*41 Decision will be entered for the respondent.
On the record it is held that petitioner has failed to establish that it is entitled to constructive average base period net income which is large enough to produce a credit greater than any of the invested capital credits used by the petitioner for the taxable years herein, or that the excess profits taxes paid by it for the years in issue are excessive and discriminatory.
*266 The respondent disallowed in full petitioner's applications for excess profits tax relief, under section 722 of the Internal Revenue *267 Code of 1939, for the fiscal years ended January 31, 1941, through January 31, 1946. The issue is *42 whether petitioner is entitled to excess profits tax relief under the provisions of section 722 (b) (2) or (b) (4).
The proceedings were heard by a commissioner of the Court, the proof consisting of stipulations of fact, oral testimony, and exhibits. The facts as proposed by the commissioner and included in his report filed herein, together with certain additional facts included in our findings set forth below, are adopted and found as our Findings of Fact.
FINDINGS OF FACT.
The petitioner is a New York corporation with its principal office in the city and State of New York. Its income and excess profits tax returns for the periods here involved were filed with the collector of internal revenue for the second district of New York.
Petitioner was organized on July 26, 1932, for the purpose of acquiring the retail department store business of James A. Hearn & Son, Inc. (hereinafter referred to as petitioner's predecessor), which retail department store had been operated under the name of Hearn in one form or another in New York City for more than 100 years. Petitioner acquired such business on July 28, 1932, by purchasing from various members of the Cowl family all of the stock of*43 petitioner's predecessor.
Immediately prior to the acquisition by petitioner the condition of the business of petitioner's predecessor was in a bad state. It was being operated by a creditors' committee. It did little or no advertising. Its inventory was badly depleted and purchases were being made on a daily basis. Employee morale was low because of the constant threat of imminent closing. The business had reached its peak 10 years before, in 1922, when net sales amounted to $ 17,866,000. From 1922 until July 28, 1932, at which time petitioner acquired the business, net sales had dwindled continuously from the above figure to $ 3,149,000 for the 6 months period from February 1, 1932, the close of its fiscal year, to July 28, 1932, when it was acquired by the petitioner. Net income had dropped from a net profit of $ 399,000 in 1924, to a net loss of $ 1,172,000 for the 11 months ending January 31, 1932, and to a net loss of $ 911,000 for the 5 months prior to the sale of the business to petitioner.
The store which petitioner's predecessor had occupied and which after July 28, 1932, was occupied by petitioner was and is located on 14th Street between Fifth and Sixth Avenues *44 in New York City. Additional premises were leased for the use of petitioner's 14th Street store as follows:
*268 (a) In October 1932, a building located at 16 West 14th Street;
(b) In February 1934, a building located at 4 West 14th Street;
(c) In September 1934, the third, fourth, and fifth floors of 34-42 West 14th Street and 33-41 West 13th Street; and
(d) In August 1936, a building located at 14 West 14th Street.
Upon acquisition of the business of its predecessor, petitioner took steps which in its opinion would build up the Hearn business and restore its lost prestige and volume of business. Additional funds were put into the business, a substantial quantity of new merchandise was acquired, and petitioner began a vigorous campaign of advertising. Upon the acquisition of the predecessor's business petitioner took over its employees, together with its executive personnel.
The acquisition of petitioner's predecessor had been by Maurice Levin and J. M. Kaplan, two men of considerable wealth but without experience in the department store field. After the organization of petitioner the top management of the business was in the hands of Maurice Levin, Leonard Ginsberg, and *45 Sidney M. Louis. Louis was without experience in the department store field but Ginsberg had been in charge of merchandising for petitioner's predecessor and was made vice president of petitioner. These three individuals decided questions of policy for petitioner, Levin having the final say in such matters. Levin, Kaplan, and Louis had many interests outside the operation of petitioner's business and served petitioner only part time during its base period years.
From petitioner's organization in 1932 to January 31, 1936, $ 2,000,000 was paid in for two classes of petitioner's preferred stock and $ 5,000 for common stock. Subsequently there were exchanges and conversions of stock and a public offering of stock in 1936. By 1938 paid-in capital stock amounted to $ 2,848,515, consisting of $ 1,426,450 for preferred stock and $ 1,422,065 for common stock. Thereafter there were no significant changes during the base period in the amount of paid-in capital stock. Stock of the petitioner was listed on the New York Curb Exchange in January 1937.
Prior to the organization of petitioner and its acquisition of the business of its predecessor all other department stores located in the 14th*46 Street district had moved to other and better locations further uptown. Prior to that time 14th Street had been a center of department store operations, but after the change in question, that location for the operation of a department store became much less desirable. At the time petitioner acquired the business of its predecessor, 14th Street had been invaded by a large number of small stores. Of these there were more than 100 located on 14th Street. There were also located on 14th Street two substantial specialty stores known as Klein's and Ohrbach's which did a large volume of business in the ready-to-wear *269 line. These two stores were in direct competition with petitioner in the lines of goods carried by them, and their management was aggressive and able. They, as well as the small stores on 14th Street, operated upon a basis which made it possible for them to undersell petitioner or force the latter to substantial reduction in prices. This was due in large measure to the fact that petitioner, as a regular department store, offers services such as credit accounts, deliveries, and exchanges, which were not offered by these other mentioned stores. The cost of such*47 services constituted a substantial portion of the cost of petitioner's sales. Many of the smaller stores operated with a minimum of overhead, due to their small size and the fact that in some cases they were operated by the proprietors without the assistance of employed personnel.
Merchandise sold by petitioner and services rendered by it were similar to those found in department stores generally. Such merchandise included, but was not limited to, the following: Wearing apparel for men, women, and children, furniture and home furnishings, dry goods, toilet goods, stationery, jewelry, silverware, luggage and leather goods, toys and sporting goods, meats and groceries, and wines and liquors. With the exception of furniture and home furnishings, falling within the class of heavy goods, the greater part of the character of goods sold by petitioner could be found in the competing stores on 14th Street. In many cases such stores carried the similar line or brand carried by petitioner. These competing stores in many cases bought the merchandise in sales of distressed goods or goods sold in liquidation of other businesses or excess inventories which other businesses found necessary to*48 dispose of.
