*190 Decision will be entered under Rule 50.
Change in Character of Business -- Section 722 (b) (4). -- Held, the petitioner changed the character of its business during the base period by developing a line of official type athletic balls different in type, function, and market from the line of rubber balls previously marketed. Constructive average base period net income determined.
*84 The petitioner seeks relief under section 722 (a) and (b) ( 4) of the Internal Revenue Code from excess profits taxes for the fiscal years ended September 30 in 1941 to 1946. The petitioner contends that its average base period net income is an inadequate standard*191 of normal earnings, that it commenced business immediately prior to the base period and changed the character of its business during the base period and the average base period net income does not reflect the normal operation for the entire base period of the business. Further, that it has established a fair and just amount representing normal earnings to be used as a constructive average base period net income.
The petitioner's excess profits tax returns for the taxable years in controversy were filed with the collector of internal revenue at Los Angeles, California.
FINDINGS OF FACT.
The petitioner was incorporated March 14, 1935, under the laws of California. Its principal office is in Los Angeles, California. For the years involved in this proceeding its books were kept and its income and excess profits tax returns were filed on the accrual basis and for fiscal years ending September 30.
The petitioner is entitled to use the excess profits credit based upon income pursuant to section 713, Internal Revenue Code. Its excess profits tax net income and the amounts of excess profits tax paid, including amounts held in the collector's suspense account, for the fiscal years ended*192 on September 30 in the years shown were:
| Fiscal year ended in -- | Excess profits | Excess profits |
| tax net income | tax paid | |
| 1941 | $ 74,738.21 | $ 7,511.94 |
| 1942 | 282,414.22 | 129,323.10 |
| 1943 | 137,709.35 | 73,141.64 |
| 1944 | 59,587.67 | 711.90 |
| 1945 | 114,639.18 | 45,484.56 |
| 1946 | 217,373.62 | 33,604.58 |
*85 The straight average of the petitioner's excess profits net income for its base period years, computed under the law applicable to its taxable year ended September 30, 1941, was $ 23,947.56; and computed under the law applicable for its taxable years ended September 30, 1942, to and including September 30, 1946, such straight average was $ 29,188.79.
For its taxable year ended September 30, 1941, the petitioner's average base period net income computed with the benefits of section 713 (f) and without the benefits of section 722 was in the amount of $ 44,265.25 and for each of its taxable years ended September 30, 1942, to and including September 30, 1946, was in the amount of $ 54,357.01.
W. J. Voit, the founder of the petitioner, died in 1946. Prior to 1921 he had been employed by various rubber manufacturers. In 1921 or 1922 he went into business with one Thompson in the *193 manufacture of rubber goods. During the 1920's he bought out Thompson and was principal stockholder of W. J. Voit Rubber Company. The principal products of that company were rubber beach balls, and "camelback," a rubber product used as a tread on automobile tires and to repair tire casings. Other products were rubber toys, mill and calendered goods, and various all-rubber balls.
The W. J. Voit Rubber Company had financial difficulties as a result of Japanese competition and a drop in the price of natural rubber. A receiver was appointed in late 1931 to operate the business under a committee of the principal creditors. Later, bankruptcy proceedings were instituted. The first report of the receiver, dated April 15, 1932, stated, in part:
Despite the trying conditions under which your Petitioner has operated, he is pleased to report that a new swimming belt and swimming ring have been developed during the receivership, necessitating the making of new coils for the use of the steam kettle, and various factory adjustments necessary for operations; that production has been maintained and samples have been supplied to the salesmen and the trade for this coming season. There has also*194 been developed and perfected a four-section ball at a reduced cost, to compete with lower-priced merchandise now on the market. The selling organization has been built up to 15 salesmen, all working on a straight commission basis of 10 or 12 per cent, instead of salary and expense, as previously paid by the defendant corporation. New accounts have been opened up and considerable money has been spent for electors, cuts and circulars, mailing of samples, etc.; on the new, as well as the old items manufactured.
There are prospective orders at the present time with Devago Company of New York, amounting to approximately $ 5,000.00; the S. & W. Coffee Company, 12,000 balls, amounting to approximately $ 5,000.00. Sears-Roebuck & Company have adopted the complete line for all stores in their western division, and Montgomery Ward will undoubtedly place large orders in the near future.
