Decision will be entered under Rule 50.
1. Mere incorporation of a long-established business immediately prior to the base period without any showing of any change of control or ownership of the enterprise is not a ground for relief under section 722 (b) (4), I. R. C. 1939. Victory Glass, Inc., 17 T. C. 381, distinguished.
2. The design and development of a "ram-type Universal turret lathe" resulted in a product that was so different from the lathes previously produced as to constitute a new "product" within section 722 (b) (4). This factor together with interrelated consideration growing out of revitalizing petitioner's system of dealerships affords basis for relief.
3. Changes in management held not to be such as to justify relief under section 722 (b) (4).
4. Progressive reduction in interest burden during base period held to result in abnormality that may be corrected in a reconstruction under section 722.
5. Petitioner's constructive average base period net income determined.
*505 The respondent has disallowed, in full, petitioner's claims for relief under section 722 of the Internal Revenue Code of 1939, *24 for the years 1940, 1941, 1942, 1944, and 1945. Petitioner now relies entirely upon section 722 (b) (4), having abandoned its claims insofar as they relate to other subsections. It seeks refunds of excess profits taxes in the following amounts for the years indicated:
| Year | Amount |
| 1940 | $ 109,951.00 |
| 1941 | 158,419.00 |
| 1942 | 270,303.00 |
| 1944 | 124,917.78 |
| 1945 | 75,529.49 |
The findings are based upon the proposed findings submitted by the commissioner who heard the case. Sec. 1114 (b), I. R. C. 1939; Rule 48, Rules of Practice Before the Tax Court of the United States.
FINDINGS OF FACT.
1. The stipulation of facts and accompanying exhibits are incorporated herein by reference.
2. The petitioner is a corporation organized under the laws of the State of Ohio on December 31, 1935. Its principal office and place of business is located at Cleveland, Ohio. Its returns for the taxable years involved, the calendar years 1940, 1941, 1942, 1944, and 1945, were filed with the collector of internal revenue for the eighteenth district of Ohio.
3. Upon its organization, the petitioner succeeded to a going business of manufacturing and selling turret lathes, cutting-off machines, and various related parts and attachments *25 therefor. It is classified as a member of the machine tool industry.
4. The original business was founded in 1891 by John G. Oliver and George C. Bardons, who operated it as a partnership until Bardons' death in 1923. John G. Oliver then purchased Bardons' interest and operated the business as a sole proprietorship until petitioner's organization. He became petitioner's president and general manager and served as president until his death in 1939. His son, *506 Lockwood Oliver, became general manager in 1936 and president in 1939.
5. Petitioner acquired all the assets and liabilities of the business in a nontaxable reorganization. John G. Oliver had paid $ 400,000 or $ 500,000 for Bardons' half interest in the business in 1923.
6. Petitioner's chief product, from the time of its organization, was turret lathes used for turning and shaping steel and other metals. Its predecessors had manufactured, principally, what is described as "plain turret lathes" under designs developed by Bardons and Oliver about 1912. These lathes were best suited to simple bar work, that is, for turning metal bars, although they were capable of limited "chucking" operations. They had either hand or power cross *26 feeds but no longitudinal feed. These plain turret lathes were improved upon from time to time as the demand from customers indicated. For instance, the coming of manufacture of automobiles called for certain design changes and improvements in turret lathes, as well as in other machine tools. The designs were changed around 1911, 1912, or 1913. Certain improvements were added from time to time after that but they were basically the same machines during the 1920's as were designed in 1912.
7. About 1929, plans were begun by petitioner's predecessor to develop a new type lathe described as a ram-type Universal turret lathe. For this purpose it employed an outstanding machine tool and lathe designer, Oskar Kylin. Lathes of this type had already been developed and were then in production by several of petitioner's competitors.
8. Designs for the following new types of lathes and the tools required for their operation were completed prior to or during the base period:
Universal Turret Lathe #5, first designed as Lathe #4, with 1 13/16" capacity in June 1930, and redesigned as Lathe #5 with 2" capacity in 1935. Again redesigned in 1938 to embody newly developed hydraulic preselector *27 and speed change.
Universal Turret Lathe #3, 1 1/2" capacity, designed early in 1934.
Universal Turret Lathe #7, first designed in 1935 and redesigned in 1938 to embody hydraulic preselector and speed change.
Electric Turret Lathe #1 was designed in November 1936.
Geared Electric Turret Lathe #2 was designed in April 1937.
