*202 Decision will be entered for the respondent.
Excess profits tax relief under section 722 (c) denied where petitioner's organization and all of its production were related to war industry and where the evidence does not show a reasonable method for a reconstruction of base period income under normal, peacetime conditions which would result in excess profits credits greater than those available to petitioner under the invested capital method.
*204 This proceeding involves claims for relief under section 722, Internal Revenue Code of 1939, for the taxable years ended March 31, 1944 and 1945. Petitioner's excess profits tax credit (determined by the invested capital method) without the benefit of section 722 was*203 $ 16,229.41 for the year ended March 31, 1944, and $ 14,301.07 for *205 the year ended March 31, 1945. Petitioner proposes a constructive average base period net income of $ 98,000.
FINDINGS OF FACT.
Petitioner is a California corporation with its principal place of business located at San Leandro, California. It is engaged in the business of manufacturing electric stud welders and the studs, nuts, washers, and other products used in stud-welding operations. Its returns were made on the basis of a fiscal year ending March 31.
Petitioner acquired the business from a sole proprietor, Edward F. Nelson, upon its incorporation in March 1942. Nelson had begun the business on a part-time basis in his garage in Vallejo, California, about June 1939. He was then employed as a welder at the Mare Island Navy Yard.
The basic function of the equipment manufactured by petitioner is the welding of steel studs to metal surfaces by use of a light, portable arc welder, referred to as a welding gun. The process employed by petitioner was invented and patented by Nelson. His first patent application was filed in 1938. That and other patents were assigned to petitioner when it took over the*204 business under a license agreement which provided for royalty payments to Nelson of 20 per cent of sales. Royalties were reduced to 10 per cent of sales in 1943.
The only other stud-welding process then in general use was "resistance welding." This required the use of heavy and comparatively expensive equipment. The initial cost of petitioner's stud-welding equipment was from $ 800 to $ 1,000 as compared with an initial cost of from $ 5,000 to $ 10,000 for resistance welding equipment. Resistance welding requires large transformers and condensers. This usually remains stationary and the work is brought to it, whereas, the Nelson welder is light and portable and is easy to operate. It is used by plumbers, electricians, iron workers, and other tradesmen, as well as trained welders.
Five welding guns were sold by Nelson in 1939. The first of those was sold to Braun Construction Company, a manufacturer of oil-refinery equipment; 2 were sold to Bethlehem Steel; and 2 to a British welder. Nelson sold 11 guns in 1940, 37 in 1941, and 12 during the first 3 months of 1942. Petitioner sold 151 guns during 1942, after it took over the business, and 261 in its first full year of operations*205 ended March 31, 1943.
The petitioner corporation was formed at the suggestion of officers of the Reconstruction Finance Corporation. Nelson had been told by naval officers, who were interested in his welding gun for shipbuilding use, that he should get a loan from the R. F. C. and expand the business. The R. F. C. was willing to make the loan but informed *206 Nelson that it could negotiate only with corporations, and advised him to incorporate the business.
Petitioner's first full year of operation was its fiscal year ended March 31, 1943. During most of that year it was engaged in building and equipping a new plant which it occupied in July 1942.
During 1940, Nelson developed and applied for a patent on a special flux-filled stud to be used with the stud-welding guns. The first patent was issued in December 1941. The stud had a hollowed-out head containing the right amount of flux for the weld. Theretofore the flux had been added during the welding in a separate operation. This caused waste and delay and for other reasons was unsatisfactory. The flux-filled studs were more expensive but the allover result was economical and highly satisfactory.