The receiver in bankruptcy operated the business until February 1935. He discontinued the manufacture of camelback. In 1934 he began the manufacture of all-rubber footballs and basketballs. Under *86 date of February 11, 1935, a report of appraisers was made giving an inventory of the assets of the*195 company. This included a list of finished merchandise showing a quantity of balls, the style number, cost, and total value of each group. The following types of balls are there listed:
| playground | hollywood | health |
| sport | play cage | spl. sport |
| foot | medicine | spl. r. craft |
| basket | wonder | soccer |
| volley | olympic | water polo |
| polo |
Costs shown range from 5 cents to $ 2 each. Footballs, for example, are listed at costs of 10 cents, 15 cents, 24 cents, 25 cents, and 48.5 cents each. Some balls are shown as "seconds." Some are listed as equipped with rubber stem, others with metal valve. The inventory did not list softballs, fabric balls, or Duro-Cord balls.
W. J. Voit performed services for the company during the receivership. In March 1935 he organized the petitioner to purchase the assets of the W. J. Voit Rubber Company from the trustees in bankruptcy. The principal part of the new capital was borrowed, and a preferred stock issue of $ 7,000 was subscribed by Clarkham Rubber Company. The borrowed capital was repaid within 2 years and the preferred stock issue was retired later.
The petitioner did not manufacture cage balls or medicine balls, which were built by its predecessors. *196 Hollywood balls, a type of beach ball, were built for a time, but later discontinued. The petitioner built sport balls, a type of thin rubber beach ball, but in a smaller quantity than its predecessor which had built approximately a million beach balls of various kinds in 1929. The petitioner's production of beach balls in 1937, 1938, and 1939 was approximately 110,000 per year. The petitioner built all-rubber footballs, basketballs, soccer balls, volley balls, and water polo balls such as were made by its predecessor, and continued the manufacture of milled rubber goods, calendered goods, mechanical goods, and rubber bladders for use in inflated balls built by other sporting goods manufacturers. In 1935 the petitioner commenced building a rubber-covered softball. During the base period the petitioner also commenced manufacture of inflated balls having a rubber cover over a fabric carcass, and tennis balls and camelback.
The term "milled goods" refers to rubber compounds mixed and rolled on a rolling mill by the petitioner for other concerns and delivered in molded form for manufacturing into rubber cement or processing into other goods. The petitioner processed rubber for *197 other manufacturers in a calendar, a 3-roll machine, for rolling rubber stock to a given gauge and width, some of which was dyed with various *87 colors. The term "mechanical goods" refers to molded rubber items such as washers and sink stoppers which the petitioner made for other manufacturers. The petitioner also manufactured other rubber athletic equipment such as baseball home plates and pitchers' boxes, and a rubber discus.
Sales of milled and calendered goods, mechanical and miscellaneous goods were normal during the base period.
Willard D. Voit, son of W. J. Voit, became president of the petitioner in 1946. He had been employed by the petitioner's predecessor prior to the receivership. He left the company and took over the manufacture of camelback on his own account when the receiver discontinued its manufacture. In late 1937 he entered the employ of the petitioner which then began the manufacture of camelback under a contract whereby Willard D. Voit was to receive 50 per cent of the profits of that part of the business. Camelback was a stable commodity sold in a mature market and by December 31, 1939, had reached a normal level of sales. Its gross sales for 1939*198 amounted to $ 315,972.07 and would not have been higher had the petitioner commenced its manufacture 2 years earlier than in late 1937.
The petitioner's net profit from camelback was 50 per cent of the profits computed under the royalty agreement with W. D. Voit. This share amounted to $ 1,600 in 1937 for the month of December, the first month of sales of camelback. In 1938 the petitioner's share was $ 21,050 and in 1939 was $ 16,996.
