*176 Decision will be entered for the respondent.
The petitioner has been a manufacturer of infants', children's, misses', and growing girls' shoes since its incorporation in 1934 when it acquired the business of Marathon which had been producing such shoes in the high-quality, high-priced field since 1923. Petitioner claimed relief under section 722 of the Internal Revenue Code of 1939 from excess profits taxes for the fiscal years ended November 30, 1941 to 1946, inclusive, on the grounds that its level of earnings during the base period was an inadequate standard of its normal earnings, largely because of economic circumstances resulting from production and sales policies instituted during the period May 1, 1934, to February 9, 1935, by a management which was eliminated on the latter date. Held:
1. The petitioner is not entitled to relief under section 722 (b) (1) or (b) (2) because the facts fail to establish that the petitioner's low base period net income was due to external physical or economic circumstances unusual in the experience of the petitioner.
2. Assuming petitioner is qualified for relief under section 722 (b) (4) because it changed the character of its business*177 immediately prior to the base period, petitioner is not entitled to relief under section 722 since it has not proved a constructive average base period net income, on the hypothesis that it changed the character of its business 2 years before it did so, which would result in greater benefits than the credits granted under section 714.
*500 The Commissioner denied in full petitioner's applications for relief under section 722 of the Internal Revenue Code of 1939 and claims for refund of excess profits*178 tax for the fiscal years ended November 30, 1941 to 1946, inclusive, and determined deficiencies in such tax for the years ended November 30, 1944 to 1946, inclusive. The questions for determination are whether the petitioner has established the existence of qualifying factors such as to entitle it to relief under subsection (b) (1), (b) (2), (b) (4), or (b) (5) of section 722 of the Code, and, if so, whether the petitioner has shown a fair and just amount representing normal earnings to be used as a constructive average base period net income under the provisions of section 722.
FINDINGS OF FACT.
Some of the facts were stipulated by the parties. We incorporate herein by this reference the stipulation and exhibits thereto attached.
Testimony in this case was heard by a commissioner appointed by this Court pursuant to section 1114 of the Internal Revenue Code of 1939, as amended by section 503 of the Revenue Act of 1943. Pursuant to Rule 48 of this Court, the commissioner filed herein a report of his findings of fact, and the parties thereafter filed certain exceptions to these findings which have been duly considered by the Court. We adopt as our findings herein the findings of*179 fact of the commissioner. 1 These are as follows:
1. The petitioner, a Wisconsin corporation, was organized on May 1, 1934, to acquire plant No. 1 and certain other assets of the Marathon *501 Shoe Company, and to manufacture infants', children's, misses', and growing girls' shoes under the trade name of "Pied Piper" and other trade names theretofore used by the Marathon Shoe Company. The petitioner's principal office and place of business is located at Wausau, Wisconsin.
2. The petitioner's excess profits tax returns for the fiscal years ended November 30, 1941 to 1946, inclusive, were filed with the collector of internal revenue for the district of Wisconsin. Excess profits taxes for those years were assessed by respondent and paid by petitioner in certain stipulated amounts within the time required by law.
3. The petitioner duly filed, on stipulated*180 dates, applications for relief under section 722 (b) (1), (b) (2), (b) (4), and (b) ( 5) of the Internal Revenue Code of 1939, and related claims for refund of excess profits taxes for the fiscal years ended November 30, 1941 to 1946, inclusive. The respondent disallowed, in full, the applications for relief and determined deficiencies in excess profits taxes for the years ended November 30, 1944, 1945, and 1946, payment of which was deferred pursuant to section 710 (a) (5).
4. At all times material herein infants', children's, misses', and growing girls' shoes have been generally classified by the shoe industry as falling into three classes: (a) Shoes in the high-quality, high-priced range; (b) shoes in the medium-quality and -priced range, with prices approximately 50 cents lower at wholesale and $ 1 lower at retail than shoes in the high-priced class; and (c) shoes in the low- or cheap-quality and -priced range, with prices ranging down to amounts considerably below the prices for shoes in the medium class.
5. At all times since about 1925 in the United States, infants', children's, misses', and growing girls' shoes in the high-quality and -priced range have been produced and sold*181 by a comparatively small group of manufacturers, which were competitors, embracing about eight or ten in number at any one time. Such group included at times material here, inter alia, Simplex Shoe Company, Milwaukee, Wisconsin; Herbst Shoe Company, Milwaukee, Wisconsin; Gilbert Shoe Company, Thiensville, Wisconsin; Waterbury Shoe Company, Brooklyn New York; J. Altschul Shoe Company, Brooklyn, New York; Marathon Shoe Company, Wausau, Wisconsin; and the petitioner.
6. The Marathon Shoe Company, hereinafter referred to as Marathon, was organized in 1914. Sometime prior to December 31, 1921, Marathon adopted the trade name Pied Piper with a distinctive trademark, both registered. During the period from 1923 until the organization of petitioner on May 1, 1934, Marathon continuously manufactured a line of infants', children's, misses', and growing girls' shoes which were sold in the high-quality, high-priced range under the trade name of Pied Piper.
*502 7. Marathon's Pied Piper line of shoes included the De Luxe, Popular, Service, and Special, all of which were produced with the same quality construction features, hereinafter mentioned. Those trade names distinguished the*182 divisions in Marathon's wholesale prices. The top-priced Pied Piper De Luxe shoes were produced from top-grade materials. The Pied Piper Popular, Service, and Special shoes were produced from good grade but less expensive materials permitting a scale of competitive prices within the industry's general classification of high-priced range. Marathon used the trade names of "Log Cabin" or "Red Schoolhouse" in place of the Pied Piper name whenever it had two retail dealers in the same city or retail sales area. Marathon also manufactured shoes under the trade name of "Marathon."