The machines required*206 for the manufacture of flux-filled studs, welding pins, and other accessories were designed and built by Nelson. During the fall of 1942 and the spring of 1943, a large portion of petitioner's production personnel was employed in manufacturing and installing this machinery. This retarded, temporarily, petitioner's production and sale of welding guns and other commodities. It was near the end of the fiscal year ended March 31, 1943, that full production under the new set-up was attained. The following table shows the orders received by petitioner and the sales made during each month of its first year of operation, April 1942 through March 1943:
| Month | ||
| 1942 | Orders received | Sales |
| April | $ 55,412.99 | $ 31,238.28 |
| May | 38,129.04 | 27,846.85 |
| June | 85,486.04 | 27,020.58 |
| July | 88,210.35 | 47,309.02 |
| August | 17,622.46 | 22,178.02 |
| September | 74,098.25 | 47,603.90 |
| October | 203,398.63 | 54,209.90 |
| November | 89,608.71 | 35,029.78 |
| December | 90,303.32 | 67,864.49 |
| 1943 | ||
| January | 117,574.48 | 59,442.91 |
| February | 41,059.56 | 90,509.78 |
| March | 338,811.18 | 140,139.53 |
| $ 1,239,715.01 | $ 650,393.04 |
| Backlog of unfilled orders | |
| December 31, 1942 | $ 374,021.61 |
| March 31, 1943 | 609,594.36 |
*207 Broken down as to commodities, petitioner's sales for that year were as follows: *207
| Insulation | |||||
| Month | Guns | Studs and | Washers | Nuts | pins and |
| ferrules | clips | ||||
| 1942 | |||||
| April | $ 10,800.45 | $ 11,012.28 | $ 1,275.46 | $ 8,150.09 | |
| May | 1,528.80 | 13,236.03 | 2,066.32 | 11,015.70 | |
| June | 4,264.90 | 13,640.73 | 2,231.05 | 6,883.90 | |
| July | 8,319.20 | 25,343.97 | 3,151.82 | 10,494.03 | |
| August | 6,659.20 | 8,214.48 | 860.03 | 6,444.31 | |
| September | 11,042.15 | 22,558.00 | 1,922.60 | 12,081.15 | |
| October | 18,553.50 | 26,058.59 | 799.97 | 8,797.84 | |
| November | 6,675.00 | 27,165.79 | 229.15 | 959.84 | |
| December | 12,451.25 | 41,048.35 | 1,738.49 | 12,626.40 | |
| 1943 | |||||
| January | 10,790.46 | 40,864.67 | 682.39 | 7,105.39 | |
| February | 29,768.65 | 43,916.68 | 1,513.35 | 14,811.10 | $ 500.00 |
| March | 50,763.70 | 66,828.62 | 639.00 | 3,042.36 | 18,865.85 |
| $ 171,617.26 | $ 339,888.19 | $ 17,109.63 | $ 102,412.11 | $ 19,365.85 |
Following is a schedule of petitioner's operations for the months of April and May 1943, prepared from petitioner's profit and loss statements:
| Gross sales | $ 455,102.92 | ||
| Deduct: Royalties at 20 per cent | 90,908.08 | $ 364,194.84 | |
| Cost of goods sold: | |||
| Inventories March 31, 1943 | $ 92,595.20 | ||
| Purchases | 151,215.21 | ||
| Manufacturing expenses | 13,585.61 | ||
| Direct labor | 37,692.88 | ||
| Indirect labor | 21,517.84 | ||
| $ 316,606.74 | |||
| Less: Inventories May 31, 1943 | 142,181.51 | 174,425.23 | |
| Gross profit on sales | $ 189,769.61 | ||
| Operating expenses: | |||
| Shipping | $ 1,322.49 | ||
| Selling and servicing | 3,338.83 | ||
| General and administrative | 4,725.28 | ||
| Fixed charges | 4,574.10 | 13,960.70 | |
| Salaries and wages: | |||
| Shipping | $ 3,879.01 | ||
| Selling and servicing | 7,791.14 | ||
| Administrative | 8,134.31 | 19,804.46 | 33,765.16 |
| Net profit from operations | $ 156,004.45 |
*208 Note: These figures are before renegotiation. Inventories at beginning and end of period based on physical count and valued at cost.
Most of petitioner's sales from the time it commenced business in 1942, through 1945, were to shipyards or shipbuilding contractors. There were then, and still are, numerous other uses for stud welding *208 which might have been developed during the base period had petitioner been in operation, such as supporting refractory linings in open hearth furnace doors, securing various types of insulation to steel surfaces, and the manufacture and maintenance of electrical, railroad, and other industrial equipment of a wide range.
It has been petitioner's experience that it required from a month to a year to sell a customer on the use of Nelson stud-welding equipment. Where basic changes of design and tooling were necessary, the sale of a customer on such equipment might take anywhere from 9 months to a year. Where there was involved merely a simple substitution of stud welding for drilling and tapping, or for hand welding, the sale was often consummated within a week to 2 months.
Among petitioner's customers in 1945, as disclosed by a customers' survey*209 dated June 1, 1945, were aircraft manufacturers, boiler manufacturers, chemical manufacturers, electrical equipment manufacturers, insulation contractors, motor vehicle manufacturers, oil refineries, pulp and paper mills, railroad and railway equipment manufacturers, shipyards, steam electric power plants, steel mills, and others. The survey listed, altogether, about 600 customers.
In November 1943, Nelson caused to be organized another corporation, Camden Stud Welding Corporation, under the laws of New Jersey. This company was organized primarily to provide warehousing, shipping, and engineering services for petitioner's customers in the eastern United States, although it was authorized to manufacture and sell stud-welding guns, as well as other accessories manufactured by petitioner. In September 1945, the corporation was moved to Lorain, Ohio, and its name changed to Nelson Stud Welding Corporation. It then set up a manufacturing plant at Lorain similar to petitioner's plant at San Leandro.
