1957 U.S. Tax Ct. LEXIS 243">*243 Decisions will be entered under Rule 50.
The petitioner held entitled to excess profits tax relief under section 722 (b) (4), I. R. C. 1939 because of base period changes in management and operation which resulted in a higher level of earnings. Constructive average base period net income determined.
27 T.C. 940">*940 This proceeding involves claims for excess profits tax relief under section 722, Internal Revenue Code of 1939, for the years 1957 U.S. Tax Ct. LEXIS 243">*244 1942, 1943, and 1944, in the respective amounts of $ 1,061,341.13, $ 2,023,025.48 and $ 614,593.17. The petitioner bases its claims for relief upon section 722 (b) (2) and section 722 (b) (4).
The instant case was heard by a commissioner of this Court. The commissioner, in accordance with approved practice, made no ultimate proposed finding of fact as to qualification for relief or constructive average base period net income. Except for the ultimate findings herein relating to qualification and constructive average base period net income (which were found by the Court), the remaining findings 27 T.C. 940">*941 as revised and adopted by the Court, are in substance (but with minor changes) the same as the proposed findings of the commissioner which were served upon the parties.
The issues involved are (1) whether or not petitioner qualifies for relief for the years in question under the provisions of section 722 (b) (2) and 722 (b) (4), or either of them; and (2), if so, the determination of a fair and just amount representing normal earnings to be used as a constructive average base period net income under the provisions of section 722.
FINDINGS OF FACT.
The stipulated facts are incorporated1957 U.S. Tax Ct. LEXIS 243">*245 herein by reference.
The Pepsodent Co., Docket No. 14995, was a corporation organized under the laws of the State of Illinois, December 12, 1916. During the years here involved, its principal office was located at Chicago, Illinois. Its returns for the taxable years were filed with the collector of internal revenue for the first district of Illinois. Lever Brothers Company, Docket No. 14994, is a corporation organized under the laws of Massachusetts, with its principal office at New York, New York.
In 1944, substantially all of the capital stock and assets of the Pepsodent Co. were acquired by Lever Brothers Company and the Pepsodent Co. was dissolved. The Pepsodent Co. remained in existence under the laws of the State of Illinois for a term of 2 years for the purpose of winding up its affairs. Within this 2-year period, the Pepsodent Co. filed a petition with this Court in the present proceeding. Lever Brothers Company, as transferee, filed identical claims for relief under section 722 as those filed by the Pepsodent Co. and is before this Court as transferee. The two proceedings have been consolidated. The amounts of excess profits taxes involved are $ 1,061,341.13 for 1942, 1957 U.S. Tax Ct. LEXIS 243">*246 $ 2,023,025.48 for 1943, and $ 614,593.17 for 1944.
The Pepsodent Co., hereinafter sometimes referred to as petitioner, was engaged in the manufacture and sale of dentifrices and related products. The business was begun in 1915 by William Ruthrauff, who had developed and patented the formula for Pepsodent toothpaste, petitioner's principal product. In 1916, the patent and business were purchased by Douglas Smith and Albert D. Lasker. Originally they acquired equal interests but later Lasker transferred some of his holdings to Smith. During the base period about 80 per cent of petitioner's stock was owned by the Smith family and 20 per cent by the Lasker family.
Douglas Smith served as petitioner's president until his death in 1927 and was succeeded by his son, Kenneth, who was then petitioner's vice president and general manager. Kenneth later acquired his father's interest in the business. In 1928, W. W. Templin was brought 27 T.C. 940">*942 into the company as executive vice president and general manager, and so continued until his resignation in August 1935.
During the period 1916 to 1941, various subsidiary corporations were formed and there were a number of changes in petitioner's1957 U.S. Tax Ct. LEXIS 243">*247 name. The details of those transactions are fully described in the stipulation of facts, which has been incorporated herein by reference, and need not be repeated.
Until about 1930, Pepsodent toothpaste was the major commodity manufactured and sold by petitioner. Petitioner also sold toothbrushes, antiseptics, and other related products in some or all of the years under consideration. These products were all advertised nationally and were distributed both domestically and abroad. Petitioner sold both to wholesale distributors and directly to retail stores. During the base period, approximately 75 per cent of petitioner's products was sold to ultimate consumers through independent retail druggists and 25 per cent through chain stores, department stores, and other retailers.
Pepsodent toothpaste, under the original formula, was an acid dentifrice, as distinguished from the commonly used alkaline types. It had no soapy or foamy ingredient. It contained pepsin acidulated with acid calcium phosphate and calcium phosphate as an abrasive. The basic formula remained unchanged until about 1930, although the proportion of the ingredients may have varied from time to time.
At the time1957 U.S. Tax Ct. LEXIS 243">*248 he acquired his interest in the petitioner company, Lasker was head of the widely known advertising firm of Lord & Thomas. He was one of the originators of modern advertising in the United States, and his firm had many large national advertising accounts. He and his firm were responsible for the earliest successful advertising of petitioner's products. He originated the advertising which featured the pepsin in Pepsodent toothpaste as a "proteolytic enzyme" and stressed its "film-removing" qualities. All of the early Pepsodent advertisements included the offer of a free sample tube of toothpaste. Millions of these free samples were distributed during the 1920's.
Petitioner was among the two or three top manufacturers of dentifrices at all times here material. From a small volume in 1916, its sales increased to nearly $ 6,000,000 in 1922. During 1928 and 1929, its sales of dentifrices dropped considerably below the 1922-1927 volume. 1 In August 1929, petitioner's executives decided to put on a radio advertising program and selected Amos 'n' Andy. The show was put on by the National Broadcasting Company. It was broadcast from 7 to 7:15 p. m., eastern standard time, 6 nights1957 U.S. Tax Ct. LEXIS 243">*249 a week. It was an immediate success and caused a deluge of orders for Pepsodent 27 T.C. 940">*943 toothpaste. To meet the demand for its products, petitioner had to put its manufacturing operations on a 2- and 3-shift basis and later increase its plant facilities.
Pepsodent toothpaste, as manufactured under the original basic formula, came under criticism from time to time because of its excessive abrasiveness. Such a criticism appeared in an article in the Journal of Dental Research in 1919. These criticisms continued and became widespread. Dentists were sometimes advising their patients against the use of Pepsodent products. In 1930, petitioner decided to change its Pepsodent toothpaste formula by abandoning the two polishing agents theretofore used, calcium phosphate and pyrocalcium phosphate, and substituting a less abrasive cleaning agent, dicalcium phosphate. The chief defect of the new formula, as it later developed, was1957 U.S. Tax Ct. LEXIS 243">*250 a pronounced grittiness and a tendency for the paste to separate and harden in the tube. The separation and hardening in the tube were found to be due, in part, to the high pressure exerted in filling the tubes.
In January 1933, there was published a book entitled "100,000,000 Guinea Pigs" by Arthur Kallet and F. J. Schlink, in which it was said:
You use toothpaste to preserve your teeth, not to scratch away the enamel so that they will be an early candidate for painless dentistry. But such is the risk you take with Pepsodent.