9. All of the above-described newly designed lathes were built and put into production soon after the designs were completed. They were not mere improvements of old types of plain turret lathes, such as were manufactured by petitioner's predecessor, but were an entirely new type of lathe. They embodied many new basic features which gave them a greatly increased capacity and versatility over the old type. They were similar to the Universal-type lathes then being *507 manufactured by some of petitioner's competitors but some of the features in petitioner's designs were original and were patented.
10. From the time of its organization the petitioner manufactured only the new-type lathes. Most of the old-type lathes then on hand, which had been manufactured by its predecessor, were disposed of in the early 1930's at reduced prices. Some of them were finally sold as scrap. *28 All of the old patterns and jigs used in their manufacture were destroyed. After 1929, 85 or 90 per cent of the turret lathes manufactured in the United States were of the Universal ram type.
11. In designing and manufacturing the new-type lathes, it was necessary for the petitioner to make new patterns and jigs, and to make or acquire new tools and other accessories. For each new lathe there was first made a complete pattern of wood. These wooden patterns were used to make molds for the metal parts. Because of its lack of working capital, the petitioner had to proceed slowly with its development plans. It manufactured much of its equipment, such as dies and jigs, in its own shop at considerable savings in cost.
12. The following schedule shows petitioner's acquisition of machinery and equipment, small tools and fixtures, and patterns and drawings, in units and dollars, and the book value of the items sold or scrapped during the base period years:
| Year | Units | Cost | Units sold | Book value |
| acquired | or scrapped | |||
| 1936 | 13 | $ 12,847.95 | 3 | $ 3.00 |
| 1937 | 12 | 22,741.60 | 4 | 1,467.00 |
| 1938 | 5 | 7,196.12 | 9 | 2,497.34 |
| 1939 | 20 | 48,977.07 | 11 | 2,432.00 |
13. Petitioner did not, during the base period, carry any completed new-type lathes in stock. *29 It built lathes only on order and to given specifications.
14. A number of changes occurred in petitioner's organization during the base period. For several years prior to his death in 1939, John G. Oliver had been in declining health and from time to time had relinquished some of his duties as active head of the business. After his death in 1939, there was a reorganization of petitioner's top personnel. Lockwood Oliver succeeded his father as president. He had been made petitioner's general manager in 1936. He was well qualified to assume his duties as head of the business. He was a graduate engineer of the Massachusetts Institute of Technology and had a thorough knowledge of most of the phases of petitioner's business. Other experienced employees in the organization were given broader duties and in some instances officers' titles. Oskar Kylin, who was brought in as a machine designer, became vice president in charge of engineering. Another employee was made vice president in charge of sales.
*508 15. The petitioner inaugurated a number of cost-saving and efficiency-promoting changes during the base period, including the purchase of bar steel in carload lots directly from the steel *30 mills, and the substitution of drop forgings and upset forgings for flat die forgings.
16. Prior to the beginning of the base period, the proprietorship had lost many of its dealer outlets and customers because of its inability to provide them with modern Universal lathes. There were only 5 or 6 exclusive dealers in the United States at the beginning of the base period. Petitioner undertook to establish responsible dealers and sales representatives in key territories throughout the United States. This was largely accomplished by the end of the base period. The petitioner, as well as its predecessors, had sales representatives in a number of foreign countries.