In 1935 the petitioner began the manufacture of a rubber-covered softball under a contract with Charles Webb, a manufacturer of rubber-covered sporting goods. The petitioner purchased yarn wound kapok centers from Wilson Sporting Goods Company, covered them with rubber and placed them in a steam mold developed by the petitioner. Difficulties resulted as the centers were not uniform in size. The large centers showed yarn through the cover and the small centers would not fill the mold and would not be sufficiently cured. Many of the softballs so built were returned by customers as defective. The petitioner immediately set to work to design a winding machine to make its own centers. Such a machine was evolved and built and by 1938 the difficulties*199 of constructing a satisfactory softball were solved. Before the petitioner's winding machine was developed, some 90,000 to 100,000 softballs had been made and sold in each year. A large number of these were returned as unsatisfactory. It was not possible to repair these returned softballs and the petitioner replaced them, bearing the cost of such replacements.
The petitioner manufactured inflated balls similar to some of those built by its predecessor. The footballs, basketballs, volley balls, soccer balls, and water polo balls built in 1935, 1936, and early 1937 were *88 of all-rubber construction. The all-rubber football was about one-eighth of an inch thick and had a surface molded to resemble leather in appearance with simulated seams and lacing. Balls of this all-rubber construction were sold by the petitioner through Wilson Sporting Goods Company. Wilson catalogs for 1937 listed Voit all-rubber footballs and volley balls at a quoted price of $ 2.25, and basketballs at $ 3. Playground balls, a type of beach ball, were listed at $ 0.60 to $ 5.25, depending on size. The catalog prices were subject to various discounts. These balls were shown as having in some cases*200 rubber valves; in others, metal valves. The rubber valve used in the petitioner's balls at that time was a rubber stem for oral inflation. The so-called metal valve first used by the petitioner's predecessor and used by the petitioner until late 1936 was a ball and spring valve, in which a metal ball held in place by a spring retained air in the ball. Inflation was accomplished by use of a special needle which depressed the ball in the valve to allow air to enter. In late 1936 or early 1937 another type of metal valve was used. This was a rubber housing in which a brass insert was molded. The insert was threaded to take a bicycle type of valve core, and a metal cap covered the opening.
The all-rubber footballs, basketballs, volley balls, soccer balls, and water polo balls built by the petitioner were not suitable for athletic use above the elementary school level. They would stretch and lose their shape if overinflated and would not endure under strenuous use. They were not designed for use in official athletic contests.
In late 1935 or early 1936 the petitioner experimented in making inflated balls with a fabric carcass and a rubber cover. The first of these were not successful*201 and the idea was dropped for a time. In 1937, after more experiments, a satisfactory product was developed. At the end of 1937 the petitioner began to build inflated balls of the type for official athletic use, employing this construction. The fabric carcass held the shape of the ball without stretching and the rubber cover proved more enduring than leather. Rubber-covered athletic balls built by the petitioner were listed in the Wilson catalog for 1938 at quoted prices of $ 7.85 to $ 9.25 for footballs and $ 7.85 for soccer, basket, volley, and water polo balls.
Certain difficulties were experienced in marketing this line of rubber-covered inflated athletic type balls. Late in 1937 or early in 1938 the petitioner constructed a carcass which was cord wound spirally in three layers in three different directions. As this could be done by machine, the ball could be produced at a lower cost. This ball, called "Duro-Cord," was manufactured for about a year in a quantity of some 35,000 to 50,000. It was found that these balls did not stand up in actual use as well as balls of the earlier fabric construction. Many of the Duro-Cord balls were returned as defective and were replaced*202 with fabric type balls, without cost to the consumer.
*89 The petitioner also experienced difficulties in marketing the rubber-covered inflated balls as a result of valve defects. The metal valve with the bicycle type core proved unsatisfactory as the valve would leak. A number of balls using this valve were returned. In 1937 one of the petitioner's competitors developed an all-rubber valve for needle inflation. The petitioner could not use this valve or similar valves used by other manufacturers as they were patented. The petitioner developed its own all-rubber valve in 1937 and applied in January 1938 for a patent thereon. After this valve was developed the petitioner removed the metal valves on returned balls and replaced them with all-rubber valves.
The construction of the rubber-covered fabric balls was more costly than that of the all-rubber balls. The fabric type ball was made in three steps:
First, a bladder was made of gussets, by hand, over a spherical shape. The valve housing was cemented into that bladder. This was put into a hollow steam jacket mold and molded into the shape of a true sphere. It was then inflated using a suitable valve to retain the air*203 during subsequent operations.
