*171 Decision will be entered under Rule 50.
Excess Profits Tax -- Relief under Section 722 (b) (4). -- The petitioner changed the character of its business by a substantial increase in its capacity for production during the base period. It has failed to establish a sufficient justification for the belief that it could have captured more business or increased its sales during any of the base period years, except for a few months in 1937, if it had had the capacity during the base period which it had at the end. Small amount of relief allowed upon the showing that some additional sales might have been made during a part of 1937 if there had been additional capacity at that time.
*1279 The only issue for decision is whether the Commissioner erred in disallowing the petitioner's application under section 722 (b) (4) for relief from excess profits tax in the amount of $ 42,831.65 for the taxable year 1940.
FINDINGS OF FACT.
The petitioner is a New York corporation, engaged in the manufacture and sale of grinding wheels. The business was started in 1910 in Buffalo, New York, and was moved to its present location at North Tonawanda, New York, in 1929. The petitioner was insolvent in 1923, was doing little business, and its relative position in the grinding wheel industry was about last. It was taken over at that time by its present management. It now ranks about fourth in the industry.
The general policy of the management of the petitioner during the period of its development was to finance expansion by using earnings rather than by selling stock or by borrowing, but about $ 45,000 par value of stock was sold in 1928 and $ 30,000 was borrowed from a bank at about that same time. Dividends have been paid in every year since 1928. The average of annual dividends for that period is over $ 20,000.
Grinding*173 wheels are abrasive tools. They are made of various kinds of abrasive particles which are molded together with different types of bonding agents. The vitrified wheels are bonded with clay and are cured in kilns. The resinoid wheels are bonded with phenol resins and are cured in ovens. Other wheels are bonded with shellac and rubber and are cured in ovens. All the various types of grinding wheels made by the petitioner must go through either a kiln or an oven in the course of their manufacture.
There has been a trend in industry, beginning in 1935, toward the use of high speed tools. This trend necessitated grinding wheels that could stand such high speeds and resinoid wheels were found to be suitable.
The petitioner manufactures approximately 85 per cent of its wheels according to the particular specifications of its individual customers. *1280 The remaining production is of standard wheels which can be sold in a general market. The wheels made ranged in size from those no larger than the head of a match to those weighing 500 pounds. Sale prices of the wheels ranged from $ 200 to $ .40 per pound.
All of the petitioner's sales were made through distributors, except for*174 the territory around the petitioner's plant. The number of distributors and the territory covered by the petitioner were not increased during the base period. The grinding wheel business is highly competitive and any new business obtained or new territory opened must be taken from competitors. The petitioner was using its earnest efforts to get what sales it could during the base period, and its sales record during that period is proportionately better than that of the members of the Grinding Wheel Manufacturers Association, as is shown by the following table:
| Sales for the | Sales for the | |
| Year | association | petitioner |
| 1929 | $ 29,836,275.00 | $ 226,830.06 |
| 1930 | 18,279,927.00 | 193,821.79 |
| 1931 | 11,606,702.00 | 172,456.91 |
| 1932 | 7,234,267.00 | 152,729.24 |
| 1933 | 10,337,265.00 | 219,455.06 |
| 1934 | 16,797,297.00 | 332,071.56 |
| 1935 | $ 21,708,430.00 | $ 477,417.10 |
| 1936 | 27,835,534.00 | 707,730.24 |
| 1937 | 32,950,042.00 | 883,784.63 |
| 1938 | 18,061,939.00 | 540,515.44 |
| 1939 | 28,261,748.00 | 988,723.31 |
| 1940 | 37,906,751.00 | 1,481,301.06 |
The following table shows the petitioner's monthly sales during pertinent years:
| 1936 | 1937 | 1938 | 1939 | 1940 | |