The case against Pepsodent can be stated briefly. For all its advertising that its cleansing agent consists only of ultra-fine particles, careful microscopical investigations (1932) showed that Pepsodent contained large sharp angular particles; a coarse grit, including angular and needle-shaped particles, some one-tenth millimeter, or larger. Whereas the standard dental abrasive -- precipitated chalk -- can scarcely be felt when ground between the teeth, one of the reporting scientists stated that Pepsodent felt very gritty when tested in this way. * * *
This book also criticized Kolynos and Pebeco toothpaste.
In 1934, an article appeared in the American1957 U.S. Tax Ct. LEXIS 243">*251 Dental Association Journal entitled "Pepsodent Not Acceptable For Dental Remedies." Salesmen for petitioner's competitors and unfriendly druggists spread the story that Pepsodent was gritty and harmful to the teeth.
During 1934, 1935, and 1936, petitioner undertook to counter the adverse effect of these criticisms by distributing pamphlets explaining the use of abrasives in dentifrices and defending its Pepsodent formula. It distributed these pamphlets to druggists, dentists, and others.
In the latter part of 1935, petitioner began experiments with a new polishing agent for Pepsodent toothpaste, known as insoluble sodium metaphosphate, on which it acquired a patent. After an experimental trial, the new formula, identified as Formula No. 50, was put into national production in November 1935. This formula was unsatisfactory from the beginning and it was changed a number of times between 1935 and April 1937, when it was abandoned, and Formula 99 27 T.C. 940">*944 was adopted. In spite of the unfavorable criticism of Pepsodent toothpaste, petitioner's sales continued to rise from an average of over $ 5,500,000 over the period 1922-1929 to approximately $ 7,800,000 in 1930, and over $ 10,500,0001957 U.S. Tax Ct. LEXIS 243">*252 in 1931. They fell back in 1932 and 1933 to near the pre-1930 average. 2 This upward trend of sales was attributed, by petitioner's officers, in large part, to the popularity of the Amos 'n' Andy show which petitioner had engaged for radio advertising in 1929.
In March 1936, petitioner began to receive numerous complaints about the separation and hardening of Pepsodent toothpaste in the tubes. Druggists and customers began returning the tubes and demanding refund of their money. Finally, petitioner instructed its representatives to check all drug stores' inventories and pick up any tubes that showed signs of hardening or separation. In efforts to correct this defect, 12 changes were made in the formula during the remainder of the year 1936, and a new formula, No. 85, was adopted in June of that year.
In the meantime, further complaints were made about the harmful effects of Pepsodent toothpaste on tooth enamel. In October1957 U.S. Tax Ct. LEXIS 243">*253 1936, an article appeared in Consumers Union Report highly critical of Pepsodent toothpaste. The article said:
It is probably safest to avoid any dentifrice claimed to have new or special abrasives, such as Pepsodent.
Pepsodent Tooth Powder (The Pepsodent Co., Chicago). 39 cents for 4-oz. can. Excessively acid; might injure enamel. Cost, per oz., 7.1 cents.
* * * *
Pepsodent (The Pepsodent Co.). 29 cents per tube. Excessively acid. There is some indication that this toothpaste may have harmful solvent action on the tooth enamel. Until the formula has been improved, or the safety of the present product proved beyond question, it must be considered as Not Acceptable. Cost per oz., dry weight, 10.3 cents.
Also, in December 1936, Dr. Samuel Gordon, Secretary of the Council on Therapeutics of the American Dental Association, hereinafter referred to as A. D. A., notified petitioner by letter of December 28, 1936, that the Bureau of Chemistry of the A. D. A. had completed laboratory tests which indicated that sodium metaphosphate used alone as a polishing agent had the effect of decalcifying human teeth. The letter gave petitioner 15 days to reply. Petitioner began1957 U.S. Tax Ct. LEXIS 243">*254 a series of tests of its toothpaste by its own and several independent laboratories and sought to delay its reply for several months until it could get reports on the tests. The same charges against Pepsodent toothpaste were made by Dr. Gordon in April 1937 in a speech before the American Pharmaceutical Association, and in an article appearing in Hygeia in August 1937.
27 T.C. 940">*945 From as early as 1919, Pepsodent and other brands of toothpaste had come under criticism from time to time in certain scientific publications both for their possible harmful effects and for misrepresentations in their advertising. An article entitled "Highfalutin Dupery," written by several doctors and dentists, was published in the Journal of Dental Research in 1919. It was stated in this article that "some of the abrasive in Pepsodent is hard and sharp enough to scratch glass." The article went on to criticize the advertisements of Pepsodent and several other leading brands of toothpaste. In the same year another such article directed at the misleading advertising of several toothpastes, including Pepsodent, written by the head of the chemistry department at Columbia University, appeared in the same 1957 U.S. Tax Ct. LEXIS 243">*255 publication.
In April 1937, petitioner adopted Formula 99 for Pepsodent toothpaste and toothpowder. In this formula tricalcium phosphate had been added to the insoluble sodium metaphosphate to eliminate its decalcifying effects. The formula also included a detergent, sodium alkyl sulphate, registered under the trade name of "Irium." This ingredient supplied Pepsodent toothpaste with a foaming agent such as found in most other dentifrices.
Formula 99 was developed by Dr. R. A. Kuever, a professor of pharmacy at the University of Iowa, who had been employed by petitioner as a consultant since its inception. Application for a patent on the formula was filed by Dr. Kuever on June 13, 1938. The patent was issued October 8, 1940, and was assigned to petitioner. Formula 99 was used by petitioner until June 25, 1941. At that time petitioner adopted Formula 407-A, but this formula was used only for about 1 month and was replaced by Formula 407.
In May 1937, petitioner furnished A. D. A. with a report of laboratory tests and experiments conducted by its own and independent laboratories in support of its contention that insoluble sodium metaphosphate had no more decalcifying effect than1957 U.S. Tax Ct. LEXIS 243">*256 certain ordinary foods, such as orange juice, and, further, that the addition of tricalcium phosphate corrected this effect. This report also questioned the accuracy of the method used by A. D. A. in conducting its tests. Various other experiments and tests were conducted to determine the effect of changes in the proportion of the ingredients in Pepsodent toothpaste and in the manufacturing processes, and several other voluminous reports were filed with the A. D. A.
In November 1939, A. D. A. gave public notice of its approval of Pepsodent toothpaste as an acceptable dental remedy. It withdrew this approval, however, in April 1941, not because of any defects in composition but because of petitioner's refusal to conduct its advertising in accordance with A. D. A.'s wishes. A. D. A. had demanded that all advertising copy be submitted to it for approval before its release. 27 T.C. 940">*946 Petitioner refused to accede to this demand because of the unfair advantages that it would give competitors who were under no such restriction.
About July 1, 1937, petitioner employed Dr. T. H. Rider as head of its scientific and research department. Dr. Rider was a graduate chemist and former instructor1957 U.S. Tax Ct. LEXIS 243">*257 at Yale University. He had served as chief chemist and director of research at the William S. Merrill Company in Cincinnati, Ohio, and as professor of pharmacology at the Cincinnati Pharmaceutical College.