Second, gussets of rubberized fabric were built around the bladder in multiple layers. This was put into a steam jacket mold and vulcanized again, forming a "carcass."
Third, the carcass was covered by hand with raw rubber of a given gauge. This was put into a third mold, having a surface like the pebble grain of leather, or smooth, depending on the type of ball, and vulcanized again. This mold gave the ball the appearance of leather as well as simulated seams. The valve core was then put in the housing. This process was different from that involved in manufacturing all-rubber balls. It required new molding equipment of different construction and different equipment for cutting out sections for the fabric carcass.
The rubber-covered fabric construction inflated balls were different from the all-rubber inflated balls in several particulars. They were of more sturdy construction, would not stretch or lose shape, required different equipment and processes to manufacture, were more costly to build, were sold at a much higher price, and were sold to different customers in competition with leather-covered athletic balls of other sporting equipment manufacturers, *204 thus requiring a different sales policy in marketing them. They were suitable for use in official athletic contests and were accepted for that purpose. Sales were made to schools, boards of recreation, and local dealers, also through national distributors such as Wilson Sporting Goods Company and A. G. Spalding & Bros. Patents on this type of construction were applied for in November 1937 and later issued.
*90 In 1938 W. J. Voit and Vernon Yale, sales representative of the petitioner, represented the petitioner at a meeting with representatives of Spalding, Wilson, and other distributors of athletic goods. A proposal was made to purchase the complete line of the petitioner's athletic equipment exclusively, taking up to $ 500,000 in goods for the first year. No formal contract was effected.
In 1938 the petitioner was adding facilities and increasing production toward an ultimate capacity of 120,000 balls per year.
In 1939 the petitioner commenced the manufacture of tennis balls. Sales of tennis balls were made in the last 3 months of 1939 amounting to $ 19,174.65. Equipment acquired in 1939 for the purpose of building tennis balls cost $ 2,606.96.
In the early base period*205 years, the petitioner sold most of its output through major national distributors of sporting goods, A. G. Spalding & Bros., Wilson Sporting Goods Company, McGregor-Goldsmith, and Rawlings. It was necessary to allow these distributors larger discounts than local dealers. By the end of 1939 the petitioner had dropped Spalding and Goldsmith and sold more than half its output directly to local dealers.
During 1939 the petitioner settled accounts with some of its salesmen for work done in prior years as well as 1939, paying the sum of $ 6,500. One-fourth of this is properly allocable to 1939. In 1939 the petitioner paid $ 1,000 to Charles Webb for release from his contract to purchase softballs at a discount when he demanded an additional discount because of discounts allowed Wilson on the petitioner's goods.
The following are indices of the petitioner's sales computed from monthly sales of sporting goods and athletic equipment:
| Month | 1938 | 1939 | 1940 | 1938-39 |
| Avg. 100 | Avg. 100 | Avg. 100 | Combined | |
| avg. | ||||
| January | 44 | 56 | 70 | 50 |
| February | 52 | 121 | 68 | 86 |
| March | 64 | 62 | 61 | 63 |
| April | 66 | 90 | 82 | 78 |
| May | 47 | 59 | 98 | 53 |
| June | 106 | 98 | 116 | 102 |
| July | 138 | 146 | 193 | 142 |
| August | 218 | 200 | 171 | 209 |
| September | 160 | 146 | 131 | 153 |
| October | 111 | 81 | 108 | 96 |
| November | 111 | 115 | 66 | 113 |
| December | 84 | 28 | 41 | 56 |
*206 The following table shows the sales of the petitioner's products by classes. The column "1940" refers to the 9 months' accounting period January 1 through September 30, 1940. *91
| Sales of products by classes | ||
| Class | 1936 | 1937 |
| A. Inflated balls | $ 52,020.07 | $ 100,498.58 |