Prior to the organization of the petitioner the operation of its predecessor for its fiscal years ending February 28, 1922, to February 28, 1931, shows totals as follows:
| Inventory | |||
| Net sales | at end of | Net income | |
| year | or (loss) | ||
| Fiscal year ending February 28 | |||
| In thousands of dollars | |||
| 1922 | $ 17,866 | $ 2,172 | $ 321 |
| 1923 | 17,124 | 2,362 | 292 |
| 1924 | 17,495 | 2,557 | 399 |
| 1925 | 16,580 | 2,347 | 301 |
| 1926 | 15,627 | 2,380 | 150 |
| 1927 | 15,399 | 2,373 | (30) |
| 1928 | 15,352 | 2,385 | 37 |
| 1929 | 13,987 | 2,150 | 116 |
| 1930 | 13,465 | 1,849 | 13 |
| 1931 | 13,616 | 2,089 | (432) |
For the fiscal years ended January 31, 1934, to January 31, 1946, petitioner's net sales, gross income, net income for Federal income *270 tax purposes, and excess profits net income (income method) were as follows:
| Excess profits | ||||
| Net income for | net income | |||
| Fiscal year ended | Net sales | Gross income | Federal income | (income |
| January 31 | tax purposes | method) | ||
| 1934 | $ 8,202,419 | $ 2,987,223 | $ 458,254 | $ 458,254 |
| 1935 | 14,176,274 | 4,037,590 | 31,313 | 61,391 |
| 1936 | 16,435,839 | 4,828,875 | 364,761 | 274,486 |
| 1937 | 17,054,072 | 5,796,757 | 569,813 | 570,364 |
| 1938 | 20,610,514 | 7,021,203 | 142,140 | 141,955 |
| 1939 | 18,341,356 | 6,159,274 | (239,937) | (239,937) |
| 1940 | 17,471,825 | 6,171,341 | 74,831 | 74,831 |
| 1941 | 17,389,409 | 6,162,645 | 349,657 | * 355,901 |
| 1942 | 18,474,120 | 6,960,417 | 594,155 | 593,980 |
| 1943 | 18,525,904 | 7,152,717 | 952,081 | 951,871 |
| 1944 | 19,653,004 | 7,570,198 | 1,053,005 | 1,052,830 |
| 1945 | 21,362,471 | 7,986,467 | 988,844 | 983,876 |
| 1946 | 23,790,231 | 8,904,886 | 1,180,904 | 1,146,987 |
Petitioner's operations during the base period years are reflected in the following statement showing petitioner's net income per books before Federal income taxes and surplus adjustments for those years, together with related items of receipts and disbursements:
| Fiscal year ended January 31 | ||||
| 1937 | 1938 | 1939 | 1940 | |
| 1 store | 3 stores | 3 stores | 3 stores | |
| Net sales | $ 17,054,072 | $ 20,610,514 | $ 18,341,356 | $ 17,471,825 |
| Gross profit | 5,148,878 | 6,160,536 | 5,205,357 | 5,306,375 |
| Purchase discounts | 497,675 | 611,474 | 562,532 | 571,291 |
| Total gross profit | $ 5,646,553 | $ 6,772,010 | $ 5,767,889 | $ 5,877,666 |
| Leased departments | ||||
| net income | 120,330 | 182,985 | 271,092 | 223,084 |
| Fur storage and misc. | ||||
| income | 29,874 | 66,208 | 120,293 | 70,591 |
| Gross income | $ 5,796,757 | $ 7,021,203 | $ 6,159,274 | $ 6,171,341 |
| Officers' salaries | $ 44,224 | $ 71,004 | $ 62,880 | $ 60,220 |
| Other salaries | 2,272,388 | 3,197,253 | 2,816,548 | 2,744,397 |
| Occupancy expense | 372,208 | 568,116 | 665,333 | 616,283 |
| Repairs and maintenance | 139,275 | 80,308 | 61,509 | 41,051 |
| Interest paid | 1,322 | 21,500 | 27,517 | 11,870 |
| Miscellaneous taxes | 64,061 | 159,986 | 177,154 | 156,722 |
| Depreciation | 75,055 | 156,318 | 151,451 | 158,992 |
| Advertising | 1,117,154 | 1,173,252 | 1,167,577 | 1,087,183 |
| Supplies | 238,057 | 341,565 | 280,847 | 282,356 |
| Services purchased | 541,710 | 652,319 | 633,493 | 604,030 |
| Unclassified | 135,670 | 190,000 | 154,568 | 148,139 |
| Traveling | 8,214 | 8,208 | 11,265 | 6,890 |
| Communication | 45,177 | 76,444 | 75,256 | 70,398 |
| Insurance | 66,066 | 103,248 | 94,313 | 87,956 |
| Professional services | 6,858 | 55,955 | 39,558 | 28,221 |
| Total expense | $ 5,127,439 | $ 6,855,476 | $ 6,419,269 | $ 6,104,708 |
| Net income (or loss) as | ||||
| per books before Federal | ||||
| income tax and surplus | ||||
| adjustments | $ 669,318 | $ 165,727 | ($ 259,995) | $ 66,633 |
*50 For the fiscal years ended January 31, 1934, to January 31, 1946, inclusive, the petitioner's gross profits (with and without discounts), *271 rent, officers' salaries, and total operating expenses as percentages of sales were as follows:
| Gross profit | |||||
| Rent | Officers' | Total | |||
| salaries | expense | ||||
| Fiscal year ended January 31 | Without | With | |||
| discount | discount | ||||
| Per cent | |||||
| 1934 | 31.31 | 34.84 | 2.95 | 0 | 30.83 |
| 1935 | 24.63 | 27.61 | 1.80 | 0 | 27.43 |
| 1936 | 25.58 | 28.60 | 1.72 | 0.22 | 27.56 |
| 1937 | 30.19 | 33.11 | 2.18 | 0.26 | 30.07 |
| 1938 | 29.89 | 32.86 | 2.76 | 0.34 | 33.26 |
| 1939 | 28.38 | 31.45 | 3.63 | 0.34 | 35.00 |
| 1940 | 30.37 | 33.64 | 3.53 | 0.34 | 34.94 |
| 1941 | 30.92 | 33.92 | 3.46 | 0.52 | 33.38 |
| 1942 | 33.51 | 36.43 | 3.08 | 0.44 | 34.12 |
| 1943 | 34.58 | 37.37 | 3.15 | 0.87 | 33.79 |
| 1944 | 34.43 | 37.24 | 2.98 | 0.86 | 33.46 |
| 1945 | 33.50 | 36.26 | 2.70 | 0.84 | 32.94 |
| 1946 | 33.49 | 36.14 | 2.51 | 1.07 | 32.67 |
Petitioner's business after the first year of its operation not having shown the gross volume of business anticipated and desired, it put into operation in September 1934 a new policy of operation which it designated a "no-profit plan." This plan it advertised extensively. Under it the policy*51 was to mark up its cost prices on merchandise in an amount sufficient only to pay expenses. It was thought that this plan would largely increase gross sales and that the increased business thus obtained could be subsequently retained by the business after the no-profit plan was discontinued. This plan was discontinued in August 1935 and another policy adopted, termed "share-the-profit plan." Under this latter plan a sales quota was set and it was agreed that at the end of the year if this quota was reached certain refunds would be made to purchasers and distributions of cash to the employees. Under this plan the markups from cost were higher than under the no-profit plan and were designed to show a profit in excess of the distributions anticipated to be made. The quota of sales was not reached from September 1935 through December 1935, during which time this plan was in operation. Although no distributions of cash were necessary to employees or to customers by the terms of this plan, the petitioner did make some distributions of cash to customers.
