*176 Decision will be entered under Rule 50.
1. Excess Profits -- Base Period -- Abnormal Deductions in Base Period -- 711 (b) (1) (J), (i), (ii) -- Consequence of Change in Manner of Operation of Business Under (K) (ii). -- Abnormalities resulting from employing inspectors and measurers in dress manufacturing business were due to a change in the manner of operation of the business within 711 (b) (1) (K) (ii).
2. Pleadings. -- Affirmative defenses not pleaded by respondent not considered.
*1201 The Commissioner denied the petitioner's claim for relief under section 711 (b) (1) (J) of the Internal Revenue Code, applicable to the fiscal year ended October 31, 1941. The petitioner contends that the Commissioner*177 erred in failing to eliminate or disallow as deductions from its base period net income the following items as abnormal deductions:
| For the year ended October 31, 1937: | ||
| Advertising expense | $ 4,116.53 | |
| Telephone and telegraph expense | 1,681.98 | |
| Moving expense | 4,951.19 | |
| Transfer and registrar fees | 8,273.46 | |
| Illinois unemployment insurance tax | 8,511.63 | |
| For the year ended October 31, 1938: | ||
| Telephone and telegraph expense | 996.93 | |
| Moving expense | 2,958.72 | |
| Illinois unemployment insurance tax | 6,022.12 | |
| Bad debts | 2,875.00 | |
| Lease cancellation expense | 1,750.00 | |
| Amortization of leasehold improvement | 3,379.11 | |
| Damage claims | 11,544.80 | |
| For the year ended October 31, 1939: | ||
| Bad debts | 1,400.00 | |
| Amortization of leasehold improvements | 4,200.17 | |
| Damage claims | 6,401.41 | |
| Wages of inspectors and measurers | 5,808.95 | |
| Additional wages to meet minimum requirements | 11,329.65 | |
| For the year ended October 31, 1940: | ||
| Advertising expense | 1,306.87 | |
| Wages of inspectors and measurers | 41,706.64 | |
| Interest | 2,370.04 | |
| Efficiency engineers' fees | 2,843.95 |
*1202 FINDINGS OF FACT.
The petitioner is a corporation. Its excess profits tax return for the fiscal year ended October*178 31, 1941, was filed with the collector of internal revenue at Boston, Massachusetts.
The petitioner, at all times material hereto, kept its books and filed its returns using an accrual system of accounting and a fiscal year ending October 31. It computed its excess profits tax credit, at all times material hereto, under the income method. It paid excess profits taxes for the taxable year in the amount of $ 83,801.60. The petitioner, on December 11, 1942, filed a claim under section 711 (b) (1) (J) of the Internal Revenue Code for refund of excess profits taxes for the fiscal year ended October 31, 1941.
The Commissioner, in his statutory notice denying the claim, explained that he had given careful consideration to the claim, but was denying it because the petitioner had not established "that the abnormality or excess claimed is not a consequence of an increase in your gross income in your base period or a decrease in the amount of some other deduction in the said base period and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by your company."
The petitioner at all times material hereto was engaged solely*179 in the business of manufacturing cotton house dresses which it sold to chain stores and department stores, to be sold by the latter at prices ranging from 59 cents to $ 2.98. Its plant was located at Chicago, Illinois, until July 1938, at which time it completed the transfer of its manufacturing activities to Fall River, Massachusetts. The purpose of moving the plant from Chicago to Fall River was to be nearer to the source of supply of the petitioner's raw material and to obtain better labor conditions.
The petitioner did not make any change in the classification of the accounts on its books at any time material hereto.
The abnormalities hereinafter found, with the exception of those relating to wages of inspectors and measurers, are not a consequence of an increase in the gross income of the petitioner in its base period, a decrease in the amount of some other deduction in its base period, or a change at any time in the type, manner of operation, size, or condition of the business engaged in by the petitioner.
Advertising.
The petitioner regularly sends circulars to the department stores and units of chain stores which sell its goods. These circulars contain photographs of*180 the dresses manufactured by the petitioner. Department stores, but not chain stores, selling the petitioner's dresses sometimes insert advertisements in local papers in which the petitioner's *1203 name is printed in connection with the advertisement of dresses manufactured by it. The petitioner pays for such advertisements. The petitioner also participates in two or three fashion shows annually and has expenses incident thereto. It does not make expenditures for any kind of advertising except as described above.