In 1935 W. W. Templin, petitioner's vice president and general manager, resigned; and thereafter an executive committee was formed to manage petitioner's business under the direction of its president, Kenneth Smith, who was also designated general manager. The committee was abolished in 1936 and the management vested in three vice presidents -- Leo C. Hoffman, in charge of production; Stuart Sherman, in charge of advertising; and Charles Luckman, in charge of sales. Templin was called back into service by petitioner in 1936 to conduct negotiations with the A.D.A. and served in that capacity for a short period of time.
Luckman was employed as petitioner's sales manager in the fall of 1935 at a salary of $ 10,000 per year. He was then 26 years of age. He had graduated from the University of Illinois with a degree in architecture in 1931, and was married in that year. Being unable to find suitable employment as an architect, he answered a newspaper advertisement of the Colgate-Palmolive1957 U.S. Tax Ct. LEXIS 243">*258 Company, in Chicago, for a salesman. He was accepted for the job and was assigned to a territory in the south side of Chicago at a salary of $ 24 a week plus bonus based on sales. He was later given other city territories and within about 1 year was made supervisor of sales to the department stores in the Loop area. His duties included helping the stores with advertising, displays, and other merchandising problems. At the end of the second year he was transferred to Milwaukee as sales manager for the State of Wisconsin and a portion of Michigan. About a year later he was transferred to Cincinnati, Ohio, as manager for a district covering 5 States with about 60 salesmen under his supervision. In the fall of 1935, he was interviewed about a position with the Pepsodent Co., and in September of that year was employed as petitioner's sales manager.
The independent drug stores were petitioner's most important retail outlet in the early 1930's. They accounted for about 75 or 80 per cent of the sales of petitioner's products. The retail merchants were in a position to exert a considerable influence over their customers' purchases of cosmetics and dentifrices, by either recommending1957 U.S. Tax Ct. LEXIS 243">*259 or advising against a particular brand. There were approximately 57,000 independent drug stores in the United States in 1935. Generally, they 27 T.C. 940">*947 were organized into State retail drug associations. About 16,000 of them belonged to the National Association of Retail Druggists.
About the middle 1930's, petitioner began to hear complaints from the retail druggists about the "loss leader" sales practice of certain chain stores and large department stores. This practice consisted of offering nationally advertised products, including toothpastes, at considerably less than regular retail prices, and sometimes under wholesale cost, in order to attract customers to the store or as a "tie-in" with some other more profitable item. Under this practice Pepsodent toothpaste, which cost the retailer 30 to 33 cents, was sometimes advertised at 17 cents a tube. The retail druggists over the country, through their associations, began to advocate the enactment of both State and Federal trade laws to prohibit the practice. The first such law was passed by the State of California in 1931. It was enacted as Assembly Bill 1228, and was generally referred to as the California Fair Trade Act. 1957 U.S. Tax Ct. LEXIS 243">*260 It authorized the execution of fair trade contracts between manufacturers and retailers controlling the retail price of products. In August 1933, the Act was amended to authorize the enforcement of such contracts by suits in the State courts. Similar laws were enacted in New York, Pennsylvania, and New Jersey, during 1935.
Petitioner entered into fair trade contracts in California during 1933. On July 2, 1935, petitioner was advised by counsel that, because of the national antitrust laws, there was doubt as to the legality of forced compliance with such contracts by a corporation engaged in interstate commerce. The California law was upheld by the highest court of that State in September 1935, but in January 1936 the New York courts held a similar law of that State unconstitutional. In the meantime, petitioner, in July 1935, notified the California retail trade that it was withdrawing from further operation under the Fair Trade Act of that State. Following that announcement, many retail druggists of California began to boycott petitioner's products and to resist their sale.
The National Association of Retail Druggists, hereinafter referred to as N. A. R. D., held its convention1957 U.S. Tax Ct. LEXIS 243">*261 in Cincinnati, Ohio, September 23, 1935. On the first day of the convention the California delegation offered a resolution condemning petitioner for its price policies and extending the California boycott of its products on a nationwide scale. Luckman had previously been informed by a California wholesale druggist that this action would be taken by the California delegation and his first assignment with petitioner was to try to defeat the resolution and to straighten out petitioner's differences with the N. A. R. D. He and Leo Hoffman both attended the convention at Cincinnati and told the California delegation that petitioner would adhere to fair 27 T.C. 940">*948 trade practices and do whatever it could to stop the price cutting of its products. They offered at that time, on behalf of petitioner, to make a contribution of $ 25,000 to the N. A. R. D. as the nucleus of a fund to seek national legislation to legalize fair trade practices on a nationwide scale. On the third day of the convention, the California delegation, after an all night session with petitioner's representatives, withdrew its resolution to censure petitioner and moved that petitioner's contribution be accepted. The1957 U.S. Tax Ct. LEXIS 243">*262 motion was carried after a fight on the floor of the convention in which it was opposed by the delegations from some of the other States.
After the N. A. R. D. convention, Luckman spent about 50 weeks on a tour of the entire United States visiting druggists and other sales outlets. In New York he cut off sales to several large retailers, including Macy's department store, which refused to agree to a no-price-cutting policy. Similar action was taken in other States. Trade with Macy's was not resumed until April 1937 after the store announced compliance with the New York Fair Trade Act. After passage of the Miller-Tydings Act in August 1937, which exempted from the operation of the national antitrust laws any contracts made under the fair trade laws, many of the other States enacted fair trade legislation, and as these laws were enacted petitioner entered into fair trade agreements in those States. Such contracts had been entered into by petitioner in about 40 States by the end of February 1938. By legal enforcement of these contracts, petitioner was able to control, and did control, the retail prices of its products.
In May 1936, petitioner began selling its products to selected1957 U.S. Tax Ct. LEXIS 243">*263 wholesalers under agreements embodying the so-called del credere plan. Prior to that time its practice generally had been to sell its products outright to any wholesaler, chain store, or department store, without any conditions as to their resale. There were about 1,100 such wholesalers in the United States. Under the del credere plan, petitioner would ship to the wholesalers on memorandums of credit and retain title to the goods. The purpose of the plan was to enable the manufacturer to control retail prices of its products. Petitioner selected about 330 reputable wholesalers to handle its products and cut off sales to all of the others. This required the retailers to obtain products either from one of the del credere wholesalers or directly from petitioner. Pamphlets were distributed to the druggists containing a list of the selected wholesalers and advising them that they might also obtain shipments directly from petitioner.
Altogether, a period of approximately 3 years after the N. A. R. D. convention in September 1935 was required to reestablish the goodwill of the retail druggists and to redevelop a satisfactory sales and price structure under the del credere1957 U.S. Tax Ct. LEXIS 243">*264 system and the fair trade practice acts of the various States. In the meantime, petitioner reorganized and 27 T.C. 940">*949 expanded its sales force. This had begun in 1934 when petitioner had a regular sales force of not over 10 salesmen. By 1939 it had over 100 salesmen organized under 9 division managers and 30 or 40 district managers. These salesmen called on both the wholesalers and retailers in their districts.
