such was not done in this case before 1940.
The circumstances and conditions here are comparable to the situations of the taxpayers in the following cases where it was held that a commitment within the meaning of (b)(4) had not been established. See ; ; ; ; .
*196 The instant case is distinguishable on its facts from ; ; and 7- .
The introduction of the conventional garden tractor in 1937 constituted a change *227 in the character of petitioner's business. The development of the all-purpose, quick-hitch garden tractor in 1939 was a development which was a normal outgrowth and closely associated with the change in character and so may be treated as accompanying that change. . The removal in 1939 of Montgomery Ward's restriction against selling garden tractors through petitioner's own dealers may be assumed here to have indicated a difference in capacity. With respect to these qualifying changes, petitioner has attempted a reconstruction of its base period income under the push-back rule. The next inquiry is whether these changes in character, if they had been made 2 years earlier, would have resulted in more earnings under the economic and other conditions as they existed during the base period.
The petitioner must show that its average base period net income was an inadequate standard of normal earnings for the entire base period because of the changes, and it must reconstruct an average base period*228 net income in order to establish a fair and just amount representing normal earnings to be used as a constructive average base period net income. It must establish, also, a reconstructed average base period net income in a large enough amount to obtain reconstructed excess profits income credits which will exceed the actual credits available without the benefit of section 722. Cf. .
In the base period years, the petitioner realized a profit in 1936 in the amount of $ 285.25, and it sustained losses in the other 3 years as follows: A loss of $ 19,864.60 in 1937; $ 9,953.57 in 1938; and $ 25,196.29 in 1939. For the base period, petitioner's average loss was $ 13,682.20. In order to establish any relief, petitioner must establish a constructive average base period net income which will convert the actual average base period loss to amounts which will provide some relief. One question is whether a sufficiently higher level of earnings would have been experienced if the changes in character in petitioner's business had occurred 2 years before they took place.
In its reconstruction, petitioner proposes to increase 1939*229 sales of garden tractors and attachments from actual net sales of $ 168,949 to $ 739,022; and to reconstruct the gross profit from such sales from $ 48,476 to $ 184,755. Such reconstruction would increase average *197 monthly sales of garden tractors and attachments from $ 12,000 to $ 61,000. After a careful consideration of all of the evidence, we are of the opinion that the maximum net sales of garden tractors and attachments petitioner could have made during 1939, under the base period economy and conditions under which petitioner was operating, could not have reached $ 739,022. Cf. .
Actually, petitioner sustained the largest amount of loss (in the base period) in 1939. In that year, the riding tractor (which Montgomery Ward had urged petitioner to produce) had been a failure and had caused a loss to petitioner of $ 12,800. Furthermore, the failure of the riding tractor had had an adverse effect on the sales of the conventional garden tractors. In the normal course of petitioner's business with Montgomery Ward, it would have insisted upon the production and trial of the riding tractor even if petitioner*230 had started the initial production of garden tractors 2 years sooner than in fact was done. It must be assumed, in applying the push-back rule, that with the production of the riding tractor 2 years earlier, and the failure thereof, there would have been the same adverse effect upon the sales of the other type of tractors. It follows, therefore, that in a reconstruction of net earnings the failure of the riding tractor, under the base period conditions, is a factor which must be taken into account as a depressing influence upon sales of garden tractors. Whatever might have an adverse effect upon Montgomery Ward's sales likewise would adversely affect the volume of petitioner's production and sales to Montgomery Ward. Petitioner's reconstruction of sales of garden tractors for 1939 does not, in our opinion, properly take into account the riding tractor failure, as a factor, in applying the push-back rule.
We believe that petitioner's reconstruction is in error in other respects, as follows: Petitioner's reconstruction of sales to its own domestic dealers under the push-back rule is without foundation. Petitioner has not established that dealer sales can be reconstructed to a larger*231 amount than the actual export sales in 1939. Also, it is incorrect to apply the push-back rule to the officers' commissions of 10 per cent. Upon the record, we do not believe that if petitioner's change in the character of its business, the making of garden tractors, had started 2 years earlier, its business would have reached such level of earnings in 1937, 1938, and 1939 that officers' commissions would have been abandoned. Petitioner has not proved that by 1937 the conditions which supported its paying commissions to Niederkorn and the other officers would have been overcome. It is incorrect to assume that this expense would have been eliminated in 1939, or before, in applying the 2-year push-back rule.
*198 Another error in petitioner's reconstruction is found in the opinions of its witnesses with respect to reconstruction of sales of garden tractors. The introduction of garden tractors into petitioner's business did not in fact result in a substantial increase in its earnings. Cf. . The opinions of petitioner's witnesses about a reconstruction of the volume of sales of garden tractors apparently were based*232 upon petitioner's book figures for sales of tractors in 1939 which were 2,381 units, plus attachments. However, the actual deliveries in 1939 were only 1,450 units. Furthermore, petitioner has failed to show a pattern of steady growth in the production and sales of garden tractors which would indicate that if the garden tractors had been produced 2 years earlier than they were actually produced for the first time, petitioner would have reached in 1939 a reconstructed production of 7,510 units as was assumed by petitioner's witnesses in their reconstruction of garden tractor sales and attachments for 1939 of $ 739,022.
We have concluded that petitioner was not committed to a change in capacity for production, with respect to the fence controllers, prior to January 1, 1940. Petitioner's reconstruction of an average base period net income in the amount of $ 131,885.33, includes reconstructed net earnings from fence controllers under the push-back rule in the amount of about $ 30,000. That amount must be eliminated from the proposed reconstruction, which reduces it to about $ 101,885.
Upon a thorough and careful consideration of the entire record, we are not convinced that if the *233 change in the character of petitioner's business had occurred 2 years sooner, there would have been a substantial increase in petitioner's earnings during the base period years. Cf. ; ; While assumptions and opinions must be used in reconstructing earnings, such assumptions must have a sound foundation associated with known facts. ; ; .
In view of petitioner's persistent record of losses, we are unable, on the record before us, to arrive at any cabpni in an amount which would produce excess profits credits larger than are available to petitioner without the benefit of section 722. Moreover, the record does not justify and support petitioner's proposed cabpni of either $ 131,885, or even about $ 101,885. We find it impossible, upon the record, to find that petitioner could properly *234 assume in its proposed cabpni a profit ratio of 25 per cent, and that its reconstructed sales of garden tractors for 1939 would amount to $ 739,022, or anywhere *199 near that amount. It follows and we so hold and find that petitioner is not entitled to any relief under section 722.
Reviewed by the Special Division.
Decision will be entered for the respondent.
Footnotes
1. Figures were combined in 1938.↩
1. With cultivator.↩
1. Petitioner's billings -- not deliveries.↩
2. Column (1) less columns (2) and (3).↩
1. In addition to the returns and allowances charged against sales on petitioner's books, returns and allowances of $ 1,593.12 for 1939 has been charged to motor rebuilding equipment sales here.↩
1. Includes garden tractor sales commissions.↩
1. None.↩
1. Sec. 722(b). * * * The tax computed under this subchapter * * * shall be considered to be excessive and discriminatory * * *, if its average base period net income is an inadequate standard of normal earnings because --
* * * *
(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. * * *↩
2. Sec. 722(b)(4). * * * 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 * * * made the change in the character of the business two years before it did so, it shall be deemed to have * * * made the change at such earlier time.↩
3. Sec. 722(b)(4). * * * 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, * * *↩