*226 Decision will be entered for the respondent.
Excess profits tax relief under section 722 denied where the evidence fails to show a basis for reconstruction of base period earnings which would result in credits as great as those allowed petitioner under the invested capital method.
*1325 This proceeding involves claims for excess profits tax relief for the years 1943, 1944, and 1945, under section 722 (b) (2), (b) (4), and (b) ( 5) of the Internal Revenue Code of 1939.
FINDINGS OF FACT.
Petitioner is a Massachusetts corporation with its principal place of business located at Lowell, Massachusetts. Its returns for the taxable years involved, the calendar years 1943, 1944, and 1945, were filed with the collector of internal*227 revenue for the district of Massachusetts.
Petitioner was organized in 1937 under a section 77B bankruptcy proceeding to take over a business of manufacturing and selling biscuits and crackers. The business was then being operated by two other corporations, Johnson Educator Food Company and Star Biscuits of America, Inc. These corporations were related through common *1326 stock ownership. The controlling interest in Johnson Educator Food Company was owned by a holding company, Johnson Educator Biscuit Company, which was a party to the reorganization. Johnson Educator Food Company had its plant at Cambridge, Massachusetts, and had a number of sales branches in New York and several other eastern seaboard States. The Star Biscuits of America, Inc., plant was located at Lowell, Massachusetts. Most of its output was sold to Johnson Educator Food Company.
In 1933, Johnson Educator Food Company developed and put on the market a new type of cracker which it sold under the trade name of "Crax." This was an all-purpose cracker which was sprayed with a butter oil soon after it was taken out of the oven. This cracker met with phenomenal success and was later copied by many of the*228 other cracker manufacturers. The sales of Crax accounted for a large increase in the company's business during 1934, 1935, and the first few months of 1936. The total sales increased from approximately 1 1/2 million dollars in 1933 to over 5 million dollars in 1955.
It was principally for the purpose of increasing the production of Crax that the stockholders of Johnson Educator Food Company, in 1934, acquired an interest in Star Biscuits of America, Inc. The purchase from that company of finished or semi-finished goods accounted for about 40 per cent of the cost of Crax sold in 1935. Also, in response to the large widespread demand for Crax, Johnson Educator Food Company, in 1934 and 1935, established a number of branch offices in the Atlantic seaboard States.
On February 5, 1936, one of Johnson Educator Food Company's trucks was involved in an accident with a passenger-carrying bus and a number of people were injured. An invesigator for the company which had insured the truck ascertained that the accident was caused by the truck driver falling asleep and plowing into the bus, which at the time was disabled by tire trouble. The truck was insured under a minimum "5 & 10" liability*229 policy ($ 5,000 liability for a single injury and $ 10,000 for multiple injuries).
On March 19, 1936, Johnson Educator Food Company filed a voluntary petition in bankruptcy under section 77B of the National Bankruptcy Act in the United States District Court for the District of Massachusetts. As grounds for the petition, it was stated:
As a result of an automobile accident in which an automobile truck of the Debtor was involved large claims in tort have been made against the Debtor, suits have been begun, and attachments have been made of the assets of the Debtor to such an extent that the Debtor has not sufficient free working capital to meet its debts as they mature or to carry on its business, that among the debts is a large indebtedness to Johnson Educator Biscuit Company, a large holder of the securities of the Debtor as hereinbefore stated. The debtor has no means of borrowing or otherwise securing funds sufficient to pay and discharge such amounts so that a reorganization of the Debtor is necessary. * * *
*1327 The balance sheet of Johnson Educator Food Company attached to the petition in bankruptcy showed, as of February 29, 1936, assets of $ 1,622,521.97, including *230 "Goodwill as per books" of $ 600,000, and liabilities of $ 1,622,521.97, including capital stock of $ 760,000 and surplus of $ 17,429.36. Claims for injuries in the automobile accident and "breach of contract" were listed as contingent liabilities of uncertain amounts and were not included in the above-stated liabilities. There were claims growing out of the automobile accident then pending of $ 118,000 and attachments in the aggregate amount of $ 29,794.55. Other suits were threatened. At the time the bankruptcy proceedings were filed, petitioner's books and accounts showed current assets of $ 380,419.06 and current liabilities of $ 546,272.48, including $ 291,000 of mortgage note payments due within 1 year.