The following table shows the net wholesale prices, after discounts, 3 at which petitioner's different products were sold over the period July 1932 through 1939, and the minimum retail prices effective after May 25, 1936:
| Net price | Minimum | |||
| Date of price list | Product | Size | per dozen | retail price |
| (cents) | ||||
| July 1932 | Toothpaste | 50-cent | $ 3.61 | |
| Antiseptic | 16 oz | 6.80 | ||
| May 1934 | Toothpaste | 50-cent | 3.61 | |
| Antiseptic | 16 oz | 6.80 | ||
| Jan. 2, 1935 | Toothpaste | 50-cent | 3.00 | |
| Antiseptic | 16 oz | 6.32 | ||
| Apr. 1935 | Toothpaste | 50-cent | 3.00 | |
| Toothpowder | 50-cent | 3.12 | ||
| Antiseptic | 16 oz | 6.32 | ||
| July 13, 1935 | Toothpaste | 50-cent | 3.24 | |
| Toothpowder | 50-cent | 3.24 | ||
| Antiseptic | 16 oz | 6.48 | ||
| May 25, 1936 | Toothpaste | 40-cent | 2.72 | 33 |
| Toothpowder | 50-cent | 3.40 | 39 | |
| Antiseptic | $ 1 | 6.80 | 79 | |
| May 5, 1937 | Antiseptic | 75-cent | 5.10 | 59 |
| Nov. 25, 1939 | Toothpaste | 40-cent | 2.72 | 33 |
| Toothpowder | 50-cent | 3.40 | 39 | |
| Liquid dentifrice | 50-cent | 3.40 | 39 | |
| Antiseptic | 75-cent | 5.10 | 59 |
In May 1936, Luckman, then serving as petitioner's sales manager, was made vice president in charge of sales. In November 1937, Stuart Sherman, vice president in charge of advertising, resigned and Luckman was put in charge of advertising as well as sales. In November 1938, Hoffman, vice president in charge of production, resigned, and Luckman took over the duties of vice president and general manager and was put in full control of the business, subject only to approval of Kenneth Smith, petitioner's president and principal stockholder. In 1943, Luckman became president of petitioner and so served until petitioner's capital stock was purchased by Lever Brothers in 1944. His salary at that time, as petitioner's president, was $ 100,000 a year. Luckman continued as president of Pepsodent as a separate division of Lever Brothers. In 1946 he was made vice president and, later1957 U.S. Tax Ct. LEXIS 243">*266 in that year, president of Lever Brothers. He resigned as president of Lever Brothers Company in 1950 and has since become a partner in the architectural and engineering firm of Pereira & Luckman of Los Angeles. His salary with Lever Brothers Company at the time of his resignation was $ 250,000 a year.
27 T.C. 940">*950 On November 27, 1939, petitioner's directors adopted a resolution approving the action of petitioner's officers in applying for insurance on the life of Luckman in the amount of $ 1,000,000. The resolution stated, in part, as follows:
Whereas, this company is receiving exceptional value from the services of Charles Luckman, its vice president and general manager, due to his experience and executive ability; and
Whereas, his death would prove an incalculable loss to the company; and
Whereas, it is desirable that insurance for the benefit of the company be placed upon his life;
Now, therefore, be it resolved that the action of the officers of this company in applying for policies of insurance on the life of Charles Luckman, in the amount of $ 1 million for the benefit of this company be and it is hereby ratified, approved and confirmed.
The insurance companies limited the1957 U.S. Tax Ct. LEXIS 243">*267 policies to $ 500,000 because of the fact that Luckman's duties required him to do so much flying.
When Luckman was put in charge of petitioner's advertising in 1937, petitioner was confronted with two advertising problems -- the high ratio of advertising costs to sales, and the radio advertising program. Prior to 1929, the bulk of petitioner's advertising costs was for space advertising in magazines and newspapers. In 1929 it began radio advertising. Its advertising was handled by the firm of Lord & Thomas until the liquidation of that firm in 1941 or 1942.
Following is a schedule of the comparative costs of the two major types of advertising (radio and space), the total consumer advertising, and the cost of consumer advertising per dollar of sales, over the period 1928 to 1939, as shown in petitioner's books and records: 4
| Consumer advertising | Cost of | |||
| consumer | ||||
| advertising | ||||
| Year | per | |||
| Radio | Space | Total | dollar of | |
| sales | ||||
| (cents) | ||||
| 1928 | $ 1,970,987.46 | $ 2,057,604.98 | 40 | |
| 1929 | $ 200,489.10 | 1,709,728.98 | 1,974,546.28 | 41 |
| 1930 | 1,018,401.30 | 1,076,529.07 | 2,239,757.16 | 27 |
| 1931 | 1,288,347.52 | 2,284,876.53 | 3,763,556.37 | 34 |
| 1932 | 1,675,424.94 | 2,089,340.10 | 3,927,525.58 | 42 |
| 1933 | 1,479,373.33 | 1,473,637.11 | 3,062,513.89 | 41 |
| 1934 | 1,555,855.20 | 1,142,441.12 | 2,740,683.90 | 44 |
| 1935 | 1,201,137.67 | 1,000,376.87 | 2,237,410.68 | 41 |
| 1936 | 1,345,425.44 | 859,755.20 | 2,253,820.22 | 41 |
| 1937 | 1,224,566.74 | 1,373,244.80 | 2,690,853.25 | 45 |
| 1938 | 748,511.27 | 1,134,910.65 | 1,971,858.27 | 35 |
| 1939 | 963,058.49 | 797,957.75 | 1,850,460.25 | 37 |
27 T.C. 940">*951 The Amos 'n' Andy radio program, which petitioner commenced in the latter part of 1929, reached a high point, under the Crossley rating system, of 39.6 per cent in 1930 and 1931. In the advertising trade a ratio of 20 per cent is regarded as acceptable for a national advertising program. The Amos 'n' Andy rating declined over the period 1933-1937, inclusive, to points at the end of each of those years of 30.0 in 1933, 21.8 in 1934, 12.4 in 1935, 13.5 in 1936, and 11.7 in 1937. By the end of 1936 the program had lost much of its effectiveness. The survey made by the advertising firm of Lord & Thomas in 1937 showed that while the program had a considerable following of loyal fans, it was not attracting many new listeners. Petitioner discontinued the show in December 1937 and thereafter, for the most of 1938, filled in its radio advertising with1957 U.S. Tax Ct. LEXIS 243">*269 temporary shows of comparatively low ratings. In October 1938 it engaged the Bob Hope show.
The Crossley rating of the Bob Hope show was 9.6 in October 1938. By November 1939 it had increased to 21.4 and in 1942 it was at the top of the list of radio shows, with a rating of 40.0 in December 1942.
