Decisions will be entered under Rule 50.
Respondent recognized petitioner's qualifications for excess profits tax relief under section 722 of the Internal Revenue Code of 1939 by reason of base period changes in the character of its business and a strike in petitioner's plant, and claims for relief for the years 1941, 1942, and 1943 were allowed in part. Claims for the years 1944, 1945, and 1946 were disallowed because of the limitations imposed by section 710 (a) (1) (B). The constructive average base period net income determined by respondent was based on actual earnings for the taxpayer's fiscal year ending November 30, 1939. Held, that petitioner had not reached its normal level of earnings under the changed conditions by the end of its base period and its constructive average base period net income is redetermined under the push-back rule.
*212 This proceeding involves deficiencies in excess profits tax and claims for refund for the fiscal years ending November 30, 1941, to November 30, 1946, inclusive, as follows:
| Refunds | ||
| Year | Deficiency | claimed |
| 1941 | $ 1,890.40 | $ 6,735.75 |
| 1942 | 6,292.06 | 32,555.27 |
| 1943 | 33,143.10 | 19,989.80 |
| 1944 | $ 22,096.57 | $ 24,278.41 |
| 1945 | 15,816.01 | 13,100.95 |
| 1946 | 1,490.23 | 1,408.88 |
The *204 deficiencies are attributable to the deferment of payment of excess profits tax under the provisions of section 710 (a) (5), Internal Revenue Code of 1939.
The deficiency notice in Docket No. 31722 contains, among other things, the following statement:
*213 It has been determined that constructive average base period net incomes in the following amounts should be used in the computation of your excess profits tax liabilities for the taxable years ended November 30, 1941, November 30, 1942, and November 30, 1943:
| Constructive average | |
| Year ended | base period net income |
| 11/30/41 | $ 33,143.42 |
| 11/30/42 | 43,870.46 |
| 11/30/43 | 43,870.46 |
It has been determined that the relief requested has been allowed in part.
In Docket No. 27455 the deficiency notice states, among other things, as follows:
It has been determined that you are entitled to use a constructive average base period net income of $ 43,870.46 in the computation of your excess profits tax liability for each of the taxable years ended November 30, 1944, November 30, 1945, and November 30, 1946. However, by reason of the 80% limitation imposed by Section 710 (a) (1) (B) of the Internal Revenue Code, the use of such constructive average base period net income *205 would not be to your advantage.
Petitioner, by appropriate assignments of error, contests the correctness of the above-described determinations of the Commissioner and alleges that "A fair and just amount representing normal earnings which should be used as a constructive average base period net income is an amount not less than $ 123,137.00." Petitioner further alleges that there are no deficiences in any of the taxable years and that there is an overpayment of excess profits taxes for each of the taxable years and that the amounts of such overpayments for these years should be computed under Rule 50, using the constructive average base period net income claimed by petitioner in place of the constructive average base period net income allowed by the Commissioner in his granting of relief in part.
An issue raised in the pleadings in Docket No. 31722 relating to the disallowance of a portion of the deductions claimed for officers' salaries in 1942 and 1943 has been conceded by the respondent.
FINDINGS OF FACT.
Many of the facts have been stipulated and are found as stipulated and are incorporated herein by reference.
Petitioner was incorporated as a Michigan corporation on January 7, 1936, *206 and its principal office is located at Muskegon, Michigan. Its returns for the years involved, the fiscal years ending November 30, 1941, to November 30, 1946, inclusive, were filed with the collector of internal revenue for the first district of Michigan. Petitioner's base period is the period beginning January 7, 1936, and ending November 30, 1940.
*214 Applications for relief and refund on Form 991 and claims for refund on Form 843 were properly and timely filed by petitioner for its 6 fiscal years ending November 30, 1941, through November 30, 1946.