A related petition in bankruptcy was filed in the same court by the holding company, Johnson Educator Biscuit Company, on January 11, 1937, and the proceedings were joined. Star Biscuits of America, Inc., was also made a party to the proceedings.
By order of the court, dated February 11, 1937, R. Lee Megowen was placed on the board of directors and put in complete charge of Johnson Educator Food Company's operations, with title of acting president. He was also put in a similar*231 position with Johnson Educator Biscuit Company by action of the directors of that company. He had had no previous connection with either of those companies.
On April 27, 1937, a plan of reorganization was approved by the court under which a new corporation, the petitioner, was created to carry on the business. In the reorganization, R. Lee Megowen replaced E. Fred Cullen as principal owner and manager of the business.
Petitioner's authorized capital stock consisted of 200,000 common shares and 57,000 class A shares, all of no par value. There was also authorization for the issuance of $ 1,000,000 of 5 per cent sinking fund 10-year debentures. All of the assets of Johnson Educator Food Company and Johnson Educator Biscuit Company, together with all the capital stock of Star Biscuits of America, Inc., were transferred to petitioner, and certain obligations of those companies were assumed by petitioner.
The final report in the bankruptcy proceedings was approved by the court on November 7, 1938. It showed that the claims against Johnson Educator Food Company, growing out of the automobile accident of February 5, 1936, were settled by payments aggregating $ 44,000, including $ 9,750*232 paid by the insurer of the truck.
The net sales and net taxable income, as determined by respondent, of Johnson Educator Food Company for the years 1920 to May 29, 1937, inclusive, and of Star Biscuits of America, Inc., for the years 1934 to May 29, 1937, were as follows: *1328
| Johnson Educator Food Co. | Star Biscuits of America, Inc. | |||
| Year | ||||
| Sales | Net income | Sales | Net income | |
| 1920 | $ 761,528.95 | ($ 14,992.92) | ||
| 1921 | 963,392.15 | 543.86 | ||
| 1922 | 961,175.82 | 25,632.61 | ||
| 1923 | 1,023,610.62 | (83,293.02) | ||
| 1924 | 1,092,063.27 | 7,822.39 | ||
| 1925 | 1,045,387.59 | (45,222.52) | ||
| 1926 | 796,471.58 | (96,158.36) | ||
| 1927 | 844,149.17 | (389.11) | ||
| 1928 | 1,423,539.50 | 139,420.45 | ||
| 1929 | 1,562,742.02 | (3,011.04) | ||
| 1930 | 1,164,506.54 | (25,557.08) | ||
| 1931 | 1,398,227.23 | 71,078.16 | ||
| 1932 | 1,732,965.13 | 1,790.79 | ||
| 1933 | 1,637,474.43 | 22,140.45 | ||
| 1934 | 2,459,850.31 | 91,344.34 | $ 53,415.45 | $ 945.36 |
| 1935 | 5,056,746.41 | 115,782.32 | 1,651,903.15 | 106,674.94 |
| 1936 | 4,767,858.31 | (46,628.04) | 1,786,198.75 | (31,274.26) |
| Jan. 1-May 29, 1937 | 1,644,422.40 | (66,266.70) | 639,724.80 | (20,171.58) |
The downward trend of net income, in relation to net sales, in 1935 and 1936 was attributed by the company's management *233 to competitive reductions in the prices of goods sold and to the increased expenses of advertising, salaries, commissions, and the cost of establishing new branch offices. The cost of sales was $ 2,211,370.45 in 1933, $ 1,849,057.54 in 1934, $ 4,061,944.40 in 1935, and $ 923,553.96 for the period January 5 to March 19, 1936. These costs include purchases from Star Biscuits of America, Inc., in the amounts of $ 50,462.37 in 1934, $ 1,650,861.79 in 1935, and $ 452,304.88 in 1936.