A no-profit plan such as petitioner put in operation is not a wise merchandising plan and does not benefit a business in the long *52 run. Its benefit is to merely increase gross sales temporarily at the expense of profits. Such a plan is not one an expert on department store operation would in fact engage in.
It is difficult for a department store to change from a policy of low markup to a policy of normal markup. Particularly at petitioner's competitive location, increasing its markup was a serious merchandising problem for petitioner. Before and during the base *272 period the petitioner engaged in aggressive and promotional selling. It found that promotional sales did not usually result in profits. Petitioner sometimes sold standard brands of merchandise below list prices, and some suppliers of standard brands did not want to sell their goods to petitioner.
In 1937 petitioner, in an endeavor to increase its business, bought two department stores, one in the Bronx and the other in Newark, New Jersey, to be operated by it under the names of "Hearns-Bronx" and "Hearns-Newark." It also contracted conditionally to acquire a third branch store operated by its owners under the name of Gertz, in Jamaica, Long Island. The agreement to acquire this store was conditioned upon petitioner realizing at least $ *53 2,600,000 from a contemplated issue of its preferred stock.
The acquisition of the Bronx and Newark stores entailed a large outlay of funds by petitioner, not only in increased inventory but in permanent improvement to these stores by the addition of facilities including escalators and the building of an additional story on one store. The premises occupied by these stores were rented, the leases being taken over by petitioner. The amounts actually spent for these items on the Bronx and Newark stores exceeded by several hundred thousand dollars the amounts that had been anticipated by petitioner's management. The total expenditures by petitioner on these stores for furniture and fixtures and leasehold improvements were in the sum of $ 1,170,577.
It was usual for branch stores like the petitioner's branch stores to take business away from the centrally located main store, and it was estimated by petitioner that the Bronx store alone would reduce the sales of the main store by 5 to 7 per cent.
The annual net sales of petitioner's main store, together with its two branch stores, during petitioner's base period and for 3 years thereafter were as follows:
| Fiscal year ended January 31 | 14th Street store | Bronx store | Newark store |
| 1937 | $ 17,054,000 | ||
| 1938 | 14,943,500 | * $ 3,772,400 | * $ 1,894,600 |
| 1939 | 12,100,700 | 3,454,000 | 2,786,600 |
| 1940 | 11,767,600 | 3,424,500 | 2,279,700 |
| 1941 | 11,957,500 | 3,453,700 | 1,978,200 |
| 1942 | 12,544,800 | 3,697,900 | 2,231,400 |
| 1943 | 12,449,200 | 3,725,400 | 2,351,300 |
By June of 1938 the petitioner recognized that sales in the Bronx and Newark stores were not up to its expectations. Sales consistently declined for each full year of the base period in each one of the petitioner's three stores. Its experience with the Newark store was especially disappointing. In this store, except for June of 1939, sales for *273 every month of the base period were lower than sales for the corresponding months of the preceding years. As a result petitioner, in September 1939, discontinued credit sales at the Newark store. Sales in that store were put on a "cash and carry" basis, and as a result sales of heavy merchandise had to be discontinued.
Annual gross profits for each of the petitioner's three stores during petitioner's base period were as follows:
| Fiscal year ended January 31 | 14th Street | Bronx | Newark |
| store | store | store | |
| 1937 | $ 5,646,553 | ||
| 1938 | 4,840,811 | * $ 1,287,354 | * $ 643,845 |
| 1939 | 3,760,262 | 1,122,526 | 885,101 |
| 1940 | 3,975,936 | 1,193,993 | 707,737 |
Before general overhead, general advertising, and officers' salaries, which were all charged*55 as expenses to petitioner's main store, expenses amounted to over $ 800,000 for each full year in each of the petitioner's two branch stores during the base period.
The opening of the two branch stores in 1937 directly led to increased cost to the petitioner thereafter. Several hundred additional employees were required in each of the petitioner's two branch stores. There was increased overhead, and the addition of depreciable assets in each of these stores increased operating expenses of the branch stores.
Unionization of the bulk of petitioner's employees occurred early in petitioner's base period. This unionization substantially and adversely affected the costs and profit-making ability of petitioner's stores. This was due not only to the additional dollar cost of labor and fringe benefits but also the hours worked. The annual increase in cost to petitioner by reason of unionization was estimated by petitioner to be from $ 150,000 to $ 200,000 per year.