In September 1945, there was created a California corporation, Nelson Sales Corporation, which became the principal sales agency in the United States and Canada for petitioner and for Nelson*210 Stud Welding Corporation. It maintained offices at Lorain, Ohio, and other points throughout its territory. This corporation was organized as successor to a partnership of which Nelson was a principal owner. It had been engaged in similar operations since February 1944.
The profits of petitioner's predecessor, the proprietorship, for the period June 1, 1939, to March 31, 1942, were as follows:
| Year ended December 31 | ||||
| June 1, 1939, | Jan. 1, 1942, | |||
| to Dec. 31, | to March 31, | |||
| 1939 | 1940 | 1941 | 1942 | |
| Sales | $ 3,445.94 | $ 7,982.08 | $ 73,007.21 | $ 33,817.34 |
| Gross profits | 1,781.60 | 5,699.11 | 39,274.78 | 13,976.32 |
| Net profit per R. A. R | 1,045.91 | 4,514.15 | 33,353.57 | 11,058.98 |
*209 Profit and loss statements of petitioner for the years March 31, 1943, to March 31, 1946, show sales, gross profits, net profits (or losses) as reported by petitioner in its returns after revenue agent's adjustments, and adjustments for renegotiation and stepped-up amortization, as follows:
| 1943 | 1944 | |
| Sales | $ 650,393.04 | $ 3,714,788.63 |
| Gross profits | 264,350.36 | 2,009,948.28 |
| Net profit (or loss) per returns | 21,236.01 | 800,854.72 |
| Net profit (or loss) after R. A. R. | ||
| adjustments | 19,783.13 | 808,540.57 |
| Renegotiation adjustments | (85,000.00) | (502,063.00) |
| Stepped-up amortization adjustments | (4,100.06) | (47,955.54) |
| Net profit (or loss) after all adjustments | (69,316.93) | 257,424.45 |
| 1945 | 1946 | |
| Sales | $ 5,604,498.09 | $ 1,937,505.90 |
| Gross profits | 2,768,565.43 | 697,251.21 |
| Net profit (or loss) per returns | 611,777.18 | (155,477.88) |
| Net profit (or loss) after R. A. R. | ||
| adjustments | 637,987.22 | (145,787.22) |
| Renegotiation adjustments | (191,613.00) | |
| Stepped-up amortization adjustments | (74,832.72) | |
| Net profit (or loss) after all adjustments | 353,064.87 | (154,583.44) |
In making the renegotiation adjustment of $ 85,000 for 1943, the Renegotiation Board allowed petitioner a royalty expense deduction of only 2.5 per cent of sales, thereby restoring $ 113,800 to net income. The adjustment of $ 85,000, with the further adjustment of $ 4,100.06 for stepped-up amortization, left petitioner with an actual net loss of $ 69,316.93. The 1945 net profits of $ 353,064.87 are after deduction of abnormal inventory write-down of $ 120,313.79 and abnormal wartime amortization of $ 136,888.32. The 1946 net loss of $ 154,583.44 reflects an abnormal inventory write-down of $ 126,164.36 and an abnormal wartime amortization of $ 67,647.47.
Petitioner's excess profits net income and its excess profits credits, computed under the invested capital method, for the taxable years*212 ended March 31, 1944 and 1945, are as follows:
| Year ended March 31 | Net income | Credits |
| 1944 | $ 114,712.93 | $ 16,229.41 |
| 1945 | 59,943.45 | 14,301.07 |
The stipulated facts are incorporated herein by this reference.
OPINION.
Respondent concedes that petitioner's license agreement with its principal stockholder, Ted Nelson, was an intangible asset which made important contributions to its income and was, therefore, a qualifying factor under section 722 (c). Respondent denies, however, that petitioner's excess profits tax credits, computed under the invested capital method, are an inadequate standard of normal earnings or that petitioner is entitled to excess profits tax relief for either of the taxable years involved.
The reconstruction of normal base period earnings under section 722 (c) is similar to that in certain types of section 722 (b) (4) cases; that is, the average base period net income is determined in relationship to what the taxpayer's earning level would have been at the *210 end of the base period if the business had been commenced 2 years prior thereto. See sec. 35.722-4 (c) of Regs. 112; E. P. C. 35; and Bulletin on Section 722, Part VII (E), p. 136. In*213 making such determination, in the instant case, it would be assumed that the taxpayer began business at December 31, 1937, with the equipment and productive capacity it possessed at the end of its first excess profits tax taxable year.