| Jan | $ 43,135.19 | $ 73,341.84 | $ 30,179.56 | $ 56,804.29 | $ 129,819.17 |
| Feb | 40,459.81 | 65,116.88 | 33,303.08 | 56,141.32 | 112,312.94 |
| Mar | 46,329.34 | 78,521.99 | 34,863.28 | 67,384.16 | 107,982.52 |
| Apr | 57,328.08 | 81,533.26 | 36,675.81 | 60,830.79 | 109,054.52 |
| May | 60,071.88 | 82,864.87 | 39,290.80 | 65,733.29 | 114,225.12 |
| June | 61,143.88 | 83,075.73 | 37,812.03 | 74,048.17 | 116,765.34 |
| July | 61,227.99 | 85,875.39 | 40,086.40 | 75,535.12 | 108,425.30 |
| Aug | 65,766.33 | 95,137.32 | 50,074.38 | 82,281.35 | 134,450.64 |
| Sept | 63,280.04 | 78,710.06 | 58,289.27 | 94,327.46 | 113,373.12 |
| Oct | 80,588.68 | 69,973.50 | 54,366.13 | 112,456.63 | 145,375.05 |
| Nov | 64,176.21 | 52,651.62 | 65,006.38 | 119,151.16 | 144,329.67 |
| Dec | 64,222.81 | 36,982.17 | 60,568.32 | 124,458.09 | 145,620.73 |
| Adjustments | * 428.520 | * 433.06 | |||
| Gross sales | 707,730.24 | 883,784.63 | 540,515.44 | 988,723.31 | 1,481,301.06 |
The average maximum capacity of the petitioner's plant, expressed in pounds, and its actual production, for each of the base period years and the taxable year were as follows:
| Maximum | Actual | |
| capacity | production | |
| Pounds | Pounds | |
| 1936 | 2,191,620 | 1,680,997 |
| 1937 | 2,521,382 | 2,170,472 |
| 1938 | 3,290,400 | 1,051,075 |
| 1939 | 3,457,301 | 2,096,926 |
| 1940 | 4,584,502 | 2,985,761 |
*1281 The actual production as between kilns and ovens in pounds was as follows:
| Kilns | Ovens | |
| Pounds | Pounds | |
| 1936 | 918,000 | 762,997 |
| 1937 | 1,206,000 | 964,472 |
| 1938 | 648,000 | 403,075 |
| 1939 | 1,080,000 | 1,016,926 |
| 1940 | 1,764,000 | 1,221,761 |
The maximum capacity of kilns and ovens on the dates indicated was as follows:
| Kilns | Ovens | Total | |
| Pounds | Pounds | Pounds | |
| Jan. 1, 1936 | 1,296,000 | 728,640 | 2,024,640 |
| Dec. 31, 1939 | 1,944,000 | 2,296,800 | 4,240,800 |
Maximum capacity makes no allowance for any breakdowns or stoppages of the kilns and ovens or for proper cooling of the kilns. There were some breakdowns during the base period which necessitated stopping for repairs, but the record does not disclose the length of time they *176 consumed. 80 per cent of maximum capacity is considered good production, allowing for breakdowns, repairs, and adequate time for the kilns to cool between each firing.
The petitioner had four kilns at the beginning of the base period. Two additional kilns were installed late in 1937 and were put in use at the beginning of 1938. The cost of the two new kilns was about $ 9,400. All six of the kilns which the petitioner had at the end of the base period were of the same size and structure.
The petitioner had five ovens at the beginning of the base period. It built eight additional ovens during that period, one in each of the following months: May, June, and August 1936; May and October 1937; September, November, and December 1939. It also built two additional ovens in 1940, one in March and one in August. The ovens installed in 1939 and thereafter were of a different type and from two to four times larger than those which had been installed in previous years. The average cost of the earlier ovens was about $ 817. The average cost of the five ovens installed in 1939 and 1940 was about $ 1,600.
There was practically no lag in the petitioner's production between the installation*177 of new kilns and ovens and the use thereof.
The petitioner was slower than usual in filling orders during the spring and summer of 1937 because it could not produce goods quickly enough with its available facilities. It failed to obtain an undisclosed amount of orders as a consequence. There were adequate facilities *1282 to provide prompt deliveries during all other portions of the base period.
The petitioner agreed in the autumn of 1938 to furnish grinding wheels to the Ford Motor Co. up to maximum sales of $ 40,000 per month. The agreement did not require Ford to take any particular quantity of the petitioner's products and it was not in writing. The petitioner made a few small sales to Ford during 1936, 1937, and 1938. It made substantial sales during the last four months of 1939 and its total sales for that year to Ford were about $ 90,000. Its sales to Ford during 1940 amounted to $ 373,282.38.