During its later base period years petitioner's salaries (other than officers' salaries) and petitioner's occupancy or rental expense became considerably larger in amount and in per cent of net sales than they had been in petitioner's*56 first base period year as reflected in the following statement:
| Salaries other than | Occupancy or rental | ||||
| officers' salaries | expenses | ||||
| Fiscal year ended | |||||
| January 31 | Net sales | ||||
| Ratio to | Ratio to | ||||
| Amount | sales | Amount | sales | ||
| Per cent | Per cent | ||||
| 1937 | $ 17,054,072 | $ 2,272,388 | 13.32 | $ 372,208 | 2.18 |
| 1938 | 20,610,514 | 3,197,253 | 15.51 | 568,116 | 2.76 |
| 1939 | 18,341,356 | 2,816,548 | 15.36 | 665,333 | 3.63 |
| 1940 | 17,471,825 | 2,744,397 | 15.71 | 616,283 | 3.53 |
*274 The petitioner's ratio of total expenses to sales increased from approximately 27.5 per cent for the fiscal years ended January 31, 1935 and 1936; to 30 per cent for the fiscal year 1937; to 33 per cent for the fiscal year 1938; and to 35 per cent for the fiscal years 1939 and 1940.
The conditional agreement entered into on May 29, 1937, to acquire the Gertz department store in Jamaica, Long Island, was not carried out. Such agreement was subject to the condition that petitioner receive $ 2,600,000 from a contemplated issue of petitioner's preferred stock. Such preferred stock was not issued. Petitioner had, on June 24, 1937, reached a tentative understanding with the First New*57 Amsterdam Corporation for the latter to undertake a new issue of $ 3,000,000 in its preferred stock. An estimated $ 350,000 of the amount realized would be the cost of underwriting. Of the expected $ 2,650,000 net receipts from this financing, in excess of $ 1,600,000 would be required under the plan of financing for the redemption of petitioner's old issue of preferred stock and something in excess of $ 1,000,000 for the purchase of the Gertz store. Although payment of approximately $ 400,000 of the purchase price of the Gertz store was to be deferred until February 10, 1939, the petitioner would naturally require funds for inventory, improvements, and operations in that store when acquired.
Petitioner's tentative understanding with the First New Amsterdam Corporation anticipated the execution of a firm underwriting agreement. Such firm underwriting agreement was never executed. Even if such firm underwriting agreement had been executed it was contemplated to carry a customary condition known as a "market clause" under which the underwriter was permitted to cancel the agreement if, in the exercise of its judgment, there was any substantial change in the financial position of*58 the petitioner or in the existing economic or market conditions taking place before the issuance of the contemplated preferred stock. Subsequent to the execution of the tentative agreement the stock market became depressed and the First New Amsterdam Corporation withdrew because of the difficulty of marketing new issue stock under such conditions. Thus, petitioner's plan for its financing by a new issue of $ 3,000,000 preferred stock was by these conditions ended prior to the execution of even a firm understanding with the underwriter.
During the months of March 1937 to December 1938, inclusive, petitioner owed varying and substantial sums to its creditor banks. During these months petitioner borrowed from three banks, namely, the Bank of Manhattan Company, the Commercial National Bank and Trust Company, and the National City Bank. During the other months of the base period the petitioner had no bank borrowings *275 except for relatively small loans for short periods during the fall of 1936 and 1939. In 1938 the petitioner had good bank credit available. All during 1939 the petitioner had bank credit available which the petitioner did not utilize. The bank credit available*59 to petitioner in 1939 totaled at least a million dollars. The petitioner's banks were eager to lend funds to the petitioner in 1939. During most of the period from September 1937 to December 1939, inclusive, the petitioner borrowed varying sums up to $ 600,000 from J. M. Kaplan and/ or his interests. The money for these loans came from Regano Corporation, a corporation controlled by J. M. Kaplan. Subordination agreements gave priority to potential creditors' claims of petitioner's banks and other creditors over the claims of Regano Corporation. On May 14, 1937, Maurice Levin made an offer in writing to furnish the money necessary for the acquisition and improvement of the Newark store and to lease such premises to the petitioner for a rental to be determined by arbitration. He made a similar offer with regard to the cost of six escalators and the building of a fourth floor at the Bronx store. Petitioner did not accept these offers as it considered the expenses in question could be met out of its own working capital. Kaplan and Levin were men of very substantial wealth and they or their corporations were ready, willing, and able to lend petitioner such funds as petitioner might*60 need for its operations during its base period. During that period petitioner's monthly cash balances were adequate for its needs and it experienced no difficulties in paying its trade creditors. Its bills were paid before they became due.
The merchandise inventories of petitioner at the end of each of the fiscal years ended January 31, 1934, to January 31, 1946, were as follows:
| Fiscal year | Merchandise |
| ended January 31 | inventories |
| 1934 | $ 1,615,294 |
| 1935 | 2,322,404 |
| 1936 | 2,456,808 |
| 1937 | 3,095,147 |
| 1938 | 2,881,369 |
| 1939 | 1,976,453 |
| 1940 | 1,891,122 |
| 1941 | $ 1,963,339 |
| 1942 | 2,490,675 |
| 1943 | 2,738,498 |
| 1944 | 2,590,778 |
| 1945 | 2,521,843 |
| 1946 | 3,208,666 |
The petitioner's annual inventory turnover figures for each of the fiscal years ended January 31, 1934, to January 31, 1942, inclusive, were as follows:
| Fiscal year | Annual inventory |
| ended January 31 | turnover |
| 1934 | 3.43 |
| 1935 | 4.75 |
| 1936 | 4.19 |
| 1937 | 3.82 |
| 1938 | 3.68 |
| 1939 | 4.31 |
| 1940 | 3.85 |
| 1941 | 4.84 |
| 1942 | 3.70 |
*276 The merchandise inventory of the petitioner at the end of each month during the petitioner's base period years was as follows:
| Fiscal year ended January 31 | ||||
| Month | 1937 | 1938 | 1939 | 1940 |
| In thousands of dollars | ||||
| February | $ 2,604 | $ 3,448 | $ 3,104 | $ 2,294 |
| March | 2,773 | 3,967 | 3,564 | 2,668 |
| April | 2,705 | 3,923 | 3,404 | 2,475 |
| May | 2,682 | 3,653 | 3,246 | 2,295 |
| June | 2,596 | 3,359 | 2,871 | 2,082 |
| July | 2,520 | 3,191 | 2,635 | 1,886 |
| August | 3,116 | 4,463 | 2,992 | 2,359 |
| September | 3,527 | 4,486 | 3,049 | 2,781 |
| October | 3,609 | 4,385 | 3,031 | 2,990 |
| November | 3,492 | 4,193 | 2,918 | 2,907 |
| December | 3,107 | 3,231 | 2,206 | 2,063 |
| January | * 3,095 | * 2,881 | * 1,976 | * 1,891 |
In the New York Federal Reserve District, merchandise stocks were at their lowest annual levels in July and August of the years 1935 to 1939, inclusive. The peak of the inventory stocks usually occurred about October 31. Petitioner's merchandise inventory remained high or increased during 1937 until the peak inventory was reached during the summer of that year. Thereafter merchandise inventories declined and remained at lower levels during the remainder of the base period.