8. In 1919 Sigmund J. Pentler and Otto R. Short, stockholders and officers of Marathon, were issued a patent covering an improvement in the manufacture of the type of shoe known in the trade as stitched-down shoes, which related to the means whereby the bottom edge of the upper was stitched or secured to the insole and outer sole. The Pentler and Short improvement was designed to afford a flat insole and to eliminate the necessity of an inner sole known as a doubler between the insole and the outer sole. The improvement was designed to avoid a widely used process (such as the Goodyear-welt process), which*183 involved a peripheral channeling of the insole which raised stiff peripheral inseam lip and required the use of a cork filler between the insole and the outer sole. The improvement was designed to achieve greater shoe flexibility which is a desirable feature in children's shoes. Pentler and Short filed application in October 1932 and were issued a patent on May 29, 1934, pertaining to a composite insole formed of two or more pieces of material for use with inseamed shoes and which was designed as an improvement without radical change of their first patent. Marathon used the first Pentler and Short patented process until the middle of 1933 and thereafter used the second Pentler and Short process until April 30, 1934.
9. In the production of all of its Pied Piper shoes, Marathon used quality materials and workmanship and the Pentler and Short insole. Also, in that line of shoes, Marathon developed and used various quality features as to the cutting, stitching, lining, etc., of the upper part of the shoe, designed to preserve proper fit and longer wear and to give the shoe a soft feel on the foot.
10. During the period from 1923 to April 30, 1934, Marathon conducted an extensive *184 and varied program of advertising the trade name of Pied Piper as representing a high-quality shoe embracing various quality construction features, including the patented insole. Marathon's total annual advertising expenses for all of its lines of *503 shoes for each of the calendar years 1922 to 1933 and for the period January 1 to April 30, 1934, were as follows:
| 1922 | $ 8,808.33 |
| 1923 | 16,609.46 |
| 1924 | 30,896.27 |
| 1925 | 29,440.13 |
| 1926 | 55,405.86 |
| 1927 | 52,022.28 |
| 1928 | 39,278.35 |
| 1929 | $ 53,299.51 |
| 1930 | 58,401.06 |
| 1931 | 43,832.74 |
| 1932 | 26,245.42 |
| 1933 | 27,159.00 |
| 1934 1 | 14,505.89 |
11. During a period of years prior to May 1, 1934, Marathon sold its shoes through its own sales organization of approximately twelve salesmen directly to retail dealers who generally operated on a franchise or exclusive agency basis for Pied Piper shoes.
12. Marathon's main plant (No. 1) located at Wausau, Wisconsin, was continuously operated at all times material here. Prior to 1928, Marathon operated two Wisconsin plants of the Wausau Shoe Manufacturing Company, plant No. 2 at Wausau from 1924 on, and plant No. 3 at Merrill from 1927 on. On June 30, 1928, Marathon*185 acquired the assets through stock purchase and liquidation of the Wausau Shoe Manufacturing Company and thereafter plants No. 2 and 3 were operated until plant No. 3 was closed down between December 30, 1930, and January 31, 1931, and plant No. 2 was closed down between June 10, 1932, and July 20, 1932. After being closed down, plants No. 2 and 3 were never reopened and Marathon continued its operations exclusively in its main plant, No. 1, until April 30, 1934.
13. Marathon's acquisition and liquidation of the Wausau Shoe Manufacturing Company in 1928 were made at the request of a St. Louis brokerage firm in connection with its purchase of 45 per cent of each stockholder's shares of Marathon stock which shares were then placed on the St. Louis Stock Exchange. That transaction was arranged by S. J. Pentler, president and general manager, and O. R. Short, vice president in charge of factory production of Marathon, following their decision to liquidate part of their controlling stock interest in Marathon.
14. From 1928 until April 30, 1934, Pentler and Short gradually became less active in Marathon's affairs and during that period the active conduct of the business was gradually assumed*186 by C. L. Barthels, secretary and assistant general manager, and by W. W. Kiss, sales manager, after January 1, 1931, but policy decisions remained subject to approval by Pentler and Short. In the spring of 1933 Kiss submitted to Marathon's board of directors a written report of his study of the company's declining net sales during 1930, 1931, and *504 1932. His analysis of the situation, aside from general business conditions, was that the decline was caused, in part, by loss of a limited number of Pied Piper dealers due to credit difficulties, competition, improper selling, and lower quality of the shoes and by loss of a great number of Pied Piper consumers due to competitive prices, lowered quality, loss of dealer representation, and lack of aggressive promotion. As a result of that report, a program was developed to meet the need for increased advertising, certain improvements in the shoes, and an improved sales program, etc., which resulted in increased production and sales during the first 4 months of 1934 as compared to 1933. With respect to Marathon's Pied Piper line of shoes, a summary of Marathon's average wholesale selling prices, for the indicated calendar years*187 and the first 4 months of 1934, is as follows:
| Average wholesale | |
| Year | selling price |
| 1922 | $ 2.48 |
| 1923 | 2.53 |
| 1924 | 2.57 |
| 1925 | 2.53 |
| 1926 | 2.58 |
| 1927 | 2.66 |
| 1928 | 2.72 |
| 1929 | $ 2.78 |
| 1930 | 2.78 |
| 1931 | 2.64 |
| 1932 | 1.89 |
| 1933 | 1.85 |
| 1934 1 | 2.27 |
15. Marathon operated at a profit for each of the calendar years 1922 to 1929, inclusive, which amounted to an average annual net profit of $ 101,756 for those years, before income taxes. Marathon incurred net losses in the amounts of $ 61,262 for 1930; $ 31,145 for 1931; $ 85,113 for 1932; $ 6,718 for 1933; and $ 23,867 for January 1 to April 30, 1934. The stipulated Exhibit 13-M, incorporated by reference, sets forth a detailed comparative statement of Marathon's operations and profit or loss for the above-mentioned periods. A comparative statement of Marathon's financial condition for the years 1922 to 1934 is set forth in Exhibit 12-L, incorporated by reference.