The following table shows the amount expended by the petitioner for advertising in the fiscal years ended October 31 from 1933 through 1941:
| 1933 | $ 1,390.34 |
| 1934 | 1,492.79 |
| 1935 | 1,720.48 |
| 1936 | 3,542.13 |
| 1937 | 7,826.40 |
| 1938 | $ 3,560.25 |
| 1939 | 3,421.22 |
| 1940 | 7,041.25 |
| 1941 | 3,709.87 |
$ 4,116.53 of the 1937 expenditure and $ 1,306.87 of the 1940 expenditure for advertising are abnormal deductions under section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Telephone and Telegraph.
The following table shows the amount expended by the petitioner for telephone and telegraph expense during its fiscal years from 1933 to 1938, inclusive, and for 1941:
| 1933 | $ 2,910.16 |
| 1934 | 3,105.83 |
| 1935 | 4,151.11 |
| 1936 | 5,228.41 |
| 1937 | $ 6,493.08 |
| 1938 | 6,927.69 |
| 1941 | 4,644.09 |
*181 $ 1,681.98 of the expenditure for 1937 and $ 996.93 of the expenditure for 1938 were abnormal deductions within the meaning of section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Moving Expense.
The following table shows expenses incurred by the petitioner in moving its plant or portions thereof during its fiscal years 1933 to 1941, inclusive.
| 1933 | None |
| 1934 | None |
| 1935 | $ 510.00 |
| 1936 | 624.17 |
| 1937 | 5,335.17 |
| 1938 | $ 4,980.42 |
| 1939 | 761.14 |
| 1940 | 622.49 |
| 1941 | 383.98 |
$ 4,951.19 of the expenditure for 1937 and $ 2,958.72 of the expenditure for 1938 were abnormal deductions within the meaning of section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Transfer and Registrar Fees.
The stock of the petitioner was closely held, was not listed on any exchange, and seldom changed hands up to 1936, when it was listed on the New York Curb Exchange. The petitioner paid no transfer *1204 agents' or registrars' fees and made no expenditure for printing stock certificates during the years 1933 to 1935, inclusive. It expended $ 3,878.60 in the fiscal year 1936, $ 10,067.49 in 1937, and $ 1,794.03 in 1941 for these purposes.
$ 8,273.46 of the total expenditure for 1937*182 was an abnormal deduction within the meaning of section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Illinois Unemployment Insurance Tax.
The petitioner paid $ 8,514.06 as unemployment insurance tax to the State of Illinois for its fiscal year 1937, $ 8,682.77 for 1938, and $ 2.43 for 1941. It had not made any payments in prior years for this same purpose.
$ 8,511.63 paid in 1937 and $ 6,022.12 of the amount paid in 1938 are abnormal deductions under section 711(b)(1)(J), as limited by (K)(iii).
Bad Debts.
The petitioner on its books and on its returns used a reserve method for bad debts. The following table shows the additions to the reserve on the books of the petitioner for the fiscal years ended October 31, 1934, through 1941:
| 1934 | $ 2,764 |
| 1935 | 2,774 |
| 1936 | 607 |
| 1937 | 200 |
| 1938 | $ 5,875 |
| 1939 | 4,400 |
| 1940 | 3,250 |
| 1941 | 3,000 |
$ 2,875 of the addition to the reserve for 1938, and $ 1,400 of the addition to the reserve for 1939, are abnormal deductions under section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Lease Cancellation.
The petitioner was the lessee of property in Chicago. It vacated the premises in July of 1938 and never used them thereafter. *183 The term of the lease continued for seven more months. The petitioner, in order to secure a cancellation of the lease in July, paid the lessor $ 1,750. It never made any similar expenditure prior thereto or in 1941. The entire amount was an abnormal deduction under section 711(b)(1)(J)(i).
Amortization of Leasehold Improvements.
The petitioner, during the years 1934 through 1939, and for 1941, made the following charges on its books to amortize leasehold improvements:
| 1934 | $ 722.78 |
| 1935 | 1,380.94 |
| 1936 | 2,538.66 |
| 1937 | 5,872.32 |
| 1938 | $ 8,646.20 |
| 1939 | 9,962.08 |
| 1941 | 5,267.09 |
*1205 $ 3,379.11 of the charge for 1938 and $ 4,200.17 of the charge for 1939 were abnormal deductions within the meaning of section 711(b)(1) (J)(ii), as limited by (K)(iii).
Damage Claims.
The petitioner entered into a contract on March 16, 1937, to purchase a million yards of a certain kind of cloth. Shortly thereafter, and before any deliveries were made, there was a decline of more than 2 cents a yard in the market price of that particular cloth, as a result of which the petitioner could not use the cloth. The vendor refused to cancel the contract, but on November 8, 1937, it *184 agreed to adjust the entire matter by a new contract for the delivery of a million yards of a different material at a price which was 2 cents a yard in excess of the current market price of this latter material. This latter contract was carried out. $ 11,544.80 of the excessive price of 2 cents per yard on the new material was paid in 1938 and the balance of $ 8,455.20 was paid in 1939. The petitioner, in 1939, paid $ 1,553.95 to settle a claim against it for encroaching on the property of another. No similar expenditures were ever made in prior years of the base period or in the taxable year.