E. P. C. 35 further summarizes the approach to reconstruction of base period earnings in 722 (c) cases as follows:
Reconstruction based upon the nature of the taxpayer and the character of its business involves problems similar to those encountered in ante-dating events where the push-back rule is used in cases under section 722 (b) (4). The new business is moved back into the pre-1940 economy but its effect on competing or related enterprises must be recognized. Elements, such as war demand, which cannot be moved back under the push-back rule, cannot be moved back under section 722 (c). In short, the problem is to determine what the performance of the particular business would have been under pre-1940 economic conditions, as these conditions would have been had it performed during that period.
While there is evidence that there were potential peacetime uses for stud-welding, as set forth in our findings, there is no satisfactory proof in the record*214 that under the peacetime conditions existing in the base period and without the impetus of war-induced shipbuilding activities, petitioner would have been able to develop a profitable stud-welding business within the 2-year period from December 31, 1937, to December 31, 1939.
Financing was readily available to petitioner through the R. F. C. because of the urgency of war conditions. There is nothing in the record to indicate that it could have procured the necessary finances on the basis of peacetime needs during the base period.
The problem of building up a market for its product would have been a serious one. The product would not have been known to any extent to peacetime users on December 31, 1937. Many prospective users had equipment for stud-welding by the process of resistance welding. While petitioner's product had some advantages, and could be used in addition to as well as in place of the resistance-welding process, it can hardly be doubted that users would have been slow to scrap the expensive equipment which they already had.
Moreover, while petitioner's experience indicates that the sales could have been effected speedily where merely a simple substitution of stud-welding*215 for drilling and tapping or hand welding was involved, it was admitted that (even when its product was established) where basic changes of design and tooling were necessary, selling a customer on the equipment might take from 9 months to a year.
There is nothing in the record to show that a sales force adequate in numbers and training could have been developed under base period *211 conditions which would have resulted in a peacetime demand at a profitable level by December 31, 1939. There is no more than the barest speculation as to what that demand might have been, or the point which it might have reached by the end of the base period. Likewise, there is no indication of what the initial development expense would have been during the first 2 years of activity under base period conditions.
Without attempting to detail all of the adverse factors indicated by the record, we merely add to what has already been said that there is no reliable basis in the record on which we might determine the effect of base period conditions on selling price, especially in dealing with a relatively unknown product.
Petitioner has been allowed excess profits credits based on invested capital of*216 $ 16,229.41 for 1944 and $ 14,301.07 for 1945. In its proposed reconstruction, petitioner takes as a starting point its actual sales for the month of March 1943, the last month of its first complete year of operations, and by relating this production to certain industrial production statistics it arrives at a constructive average base period net income of $ 98,000. This figure is based on 1939 constructive net sales of $ 1,071,700 and a net profit for the year, computed on a 10 per cent ratio of net income to net sales, of $ 107,200.
We realize petitioner's difficulties in reconstructing base period earnings, but we cannot accept a reconstruction based initially on wartime sales and back-cast on a purely speculative basis. Nor can we substitute our own judgment when there is no basis in the record for the exercise of judgment. On the contrary, we might well say here, as we said in Jackson-Raymond Co., 23 T. C. 826, 836, that "* * * we cannot escape the conviction that petitioner's business gained the success it did largely because of war conditions, and that no acceptable basis for reconstructing it as a normal, peacetime enterprise has been established. *217 Compare Crowncraft, Inc., 16 T. C. 690; Fezandie & Sperrle, Inc., 5 T.C. 1185">5 T. C. 1185."
We said in Crowncraft, Inc., 16 T. C. 690, 698, in denying relief under section 722 to a manufacturer of aircraft assembly jigs, that:
It [the taxpayer's business] grew up with the war, was successful because of the war, and ceased with the ending of hostilities. Excess profits taxes were imposed not only to raise revenue, but to take the "excess profits out of war." Petitioner's excess profits are exactly the type of profits such taxing provisions were intended to cover. Fezandie & Sperrle, Inc., 5 T. C. 1185 (1945). * * *
While petitioner's operations did not end with the war, the important consideration is that it grew up with the war and was successful because of the war. And it has not established what it might have accomplished under base period conditions.
*212 For the reasons stated, we think that respondent's disallowance of petitioner's claims for relief must be sustained because of the failure of petitioner to meet his burden of establishing any acceptable basis*218 for a reconstructed average base period net income that would result in greater excess profits credits than those available to petitioner under the invested capital method. See Green Spring Dairy, Inc., 18 T. C. 217; Sartor Jewelry Co., 22 T.C. 773">22 T. C. 773.
Reviewed by the Special Division.
Decision will be entered for the respondent.