The inventories of the finished goods on hand during pertinent years were as follows:
| 1/1/36 | 12/31/36 | 12/31/37 | 12/31/38 | 12/31/39 | 12/31/40 |
| $ 71,384.46 | $ 83,465.91 | $ 120,279.22 | $ 118,395.62 | $ 116,208.23 | $ 132,151.97 |
The petitioner's net profit before Federal*178 income taxes, its fixed assets less depreciation, and its surplus for a period of years are shown in the following table:
| Net profits | Fixed assets, | ||
| Year | before Federal | less depreciation | Surplus |
| income taxes | |||
| 1925 | $ 6,550.21 | ||
| 1926 | 21,490.50 | ||
| 1927 | 37,776.76 | ||
| 1928 | 42,635.10 | $ 70,412.08 | $ 1,897.78 |
| 1929 | 44,825.88 | 140,731.60 | 29,978.18 |
| 1930 | 27,605.33 | 135,667.32 | 43,603.36 |
| 1931 | 20,329.18 | 130,293.58 | 56,577.30 |
| 1932 | 12,482.13 | 123,714.12 | 64,701.51 |
| 1933 | 24,038.97 | 126,935.30 | 80,067.48 |
| 1934 | 53,460.62 | 129,895.08 | 109,489.08 |
| 1935 | 111,249.33 | 168,119.56 | 183,766.83 |
| 1936 | 171,222.35 | 226,956.35 | 256,387.42 |
| 1937 | 177,736.52 | 359,297.43 | 362,447.72 |
| 1938 | 76,942.80 | 347,747.49 | 409,750.51 |
| 1939 | 217,410.12 | 376,569.14 | 553,257.98 |
| 1940 | 364,390.25 | 436,808.44 | 154,129.72 |
The petitioner paid an excess profits tax of $ 52,134.41 for the calendar year 1940. It was entitled to use an excess profits credit based on income pursuant to section 713 of the Internal Revenue Code. Its 1940 return showed normal tax net income, income tax, and excess profits net income for each of the years in the base period and for the taxable year as follows:
| Normal tax | Income tax | Excess profits | |
| Year | net income | net income | |
| 1936 | $ 171,222.35 | $ 38,107.58 | $ 133,114.77 |
| 1937 | 177,736.52 | 51,064.38 | 131,005.48 |
| 1938 | 76,942.80 | 14,233.98 | 62,708.82 |
| 1939 | 216,677.81 | 40,350.34 | 176,327.47 |
| 1940 | * 364,390.55 | 87,453.73 | 276,085.69 |
*1283 The petitioner's average base period net income is shown on its 1940 returns as $ 125,789.13.
An application for relief under section 722 (b) (4) of the code and claim for refund based thereon in the amount of $ 42,831.65 was duly filed by the petitioner and denied by the respondent.
The petitioner changed the character of its business during the base period years within the meaning of section 722 (b) (4) by reason of a substantial increase in its capacity for production. Its actual average base period net income is an inadequate standard of normal earnings to the extent of $ 2,000.
OPINION.
Section 722 allows relief from excess profits tax in certain cases through substitution of a constructive average base period net income for the actual earnings of that period. The general rule of 722 (a) is that a taxpayer which establishes that its excess profits tax is excessive and discriminatory 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 purpose of an excess profits tax*180 based upon a comparison of normal earnings and earnings during an excess profits tax period, may have its tax computed by using the constructive average base period net income instead of its actual average base period net income. It is provided in (b) (4) that the tax shall be considered to be excessive and discriminatory if the taxpayer's average base period net income is an inadequate standard of normal earnings because the taxpayer 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. It further provides that "change in the character of the business" includes "a difference in the capacity for production." This petitioner substantially increased its capacity for production during the base period. The maximum capacity of its ovens at the end of the base period was about three times what it was at the beginning of the base period. The maximum capacity of its kilns at the end of the base period was about 50 per cent more than it was at the beginning of the period. Thus, the petitioner has established that there was a "change in the character of the business" during the*181 base period within the meaning of those words as used in section 722 (b) (4).
The petitioner calls attention to the Ford agreement for one purpose only, and that is to show that there was a change in the character of its business on December 31, 1939, within the meaning of section 722 (b) (4), as a result of a course of action to which it was committed prior to January 1, 1940, under the agreement with Ford. It is not necessary to decide that question in view of the finding that there *1284 was a change in the character of the business by reason of an increase in capacity during the base period, and no claim is made, or ever has been, for the application of the push back rule to the Ford sales.
The next question is whether the average base period net income is an inadequate standard of normal earnings because of the change in the character of the business. This, as the petitioner recognizes, is the most important question in this case. The following statement of the petitioner's contention is taken from its reply brief:
Fundamentally, the petitioner's contention is that if it had [had] 1939 capacity all through the base period years, it would have sold in each of the base*182 period years substantially more than it actually sold.
It is true that the heating process could not be shortened. It claims that its kilns and ovens formed a "bottleneck" during the base period years which limited its production and sales, and, if it had not been so restricted by that limitation upon its capacity, more finished goods could have been manufactured, handled, and sold by the other parts of its organization. Unless there is sufficient reason to believe that greater capacity in each year of the base period would have resulted in greater sales in each, then there is no reason urged for using other than actual earnings for that year. The petitioner suggests, as the final step, that "a fair and just amount representing normal earnings" is a constructive average base period net income based upon its actual sales, either for the last three months or for the last six months of 1939, upon the theory that, if it had had the capacity throughout the base period which it had at the end of that period, it would have captured as much business throughout that period as it actually captured during the last three months or during the last six months of the period. It is not asking*183 that sales to Ford after December 31, 1939, be considered.