By January 1938 the petitioner was heavily overstocked with merchandise inventory. It was then carrying about $ 1,000,000 more than was necessary. The excessive inventory was due in part to the falling off of business. By January 1938 the petitioner decided upon an operating policy of considerably lowered merchandise inventories. Such policy was to be followed out regardless of whether or not the petitioner was in need of cash. Such policy was expected to reduce merchandise inventories by $ 600,000 to $ 1,000,000. This policy of operating with small inventories was maintained during the remainder of petitioner's base period and was in effect*62 in 1939 when ample credit was available to petitioner. In the fall of that year the petitioner took no steps to increase its merchandise inventories although it anticipated price rises. Not to buy merchandise inventory, if needed, especially when credit was available, is not good merchandising.
For the fiscal years ended January 31, 1936 to 1946, inclusive, the salaries paid to officers of petitioner, as shown by its Federal income tax returns, were as follows: *277
| Fiscal year ended January 31 | Leonard | Maurice | Sidney | All |
| Ginsberg | Levin | M. Louis | others | |
| 1936 | $ 25,000 | $ 11,100 | ||
| 1937 | 25,481 | $ 2,564 | $ 5,128 | 11,051 |
| 1938 | 29,711 | 5,016 | 10,032 | 26,244 |
| 1939 | 29,269 | 9,295 | 24,315 | |
| 1940 | 27,000 | 9,001 | 24,219 | |
| 1941 | 38,615 | 17,096 | 34,687 | |
| 1942 | 32,336 | 16,846 | 31,442 | |
| 1943 | 48,106 | 30,048 | 32,054 | 50,101 |
| 1944 | 54,558 | 30,048 | 37,103 | 46,592 |
| 1945 | 61,664 | 30,096 | 39,480 | 48,427 |
| 1946 | 64,707 | 30,048 | 41,487 | 115,771 |
During the petitioner's base period the salaries of Levin and Louis were set at low figures by contracts between these officers and petitioner. During the base period and 2 years thereafter Levin and Louis did not devote their full time*63 to the business of petitioner. During the base period and for at least 2 years thereafter Levin was president and later chairman of the board of petitioner, and Louis was secretary, executive vice president, and/or treasurer of the petitioner.
The operation of a department store is a complicated matter calling for the best ability and competency of executives trained in that field. Prior to 1932, Levin, Kaplan, and Louis had had no experience in the department store field. Ginsberg, who had been taken over from petitioner's predecessor and placed in charge of the merchandising operations of petitioner, had not theretofore been in a top executive position, except as vice president in charge of merchandising with petitioner's predecessor during the distressing last years of its operation. At the time of the hearing of this proceeding Ginsberg and Louis were no longer in the department store field.
For the fiscal years ended January 31, 1938, to January 31, 1942, inclusive, the net incomes or losses by stores as compiled from petitioner's yearly operating and financial statements were as follows:
| 14th Street | Bronx store | Newark store | |
| store | |||
| Fiscal year ended January 31 | |||
| In thousands of dollars | |||
| 1938 | ($ 289) | $ 461 | ($ 7) |
| 1939 | (626) | 386 | (20) |
| 1940 | (282) | 445 | (97) |
| 1941 | (119) | 484 | (8) |
| 1942 | (22) | 564 | 115 |
*64 Note: Loss figures are in parentheses. All general overhead and advertising were charged to the 14th Street store.
Sales in the petitioner's Newark store were declining during petitioner's base period years. Instead of enjoying earnings during the base period years, petitioner's Newark store suffered progressively *278 increasing losses from operations, even though all general overhead and advertising were charged to the 14th Street store. The petitioner's Newark store was not successful during the base period years and for at least 2 years thereafter.
Sales in the petitioner's Bronx store were declining during the petitioner's base period years. Earnings and gross profits of the Bronx store were lower in the base period years ended January 31, 1939, and January 31, 1940, than the earnings and gross profits had been for that store during the period ended January 31, 1938. The period ended January 31, 1938, was not a full year and was the initial period of the operation of the Bronx store by the petitioner.
Sales in the petitioner's 14th Street store were declining during the petitioner's base period years. For the last 3 years of the base period the 14th Street store had*65 losses after being charged with all of the petitioner's general overhead and advertising. The gross profits of the 14th Street store for the fiscal year ended January 31, 1938, were more than $ 800,000 under the gross profits for the fiscal year ended January 31, 1937. The gross profits of the 14th Street store for the fiscal year ended January 31, 1939, were more than $ 1,000,000 under the gross profits for the fiscal year ended January 31, 1938. The gross profits of the 14th Street store for the fiscal year ended January 31, 1940, were more than $ 1,600,000 under the gross profits for the fiscal year ended January 31, 1937.
After the fiscal year ended January 31, 1938, the annual net sales of the petitioner for all stores consistently declined for each base period year and for 1 year thereafter. In the fiscal years ended January 31, 1939, 1940, and 1941, the total gross income of the petitioner from all stores was more than $ 800,000 under the gross income for the fiscal year ended January 31, 1938. The excess profits net income (income method) of the petitioner during its base period years was considerably less when it operated three stores than such income had been previously*66 when it had operated only one store.
During the year 1936 the department store industry in general experienced rising sales and rising prices. Starting in May of 1937, the department store sales trend was downward until May of 1938. Thereafter, through December of 1939, the department store sales trend was upward. It is characteristic and usual for department store sales to vary with business conditions in general. The decreased level of department store sales in 1938 was not an unusual economic circumstance.