| B. Softballs and playground balls | 13,729.48 | 34,216.34 |
| C. Other athletic equipment | 707.73 | 736.88 |
| D. Mill and calendered goods | 33,539.84 | 34,694.62 |
| E. Mechanical goods and miscellaneous | 27,492.57 | 34,606.74 |
| F. Camelback | None | 28,743.83 |
| Total sales | $ 127,489.69 | $ 233,496.99 |
| Sales of products by classes | |||
| Class | 1938 | 1939 | 1940 |
| A. Inflated balls | $ 215,230.35 | $ 199,004.37 | $ 177,240.30 |
| B. Softballs and playground balls | 48,824.41 | 52,366.60 | 45,447.78 |
| C. Other athletic equipment | 1,266.01 | 2,022.57 | 28,452.41 |
| D. Mill and calendered goods | 29,336.77 | 31,995.91 | 36,533.85 |
| E. Mechanical goods and miscellaneous | 31,073.85 | 53,667.68 | 23,006.13 |
| F. Camelback | 283,726.47 | 315,972.48 | 202,516.86 |
| Total sales | $ 609,457.86 | $ 655,029.61 | $ 513,197.33 |
The following is a condensed comparative statement of the petitioner's income and expense as recorded on its books prior to adjustments*207 made by revenue agents:
| CONDENSED COMPARATIVE STATEMENT OF INCOME AND EXPENSE | ||
| Period | ||
| 1-1-40 to | 1939 | |
| 9-30-40 | ||
| SALES: | ||
| Sporting goods | $ 251,140.49 | $ 253,393.54 |
| All other | 262,056.84 | 401,636.07 |
| 513,197.33 | 655,029.61 | |
| COST OF GOODS SOLD: | ||
| Inventories -- Beginning | 71,101.44 | 50,324.48 |
| Purchases | 204,771.01 | 285,121.81 |
| Labor | 95,419.28 | 112,512.87 |
| Royalties paid | 9,525.77 | 10,943.58 |
| Overhead expenses | 35,580.40 | 42,922.90 |
| 416,397.90 | 501,825.64 | |
| Less -- Inventories at end | 76,985.73 | 71,101.44 |
| Cost of goods sold | 339,412.17 | 430,724.20 |
| Gross profit | 173,785.16 | 224,305.41 |
| Selling and delivery expenses | 70,366.52 | 92,932.29 |
| Adm. and gen. expenses | 37,316.04 | 59,615.25 |
| 66,102.60 | 71,757.87 | |
| Other income | 1,801.30 | 1,275.33 |
| Other expense | 31,118.55 | 31,536.02 |
| NET PROFIT BEFORE FEDERAL | ||
| TAXES | 36,785.35 | 41,497.18 |
| CONDENSED COMPARATIVE STATEMENT OF INCOME AND EXPENSE | |||
| 1938 | 1937 | 1936 | |
| SALES: | |||
| Sporting goods | $ 265,320.77 | $ 135,451.80 | $ 66,457.28 |
| All other | 344,137.09 | 98,045.19 | 61,032.41 |
| 609,457.86 | 233,496.99 | 127,489.69 | |
| COST OF GOODS SOLD: | |||
| Inventories -- Beginning | 40,757.36 | 21,076.46 | 12,094.73 |
| Purchases | 242,517.42 | 94,805.38 | 42,546.31 |
| Labor | 125,481.29 | 61,094.06 | 39,200.41 |
| Royalties paid | 29,209.53 | 1,178.75 | |
| Overhead expenses | 57,929.25 | 29,589.39 | 18,489.27 |
| 495,894.85 | 207,744.04 | 112,330.72 | |
| Less -- Inventories at end | 50,324.48 | 40,757.36 | 21,076.46 |
| Cost of goods sold | 445,570.37 | 166,986.68 | 91,254.26 |
| Gross profit | 163,887.49 | 66,510.31 | 36,235.43 |
| Selling and delivery expenses | 63,654.88 | 28,338.77 | 14,222.55 |
| Adm. and gen. expenses | 33,286.71 | 21,259.04 | 17,003.56 |
| 66,945.90 | 16,912.50 | 5,009.32 | |
| Other income | 836.34 | 1,316.30 | 2,536.31 |
| Other expense | 13,425.23 | 5,256.97 | 5,888.54 |
| NET PROFIT BEFORE FEDERAL | |||
| TAXES | 54,357.01 | 12,971.83 | 1,657.09 |
*208 Census of Manufacturer, sporting goods industry for 1935, 1937, and 1939, gives the following figures for values of products (000 omitted):
| Product | 1935 | 1937 | 1939 |
| Footballs | $ 910 | $ 1.089 | $ 1,963 |
| Other inflated balls | 749 | 1,121 | 1,447 |
| Baseballs (including softballs) | 2,594 | 2,301 | 3,251 |
| Tennis balls | 1,263 | 1,697 | 1,452 |
| All products | 34,363 | 44,460 | 64,753 |
*92 The following are indices based upon 1939 equals 100:
| Base period | ||||
| 1936 | 1937 | 1938 | average | |
| Total U. S. industrial production | 94.5 | 103.7 | 81.7 | 95.0 |
| Southern Calif, bus. activity | 89.3 | 98.3 | 92.9 | 95.1 |
| Total receipts, U. S. corporations | 99.8 | 107.1 | 90.6 | 99.4 |
| Net profits -- General business | 102.0 | 101.4 | 61.3 | 91.2 |
| Sales of 3 competitors -- Athletic goods | 88.8 | 96.8 | 95.6 | 95.3 |
| Profits -- One competitor -- Athletic goods | 52.4 | 26.0 | 75.8 | 63.6 |