Petitioner's business is the manufacture and sale of buses. The business was established many years ago. Its assets were acquired by Thomas H. Hume, the principal creditor in a receivership sale in 1931. Hume operated the business as a sole proprietorship until it was incorporated January 7, 1936. Frank W. Feeney, who had been associated with Hume in the business for a number of years, became petitioner's president and Hume its treasurer and vice president. They have continued in those positions until the present time.
At the time of its organization petitioner's business consisted primarily of the manufacture and sale of bus bodies *207 for passenger-carrying vehicles. The bodies were designed and built by the petitioner and were mounted on truck chassis furnished by the customers or purchased by the petitioner from chassis dealers. The bus bodies were sold to chassis manufacturers and their dealers who in turn sold the completed buses to the ultimate operators. This type of bus was known as a non-integral bus.
In addition to the bus bodies, petitioner also manufactured, during 1936 and throughout the base period, what it called sedan buses. This was a 4-door passenger automobile which petitioner cut in two between the front and rear doors and elongated by extending the chassis frame and inserting a new body section. They seated about 11 passengers. They were identified as Model 100 conversions.
Most of the bus bodies manufactured by petitioner prior to 1937 were made primarily of wood with a few steel or other metal parts, such as braces and angle irons. The exteriors were covered with a sheet metal nailed or riveted to the wooden frame. These were referred to as composite bodies.
In about 1927, one or more of the large companies began manufacturing all-metal buses with the chassis and body built as a single unit. *208 These were referred to as integral, transit-type buses. They were distinguished in appearance by the absence of hoods, such as were found on conventional automobile and truck chassis. The integral, transit-type buses came into rapid favor, especially with the public carriers, and by 1938 most of the large companies had begun manufacturing buses of that type.
Petitioner began building all-metal bus bodies in 1936. In so doing, it called upon the Aluminum Company of America and others for advice as to structural problems and the use of different metals. Petitioner's volume of business was small compared with that of the large *215 bus manufacturers, such as General Motors, Twin Coach, White, Mack, and ACF-Brill.
Petitioner continued manufacturing bus bodies exclusively until sometime in 1937. By that time it realized that to hold its position in the industry it would have to change the nature of its product and begin building integral, transit-type buses. An integral bus is a bus in which the design is made from the ground up, the substructure on which the body rests being an integral part of the body itself. In preparing for the change petitioner consulted with construction engineers *209 and suppliers of engines, transmissions, axles, and other necessary parts for assembling a complete integral bus.
In April 1938, petitioner sold and delivered its first all-metal integral, transit-type bus. It had a seating capacity of 24 passengers. During the remainder of its base period it introduced five other integral-type models. Some or all of these various models differed in general design, wheelbase, allover lengths, height, motor power, and other respects. All but one of the models were for intercity use. All of them contained standard parts such as Chevrolet and Hercules engines, Timken axles, W. C. Lipe clutches, Clarke gears, Spicer universals, Ross steering gear, and Borg-Warner brakes.
Petitioner's territorial market during the base period consisted principally of the States east of the Rocky Mountains, except New York, New Jersey, and Canada. Almost all of its sales were in cities of less than 100,000 population.