Included in petitioner's competition were large New York City department stores such as R. H. Macy & Co., Gimbel Bros., Bloomingdale Bros., and Abraham & Straus. R. H. Macy & Co. had a much *279 greater volume, a higher markup, and a better location than petitioner. The petitioner's prices, volumes, markups, and dollar amount of average sale were lower than such items were for Bloomingdale Bros. and Abraham & Straus, and petitioner's location was different from theirs. The other New York City department stores mentioned carried the same kinds of merchandise that petitioner did. To the extent that petitioner sold the same kind of merchandise at lower prices than the*67 competitors did, the petitioner's expenses would tend to be a greater percentage of sales for the petitioner than for its competitors. Because of differences in management ability, the stature of members of the board of directors, sales volume, retail techniques, research, and size of average sale, Bloomingdale Bros., and Abraham & Straus were not comparable competitors of petitioner to the extent of having comparable operational figures.
For the years 1935 to 1939 the petitioner's sales, when compared with department store sales in general, reflect the declining condition of the petitioner. The petitioner's sales decreased, relative to department store sales in general, after the petitioner's two branch stores had been acquired in 1937. Despite an upward trend in sales of the department store industry in 1938, the petitioner had a generally downward trend in sales during the entire base period after 1937.
The petitioner spent large sums on advertising during the base period years and prior thereto. Its ratio of advertising expenses to net sales averaged more than 6 per cent during petitioner's base period years, the fiscal years ended January 31, 1937, to January 31, 1940, inclusive. *68 For department stores in general, the ratio of advertising expenses to net sales averaged less than 4 per cent for the calendar years 1936 to 1939, inclusive.
For the taxable years here involved, excess profits net incomes and excess profits credits of the petitioner were based on the invested capital credit method and were as follows:
| Year ended January 31 | Excess profits | Excess profits |
| net income | credit | |
| 1941 | $ 274,656.04 | $ 247,093.19 |
| 1942 | 599,471.18 | 273,842.46 |
| 1943 | 956,802.99 | 284,192.50 |
| 1944 | 1,053,497.58 | 278,523.70 |
| 1945 | 984,176.23 | 291,952.80 |
| 1946 | 1,157,582.06 | 297,496.38 |
Excess profits net income or net loss (income credit method), with total and arithmetic average thereof, for the petitioner for its base period years would be as follows: *280
| For use in the | ||
| For use in the | taxable years | |
| taxable year | ended Jan. 31, | |
| Year ended January 31 | ended Jan. 31, | 1942, 1943, 1944, |
| 1940 | 1945, and 1946 | |
| 1937 | $ 486,098 | $ 570,364 |
| 1938 | 117,777 | 141,955 |
| 1939 | (239,937) | (239,937) |
| 1940 | 62,515 | 74,831 |
| Total | $ 426,453 | $ 547,213 |
| Average | $ 106,613 | $ 136,803 |
The required increases in petitioner's actual average base*69 period income (arithmetic average) to equal the average base period net income equivalent of petitioner's actual excess profits credit (based on invested capital) would be as follows:
| Required increase | |
| Fiscal year | in average base |
| ended January 31 | period net income |
| 1941 | $ 153,485.09 |
| 1942 | 151,452.22 |
| 1943 | 162,347.00 |
| 1944 | 156,379.84 |
| 1945 | 170,515.74 |
| 1946 | 215,983.09 |
The petitioner's actual excess profits credits (based on invested capital) converted to an equivalent average base period net income would be as follows:
| Year ended | Equivalent average |
| January 31 | base period net income |
| 1941 | $ 260,098.09 |
| 1942 | 288,255.22 |
| 1943 | 299,150.00 |
| 1944 | 293,182.84 |
| 1945 | 307,318.74 |
| 1946 | 352,786.09 |
The petitioner first made a claim for relief under section 722 (b) (5) on its supplement to application for relief under section 722 of the Internal Revenue Code of 1939. This supplement was filed with the Commissioner of Internal Revenue on October 22, 1947, which date is more than 3 years after the due date for the filing of petitioner's tax returns for the fiscal years which ended January 31, 1941, 1942, 1943, and 1944. Only in its application*70 for relief filed on Form 991 for the fiscal year ended January 31, 1946, did petitioner indicate a claim under section 722 (b) (5) for that year.
After increasing its capacity for operations by the addition of two branch stores in 1937, the petitioner failed to realize increased earnings because its sales declined and its costs increased. The decline in sales was due to lack of demand for petitioner's goods, in other words, to lack of customers. The lack of demand for petitioner's goods was *281 caused by the petitioner's competition and the petitioner's merchandising policies. The increased costs of the petitioner were due to the expansion, financial, and merchandising policies of the petitioner. The decline in sales and the increase in costs for the petitioner resulted from competition and/or the expansion, financial, and merchandising policies of the petitioner. Such policies and competition are the reasons for the failure of petitioner to realize increased earnings after its increase in capacity for operations.
The petitioner was not depressed during its base period. The petitioner's average base period sales were about $ 18,400,000 per year. Omitting the relatively*71 short period from March 1, 1931, to January 31, 1933, for which figures are not available, the average sales of the petitioner and its predecessor for the period from March 1, 1921, to January 31, 1940, were about $ 15,800,000 per year. Hence, the average base period sales were more than the average long-term sales. The petitioner's average excess profits net income was about $ 137,000 per year for the base period years. This figure was not much below the long-term average net income of about $ 150,000 per year of the petitioner and its predecessor for the periods from March 1, 1921, to February 28, 1931, and from February 1, 1933, to January 31, 1940. The petitioner's average base period sales of about $ 18,400,000 were considerably larger than the average sales of about $ 16,000,000 of the longer period of the petitioner from February 1, 1933, to January 31, 1940, inclusive.
After March of 1937, the monthly sales of the petitioner's 14th Street store for every month in 1937 were lower than sales of that store during the corresponding months of 1936. This decline in petitioner's sales at its 14th Street store had begun at least several months before the occurrence of any of *72 the alleged difficulties of the petitioner.