After taking over the business in 1937, petitioner continued operations with substantially the same facilities that had been in use by its predecessor companies. There were some changes in management personnel and also in office and plant arrangements. There was an increase in the production facilities at the Lowell plant, formerly operated by Star Biscuits of America, Inc., and a decrease at the Cambridge plant which had been occupied by Johnson Educator Food Company. The floor space at the Lowell plant was trebled within the next few years. Approximately $ 102,000 was spent on plant and facilities in 1937, and $ 54,000 in 1938. The equipment at the Cambridge plant was in poor condition, and some of *234 it was abandoned as useless. There was also labor trouble at the Cambridge plant. From about 82 to 92 per cent of petitioner's production through 1939 was at the Lowell plant.
One of the changes which petitioner made in operations was to increase the production of packaged goods in proportion to bulk goods. The percentage of packaged goods was increased from about 36 per cent of the total production, in pounds, in 1936 to over 55 per cent in 1938, and to approximately 60 per cent in 1939. This trend towards the increase of packaged goods was common in the industry during that period.
*1329 Petitioner's net income or loss, as finally determined by respondent, for the period May 29 to December 31, 1937, and for each of the calendar years 1938 and 1939, inclusive, was as follows:
| Net income | |
| Year | (or loss) -- final |
| May 29 to Dec. 31, 1937 | ($ 93,958.10) |
| 1938 | (13.46) |
| 1939 | (127,512.99) |
For 1935, the production of Crax by petitioner's predecessors amounted, in pounds of finished goods, to approximately 40 per cent of total production. For the base period years, it averaged about 25 per cent; the decrease in Crax sales after 1935 was due in large part to the competition*235 from similar products which had been brought out by competitors.
One of Johnson Educator Food Company's largest customers was the Great Atlantic & Pacific Tea Company. Its purchases amounted to approximately $ 497,000 in 1933, $ 532,000 in 1934, $ 871,000 in 1935, and $ 115,000 up to March 19, 1936. A. & P. stopped all purchases from the company when it filed the bankruptcy petition on March 19, 1936. In addition to the adverse effects of the bankruptcy proceedings on the relationship of the companies, there were differences between them growing out of sales policies.
After the reorganization and during 1937, petitioner reestablished business relations with A. & P. Its sales to A. & P. amounted to approximately $ 81,533 in 1938, and increased to nearly $ 100,000 in 1939.
The cracker and biscuit industry is a highly competitive one and tends towards centralization in a few large concerns. In 1939, four companies accounted for approximately 77 per cent of the reported sales in the United States. The profit margin in the industry is usually small. It is customary for manufacturers to offer trade discounts and other inducements to customers. In 1939, petitioner adopted a new discount*236 plan of issuing merchandise dividends of from 3 to 5 per cent of a customer's purchases. The dividend checks were accepted by petitioner as payment for goods purchased. Successful products of one manufacturer are soon copied by other manufacturers. In 1935, National Biscuit Company, the largest manufacturer in the United States, brought out "Ritz" crackers in competition to Crax. Other manufacturers added crackers of that type to their lines.