16. The size ranges included in Marathon's growing girls' classifications are generally included in "women's" classifications in Government statistical bulletins.
17. The following table shows Marathon's production for the years 1922 through 1933, *188 and the first 4 months of 1934, by plants, the total production in all plants, the total annual United States shoe production in infants', misses' and children's, and women's shoes in millions of pairs for these periods, and the per cent of total Marathon production to such United States shoe production. *505
| United | ||||||
| States shoe | Per cent of | |||||
| production, | Marathon | |||||
| Plant | Plant | Plant | infants', | total | ||
| Year | No. 1 | No. 2 | No. 3 | Total | misses' and | production to |
| children's, | United | |||||
| and women's | States shoe | |||||
| (millions of | production | |||||
| pairs) | ||||||
| 1922 | 263,173 | 263,173 | 168 | .1567 | ||
| 1923 | 338,989 | 338,989 | 177 | .1915 | ||
| 1924 | 403,415 | 44,952 | 448,367 | 164 | .2734 | |
| 1925 | 360,935 | 121,731 | 482,666 | 168 | .2873 | |
| 1926 | 363,865 | 237,522 | 601,387 | 173 | .3476 | |
| 1927 | 343,273 | 278,192 | 51,479 | 672,944 | 180 | .3739 |
| 1928 | 285,742 | 253,557 | 116,410 | 655,709 | 185 | .3544 |
| 1929 | 258,263 | 238,328 | 70,833 | 567,424 | 195 | .2910 |
| 1930 | 232,455 | 215,095 | 58,124 | 505,674 | 163 | .3102 |
| 1931 | 238,772 | 153,613 | 392,385 | 165 | .2378 | |
| 1932 | 230,049 | 68,281 | 298,330 | 163 | .1830 | |
| 1933 | 281,663 | 281,663 | 182 | .1548 | ||
| 1934 1 | 112,771 | 112,771 | 70 | .1611 |
18. The following table shows in thousands of pairs the production for 4-month periods and the total for the year in the United States of infants', misses' and children's, and women's shoes for 1932, 1933, and the first 4 months of 1934.
| United States Shoe Production. | ||||
| (In thousands of pairs) | ||||
| Year | Infants' | Misses' and | Women's | Total |
| children's | ||||
| 1932 | ||||
| Jan.-Apr | 6,258 | 13,530 | 40,772 | 60,560 |
| May-Aug | 4,287 | 9,767 | 36,907 | 50,961 |
| Sept.-Dec | 5,108 | 10,303 | 36,265 | 51,676 |
| Total | 15,653 | 33,600 | 113,944 | 163,197 |
| 1933 | ||||
| Jan.-Apr | 5,845 | 11,427 | 42,977 | 60,249 |
| May-Aug | 7,173 | 12,727 | 51,119 | 71,019 |
| Sept.-Dec | 5,560 | 9,025 | 36,645 | 51,230 |
| Total | 18,578 | 33,179 | 130,741 | 182,498 |
| 1934 | ||||
| Jan.-Apr | 7,325 | 12,679 | 50,492 | 70,496 |
19. The following table shows in pairs the production for 4-month periods and the total for the year in Marathon's plant No. 1 of infants', misses' and children's, and women's shoes for 1932, 1933, and the first 4 months of 1934. *506
| Marathon Shoe Company -- Plant No. 1. | ||||
| Year | Infants' | Misses' and | Women's | Total |
| children's | ||||
| 1932 | ||||
| Jan.-Apr | 2,328 | 54,222 | 28,721 | 85,271 |
| May-Aug | 8,080 | 29,522 | 13,490 | 51,092 |
| Sept.-Dec | 26,371 | 56,074 | 11,207 | 93,652 |
| Total | 36,779 | 139,818 | 53,418 | 230,015 |
| 1933 | ||||
| Jan.-Apr | 28,371 | 50,056 | 17,663 | 96,090 |
| May-Aug | 32,033 | 57,031 | 12,393 | 101,457 |
| Sept.-Dec | 24,727 | 44,533 | 14,856 | 84,116 |
| Total | 85,131 | 151,620 | 44,912 | 281,663 |
| 1934 | ||||
| Jan.-Apr | 23,301 | 53,731 | 35,739 | 112,771 |
*190 20. The following table (computed from the tables in the next two preceding paragraphs) shows the percentage of Marathon's plant No. 1, total production, and production of infants', misses' and children's, and women's shoes to industry production by years and by 4-month periods, for 1932, 1933, and the first 4 months of 1934.