A department store should complete its developmental period and operate profitably in 3 years. Despite the hindrance of a depression, but with experienced and competent management, a large department store in New York City found itself within the 3 years following its 1930 reorganization. The longest developmental period estimate, indicated by the petitioner's expert witness, was 5 years and this was for a new store. Having taken over an established store in 1932, the petitioner should certainly have completed its developmental period with its main store before 1939.
With 2 years additional experience, the petitioner's level of sales and earnings would not have been higher than the actual level of the petitioner for its last base period year, the fiscal year ended January 31, 1940. The petitioner's operations during its base period and thereafter evidenced no true growth in the petitioner's sales, in the petitioner's gross profits, or in the petitioner's earnings.
*282 The petitioner has failed to establish that its business was depressed in the base period because of temporary economic circumstances unusual in the case of petitioner.
*73 The petitioner did not change the character of its business by a change in the operation or management of its business during the base period.
There was a change in the character of the petitioner's business during the base period because of an increase in capacity for operations, in that two branch stores were opened by petitioner in 1937, but increased earnings for the petitioner did not result from the petitioner's increase in capacity for operations.
The petitioner has failed to establish that its business did not reach the earning level which it would have reached if the petitioner had made its change in capacity for operations 2 years before it did so.
Petitioner has failed to establish that its business was in an organizational and developmental stage at the end of its base period.
Petitioner has failed to establish that its business was affected by any other factor which would not be inconsistent with the principles underlying the provisions of section 722 (b) or with the conditions and limitations enumerated therein.
Petitioner has failed to establish that it is entitled to constructive average base period net income which is large enough to produce a credit greater than *74 any of the invested capital credits used by the petitioner for the taxable years herein, or that the excess profits taxes paid by it for the years in issue are excessive and discriminatory.
OPINION.
At the hearing the petitioner asserted a claim for relief under section 722 (b) (2), (b) (4), and (b) (5). 1 The record *283 contains no facts indicating that petitioner is entitled to relief under section 722 (b) (5) and such section is not mentioned in brief filed by petitioner, and it is assumed that this contention is abandoned.
*75 It is petitioner's contention under section 722 (b) (2) that its business was depressed during the base period by its failure to obtain certain refinancing which it had contemplated, this failure having resulted in its being without adequate working capital which caused an involuntary reduction in inventory.
To sustain this contention the burden is upon petitioner to show that its business was depressed by a temporary economic circumstance "unusual in the case of the taxpayer." Wadley Co., 17 T. C. 269; Lamar Creamery Co., 8 T.C. 928">8 T. C. 928. The facts as established by the record show to our satisfaction that the failure to obtain the refinancing contemplated was not due to any economic circumstance peculiar to the petitioner.
The facts, briefly stated, with respect to this circumstance are that the petitioner in 1937 embarked upon a program of expansion and acquired two department stores, one in the Bronx and the other in Newark, New Jersey. The acquisition of these stores was financed by the petitioner from its operating capital and was made at considerable expense. In one of the stores, although it occupied rented premises, *76 extensive repairs and additions were made, including an additional story on the building and escalators. The cost of these improvements was far in excess of what was anticipated by petitioner. It also contracted to acquire a third department store at Jamaica, Long Island, this commitment being conditioned upon its securing a refinancing by a sale of preferred stock of $ 3,000,000. Of this amount, $ 350,000 was the estimated underwriting expense and of the balance of $ 2,650,000, in excess of $ 1,600,000 was to be used in retirement of outstanding preferred stock and more than $ 1,000,000 would be obligated for the purchase of the Jamaica store. It will thus be seen *284 that from such financing little, if any, would be left as operating capital to petitioner.
We have found that petitioner had no firm understanding with the underwriter with respect to this refinancing, it being entirely contingent upon the condition of the stock market at the time. If the market was down and would not absorb the new issue of stock, the refinancing would not be accomplished. When the time arrived, the stock market was down and due to such fact the issue and sale of the new preferred stock*77 was not possible. Had petitioner possessed a definite contract with the underwriter obligating the latter under any condition to underwrite the new issue of stock and this contract had been breached by the underwriter, the circumstance would have been peculiar to the petitioner. This, however, was not the case, and the circumstance making impossible the issuance and sale of new stock was a depression in the stock market having a general effect of curtailing issue and sale of new stock issues by all corporations.
It is our conclusion, in the light of the facts as above detailed, that the failure of petitioner to secure the refinancing it contemplated was not a factor under subsection (b) (2) which would qualify as a temporary economic circumstance unusual in the case of the taxpayer. It is manifest from the record of petitioner's operations and profits during the base period that things were not well with the business and that it was definitely losing ground, and that this condition was not similar to that of other department stores in the New York City area. However, the record is convincing that this condition was not due to a circumstance external and not subject to control *78 by petitioner but was due primarily to its very unwise business policies together with very severe competition.
Petitioner was organized to take over a department store which had been operating in New York City for more than 100 years. It had formerly been very profitable and its owners had been able merchants. Of late years the younger generation in the family of its owners had taken little interest in the business, and matters, in consequence, had gone from bad to worse and for several years prior to its acquisition by petitioner the business had sustained large losses. It was located on 14th Street in New York City in a neighborhood which had been the general location of many of the largest and most prosperous department stores in New York. These stores had moved their location uptown because of the fact that the 14th Street neighborhood had become undesirable. On this street, near the petitioner, were located more than 100 small specialty stores competing directly with the petitioner in sale of men's and women's apparel and personal accessories. They were operated at far less expense in selling than *285 was the petitioner and a large portion of their inventory was purchased*79 from receivers of bankrupt establishments or overstocks of merchandise of businesses which were forced to liquidate to obtain additional working capital. These conditions made it possible for these businesses to operate on a much smaller markup in price than petitioner.
Another circumstance contributing to the so-called depression in petitioner's business was the fact that it was operated and its policies determined by the two individuals who had purchased it, together with their attorney. None of these three individuals had any experience in the operation of a department store, which the record shows is a very specialized business requiring a particular type of executive ability. The three individuals in question also devoted only a portion of their time to the operation of petitioner as they possessed many other active business interests.