The petitioner changed the character of its business during the base period and by the end of that period its business had not reached the earnings level it would have reached had the changes been made 2 years earlier.
The petitioner's average base period net income is an inadequate standard of normal earnings. A fair and just amount *209 representing normal earnings to be used by the petitioner as a constructive average base period net income is $ 60,000.
OPINION.
We are convinced that the petitioner changed the character of its business during the base period years within the intent of section 722 (a) and (b) ( 4) of the Internal Revenue Code. 1 The essential nature of the change was a conversion from the manufacture of all-rubber balls which can be characterized as playthings, to the building of rubber-covered fabric carcass balls of a quality and durability suitable for use in official athletic contests. This brought *93 about a "difference in the products" within the scope of subparagraph (4). In this change the petitioner experienced unusual and abnormal expenses and losses during the development stage in replacing or repairing balls which proved defective in usage by customers and in reselling customers who, because of these defects had become dissatisfied with the performance of the balls purchased. Because of these abnormal costs and sales difficulties the earnings from the new products had not reached a normal level by the end of the base period and the actual base period net income was an inadequate*210 standard of normal earnings.
*211 The respondent contends that there was no essential difference in the products, that the petitioner built footballs and basketballs prior to the base period and that the fabric carcass balls were merely improved products of the same type, built for the same purpose and serving the same markets. In addition, the respondent argues that the petitioner had to improve its balls to stay in business and meet competition, and that the addition of softballs and tennis balls to its line of goods is not sufficient to amount to a change in the products within the meaning of the statute.
We think the evidence establishes that the rubber-covered fabric carcass, inflated balls were a new product, made by different manufacturing methods, offered for sale in a different market and at a considerably higher price, and in competition with official athletic balls of other manufacturers not previously competitors, and that this new product materially affected the petitioner's earnings. These were not mere improvements in the line previously built by the petitioner. They were a departure from that line. The petitioner and Webb originated the rubber-covered inflated athletic ball of the caliber for use*212 in high class play. The petitioner's balls were sold in competition with leather-covered balls of Spalding, Wilson, and Goldsmith and could be sold at a lower price. The petitioner's rubber-covered balls proved longer lasting than the leather-covered balls and were in demand by schools and recreational groups to which their lower price and greater durability were important considerations.
The rubber-covered softball was a product first built in 1935, immediately prior to the base period. The petitioner experienced difficulties in its development, had a number of rejections, replaced many of those sold in the early years and did not develop a satisfactory softball until 1938. Some excessive costs were incurred on this account in 1936, 1937, and 1938 and possibly in 1939 which we consider to be abnormal and which tended to render the actual earnings of those years an inadequate standard of normal earnings.
The respondent concedes that "camelback" was a new product to the petitioner and that a reconstruction of earnings is warranted on that *94 account, but asserts that a reconstruction based upon that factor alone will not give a constructive average net income equal to the*213 average computed under section 713 (f). The parties have agreed that the sales of camelback would not have been higher than actual 1939 sales had the petitioner commenced its manufacture 2 years earlier.