The following table shows petitioner's sales of composite bodies, metal bodies, integral buses, and Model 100 conversions, for its taxable years 1936 to 1941, inclusive:
| Year | Composite | Metal | Integral | Model |
| bodies | bodies | buses | 100 | |
| conversions | ||||
| 1936 | 202 | 4 | 94 | |
| 1937 | 91 | 52 | 53 | |
| 1938 | 19 | 21 | 37 | 21 |
| 1939 | 6 | 16 | 103 | 27 |
| 1940 | 1 | 66 | 1*210 22 | |
| 1941 | 150 | 49 |
As petitioner got into the production of integral buses, its sales to the chassis manufacturers and dealers gradually fell off and sales to operators increased. The following table shows petitioner's sales of mounted bus bodies and integral buses, exclusive of Model 100 sedans, to manufacturers, dealers, and operators, both in units and dollar values, for the calendar years 1936 to June 1, 1940: *216
| Percentage | |||
| Number | Dollar value | of total | |
| of units | dollar sales | ||
| 1936 | |||
| Manufacturers | 81 | $ 199,963 | 38 |
| Dealers | 62 | 126,853 | 27 |
| Operators | 89 | 199,789 | 35 |
| 232 | $ 526,605 | 100 | |
| 1937 | |||
| Manufacturers | 28 | $ 90,414 | 21 |
| Dealers | 34 | 78,321 | 18 |
| Operators | 72 | 258,539 | 61 |
| 134 | $ 427,274 | 100 | |
| 1938 | |||
| Manufacturers | 15 | $ 70,446 | 18 |
| Dealers | 14 | 55,241 | 14 |
| Operators | 54 | 268,410 | 68 |
| 83 | $ 394,097 | 100 | |
| 1939 | |||
| Manufacturers | 10 | $ 45,728 | 7 |
| Dealers | 9 | 33,610 | 5 |
| Operators | 93 | 571,546 | 88 |
| 112 | $ 650,884 | 100 | |
| Jan. 1 to June 1, 1940 | |||
| Manufacturers | |||
| Dealers | |||
| Operators | 41 | $ 229,476 | 100 |
| 41 | $ 229,476 | 100 |
A strike occurred in petitioner's plant on June 8, 1940, which resulted in a complete shutdown. Work was resumed October 22 of that year. Petitioner had no production during that period, although it did sell some of its demonstrator buses.
Petitioner's month-by-month sales of integral buses over the period April *211 1938 through November 1940 were as follows:
| Month | 1938 | 1939 | 1940 |
| January | 6 | 8 | |
| February | 2 | 5 | |
| March | 9 | 4 | |
| April | 6 | 8 | 11 |
| May | 1 | 11 | 11 |
| June | 9 | 13 | 3 |
| July | 4 | 17 | 0 |
| August | 5 | 4 | 2 |
| September | 3 | 10 | 0 |
| October | 4 | 7 | 3 |
| November | 5 | 8 | 7 |
| December | 8 | 12 |
Petitioner's production of buses was only a small portion of the total industry production in the United States. It varied during the base period years from about 1 per cent to about 3 per cent. The percentage declined in 1937 and 1938, recovered somewhat in 1939, and fell off sharply in 1940 when the strike in petitioner's plant occurred.
*217 After introduction of the integral bus, petitioner carried a complete line of service and spare parts for them. It got out a printed catalog listing and pricing all of these parts. The parts were usually marked up 100 per cent and were sold at a discount of 25 per cent on catalog prices. Petitioner had previously sold parts but had not carried an inventory of them as a service feature. The volume of parts sales and profits increased with the age and usage of the buses sold by the petitioner. The sales of parts over the period 1936 to 1945, inclusive, were as follows:
| Fiscal year | Petitioner's |
| ended November 30 | parts sales |
| 1936 | $ 7,835 |
| 1937 | 11,950 |
| 1938 | 8,539 |
| 1939 | 9,874 |
| 4-year average | 9,550 |
| 1940 | 22,929 |
| 1941 | 40,369 |
| 1942 | 70,685 |
| 1943 | 119,430 |
| 1944 | 226,202 |
| 1945 | 326,000 |
*212 Petitioner did not maintain a large sales force. It had one or two regular salesmen and on occasions its officers assisted in selling. With the introduction of the integral buses, petitioner increased its sales activities. In the latter part of 1939, petitioner employed a full-time sales agent in Canada on a salary basis. It advertised regularly in trade papers. Over the period 1936-1939 salesmen's salaries and commissions and sales expenses were as follows:
| Salesmen's | ||
| Fiscal year ended November 30 | salaries and | Sales travel |
| commissions | and expense | |
| 1936 | $ 7,939 | $ 8,585 |
| 1937 | 8,025 | 7,294 |
| 1938 | 10,575 | 12,373 |
| 1939 | 17,000 | 17,540 |
Before the introduction of the integral buses, most of petitioner's sales were for cash. It had no means of protecting itself on credit sales for the reason that it did not acquire title to the chassis and could not retain a chattel mortgage on the entire unit. In selling integral buses, it inaugurated a credit system under which it retained title to the bus until the full purchase price had been paid. The sales price of bus bodies manufactured by the petitioner ranged from about $ 1,400 to $ 2,500 while its integral buses sold for from $ 4,600 to $ 10,000. During the period *213 January 1, 1936, through May 31, 1940, petitioner's *218 "financed" sales of mounted bus bodies and integral buses, excluding conversions, were as follows:
| Number of | ||||
| Date 1 | units | Dollar value | ||
| 1936 | 9 | $ 16,255.20 | ||
| 1937 | 10 | 42,442.08 | ||
| 1938: | ||||
| January-March 31 | 2 | $ 8,964.08 | ||
| April 1-December 31 | 23 | 123,253.30 | ||
| 25 | 132,217.38 | |||
| 1939: | ||||
| January-May 31 | 13 | 86,458.47 | ||
| June 1-December 31 | 32 | 180,609.38 | ||
| 45 | 267,067.85 | |||
| 1940: January-May 31 | 17 | 95,105.13 |
The following is a condensed profit and loss statement of petitioner's operations for the taxable years ended November 30, 1936, to November 30, 1942, showing net sales, gross profits, compensation of officers, salaries and wages, total deductions, and net income (or losses) as adjusted by revenue agent:
| Comparative Profit and Loss Statements (Cents Omitted) per | ||||
| Federal Income Tax Returns After Revenue Agent Corrections 1*214 | ||||
| November 30 | ||||
| 1936 | 1937 | 1938 | 1939 | |
| Net sales | $ 583,739 | $ 491,598 | $ 393,255 | $ 781,539 |
| Gross profits | 134,723 | 63,286 | 68,827 | 155,475 |
| Compensation of officers | 10,425 | 13,455 | 14,875 | 29,000 |
| Salaries and wages | 14,284 | 16,541 | 17,270 | 25,571 |
| Total deductions | 67,193 | 78,622 | 81,843 | 119,985 |
| Net income (or losses) | 71,942 | (12,112) | (7,632) | 48,103 |
| Comparative Profit and Loss Statements (Cents Omitted) per | |||
| Federal Income Tax Returns After Revenue Agent Corrections 1 | |||
| November 30 | |||
| 1940 | 1941 | 1942 | |
| Net sales | $ 511,924 | $ 1,127,317 | $ 1,317,150 |
| Gross profits | 85,607 | 212,130 | 312,903 |
| Compensation of officers | 13,125 | 21,600 | 39,783 |
| Salaries and wages | 23,015 | 33,082 | 38,110 |
| Total deductions | 95,930 | 132,423 | 140,718 |
| Net income (or losses) | (4,330) | 90,249 | 186,885 |
Petitioner's excess profits net income for the taxable years 1941-1946, inclusive, as determined by respondent, was as follows:
| Excess profits | |
| Year ending November 30 | net income |
| 1941 | $ 68,573.41 |
| 1942 | 186,096.84 |
| 1943 | 185,897.79 |
| 1944 | 254,194.21 |
| 1945 | 346,052.27 |
| 1946 | 307,401.24 |
ULTIMATE FACTS.
During the base period, petitioner changed the character of its business and as a result thereof its average base period net income does *219 not reflect the normal operation for the entire base period of the business.
Petitioner's business did not reach by the end of its base period the earning level which it would have reached if the change in the character of its business had occurred 2 years earlier.
Petitioner's average base period net income is an inadequate standard of normal earnings.
Petitioner's excess profits tax for the fiscal years ending November 30, 1941, through November 30, 1946, computed without the benefit of section 722 results in an excessive and discriminatory tax.