The entire amount paid in 1938 and $ 6,401.41 of the amount paid in 1939 were abnormal deductions under section 711(b)(1)(J) or (H), as limited by (K) (iii).
Wages of Measurers and Inspectors.
The petitioner, in its fiscal year 1939, began to employ measurers and inspectors. These men were employed because the petitioner had received so many complaints from customers that its dresses were not running true to size. The inspectors and measurers spent their time inspecting and measuring garments throughout the plant in an effort to discover where mistakes were being made and to*185 bring about the correction of those mistakes. The amounts paid to these inspectors and measurers were as follows for the fiscal years ended October 31:
| 1939 | $ 6,312.15 |
| 1940 | 43,679.19 |
| 1941 | 503.20 |
No similar expenditures were made for the years 1935 to 1938, inclusive.
Minimum Wage.
The petitioner never made any payments to its employees to bring their compensation up to minimum wage standards required by law until its fiscal year 1938, when it paid $ 8,308.89 for that purpose. It paid $ 93,025.42 on this account in 1939 and $ 81,695.77 in the taxable year ended October 31, 1941.
*1206 $ 11,329.65 of the amount which it paid in 1939 was an abnormal deduction within the meaning of section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Interest.
The following table shows the amount of interest which the petitioner paid on borrowed money for its fiscal years 1936 through 1941:
| 1936 | $ 4,362.83 |
| 1937 | 2,235.30 |
| 1938 | 3,895.28 |
| 1939 | $ 4,210.57 |
| 1940 | 6,965.04 |
| 1941 | 2,375.23 |
$ 2,370.04 of the interest payment for 1940 was an abnormal deduction within the meaning of section 711 (b) (1) (J) (ii), as limited by (K) (iii).
Fees of Efficiency Engineers*186 .
The petitioner, during the fiscal year ended October 31, 1940, employed a firm of efficiency engineers. It made a time and motion study and furnished a report to the petitioner, but the recommendations were never put into effect. The firm was paid a fee in that year of $ 550 for this work. The petitioner in that same year employed another efficiency engineer to make a similar study, to be followed by recommendations. This engineer was paid $ 2,293.95 during that year for his services. His recommendation for relocating some of the sewing machines used by the petitioner was adopted and resulted in improved efficiency in the operation of the plant. The petitioner had never previously employed efficiency engineers. The petitioner did not employ any efficiency engineers during the taxable year ended October 31, 1941.
The expenditure of $ 2,843.95 for the fiscal year 1940 was in its entirety an abnormal deduction within the meaning of section 711 (b) (1) (J) (i), as limited by (K) (iii).
OPINION.
The petitioner filed a claim for relief under section 711 (b) (1) (J). Section 711 is entitled "Excess Profits Net Income." (b) is entitled "Taxable Years in Base Period." (1) is entitled*187 "General Rule and Adjustments" and provides that certain adjustments shall be made to net income of the base period years. One of the adjustments is set forth in (J), entitled "Abnormal Deductions." It provides that, under regulations for the determination of the classification of deductions:
(i) Deductions of any class shall not be allowed if deductions of such class were abnormal for the taxpayer, and
*1207 (ii) If the class of deductions was normal for the taxpayer, but the deductions of such class were in excess of 125 per centum of the average amount of deductions of such class for the four previous taxable years, they shall be disallowed in an amount equal to such excess.
Rules for the application of this subparagraph and others are set forth in subparagraph (K). One of them is that the deduction shall not be disallowed "unless the taxpayer establishes that the abnormality or excess is not a consequence of an increase in the gross income of the taxpayer in its base period or a decrease in the amount of some other deduction in its base period, and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged*188 in by the taxpayer." Another provision is that the amount to be disallowed shall not exceed the amount by which the deductions of the class for the base year exceed the deductions of the class for the taxable year.