The following table shows a comparison of the net sales of petitioner and its predecessor companies with those of their three largest competitors -- National Biscuit Company, Loose-Wiles Biscuit Company, and United Biscuit Company -- over the period 1934-1939, inclusive: *1330
| Net sales | |||
| Year | Ratio | ||
| Three | Petitioner | (per cent) | |
| companies (000 | and | ||
| omitted) | predecessors (000 | ||
| omitted) | |||
| 1934 | $ 132,806 | $ 2,460 | 1.85 |
| 1935 | 138,694 | 5,057 | 3.65 |
| 1936 | 150,724 | 4,769 | 3.16 |
| 1937 | 160,783 | 3,807 | 2.36 |
| 1938 | 150,836 | 3,893 | 2.58 |
| 1939 | 150,400 | 3,688 | 2.45 |
The following figures reflect the operations of the three largest manufacturers -- National Biscuit Company, Loose-Wiles Biscuit Company, and United Biscuit*237 Company -- for the years 1934 through 1938, inclusive, together with those of several smaller companies for 1939:
| Total net | Percentage | ||
| Year | Total sales | profits (000 | of profits to |
| (000 omitted) | omitted) | sales | |
| 1934 | $ 132,806 | $ 16,240 | 12.2 |
| 1935 | 141,672 | 14,594 | 10.3 |
| 1936 | 157,832 | 19,226 | 12.2 |
| 1937 | 168,806 | 16,727 | 9.9 |
| 1938 | 158,517 | 18,715 | 11.8 |
| 1939 1 | 158,907 | 18,276 | 11.5 |
Petitioner's excess profits net income, or loss, for each of the years 1937 to 1939, inclusive, before and after deductions of net operating losses for prior years, was as follows:
| EPNI before | EPNI after | ||
| Period | net loss | Net loss | net loss |
| deductions | deductions | deductions | |
| May 29 to Dec. 31, 1937 | ($ 93,958.10) | ($ 93,958.10) | |
| 1938 | (693.46) | (693.46) | |
| 1939 | (127,512.99) | (127,512.99) |
Petitioner's excess profits credits for the taxable years 1943, 1944, and 1945 computed under the invested capital method are as follows:
| 1943 Credit: | |
| Carryover from 1941 | $ 63,440.80 |
| Carryover from 1942 | 62,293.93 |
| Applicable to 1943 | 57,659.35 |
| Total credit recd. in 1943 | $ 183,394.08 |
| 1944 Credit | $ 52,674.33 |
| 1945 Credit | $ 37,478.98 |
The*238 stipulated facts, insofar as they are not specifically set out above, are incorporated herein by this reference.
*1331 OPINION.
Petitioner's claims for excess profits tax relief are based on section 722 (b) (2), (b) (4), and (b) (5). It contends that its business was depressed in the base period because of the automobile accident involving one of its trucks, and the consequent bankruptcy proceedings, loss of customers, and increased operating costs; which, it contends, were "temporary economic circumstances" within the meaning of section 722 (b) (2). It further contends, under subsection (b) (4), that its average base period net income is an inadequate standard of normal earnings because of the fact that it began business during the base period and its average base period net income does not reflect normal operations for the entire base period. The claim under subsection (b) (5) is in the nature of an alternative claim to be considered only in the event that subsections (b) (2) and (b) (4) are held to be inapplicable.
The respondent concedes that petitioner was incorporated and began business in 1937 and is, therefore, entitled to have its average base period net income reconstructed*239 under the push-back rule in accordance with subsection (b) (4) of section 722. The evidence is that in the reorganization under which petitioner was incorporated new capital was brought into the business and there were substantial changes in the common stock ownership and management. Cf. Bardons & Oliver, Inc., 25 T. C. 504 (1955); Victory Glass, Inc., 17 T. C. 381 (1951).
Respondent maintains, however, that the evidence affords no basis for a reconstruction that would result in an average base period net income sufficient to produce excess profits credits as great as those which have been allowed to petitioner under the invested capital method. These credits were $ 57,659.35 for 1943 (the total credit for 1943 with carryovers from 1941 and 1942 was $ 183,394.08), $ 52,674.33 for 1944, and $ 37,478.98 for 1945.