Petitioner's constructive average base period net income for the fiscal years *215 ending November 30, 1942, through November 30, 1946, is the amount of $ 72,500; for the fiscal year ending November 30, 1941, it is the same except for adjustment on account of income tax. See East Texas Motor Freight Lines, 7 T.C. 579">7 T. C. 579.
OPINION.
Petitioner's claim for relief is based primarily on the ground that the character of its business was changed during the base period, within the meaning of section 722 (b) (4), from that of a builder of composite wood bus bodies to that of a builder of integral all-metal buses, and that its average base period net income does not reflect the normal operation of the business, as changed. Petitioner also claims that the business did not reach by the end of the base period the earning level that it would have reached had the change in the character of its business been made 2 years earlier, and petitioner is therefore entitled to reconstruct its normal average base period net income by assuming that the change in the character of its business had been made 2 years earlier.
Petitioner has also claimed that it is entitled to relief under section 722 (b) (1) because during the last year of its base period, from June 8 through October 19, 1940, petitioner's *216 normal operation was completely disrupted by a strike at its plant. However, no relief is prayed for separately on this ground because the strike occurred after December 31, 1939, and petitioner therefore says such relief depends on the constructive level of normal base period earnings granted petitioner on its claim under section 722 (b) (4).
Respondent allowed petitioner's claims for relief in part and determined its constructive average base period net income for the taxable years at issue as follows: *220
| Constructive average base | |
| Year ending November 30 | period net income |
| 1941 | $ 33,143.42 |
| 1942-1946 | 43,870.46 |
Such determination resulted in a partial reduction of petitioner's excess profits tax for the taxable years 1941, 1942, and 1943, but in no reduction for the taxable years 1944, 1945, and 1946 due to the 80 per cent limitation imposed by section 710 (a) (1) (B) of the 1939 Code.
Petitioner's average base period net income, computed without the benefit of section 722, is $ 18,277.22 for 1941 and $ 26,192.29 for the other taxable years. Petitioner contends here that it is entitled to a constructive average base period net income of $ 123,137.
While the respondent concedes that there *217 was a base period "change in the operations" of petitioner's business by reason of its introduction of the integral-type buses, he denies that there was any difference in petitioner's products. He argues this point at considerable length in his brief. This argument seems to us without merit. Relief under subsection (b) (4) is predicated upon a base period change "in the character of the business"; and such a change is defined as including "a change in the operation or management of the business" or "a difference in the products." Whether the change in the character of petitioner's business came about by a change in operation, or a difference in products, or both, our task of determining a fair and just amount representing petitioner's normal base period earnings under the changed conditions remains the same.
We might observe at this point that although it has been stipulated that petitioner's base period began January 7, 1936, and extended to November 30, 1940, in reconstructing normal base period earnings no consideration can be given to events taking place after December 31, 1939. See Wisconsin Farmer Co., 14 T.C. 1021">14 T. C. 1021. The changes to consider here all took place prior to January *218 1, 1940.
The evidence before us leaves little doubt that petitioner was losing business and losing its competitive position in the bus market during much of its base period because of its failure to follow the industry-wide transition to the integral transit-type bus. It decided to make the changeover in 1937 and sold its first integral-type bus of its own manufacture in April 1938. This change from the manufacture of bus bodies to the manufacture of complete integral-type buses was a substantial change and it affected all departments of petitioner's business. It is true that petitioner continued to build bus bodies but in addition it had to go out in the market and purchase the motors, axles, wheels, and other parts for the assembled chassis on which the bodies were to be built. In the sales end of the business, petitioner had to establish a market for its integral-type buses. Its sales commissions *221 and selling expenses more than doubled over the period 1936-1939. These changes necessarily took time and required a considerable development period.