The petitioner filed a claim on Form 843 setting forth 21 alleged abnormalities, or excessive deductions, of 13 different classes in the 4 base period years, which it contends should be disallowed and its net income for those base periods correspondingly increased. The Commissioner stated in his notice that he had carefully considered the claim, but had denied it because the petitioner had not established "that the abnormality or excess claimed is not a consequence of an increase in your gross income in your base period or a decrease in the amount of some other deduction in the said base period and is not a consequence of a change at any time in the type, manner of operation, size, or condition of the business engaged in by your company." The pleadings place in issue the question of whether or not the abnormalities were a consequence of an increase in gross income, a decrease in some other deduction, or a change in the type, manner of operation, size, or condition of the*189 business. The amount of each abnormality emerges largely, if not entirely, by the use of simple mathematics, once a proper classification is selected. Figures showing the exact amount of each abnormality are in evidence and there is no difference between the parties as to the figures themselves. The petitioner has introduced evidence in regard to each abnormality to show that it was not a consequence of an increase in gross income, a decrease in some other deduction, or a change in the type, manner of operation, size, or condition of the business. It has made out a prima facie case on this issue in so far as it relates to all of the items except wages of inspectors and measurers. The Commissioner has not overcome that showing and, indeed, has made little or no effort to do so. He argues that several of the expenditures resulted in certain changes, but that is not material -- the issue under the statute is whether the abnormality was the consequence of one of the changes mentioned in the statute. *1208 R. C. Harvey Co., 5 T. C. 431. Thus, on the only issue presented by the pleadings, the petitioner wins except as to the one item.
The Commissioner*190 argues in his brief that (1) some of the items relied upon by the petitioner are not "abnormal deductions," since they are not deductible under section 23, but are a part of the cost of goods sold, (2) some of the items do not constitute a separate class for the purpose of the computation of an abnormality under section 711 (b) (1) (J), and (3) one item comes under (H), not (J), and must be disallowed because (H) was not mentioned in the claim. These are affirmative defenses not mentioned in the notice rejecting the claim and not pleaded. The petitioner received notice that its claim was rejected for certain definitely stated reasons. It can not fairly be required to anticipate these other defenses or to introduce evidence to negative unfavorable possibilities upon which they are conjectured. The respondent, if he desired to inject such issues into this proceeding, should have pleaded those defenses, as required by the rules of the Court. Since they are not properly before us, they may not be considered as possible bases for denying the claim, either in whole or in part. Maltine Co., 5 T. C. 1265; Warner G. Baird, 42 B. T. A. 970;*191 Robert C. Coffey, 21 B. T. A. 1242.
The petitioner began to employ inspectors and measurers in 1939 to overcome what it regarded as a serious defect in the manner of operation of its business. The fault in the manner of operation of the business was that too many garments which did not conform to the required standards of size were going out to the customers. Many of these were being returned and had to be done over at additional cost to the petitioner, but the petitioner's chief concern was that its customers would become dissatisfied. The petitioner, therefore, decided to change and actually changed the manner of operation of its business to this extent -- it employed about 30 inspectors and measurers who were instructed to watch the operations of the various employees, to inspect and measure garments as they saw fit during the process of manufacture in an effort to discover where the mistakes in size were being made, and to eliminate the making of those mistakes as far as possible, either by pointing out the faults in their method of operation to various employees, or by instructing individual employees so that the errors did not occur so frequently. *192 A substantial sum was paid as wages to these employees during 1939 and a much larger amount was paid to them in 1940. They apparently performed their duties successfully and it was found after 1940 that their services were no longer necessary in that thereafter the number of garments which did not conform to the standards of size was tolerable.
The test laid down by subsection (K) (ii) is whether the abnormality is a consequence of the change. The question of whether some change was a consequence of the abnormality is immaterial. *1209 R. C. Harvey Co., supra. It is immaterial whether some change in the manner of operation of the business resulted from the employment of inspectors and measurers. The important point is that the abnormalities in the wages of these employees was a consequence of a change in the manner of operation of the business. If there had been no change in the manner of operation of the business, the inspectors and measurers would never have been employed and no abnormality would have resulted, so that the very act of employing these people and using them was a change in the manner of operation of the business and the*193 abnormality was a consequence of that change.
The important distinction between cause and effect in this connection can be illustrated by comparing the employment of inspectors and measurers with the employment of efficiency engineers. The engineers were employed merely to study the manner of operation of the business. They took no part in and made no contribution to the operation of the business, so that the employment of those engineers did not itself change the manner of operation of the business. Changes which they recommended as a result of their studies were later put into effect. Those changes were a consequence of the employment of the experts. But the employment of the experts was not a consequence of any change in the manner of operation of the business. Cf. R. C. Harvey Co., supra.
There was a change in 1939 and 1940 in the manner of operation of the business of the taxpayer to the extent that inspectors and measurers were employed and used in the business. The abnormalities for 1939 and 1940 in the wages of these employees are a direct consequence of that change in the manner of operation of the business. Subsection (K) (ii) provides*194 that under such circumstances no disallowance of the deduction is to be made. This result, so far as we can see, is in accordance with the spirit and purpose of section 711.
Decision will be entered under Rule 50.