As to petitioner's subsection (b) (2) claim, respondent's position is that the evidence fails to show that petitioner's base period income was depressed because of temporary economic circumstances. He attributes petitioner's base period losses to insufficient working capital, intense competition in the industry, *240 high cost of operations, and bad management. He maintains that none of these were "temporary economic factors unusual to the taxpayer" within the purview of subsection (b) (2). Respondent further contends that in any event the evidence of record affords no basis for a reconstruction of petitioner's base period earnings under base period conditions, either under subsection (b) (4) or subsection (b) (2).
Whether petitioner's base period income is an inadequate standard of normal earnings because of any of the events or circumstances described *1332 in the several subsections of 722 (b) upon which petitioner relies, and whether the evidence affords a basis for a reconstruction of base period earnings which would result in credits greater than those available to petitioner under the invested capital method, are the questions which we must determine.
Petitioner was a new corporation with new investors and, hence, was entitled to relief as having been formed during the base period as governed by section 722 (b) (4), Victory Glass, Inc., supra. This is not a mere continuation in a different form, without change of ownership or management, as was Bardons & Oliver, Inc., supra.*241 Respondent agreed that petitioner qualifies for relief under subsection (b) (4), and no issue remains in this respect. But, since petitioner commenced business in 1937, it could not have experienced any of the events which occurred previous to that time. The automobile accident, the damage suits, the loss of customers, the bankruptcy proceedings, all took place before petitioner ever came into existence. Cf. Victory Glass, Inc., supra. It, therefore, cannot qualify under subsection (b) (2).
Aside from qualification, petitioner relies on the history of its predecessor to justify its reconstruction. Even if, as a matter of evidence, we accept this approach and look to the record of the predecessor's experience and earnings, the record still fails to establish that by the end of the base period petitioner's earnings would have reached such a point that any reconstruction would give it a greater excess profits credit than that originally allowed it under the invested capital method.
Petitioner's predecessor, Johnson Educator Food Company, had a history of sporadic earnings. For the period 1920-1930, losses greatly exceeded earnings. There was net income*242 in each year for the 1931-1935 period, the average being about $ 60,000 per year. The comparatively large profits in 1934 and 1935, amounting to $ 91,344.34 and $ 115,782.32, respectively, were due, in large part, to the popularity of Crax, which in 1935 accounted for approximately 40 per cent of total production.
The inroads of competitive products, such as Ritz, brought out by National Biscuit Company in 1935, began to be felt in 1936; and for the base period years the sale of Crax averaged only about 25 per cent of total sales. The total sales of the business decreased from $ 5,056,746.41 in 1935 to $ 4,767,858.31 in 1936, and to below $ 4,000,000 in each of the years 1937, 1938, and 1939. This decline in Crax sales was caused not so much by the reorganization of the internal difficulties of petitioner and its predecessors as by the introduction of competitive products by other manufacturers. The evidence does not indicate that at the end of the base period there was any likelihood that Crax would ever regain its former supremacy in the market.
*1333 Some of the reasons given for the reduction of the ratio of net income to sales of this business in the base period were*243 competitive prices, increased cost of advertising, and the establishment of branch offices. It is not shown how or to what extent these conditions would have been affected by an additional 2 years' experience for petitioner.
One of the factors said to have contributed to high operating costs was the necessity for continuing operations at the Cambridge plant. Petitioner wanted to close out that plant and concentrate all of its operations at the Lowell plant. It undertook to sell the property but could not obtain a satisfactory offer during the base period. Again, there is no indication that this condition was in any way connected with any of the alleged 722 factors.
As we see it, petitioner's situation at the end of the base period, after more than 2 years of operations, shows but little, if any, signs of improvement. There is no convincing proof that its depressed condition would have been any better if it had commenced 2 years earlier or that the depressed income was to any appreciable extent attributable to any of the factors upon which petitioner bases his claims for relief.
In no event would the evidence of record support a reconstruction of base period earnings that would*244 yield credits as great as those already available to petitioner under the invested capital method.
Reviewed by the Special Division.
Decision will be entered for the respondent.
Footnotes
1. 6 companies.↩