Petitioner's net sales fell off from $ 583,739 in 1936 to $ 491,598 in 1937, and $ 393,255 in 1938. It had a net profit of $ 71,942 *219 in 1936, net losses of $ 12,112 in 1937 and $ 7,632 in 1938. There was a recovery in 1939 with net sales of $ 781,539 and a net profit of $ 48,103. There is no reason to doubt, on the evidence before us, that this upward trend would have continued in 1940 but for the strike which closed petitioner's plant from June 8 to October 22 of that year. As a result of the strike, petitioner's 1940 net sales fell back to $ 511,924 and it had a loss of $ 4,330. The upward trend was resumed in 1941.
Respondent takes the position that petitioner reached its normal level of earnings under the changed operations by the end of its fiscal year 1939. He has computed petitioner's constructive average base period net income by backcasting petitioner's actual earnings of $ 48,103 for its fiscal year 1939 on a 91.2 general business index. Petitioner does not question the use of the general business index for backcasting but it does contend that the Commissioner erred in his use of $ 48,103 for backcasting. It is petitioner's contention that when the 2-year push-back rule is applied its constructive net income for its fiscal year 1940 is $ 135,018 and that when this is backcast by 0.912, its constructive *220 average base period net income is $ 123,137. This latter figure is the constructive average base period net income which petitioner contends should be used in computing the measure of its relief under section 722, instead of the $ 43,870.46 which the Commissioner has used.
Petitioner did not sell its first integral, transit-type bus until April 1938. Its total for that year was 37 buses and its total dollar sales were $ 393,255. In 1939, 103 integral buses were sold, and total dollar sales amounted to $ 781,539. In the table shown in our Findings of Fact, petitioner's sales of bodies were decreasing and the sales of integral buses were increasing.
We have found as a fact that by the end of petitioner's base period petitioner had not reached the level of earnings it would have reached if the change in its business, that is, the change from manufacturing bodies to manufacturing integral buses, had occurred 2 years earlier than it did. At the end of 1939, petitioner had had an experience of 1 year and about 7 months in manufacturing and marketing integral buses. It sold 37 buses in 1938 and 103 in 1939. Of the 1939 sales, 80 were in the last 6 months of that fiscal year. This indicates *221 a continuing growth of the business throughout 1939. This growth might have been completed and a normal level of earnings reached in the last base period year, 1940, but for the strike *222 which closed petitioner's plant from June 8 to October 22 in that year. The effect of the strike carried over into the year 1941. With 2 years' additional experience under the base period changes, we think that petitioner would in all probability have reached a normal level of earnings both in the manufacture and sale of integral buses and in the sale of parts in the fiscal year 1939. Absent the strike, this level would have been maintained or perhaps exceeded in 1940.
Petitioner established a separate department for supplying replacement parts to its customers as a necessary adjunct of the business of manufacturing integral buses. This developed into a profitable branch of the business. The evidence is that ordinarily the need for substantial replacement parts for a bus begins after about 18 months or 2 years of use and continues for the life of the bus. The sales in the parts and service department increased from $ 9,874 in 1939, which was about the 1936-1939 average, to approximately $ 23,000 *222 in 1940. At the end of 1939, there were 16 of petitioner's buses that had been in service as long as 18 months but none for as much as 2 years.
With petitioner's 2 years' additional experience in manufacturing and selling integral buses, based on the conditions existing at the close of the year 1939 and on the outlook for petitioner's business at that time, and making what we consider proper adjustments for increased sales of buses and replacement parts, we think that a fair and just amount representing constructive average base period earnings is $ 72,500. This amount is subject to the statutory adjustment for taxes in computing the constructive average base period net income for the fiscal year ended November 30, 1941.
Reviewed by the Special Division.
Decisions will be entered under Rule 50.
Footnotes
1. This was the year of the strike.
1. There were no sales of integral buses before April 1, 1938.↩
1. It is now stipulated that petitioner's net income was $ 182,596.84 for 1942, and $ 182,397.79 for 1943, and that these adjustments will be given effect under Rule 50.