17. The following schedule shows the number and types of machine tools sold by the petitioner and its predecessor during the period 1930 to 1939, inclusive, divided as between domestic and foreign shipments:
| 1930 | 1931 | 1932 | 1933 | 1934 | 1935 | 1936 | 1937 | 1938 | 1939 | |
| Domestic shipments: | ||||||||||
| New-model turret lathes | 6 | 6 | 5 | 12 | 11 | 47 | 73 | 48 | 55 | |
| Old-model turret lathes | 25 | 20 | 1 | 18 | 9 | 7 | 12 | 9 | 1 | |
| Cutting-off machines | 27 | 9 | 1 | 3 | 10 | 19 | 35 | 5 | 6 | |
| Special machines | 1 | |||||||||
| Total domestic | 52 | 35 | 8 | 23 | 24 | 28 | 78 | 117 | 54 | 62 |
| Foreign shipments: | ||||||||||
| New-model turret lathes | 32 | 97 | 28 | 144 | ||||||
| Old-model turret lathes | 2 | 12 | ||||||||
| Cutting-off machines | 2 | 5 | 2 | 7 | ||||||
| Total foreign | 2 | 2 | 17 | 34 | 104 | 28 | 144 | |||
| Total domestic and | ||||||||||
| foreign sales | 54 | 35 | 8 | 23 | 26 | 45 | 112 | 221 | 82 | 206 |
18. *31 The total shipments of ram-type turret lathes by the whole industry during the period 1935 to 1940, inclusive, as compiled by the Machine Tool Builders Association, were as follows:
| Year | Units |
| 1935 | 690 |
| 1936 | 1387 |
| 1937 | 2128 |
| 1938 | 1267 |
| 1939 | 2084 |
| 1940 | 3781 |
19. The United States exports of turret lathes and the number of units and dollar value thereof for the years 1926 through 1939, were as follows:
| Total | ||
| Year | Number | Dollars |
| 1926 | 156 | 325,854 |
| 1927 | 279 | 846,435 |
| 1928 | 434 | 1,109,752 |
| 1929 | 522 | 1,405,087 |
| 1930 | 404 | 1,402,304 |
| 1931 | 226 | 715,037 |
| 1932 | 42 | 92,976 |
| 1933 | 117 | 206,241 |
| 1934 | 231 | 567,989 |
| 1935 | 320 | 881,056 |
| 1936 | 674 | 1,847,360 |
| 1937 | 1,230 | 3,838,608 |
| 1938 | 1,339 | 5,986,030 |
| 1939 | 1,799 | 7,485,976 |
*509 20. The net sales and net profits or losses of petitioner and its predecessors for the years 1912 to 1939, inclusive, were as follows:
| Year | Net sales | Net profits | |
| (or losses) | |||
| Predecessor partnership | 1912 | $ 293,334.09 | $ 148,383.73 |
| 1913 | 263,977.21 | 35,794.58 | |
| 1914 | 236,144.48 | 8,666.42 | |
| 1915 | 649,918.86 | 177,565.62 | |
| 1916 | 954,543.33 | 364,635.79 | |
| 1917 | 881,110.68 | 235,065.23 | |
| 1918 | 837,087.89 | 149,729.30 | |
| 1919 | 660,003.27 | 100,150.44 | |
| 1920 | 665,343.90 | 28,341.09 | |
| 1921 | 101,077.13 | (105,161.74) | |
| 1922 | 139,990.64 | (70,120.30) | |
| 1923 | 267,861.36 | (19,884.99) | |
| Sole proprietorship | 1924 | 123,731.13 | (67,168.79) |
| 1925 | 215,200.99 | (18,773.66) | |
| 1926 | 333,200.67 | (10,054.60) | |
| 1927 | 304,641.44 | (16,740.42) | |
| 1928 | 297,533.51 | (42,042.00) | |
| 1929 | 664,578.21 | 58,588.65 | |
| 1930 | 462,465.13 | 44,461.33 | |
| 1931 | 102,027.33 | (78,940.05) | |
| 1932 | 19,406.71 | (34,051.41) | |
| 1933 | 54,027.48 | (12,602.26) | |
| 1934 | 119,452.44 | (11,333.13) | |
| 1935 | 179,654.35 | (9,616.67) | |
| Petitioner corporation | 1936 | 428,827.56 | 7,612.32 |
| 1937 | 801,223.08 | 66,979.80 | |
| 1938 | 350,007.27 | 11,798.01 | |
| 1939 | 598,840.16 | 80,415.56 | |
| 1912-1935 av | $ 367,763.01 | $ 35,620.51 | |
| 1922-1935 av | 234,555.10 | (20,591.31) | |
| 1922-1939 av | 303,481.64 | (6,748.79) | |
| 1936-1939 av | 544,724.52 | 41,701.42 |
*32 21. The following is an index of total net income of all corporations in the United States, of 32 machine tool companies in the United States, and of the 3 principal competitors of the petitioner, for the years 1922 to 1939, inclusive:
| Index corpo-rate | Net income | Net income | |
| earnings | of 32 machine | of 3 | |
| Year | in the U.S. | tool | competitors |
| 1922-1939=100 | companies | ||
| ($ 000) | ($ 000) | ||
| 1922 | 138.9 | (5,828) | (88) |
| 1923 | 183.7 | 6,707 | 398 |
| 1924 | 156.2 | (1,690) | 89 |
| 1925 | 221.9 | 4,286 | 519 |
| 1926 | 218.5 | 7,904 | 1,021 |
| 1927 | 189.6 | 3,920 | 255 |
| 1928 | 239.6 | 16,219 | 1,769 |
| 1929 | 254.5 | 22,588 | 2,342 |
| 1930 | 45.2 | (870) | (413) |
| 1931 | (95.7) | (11,545) | (1,016) |
| 1932 | (164.3) | (12,353) | (919) |
| 1933 | (74.2) | (7,083) | (454) |
| 1934 | 2.7 | (1,273) | 24 |
| 1935 | 49.4 | 3,129 | 766 |
| 1936 | 127.3 | 11,409 | 1,853 |
| 1937 | 128.3 | 25,046 | 4,312 |
| 1938 | 46.8 | 7,966 | 1,503 |
| 1939 | 131.3 | 17,574 | 3,770 |
| 1922-1939 av | 100.0 | 4,784 | 873 |
| 1936-1939 av | 108.4 | 15,499 | 2,859 |
*510 22. In 1938 petitioner received a condemnation award of $ 162,906 for property taken over for a highway bridge. The condemned property consisted of a strip of land, a small portion of petitioner's main 6-story factory building and a boilerhouse. Petitioner was required to relocate the locker rooms and washrooms on each of the 6 floors, and the boiler room. The award of $ 162,906 *33 was allocated, $ 97,904 for land and buildings and $ 65,002 for damages. Petitioner realized a gain thereon of $ 50,188.56.