The following table shows the net sales, gross profits, operating profit (or loss), total net income, and the ratio of net income to net sales of petitioner and component corporations (sec. 742, I. R. C. 1939), as shown in consolidated profit and loss statements for each of the years 1922 to 1943, inclusive:
| Operating | Total net | Ratio of net | |||
| Year | Net sales | Gross profits | profit | income | income to |
| (or loss) | net sales | ||||
| (per cent) | |||||
| 1922 | $ 5,962,955.60 | $ 4,875,717.25 | $ 1,594,327.84 | $ 1,686,304.62 | 28.3 |
| 1923 | 5,602,543.67 | 4,571,324.22 | 1,224,993.44 | 1,271,524.99 | 22.7 |
| 1924 | 5,355,357.91 | 4,335,765.10 | 1,290,708.31 | 1,398,038.23 | 26.1 |
| 1925 | 5,560,752.64 | 4,459,164.68 | 1,429,797.42 | 1,538,319.83 | 27.7 |
| 1926 | 5,326,002.71 | 4,224,935.89 | 939,035.97 | 1,007,408.10 | 18.9 |
| 1927 | 5,359,639.14 | 4,238,142.48 | 720,737.89 | 832,427.35 | 15.5 |
| 1928 | 4,827,724.88 | 3,870,465.57 | 797,407.35 | 964,119.26 | 20.0 |
| 1929 | 4,555,930.52 | 3,661,027.46 | 512,081.68 | 741,398.85 | 16.3 |
| 1930 | 7,800,362.59 | 6,401,312.39 | 2,714,399.00 | 2,933,113.33 | 37.6 |
| 1931 | 10,590,634.49 | 8,642,119.75 | 2,770,630.66 | 2,393,544.94 | 22.6 |
| 1932 | 8,982,724.36 | 7,361,518.43 | 1,928,686.61 | 1,929,143.30 | 21.5 |
| 1933 | 7,234,943.64 | 5,930,899.92 | 1,478,849.96 | 1,661,168.08 | 23.0 |
| 1934 | 5,895,043.13 | 4,716,959.48 | 459,780.17 | 543,228.64 | 9.2 |
| 1935 | 5,227,927.27 | 4,062,493.28 | (100,067.03) | 132,108.90 | 2.5 |
| 1936 | 5,290,291.79 | 3,925,530.37 | (124,365.82) | 62,522.13 | 1.2 |
| 1937 | 5,824,305.19 | 4,196,280.98 | (100,403.91) | 40,783.72 | 0.7 |
| 1938 | 5,495,485.63 | 3,866,746.83 | 480,010.66 | 559,777.74 | 10.2 |
| 1939 | 4,905,684.23 | 3,629,286.43 | 189,493.19 | 285,965.77 | 5.8 |
| 1940 | 4,721,333.44 | 3,462,683.33 | 126,200.40 | 190,904.46 | 4.0 |
| 1941 | 6,550,761.29 | 4,597,118.36 | 1,134,761.63 | 1,224,861.97 | 18.7 |
| 1942 | 7,535,933.06 | 5,451,374.42 | 1,604,386.02 | 1,723,137.03 | 22.9 |
| 1943 | 10,400,555.57 | 7,116,894.00 | 2,765,528.91 | 2,886,176.99 | 27.8 |
1957 U.S. Tax Ct. LEXIS 243">*270 For the period 1922 to 1943, inclusive, the expenses of petitioner and component corporations, broken down as to certain categories, were as follows: 27 T.C. 940">*952
| Year | Advertising, | Consumer and | Trade | Other | Total expenses |
| radio, space, etc. | trade promotion | survey | expenses | ||
| 1922 | $ 2,091,227.19 | $ 486,184.84 | $ 703,977.38 | $ 3,281,389.41 | |
| 1923 | 2,132,636.59 | 553,259.02 | 660,435.17 | 3,346,330.78 | |
| 1924 | 1,802,392.37 | 580,300.62 | 662,363.80 | 3,045,056.79 | |
| 1925 | 1,844,949.37 | 440,867.00 | 743,550.89 | 3,029,367.26 | |
| 1926 | 2,089,525.68 | 470,259.66 | 726,114.58 | 3,285,899.92 | |
| 1927 | 2,314,976.19 | 395,562.05 | 806,866.35 | 3,517,404.59 | |
| 1928 | 2,057,604.98 | 316,564.54 | 698,888.70 | 3,073,058.22 | |
| 1929 | 1,974,546.28 | 370,102.93 | 804,296.57 | 3,148,945.78 | |
| 1930 | 2,239,757.16 | 370,672.87 | 1,076,483.36 | 3,686,913.39 | |
| 1931 | 3,763,556.37 | 581,465.07 | 1,526,467.65 | 5,871,489.09 | |
| 1932 | 3,927,525.58 | 328,923.41 | 1,176,382.83 | 5,432,831.82 | |
| 1933 | 3,062,513.89 | 309,429.23 | 1,080,106.84 | 4,452,049.96 | |
| 1934 | 2,740,683.90 | 280,068.12 | $ 5,400.00 | 1,231,027.29 | 4,257,179.31 |
| 1935 | 2,237,410.68 | 595,274.34 | 1,329,875.29 | 4,162,560.31 | |
| 1936 | 2,253,820.22 | 331,840.05 | 6,635.25 | 1,457,600.67 | 4,049,896.19 |
| 1937 | 2,690,853.25 | 376,577.35 | 22,387.40 | 1,206,866.89 | 4,296,684.89 |
| 1938 | 1,971,858.27 | 336,413.01 | 35,408.28 | 1,043,056.61 | 3,386,736.17 |
| 1939 | 1,850,460.25 | 442,555.25 | 31,732.00 | 1,115,045.74 | 3,439,793.24 |
| 1940 | 1,721,715.61 | 504,199.37 | 41,880.84 | 1,068,687.11 | 3,336,482.93 |
| 1941 | 1,616,102.15 | 604,621.38 | 41,740.55 | 1,199,892.65 | 3,462,356.73 |
| 1942 | 2,117,505.38 | 346,000.83 | 41,023.64 | 1,342,458.55 | 3,846,988.40 |
| 1943 | 2,406,741.22 | 257,915.34 | 49,913.41 | 1,636,795.12 | 4,351,365.09 |
1957 U.S. Tax Ct. LEXIS 243">*271 The consolidated net sales of petitioner and component corporations for the 1922-1943 period, broken down for the different commodities sold, were as follows:
| Year | Dentifrices | Toothbrushes | Antiseptic |
| 1922 | $ 5,923,034.14 | $ 39,921.46 | |
| 1923 | 5,501,147.88 | 93,069.92 | $ 8,325.87 |
| 1924 | 5,282,264.66 | 58,833.03 | 14,260.22 |
| 1925 | 5,514,491.11 | 41,668.14 | 4,593.39 |
| 1926 | 5,300,752.14 | 23,479.15 | 1,771.42 |
| 1927 | 5,343,080.01 | 16,418.58 | 140.55 |
| 1928 | 4,818,487.59 | 8,911.84 | 325.45 |
| 1929 | 4,550,032.70 | 5,806.46 | 91.36 |
| 1930 | 7,797,694.33 | 2,668.26 | |
| 1931 | 7,558,707.93 | 1,566.38 | 3,030,360.18 |
| 1932 | 5,735,541.19 | 1,146.78 | 3,246,036.39 |
| 1933 | 4,759,882.03 | 965.75 | 2,191,578.52 |
| 1934 | 3,534,086.64 | 1,663,801.03 | |
| 1935 | 3,399,100.47 | 1,457,464.85 | |
| 1936 | 3,565,819.15 | 1,568,668.21 | |
| 1937 | 4,196,871.45 | 1,582,496.10 | |
| 1938 | 4,215,783.47 | 1,228,513.37 | |
| 1939 | 4,120,522.59 | 713,707.40 | |
| 1940 | 3,925,042.30 | 742,760.79 | |
| 1941 | 4,940,081.18 | 906,984.74 | 646,769.77 |
| 1942 | 6,044,554.53 | 785,947.78 | 657,393.69 |
| 1943 | 8,135,748.96 | 1,368,183.84 | 846,304.55 |