| Percentage of Marathon Plant No. 1 Production to Industry. | ||||
| Year | Infants' | Misses' and | Women's | Total |
| children's | ||||
| 1932 | ||||
| Jan.-Apr | .0372 | .4008 | .0704 | .1408 |
| May-Aug | .1885 | .3023 | .0366 | .1003 |
| Sept.-Dec | .5163 | .5442 | .0309 | .1812 |
| Percentage for year | .2350 | .4161 | .0469 | .1409 |
| 1933 | ||||
| Jan.-Apr | .4854 | .4381 | .0411 | .1595 |
| May-Aug | .4466 | .4481 | .0242 | .1429 |
| Sept.-Dec | .4449 | .4935 | .0405 | .1642 |
| Percentage for year | .4582 | .4570 | .0344 | .1543 |
| 1934 | ||||
| Jan.-Apr | .3181 | .4238 | .0708 | .1600 |
21. The petitioner was organized on May 1, 1934, as part of a plan of liquidation of Marathon which exchanged certain fixed assets including goodwill, trade names, and trade-marks at a fixed value of $ 45,000, and quick assets consisting of raw materials and finished goods at a fixed value of $ 85,000, and shoe machinery leases and other property*191 for 13,000 shares of petitioner's $ 10-par-value preferred stock and 2,600 shares of petitioner's no-par-value voting common stock. The remainder of petitioner's capital stock, consisting of 2,000 shares of preferred and 400 shares of common, was purchased for $ 20,000 by Huth & James Shoe Company, a Wisconsin corporation hereinafter referred to as Huth & James. Petitioner then entered into an agreement to purchase Marathon's Wausau, Wisconsin, plant No. 1 and certain operating real estate for $ 50,000.
*507 22. In connection with the plan to liquidate Marathon and incident to the organization of petitioner, a management contract was entered into on April 12, 1934, between Marathon and Huth & James. On May 1, 1934, petitioner ratified the management contract whereby Huth & James agreed to manage and supervise the business of petitioner for the period beginning May 1, 1934, and ending June 15, 1936. The management contract was in effect from May 1, 1934, through February 9, 1935.
23. Huth & James was an experienced and successful Milwaukee, Wisconsin, manufacturer of shoes produced to sell in the high-, medium-, and less-than-medium-priced ranges. In 1933 and 1934 Huth & *192 James's major business was the manufacture of growing girls' shoes (producing from 4,200 to 4,800 pairs a day), and Huth & James's highest price range was less than, but approached, the prices for Pied Piper growing girls' shoes. E. C. Huth, who had been in the shoe business since 1920 and who was president of Huth & James, became president of petitioner. While the above-mentioned management contract was in effect, E. C. Huth divided his time between the Huth & James plant in Milwaukee and the petitioner's plant in Wausau.
24. On May 1, 1934, Huth & James took over the management of petitioner's business. On or about the same date, all employees of Marathon, with the exception of C. L. Barthels, secretary and assistant general manager, were notified that their status as employees of Marathon was terminated and that they could apply for employment by petitioner. Marathon's sales manager (Kiss) and production superintendent (Filsinger) were not employed by petitioner. Barthels was employed as an officer of petitioner. E. C. Huth became petitioner's first sales manager and Frank Fuchs and E. J. Beckmann, employees of Huth & James, became petitioner's first production superintendent*193 and purchasing agent, respectively. Only five or six of Marathon's salesmen were employed by petitioner, and its remaining salesmen were Huth & James's employees.
25. Huth & James closed down petitioner's shoe plant for a period of time in May 1934 and made changes in production methods and machinery, including installations for making stitched-down shoes. When the plant was opened, petitioner commenced producing both stitched-down shoes and Goodyear-welt shoes. During 1934 Huth & James made some changes in the cutting and production procedures, and in the fall of 1934 ceased to use the Pentler and Short patented insole process in petitioner's manufacture of Pied Piper shoes. During 1934 Huth & James also made varying reductions in the wholesale selling prices of various classes and styles of Pied Piper shoes, as compared to the prices for those shoes during the first 4 months of *508 1934. Petitioner's average wholesale selling prices were $ 2.02 for the 7-month period, May 1 to November 30, 1934, as compared to Marathon's Pied Piper average wholesale selling prices of $ 2.27 for the first 4 months of 1934. During the period of the Huth & James management of petitioner, *194 some of the Pied Piper dealers became dissatisfied with the changes in the quality of Pied Piper shoes and with the factory service.
26. On February 9, 1935, Huth & James terminated its contract with Marathon and its management of petitioner's business and sold its entire stock interest in petitioner to Marathon for $ 10,000. Huth & James terminated that contract at its own request because, in its opinion, the business of Marathon and petitioner had deteriorated to a greater extent than Huth & James had originally thought.
27. Immediately upon the termination of the Huth & James contract, the active management of petitioner was conducted by C. L. Barthels and W. W. Kiss (formerly Marathon's sales manager) who became sales manager of petitioner. It was decided as a matter of policy to return to the Marathon methods of production; the use of the Pentler and Short insole process was resumed and the production of the type of stitched-down shoe manufactured under Huth & James was discontinued. Filsinger, who had been Marathon's production manager, became the petitioner's production manager. Huth & James had not prepared a Pied Piper shoe catalog for the spring of 1935, and Kiss prepared*195 and issued a cheap catalog which did not meet the former Pied Piper standard because of limitations of time and money.
28. The petitioner's plant was closed down from March 12, 1935, through April 4, 1935. On June 8, 1935, petitioner's board of directors adopted a resolution turning down an offer of a loan from the City of Wausau and directing the officers to liquidate the petitioner's business. Petitioner's plant was closed down from June 8, 1935, through July 16, 1935. On July 8, 1935, the board of directors authorized that petitioner's plant was to commence and continue operations until advance orders for the fall trade had been filled, and that efforts be devoted to securing subscriptions to a new stock issue as hereinafter mentioned.
29. Following the termination of the Huth & James management contract, a small group of former Marathon employees and Wausau businessmen, led by Barthels, Kiss, and Otto Muenchow, undertook a plan to refinance the petitioner and reorganize its business. Such undertaking was not accomplished until September 30, 1935, when new management took over petitioner's business.
30. On March 9, 1935, Marathon granted petitioner an option to buy all of the*196 petitioner's stock owned by Marathon for the sum *509 of $ 75,000. On the same day, petitioner's board of directors voted to accept such option.