The respondent also concedes that tennis balls, manufactured for the first time in late 1939, were a new product, but contends that the addition of a single product to a variety line, where some items are added from time to time and others dropped, does not amount to a change in character of the business for purposes of section 722 (b) (4). Nonetheless we think the petitioner is entitled to have the introduction of this item to its line taken into consideration in reconstructing its average base period net income.
The parties agree that actual sales of other items manufactured were normal during the base period years.
The petitioner's sporting goods sales in 1937 were double the 1936 sales. In 1938, the first year of sales of the new fabric carcass balls, the sales volume was nearly double that for 1937. In 1939, however, there was a slight falling off, which the petitioner, and based on the record we think properly, attributes to loss of customers who found goods to be defective. *214 In the first 9 months of 1940, the trend of sporting goods sales was again upward, as sales for 9 months were approximately equal to sales for the year 1939. This indicates that a normal level of sales had not been reached by the end of 1939.
The petitioner has presented computations which it contends support its conclusion that a fair and just amount representing normal earnings to be used as a constructive average base period net income is not less than $ 83,969.53. This compares with averages of $ 44,265.25 as to 1941 and $ 54,357.01 as to other years computed under section 713 (f) and allowed by the respondent.
The respondent has presented a computation which, he argues, shows that if the petitioner's production difficulties reduced its total earnings by as much as 25 per cent, the constructive earnings would be $ 48,000, less than the $ 54,357 average allowed under the growth formula of section 713 (f).
The respondent further objects to the petitioner's assumptions and computations as depending upon the recollection of one witness and without support by records or other evidence. The witness, Thomas Edkins, was purchasing agent and secretary-treausrer of the petitioner. *215 He was employed by the petitioner's predcessor from 1924 and by the petitioner from its inception. He is a registered mechanical engineer, and had much to do with the experimentation and development leading to the production of the fabric carcass balls and softballs. He was familiar with the lines of rubber goods manufactured by the petitioner. He had assisted in preparing the petitioner's *95 claims for relief under section 722, the first of which were filed in 1943 and which were based upon his recollection in 1943 of the facts in the base period years. The petitioner kept no records of returned merchandise, but made replacements out of stock or made repairs the cost of which was absorbed in the cost of goods sold. Edkins' recollection is the best available evidence of the quantities of returns and the cost of replacements or repairs. Even though it may be inaccurate in some particulars, it merits consideration.
Edkins estimated that some 85,000 to 90,000 inflated balls were built and sold using the metal valve with the bicycle type of core, that at least 50 per cent of these were returned as defective, that 75 per cent of the returned balls were repaired and the remainder*216 were replaced. Repairs cost about 25 cents per ball and replacement with a "second" quality ball cost 75 to 80 cents each. Edkins also estimated that in 1938 some 35,000 to 50,000 Duro-Cord balls were built and that over 50 per cent of them were returned as defective due to fractured carcasses. Some of these were returned by dealers or picked up by the petitioner's agents prior to retail sale. These balls could not be repaired. They were at first replaced with another Duro-Cord ball at a cost of about $ 2, later replacements were made with fabric balls at a factory cost of 75 cents to $ 1 exclusive of packaging and delivery. Edkins made an estimate as to the cost of replacing softballs, stating that some 90,000 to 100,000 were built in each year, that from 25 to 40 per cent were found to be defective, that the cost of replacement was about 40 to 45 cents each.
On the basis of these estimates the petitioner computes the cost of repairing or replacing balls in 1938 and 1939 as follows:
| Cause | 1938 | 1939 |
| Valve trouble | $ 7,435 | $ 4,462 |
| Duro-Cord balls | 17,150 | 8,750 |
| Softballs | 12,600 | 9,000 |
| Totals | $ 37,185 | $ 22,212 |
| Per cent of total sales | 6.1 | 3.39 |
| Per cent of sales of sporting goods | 14.01 | 8.76 |
*217 We do not have to accept these estimates as being accurate to know that there were abnormal costs of some considerable degree in those years. Witnesses testified that a normal volume of returns of this type of athletic goods on account of defects would not exceed 2 per cent of sales, and that returns of 25 to 50 per cent were clearly abnormal. One of the purposes of the 2-year rule was to permit taxpayers to overcome losses incurred in the initial development of a new or changed business and to establish within an assumed additional 2 years a normal earnings level. E. P. C. S. 5 and 6, 1946-2 C. B. 122, 123.