| Year | Junis Cream | Gets-It | Total |
| 1922 | $ 5,962,955.60 | ||
| 1923 | 5,602,543.67 | ||
| 1924 | 5,355,357.91 | ||
| 1925 | 5,560,752.64 | ||
| 1926 | 5,326,002.71 | ||
| 1927 | 5,359,639.14 | ||
| 1928 | 4,827,724.88 | ||
| 1929 | 4,555,930.52 | ||
| 1930 | 7,800,362.59 | ||
| 1931 | 10,590,634.49 | ||
| 1932 | 8,982,724.36 | ||
| 1933 | $ 282,517.34 | 7,234,943.62 | |
| 1934 | 697,155.46 | 5,895,043.13 | |
| 1935 | 371,361.95 | 5,227,927.27 | |
| 1936 | 155,804.43 | 5,290,291.79 | |
| 1937 | 44,937.64 | 5,824,305.19 | |
| 1938 | $ 51,188.79 | 5,495,485.63 | |
| 1939 | 71,454.24 | 4,905,684.23 | |
| 1940 | 53,530.35 | 4,721,333.44 | |
| 1941 | 56,925.60 | 6,550,761.29 | |
| 1942 | 48,037.06 | 7,535,933.06 | |
| 1943 | 50,318.22 | 10,400,555.57 |
1957 U.S. Tax Ct. LEXIS 243">*272 The following schedule shows, for the years 1931 to 1942, inclusive, the profits (or losses) on each of the four major items manufactured and sold by petitioner during the base period: 527 T.C. 940">*953
| Year | Toothpaste | Toothpowder | Liquid | Antiseptic |
| dentifrices | ||||
| 1931 | $ 2,974,637 | ($ 154,155) | ||
| 1932 | 1,808,275 | (65,538) | ||
| 1933 | 1,863,286 | 146,724 | ||
| 1934 | 709,160 | 117,633 | ||
| 1935 | 375,540 | ($ 467,464) | 180,111 | |
| 1936 | 126,098 | (217,549) | 221,479 | |
| 1937 | 222,039 | (334,364) | 114,896 | |
| 1938 | 450,042 | 60,781 | 59,248 | |
| 1939 | 259,416 | 256,915 | ($ 111,334) | (154,144) |
| 1940 | 298,655 | 79,716 | (88,634) | 69,838 |
| 1941 | 844,514 | 546,467 | 22,834 | 187,751 |
| 1942 | 1,544,118 | 560,212 | 56,891 | 260,609 |
1957 U.S. Tax Ct. LEXIS 243">*273 The following table shows, for purposes of comparison, the sales of Pepsodent dentifrices by the petitioner for the period 1922 to 1943, inclusive; the sales of Listerine dentifrices by Lambert Company for the period 1922 to 1943, inclusive; the sales of Ipana dentifrices by Bristol-Myers Company for the period 1929 to 1943, inclusive; and the sales of Colgate dentifrices by Colgate-Palmolive Company for the period 1929 to 1943, inclusive:
| Year | Pepsodent | Listerine | Ipana | Colgate (000 |
| omitted) | ||||
| 1922 | $ 5,923,034.14 | $ 264,768 | ||
| 1923 | 5,501,147.88 | 233,552 | ||
| 1924 | 5,282,264.66 | 313,672 | ||
| 1925 | 5,514,491.11 | 640,100 | ||
| 1926 | 5,300,752.14 | 1,898,996 | ||
| 1927 | 5,343,080.01 | 2,960,063 | ||
| 1928 | 4,818,487.59 | 3,949,413 | ||
| 1929 | 4,550,032.70 | 4,022,964 | $ 3,018,942 | 1 $ 5,802 |
| 1930 | 7,797,694.33 | 4,077,486 | 3,586,283 | 1 4,390 |
| 1931 | 7,558,707.93 | 3,861,292 | 4,004,124 | 1 4,629 |
| 1932 | 5,735,541.19 | 3,106,326 | 3,967,601 | 1 2,914 |
| 1933 | 4,759,882.03 | 2,442,336 | 3,475,200 | 1 2,692 |
| 1934 | 3,534,086.64 | 2,590,437 | 3,649,619 | 1 2,780 |
| 1935 | 3,399,100.47 | 2,455,827 | 3,995,175 | 3,990 |
| 1936 | 3,565,819.15 | 1,972,607 | 4,410,404 | 4,793 |
| 1937 | 4,196,871.45 | 1,749,529 | 4,605,047 | 5,322 |
| 1938 | 4,215,783.47 | 1,959,642 | 4,701,173 | 5,837 |
| 1939 | 4,120,522.59 | 1,594,664 | 4,852,557 | 6,548 |
| 1940 | 3,925,042.30 | 1,365,773 | 4,963,272 | 7,564 |
| 1941 | 4,940,081.18 | 1,374,499 | 6,089,618 | 9,059 |
| 1942 | 6,044,554.53 | 1,583,223 | 6,379,828 | 9,669 |
| 1943 | 8,135,748.96 | 2,344,095 | 6,622,477 | 11,335 |
Petitioner's average base period net income used in computing excess profits credit for the years 1942, 1943, and 1944, computed under the income method (sec. 713, I. R. C. 1939) is as follows:
| The Pepsodent | ||
| Co. (including | ||
| subsidiaries | ||
| The Pepsodent | under | |
| Base period year | Co. (alone) | Supplement A) |
| 1936 | ($ 183,831.22) | ($ 166,503.17) |
| 1937 | (65,493.71) | (25,781.79) |
| 1938 | 526,271.89 | 530,227.43 |
| 1939 | 275,314.36 | 275,948.93 |
| Aggregate | $ 552,261.32 | $ 613,891.40 |
| Arithmetic average | 138,065.33 | 153,472.85 |
| Average base period net income as computed | ||
| under section 713 (f), I. R. C. | 526,271.89 | 530,227.43 |
27 T.C. 940">*954 Petitioner's excess profits net income, excess profits credit, and excess profits tax liability, as determined by respondent, for each of the taxable years, 1942, 1943, and 1944, are as follows:
| Excess profits | Excess profits | Excess profits | |
| Year | net income | credit | tax liabilities |
| 1942 | $ 1,722,974.43 | $ 503,716.06 | $ 1,061,341.13 |
| 1943 | 2,824,820.35 | 503,716.06 | 2,023,025.48 |
| 1944 | 1,170,199.11 | 1 441,376.69 | 614,593.17 |
The computation of the petitioner's excess profits tax for the years 1942, 1943, and 1944, without the benefit of section 722, Internal Revenue Code of 1939, results in an excessive and discriminatory tax.
The petitioner is entitled to use the excess profits credit, based on income, pursuant to section 713, Internal Revenue Code of 1939.
The petitioner, during the base period, made changes in its management and operation which resulted in a higher level of earnings and the average base period net income does not reflect the normal operation for the entire base period of the business. The business of the petitioner did not reach, by the end of the base period, the earning level which it would have reached if the petitioner had made the changes in management and operations 2 years before it did so.