23. Petitioner's average borrowed capital and equity invested capital for the base period years, and the interest paid in those years, were as follows:
| Base period years | ||||
| 1936 | 1937 | 1938 | 1939 | |
| (1) Average borrowed | ||||
| capital | $ 186,085.72 | $ 163,677.02 | $ 125,301.22 | $ 33,473.23 |
| (2) Borrowed capital as of | ||||
| Dec. 31, 1939 | 23,710.00 | 23,710.00 | 23,710.00 | 23,710.00 |
| (3) Decrease in borrowed | ||||
| capital | $ 162,375.72 | $ 139,967.02 | $ 101,591.22 | $ 9,763.23 |
| (4) Average equity invested | ||||
| capital | $ 500.00 | $ 1,803.67 | $ 42,306.84 | $ 125,050.41 |
| (5) Equity invested capital | ||||
| as of Dec. 31, 1939 | 178,736.53 | 178,736.53 | 178,736.53 | 178,736.53 |
| (6) Increase in equity | ||||
| invested capital | $ 178,236.53 | $ 176,932.86 | $ 136,429.69 | $ 53,686.12 |
| (7) Recognized decrease in | ||||
| borrowed capital | ||||
| (item (3) or (6), | ||||
| whichever is smaller) | $ 162,375.72 | $ 139,967.02 | $ 101,591.22 | $ 9,763.23 |
| (8) Interest paid | 12,418.00 | 9,126.97 | 7,187.92 | 2,199.10 |
24. Petitioner's excess profits net income, excess profits credits, and excess profits tax liabilities for the taxable years involved, as determined by the respondent, without any adjustment under section 722 of the Internal Revenue Code, were *34 as follows:
| Year | Excess profits | Excess profits | Excess profits |
| net income | credits | tax liabilities | |
| 1940 | $ 438,975.55 | $ 33,652.99 | $ 159,145.15 |
| 1941 | 912,450.95 | 49,467.57 | 468,790.03 |
| 1942 | 887,840.04 | 52,219.47 | 698,452.53 |
| 1944 | 1 194,486.70 | 2 74,112.57 | 18,879.78 |
| 1945 | 177,082.20 | 75,339.50 | 78,440.01 |
25. Petitioner's average base period net income is an inadequate standard of normal earnings because of a change in character of the business that was not completed until after the commencement of the base period and the average base period net income does not reflect the normal operation for the entire base period of the business. A fair and just amount representing normal earnings to be used by petitioner as a constructive average base period net income is an amount equal *511 to $ 20,000 more than petitioner's average base period net income otherwise determined without the benefit of section 722, Internal Revenue Code of 1939.
OPINION.
Petitioner *35 seeks relief under section 722, Internal Revenue Code of 1939, with respect to its excess profits taxes for the years 1940-1942, and 1944-1945. It has abandoned all grounds other than those asserted under section 722 (b) (4). 1*36
Various reasons are given for the relief claimed under (b) (4). Petitioner argues that it "commenced business" at or immediately *37 prior to the beginning of the base period, since it was incorporated on December 31, 1935. However, the business had been in existence since 1891, first as a partnership until 1923 and then as a sole proprietorship until the date of incorporation. It does not appear from the facts before us that the incorporation brought about any change in the ownership or control of the enterprise. This was not a situation such as was present in Victory Glass, Inc., 17 T. C. 381, where the old owners were superseded by creditors and by persons who invested fresh capital, and where the new owners gave direction to the enterprise in such manner that it was thought to be in fact as well as in theory an entirely different company. In the present case there was merely an incorporation of an existing enterprise without any consequences relevant to the application of section 722 flowing from such incorporation. Had the enterprise been incorporated 2 years earlier there is no proof that petitioner would have had a more favorable *512 earnings experience during the base period by reason of that fact. We reject petitioner's contention that it is entitled to relief because it "commenced" business at or immediately *38 prior to the beginning of the base period.