31. On April 15, 1935, petitioner amended its articles of incorporation to authorize the issue and sale of stock to obtain the funds necessary to exercise the option. Pursuant to requirements of the Wisconsin Public Service Commission with which such stock was to be registered, an escrow agreement was entered into with the Citizens State Bank, pursuant to which the money to be paid on stock subscriptions should be paid to the Citizens State Bank, to be released to Marathon in payment for the stock when subscriptions should equal $ 75,000. Subscriptions exceeded $ 75,000 on August 27, 1935, and thereafter the escrow agreement was performed and petitioner purchased and retired the stock of petitioner owned by Marathon. The solicitation of subscriptions to the newly authorized stock was organized and conducted by Kiss and Barthels, who also conducted negotiations for a loan from the City of Wausau.
32. On May 1, 1935, all of the real estate and buildings conveyed to petitioner on May 1, 1934, were reconveyed by petitioner to Marathon*197 in consideration of the cancellation and satisfaction of the notes and mortgage given by petitioner to Marathon on May 1, 1934.
33. In October 1935 petitioner borrowed from the City of Wausau, Wisconsin, the sum of $ 50,000 and purchased from Marathon for the sum of $ 25,000 the land and buildings comprising petitioner's plant. Petitioner thereupon deeded such land and buildings to the City of Wausau and that city reconveyed the same to petitioner under a land contract to secure the $ 50,000 loan.
34. A special meeting of the new stockholders of petitioner was held on September 30, 1935, at which the resignations of the board of directors and officers of petitioner were accepted. A new board of directors was elected consisting of the nine largest stockholders of whom only three, namely, S. J. Pentler, C. L. Barthels, and Otto Muenchow, had served previously as officers or directors of petitioner or Marathon. Of the new officers, only Otto Muenchow, president, and C. L. Barthels, vice president, had served previously as officers or directors of petitioner or Marathon.
35. The new management took over the active conduct of petitioner's business on September 30, 1935, and thereafter, *198 throughout the base period years, generally followed the former Marathon policies and methods of production, including the Pentler and Short insole and high-quality construction features, materials, and workmanship, in manufacturing and selling the Pied Piper line of infants', children's, misses', and growing girls' shoes.
36. The new management increased the petitioner's wholesale prices on various styles and classes of shoes as rapidly as the then existing *510 business conditions and competition would permit. The petitioner's average wholesale selling prices, for the indicated fiscal years ended November 30, were as follows:
| Year ended | Average wholesale |
| November 30 | selling price |
| 1934 1 | $ 2.02 |
| 1935 | 2.08 |
| 1936 | 2.26 |
| 1937 | 2.41 |
| 1938 | 2.49 |
| 1939 | 2.46 |
| 1940 | 2.52 |
37. During the period from 1930 to May 1, 1934, Marathon had an experienced group of about twelve Pied Piper shoe salesmen with negligible turnover. On February 9, 1935, and for a period of time thereafter, including September 30, 1935, petitioner's active salesmen consisted of only five former Marathon salesmen who had been employed by petitioner*199 during the Huth & James management. Petitioner's sales manager, Kiss, experienced great difficulty in obtaining qualified experienced salesmen. From September 30, 1935, and throughout the base period years, the turnover among petitioner's new salesmen was high for the reasons that experienced salesmen of high-quality infants', children's, and growing girls' shoes were unwilling to undertake the task of building up the Pied Piper reputation without a guarantee of more compensation than they could receive from competing manufacturers, and petitioner was not financially able to pay the industry scale of compensation for experienced salesmen.
38. Prior to the organization of petitioner, Marathon experienced the loss of some of its dealer customers through competition and otherwise. During the Huth & James management of petitioner, and subsequent thereto, petitioner lost the accounts of some former Marathon dealer customers because of dissatisfaction with Pied Piper quality and service under Huth & James. During the Huth & James management, numerous new dealer customers of petitioner's shoes were developed but many of them were lost by petitioner during the base period years. Also, *200 during the base period years, the petitioner gradually lost some of its former Marathon dealer customers for various reasons and gradually developed numerous new dealer customers. The petitioner's experience was that the loss of a dealer and also the development of a new dealer account was usually a gradual process. In liquidating the stock of the line of shoes being discontinued, the dealer continued to make declining purchases to fill in odd lots during *511 the period of developing customer demand for the new line of shoes. A dealer once lost was hard to regain. Incorporated herein by reference are exhibits pertaining to petitioner's dealer accounts during the period from May 1, 1934, to the fiscal year ended November 30, 1942, namely, Exhibit 45 listing all dealers throughout the United States; Exhibit 46 listing accounts active under Huth & James management and later lost; Exhibit 47 listing Marathon accounts ultimately lost; Exhibit 48 listing accounts sensitive to price increases; Exhibit 49 listing Marathon accounts which remained with petitioner through the base period; and Exhibit 50 listing accounts first developed after the Huth & James period of management.