A fair and just amount representing normal earnings to be used as a constructive average base period net income for the purpose of computing the petitioner's excess profits credit for 1942, 1943, and 1944, is $ 646,000.
OPINION.
The petitioner claims excess profits tax relief1957 U.S. Tax Ct. LEXIS 243">*276 both under sections 722 (b) (2) and 722 (b) (4), Internal Revenue Code of 1939. It contends, under subsection (b) (2), that its base period income was depressed by "temporary economic circumstances." Under (b) (4), it contends that there were substantial base period changes in the management and operation of the business which resulted in a higher level of earnings during the later years of the base period, but that the business had not reached the level it would have attained if the changes had been made 2 years earlier.
The respondent's position is that petitioner's depressed base period earnings were not due to any temporary economic circumstances within the meaning of section 722 (b) (2) but resulted from bad management and unsound internal policies. He denies that there were any substantial base period changes in the management or operation of the business within the meaning of subsection (b) (4). He states in his brief that petitioner's low base period earnings were due "to internal conditions in the company, namely, a failure to maintain the 27 T.C. 940">*955 rate of gross profit previously enjoyed prior to the base period and its failure to properly control its expenses," citing1957 U.S. Tax Ct. LEXIS 243">*277 Foskett & Bishop Co., 16 T.C. 456; Toledo Stove & Range Co., 16 T.C. 1125; and Granite Construction Co., 19 T.C. 163.
To begin with, it is clear (and respondent does not deny) that petitioner's base period earnings were depressed. Its average net income for the 13-year period, 1922 to 1934, inclusive, was $ 1,374,925. The lowest net income for any year of that period, 1934, was $ 543,228.64. Petitioner's actual average base period net income was $ 237,262.34. Its average base period net income for use in computing excess profits credit under section 713, Internal Revenue Code of 1939 (without the benefit of section 713 (f)), was $ 153,472.85, and under section 713 (f) was $ 530,227.43. Petitioner's base period depression actually began in 1934 or 1935. It had a net income in 1935 of only $ 132,108.90. In 1933, its net income was $ 1,661,168.08.
We think the record supports the view that the depressed base period earnings were in the main attributable to the following factors: (a) Criticism asserting that petitioner's toothpaste had harmful effects on tooth enamel appearing in several1957 U.S. Tax Ct. LEXIS 243">*278 books and articles, and the spreading of unfavorable stories by unfriendly druggists and salesmen for competitors; (b) complaints from druggists and retail customers about the separation and hardening of the toothpaste accompanied by returns of tubes and demands for refunds; (c) antagonism of druggists and other outlets because of sales policies, including withdrawal on advice of counsel from operation under fair trade laws in 1935; and (d) the loss of effectiveness as a medium of advertising of the Amos 'n' Andy radio program.
Since we hold, infra, that petitioner has qualified for relief under section 722 (b) (4), it is unnecessary under the circumstances of the instant case for us to determine whether any of the factors depressing earnings was a basis for qualification under (b) (2). After our determination of normal earnings in relation to (b) (4), there is no basis under these circumstances for separate and additional relief under (b) (2). We turn, therefore, to a consideration of qualification under (b) (4).
We think the record supports the view that a significant change in management emerged from the successive events which included Luckman's employment as sales manager1957 U.S. Tax Ct. LEXIS 243">*279 in the fall of 1935, his advancement to vice president in charge of sales in 1936, the arrangement putting him in charge of advertising as well as sales in 1937, and finally his appointment as general manager as well as vice president in 1938, at which time he was put in practical control of the business subject only to supervision by Smith. The active management was left largely to Luckman. Promotions and employment of new key 27 T.C. 940">*956 personnel were likewise made from time to time. Such changes cannot be evaluated separately, but must be kept in mind in integrating their effect with the changes in operations considered infra.
Our findings set forth the facts concerning the attacks upon and criticisms leveled at petitioner's toothpaste. These attacks and criticisms arose from many sources. To counteract them, a number of experiments were made and successive formulae developed, but they proved unsatisfactory for various reasons. In June 1936, a new formula, No. 85, was adopted to prevent separation and hardening of toothpaste. In April 1937, Formula 99 was adopted for both toothpaste and toothpowder. Its main objective was to eliminate decalcifying effects. It also included1957 U.S. Tax Ct. LEXIS 243">*280 a detergent registered under the trade name of Irium which supplied the toothpaste with a foaming agent which was an important factor from the customer's perspective. This formula was used for the balance of the base period (and until June 1941). The adoption of Formula 99, eliminating decalcifying effects and supported by reports of laboratory tests and experiments, was of basic importance in counteracting criticism of petitioner's toothpaste; and the American Dental Association, an important and powerful critic of petitioner's product, finally approved the formula in November 1939, as an acceptable dental remedy.
Our findings likewise refer to the complaints from retail druggists about the loss leader sales practices of certain chain stores and department stores. As a result, fair trade laws were enacted in four jurisdictions, including California, to prevent these practices. Petitioner entered into fair trade contracts in California during 1933. In July 1935, petitioner was advised by counsel that, because of the antitrust laws, there was doubt as to the legality of forced compliance with fair trade contracts by a corporation engaged in interstate commerce. As a result, petitioner, 1957 U.S. Tax Ct. LEXIS 243">*281 during the same month, notified the California retail trade that it was withdrawing from further operation under the Fair Trade Act. Following this announcement, many retail druggists began to boycott petitioner's products.
In September 1935, the National Association of Retail Druggists held its convention, and a resolution was offered to condemn petitioner for its price policies and to extend the boycott on a nationwide basis. Luckman (who had advance information as to the contemplated action) and Hoffman attended the convention, and stated that petitioner would adhere to fair trade practices and do whatever it could to stop price cutting of its products. A contribution of $ 25,000 was offered on behalf of petitioner as the nucleus of a fund to seek national legislation to legalize fair trade practices. The contribution was accepted and the resolution of censure, which would have been very damaging, was withdrawn.
27 T.C. 940">*957 After the N. A. R. D. convention, Luckman made an extended tour of the United States, visiting druggists and other sales outlets in relation to fair trade practices. He cut off sales to Macy's and several other retailers which refused to agree not to cut 1957 U.S. Tax Ct. LEXIS 243">*282 prices. This action was temporarily harmful to the business but its ultimate effect was to build goodwill with the smaller retail outlets which opposed price cutting in that it demonstrated to them that petitioner intended in fact to comply with fair trade practices.
In May 1936, as a means of controlling retail prices of its products, petitioner limited the wholesale sale of its products to about 330 selected wholesalers (out of about 1,100 wholesalers in the United States) under agreements following the del credere plan described in our findings. Here again the purpose, harmful initially, contributed to the establishment of petitioner's intent to go along with fair trade practices.
In August 1937, the Miller-Tydings Act was passed exempting from the antitrust laws contracts made pursuant to fair trade laws. Thereupon, many additional States passed fair trade acts, and by the end of February 1938, petitioner had entered into such contracts in about 40 States, thus complying with its previously expressed intent.
The adoption of the del credere plan and the various other steps taken to comply with fair trade practices were largely under Luckman's direction.