On the other hand, we think that petitioner has shown that it qualifies for relief under (b) (4) by reason of a change in the character of the business. The principal product manufactured by petitioner's predecessors was a so-called plain turret lathe based on designs that had been in existence for many years. In 1929 an outstanding designer, Oskar Kylin, was hired to develop a new type of lathe, and he began to design a new line of lathes referred to as ram-type Universal turret lathes. The design and development of such a new line was not a matter of months; it involved years of work and experimentation. The "line" comprehended five different sizes, some of which were ready to go into production prior to the beginning of the base period, and some of which were not completed until after commencement of the base period.
These ram-type lathes were not merely an improved version of the old plain turret lathes, but, as our findings state, were an entirely new type of lathe. With this new product petitioner was able to meet competition far more successfully than had been the case when the enterprise was manufacturing and selling the old product. *39 Our findings show the number of new-type lathes sold by petitioner and those sold by the entire industry. From these figures it appears that petitioner's immediate predecessor had only 1.6 per cent of total industry sales of this product in 1935, that petitioner had 5.7 per cent in 1936, 8 per cent in 1937, 6 per cent in 1938, and 9.5 per cent in 1939. Thus, except for 1938 which apparently was a slump year for the whole industry, petitioner experienced steady growth and improved its relative position in the industry during the base period. We are satisfied that petitioner attained its normal competitive position in the industry only during the last year of the base period, and that it is entitled to relief under section 722 (b) (4).
Closely related to this ground for relief is the argument that prior to the base period the distribution system of the business deteriorated since it lost dealer outlets and customers because of its inability to provide them with the new type of lathe; and that after the new line was established during the base period petitioner was able to and in fact did revitalize its network of dealerships. Whether this is an independent ground for relief is a matter *40 that need not be decided since it is inextricably interwoven with the "new product" ground that we have approved, and in our reconstruction we have taken it into account.
*513 Another ground alleged as a basis for relief is one based on "new management." We have examined the facts carefully in this connection, and do not find any such fundamental change in management as would justify relief on this ground.
Petitioner argues also that it is entitled to relief by reason of a difference in the ratio of nonborrowed capital to total capital. The facts do warrant the conclusion that as a result of increase in equity capital at the expense of borrowed capital there was a steady decrease in the interest burden during the base period. The abnormality occasioned by this consideration may be rectified in a reconstruction regardless of whether, standing alone, it would be an independent ground for relief, see Southern California Edison Co., 19 T. C. 935, 996-997, and we have given effect to it in our reconstruction.
We do not find it necessary to discuss all of the various other points raised by both sides, but have taken them into account in our ultimate conclusion. The reconstruction presented by *41 petitioner was based upon some hypotheses that we could not accept. Nevertheless, since we are persuaded by the record as a whole that relief is appropriate, our ultimate finding reflects our best judgment on the facts before us that petitioner is entitled to a constructive average base period net income of $ 20,000 in excess of its average base period net income computed without regard to section 722. Cf. Radio Shack Corporation, 19 T.C. 756">19 T. C. 756.
Reviewed by the Special Division.
Decision will be entered under Rule 50.
Footnotes
1. Before a net operating loss carryback adjustment from 1946 of $ 13,307.23.↩
2. Before an unused excess profits credit carryback from 1946.
(Petitioner's excess profits net income and excess profits credits for the years 1940 and 1941 were computed under the income credit method and for 1942, 1944, and 1945 under the invested capital method.)↩
1. SEC. 722. GENERAL RELIEF -- CONSTRUCTIVE AVERAGE BASE PERIOD NET INCOME.
(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 subparagraph, 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, a difference in the ratio of nonborrowed capital to total capital, * * * Any change in the capacity for production or operation of the business consummated during any taxable year ending after December 31, 1939, as a result of a course of action to which the taxpayer was committed prior to January 1, 1940, or any acquisition before May 31, 1941, from a competitor engaged in the dissemination of information through the public press, of substantially all the assets of such competitor employed in such business with the result that competition between the taxpayer and the competitor existing before January 1, 1940, was eliminated, shall be deemed to be a change on December 31, 1939, in the character of the business, or