39. *201 An analysis of shoe production in plant No. 1 (pairs of shoes) of Marathon and petitioner for the years 1931 through 1939 and the monthly average, with petitioner's November 30 fiscal year production figures converted to calendar year basis for comparative purposes, is as follows:
| Plant No. 1 | |||
| Year | |||
| Marathon | Pied Piper | Monthly | |
| Shoe Co. | average | ||
| 1931 | 238,772 | 19,897 | |
| 1932 | 230,049 | 19,171 | |
| 1933 | 281,663 | 23,472 | |
| 1934 1 | 112,771 | 28,193 | |
| 1934 2 | 150,174 | 18,772 | |
| 1935 | 234,560 | 19,547 | |
| 1936 | 223,294 | 18,608 | |
| 1937 | 218,221 1/2 | 18,185 | |
| 1938 | 169,956 | 14,163 | |
| 1939 | 174,472 1/2 | 14,539 |
40. The following tables show, in pairs, industry production, petitioner's production, and the per cent of petitioner's production to the industry for the period May 1, 1934, to November 30, 1934, and for the fiscal years ended November 30, 1935 through 1939.
| COMPARISON OF PIED PIPER SHOE COMPANY PRODUCTION WITH | ||||
| INDUSTRY PRODUCTION. | ||||
| Industry Production (in Pairs) | ||||
| Infants' | Misses' and | Women's | Total | |
| children's | ||||
| May 1, 1934, to | ||||
| Nov. 30, 1934 | 10,739,000 | 19,440,000 | 74,807,000 | 104,986,000 |
| Year ended | ||||
| November 30 | ||||
| 1935 | 20,768,000 | 36,808,000 | 143,183,000 | 200,759,000 |
| 1936 | 21,504,000 | 36,592,000 | 160,549,000 | 218,645,000 |
| 1937 | 23,468,000 | 40,801,000 | 153,209,000 | 217,478,000 |
| 1938 | 20,751,000 | 38,902,000 | 145,091,000 | 204,744,000 |
| 1939 | 24,232,000 | 44,031,000 | 167,388,000 | 235,651,000 |
| Pied Piper Shoe Production (in Pairs) | ||||
| May 1, 1934, to | ||||
| Nov. 30, 1934 | 37,741 | 80,085 | 25,922 | 143,748 |
| Year ended | ||||
| November 30 | ||||
| 1935 | 63,802 | 113,260 | 42,387 | 219,449 |
| 1936 | 64,129 | 109,503 | 52,830 | 226,462 |
| 1937 | 60,758 1/2 | 103,230 | 59,363 1/2 | 223,352 |
| 1938 | 46,261 | 82,076 | 43,743 | 172,080 |
| 1939 | 53,430 | 78,837 | 41,255 1/2 | 173,522 1/2 |
| Per Cent of Pied Piper to Industry | ||||
| May 1, 1934, to | ||||
| Nov. 30, 1934 | .351 | .412 | .035 | .137 |
| Year ended | ||||
| November 30 | ||||
| 1935 | .307 | .308 | .030 | .109 |
| 1936 | .298 | .299 | .033 | .104 |
| 1937 | .259 | .253 | .039 | .103 |
| 1938 | .223 | .211 | .030 | .084 |
| 1939 | .220 | .179 | .025 | .074 |
*202 *512 41. Petitioner's operations resulted in net losses for the period May 1 to November 30, 1934, and the fiscal years ended November 30, 1936, 1937, 1938, and 1939, and resulted in profits for the fiscal years ended November 30, 1935 and 1940. For those periods Exhibits 14-N, 15-O, and 16-P, incorporated by reference, show comparative statements of petitioner's financial condition, operations, and profit and loss per tax returns as corrected by revenue agents' reports, respectively.
42. The petitioner is entitled to use the excess profits credit based upon income pursuant to section 713, or based upon invested capital pursuant to section 714 of the Internal Revenue Code of 1939. The petitioner's excess profits net income (or loss), computed without reference to Code section 722 for each of its base period years, is as follows:
| Excess profits | |
| Taxable year | net income (or loss) |
| ended November 30 | base period years |
| 1937 | ($ 203.86) |
| 1938 | (1,594.90) |
| 1939 | (4,660.85) |
| 1940 | 8,387.91 |
43. The actual credits used by petitioner, in computing its excess profits tax liability, the refunds claimed, and the asserted deficiencies for the taxable years in controversy, *203 are as follows:
| Actual credits | |||
| Taxable year ended | under sec. 714 | Refund | Deficiency |
| November 30 | taxable years | claimed | |
| 1941 | $ 15,480.22 | $ 782.22 | |
| 1942 | 16,247.39 | 22,874.75 | |
| 1943 | 16,939.92 | 43,724.05 | |
| 1944 | 18,634.05 | 18,612.51 | $ 9,167.36 |
| 1945 | 16,706.61 | 22,917.95 | 11,287.94 |
| 1946 | 17,803.78 | 2,953.34 | 1,247.71 |
*513 OPINION.
In this proceeding the petitioner contests the respondent's disallowance of its application for relief under section 722 of the Internal Revenue Code of 1939. Specifically, the petitioner invokes subparagraphs (b) (1), (b) (2), (b) (4), and (b) (5) of section 722. 2
*204 The petitioner's claim for section 722 relief is based substantially on the following summary of facts: Petitioner's predecessor corporation, hereinafter referred to as Marathon, was a manufacturer of high-quality and high-priced children's and ladies' shoes with certain outstanding features such as a patented insole designed to achieve greater flexibility in children's shoes. The petitioner was organized in 1934 to acquire the assets of Marathon in that year. In connection with the liquidation of Marathon and incident to the organization of petitioner, the management and supervision of its business was assigned to another shoe manufacturer, Huth & James, which was a substantial stockholder at that time in petitioner and which was represented by some of its officers on petitioner's board of directors, for a period to last from May 1, 1934, until June 15, 1936. This contract was ratified by appropriate corporate action on the part of petitioner. Huth & James instituted many changes in the petitioner's operations, including the discontinuance of the use of the patented insole process which was an important feature of the high-quality shoe previously *514 manufactured by Marathon. *205 These and other changes in policies resulted in the lowering of the price and quality of the shoes produced by the petitioner with the consequence that a number of the old customers of Pied Piper shoes became dissatisfied with the petitioner's products and ceased to do business with the petitioner. Huth & James terminated the management contract prematurely on February 9, 1935, because of the petitioner's deteriorating business condition. After a period of internal reorganization during which the plant was shut down twice, a different management took over the active conduct of petitioner's business and generally followed the former Marathon policies and methods of production, including the use of the patented insole process and high-quality construction features, materials, and workmanship. The new management increased the price of its shoe products as rapidly as conditions would permit and tried to produce shoes comparable to those produced by Marathon. The new management believed that the petitioner's success was dependent on rebuilding the Pied Piper shoe reputation.