Beginning in 19341957 U.S. Tax Ct. LEXIS 243">*283 (when petitioner had a regular sales force of not over 10 salesmen) petitioner began reorganizing its sales force and, by 1939, had over 100 salesmen organized under 9 division managers and 30 to 40 district managers, contacting both wholesalers and retailers in their districts. Much of this development was under Luckman's direction.
Advertising was a very important factor in promoting petitioner's sales. While radio was only one medium, it was highly significant. This is amply demonstrated by results during both the period of great effectiveness of the Amos 'n' Andy show as a sales promotion medium for petitioner and the period of its loss of such effectiveness. The Bob Hope show proved to be a valuable successor, but, while growing in effectiveness through 1939, it had not reached its normal level of effectiveness by the end of the base period. It is apparent that some such medium of advertising was a vital necessity for sales promotion of products of the nature of petitioner's. The Amos 'n' Andy show was discontinued by petitioner in December 1937 and Bob Hope was engaged in October 1938. Luckman did not personally select Bob Hope, but was active in shaping the nature of1957 U.S. Tax Ct. LEXIS 243">*284 the show as an advertising medium.
We have reviewed the changes in management and operations in some detail because we think they must be taken in the aggregate and 27 T.C. 940">*958 integrated in assessing the results which they produced during the base period and in indicating the potential increase which would have resulted if the changes had been made 2 years earlier. We think that they qualify petitioner for relief under section 722 (b) (4). A consideration of the whole record demonstrates that they were largely responsible for the increased earnings in 1938 and 1939, and that the level of these earnings would have been materially higher at the end of 1939 if the aggregate, significant changes had been made 2 years earlier.
On the question of determination of constructive average base period net income, we have given careful consideration to the reconstruction of earnings for 1939, and in doing so, we have given such weight to the push-back rule in relation to dentrifrices as we deemed appropriate in order to determine the level which such earnings would have reached under base period conditions by the end of 1939 if the changes appropriately considered under the push-back rule had1957 U.S. Tax Ct. LEXIS 243">*285 been made 2 years earlier. We have likewise given consideration to backcasting techniques in order to reach average constructive dentifrice earnings for the entire base period. We do not think the evidence warrants application of the push-back rule to antiseptics although we have otherwise given consideration to antiseptics in our reconstruction.
Petitioner claims a constructive average base period net income of $ 1,304,472.25. Upon the record, we think it is clear that this amount is highly excessive. On the other hand, we think that respondent's position that there is no basis for a reconstruction which would give relief in excess of the credit of $ 530,227.43 under section 713 (f) is also erroneous.
Upon consideration of the entire record, and applying our judgment in integrating the numerous factors involved, we have determined a constructive average base period net income of $ 646,000. In reaching this conclusion, we do not suggest that we have achieved precision where precision is impossible. Constructive average base period net income need not be determined with mathematical exactness. Danco Co., 17 T.C. 1493. If the rule were otherwise, 1957 U.S. Tax Ct. LEXIS 243">*286 it would presuppose a burden of proof resting upon petitioner which it would find impossible to meet in cases of this type and would be wholly inconsistent with the relief objectives of section 722.
Decisions will be entered under Rule 50.
Murdock and Raum, JJ., dissenting: The average base period net income, as computed under section 713 (f), is almost $ 400,000 greater than the actual average base period net income. It is not clear from 27 T.C. 940">*959 the prevailing opinion just what is being pushed back under the push-back rule or just what effect pushing back the increased authority of Luckman would have. The net sales, after being fairly constant from 1934 through 1938, went down in 1939 and they continued to go down in 1940, despite the enhanced importance of Luckman in management. The net sales of this petitioner did not vary greatly from year to year over a long period except for the years 1930 through 1933, when the Amos 'n' Andy show was at its peak, and then began to increase in 1941. The reasons for the post-1939 changes are not at all clear, if they can be considered. For aught we know, the increased amount of sales may have been attributable in 1957 U.S. Tax Ct. LEXIS 243">*287 most part to increased unit prices obtained in the early war years rather than to any increase in quantity of merchandise sold.
The petitioner ceased to sponsor Amos 'n' Andy in December 1937. The expenditures for "Advertising, Radio, Space, etc." dropped about $ 700,000 in 1938 from what they had been in 1937, and the drop in total expenses was over $ 900,000. The net earnings for 1938 exceeded those for 1937 by over $ 500,000. The large drop in 1938 expenses might well account for the increased earnings for that year over those for the 2 previous years. What, if anything, Luckman had to do with the termination of the Amos 'n' Andy contract, is not disclosed in the findings. The earnings dropped in 1939 and 1940, despite the fact that Luckman's importance in management had been increasing since 1936.
In order to prevail here, the petitioner must show that upon a 2-year push back of the appropriate events -- whatever they may be -- it would have attained, by the end of the base period, a level of earnings that would call not only for a constructive average base period net income in excess of its actual average base period net income but also in excess of the average base period1957 U.S. Tax Ct. LEXIS 243">*288 net income computed with the benefits of section 713 (f). Acme Breweries, 15 T.C. 682; Midvale Co., 19 T.C. 1216. The petitioner's actual average base period net income was $ 138,065.33. The benefits conferred by section 713 (f) artificially raise that figure to $ 526,271.89. The burden of proof is upon the petitioner, and nothing set forth in the majority Opinion indicates a showing by the petitioner that if Luckman had appeared on the scene 2 years earlier, its earnings picture would have improved so remarkably as to surpass the $ 526,271.89 average computed under section 713 (f). In the face of a pattern of declining earnings immediately after 1938, not satisfactorily explained, it seems clear that the petitioner has not carried its burden. No amount of sterile mathematical computations can effectively supply the answer to the blunt question: Would the petitioner's earnings in fact have increased to such a level that its 27 T.C. 940">*960 recomputed base period net income would have risen not only beyond its actual average of $ 138,065.33, but also beyond $ 526,271.89? Nothing set forth in the majority Opinion gives 1957 U.S. Tax Ct. LEXIS 243">*289 confidence that the petitioner has presented facts justifying an affirmative answer to that question.
Footnotes
1. Complete statistics of petitioner's sales of various products will be shown hereinafter.↩
2. The complete record of petitioner's sales and net profits, in tabular form, is shown below.↩
3. The discounts amounted to about 15 per cent on all products except for the period July 1, 1935, to May 25, 1936, when they were 10 per cent.↩
4. The figures for costs of all types of advertising for the years 1922 to 1942, inclusive, are shown in Exhibit 15 and are incorporated herein by this reference.↩
5. We have given consideration to respondent's contention that the foregoing schedule (based on Exhibit 17) is inconsistent in some respects with stipulated Exhibits 2B and 3. Exhibit 17 was admitted in evidence without objection (although later there was a motion to strike) and it is clear that it was based upon cost accounting techniques which include the exercise of judgment in allocation of costs and expenses. We accept the schedule as illustrative of the net profit per product picture from the cost accounting perspective.↩
1. The figures for dental cream and some other products of Colgate for 1929 to 1934, inclusive, are not fully available and to that extent are not reflected in the table.↩
1. The excess profits credit of $ 503,716.06 was reduced by a net capital reduction in the amount of $ 62,339.37.↩