The business of the petitioner was not new during the base period, but was then well established. The present management had taken over in 1923. The evidence shows that the management and sales force were aggressive and were doing everything which they could to make sales and to obtain additional business all during the base period. The petitioner was doing better than most of its competitors in obtaining and retaining customers during those years. It was increasing its capacity as it saw the need therefor.
However, the petitioner was not able to sell during 1936 as much merchandise, despite the earnest efforts of its salesmen, as it could have produced in that year without overtaxing its capacity or as it actually produced. Its kilns and ovens were not operated at full actual capacity during that year and sales for the year did not equal actual production. Inventories of finished goods increased. The evidence shows also that the petitioner was building kilns and ovens *1285 just as fast as need for them appeared. It had sufficient funds at all times during the base period with which to build such additional kilns*184 or ovens as it deemed necessary. The president of the petitioner testified that it needed an office building in 1936 more than it needed kilns. It built some additional ovens during 1936. The record as a whole does not justify the conclusion that a lack of capacity to produce restricted sales during 1936 or, to state it differently, that the petitioner's sales for that year would have been larger if its capacity had been substantially greater.
It is quite apparent, and one of the officers of the petitioner conceded, that the petitioner's profits from about September 1937 until some time in 1939 were limited by its ability to sell its product and not by its ability to manufacture. Its sales for that period fell below what they had been previously, showing clearly that the petitioner then had capacity to produce more goods than it could sell. Business improved in the latter part of 1939. Just how much of the improvement was due to the stimulus of war does not appear. The petitioner seeks to use its earnings for the latter part of 1939 as a basis for reconstructing its earnings for the earlier period. It seems satisfied with late 1939 earnings and it makes no claim that they *185 should be increased in arriving at constructive net income. It did not sell as many pounds of wheels in 1939 as it had produced in 1937, even though 1939 capacity exceeded that of 1937. The petitioner's actual earnings for 1936, 1938, 1939, and the first and last three months of 1937 were an adequate standard or measure of its normal earnings.
The above discussion covers the entire base period except for six months of 1937. That was a busy period. Two or three witnesses, key employees or officers of the petitioner, expressed opinion that the petitioner could have made some additional sales during the base period or portions thereof if it had had greater capacity for production. Other evidence shows that this was unlikely except for a part of 1937. There was also a statement by one of this same group that the petitioner was unable to make deliveries on orders with its usual promptness during all or some part of the first nine months of 1937 and prospective customers gave to competitors some orders which the petitioner might have received if the customers could have been assured of prompt deliveries. Ordinarily, a kiln must be allowed to cool after a firing before workmen can *186 unload it and reload it for a new firing. There is testimony that the kilns were not only being used to capacity during some part or all of the first nine months of 1937, but that the unloading operations were begun one day sooner during that period than would have been the case under ordinary operations. The actual production for 1937 was slightly in excess of 80 per cent of the maximum theoretical capacity for the year. The *1286 petitioner regarded 80 per cent of that maximum as good production, taking into consideration repairs, breakdowns, and the necessary cooling periods between firings of kilns. Still inventories of finished goods increased in 1937. It seems fair to conclude from the entire record that the petitioner probably would have made some additional sales during the spring and summer of 1937 if it had had some additional capacity at that time. This is the strongest point in the petitioner's case.
This record does not show with any clarity how much the petitioner's income for 1937 might have been increased if it had had ample capacity in that year to enable it to make prompt deliveries. The situation which developed at that time was apparently only a temporary*187 one, such as might be expected in any business, and perhaps no relief should be granted. The record does not show the volume of sales which was lost or that it was substantial. If the petitioner had had additional kilns and ovens in 1937 when it had some need for them, it would have had additional depreciation in that year and perhaps also in 1938 and 1939, with the result that its average constructive base period net income would not have been increased 100 per cent by the income from the lost sales of 1937. This record does not justify a holding that the constructive average base period net income exceeded actual average base period net income by more than $ 2,000, but, following the principle of Cohan v. Commissioner, 39 Fed. (2d) 540, the finding is hereby made that a fair and just amount representing normal earnings for the base period to be used as a constructive average base period net income is $ 2,000 more than actual average base period net income.
Reviewed by the Special Division.
Decision will be entered under Rule 50.