To prevail in its claim for relief under section 722 (b) (1), it is mandatory for petitioner to show (1) that*206 its normal production output or operation was interrupted or diminished in the base period because of the occurrence, either during or immediately prior thereto, of an event unusual and peculiar in the experience of the taxpayer, and (2) that the average base period net income was an inadequate standard of its normal earnings. The petitioner also claims relief under subsection (b) (2), whereby it must show that its business was depressed by temporary economic circumstances. In Toledo Stove & Range Co., 1125">16 T. C. 1125, 1130, we said:
This Court has heretofore approved in Foskett & Bishop Co., supra, the following provision of the Bulletin on Section 722 of the Internal Revenue Code, part III, page 16, issued by the Commissioner on November 2, 1944:
The term "economic" includes any event or circumstance, general in its impact or externally caused with respect to a particular taxpayer, which has repercussions on the costs, expenses, selling prices, or volume of sales of either an individual taxpayer or an industry. Thus, not every event or circumstance which has an adverse effect on a taxpayer's profits may serve to qualify that taxpayer for*207 relief under subsection (b) (2). First, the temporary and unusual character of the circumstance or event must be clearly established. Second, the cause of the temporary depression must be shown to be external to the taxpayer, in the sense that it was not brought about primarily by a managerial decision. A taxpayer cannot qualify for relief under subsection (b) (2) because its earnings were temporarily reduced in the base period in consequence of its own business policies, internally determined. * * *
"In general, (b) (1) deals with physical events which produce the required consequences, whereas (b) (2) deals with economic events *515 which cause the consequences involved." Southern California Edison Co., 19 T. C. 935, 980.We do not agree with the petitioner that these events or circumstances fall into the category of physical or economic circumstances as are contemplated by either (b) (1) or (b) (2). The closing down of the petitioner's plant at two different times during the reorganization which took place following the exit of the Huth & James management is not the type of physical event contemplated under subsection (b) (1). The *208 regulations enumerate fires, floods, and explosions as being the type of events contemplated by subsection (b) (1). Regs. 112, sec. 35.722-3 (a). Here the closing of the plant was an act of the petitioner's management. At most it could be said to have been brought about by the reorganization of management and policy forced by the departure of Huth & James. This is not a physical event such as would qualify the petitioner for relief under section 722 (b) (1).
The economic events or circumstances which caused the depression in business during the base period must be shown to be "external to the taxpayer, in the sense that it was not brought about primarily by a managerial decision. The taxpayer cannot qualify for relief under subsection (b) (2) because its earnings were temporarily reduced in the base period in consequence of its own business policies, internally determined. * * *" Bulletin on Section 722 of the Internal Revenue Code issued by the Commissioner on November 2, 1944. The "statute was not designed to counteract errors of business judgment or to underwrite unwise business policies." Granite Construction Co., 19 T. C. 163. Since both the*209 unusual events relied upon by petitioner under (b) (1) and the temporary economic circumstances or events relied upon by petitioner under (b) (2) were results of its own internal business policies, petitioner is not qualified for relief under either of those subsections of section 722.
Petitioner seeks to avoid the result which we have reached with regard to the availability to it of subsections (b) (1) and (b) (2) by arguing that the depression of its business during the base period was caused by the Huth & James management of its business; that this management was illegal and void since the contract under which it exercised this management deprived petitioner's board of directors of its managerial function; and that, since the acts of the Huth & James management did not therefore represent the policies or decisions of petitioner, they must be considered as "external" so far as the petitioner was concerned.
We do not believe that the Huth & James management contract was illegal under the circumstances of the instant case. It was for *516 a comparatively short term, it put the temporary management in the hands of an experienced and successful shoe company which held a substantial*210 stock interest in petitioner, its terms were in no way onerous with regard to petitioner, and it was unanimously ratified by all of petitioner's incorporators and subscribers to its capital stock at the time of its organization meeting. Cf. Sherman & Ellis, Inc. v. Indiana Mutual Casualty Co., (C. A. 7, 1930) 41 F. 2d 588. Its validity has never been questioned, directly or indirectly, since petitioner's new management took over the conduct of its business in 1935. It is stipulated by the parties that "The management contract [with Huth & James] was ratified by Petitioner * * *."
Even if this management contract were illegal in the sense that it could not be enforced or could be successfully questioned in a stockholder's suit, it is nevertheless an "illegality" of petitioner's own choosing adopted by all of its incorporators and stockholders at the very meeting of petitioner's organization. We are unable to see how this management thus chosen can be considered as an external circumstance beyond petitioner's control.
The petitioner next claims relief under subsection (b) (4). To be entitled to relief under this subsection the petitioner must show*211 that it "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." The respondent concedes, and we agree, that there was a change of management when the new management took over operation of the business after Huth & James terminated its management contract in 1935. However, respondent contends that this did not occur "immediately prior to the base period."