Under such conditions petitioner expanded its business by purchasing two additional department stores and contracting for the purchase of a third. The record shows that the acquisition of the Bronx and Newark stores was little less than disastrous. In addition, petitioner adopted a policy of operation which, the record clearly shows, wise *80 department store operators would never adopt. The first step was the adoption of a "no-profit plan" under which inventory was marked up only to the extent necessary to cover selling costs and expenses. This was widely advertised. Petitioner's own expert witness characterized this plan as one that in his opinion no sane business would adopt. Following this, it adopted a "share-the-profit plan" which proved unworkable.
Following this, it decided upon a reduction in inventory which it claims was involuntary by reason of the fact that the refinancing plan had not gone through. The record does not bear out this claim. The reduction in inventory appears to have been deliberately made as a matter of policy and not because of a lack of operating capital, as petitioner had bank credit available and its owners were men of very large fortunes who, the record indicates, stood ready and willing to advance it any funds it might need. This voluntary reduction in inventory was made at the very time when other department stores were increasing their inventories to the peak in anticipation of the 3 months of October, November, and December, which are the largest sale months in the year for such*81 a business.
The business of petitioner consistently declined during the base period, and upon the record as a whole we are convinced that this was due to unwise business management. In Granite Construction Co., 163">19 T. C. 163, we said: "The statute was not designed to counteract *286 errors of business judgment or to underwrite unwise business policies," and in Foskett & Bishop Co., 16 T. C. 456, we said: "the circumstance of poor management cannot be construed to be an economic circumstance * * *."
In fact, we cannot even assume that if the refinancing desired by petitioner had gone through the result would have been a benefit to petitioner. It would have entailed acquisition of the Jamaica store which we assume would have been operated with the same lack of judgment experienced in petitioner's other three stores, in which event petitioner's troubles might well have merely increased.
For the reasons set out above we are unable to find any proof in the record of a fact or condition justifying petitioner to relief under subsection (b) (2). It is, however, clearly shown to have a factor under subsection (b) (4) in that*82 it changed the character of its business by reason of the acquisition of two additional stores during the base period and later by the elimination of certain large departments in one of these stores and the discontinuance there of credit sales and deliveries.
These factors under (b) (4) entitle petitioner to a reconstruction of average base period net income under the 2-year "push-back" rule if it be established that, following the changes, sales and income increased and had not reached by the close of the base period the level that it would have attained had the qualifying changes occurred 2 years earlier. As we said in Southern California Edison Co., 19 T. C. 935: "Certainly, in noncommitment (b) (4) cases it is clear that where increased capacity is the basis for relief the pivotal inquiry is whether such increased capacity would have resulted in increased earnings during the base period. Cf. National Grinding Wheel Co., 8 T. C. 1278; Green Spring Dairy, Inc., 18 T.C. 217">18 T. C. 217; Schneider's Modern Bakery, Inc., 19 T.C. 763">19 T. C. 763."
Upon the record it appears clear *83 that petitioner has not shown that application of the 2-year "push-back" rule would entitle it to any relief. A reconstruction on such basis would not result in a figure giving relief, as petitioner's downgrade movement upon its acquisition of the two additional stores would begin 2 years earlier and would not result in a higher level of reconstructed earnings.
Petitioner has introduced through an expert witness three reconstructions of base period net income, all of which result in a tremendous increase which would entitle petitioner, if carried into effect, to much larger refunds for the taxable years than are here actually claimed by petitioner. Two of these computations have been made under (b) (2) upon the assumption that the refinancing contemplated had been successful. Although in that case the Jamaica store would *287 have been acquired, such activities as it might have had are not reflected in the computations. In one of the computations petitioner's witness has attempted to apply the "push-back" rule. There is statutory provision for application of the so-called 2-year push-back rule for qualifying factors arising under section 722 (b) (4), but no such provision*84 exists for qualifying factors arising under section 722 (b) (2). In view of our holding that the factors claimed by petitioner under (b) (2) do not apply, as any depression in petitioner's business was due to unwise management and severe competition, neither one of which is a qualifying factor, neither one of these reconstructions could be sustained.
The third reconstruction was made as under (b) (4), using the "push-back." For the reasons stated above, however, application of the push-back rule would not result in a figure which would entitle petitioner to any relief. All three of petitioner's reconstructions appear to be based mainly upon the abstract opinion of the witness that the petitioner would under other circumstances have done differently from what was done and that had such action been taken conditions would have improved and in his opinion would have resulted in large earnings. These reconstructions appear to fall more within the category of "wishful thinking" than ones made upon the basis of the facts actually disclosed by the record.
Respondent has introduced two recomputations of alleged base period net income, each made by an expert highly qualified. In neither*85 computation is the 2-year "push-back" rule reflected, as justification for its application does not exist. Both computations are made upon the basis of the figures established by the record. One of these reconstructions arrives at a constructive average base period net income of $ 71,700 and the other of $ 72,000. In both these recomputations, sales for 1939 were reconstructed and backcast in accordance with E. P. C.'s 42 and 30, to obtain reconstructed sales for 1936, 1937, and 1938. We think these reconstructions are made upon the proper basis. They both arrive at constructive average base period net income in an amount resulting in an excess profits tax credit to petitioner in an amount far less than that to which it was entitled and has been allowed in computation of excess profits tax upon the basis of invested capital. Accordingly, petitioner has not established that the excess profits taxes paid by it for the years in issue are excessive and discriminatory.
Reviewed by the Special Division.
Decision will be entered for the respondent.
Footnotes
*. No deduction made for Federal income taxes of $ 83,876, applicable only in this year.↩
*. Store open for only part of the year.↩
*. Store open for only part of the year.↩
*. Reserve for discounts deducted only in year-end inventory.↩
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 --
* * * *
(2) the business of the taxpayer was depressed in the base period because of temporary economic circumstances unusual in the case of such taxpayer or because of the fact that an industry of which such taxpayer was a member was depressed by reason of temporary economic events unusual in the case of such industry.
* * * *
(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, and the acquisition before January 1, 1940, of all or part of the assets of a competitor, with the result that the competition of such competitor was eliminated or diminished. 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
(5) of any other factor affecting the taxpayer's business which may reasonably be considered as resulting in an inadequate standard of normal earnings during the base period and the application of this section to the taxpayer would not be inconsistent with the principles underlying the provisions of this subsection, and with the conditions and limitations enumerated therein.↩