The petitioner's reconstruction presents several difficulties. It uses a graphic projection of sales of sporting goods from the 1936 figure *96 through the 1939 figure and extended for 2 years to reach $ 380,000. This makes use of figures for 1936 and 1937, which were prior to the sales of the fabric carcass balls and are of little meaning in ascertaining the normal sales level of such balls. If we accept the petitioner's premise that the drop in sales in 1939 was due to rejections of merchandise and that an increased future volume was predictable*218 at the end of that year, we still have to guess at the prospective rate of increase to estimate the normal level to be reached in two additional years of theoretically normal operations. The reported offer of Spalding, Wilson, and other manufacturers in 1938 to accept up to $ 500,000 worth of athletic goods from the petitioner in a year would indicate a substantial unfilled demand, but no contract was effected and the failure to reach an agreement has not been explained. The petitioner's reconstruction of expenses compares 1938 and 1939 figures with 1940 figures and in so doing violates the statutory prohibition against consideration of post-1939 events in a reconstruction. The figures of sales of inflated balls alone show a downward trend in 1939 as compared with 1938, as do also figures of sporting goods and of net profits.
We think it is reasonable to assume that had the manufacture of the fabric carcass balls commenced 2 years earlier, the problems of initial production would have been solved, the abnormal costs would have been reduced or eliminated, and a normal level of earnings would have been reached by the end of 1939. This level would have been considerably higher than*219 that actually attained.
We have considered the trend of sales of the petitioner's new products, the probable level such sales would have reached had the change in products occurred 2 years earlier, and the ratio of normal expenses, after elimination of abnormal items, to sales and have found that $ 60,000 is a fair and just amount representing normal earnings to be used as a constructive average base period net income.
The parties have stipulated that the excess profits credit for the taxable years involved is to be determined by making reductions on account of net capital reductions under section 713 (A)(1)(c) of the Internal Revenue Code in the amount of $ 833.04 for the fiscal years ended in 1942 to 1946. No such reduction is required as to the fiscal year ended in 1941.
The parties have stipulated that the constructive average base period net income applicable for the taxable year ended in 1941 is to be reduced by 18 per cent representing the income tax adjustment required to be made in determining excess profits net income for the taxable year of the base period, under the law applicable for the taxable year ended in 1941.
Reviewed by the Special Division.
Decision will be*220 entered under Rule 50.
Footnotes
1. SEC. 722. (a) General Rule. -- In any case in which the taxpayer establishes that the tax computed under this subchapter (without the benefit of this section) results in an excessive and discriminatory tax and establishes what would be a fair and just amount representing normal earnings to be used as a constructive average base period net income for the purposes of an excess profits tax based upon a comparison of normal earnings and earnings during an excess profits tax period, the tax shall be determined by using such constructive average base period net income in lieu of the average base period net income otherwise determined under this subchapter. In determining such constructive average base period net income, no regard shall be had to events or conditions affecting the taxpayer, the industry of which it is a member, or taxpayers generally occurring or existing after December 31, 1939, * * *
(b) Taxpayers Using Average Earnings Method. -- The tax computed under this subchapter (without the benefit of this section) shall be considered to be excessive and discriminatory in the case of a taxpayer entitled to use the excess profits credit based on income pursuant to section 713, if its average base period net income is an inadequate standard of normal earnings because --
* * * *
(4) the taxpayer, either during or immediately prior to the base period, commenced business or changed the character of the business and the average base period net income does not reflect the normal operation for the entire base period of the business. If the business of the taxpayer did not reach, by the end of the base period, the earning level which it would have reached if the taxpayer had commenced business or made the change in the character of the business two years before it did so, it shall be deemed to have commenced the business or made the change at such earlier time. For the purposes of this sub-paragraph, the term "change in the character of the business" includes a change in the operation or management of the business, a difference in the products or services furnished, a difference in the capacity for production or operation, * * *↩