Assuming the qualification of petitioner for relief under section 722 (b) (4), before petitioner can be granted relief under section 722 it must show, pursuant to section 722 (a), "what would be a fair and just amount representing normal earnings * * *." Unless and until it proves a constructive average base period net income which will provide income credits greater than the invested capital credits actually used by it under section 714, no relief will be forthcoming here under section 722. Hugo Brand Tannery, Inc., 20 T. C. 990, 998; Green Spring Dairy, Inc., 18 T.C. 217">18 T. C. 217, 237.
Petitioner*212 in its attempt to prove what would be a fair and just amount representing normal earnings has presented voluminous and elaborate testimony. Its validity rests upon one basic assumption. Petitioner's position on this point is indicated by the following quotations from its brief:
*517 The basic assumption underlying petitioner's reconstruction, as has been explained above, is that if the damage to petitioner's product reputation and sales organization which resulted from Huth & James' period of operation and persisted throughout petitioner's base period is eliminated from consideration, then petitioner during its base period would have maintained the same relative position in the infants', misses', children's and growing girls' shoe market that its predecessor, Marathon, held in the period prior to May 1, 1934.
* * * *
With respect to section 722 (b) (4), if the Huth and James period of operation and the reorganization that followed are pushed back two years to 1932 and 1933, then petitioner by the end of its base period, November 30, 1940, would have overcome the damage to its product reputation, rebuilt its sales organization and regained the relative industry position held*213 by Marathon prior to the Huth and James period of operation.
* * * *
If the Huth and James period of management and the following reorganization of the business are pushed back two years to the years 1932 and 1933, there is much to support the conclusion that with two more years in which to recover its position, petitioner would have overcome the damage to its product reputation, rebuilt its sales and dealer organization, and regained Marathon's relative position in the industry by November 30, 1940, at the end of its base period. The year 1933 was the depth of the depression and markets at that time were more disorganized than they were two years later. Obviously, the damage to product reputation would not have quite the same effect at the depth of the depression as it did have two years later. Considering this factor, together with the fact that petitioner made a substantial gain in the last year of its base period, it is reasonable to assume that petitioner by the end of its base period would have regained the position in the children's, misses' and growing girls' shoe market held by Marathon prior to May 1, 1934 with two more years in which to overcome the handicap of its damaged*214 product reputation and disorganized sales force and dealer organization.
The reasonableness of petitioner's assumption is strengthened by reference to petitioner's corporate income tax returns for the fiscal years ended November 30, 1941, 1942 and 1943, introduced in evidence as Exhibits 76, 77 and 78. Compared with the figures for the last base period year ended November 30, 1940 (Stipulated Exhibit No. 15-0), these exhibits demonstrate that petitioner did actually recover after two more years. And the Court should take judicial notice that children's, misses', infants' and growing girls' shoes are not items customarily sold to the government or the armed forces. In other words, war orders were not involved. * * *
We are unable to agree with petitioner's "basic assumption."
Petitioner's new management which took over the conduct of its business on September 30, 1935, not only was faced by the problems created during the management of Huth & James and those arising as a result of the tired management of Marathon during the years when Pentler and Short were seeking to liquidate their interests, but it was also faced by the problems necessarily faced by the small group of manufacturers*215 of infants', children's, misses', and growing girls' shoes in the high-quality and high-priced range, of which petitioner *518 was one, during a time immediately following the most severe economic collapse in our history. During this great depression, it is natural to assume, and the entire record herein indicates, that consumers became extremely price conscious and became more interested in buying merchandise attractive by reason of price than merchandise attractive by reason of superlative quality. It is also obvious from the record that buying habits in the shoe business are slow to change. Even though we were entitled to consider post-base period events, it would be our judgment that not until the national economy was stimulated by armament production and preparations for war in 1940 and 1941, and more people had appreciably more money to spend, would it be natural for such a change in buying habits (with greater consideration being given to quality than to price) to begin. But until then the manufacturers of high-quality and high-priced merchandise would be at a disadvantage as compared with manufacturers of similar merchandise which was low priced even though low quality.
*216 There is nothing in the record to show how petitioner's competitors in the small group who manufactured similarly high-quality and high-priced shoes were faring in comparison with the shoe industry as a whole; but the record does show that petitioner, even 5 years after the termination of the Huth & James management, was obtaining a smaller proportion of industry business than ever before.
In the absence of information concerning the proportion of industry business obtained by petitioner's competitors, we must conclude that a large part of petitioner's economic problems was more fundamental than that arising from the Huth & James management, and that even though this management was pushed back 2 years there is no practical probability shown by the record herein that petitioner's earnings and profits would have reached a figure by November 30, 1940, which would support a reconstructed average base period net income for petitioner, resulting in credits available to it in excess of those allowed to it under section 714.
Since we do not agree with the "basic assumption" of petitioner's reconstruction, it is unnecessary for us to consider the various attacks made by respondent on the statistical*217 steps taken by petitioner in working out the final figures submitted as its constructive average base period net income.
Petitioner does not seriously press its claim to relief under section 722 (b) (5). Obviously, it is not entitled to relief under this subsection. See Granite Construction Co., supra;Mitchell & Co., 20 T.C. 110">20 T. C. 110.
Reviewed by the Special Division.
Decision will be entered for the respondent.
Footnotes
1. Except for a slight modification of paragraph 10 of such findings, infra↩, setting out the advertising expense by years, rather than in terms of averages.
1. January 1 to April 30.↩
1. January 1 to April 30.↩
1. January through April.↩
1. May 1 to November 30.↩
1. January 1 to April 30.↩
2. May 1 to December 31.↩
2. 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 --
(1) in one or more taxable years in the base period normal production, output, or operation was interrupted or diminished because of the occurrence, either immediately prior to, or during the base period, of events unusual and peculiar in the experience of such taxpayer,
(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, * * *
(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.↩